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HELEN ANDERSON[*]
The debate about directors’ personal liability for failure to take into account the interests of creditors continues to rage. A great deal has been written by economists, social and legal theorists and even psychologists to explain the way companies can and should operate. The acknowledgement of a fiduciary duty to take into account the interests of creditors could arguably be attributed to a recognition of the economic claims of creditors upon a company’s demise. Despite this, courts generally persist with the traditional rules of corporate law, such as directors’ fiduciary duties and the separate legal entity doctrine from Salomon v Salomon & Co Ltd,[1] even though these have some significant theoretical and practical limitations. Even where courts adopt economic analyses, for example, of residual risk, these are quickly subsumed in familiar and comfortable doctrines.
Part II of this article will examine the various theories of the company with reference to the question of directors’ duty to take creditors’ interests into account. While this is only one of the areas where creditors can take action against directors, it is a highly contentious one and serves as a good illustration of the courts’ adoption of traditional views.[2]
Part III will give an overview of separate legal entity and its limitations, as well as the current law in this area and the opinions of commentators. Part IV will give the author’s opinion on why courts continue to ignore most of the enormous amount of literature on the theory of the corporation and to hold firm to the established common law rules.
It will be seen that there is no absolute ‘theory of the company’ to guide the determination of corporate law. In addition, models of the corporation[3] are necessarily simplified and therefore limited in their ability to explain or predict corporate law. For example, the nexus of contracts analysis of corporate law is based on an ‘information symmetry assumption’, which suggests that ‘parties have equivalent access to relevant information and the capacity to evaluate the information in light of their respective interests’.[4] Generalisations are often made about the place of directors and shareholders in the corporate structure, which overlook the fact that companies range from one director/one shareholder enterprises to massive multinational conglomerates, characterised by a separation of ownership and control.[5] Shareholders are often assumed to be only interested in their dividends and the residual value of their stock, preferring to ‘walk’ than fight for director replacement.[6]
This ignores the reality of proprietary companies which comprise the vast majority of companies in Australia.[7] These companies’ shares are not traded on the Australian Stock Exchange and therefore shareholders are not able to leave the companies easily in response to poor decision making. The issue of personal liability to creditors is just as vital for the directors and shareholders of proprietary companies as it is for directors of large companies.[8] This general failure to acknowledge that closely held corporations are fundamentally different in social and economic terms, if not legal terms, from publicly held corporations is a major limitation in the usefulness of social and economic theory in determining the appropriate way in which the law should treat creditors’ claims against directors.
The following discussion will examine the currently popular models of the corporation, in the context of their ability to assist courts in determining whether directors ought to owe a duty to consider creditor interests.
One of the leading theories of economic analysis of corporate law[9] is that the company is a nexus of contracts.[10] Rather than being a separate entity, the contractarian views the company as a convenient fiction to aggregate inputs and to facilitate contracts,[11] express and implied, between various parties – employees, suppliers, creditors and consumers. Shareholders are just one of these factors of production, and their contribution of equity capital is merely one type of input into the company.[12] The usefulness of this model is in the recognition of the central role played by the relationships, contractual and otherwise, into which the company enters.[13]
Mandatory corporate laws are considered ‘anti-contractarian’ because of the impossibility of laying down one set of rules that govern all the possible circumstances of contracts which are made between all the various parties.[14] Both ex ante rules by legislatures and ex post interpretation by courts interfere with the process of negotiation of parties’ agreements with the company.[15] The ‘business judgment rule’[16] is a reflection of this way of thinking - that parliaments should simply lay down ‘enabling statutes’ which permit directors to formulate their own way of managing the company without scrutiny of their decisions and without the need to adhere to rigid strictures.[17]
For the contractarian, therefore, the acceptable role of corporate law is to reduce the costs of contracting. Agency costs are an important part of this theoretical consideration.[18] In corporate law terms, the company is the principal and the directors are their agents. Agents traditionally act according to fiduciary duties in their dealings with the principal, for example by avoiding conflicts or making private profits. These fiduciary duties are reflected in the duties owed by directors to the company they represent.
But in the corporate setting, the term ‘agent’ is used more broadly to capture the position wherever ‘there is an arrangement in which one person’s [the principal’s] welfare depends on what another person [the agent] does.'[19] According to Jensen and Meckling, ‘there is good reason to believe that the agent will not always act in the best interests of the principal.’[20] Agency costs, therefore, are the costs incurred in ensuring that the principal’s welfare is protected.[21] These include monitoring costs and bonding costs. Monitoring costs are costs incurred, for example, by the company in checking on the directors’ behaviour or by the employment of multiple directors, who effectively monitor each other. Making decisions as a group reduces the ability of directors to make decisions in their own interests. Bonding costs are incurred where, for example, the company provides incentives to the directors to avoid misbehaviour, such as by giving them stock or options in the company. Agency costs also include a residual loss which is the cost of a divergence between the principal and the agent’s interests which cannot be captured by either monitoring or bonding.[22]
As mentioned above, for supporters of the ‘nexus of contracts’ theory, one aim of corporate law is to reduce the costs of contracting. But in the case of small closely held companies, which comprise the majority of companies, the agency cost argument loses much of its validity because there is an identity of interest between the company as a separate entity and the director. Frequently the directors and members of their families will also be the company’s only shareholders. The directors as agents will therefore act in the best interests of the company because their interests coincide.
But sometimes the principals are the company’s creditors, and the company, which has their money, is their agent. Creditors give rise to agency costs because there is a significant divergence of interest between the directors, who are under a duty to act in the best interests of the company, and the creditors. Debt money is used by the directors, not for the benefit of creditors, but for the benefit of the company and its shareholders by way of increased profitability and dividend. The extra profit generated by the debt capital does not flow back to creditors, yet creditors share the losses of a company’s liquidation. Creditors therefore incur monitoring costs to try to ensure that their funds are not used improperly.
In times of doubtful solvency, when the interests of creditors ought to receive more attention than usual, agency theory suggests that directors’ behaviour will deteriorate in terms of protecting creditors, in a last ditched attempt to preserve their principal, the company, and to save the funds of the shareholders.
Yet from a shareholder’s point of view, agency theory could also support an argument in favour of directors being personally liable to creditors in times of insolvency. The cost of capital supplied by creditors, with some important exceptions outlined below, incorporates a premium to cover these agency costs, in monitoring and allowing for residual loss. Shareholders pay this premium by way of a reduced dividend, due to the increased cost of debt. Anything that makes debt riskier makes it more expensive. Bonding costs, whereby the directors are bonded to creditors in the event of liquidation, are a cheaper alternative for shareholders than monitoring by creditors.[23] But this may well be a ‘swings and roundabouts’ proposition. If directors are held to be personally liable to creditors, this could ‘cost’ the company and its shareholders in one of two ways. Either the fear of liability will cause the directors to become risk-averse, possibly thereby reducing the profitability of the company, or else directors will demand compensation from the company for bearing these risks.
One problem that immediately stems from the use of contract to define the relationship of the parties is the determination of the content of these agreements. Kornhauser remarks:
Complications arise in corporate transactions ... because the relevant ‘agreement’ is generally unwritten, frequently ambiguous or contradictory and often not an agreement at all. Rather the nexus of contracts approach constructs an agreement out of the interests of the relevant parties.[24]
Therefore, because of the complexity of managing and understanding the interplay of agency costs, they lack usefulness in assisting courts to determine the issue of directors’ personal liability to creditors. Easterbrook and Fischel conclude that:
To understand corporate law you must understand how the balance of advantage among devices for controlling agency costs differs across firms and shifts from time to time. The role of corporate law at any instant is to establish rights among participants in the venture. Who governs? For whose benefit? But without answering difficult questions about the effectiveness of different devices for controlling agency costs, we cannot tell the appropriate allocation of rights.[25]
Bratton describes the nexus of contracts theory by saying ‘[i]t has not been well understood even though it has been well accepted.’ While useful as a metaphor, he argues that it ‘resists empirical verification’ and is ‘a tautology – a statement true by definition’.[26]
Agency theory and the company as a nexus of contracts, therefore, lack normative value and do not give a clear indication of the way in which the question of directors’ personal liability to creditors ought to be settled. This is a major limitation on its adoption by the courts as a guiding principle to settle disputes between directors and creditors.
Not all legal scholars adopt the agency/nexus of contracts approach to law and economics theory.[27] Early theorists considered that directors of companies were trustees, although the beneficiaries of their duties were debatable. Professor Berle contended that corporate powers were notionally held in trust for the shareholders whilst Professor Dodd maintained that these powers were held in trust for the entire community, although he later conceded that these views were ‘unworkable and conceptually unsound’.[28]
This theory is not presently in fashion, and there are a number of valid reasons why it is not a true representation of the corporate model. First, a trustee traditionally has a duty to act cautiously and to preserve the trust property. Directors, on the other hand, are called upon to maximise the company’s profit for the benefit of shareholders, by the judicious use of risk and entrepreneurship. Secondly, the trust property is vested in the trustee whereas company property is owned by the company itself and not its directors. Thirdly, trustees can not make a personal profit from carrying out their trusteeship, whereas directors can, subject to making appropriate disclosures,[29] as well as in their capacity as shareholders. Kornhauser comments that ‘[u]nlike contract, which allows much discrimination in allocating entitlements among parties to the agreement, trust does not seem adequately flexible to explain the complex allocation of obligations and privileges among this web of actors.’[30]
Calling directors trustees, or fiduciary agents, of the corporate powers that are vested in them, as Heydon suggests,[31] simply means that the duty is not breached if it is exercised for the purpose for which it was conferred. Perhaps the better view on the question of directors as trustees is that expressed by Lord Russell of Killowen in Regal (Hastings) Ltd v Gulliver[32] where he said that directors are ‘a creature of statute and occupy a position peculiar to themselves.’[33] Trustee theory, therefore, is of little help in determining the appropriate way of resolving the question of directors’ personal liability to creditors. Even the proposition that directors become trustees for creditors when the company nears insolvency is unhelpful, as they still have a fiduciary duty to the company itself which may conflict with any supposed duty in trust to creditors as beneficiaries.
Bainbridge examines a number of alternatives to the agency and trustee models.[34] Managerial theory[35] looks at the corporation as a hierarchy dominated by professional managers to whom the board of directors, as figureheads, have delegated all real decision making power. With shareholders largely irrelevant, this theory describes managers as ‘autonomous actors free to pursue whatever interests they choose (or society directs)’.[36] This model, like many others, has more relevance to large publicly held companies[37] than to small companies where the same person is frequently director, manager and principal shareholder. Under managerial theory, directors would have no special duty to consider creditors.
