Abstract
Many common law jurisdictions recognise that directors have an obligation to consider the interests of company creditors when the company is experiencing financial distress. Despite numerous cases attempting to crystalise legal principles related to this obligation and significant academic commentary on the topic, the parameters of the obligation remain uncertain. This paper provides an analytical comparison of the latest case law in Australia and the UK concerning the two most important issues that exist in relation to this obligation, namely when is the obligation triggered and what do directors have to do to ensure that they comply with the obligation. We found that the UK courts appear to be adopting a much more restrictive approach regarding the trigger for the obligation, whereas the obligation may arise much earlier in Australia, due to the liberal framing of the trigger. An analysis of case law also revealed that the weight attached to the interests of creditors once the obligation is triggered seems to be much more significant in the UK, compared to Australia. This analysis is important as there is no doubt that courts in other common law jurisdictions, and particularly in the Commonwealth, will examine the Australian and UK jurisprudence in making their decisions in relation to any claim that directors have failed to comply with the obligation to consider the interests of creditors.
Keywords
Introduction
For the most part, in common law jurisdictions directors have a duty to act in the best interests of their company
1
and this effectively means the interests of the company's shareholders.
2
However, in many of these jurisdictions, if the company is in financial distress there is a shift in the focus of the duty and directors are obliged to consider creditor interests in the management of their company. The basis for this obligation can be traced back to the dictum of Mason J of the High Court of Australia in Walker v Wimborne
3
when his Honour said (with Barwick CJ concurring) that: In this respect it should be emphasised that the directors of a company in discharging their duty to the company must take into account the interests of its shareholders and its creditors. 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… [a creditor's] interests may be prejudiced by the movement of funds between companies in the event that the companies become insolvent.
4
While the obligation imposed on directors in relation to creditor interests has been the subject of many decided cases in common law jurisdictions, such as Ireland, 8 Canada, 9 Hong Kong 10 and New Zealand, 11 the two jurisdictions from where we find the most comment and discussion, and which has in turn led to the greatest development of the obligation, is Australia and the UK. This is exemplified, first, by the fact that even though it is nearly 40 years old, the judgment of Street CJ in the New South Wales Court of Appeal case of Kinsela v Russell Kinsela Pty Ltd 12 is regularly cited and much of it approved in recent case law, as are the decisions of the Western Australia Supreme Court both at first instance 13 and on appeal 14 in The Bell Group Ltd (ACN 008 666 993) v Westpac Banking Corporation. Secondly, by the fact that there has been a lot of case law in the UK since 2002 dealing with claims based on a breach of the obligation and in 2022 the UK Supreme Court handed down a substantial and comprehensive judgment in BTI 2014 LLC v Sequana SA 15 which focused on the obligation.
This paper provides an analytical comparison of the law in Australia and the UK concerning the two most important issues that exist in relation to this obligation to consider creditor interests, namely when is the obligation triggered and what do directors have to do to ensure that they comply with the obligation? 16 It is submitted that this analysis is important as there is no doubt that courts in other common law jurisdictions, and particularly in the Commonwealth, will examine the Australian and UK jurisprudence in making their decisions in relation to any claim that directors have failed to comply with the obligation to consider the interests of creditors, particularly as these two jurisdictions are at the forefront of the developments in this area. The approach adopted by the judiciary in each of these jurisdictions, as well as any potential divergence between the jurisdictions, are therefore significant to the development of the obligation in other Commonwealth and common law jurisdictions. 17 This matter has become of even greater importance since the delivery of the judgment of the UK Supreme Court in Sequana, 18 which has created a lot of interest across the common law world. The paper seeks to drill down as far as the cases are concerned in an attempt to identify and consider the approach which the UK and Australian courts have adopted in order to provide some insight for courts in common law jurisdictions.
The paper develops as follows. First, there is a brief background to the obligation. Secondly, it provides an overview of some of the arguments advanced in favour of the obligation. 19 Thirdly, there is an analysis of the law in Australia and the UK concerning the point at which the obligation arises. Next, the paper analyses the law in Australia and the UK as to what the law requires directors to do when the obligation applies. Finally, there are some concluding remarks.
Background
As mentioned earlier, following the comments of Mason J in Walker 20 that directors must undertake some consideration for the interests of their companies’ creditors, a number of cases in New Zealand and Australia applied them as did the English Court of Appeal in West Mercia Safetywear. 21 A jurisprudence began to evolve during the 1980s, although the development of the law tended to be ad hoc, leading the Federal Court of Australia to say that the law was in a state of uncertainty. In Re New World Alliance Pty Ltd (rec and mgr apptd), Sycotex Pty Ltd v Baseler 22 it was said that the authorities in this area were somewhat unsatisfactory and this was partly due to the fact that statements in some cases appeared to have resulted from a misreading of comments by Mason J in Walker. 23
Since the early 1990s we have seen many cases decided in both Australia and the UK whereby directors have been found liable for not considering the interests of their companies’ creditors. In obiter the Australian High Court in 2000 in Spies v The Queen 24 acknowledged the existence of the obligation and, arguably, the most famous case in Australia which concerned the obligation came in 2008, the case of The Bell Group (No 9). 25 The decision, delivered by Owen J of the Supreme Court of Western Australia, was a mammoth one in length and it found that directors had not complied with the obligation to consider the interests of creditors and held banks liable as knowing third parties. The decision was appealed to the Court of Appeal in Western Australia 26 and by a 2-1 majority the appeal was dismissed. The English Court of Appeal got another chance to give an opinion on the obligation in 2019 in BTI 2014 LLC v Sequana SA. 27 David Richards LJ (as he then was) (and with whom Longmore and Henderson LJJ agreed) accepted that the obligation applied where a company was insolvent, and it could arise where a company's financial circumstances were dire and short of insolvency. The judgment of the Court of Appeal was appealed and after a wait of 18 months the UK Supreme Court handed down a judgment which, again, acknowledged the existence of the obligation.
