Towards an Optimal Model of Directors’ Duties in the Zone of Insolvency: A Comparative Assessment

By Aurelio Gurrea-Martínez (Singapore Management University)

Introduction

When a company becomes factually insolvent but it is not yet subject to a formal insolvency proceeding, the shareholders –or the directors acting on their behalf– may engage, even in good faith, in various forms of behaviour that can divert or destroy value at the expense of the creditors. For this reason, most jurisdictions around the world provide a variety of legal strategies to respond to this form of shareholder opportunism. One of these strategies is the imposition of special directors’ duties in the zone of insolvency.

Regulatory models of directors’ duties in the zone of insolvency

In a recent article, I analyse the primary regulatory models of directors’ duties in the zone of insolvency observed internationally. From a sample of more than 20 countries from Asia, Australia, Europe, Latin America, Africa, and North America, I distinguish six regulatory models: (i) the imposition of a duty to initiate insolvency proceedings, generally found in Europe; (ii) the imposition of a duty to recapitalise or liquidate the company, typically existing in Europe and Latin America; (iii) the imposition of a duty to minimise losses for the creditors, existing in the United Kingdom; (iv) the imposition of a duty to prevent the company from incurring new debts, existing in countries like Australia and South Africa; (v) the imposition of a duty to prevent the company from incurring new debts that cannot be paid in full, existing in Singapore and New Zealand; and (vi) the imposition of a duty to keep maximising the value of the firm, as it exists in Canada and the United States. Moreover, it should be taking into that, in addition to these special duties generally imposed in the zone of insolvency, corporate directors can be subject to other creditor-related duties. For instance, in the United Kingdom, Australia and Singapore, corporate directors might be required to take into account the interests of the creditors under certain circumstances. In New Zealand, directors can be liable for ‘reckless decision’ ultimately harming the creditors.

After analysing the features, advantages and weaknesses of these models, my paper argues that the desirability of each regulatory model depends on a variety of country-specific factors, including divergences in corporate ownership structures, debt structures, level of financial development, efficiency of the insolvency framework, and sophistication of the judiciary.

Country-specific factors affecting the desirability of a regulatory model

Corporate ownership structures

In countries with many micro and small enterprises as well as large controlled firms, as it happens in most countries around the word, there is a greater alignment of incentives between directors and shareholders. Therefore, in the event of insolvency, the directors will have more incentives to engage in a series of opportunistic behaviour that will advance the shareholders’ interests even if it is at the expense of the creditors. As a result, a more interventionist approach to protect creditors, such as the duty to initiate insolvency proceedings, may make more sense in these countries. Otherwise, even if the directors do not ultimately act in the interest of the shareholders once the company becomes insolvent, the risk of being exposed to opportunistic behaviour by the debtor may encourage creditors to increase the cost of debt, harming firms’ access to debt finance.

By contrast, in countries like the United Kingdom and the United States, where large companies usually have dispersed ownership structures, a more flexible approach for the regulation of directors’ duties in the zone of insolvency may be more justified. Therefore, the duty to maximise the interest of the company or a duty to take steps to minimise potential losses for the creditors will be more desirable in the context of large listed companies. In companies with dispersed ownership structures, the directors will be less influenced by the shareholders. Therefore, by being in a better position to preserve their independence, they will have incentives to make value-maximising decisions, even if, in the event of insolvency, these decisions do not always favour the interests of the shareholders. If the shareholders are unhappy with these decisions, the existence of more pronounced collective action problems existing in companies with dispersed ownership structures will prevent them from quickly removing the directors. Thus, while this separation of management and control is the primary source of agency problems between directors and shareholders in the context of solvent firms, it can actually be desirable for the creditors in the context of insolvent firms.

Debt structures

In companies with simple debt structures, as generally occurs in MSMEs, creditors do not face significant coordination costs. Therefore, reaching an out-of-court agreement between debtors and creditors will be much easier. As a result, since insolvency proceedings might not be needed, it would not make sense to impose a duty to file an insolvency petition in countries mainly formed by MSMEs. By contrast, in countries where companies usually have dispersed debt structures, the provisions and special forum for renegotiation and the adjustment of debts provided by insolvency laws will be more needed. Therefore, forcing companies to initiate insolvency proceedings may be more justified.

Sophistication of the judiciary

In countries with sophisticated courts, as it happens in the United States, the United Kingdom and Singapore, it will make sense to give more discretion to the courts. Therefore, the imposition of duties seeking to take actions to minimise losses for the company may be more justified in these countries. By contrast, in countries without sophisticated courts, as it is usually occurs in many emerging markets and some advanced economies, this discretion should be reduced. For this reason, the use of rules rather than standards should be favoured. As a result, a duty to initiate insolvency proceedings may be more desirable in countries without sophisticated courts.

Efficiency of the insolvency system

In many countries, the insolvency framework is not very efficient. These inefficiencies can be due to the existence of inefficient laws, inefficient judicial systems, or both. Regardless of the reason, the commencement of insolvency proceedings can be value-destructive for both debtors and creditors. For this reason, imposing a duty to initiate insolvency proceedings does not seem a desirable policy in countries with inefficient insolvency frameworks. As a result, in these countries, regulators and policymakers should adopt other models of directors’ duties in the zone of insolvency.

Level of financial development

In countries with developed financial systems, viable companies often have access to finance. Therefore, these countries may afford implementing a regulatory model of directors’ duties in the zone of insolvency that might not be in the best interest of the creditors, and therefore it can lead to an ex ante increase in the cost of debt. However, in many countries around the world, and particularly in emerging economies, companies face significant problems having access to finance even if they are viable companies not facing financial trouble. Hence, adopting a solution that does not credibly solve the risk of shareholder opportunism in the zone of insolvency can exacerbate the problems associated with not having enough access to finance. As a result, in these latter jurisdictions, the duty to initiate insolvency proceedings may make more sense. However, since many companies with underdeveloped financial systems also have inefficient insolvency framework, forcing companies to initiate an insolvency proceeding may end up doing more harm than good for the creditors. Therefore, instead of a duty to initiate insolvency proceedings, perhaps it would make more sense to impose a duty to prevent the company from incurring new debts if the directors know, or ought to have known, that the company will not be able to repay the new debts in full.

Conclusion

Unfortunately for regulators and policymakers, most countries have mixed features. Therefore, designing a desirable model of directors’ duties in the zone of insolvency is not that easy. For example, in many countries, and especially in emerging markets, the insolvency system is not very efficient, the judiciary is not highly sophisticated, and most businesses are MSMEs or large controlled firms. In those situations, the duty to maximise the value of the firm should be eschewed due to the high risk of shareholder opportunism in the zone of insolvency. Likewise, if courts are not very sophisticated, judging ex post directors’ actions to minimise losses for the creditors does not seem a desirable option either. Finally, imposing a duty to initiate a value-destroying insolvency proceeding will probably do more harm than good for both debtors and creditors. In these jurisdictions, regulators and policymakers may need to be more creative when designing a system of directors’ duties in the zone of insolvency. For that purpose, the adoption of a new model, or a combination of existing approaches, can probably be more appropriate. Moreover, it should be kept in mind that countries have different types of companies (e.g., MSMEs, large controlled firms, etc). For this reason, different regulatory approaches may be required for different types of firms.