The shareholder primacy theory recognises the special place of shareholders as the residual owner of the firm,[38] with a power to remove directors and as the beneficiaries of directors’ fiduciary duties. Under this model, the directors and officers of the company have a stewardship role over the shareholders’ interests, and a stated obligation to maximise shareholder wealth. But it does not acknowledge the reality that shareholders lack control over the company’s long term strategies or its day to day operations.[39] Under the shareholder primacy theory, no duty owed by directors to consider the interests of creditors would be recognised.
Bainbridge argues that any model of the company, beset as it is with simplifying assumptions, ‘is properly judged by its predictive power with respect to the phenomena it purports to explain, not by whether it is a valid description of an objective reality.’[40] He posits a different theory of company control, which he asserts has predictive power – director primacy, based on the ‘nexus of contracts’ model. In this model, the board is not just an agent of the company or its shareholders, as contractarians would usually argue, but rather is the body which is the centre of the company’s contracts, its factors of production. ‘The board’s powers flow from that set of contracts in its totality and not just from shareholders’.[41]
The key element of the director primacy model is the fiat exercised by the board.[42] While it is true that the contracts are made with the company and not with the board, the model recognises that the board is the decision making authority charged with the responsibility of making those contracts, executing them and enforcing them. This decision making authority must be preserved against challenge by shareholders or the court. Bainbridge says:
Achieving an appropriate mix between authority and accountability is a daunting task, but a necessary one. Ultimately, authority and accountability cannot be reconciled. At some point, greater accountability necessarily makes the decision making process less efficient, while highly efficient decision making structures necessarily entail nonreviewable discretion.[43]
The director primacy theory holds that the board at the centre of the nexus of contracts is necessary to reconcile competing interests and priorities. Shareholders care about their dividends and the residual value of the company. Creditors are interested in prompt payment of their accounts. Employees care about wages and employment conditions. This reconciliation cannot be achieved by market forces but rather by the authority exercised by the board.[44]
But the director primacy model could be used to argue either in favour of recognition of directors’ personal liability to creditors or against it. The nexus of contracts with the board at its centre includes contracts with creditors, so that the board’s ‘power’ partly emanates from creditors, supporting a duty in relation to creditors. On the other hand, primacy by its very nature means that directors are not answerable to others, as accountability undermines the authority which lies at the heart of the theory. Bainbridge argues that the predictive power of the model, its ability to explain and predict corporate law rules, ‘is demonstrated in the host of legal doctrines and governance structures that resolve the tension between authority and accountability in favour of the former.’[45] This comment, however, is made in the context of American corporate law. Whether this is true of Australia will be discussed later in this paper.
The question whether directors should owe a duty to consider creditors interests should also be looked at in the context of creditor behaviour and type. Theorists argue that no duty should be owed because creditors can diversify away their risk, charge more for their goods and services or seek personal sureties from company directors. For example, Wishart says:
Creditors charge interest for the service they render. Built into that fee is compensation for the risk of loss they bear. The greater the risk of loss, the more is charged to compensate for that risk. Creditors cannot complain that insolvency as such has caused them loss because they have contracted to bear that risk, and have built compensation for bearing it into the cost of credit. If creditors do not charge for the probability of certain events happening, they should not be supported in their foolishness. They should not survive to charge less than wiser people.[46]
Easterbrook and Fischel echo these sentiments in saying that ‘[a]s long as these risks are known, the firm pays for the freedom to engage in risky activities. ... The firm must offer a better risk-return combination to attract investment.’[47] Wishart argues that the idea of directors acting in the interests of various stakeholders in the company ‘fails the test of economics. It does not cope with the idea of remuneration for risk – that the law should find which party most efficiently deals with uncompensated risk.’[48]
But these arguments are predicated on an ‘efficient markets’ hypothesis and even the proponents of this theoretical outlook are prepared to admit that markets do not always work efficiently.[49] They do not take into account different creditor types or different company types. These are discussed below.
In addition, creditors may undertake to bear a particular level of risk, and charge for it, based upon factors such as industry norms, financial ratios relating equity to loan capital, the history of the enterprise, industrial relations with employees and the like. If the directors of a company choose to take additional risks,[50] of which the creditors are unaware, creditors will not charge more to be compensated for these. Arrow comments that ‘[i]t is a plausible hypothesis that individuals are unable to recognise that there will be many surprises in the future; in short, as much ... evidence tends to confirm, there is a tendency to underestimate uncertainties.’[51]
The ‘pool of capital’ model[52] favours shareholders because they are not only the contributors of capital but also the residual claimants of the company’s profits. Under the model, directors are appointed to manage those funds for the shareholders. Creditors, on the other hand, have a separate arrangement with the company into which they have factored their risk.[53] But this model is flawed. In reality, companies also function on the capital contributed by creditors,[54] and in times of insolvency when creditors are no longer able to expect their fixed return, they become the residual claimants of the company’s profits.[55]
Blair points out that ‘none of the participants in the enterprise own those assets any more’,[56] not shareholders, not creditors. Both simply have certain specialised claims against the company for repayment. According to Sealy, ‘we must get away altogether from the idea that "the company" is the associated membership, and think instead of a fund – all the sums under the directors’ control for which in law they are or may be accountable.’[57]
Therefore, the ability of creditors to factor risk into their required rate of return should not be used as a reason to deny a duty to take into account the interests of creditors. In addition, creditors are not a homogenous group, which makes it impossible to make generalisations about their need for protection. Some are wealthy and powerful, holding security over the corporation’s major assets or personal guarantees from the directors. Others are protected in different ways. They may diversify their client base so that non payment by one does not lead to their own financial ruin. They may have short term credit periods, which allow them to carefully assess credit worthiness with current information about the company’s financial stability. As discussed above, the prices they charge for their goods may incorporate a premium to compensate them for the risk of non-payment.[58]
But not all creditors are able to protect themselves in these ways. Suppliers of specialised products frequently cannot diversify their client bases.[59] While their long term relationship with their client may bring knowledge that partly compensates them for the lack of diversity, nonetheless they may lack the ability to seek customers elsewhere because of existing contractual obligations to a possibly financially unstable customer. In addition, economic conditions in reality may lessen a supplier’s theoretical ability to pass on the costs associated with the risk of their client’s insolvency. Creditors are also affected by the size of the company they are dealing with. Small closely held companies are more likely to deprive creditors of vital information about solvency than large companies with mandated public disclosure or a board well separated from its shareholders.[60]
Employees, while technically termed ‘voluntary’ creditors, face special difficulties. Unlike trade creditors, employees do not have the ability to diversify their risk.[61] In times of high unemployment, employees may be faced with a difficult decision between unemployment and a financially unstable employer.
Some employees are compensated for their lack of ability to diversify by having superior access to information about their employer’s financial position.[62] In addition, senior employees can seek added remuneration in exchange for running the risks associated with possible financial instability. However, not all employees are in this favourable position, and the ones who are most likely to need the protection of the law are also the ones least likely to be privy to the company’s private financial woes.[63]
An even more deserving class of plaintiff is the involuntary tort creditor, such as a plaintiff injured by the negligence of the defendant company. These creditors have a need for compensation, have no ability to diversify their risk and no ex ante information about the financial position of the company.
Despite the deserving position of employees and some other creditors, Halpern, Trebilcock and Turnbull reminds us that ‘fashioning a rule that clearly differentiates these situations is likely to be difficult’.[64] The problem therefore with making generalisations about creditors which do not acknowledge the fundamental differences between them is that courts find it difficult to use these arguments to achieve a satisfactory determination of the law regarding directors’ personal liability to them.
There are arguments both for and against the imposition of personal liability on directors relating to its effect on their behaviour. In relation to criminal liability, the report of the Senate Standing Committee on Legal and Constitutional Affairs, entitled Company Directors’ Duties said:
Where there is a practice of prosecuting corporations rather than individuals, no matter what the circumstances, there is a risk that people within the company who ought to be held liable will never be called to account for their actions. This practice is often followed as a matter of convenience and has no policy underpinning it.... No proper thought is given to the best means of preventing future misconduct. [65]
Deterrence, therefore, is an important argument favouring personal liability to creditors. It could be said that this is unnecessary for directors of large companies, who have a lot to lose by breaching their duties. They risk exposure by virtue of the disclosure regimes to which they are subject, such as audits, annual and half yearly reports and the like. They risk losing their positions, salaries, bonuses and reputations.[66] On the other hand, directors of small companies do not always have such incentives, so that the major advantage of imposing liability on them to creditors would be to discourage directors from making improper use of their positions and the powers conferred upon them.
However, directors already have clear duties to the company, which are enforceable at times of insolvency by the company’s liquidator. The benefit of these actions flow through to the creditors as a whole. It could be argued that these duties already provide an adequate deterrent to directors from making improper use of their powers.
More importantly, the difficulty with a regime which is quick to impose liability is that directors’ fear of liability may make them overly cautious. This risk-averse behaviour on behalf of directors can be detrimental to the achievement of the company’s profit and wealth maximization objectives. In addition, experienced, well qualified business people may be reluctant to take up directorships, thus depriving companies of a valuable resource.
Therefore, because arguments can be made both in favour of, as well as against, imposing liability on directors because of the probable effect it will have on their behaviour, this is a difficult matter for courts to consider in terms of fashioning a law for directors’ personal liability to creditors.
Therefore it can be seen that the economic theories of the company do not provide useful guidance for courts in determining whether a duty to take into account the interests of creditors should be acknowledged. While they may seek to describe the relationships which exist between various parties connected with the company, they offer little by way of practical advice on how courts are to address conflicts between those parties. They are subject to fashion, and are frequently beset by simplifying assumptions, for example relating to the ability of creditors to factor the cost of risk into their required rate of return. They also fail to adequately consider the difference between large listed companies and small ‘one-man’ companies. In addition, some tests can be used to argue both for and against a recognition of a duty. Courts therefore find these tests unhelpful and prefer the stability and certainty of the long-standing doctrines of separate legal entity and limited liability.
Directors take into account many interests in day to day business because it is in the best interests of the company to do so. Companies benefit by having creditors who are treated well and are therefore happy to do business with them. They benefit from having contented, well cared for employees. They benefit from being seen to be good corporate citizens.[67] With directors behaving ethically and morally, there is a confluence of the economic imperatives of incorporation and the legal ones.
But corporate law has evolved to impose many fiduciary duties on directors, which they owe to the company. The company therefore cannot be seen by the law to be an amorphous nexus of contracts but rather is a real entity to which legally enforceable duties are owed.[68] What is in issue therefore is not the fact of directors taking into account other parties’ interests - the issue is whether directors have a duty, or even a capacity, to take those interests into account when doing so would conflict with their duties to the company.[69]
The discussion by courts on this issue therefore centres on the extent of their fiduciary duty, in the context of the traditional legal doctrines of separate legal entity and limited liability. [70] These concepts, and their criticisms, will now be discussed, followed by an outline of the current law on the issue of the duty of directors to take into account the interests of creditors. The law will then be analysed. Finally, the position of groups of companies will be examined as an instance of the separate legal entity doctrine’s triumph over the economic realities of modern corporate life.