As mentioned earlier, over the whole period of the existence of the obligation, the two issues that have caused some concern and led to general uncertainty are (1) when is the obligation triggered? (2) how must directors, who are subject to the obligation, act in relation to the creditors and their interests? This leads us to an examination of these two issues by considering and analysing the approach(es) that is evident in Australia and the UK in order to determine whether it is possible to arrive at greater certainty and understanding of what is the trigger for the obligation and what are directors to do when subject to the obligation.
It must be emphasised that directors do not owe a duty to creditors. The obligation to consider creditors’ interests is an aspect of the directors’ duty to act in the best interests of the company. Hence, in the paper we refer to the directors’ responsibility as an obligation.
Rationale 28
Numerous arguments have been advanced for the extension of directors’ duties to include creditors’ interests, often from an economic perspective. The first of these relates to identifying the residual risk-bearers in a company, depending on the financial state of the company. Shareholders are typically afforded the status of residual risk-bearers, as it is assumed that this status would provide them with the appropriate incentives to make discretionary decisions; and as they are regarded as the group most capable of absorbing any losses resulting from poor corporate performance and therefore carrying the risk of failure, should be entitled to the company's residual income.
29
Their position as residual risk-bearers is also supported by the accounting statement that shareholders’ equity is represented by the difference between assets and liabilities. However, when the company experiences financial distress, limited liability serves to displace the risk that shareholders normally carry onto creditors, resulting in the latter effectively becoming the residual risk-bearers, with the obligation to consider creditors interests ‘seek[ing] to mitigate the shift’.
30
On the basis of this approach, it is broadly accepted that creditors are to displace shareholders as residual risk-bearers when the company experiences financial distress.
31
This justification appears to be the one espoused by the court in Kinsela v Russell Kinsela Pty Ltd (in liq), with the court stating: 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 the 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.
32
Shareholders get all the benefits from the firm's success – if a risky venture pays off, they get all the return. Yet if it fails, they do not bear the full cost of failure – creditors will bear some of this cost. The concern, from an economic perspective, is that this may lead to a form of moral hazard if shareholders are able to externalise the risk of their activities, to the extent that those risks exceed their capital contributions.
35
A third reason advanced for the obligation is that the company may be prejudiced by directors not taking the interests of creditors into consideration. 38 This rationale is supported by Owen J in The Bell Group Ltd (in liq) v Westpac Banking Corporation (No 9), 39 and was also a view expressed by Mason J in Walker v Wimborne. 40
Finally, in Sequana Lady Arden said that the reason for the obligation was that the obligation redressed the situation in which creditors, who had a greater economic interest in the company than shareholders on insolvency had no control over the conduct of its business. 41 The other judges, and particularly Lords Reid and Hodge, generally agreed with that view.
The trigger
Financial distress and creditors’ interests
The Australian case of Walker 42 is often cited as the precursor for the extension of directors’ obligations to include creditors’ interests as part of their duty to their company. 43 Even though Mason J did not explicitly link the existence of the obligation to creditors to the company's financial state, a series of subsequent decisions highlight the relevance of this aspect. In Australia, cases on this point seem to indicate different views. In one of the earliest cases after Walker 44 in which a duty to creditors was recognised – Ring v Sutton, 45 the impugned transactions were performed while the companies were still solvent. This judgment was widely criticised, however, 46 and in a subsequent decision, Grove v Flavel, 47 the court indicated that it was not persuaded by a proposition that Ring v Sutton supported the notion of a duty of directors to consider creditors’ interests independent from insolvency or financial difficulties. 48 This conclusion chimes with comments in an English Court of Appeal judgment of the 1980s, Multinational Gas and Petrochemical Co v Multinational Gas and Petrochemical Services Ltd. 49 Here the Court rejected the argument that the directors owed an obligation to take into account creditors’ interests after the directors made a bad decision, when the company was amply solvent at the time. Subsequent UK decisions have clearly espoused the fact that financial distress of some sort was a prerequisite to the advent of the obligation. Thus, some degree of financial instability or distress is required for the obligation to creditors to be activated. This concept is phrased in different ways, which creates uncertainty regarding the point in time when the duty arises.