The consensus is that directors’ duties, whether to consider creditor interests or any other duty, are owed to the company. The imposition of fiduciary duties is based on the fact that the company, as a separate legal entity, is vulnerable to abuse of power by directors, and that these duties ensure that directors will act in the best interests of that other legal person.
In accordance with the principles laid down in Salomon v Salomon & Co Ltd, [71] an act committed in the name of the company is regarded as its own act by virtue of the company’s separate personality as a distinct legal entity.
Judges have often indicated a reluctance to hold a director personally liable, because to do so would undermine the separate legal entity doctrine. The argument is made that while there might be valid economic or social policy reasons why a director should take responsibility for the debts of a company in some circumstances, nonetheless the creditor’s contract is with the company and not the director. Directors merely act on the company’s behalf.
In addition, courts acknowledge that persons dealing with companies realise that the company and its shareholders are separate. While the expression ‘limited liability’ does not refer to the liability of directors,[72] it does mean that companies are risk taking vehicles, and do not guarantee the funds of shareholders, creditors, employees or customers. This is widely known and accepted in the business community.
But there are a number of problems with the application of separate legal entity as a rule to determine whether directors should consider creditor interests. Sealy questions strict adherence to a doctrine that evolved when the commercial world was a very different place than it is today. He says ‘Have we given proper thought to filling the vacuum left by the abolition of ultra vires, or to the adequacy of the "maintenance of capital" principle to deal with the ubiquitous two dollar company?'[73]
Using separate legal entity to justify a denial of directors’ personal responsibility can lead to poor behaviour on the part of directors. When a company is on the brink of failure, the directors, representing the company’s controlling shareholders, may seek to benefit themselves or other companies in the group at the expense of creditors.[74] Wishart explains:
When income is insufficient to meet the demands of creditors, shareholders have no incentive to exercise their control over management to maximise (their) income. As the nexus between the possible receipt of net income and interest in residual assets dissolves, shareholders move to preserve the residual assets for themselves ... If company income has failed to the extent that there appears to be no residual assets after payment of creditors, the creditors themselves represent a new nexus of residual cash flow and asset recipients. ... Prior to the appointment of a liquidator or receiver, the controllers of the company may perceive that various strategies will gain for them more than sticking with the established order.[75]
Halpern, Trebilcock and Turnbull conclude that the abuse of separate legal entity and limited liability by shareholders is greater in small closely held companies, because the principal shareholders are likely to comprise the board of directors.[76] The authors advocate an unlimited liability regime for these companies as a means of reducing the incentive to transfer the risk of insolvency to creditors. [77] However, they concede that there would be
difficulties associated with attempting to distinguish by law small from large corporations for the purpose of applying different liability regimes, and that the distinction may induce some perverse and wasteful incentive effects as firms seek to manipulate internal structures to ensure compliance with the requirements of the preferred regime.[78]
Sealy argues that ‘the one unassailable concept in our company law appears to be that of limited liability’[79] and that it is the absolute protection accorded to shareholders that diverts judicial attention to the only other parties who could be responsible, namely the company’s directors. However, in small companies, where the director is acting as much as a shareholder as he is as a director, the imposition of liability on the director could undermine the concept of limited liability as well as that of separate legal entity.
Easterbrook and Fischel[80] suggest a number of ways of reducing the ‘moral hazard’ associated with this abuse of the separate corporate personality.[81] They include piercing the corporate veil to make shareholders liable for the company’s debts, legislatively imposing minimum capitalisation requirements, mandating insurance and imposing liability on managers of the corporation.
Each have significant drawbacks. As with unlimited liability, lifting the corporate veil to make shareholders liable for the company’s debts would undermine much of the rationale of incorporation. Establishing large companies would be difficult as shareholders would be unwilling to delegate management to the board of directors or would be forced to incur substantial monitoring costs. Diversification of investment, which is so beneficial to the economy, would be stifled as shareholders seek to minimise liability by investing in few enterprises.
Easterbrook and Fischel point out that ‘[t]he lower a firm’s capitalization, the higher the probability that it will engage in excessively risky activities’.[82] This is a particular problem with subsidiaries which are sometimes incorporated with little capitalisation expressly for the purpose of undertaking risky projects and are then jettisoned by the parent company if the project fails, leaving creditors without any recovery.[83] Imposing minimum capital requirements has the problem of imposing administrative costs and interfering with the company’s ability to be flexible in its financing.
Mandatory insurance requirements are also problematic. First, a decision would need to be made about whether the insurance would cover all creditors, including employees and trade creditors, or just involuntary creditors. Secondly, insurance may encourage risky behaviour, especially where the insurer was unable to monitor the level of risk[84] in order to increase premiums for companies engaging in such behaviour.
Thirdly, the cost of the premiums could be also be very high, especially if all creditors were covered, and would need to be passed on to shareholders by way of poorer returns or else to the community in the form of higher prices for products. Either would have a significant effect economically, as shareholders may be unwilling to invest if returns decrease. The authors sum up shareholders reluctance to insure thus: ‘Investors can diversify, which is a cheap way to reduce risk. Limited liability facilitates this diversification. Thus investors should not be willing to pay insurers to reduce risk. Why buy something you already have for free?’[85]
Imposing personal managerial responsibility, whether of directors or their delegates, is another way to deal with the moral hazard occasioned by the separate legal entity principle. It is also not without cost, as the managers, including directors, would demand compensation for being exposed to this liability. One way to minimise the compensation demanded would be to provide indemnification insurance but this would undermine the risk minimisation objective of managerial responsibility and give rise to the problems of insurance discussed above. However, in the absence of indemnification insurance, one advantage of managerial responsibility would be to ensure that the measures outlined above are not abused. It would encourage managers to ensure that the company’s capitalisation is maintained and that risks are minimised so that whatever insurance the company could afford is sufficient to cover its liabilities.
However, as the authors point out:
The problem with managerial liability is that risk shifting may not work perfectly. ... [A] legal rule of managerial liability creates risks for a group with a comparative disadvantage in bearing that risk. This inefficiency leads to both an increase in the competitive wage for managers and a shift away from risky activities. And there is no guarantee that the social costs of this shift away from risky activities will not exceed the social costs of the excessively risky activities in the absence of managerial liability.[86]
Despite the many objections that can be raised against the doctrine and the difficulties outlined by commentators in dealing with those objections, it is the idea of separate legal entity that generally makes courts reluctant to impose personal liability on directors to creditors.[87]
There is some degree of uncertainty concerning the precise formulation of any duty by directors to consider the interests of creditors. However, in general terms, it is agreed that a duty exists to consider the interests of creditors when a company is insolvent or approaching insolvency, that it is not enforceable by the creditors themselves but rather by the liquidator on their behalf and that shareholders cannot ratify its breach when the company is insolvent. What follows is a brief analysis of the cases which establish these rules, showing how the traditional notions of corporate law, such as fiduciary duties and the separate legal entity principle, are used in the courts’ determinations.
Courts agree that any duty to take into account the interests of creditors does not arise when the company is solvent and not in imminent danger of becoming insolvent. This is for the simple reason that solvency means that creditors are being paid on time.[88] No duty is owed because none needs to be owed. The situation is arguably different when the company is insolvent or nearing insolvency. In Walker v Wimborne[89] Mason J stated that
it should be emphasised that the directors of a company in discharging their duty to the company must take account of the interests of its shareholders and its creditors.[90] Any failure by the directors to take into account the interests of creditors will have adverse consequences for the company as well as for them. The creditor of a company ... must look to that company for payment.[91]
This remark has lead to a great deal of conflicting authority and controversy about whether His Honour intended to lay down a duty to take into account the interests of creditors and whether such a right could be enforceable by the creditors themselves. Dabner comments:
It has been argued that this formulation of a duty derives from a misconception of the comments made by Mason J. His Honour was not enunciating a separate duty but simply recognising that sometimes the best interests of the company require paying attention to the interests of creditors.[92]
Other cases, both Australian and overseas, have followed the lead set by Walker in recognising a duty to take into account the interests of creditors. In Ring v Sutton, the New South Wales Court of Appeal recognised the right of a liquidator to challenge the terms of a loan made at uncommercial rates by a company’s director to himself, as not being ‘in the interests of the creditors’.[93] Lord Diplock in Lonhro Ltd v Steel Petroleum Co Ltd also observed that ‘the best interests of the company...are not exclusively those of the shareholders but may include those of its creditors’.[94]
In Re Horsley and Weight Ltd [95] Templeman and Cumming-Bruce LJJ noted the relevance of alleged misfeasance upon creditors. The New South Wales Court of Appeal in Kinsela v Russell Kinsela Pty Ltd (in liq) [96] relied on Walker and Cooke J of the Court of Appeal of New Zealand in Nicholson v Permakraft (NZ) Ltd (in liq)[97] in acknowledging ‘[t]he obligation by directors to consider, in appropriate circumstances, the interests of creditors’.[98] One of the clearest statements in favour of the duty to take into account the interests of creditors came from the judgment of Lord Templeman[99] in Winkworth v Edward Baron Development Co Ltd:
[A] company is not bound to pay off every debt as soon as it is incurred, and the company is not obliged to avoid all ventures which involve an element of risk but the company owes a duty to its creditors to keep its property inviolate and available for the repayment of its debts. The conscience of the company, as well as its management, is confided to its directors. A duty is owed by the directors to the company and to the creditors of the company to ensure that the affairs of the company are properly administered and that its property is not dissipated or exploited for the benefit of the directors themselves to the detriment of the creditors. [100]
Grove v Flavel [101] rejected the proposition that there was a duty owed by directors to protect the interests of creditors,[102] but found that a director who acts to the detriment of creditors, knowing that ‘the company faces a risk of liquidation ... which is a real and not a remote risk’ is acting ‘improperly’.[103] This was in breach of s 229(3) of the Companies Code,[104] a criminal offence at the time, because the Court considered that a failure to protect the interests of the creditors at a time of imminent insolvency was an improper use of information.
This approach was also taken in Jeffree v National Companies and Securities Commission [105] by the Supreme Court of Western Australia. When a director transferred company assets to a new company to put them out of the reach of creditors, he was charged with making an improper use of his position under s 229(4) of the Companies Code.[106] The Court held that the director owed fiduciary duties to present and future creditors of the company.[107]
Not all courts agree with this line of reasoning. In Multinational Gas & Petrochemical Co Ltd v Multinational Gas & Petrochemical Services Ltd, Dillon LJ said:
The directors indeed stand in a fiduciary relationship to the company, as they are appointed to manage the affairs of the company, and they owe fiduciary duties to the company though not to the creditors, present or future, or to individual shareholders. [108]
Accordingly, it can be seen that in trying to determine whether a duty to consider creditors’ interests exists, courts retreat to deliberations on directors’ behaviour in the context of their fiduciary duty to the company as a separate legal entity, rather than any consideration of the economic consequences of such a finding. Similarly the duty owed by directors to take into account the interests of creditors is a duty owed to the company, and not one owed to, and enforceable by, creditors directly. This view is not without its critics. Sealy remarks ‘A supposed legal duty which is not matched by a remedy is a nonsense.’[109] However, the majority of cases and commentators[110] have concluded that the duty is not a separate one but is protected by the fact that shareholders are not permitted to ratify its breach and therefore deny the creditors’ rights which can be enforced on their behalf by the liquidator. Gummow J explained the argument in Re New World Alliance; Sycotex v Baseler:
It is clear that the duty to take into account the interests of creditors is merely a restriction on the right of shareholders to ratify breaches of the duty owed to the company. The restriction is similar to that found in cases involving fraud on the minority. Where a company is insolvent or nearing insolvency, the creditors are to be seen as having a direct interest in the company and that interest cannot be overridden by the shareholders. This restriction does not, in the absence of any conferral of such a right by statute, confer upon creditors any general law right against former directors of the company to recover losses suffered by those creditors. [111]
His Honour’s comments about creditors ‘having a direct interest in the company’ at times of insolvency appears to recognise theories such as the nexus of contracts. But immediately Gummow J reminds us that even a direct interest does not give creditors any right of action against directors, an affirmation of the traditional view of fiduciary duties being owed only to the company.
This passage was quoted with approval by the High Court[112] in Spies v The Queen, [113] with the Court commenting:
Hence the view that it is ‘extremely doubtful’ whether Mason J (in Walker v Wimborne) ‘intended to suggest that directors owe an independent duty directly to creditors’.[114] To give some unsecured creditors remedies in an insolvency which are denied to others would undermine the basic principle of pari passu participation by creditors.
In so far as the remarks in Grove v Flavel [115] suggest that the directors owe an independent duty to, and enforceable by, the creditors by reason of their position as directors, they are contrary to principle and later authority.[116]
Spies, however, was not a case directly concerned with the issue of directors’ duties to creditors. Its remarks on the subject were brief and the issue was quickly dismissed by the court. The decision in Spies has subsequently been examined in Geneva Finance Ltd v Resource & Industry Ltd, a decision of the Supreme Court of Western Australia. EM Heenan J said:
[T]he orthodox articulation of the duty is that a director of a company, especially if the company is approaching insolvency, is obliged to consider the interests of creditors as part of the discharge of his duty to the company itself, but that he does not have any direct duty to the creditors and certainly not one enforceable by the creditors themselves.[117]
If the duty to take into account the interests of creditors is owed to the company, then it will enforced against the directors by the company’s liquidator, on behalf of all creditors. As discussed above, this view is supported by both cases and commentators. The proceeds of the action will be placed with the amounts realised from the sale of corporate assets and distributed pari passu to creditors in accordance with the rules contained in s 556 of the Corporations Act 2001.
When the company is solvent, directors, on behalf of the company, would not take action against themselves for breach of duty, but Wishart points out that this problem is overcome when the company is insolvent as the liquidator steps into the directors’ shoes to wind up the affairs of the company: ‘When a liquidator has been appointed, these problems evaporate because the liquidator represents the creditor yet acts as the company, thus achieving the necessary nexus of subject and object of the duty.’[118]
However, if the duty were to be enforceable by the creditors themselves, then a number of problems would arise.[119] First, the claims of the individual creditors would compete with the claim of the liquidator, leading to a situation where the creditor taking the individual action may receive more than the creditors whose interests are represented by the liquidator. Secondly, rather than a single suit by the liquidator, there could be a flood of litigation by creditors, multiplying legal costs and clogging courts. Indeed, the possibility of double recovery arises, if the liquidator takes action on behalf of creditors as a whole (either in contract or for breach of duty to consider their interests) and a creditor individually takes action as well.
Again, therefore, the law shows a consideration of traditional corporate rules. While some courts come close to recognising the economic reality that creditors have an interest in the company as it approaches insolvency, the consensus is that creditors are outside the company and thus are not owed any direct duty by directors. Their duty remains to the separate legal entity which is the company.
As discussed above, courts consider that the duty to take into account the interests of creditors should arise when the company is insolvent or nearing insolvency, rather than during solvency. This is based on both economic and practical arguments, and is one of the few occasions when courts are willing to acknowledge the interests of creditors in economic rather than purely legal terms. At approaching insolvency, the residual risk has shifted from the shareholders to the creditors. In addition, the interests of the creditors, shareholders and company are united in the preservation of its assets.
However, not all commentators agree with the time that the duty should arise. One of the problems is that the behaviour which is contrary to the creditors’ interests may be committed during periods of solvency and then ratified by the shareholders, despite reducing the funds available to creditors when the company does finally succumb to insolvency.[120] Sealy argues that it is artificial to distinguish between times when the company is ‘playing with shareholder’s money’[121] and playing with creditors’ money:
The question both for the directors at the time, and the court sitting in review, is whether the directors are behaving responsibly or irresponsibly within the proper limits of business judgment; the directors can only look at the matter broadly, even intuitively, and so should the court.[122]
Yet in spite of the economic validity of this argument, courts still cautiously adhere to the rule requiring actual or impending insolvency. The issue of ratification has also been given substantial judicial attention. The consensus is that the shareholders can ratify breaches of duty which take place when the company is solvent, but lose that right upon its insolvency. For example, Street CJ in Kinsela observed:
(Bamford v Bamford and Winthrop v Winns) were not intended to, and do not, apply in a situation in which the interests of the company as a whole involve the rights of creditors as distinct from the rights of shareholders. In a solvent company the proprietary interests of the shareholders entitle them as a general body to be regarded as the company when questions of the duty of directors arise. If, as a general body, they authorise or ratify a particular action of the directors, there can be no challenge to the validity of what the directors have done. But where a company is insolvent the interests of creditors intrude. They become prospectively entitled, through the mechanism of liquidation, to displace the power of the shareholders and directors to deal with the company’s assets. It is in a practical sense their assets and not the shareholders’ assets that, through the medium of the company, are under the management of the directors pending either liquidation, return to solvency, or the imposition of some alternative administration. [123]
This opinion has been confirmed in Pascoe v Lucas,[124] Rolled Steel Products (Holdings) Ltd v British Steel Corporation,[125] and Multinational Gas & Petrochemical Co Ltd v Multinational Gas & Petrochemical Services Ltd.[126]
Yet despite Street CJ’s words in Kinsela that creditors ‘displace the power of the shareholders and directors’ and the description of the company’s assets as now belonging to the creditors, nonetheless the courts are not departing from their traditional position of the company as a separate legal entity. The fact remains that the creditors have no direct right to sue, as this is in the hands of the liquidator representing the company.
The discussions above show that courts generally adhere to the traditional legal notions of corporate law in determining the rules concerning the duty of directors to take creditor interests into account. Separate legal entity is relied upon to justify a denial of a personal right of creditors to sue directors for breach of the duty. Directors’ fiduciary duties, owed as they are to the company as a separate being, rather than to the shareholders or creditors, justify this limited expression of the duty to consider creditor interests.
But separate legal entity is also relevant in justifying the argument that directors should owe a duty of care to creditors. The directors and majority shareholders of a financially threatened company, having lost their own stake in the future of the company, may choose to gamble with creditors’ funds in an attempt to save the company. As Cooke J remarked in Nicholson, ‘The recognition of duties to creditors ... is justified by the concept that limited liability is a privilege. It is a privilege healthy as tending to the expansion of opportunities and commerce, but it is open to abuse’.[127]
With respect, Cooke J here is possibly confusing the limited liability of shareholders with the separate legal entity concept, which is the principle restricting actions against directors for behaviour committed on behalf of the company. Nonetheless, the argument is a sound one on a broader analysis – that the essence of incorporation is the creation of a separate legal entity to manage the funds of shareholders who need limited liability for the economic reasons stated in the first part of this paper. Indeed, with closely held corporations, where the directors are also the company’s major or sole shareholders, the concepts of limited liability and separate legal entity are closely tied. Incorporation is the privilege which is open to abuse by directors, charged with a responsibility by shareholders to maximise the company’s profits, the ‘expansion of opportunities and commerce’ referred to by Cooke J
In analysing the courts’ reliance on traditional notions in the issue of a duty to take creditors’ interests into account, it is necessary to look at the role of directors in the company and the meaning of the expression ‘acting bona fide for the benefit of the company was a whole’ in conjunction with the separate legal entity principle.
As discussed in Part II, economists and legal and social theorists look at the role of directors and companies broadly. As early as 1932, commentators were looking beyond the interests of shareholders to the corporation’s wider impact on society. Berle and Means argued that ‘[n]either the claims of ownership nor those of control can stand against the paramount interests of the community ... It remains only for the claims of the community to be put forward with clarity and force.’[128]
Courts, however, have traditionally viewed the matter more narrowly.[129] The High Court in Ngurli v McCann said:
[P]owers conferred upon directors by the articles of association of companies must be used bona fide for the benefit of the company as a whole ... the phrase ‘company as a whole’ does not ... mean the company as a commercial entity, distinct from the corporators: it means the corporators as a general body.[130]
Commentators have been divided about the court’s conclusions regarding the finding of a duty to take account of the interests of creditors. While acknowledging that the finding of a duty is beneficial ‘from the standpoint of raising commercial reality and imposing minimum standards below which directors must not fall’, Dawson[131] has argued for a return to the traditional view that a company is formed for the benefit of its shareholders. The shareholders are the ones contributing their capital to be used for the company’s purposes. The shareholders are the one who elect, and are represented by, the directors.[132]
After examining the contradictory decisions in Nicholson v Permakraft (NZ) Ltd (in liq)[133] and Multinational Gas & Petrochemical Co Ltd v Multinational Gas & Petrochemical Services Ltd,[134] Dawson says:
[T]he root cause of the differences in the recent cases lies in the meaning to be given to the term ‘company’. When it was said that directors owed fiduciary duties to the company, it used to mean that they were bound to exercise their powers in the best financial interests of the shareholders. ... The recent trend in the cases shows courts utilising the concept of the separate legal entity to increase significantly the range of considerations that directors are entitled, and at times, bound, to take into account in exercising their powers. ...
But this metaphor of the company as a separate legal person can be pressed too far. ... It is easy to forget that the metaphor ... is merely a convenient short-hand to describe how and under what conditions the names of corporate bodies are used in practice for the purpose of giving effect to the legal relations that are created when people associate together for the purpose of carrying on a business venture.[135]
With a clause in the company’s constitution spelling out shareholder wealth maximisation as the company’s object, having regard to the interests of creditors could have been once considered ultra vires.[136] Dawson argues that the new standpoint, expressed in cases like Walker and Nicholson, is difficult to reconcile with the idea of ratification of breach of duty. The rationale for ratification is that shareholders can approve breaches of duty by directors because the directors are acting on behalf of the shareholders. If directors are acting for the benefit of a number of parties, then shareholders should lose this right to ratify.