Required degree of financial distress
In Kinsela, the court indicated that where ‘a company is insolvent the interests of the creditors intrude’ 50 and that ‘the directors’ duty to a company as a whole extends in an insolvency context to not prejudicing the interests of creditors’. 51 As the company in this case was obviously insolvent, there was no need for the court to formulate a trigger that would apply more broadly. The court expressed reluctance to ‘attempt to formulate a general test of the degree of financial instability which would impose upon directors an obligation to consider the interests of creditors’, and seemed to hint that the degree of financial distress would determine the extent to which the directors could ‘justifiably expose the company’. 52 Owen J indicated support for the notion that the ‘degree of financial instability and the degree of risk to the creditors are interrelated’ in The Bell Group (No 9). 53 There are a plethora of UK decisions 54 where the courts have accepted that the obligation is triggered when a company is insolvent, such as Re Pantone 485 Ltd, 55 Colin Gwyer v London Wharf (Limehouse) Ltd, 56 Re Cityspan Ltd, 57 Roberts v Frohlich, 58 Re HLC Environmental Projects Ltd, 59 and Re Bowe Watts Clargo Ltd 60 at first instance, and David Richards LJ indicated in several parts of his leading judgment in the Court of Appeal in Sequana 61 that the obligation is triggered by insolvency. 62 On appeal, the Supreme Court agreed, 63 although Lord Briggs exhibited a more restrictive trigger, saying that insolvency could only be a trigger where insolvent liquidation or administration is probable and there is no light at the end of the tunnel for the company. His Lordship was concerned that what could be temporary insolvency for a company should not be considered as a trigger for the obligation.
In Australian cases where the insolvency of the company was not as obvious, the court did not hesitate to embrace a broader formulation of the trigger. The circumstances that could trigger the duty to creditors have been described in any number of ways, for example ‘a real and not remote risk of liquidation’; 64 ‘a real risk of insolvency’; 65 ‘Kinsela insolvency’; 66 ‘insolvent or nearing insolvency’; 67 ‘insolvent, nearly insolvent or of doubtful solvency’; 68 ‘insolvent, [whether] there should have been concern for its solvency, or [whether] its solvency would be jeopardised by the [transaction]’; 69 ‘actually insolvent or very close to inevitable insolvency’; 70 ‘imminent insolvency’; 71 ‘impending insolvency’; 72 ‘approaching insolvency’; 73 ‘facing insolvency’; 74 ‘a financial state short of actual solvency’; 75 ‘a financial state short of insolvency…including ‘doubtful solvency’; 76 ‘actual or prospective insolvency’; 77 ‘the context of insolvency or near insolvency, which includes a real and not remote risk that creditors will be prejudiced by the dealing in question’; 78 ‘the company's poor financial position’; 79 and so forth.
The English courts have not been as productive in devising formulae for the triggering of the obligation prior to actual insolvency. This was probably largely due to the fact that most of the cases that have reached the courts involved companies that were insolvent at the time of the directors’ alleged miscreant behaviour and so the courts have not had to be precise about when the obligation might arise prior to insolvency. In the High Court of England and Wales, in Colin Gwyer,
80
the deputy judge said that the obligation may arise when the company is doubtfully solvent or on the verge of insolvency,
81
and earlier Sir Richard Scott VC in Facia Footwear Ltd v Hinchliffe
82
referred to the obligation occurring when a company is in a parlous financial state.
83
In Re HLC Environmental
84
John Randall QC (sitting as a deputy judge of the High Court of England and Wales) said, after referring to several of the formulae mentioned in the cases, some of which are set out above, that they add up to the same thing, something that Lord Reed PSC noted in Sequana.
85
The former opined that: I do not detect any difference in principle behind these varying verbal formulations. It is clear that established, definite insolvency before the transaction or dealing in question is not a pre-requisite for a duty to consider the interests of creditors to arise.
86
In the Court of Appeal in Sequana,
88
David Richards LJ observed that judges had shied away from a single form of words, and they had chosen instead to employ a variety of expressions.
89
His Lordship declined to give his imprimatur to any of the existing formulae and was critical of many of them. The judge said that some of the descriptions considered convey something less than insolvency, but he felt that they were too vague to serve as a useful test for determining when the obligation arose.
90
The judge cautiously espoused the view that the obligation could be triggered before insolvency and held that the obligation arose when the directors knew or should have known that the company was or was likely to become insolvent. However, on appeal the Supreme Court disagreed with this as the trigger. While the Supreme Court judges did not approve of any of the formulae set out above, a majority of judges (Lords Reed and Hodge and Lady Arden) did indicate that the obligation might arise prior to insolvency, and that was when a company was bordering on insolvency.
91
Lord Briggs (with whom Lord Kitchen agreed) did not refer to the obligation being triggered when a company is bordering on insolvency. He said that: I would prefer a formulation in which either imminent insolvency (ie an insolvency which directors know or ought to know is just round the corner and going to happen) or the probability of an insolvent liquidation (or administration) about which the directors know or ought to know, are sufficient triggers for the engagement of the creditor duty.