Heydon also examines the meaning of the phrase ‘Directors must act bona fide for the benefit of the company as a whole’.[137] He posits four possible meanings of the expression: first, that directors are fiduciary agents; second, that directors act for the corporation; third, that directors act for the benefit of shareholders; and finally, that directors act for the benefit of all persons connected with the company.
While the first ‘has the merit of preserving harmony and connection with general principle’, its breadth leads to difficulties because of the ‘wide range of duties that are labelled “fiduciary”’.[138] The second possible meaning clearly excludes outsiders, including creditors, but does not adequately distinguish between the company itself and its corporators. For example, the best interests of the company could be the separate legal entity itself, or it could be the current shareholders behind the company, or it could be the total present and future shareholding of the company.
Heydon’s third meaning is that directors act for the benefit of the shareholders. This test has the advantage of being echoed in the Corporations Act 2001. For example, the oppression provision in s 232 speaks of conduct which is ‘contrary to the interests of the members as a whole’, as does the winding up remedy in s 461. In addition, the writer points out that the interests of the company are often indistinct from those of the shareholders.
The final meaning is that directors act for all stakeholders in the company – shareholders, creditors and others. As mentioned above, Heydon asserts that Mason J in Walker did not intend to extend a duty to creditors, but that some later cases,[139] misreading the judgment, have done so. He describes the duty as one of ‘imperfect obligation’ because the creditors themselves are unable to enforce it.
He concludes that:
Directors owe duties to the company, even though in fulfilling them it may be proper to take into account the interests of shareholders, beneficiaries in trusts of shares, employees and persons who have contracted or may contract with the company. ...
... the law permits many interests and purposes to be advantaged by company directors, as long as there is a purpose of gaining in that way a benefit to the company.[140]
Reynard’s conclusion is somewhat different, finding that a duty to take into account the interests of creditors is ‘ ... contrary to principle and long established authority’. He says:
If the directors owe their duty to the company, how can it be denied that a fully informed general meeting can excuse a breach of that duty? ... If on the other hand directors owe a duty to creditors (as distinct from taking account of creditors interests when discharging the directors’ duty to the company) why is it that the creditors are not entitled to sue in equity to enjoin breach of that duty?[141]
Hence the fiduciary duty of directors to the company as a separate legal entity is at the heart of the law concerning the duty to consider creditor interests. While the abuse of the separate legal entity concept can lead to moral hazard and therefore arguably ought to justify a personal duty to creditors, it can be seen that the courts do not go that far. Commentators are divided about the role of separate legal entity in the formation of the law in this area. The following discussion concerns groups of companies, and it will be seen that it is a prime example of where separate legal entity prevails over the economic realities of modern corporate life.
Groups of companies give rise to special problems in the discussion of the directors’ duty to take into account the interests of creditors. It is often in the context of a director transferring funds from one company to another company in a formal or informal group, rendering the former insolvent and depriving its creditors of a remedy, that the issue of the duty arises. Indeed Walker v Wimborne is a precedent as much for its statement about directors’ duties to each individual company, as a separate legal entity, in a group, as it is about directors’ duty to take into account the interests of creditors.
In Briggs v James Hardie & Co Pty Ltd Rogers AJA said:
The proposition that a company has a separate legal personality from its corporators survived the coming into existence of the large numbers of wholly owned subsidiaries of companies and their complete domination by their holding company ... There was continued adherence to the principle recognised by Salomon v A Salomon & Co Ltd [1897] AC 22, notwithstanding that for a number of purposes, legislation recognised the existence of a group of companies as a single entity. [142]
The question is, can a director do what he believes to be in the best interests of the group as a whole, or must he take into account only the interests of each individual company, regardless of the effect on other companies in the group? There are two possible approaches. The first is from the English case of Charterbridge Corporation v Lloyds Bank Ltd .[143] The test[144] is enunciated by Pennycuick J as follows:
Each company in the group is a separate legal entity and the directors of a particular company are not entitled to sacrifice the interests of that company. This becomes apparent when one considers the case where the particular company has separate creditors. The proper test, I think, in the absence of actual separate consideration, must be whether an intelligent and honest man in the position of a director of the company concerned, could, in the whole of the existing circumstances, have reasonably believed that the transactions were for the benefit of the company.[145]
The second approach is that of Mason J in Walker, who said:
[T]he emphasis given by the primary judge to the circumstance that the group derived a benefit from the transaction tended to obscure the fundamental principles that each of the companies was a separate and independent legal entity, and that it was the duty of the directors of Asiatic to consult its interests and its interests alone in deciding whether payments should be made to other companies. ... The creditor of a company, whether it be a member of a ‘group’ of companies in the accepted sense of that term or not, must look to that company for payment. His interests may be prejudiced by the movement of funds between companies in the event that the companies become insolvent.[146]
In Australia, there is some debate about whether the correct test is that of Charterbridge or Walker. In ANZ Executors and Trustee Co Ltd v Qintex, Byrne J, citing Walker, said:
[W]hether the assumption of a liability to ANZ could be advantageous must be assessed from the perspective of the subsidiary concerned and with its particular interests exclusively in mind... The separate legal personality of group members demands no less. ... Perhaps in different days a subsidiary might have detected a sufficient prospect of separate benefit that a commitment to a guarantee could be seen as genuinely for that company’s business purposes, something to advance its own welfare (citing Charterbridge). If so, those times are past. [147]
In Equiticorp v BNZ, it was agreed by all parties on appeal that the Charterbridge test should be applied as it had been by Giles J at first instance. The majority in Equiticorp therefore adopted the Charterbridge test, but with reservations. Clarke and Cripps JJA remarked:
A particular difficulty arises when the directors of the particular company enter into the transaction on behalf of that company because they consider that the transaction is of benefit to the group as a whole and do not give separate consideration to the benefit of their company.
The directors are bound to exercise their powers, bona fide, in what they consider is in the interests of the company and not for any collateral purpose. Whether they did so or not is a question of fact ...[148]
On the facts it was held that there was no breach of fiduciary duty, although the majority of the court only looked at the interests of the shareholders of the various companies within the group, since the interests of the creditors was not raised at first instance.
Kirby P, dissenting, held that the Australian position,[149] beginning with Walker v Wimborne, required directors to ‘consider the separate position of their company within a group’. He said that the opposing view
would set at nought the separate identity of the corporations and the duties which are owed in each case separately to the company as a whole, even by directors who hold office in a number of corporations in a corporate group. The requirement concerning ratification of otherwise unauthorised conduct by the shareholders of a company is not a mere technicality. It is a rule which imposes on companies the beneficial discipline of the law for the protection of investors and creditors and, through them, of the community which is so dependent on corporations for its economic well-being.[150] This is not to say that a consequential effect of the advantage to members of a group of companies could not be taken into account by an honest and intelligent director ... of a particular company in deciding what that company should do.[151]
Unfortunately, Equiticorp does not clarify the situation in Australia. According to Cross and Webster:
The uncertainties arising out of Equiticorp flow not only from Kirby P’s strong dissenting judgment, but also from the fact that the majority judgment is not particularly clear regarding the principles to be adopted. Nonetheless Equiticorp appears to open the door for directors to take a more global view in relation to corporate groups than has been permitted in the past.[152]
In Lyford v CBA,[153] the Federal Court looked at the decision in Equiticorp. The New South Wales Supreme Court’s treatment of, and ambivalence towards, the Charterbridge test was discussed, and the court in Lyford concluded that ‘It is not therefore correct to say that in Equiticorp, Charterbridge was “accepted as part of our law”’. The traditional Walker approach was also upheld in Wimborne v Brien by the New South Wales Court of Appeal, where Dunford AJA stated:
However, to treat the companies as a single group without regard to their separate assets and liabilities would have breached a fundamental concept of company law – namely that except in respect of limited statutory exceptions eg Corporations Law ss.46 and 50 (subsidiaries and related bodies corporate), s.294A to 295B (consolidated balance sheets) – there is no such thing as a ‘group’ and each company must be treated as a separate entity: Walker v Wimborne and it was the duty of the respondent as liquidator of Langrenus to have regard only to its interests being the interests of its shareholders and its creditors as such. [154]
On the other hand, a different New South Wales Court of Appeal in Linton v Telnet[155] applied Charterbridge,[156] as did Hansen J of the Supreme Court of Victoria in Farrow Finance Co Ltd (in Liq) v Farrow Properties Pty Ltd (in liq).[157] Learned commentators have criticised the harsh approach of Walker while also decrying the uncertainty brought about by the more flexible Charterbridge. Baxt and Lane say:
These varied approaches embody an ongoing tension within the law between the desire for commercial realism and the fundamental notion of the corporation as a separate entity. ... While allowing Salomon to remain intact, the price of ‘piercing the veil’ jurisprudence has been a loss of predictability and a growing tension within the law. ... The prevailing approach within all major common law jurisdictions has been to accommodate corporate groups through a policy of special provisions – additions or exceptions to the ordinary rules that were formulated with individual companies as the norm. [158]
Farrar comments:
A more elaborate reform of enterprise liability based on some concept of group legal personality or automatic group responsibility [159] would probably create as many problems as it would solve. Since we are currently seeking to escape from the straightjacket of separate legal personality, it seems a mistake to seek refuge in a larger concept of group legal personality or responsibility, enticing though this may be because of its apparent reflection of commercial reality.[160]
The problem of moral hazard occurs with groups of companies in much the same way that it does with the shareholders of individual companies. Easterbrook and Fischel describe it as follows:
If limited liability is absolute, a parent can form a subsidiary with minimum capitalisation for the purposes of engaging in risky activities. If things go well, the parent captures the benefits. If things go poorly, the subsidiary declares bankruptcy [to the detriment of its outstanding unsecured creditors] and the parent creates another with the same managers to engage in the same activities. The asymmetry between benefits and cost, if limited liability is absolute, would create incentives to engage in a socially excessive amount of risk activities. [161]
However, imposing liability on the parent company has disadvantages as well:
[T]he value of recovery rights of unsecured creditors of a parent company could be diminished through that company’s exposure to the financial risks of all the group’s activities. At the same time, creditors of controlled group companies could gain a windfall from the parent company providing, in effect, a form of liability insurance against any defaults by its group companies.[162]
Rogers CJ in Qintex Australia Finance Ltd v Schroeders Australia Ltd said
It may be desirable for parliament to consider whether this distinction between the law and commercial practice should be maintained. ... there is a great deal to be said for the suggestion ... that assets and liabilities of the parent and the subsidiaries should be aggregated. It may be argued that there is justification for preserving the same attitude in relation to the demised companies as was displayed during their active commercial life. [163]
Fridman disagrees with Rogers’ opinion, believing that it would cause more problems than it would solve.[164] He suggests that the oppressive conduct remedy[165] is a more appropriate way to deal with abuses of the separate legal entity rule by companies in a group. In discussing the judgment he says that: ‘Clearly the problem of identifying which member of a corporate group should be responsible for a given obligation should not be resolved by destroying the notion of corporate personality that has been enshrined in the law since Salomon v Salomon ...’.[166]
Despite all of the theoretical debates, courts do not cite the prevailing economic theory of the nexus of contracts, and rarely cite other economic or policy considerations in determining whether directors should be personally liable to creditors for failure to take their interests into account. The few references that have been made to economic ideas are quickly incorporated into familiar legal concepts like fiduciary duty, ratification of breach and the separate legal entity doctrine.