92
The Sequana dicta might also be regarded by some State and Territory Supreme Court judges and Federal Court judges in Australia as highly persuasive. 94 Having said that, the Supreme Court rejected the notion that the obligation arises when there is a real and not a remote risk of insolvency and yet several State and Federal courts have accepted this formula as a trigger and, therefore, might reject what the UK Supreme Court had to say on the matter of a pre-insolvency trigger. 95
Even though the notions discussed above in relation to what is the relevant trigger, all point towards financial instability, the degree of financial distress that is required to activate the duty to creditors is by no means clear. 96 There is an obvious difference between a degree of financial distress that would indicate, for example, a company being ‘actually insolvent or very close to inevitable insolvency’; 97 ‘bordering on insolvency’, 98 or ‘impending insolvency’; 99 compared to a financial state of affairs that can be described as no more than a ‘poor financial position’ 100 – a state that could be very far removed from ‘impending insolvency’. There is an attempt to deal with this nuance difference in one of the more recent cases – Termite Resources NL. 101 The court indicates that the company in question was not ‘insolvent or nearing insolvency’, but that ‘the authorities indicate that test is broader than ‘nearing insolvency’ or ‘doubtful solvency’ and that the obligation to creditors ‘is enlivened when there is a ‘real and not remote risk of insolvency’. 102 It is debatable whether this explanation serves to provide clarity regarding the required degree of financial distress that would trigger the obligation to creditors and has been rejected by the UK Supreme Court. The same could be said for the formulations given by the UK Supreme Court. The judges who advocated ‘bordering on insolvency’ as being a trigger did not elaborate on what they meant by the term. Does it mean ‘nearing insolvency’, ‘close to insolvency’, ‘verging on insolvency’ or what? As far as the trigger favoured by Lord Briggs, ‘imminent insolvency’, is concerned, his Lordship saw it occurring when directors know or ought to know insolvency is just round the corner and going to happen. 103 This might well be different from ‘bordering on insolvency’ which may be regarded as being something that occurs at a point further away from actual insolvency than imminent insolvency, but the distinction is not clear, if there is in fact a distinction. Thus, the position taken by the Supreme Court does not assist the achievement of greater certainty in relation to the trigger. 104 What it does do is to reject unequivocally the view espoused in Kalls Enterprises and later cases like Termite Resources NL 105 that the obligation arises when there is a real and not a remote risk of insolvency. This means that courts in other common law jurisdictions will have to decide whether they feel that it is appropriate to embrace a position which is on the liberal side of a construction of the obligation as adopted in Australia or follow the more restrictive Sequana approach.
Relevance of impact on creditors
The uncertainty concerning the trigger pre-insolvency is exacerbated by the fact that the trigger is not applied as an independent mechanism in some instances, but linked to the potential impact that director conduct could have on creditors’ interests. In Kalls Enterprises, 106 for example, the court states that ‘the company need not be insolvent at the time and the directors must consider [the] interests [of creditors] if there is a real and not remote risk that they will be prejudiced by the dealing in question’. 107 It is possible to see UK courts also link impact with the state of the company as constituting the basis for the obligation to arise. In Re MDA Investment Management Ltd 108 Park J stated the duty arose where the company, ‘whether technically insolvent or not, is in financial difficulties to the extent that its creditors are at risk’. 109 In like manner Lewison J (as he then was) in Ultraframe Ltd v Fielding 110 held that ‘when a company, whether technically insolvent or not, is in financial difficulties to the extent that its creditors are at risk, the duties which the directors owe to the company are extended so as to encompass the interests of the company's creditors as a whole’. 111
Relevance of directors’ knowledge of financial distress
The way in which the trigger is expressed in Grove suggests that knowledge on the part of the director is required in order for the obligation to creditors to arise: ‘[a] director of a company…who, upon acquiring information which leads him to believe that the company is facing a risk of liquidation’; ‘the “duty” of a director to have regard to the interest of creditors when the company is known to be insolvent’; and ‘knowledge of a real risk of insolvency’. 112 This could raise the question as to whether a director must have knowledge of the company's particular financial state of affairs in order for the obligation to be triggered. In light of expectations that directors be familiar with a company's financial state, 113 it is submitted that subjective knowledge of financial instability would not be required to trigger the duty. This argument is supported by statements of the court to the effect that the interests of creditors should be taken into consideration ‘where objective circumstances require this’. 114
This issue has not been completely resolved in the UK. In Sequana 115 a majority of Lord Briggs (with whom Lord Kitchin concurred) and Lord Hodge considered that the obligation would arise if the directors knew or ought to know that the company was insolvent or bordering on insolvency or that an insolvent liquidation or administration was probable. Whereas Lord Reed 116 was less certain than Lords Briggs and Hodge that it was essential that the directors ‘know or ought to know’ that the company was insolvent or bordering on insolvency, or that an insolvent liquidation or administration was probable, and felt that it was unnecessary and inappropriate to express a concluded view on the issue without hearing argument on the matter. Likewise, Lady Arden said that she would leave the matter to another day. 117 However, the majority approach is consistent with that taken in earlier cases. For instance, in Re HLC Environmental 118 the deputy judge rejected the submission that the obligation is only triggered if the director was aware that the company was in the financial state that triggered the obligation. The test propounded by the majority in Sequana on knowledge is not dependent totally on subjective considerations and this is consistent with the test for wrongful trading in the UK, 119 namely the director is liable if he or she knew or ought to have concluded that there was no reasonable prospect of the company avoiding insolvency liquidation, and also the test for insolvent trading in Australia, namely that directors do not need to know that their company was insolvent when debts were incurred before they can be liable if there are reasonable grounds for suspecting that the company is insolvent. 120
Point in time of financial distress
Another issue regarding the trigger is closely related to the way in which the content of the duty is phrased, particularly in cases where the obligation to creditors is essentially seen as nothing but a restriction on the right of shareholders to ratify a breach of directors’ duties.
121
The question that arises is whether the financial difficulty or insolvency of the company should have been present at the point in time when directors performed the actions complained of, or rather at the point in time when shareholders attempt to ratify the breach of directors’ duties. In Australasian Annuities Pty Ltd (in liq) v Rowley Super Fund Pty Ltd,
122
and on appeal, Australasian Annuities Pty Ltd (in liq)(recs and mgrs apptd) v Rowley Super Fund Pty Ltd,
123
for example, a company was clearly solvent at the point in time when the breach of directors’ duties occurred, but insolvent at the time of the purported ratification. Warren CJ expressed unequivocal support for the relevant point in time being the point at which the purported ratification took place,
124
with similar sentiments echoed by Garde AJA.
125
Reliance was placed on the following passage from Kinsela: It is, to my mind, legally and logically acceptable to recognise that, where directors are involved in a breach of their duty to the company affecting the interests of shareholders, then shareholders can either authorise that breach in prospect or ratify it in retrospect. Where, however, the interests at risk are those of creditors I see no reason in law or in logic to recognise that the shareholders can authorise the breach. Once it is accepted, as in my view it must be, that the directors’ duty to a company as a whole extends in an insolvency context to not prejudicing the interests of creditors (Nicholson v Permakraft (NZ) Ltd and Walker v Wimborne) the shareholders do not have the power or authority to absolve the directors from that breach.
126
Summary
The Australian legal principles appear far from clear insofar as the trigger of the obligation to creditors is concerned. It has been acknowledged that ‘[t]he Courts have avoided formulating any general test of the degree of financial instability necessary to give rise to a duty by directors of a company to consider the interests of its creditors’. 131 The same could be said about the UK decisions. Even though there is a UK Supreme Court judgment on the subject, the judges have provided two differently expressed pre-insolvency triggers, ‘bordering on insolvency’ and ‘imminent insolvency’, and it is not clear what they mean and whether they are the same or close in meaning. However, it does appear as if the UK decisions suggest a point that is much closer to actual insolvency, compared to the position in Australia. This could mean that in the future UK liquidators will be more reluctant than their Australian counterparts to institute proceedings against directors for breach of the obligation. Also, it might provide directors in the UK with some comfort, as it would appear that they will not need to be concerned about creditor interests until insolvency is near. Arguably, that gives them greater certainty than they have had. It might also provide some solace for non-creditor stakeholders as it means that directors would be able to have regard for their interests until insolvency is close or has occurred. 132 This would, therefore, arguably enhance the enlightened shareholder value approach that exists in the UK.
While there is uncertainty pre-insolvency, both the Australian and UK courts appear to accept that insolvency constitutes a trigger, although in Sequana the majority of judges were concerned that this must not be temporary insolvency. On one hand, the reluctance to provide a definitive trigger is beneficial to the extent that it allows for flexibility and the opportunity for judicial discretion on a case-by-case basis. On the other hand, the obvious disadvantage is that directors do not have a clear idea of when the obligation is enlivened and accordingly when to tailor their conduct to ensure compliance with the obligation.
Content of the obligation
This part considers what directors need to do in order to comply with the obligation if it has been triggered.
Creditors’ interests and ratification of a breach of directors’ duties
There is a significant amount of uncertainty regarding the content of the duty to consider the interests of creditors. 133 The court in Bell Group (No 9) aptly notes that ‘[t]he nature and content of the duty, in so far as it affects creditors, has been a matter of controversy in Australia for many years’. 134 Commentators have described the parameters of the duty to creditors as ‘troublesome’ 135 and a ‘doctrinal mess’. 136
In one of the earlier and most oft-cited cases on directors’ duties to creditors, Kinsela, the court explains the obligation to consider the interests of creditors as follows: Where…the interests at risk are those of creditors I see no reason in law or in logic to recognise that the shareholders can authorise the breach. Once it is accepted, as in my view it must be, that the directors’ duty to a company as a whole extends in an insolvency context to not prejudicing the interests of creditors, the shareholders do not have the power or authority to absolve the directors from that breach.
137
This approach seems to suggest that directors do not have to take any action or refrain from putting into effect any strategy that would be implemented if the obligation had not been triggered.
The above passage has been cited with approval by the Australian High Court in Spies,
140
potentially offering support for an interpretation that the duty to creditors involves no more than curbing shareholder power to ratify a breach of directors’ duties. However, it is important to note that the High Court relies on this statement in regard to the ability (or inability) of creditors to directly enforce the duty, unequivocally stating that any remarks suggesting that ‘directors owe an independent duty to, and enforceable by, the creditors by reason of their position as directors…are contrary to principle…and do not correctly state the law’.
141
Rather than narrowing the scope or content of the duty, it is suggested that the High Court only confirmed that the duty to creditors is an indirect, rather than direct duty to creditors, to be mediated through the legal person of the company. This interpretation is supported in The Bell Group (No 9), with Owen J stating: [With reference to] the proposition that Spies rejected the notion of an obligation to consider the interests of creditors. I do not read anything in the judgment as compelling that conclusion…I am not able to accept the position urged on me by the banks if, as I have broadly interpreted it, it means relegating the position of creditors to virtual insignificance (save on questions of ratification).
142
Consideration of creditor interests versus shareholder interests
Even though the clarification in Spies 148 regarding the enforceability of the obligation to creditors is seen as a positive development, many recognise that the judgment left a number of questions unanswered. 149 Does the obligation to creditors imply that directors should shift their attention from shareholder interests to creditor interests once the obligation is triggered? Or are directors required to balance the interests of creditors and shareholders, in complying with their obligations to the company? Or should directors’ duties perhaps be seen as operating on a continuum with shareholder interests and creditor interests at opposite ends, where the extent to which creditor interests merit consideration, as compared to shareholder interests, depending on the particular degree of financial instability?