Gilligan maintains that the law is adaptive:
This protection of the public interest on both equity and efficiency grounds is also a major justification for much company law, which itself may be economically, politically or socially motivated. The purpose of business regulation and/or company law may be to advance business interests and/or to provide reassurance to the community. ...
Law has to provide just outcomes on an individual basis whilst delivering universal norms, and the elements of this equation can ebb and flow. ... Law and regulation are reflexive in that, as they contribute towards construction of the social world, they are simultaneously being constructed by that social world.[167]
These sentiments are echoed by McBarnet, when she says:
... if the law is in the interests of capital it is not simply because it is handed over on a plate by predetermined structures, however complex, or by a captive state, but because of continuous work upon it on a day to day pragmatic basis to try and make it fit the specific, dynamic and sometimes conflicting interests of the moment.[168]
Yet despite the arguably adaptive and dynamic nature of the law, courts still largely ignore corporate models in favour of doctrines which have been around for over 100 years. In my opinion, there are a number of reasons for this approach.
First, the theories are often contradictory. While the nexus of contracts is currently in fashion and widely cited in the economic literature, it is by no means the only model currently under consideration by legal and economic theorists. As discussed above, there are a variety of theories still being propounded, as well as a number which are have been abandoned. If courts were to embrace any of these as a basis for their judgments, it would be awkward if the model later lost its endorsement by scholars in that area as a true representation of the ‘theory of the firm’.
Secondly, they are often hard to understand, replete as they are with specialised jargon, and still harder to explain. If a court were persuaded of the validity of any of the theories, it would require proof that this particular one, and not its contradictory cousins, was truly the correct one to guide their determinations. This would involve large amounts of time and argument, not to mention a detailed understanding of economics on the part of counsel, to convince the bench. This is unlikely to happen.
Thirdly, as discussed above, these theories are necessarily based on simplifications and generalisations, which make them difficult to apply in cases in which the generalisations do not hold. Many are based on the model of the public corporation, complete with a separation of ownership and management and publicly traded shares, yet the vast majority of companies are proprietary limited companies. The supposed agreements which underlie the nexus of contracts model are not often expressly stated and may be construed in different ways by the purported parties to them.
Fourthly, even where the generalisations do apply, the models do not give clear indications of the approach that courts should take. Wishart says:
The problem with economic theory is that it does not say what should be done. It only provides a means of assessing what is being or is to be done; it refines and precisely describes the problems, but can only test, rather than make, recommendations.[169]
Fifthly, the most well accepted of the economic theories, the nexus of contracts, can be used to both support and deny a duty by directors to take into account the interests of creditors. If a company is nothing more than the fictional confluence of contracts between various parties, none of them more important than any other, creditors surely should have rights which are directly enforceable by them. Yet the majority of courts have found that a direct duty to creditors, enforceable by them, would involve a conflict with the fundamental notion of the directors’ fiduciary duty to the company. Equally, the neo-classical view of the company as a vehicle for the maximisation of shareholder profits would militate against directors having to pay any regard to creditors’ interests.[170]
Finally, courts are supposed to be law appliers, not law makers. Legislators face the temptation to leave decision making to courts which have the flexibility, ex post, to deal with any particular circumstance which might arise, rather than having to deal with every circumstance, ex ante. But the problem with common law as the adoption point for economic theory is that different courts might adopt different ones. Creditors as beneficiaries of a trust upon insolvency might gain currency in one forum, and the director primacy theory might find favour somewhere else.
The appropriate place for the implementation of economic and social theories is legislation. In this regard the words of Mr Justice Heydon[171] should be heeded:
The rule of law operates on principles which are known or readily discoverable and hence do not change erratically without notice; which are reasonably clear; which apply uniformly and generally, not in a discriminatory way ...[172]
The duty of a court is not to make the law or debate the merits of particular laws, but to do justice according to the law. ... It is legislatures which create new laws. ... Judges are given substantial security of tenure in order to protect them from shifts in the popular will and from the consequences of arousing the displeasure of either the public or the government. The tenure of politicians, on the other hand, is insecure precisely in order to expose them to shifts in the popular will and to enable those shifts to be reflected in parliamentary legislation.[173]
[Legislatures] are superior to the fumbling discussions which can take place when judges attempt to reason towards radical legal changes – when they seek to ‘balance’ in a rather windy way ‘interests’ and ‘policies’ and ‘needs’ and ‘values’, none of them empirically established and few of them clearly articulated.[174]
The model of the firm, as debated by economic, social and legal theorists, has occupied some of the great academic minds of the 20th century.[175] Despite the multitude of theories which they have propounded, or perhaps because of them, courts have adhered fairly rigidly to the traditional and familiar principles of company law.
Agency theory and the nexus of contracts model is the most well accepted of the theories, but it is not recognised by courts, perhaps because it lacks normative value. It is based on generalisations and a model of the company which does not represent the majority of companies. It also does not give a clear indication of the way in which courts should approach the question of directors’ personal liability to creditors. Other economic theories of the firm suffer from similar criticisms.
Economic arguments about creditor behaviour are occasionally cited by courts. For example, the idea that creditors should not be able to recover because they have already factored the risk of loss into the cost of their transactions is sometimes mentioned judicially. But this type of proposition is flawed because it fails to recognise a range of creditor types. Similarly, comments about liability leading directors to be risk averse to the detriment of the company is based upon economics, but this needs to be balanced against the decreased cost of capital which a decrease in risk would achieve.
Perhaps because of these complications and contradictions, courts largely steer clear of economic and social theories, preferring the safety of separate legal entity, limited liability and fiduciary duty. These have been used to achieve a balance between the claims of creditors and the protection of directors. Although economic considerations are referred to in finding that the duty arises when the company nears insolvency, as the creditors now bear the residual risk, the acknowledgment of a duty to take into account the interests of creditors is done by expanding the content of directors’ fiduciary duties. By recognising that the duty is owed to the company and not to creditors directly, the sanctity of separate legal entity is maintained, despite the limitations of that doctrine and the risks of moral hazard.. This adherence to separate legal entity is particularly apparent with groups of companies, where the strict application of the doctrine can sometimes lead to commercially unrealistic situations.
The use of traditional legal doctrines may be an awkward way to accommodate the expansion of directors’ duties towards the company, but they provide a measure of certainty which adoption of economic and social theories of the firm cannot.
[*] Senior Lecturer, Department of Business Law and Taxation, Monash University, Clayton Campus.
[1] [1897] AC 22.
[2] Whether directors owe a duty of care in negligence to those that deal with them qua directors is another area where the doctrine of separate legal entity and the director as ‘directing mind and will’ are often taken into account by the courts.
[3] Indeed, Hart says ‘Most formal models of the firm are extremely rudimentary, capable only of portraying hypothetical firms that bear little relation to the complex organisations we see in the world’. Oliver Hart, ‘An Economist’s Perspective on the Theory of the Firm’ (1989) 89 Columbia Law Review 1757, 1757.
[4] Jeffrey Gordon, ‘The Mandatory Structure of Corporate Law’ (1989) 89 Columbia Law Review 1549, 1556.
[5] For example, Easterbrook and Fischel say in support of the nexus of contracts theory, ‘After all, investors do not sit down and haggle among themselves about the terms. As a rule investors buy stock in the market and know little more than its price. ...[but] In general, all the terms in corporate governance are contractual in the sense that they are fully priced in transactions among the interested parties. They are thereafter tested for desirable properties; the firms that pick the wrong terms will fail in competition with other firms competing for capital.’ Frank Easterbrook and Daniel Fischel, ‘The Corporate Contract’ (1989) 89 Columbia Law Review 1416, 1429-1430.
[6] For example, portfolio theory explains how shareholders diversify their risk, leading to a lower required rate of return on their investments. This is based on the idea of investment in a wide range of companies and therefore on the separation of ownership and management.
[7] There are approximately 1,232,150 companies in Australia, of which approximately 1,213,400 are proprietary companies and 18,750 are public companies. Approximately 1,400 public companies are listed on the Stock Exchange. Email from Debbie Cowley, Product Team, ASIC, to Helen Anderson, 15 April, 2003.
[8] Equally, it could be argued that large companies, although less common than small ones, generally have more creditors in number and more money owing to those creditors.
[9] Wishart notes that ‘There are many, mostly inconsistent, streams of research, although the formal agency model of the Rochester School of Management and the governance mechanism model of Macneil and Williamson have come to dominate the field. (footnote omitted) Little of this theory originally dealt explicitly with corporations law although the formal agency model spoke of the corporation as a ‘nexus of contracts’. David Wishart, ‘Critiquing law and economics: A review of Michael J Whincop, ‘An Economic and Jurisprudential Genealogy of Corporate Law’ (2002) 14 Australian Journal of Corporate Law 74, 74.
[10] The leading authors in this area are Ronald Coase, ‘The Nature of the Firm’ (1937) 4 Economica 386; Armen Alchian and Harold Demsetz, ‘Production, Information Costs and Economic Organisation’ (1972) 62 American Economic Review 777; Eugene Fama and Michael Jensen, ‘Separation of Ownership and Control’ (1983) 26 Journal of Law & Economics 301; Hart, above n 3; Michael Jensen and William Meckling, ‘Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure’ (1976) 3 Journal of Financial Economics 305. Jensen and Meckling say that the ‘firm is not an individual ... [but] is a legal fiction which serves as a focus for a complete process in which the conflicting objectives of individuals (some of whom may ‘represent’ other organizations) are brought to equilibrium within a framework of contractual relations’ at 311-12.
[11] The word ‘contracts’ is not meant literally in this context. Instead it refers to the more general relationships between the various parties. Companies have relationships with the eventual consumers of their products despite a lack of privity of contract between them. Companies have relationships with the community at large, for example in their environmental responsibilities. Christopher Riley, ‘Contracting Out of Company Law: Section 459 of the Companies Act 1985 and the Role of the Courts’ (1992) 55 Modern Law Review 782, 785-6.
[12] William Bratton, ‘The Nexus of Contracts’ Corporation: A Critical Appraisal’ (1989) 74 Cornell Law
Review 407, 420.
[13] Hart, above n 3, 1764.
[14] Riley, above n 11, 784; Easterbrook and Fischel, above n 5, 1418.
[15] Eisenberg argues that mandatory rules are necessary to compensate for a lack of information between contracting parties because the idea of achieving economic efficiency through the process of bargaining loses its force if parties are ill-informed. Melvin Eisenberg, ‘The Structure of Corporation Law’ (1989) 89 Columbia Law Review 1461, 1463.
[16] Corporations Act 2001 s 180(2).
[17] Easterbrook and Fischel, above n 5, 1417.
[18] This area of study is also known as transaction cost economics. The purpose of firms is to reduce the cost of transactions. See further Coase, above n 10; Alchian and Demsetz, above n 10; Hart, above n 3, 1760-1763.
[19] Robert Pindyck and Daniel Rubinfeld, Microeconomics (4th ed, 1998) 632.
[20] Jensen and Meckling, above n 10, 308.
[21] In essence, agency costs are the costs incurred by the inanimate company being obliged to delegate its powers and functions to human beings, namely the directors.
[22] Jensen and Meckling, above n 10, 308; Easterbrook and Fischel, above n 5, 1424.
[23] Rizwaan Mokal, ‘An Agency Cost Analysis of the Wrongful Trading Provisions: Redistribution, Perverse Incentives and The Creditor’s Bargain’ (2000) 59 Cambridge Law Journal 335, 349.
[24] Lewis Kornhauser, ‘The Nexus of Contracts Approach to Corporations: A Comment on Easterbrook and Fischel’ (1989) 89 Columbia Law Review 1449, 1451.
[25] Easterbrook and Fischel, above n 5, 1428.
[26] Bratton, above n 12, 410.
[27] There are many other theories of the corporation. Gilligan’s discussion includes ‘real entity theory’, which is based on the notion of the company as an entity separate from its shareholders; ‘autopoetic theory’ which emphasises the idea that company’s own systems manage its organisation and that company law ‘self-reproduces’; and ‘concession theory’, which sees the corporation as a privilege bestowed by the government, thereby justifying government interference. George Gilligan, ‘Company Law and the Regulation of Financial Services in the Twenty-First Century: A Socio-Legal Perspective’ (2001) 3 International and Comparative Corporate Law Journal 33, 36.
[28] E Merrick Dodd, ‘For Whom Are Corporate Managers Trustees?’ (1932) 45 Harvard Law Review 1145; Adolf Berle, ‘For Whom Corporate Managers Are Trustees’ (1932) 45 Harvard Law Review 1365; E Merrick Dodd, ‘Book Review’ (1942) 9 University of Chicago Law Review 538.
[29] For example the Related Parties and Financial Benefits provisions of Part 2E of the Corporations Act 2001, for public companies. Also s 191 which requires a director to give notice of a material personal interest in a matter relating to the affairs of the company.
[30] Kornhauser, above n 24, 1450.
[31] JD (John Dyson) Heydon, ‘Directors’ Duties and the Company’s Interests’ in PD Finn (ed), Equity and Commercial Relationships, (1987) 120, 120-122.
[32] [1942] UKHL 1; [1942] 1 All ER 378.
[33] Ibid 387.
[34] Stephen Bainbridge, ‘The Board of Directors as Nexus of Contracts: a Critique of Gulati, Klein and Zolt’s “Connected Contracts” Model’ UCLA School of Law Research Paper No 02-05 January 2002, <http://papers.ssrn.com/sol3/papers.cfm> at 21 March 2002.
[35] See further William Bratton, ‘The New Economic Theory of the Firm: Critical Perspectives from History’ (1989) 41 Stanford Law Review 1471.
[36] Bainbridge, above n 34, 4.
[37] Francesco Bonollo, ‘The Nexus of Contracts and Close Corporation Appraisal’ (2001) 12 Australian Journal of Corporate Law 165.
[38] Melvin Eisenberg, ‘The Conception that the Corporation is a Nexus of Contracts and the Dual Nature of the Firm’ (1999) 24 Journal of Corporation Law 819, 825, where the ‘ownership’ rights of shareholders were supported by their ‘rights to possess, use and manage, and the rights to income and capital’. These ‘rights’ obviously can only be exercised by the shareholders collectively, acting as the company, and not individually. Bainbridge comments that ‘to the extent that possessory and control rights are indicia of a property right, the board is a better candidate for identification as the corporation’s owner than are the shareholders’. Bainbridge, above n 34, 14.
[39] Automatic Self Cleansing Filter Syndicate v Cunninghame [1906] UKLawRpCh 45; [1906] 2 Ch 34. Even if shareholders had the power to make decisions on behalf of the company, they lack the information to do so properly. Obtaining this information would involve shareholders incurring enormous costs, which would have to be met by the company.
[40] Bainbridge, above n 34, 2.
[41] Ibid 7.
[42] Margaret Blair and Lynn Stout, ‘A Team Production Theory of Corporate Law’ (1999) 85 Virginia Law Review 247, who argue that directors ‘are not subject to direct control or supervision by anyone, including the firm’s shareholders’ at 290. (emphasis in original)
[43] Bainbridge, above n 34, 6.
[44] Ibid 21-22.
[45] Ibid 8.
[46] David Wishart, ‘Models and Theories of Directors’ Duties to Creditors’ (1991) 14 New Zealand Universities Law Review 323, 336. See also Ross Grantham, 'The Judicial Extension of Director’s Duties to Creditors' [1991] Journal of Business Law 1, 2.
[47] Frank Easterbrook and Daniel Fischel, The Economic Structure of Corporate Law (1991) 50. See also Ross Grantham, ‘Directors’ Duties and Insolvent Companies’ (1991) 54 Modern Law Review 576, 579. Posner also comments, ‘the interest rate on a loan is payment not only for renting capital but also for the risk that the borrower will fail to return it’: Richard Posner, ‘The Rights of Creditors of Affiliated Corporations’ (1976) 43 University of Chicago Law Review 499, 501.
[48] Wishart, above n 46, 338.
[49] Ibid 336. Also Grantham, above n 46, 2.
[50] Eisenberg comments ‘It is almost impossible to deal adequately with this potential for ex post opportunism by ex post contracting’: Eisenberg, above n 15, 1465.
[51] Kenneth Arrow, ‘Risk Perception in Psychology and Economics’ (1982) 20 Economic Inquiry 1, 5.
[52] Francis Dawson, ‘Acting in the Best Interests of the Company – For Whom are Directors Trustees?’ (1984) 11 New Zealand Universities Law Review 68, 81.
[53] Wishart, above n 46, 339.
[54] Indeed, Sealy argues that ‘The old "trust" of shareholders’ money, like the rules for the maintenance of capital, cannot cope when the only significant capital is loan capital’: Len Sealy, ‘Directors’ Wider Responsibilities – Problems Conceptual, Practical and Procedural’ [1987] MonashULawRw 7; (1987) 13 Monash University Law Review 164, 174.
[55] Jensen and Meckling, above n 10, 310.
[56] Margaret Blair, ‘Team Production Theory and Corporate Law’, Georgetown University Law Centre 2001 Working Paper Series, <http://papers.ssrn.com/abstract=281818> at 25 November 2001, 3.
[57] Sealy, above n 54, 175.
[58] Easterbrook and Fischel, above n 47, 50.
[59] An example would be the makers of car components for a particular car manufacturer.
[60] Wishart, above n 46, 336.
[61] Paul Halpern, Michael Trebilcock and Stuart Turnbull, ‘An Economic Analysis of Limited Liability in Corporation Law’ [1980] University of Toronto Law Journal 117, 149.
[62] Ibid 143.
[63] However, note the insertion of Part 5.8A of the Corporations Act 2001, introduced by the Corporations Law Amendment (Employee Entitlements) Act 2000, which has as its object ‘to protect the entitlements of a company’s employees from agreements and transactions that are entered into with the intention of defeating the recovery of those entitlements.’
[64] Halpern, Trebilcock and Turnbull, above n 61, 150. Wishart also says, after discussing different classes of creditor, ‘The calculus thus becomes frighteningly complicated or unacceptably unpredictable.’ Wishart, above n 46, 332.
[65] Senate Standing Committee on Legal and Constitutional Affairs, Company Directors’ Duties (1989) 179.
[66] Not all directors of large companies, such as the directors of One.Tel, are detected in the improper use of their positions until creditor funds are lost, nor did the fear of losing entitlements or their reputations apparently deter their improper behaviour.
[67] The submission of Dr Pascoe of the Business Council of Australia to the Senate Standing Committee of Legal and Constitutional Affairs, Company Directors' Duties, (1989) 63 was that bad management of the interests of creditors and employees was bad management of the company and therefore against the interests of shareholders. Sealy also argues that a ‘corporate enterprise’ approach which takes into account the interests of customers and the workforce, among others, would ‘more accurately reflect the modern directors’ own attitudes’. Sealy, above n 54, 174.
[68] The conceptualisation of the company as a separate legal person is known as reification, the process of making an abstract idea real or concrete.
[69] See Sealy, above n 54, 176; Wishart, above n 46, 331. See also Tom Bostock, ‘To Whom Are the Duties of a Company Director Owed ?’ (Seminar of the Australian Institute of Company Directors and the Centre for Corporate Law and Securities Regulation, University of Melbourne, 8 November, 2000) 3.
[70] Sealy, above n 54, 181.
[71] [1897] AC 22.
[72] Although, as some commentators have astutely observed, judges in leading cases have sometimes mistakenly confused the two principles. See David Wishart, ‘The Personal Liability of Directors in Tort, [1992] Company and Securities Law Journal 363 and Zipora Cohen, ‘Directors’ Negligence Liability to Creditors: A Comparative and Critical View’ (2001) 26 The Journal of Corporation Law 351.
[73] Sealy, above n 54, 164.
[74] Wishart, above n 46, 333. This risk is greater with small companies, where the directors are more likely to be the controlling shareholders. In large corporations, management may be well separated from shareholders and have a greater incentive to save the company to retain their remuneration and bonuses.
[75] Wishart, above n 46, 334.
[76] Halpern, Trebilcock and Turnbull, above n 61, 147–149.
[77] Ibid 149.
[78] Ibid 148.
[79] Sealy, above n 54, 180.
[80] Easterbrook and Fischel, above n 47, 60.
[81] Wishart argues with the expression ‘moral hazard’. ‘But why is it wrong? The controllers are using lawful powers, which a creditor should have been able to predict. It is tautologous to assert that it is wrong because it breaches a duty, therefore a duty should exist.’ Wishart, above n 46, 335.
[82] Easterbrook and Fischel, above n 47, 60.
[83] See further Halpern, Trebilcock and Turnbull, above n 61, 124.