Careful consideration of some of these issues can be found in Bell Group v Westpac Banking Corporation (No 9). 150 In assessing the parameters of the obligation, Owen J indicates that the authorities do not demand ‘that the interests of creditors be treated as paramount’, 151 but only ‘emphasise the importance of treating the position of creditors with due deference’. 152 This prevents ‘substituting for the duty to act in the interests of the company, a duty to act in the interests of creditors’. 153
Directors remain required to act in the best interests of the company. However, company interests may intersect with those of shareholders, 154 or those of creditors where the obligation to creditors is triggered. That said, irrespective of whether it is the interests of the shareholders or creditors intersecting with the interests of the company, their interests remain separate and distinct from the ‘interests of the company’. 155 Also, the company potentially being in financial difficulty does not mean that shareholder interests are ‘supplanted’ by those of creditors. In fact, Owen J emphatically states that ‘[r]egardless of the financial situation of a company (short of a winding up and dissolution), the shareholders retain their interest’. 156
Certainly, the judges in Sequana appear to accept that when solvent the company interests are equivalent to the shareholders, 157 but when the company is insolvent then there is a shift and the creditors have the main economic interest in the company and their interests are the company's, 158 although they do clearly state that shareholders’ interests as well as those of creditors must still be considered. Commentators have described this approach as a ‘balancing exercise that directors must undertake to include the interests of different stakeholders that make up the interests of the company’. 159 While the Supreme Court in Sequana referred to the need for directors to engage in balancing, this exercise was clearly limited to the shareholders and creditors.
In Australia, uncertainty remains in regard to how directors should deal with the interests of creditors when the obligation to consider creditors’ interests is triggered. Should the approach suggested by Owen J in The Bell Group (No 9) 160 be followed, where interests of certain groups of stakeholders could intersect with those of the company, and under particular circumstances, depending on the company's financial state, the interests of company creditors could intersect with those of the company. According to Owen J, creditor interests are not paramount and do not replace those of shareholders, which means that it is likely directors are expected to balance the interests of the group with reference to the particular degree of financial instability. Some commentators suggest that Termite Resources NL 161 follows a different approach, namely ‘prioritising’ creditors’ interests once the duty is triggered, and express a preference for this approach as the ‘balancing of interests’ approach could cause uncertainty. 162
It might be argued that until the advent of the judgment in Sequana the UK position on what the directors were required to do when subject to the obligation was, in some respects, at least, clearer than in Australia. There was clear unequivocal authority at the High Court level that when a company was insolvent the interests of the creditors were paramount, 163 and the Court of Appeal in Sequana accepted this. 164 Things were less clear when the company was not insolvent but in some sort of financial malaise, for while there was a majority of first instance judges who said that the creditors’ interests were to be regarded as paramount in such a situation, 165 other decisions indicated that shareholder interests were still relevant. In Re MDA Investment Management Ltd 166 Park J stated that when a company is in financial difficulties, although not insolvent, the directors’ duties owed to the company are extended so as to include the interests of the company's creditors as a whole, in addition to those of the shareholders. This statement appeared to be cited with approval in Re Kudos Business Solutions Ltd, 167 and Lewison J in Ultraframe 168 took the same approach and said that when a company is in financial difficulties the duties which the directors owe to the company are extended so as to encompass the interests of the company's creditors as a whole, as well as those of the shareholders. 169 In the Supreme Court in Sequana there was no absolute consistency among the judges when it came to the significance of creditor interests on the obligation being triggered before insolvency. Lord Reed said the interests of creditors acquire a discrete significance from those of shareholders, and require separate consideration, once the company's insolvency is imminent, as well as when insolvent liquidation or administration becomes probable. 170 Thus, this suggests paramountcy can apply prior to insolvency, but only when insolvency is extremely close. However, Lord Briggs (with whom Lords Hodge and Kitchin agreed) said that practical common-sense pointed strongly against a duty to treat creditors’ interests as paramount when insolvency was imminent. 171 It will be recalled that, according to Lord Briggs, imminent insolvency is when directors know or ought to know that insolvency is ‘just round the corner and going to happen’. 172 Lord Briggs had said earlier in his judgment that ‘creditors are not to be treated as having the main economic stake in the company at least while a company is solvent or, if insolvent, while there is still light at the end of the tunnel’. 173 It is only if the creditors had the main economic interest, it is likely we can say that their interests should be seen as paramount. But this is not going to be, according to the majority in Sequana, until insolvent liquidation or administration is inevitable. Therefore, it seems that creditors’ interests are not to be seen as paramount at least prior to insolvency eventuating, and only then if liquidation or administration is probable.