[84] Halpern, Trebilcock and Turnbull point out that information for monitoring is costly and that ‘the insurance payment is typically independent of the actions of the insured’: Ibid 140.
[85] Easterbrook and Fischel, above n 47, 53.
[86] Ibid 62.
[87] Wishart, above n 46, 335.
[88] Section 95A of the Corporations Act 2001 provides that (1) ‘ A person is solvent if, and only if, the person is able to pay all the person’s debts, as and when they become due and payable. (2) A person who is not solvent is insolvent.’
[89] [1976] HCA 7; (1976) 137 CLR 1.
[90] Pennycuick J in Charterbridge Corporation Pty Ltd v Lloyds Bank Ltd had also referred, as obiter, to the ‘interests of creditors’ [1970] Ch 62, 74.
[91] [1976] HCA 7; (1976) 137 CLR 1, 5-6.
[92] Justin Dabner, ‘Directors’ Duties – The Schizoid Company’ (1988) 6 Company and Securities Law Journal 105, 105; Hart, above n 3.
[93] (1980) 5 ACLR 546, 547.
[94] [1980] 1 WLR 627, 634.
[97] [1985] NZCA 15; [1985] 1 NZLR 242.
[98] (1986) 4 NSWLR 722, 732.
[99] Lord Griffiths, Lord Mackay of Clashfern and Lord Ackner concurring.
[100] [1987] 1 All ER 114, 118.
[102] Ibid 662.
[103] Ibid 662-3.
[104] Now s 183(1) of the Corporations Act 2001.
[106] Now s 182(1)(b) of the Corporations Law 2001.
[107] (1989) 15 ACLR 217, 221-2 (Wallace J); 227 (Brisden J and Pidgeon J agreed). The approach taken in Grove and Jeffree prompted the Senate Standing Committee on Legal and Constitutional Affairs Company Directors’ Duties (1989) to recommend that criminal sanctions not be imposed in the absence of criminal intent and that civil penalties be introduced to deal with these situations, at 80, paras 5.56 and 5.57.
[108] [1983] 1 Ch 258, 288.
[109] Sealy, above n 54, 177.
[110] See for example Dabner, above n 92; Richard Fisher, ‘Preferences and Other Antecedent Transactions: Do Directors Owe a Duty to Creditors?’ (1995) 8 Corporate and Business Law Journal 203.
[111] [1994] FCA 1117; (1994) 122 ALR 531, 550.
[112] Gaudron, McHugh, Gummow and Hayne JJ in a joint judgment, Callinan J concurring in a separate judgment. Interestingly, in the Victorian Court of Appeal, Hayne JA (as he then was) in Fitzroy Football Club Ltd v Bondborough Pty Ltd (1997) 15 ACLC 638, 643 casts doubts on the existence of the duty at all. His Honour said ‘Even if there was a duty not to prejudice the interests of creditors, I consider that there was in fact no prejudice...’ (emphasis added). See further Robert Baxt, ‘Do Directors Owe Duties to Creditors – Some Doubts Raised by the Victorian Court of Appeal’ (1997) Company and Securities Law Journal 373, 374-375.
[113] [2000] HCA 43; (2000) 201 CLR 603, 636-637. See further John Duns, ‘The High Court on Duty to Creditors’ (2001) 9 Insolvency Law Journal 40; Ian Ramsay, ‘High Court Confirms Directors Owe No Duty to Creditors’ (2000) 52 Keeping Good Companies 523; Desmond Fagan, ‘An Aberration in the Criminal Law: Spies v The Queen’ (2000) 20 Australian Bar Review 173. For a robust debate on the issue of whether Spies resolves the question of an independent duty, see James McConvill, ‘Directors Duties to Creditors in Australia after Spies v The Queen’ (2002) Company and Securities Law Journal 4 and its rejoinder by Anil Hargovan, ‘Directors’ Duties to Creditors in Australia after Spies v The Queen – Is the Development of an Independent Duty Dead or Alive?’ (2003) 21 Company and Securities Law Journal 390, 399-403.
[114] The High Court was quoting from the article by J D Heydon , above n 31, 126.
[115] (1986) 43 SASR 410, 417-420.
[116] Kuwait Asia Bank EC v National Mutual Life Nominees Ltd [1991] 1 AC 187; Re New World Alliance Pty Ltd; Sycotex v Baseler [1994] FCA 1117; (1994) 122 ALR 531. See also John Farrar, Farrar’s Company Law (4th ed, 1998) 382-385. Referring to Grove, Dabner, above n 92, 106-107 also comments that ‘it is submitted with respect that this aspect of the judgment is tenuous, relying as it does upon a vague and inconclusive passage in the judgment of the New South Wales Court of Appeal in Ring v Sutton’.
[117] (2002) 20 ACLC 1427, 1438.
[118] Wishart, above n 46, 326.
[119] Ibid 330-331.
[120] Sealy, above n 54, 179.
[121] Ibid.
[122] Ibid.
[123] (1986) 4 NSWLR 722, 730.
[124] (1998) 16 ACLC 1247, 1273 (Debelle J).
[125] [1986] Ch 246, 296-297 (Slade LJ).
[126] [1983] 1 Ch 258, 269 (Lawton LJ), 289-290 (Dillon LJ).
[127] (1985) 3 ACLC 453, 459.
[128] Adolf Berle and Gardiner Means, The Modern Corporation and Private Property (1932, revised edition, 1968) 312.
[129] Percival v Wright [1902] UKLawRpCh 125; [1902] 2 Ch 421; Re Smith and Fawcett [1942] Ch 304, 306 (Greene MR); Allen v Gold Reefs of West Africa Ltd [1900] UKLawRpCh 37; [1900] 1 Ch 656, 671 (Lindley MR); Peters American Delicacy Co v Heath (1939) 61 CLR 451, 480.
[130] [1953] HCA 39; (1953) 90 CLR 425, 438 citing the judgment of Evershed MR in Greenhalgh v Arderne Cinemas [1951] Ch 286, 291 (Court of Appeal).
[131] Dawson, above n 52, 72-77.
[132] Ibid 78.
[133] (1985) 3 ACLC 453.
[135] Dawson, above n 52, 77.
[136] This doctrine has now been abolished. The Company Law Review Act 1998 has also removed the requirement that a company have a constitution.
[137] Heydon, above n 31, 120.
[138] Ibid 121.
[139] Nicholson v Permakraft (NZ) Ltd (in liq) (1985) 3 ACLC 453; Ring v Sutton (1980) 5 ACLR 546; Re Horsley & Weight [1982] Ch 442, 454-456; Multinational Gas & Petrochemical Co Ltd v Multinational Gas & Petrochemical Services Ltd [1983] 1 Ch 258.
[140] Heydon, above n 31, 134-135.
[141] Ian Reynard, Commentary on Heydon, ‘Directors’ Duties and the Company’s Interests’, above n 31, 140.
[142] (1989) 7 ACLC 841, 861.
[144] This test is variously described as ‘flexible’ - John Farrar, ‘Legal Issues Involving Corporate Groups’ (1998) 16 Company and Securities Law Journal 184, 187; ‘objective’ - Kaylene Cross and Jon Webster ‘Issues Facing Directors of Corporate Groups’ (1997) 25 Australian Business Law Review 436, 437; and ‘lenient’ - Robert Baxt and Timothy Lane, ‘Developments in Relation to Corporate Groups and the Responsibilities of Directors – Some Insights and New Directions’ (1998) 16 Company and Securities Law Journal 628, 632.
[145] (1970) Ch 62, 74.
[146] [1976] HCA 7; (1976) 137 CLR 1, 5-6.
[147] (1990) 8 ACLC 791, 797. In this case, the solvent subsidiaries of a holding company transferred assets to help the parent company meet its debts. This was obviously disadvantageous from the point of view of the subsidiaries’ creditors. The asset transferral was not considered to be for the purposes of the companies, but the creditors’ interests would only be relevant if the subsidiaries were facing insolvency. On appeal to the Queensland Full Court of the Supreme Court, McPherson J said ‘For a commercial or a trading company confronting insolvency to make a gift of its assets in derogation of the interests of creditors is not to use powers or purposes for their corporate [purpose] but to do so for a non-corporate purpose’ (1990) 8 ACLC 980, 989.
[148] [1993] 32 NSWLR 50, 147-148.
[149] Walker was also followed in Ring v Sutton (1980) 5 ACLR 546.
[150] (1993) 32 NSWLR 50, 92.
[151] (1993) 32 NSWLR 50, 99.
[152] Cross and Webster, above n 144, 439.
[153] [1995] FCA 1261; (1995) 13 ACLC 900, 914.
[154] (1997) 15 ACLC 793, 797.
[155] [1999] NSWCA 33; (1999) 17 ACLC 619, 625.
[156] Citing Equiticorp, Reid Murray Holdings Ltd (in Liq) v David Murray Holdings Pty Ltd (1972) 5 SASR 386 and Australian National Industries v Greater Pacific Investments Pty Ltd (in Liq) (No.3) (1992) 7 ACSR 176 as authority for so doing.
[157] (1998) 16 ACLC 897, 926. Charterbridge was also applied in Japan Abrasive Materials Pty Ltd v Australian Fused Materials (1998) 16 ACLC 1172, 1180.
[158] Baxt and Lane, above n 144, 629.
[159] See further Anthea Nolan, ‘The Position of Unsecured Creditors of Corporate Groups: Towards a Group Responsibility Solution Which Gives Fairness and Equity a Role’ (1993) 11 Company and Securities Law Journal 461.
[160] Farrar, above n 144, 201.
[161] Frank Easterbrook and Daniel Fischel, ‘Limited Liability and the Corporation’ (1985) 52 University of Chicago Law Review 89, 111.
[162] Corporate Groups Final Report of the Companies and Securities Advisory Committee, May 2000 (CASAC Report), 24.
[163] [1991] 3 ACSR 267, 269.
[164] Saul Fridman, ‘Removal of the Corporate Veil: Suggestions for Law Reform in Qintex Australia Finance Ltd v Schroeders Australia Ltd’ (1991) 19 Australian Business Law Review 211, 213.
[165] Currently found in s 232 of the Corporations Act 2001.
[166] Fridman, above n 164, 213.
[167] Gilligan, above n 27, 41.
[168] Doreen McBarnet, ‘Law and Capital: The Role of Legal Form and Legal Actors’ (1984) 12 International Journal of the Sociology of Law 231, 233.
[169] Wishart, above n 46, 336.
[170] Grantham, above n 46, 12.
[171] Justice JD Heydon, ‘Judicial Activism and the Death of the Rule of Law’ (2003) 23 Australian Bar Review 110.
[172] Ibid 112.
[173] Ibid 124.
[174] Ibid 125.
[175] For example, Posner and Easterbrook are both judges on the US Court of Appeals. Arrow and Coase are both Nobel Prize winners for Economic Sciences.
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