Both the Australian jurisprudence and the Supreme Court in Sequana advocated the position that directors were to consider the shareholders and the creditors’ interests, and, certainly, in the case of the Sequana, until a company's insolvent liquidation or administration is inevitable. Thus, this appears to suggest that it may be necessary for the courts to engage in a balancing exercise; balancing the interests of the shareholders and the creditors. What balancing actually entails in this context is difficult to ascertain. The cases provide little or no assistance. ‘Balancing’ involves, according to the Cambridge Dictionary: ‘to give several things equal amounts of importance, time, or money so that a situation is successful’. 174 Some commentators have expressed it as ‘assessing, weighing and addressing the competing claims of those who have a stake in the actions of the organization’. 175 Other commentators have pointed to another definition, namely that it involves weighing competing interests and analysing the relative strengths of the interests. 176 Whatever position one takes on this we have to acknowledge that the problem for directors is that when a company is in a financially parlous state the interests of shareholders and creditors can be ‘starkly divergent’, 177 and that could make the balancing task extremely difficult. Certainly, if balancing is required this might be seen as imposing greater burdens on directors who might see themselves as already subject to significant regulatory oversight within corporate governance frameworks. For instance, in the UK directors must have regard, as part of their duty pursuant to s 172(1) of the Companies Act 2006, to the interests of several stakeholder interests when determining what will promote the success of the company's business. Any requirement to engage in balancing has general been regarded in the corporate governance literature as causing significant problems in reviewing directorial conduct.
The judges in Sequana, seem to suggest that once the obligation arises and a balancing exercise must occur, the relative weight that is placed on each interest holder might be determined by a sliding scale, that is, the closer to insolvent liquidation or administration the company gets, the more weight should be given to creditors’ interests, and when one gets to the point where insolvent liquidation or administration is inevitable, the creditors’ interests become paramount. While not referring to a scale, Owen J in Bell Group opined that the greater the risk to creditors, the more directors should take the interests of creditors into consideration, 178 which suggests his reasoning is close to that of the UK judges, although he does not ever get to the point of saying that the creditors’ interests are paramount at any stage. In fact, his Honour was concerned that if a court accepted that creditors’ interests were paramount it ‘would come perilously close to substituting for the duty to act in the interests of the company, a duty to act in the interests of creditors’. 179 More recently, White J in Termite Resources NL 180 appeared to agree with the comments in Ford, Austin and Ramsay's Principles of Corporations Law, 181 which expressed the view that the closer the company is to insolvency, then the greater the weight that should be given by directors to the interests of creditors. 182
Proscriptive or prescriptive obligation?
It is furthermore uncertain what is meant by an obligation to ‘consider’ creditor interests. 183 Telling directors to consider creditor interests might be seen as verging ‘on the facile as it does not tell us exactly how directors should act, or how far directors have to go in fulfilling the requirement to consider the interests of creditors’. 184 The fact of the matter is that most cases do not address this issue. Does the obligation to consider creditors’ interests impose a positive obligation on directors to act in a particular way, or should they merely refrain from performing certain acts under the obligation to creditors?
In Australia, this question is further complicated by uncertainty regarding the appropriateness of classifying directors’ duty to act bona fide in the interests of the company as ‘fiduciary’. This uncertainty, as well as the question of whether fiduciary duties are proscriptive or prescriptive in nature, 185 confronted Owen J in the Bell Group case at first instance. 186
Owen J elaborated on what is expected of directors insofar as they have an obligation to ‘consider’ the interests of creditors as ‘part of the duty to act in the interests of the company as a whole’,
187
explaining that [i]n a group situation such as this, it demanded a tracing exercise to ascertain the effect on creditors of what was proposed…The directors did not do that tracing exercise. They did not ascertain the extent of external creditors of individual companies and nor did they consider how those creditors would be affected by what was proposed.
188
Owen J recognises that his framing of the obligation (prescriptively) ‘can have overtones of negligence’ 194 and that ‘at first glance this may seem to be a failure of care skill and diligence’, 195 but ultimately concludes that the case as pleaded is not ‘negligence dressed up as misconduct of a different genre’. 196 Even though Owen J provided examples of director conduct that would indicate a breach of their obligations, the obligation was expressed as an obligation on directors to ‘consider’ the interests of creditors, rather than as a duty to actively protect the interests of creditors. 197
On appeal in Bell Group a different approach, from that taken by Owen J, was adopted, with some statements potentially being able to cause confusion. Lee AJA, for example, suggests: Once it appears that a company is insolvent, creditors of the company are regarded as having a direct interest in the company…in the sense that an obligation will then be imposed on the company not to prejudice the interests of the creditors. The fiduciary duty of a director to act bona fide in the best interests of the company would require the director not to have the company ignore or attempt to defeat that obligation to creditors.
198
Statements by Drummond AJA in the Bell Group appeal furthermore suggest a willingness to extend the scope of the obligation beyond how it is expressed in the trial judgment, by requiring directors to ‘have regard and give proper effect to the interests of creditors. 200 Drummond AJA also indicates that the duty ‘will not ordinarily be satisfied by directors who consider the impact that entry into a particular transaction by the company will have on its creditors but proceed with the transaction even though it causes significant prejudice to those creditors’ and that non-compliance exposes directors to being ‘in breach of their fiduciary duty to the company to exercise their powers for proper purposes’. 201
This formulation goes beyond the balancing act suggested by Owen J and other authorities, and has been criticised by commentators. 202 It has also been suggested that a positive expression of the duty, requiring directors to do something, ‘does not sit easily with a proper understanding of directors’ duties’. 203 Placing the duty in the context of the ‘proper purposes’ obligation is also unusual. Commentators suggest that the preference for the more objective obligation, compared to the subjective duty to act in good faith in the interests of the company, allows the court to ‘review the directors’ decisions, and supports a more interventionist approach in commercial decision-making’. 204
The position adopted in the appeal decision appears not to have been embraced in later decisions. The statement by Gleeson JA in Re IW4U that ‘[i]n the context of insolvency or near insolvency, which includes a real and not remote risk that creditors will be prejudiced by the dealing in question…, the standard under s 181(1) of the Corporations Act 2001 entails an obligation on the directors to take into account the interests of creditors’ 205 is illustrative and indicates support for what has been labelled the ‘consider-creditors theory’. This statement has been cited again in a number of subsequent decisions. 206
The above discussion suggests that while the Australian position in respect of the contours of the duty remains uncertain, 207 it seems to favour a construct in terms of which directors are required to consider the interests of creditors, 208 without being subject to a positive obligation to actively protect creditors’ interests. While there are, as explained earlier, comments from some UK judges that envisage an obligation to act positively in favour of the creditors, there does not appear to be a strong thread running through the cases that requires this. The principle also remains that directors primarily owe their duties to the company and should therefore consider the interests of the company first and foremost when exercising their powers, and that the interests of a creditor, even a significant creditor, should not be ‘equated’ with the interests of the company. 209
Summary
While there is some agreement between the Australian authorities and the UK Supreme Court concerning the content of the obligation, the point at which they seem to part company is where a company's insolvent liquidation or administration is inevitable. Sequana provides that at this point the creditors’ interests do become paramount whereas the bulk of the Australian cases do not, even though at this point we can surmise that the creditors’ interests would be regarded as carrying more weight.
Conclusion
The Sequana judgment has been eagerly awaited, and many are watching closely to assess the impact of the judgment in their jurisdiction. At first glance, it seems that Sequana signals a divergence from the current legal position in Australia, regarding the two issues discussed in this paper. In relation to the trigger for the obligation to consider the interests of creditors, the UK courts appear to be adopting a much more restrictive approach, indicating that the obligation will only be enlivened when the company's affairs are bordering on insolvency or insolvency is imminent, whereas the obligation may arise much earlier in Australia, due to the liberal framing of the trigger. Furthermore, the weight attached to the interests of creditors once the obligation is triggered seems to be much more significant in the UK, where creditor interests could indeed become paramount at this point, potentially even displacing shareholder interests, compared to Australia, where creditor interests are seen as having the potential to intersect with those of the company to some extent, but not necessarily to the exclusion of shareholder interests. The difference in approach is consistent with the rationale for the obligation based on the idea of creditors becoming the residual risk-bearers, effectively displacing shareholders in that sense. As discussed, this displacement is linked to the company being insolvent, however. 210 The emphasis on creditors’ interests when insolvency is imminent, as stated in Sequana, is therefore justifiable and explicable on the basis of this particular rationale for the obligation. It also provides a possible explanation for the divergence in approach between the jurisdictions, where the Australia trigger is much more liberal, and therefore not able to eventuate a ‘shift’ to creditors’ interests becoming paramount in the same way that imminent insolvency would be able to achieve.
However, when considering the way in which the content of the obligation is expressed in both jurisdictions in conjunction with the trigger, the approach may not be as divergent as would appear at first glance. While English case law appears to be more accepting of the notion that creditor interests are paramount once the obligation is triggered, even to the extent that their interests could displace those of shareholders, the way in which Australian case law paints the obligation, indicating that there is a direct correlation between the extent to which creditors interests could intersect with those of the company and the degree of financial instability, potentially allows for a result that is not necessarily that dissimilar. If it is accepted that the closer a company is to insolvency, the more directors should give regard to the interests of creditors, an argument could be made that the approach is theoretically open to a suggestion that where the company is on the brink of insolvency, creditors interests have intruded so far that these interests have effectively displaced those of shareholders, similar to the position in England. It is interesting to consider the Australian approach that seems to suggest a gradual progression from shareholder interests being paramount to creditors interests intruding in proportion to the extent to which the company is experiencing financial distress, against the policy rationales for the obligation to consider creditor interests. The Australian approach does not appear to embrace the notion of creditors as residual risk-bearers to the same extent as Sequana, but instead is more aligned with the rationale that the company will ultimately suffer harm if creditor interests are neglected under circumstances of financial distress.
A significant difference is, of course, that prior to the point of ‘imminent insolvency’, or the company ‘bordering on insolvency’, creditors in England will have no protection in terms of an obligation to consider their interests, whereas Australian creditors may have some protection in terms of this obligation, even though it will be proportionately reduced the further removed the company is from a state of insolvency.
The Australian approach allows for more flexibility and greater discretion for the court to judge the conduct of directors from a commercial perspective, in order to establish whether sufficient consideration was given to creditor interests. This would require the court to ‘sit in review of business decisions’ 211 – something which the court is traditionally reluctant to do. 212 The narrower approach of the UK judiciary, on the other hand, provides more certainty to directors in relation to when creditor interests should be considered and also provides enhanced clarity in respect of the relevant weight that should be attached to creditor interests in comparison to shareholder interests, succeeding in addressing, to some extent, one of the longstanding concerns in regard to the burden that this obligation places on directors. 213
The judgment in Sequana has no doubt progressed the development of the law in relation to the obligation to consider creditors’ interests, albeit incrementally, and it will be interesting to see how other Commonwealth jurisdictions respond to the effect of this judgment, and to the divergence with the Australian position that is starting to appear.
Conflict of interest
The authors declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.
