Leash or noose: regulating the conduct of directors of an insolvent company
By Clayton Chong (WongPartnership LLP)
When one imagines the hypothetical director that insolvency law tries to regulate, three archetypes come to mind: the Founder, the Independent Director and the Crook.
There can be no question that the law should keep a leash on the Crook and impose heavy sanctions to deter his worst impulses. But the challenge is in making sure that the leash on the Crook does not end up being a noose around the neck of the entrepreneurial Founder or the diligent Independent Director. Yet, the Founder is no saint either and must be restrained from taking gambles to revive the business, especially if it comes at the expense of creditors. Furthermore, the law cannot be so strict that it pushes the Independent Director to act defensively and refuse to undertake ventures that can benefit creditors and other stakeholders.
A balance and compromise must therefore be struck. There is no perfect answer or ideal solution for every country, because the balance and compromise requires a negotiation of a country’s social contract. The political, economic, social and cultural values of a country shape what is a fair and just way for formulating the rules that govern how directors and companies should behave. This cuts across issues that are fundamental to the organisation of a state – corporate responsibility to the community, the efficient functioning of trade and commerce in the economy, creation and preservation of jobs, and the allocation of costs and benefits of entrepreneurial risk-taking.
It is for this reason that there is no “one-size-fits-all” solution for every country. However, understanding the construct of different insolvency regimes can be helpful in providing insight and ideas to inform and guide each country’s own insolvency law reform efforts. In this article, we consider the laws of various jurisdictions (primarily Singapore) to discuss three broad themes, namely: (1) the appropriate latitude to be given to directors to exercise commercial judgment when making decisions for the company; (2) balancing the policy aims of promoting a rescue culture and protecting creditors' interest under the wrongful trading regime; and (3) the importance of building an effective enforcement framework.
Latitude for commercial judgment – how wide or narrow should it be?
The law relating to avoidance of transactions helps to bring the issue of commercial judgment into sharp relief. There is an interesting contrast in the legislative approaches in India and Singapore in determining whether an undervalue transaction or undue preference should be unwound. As a broad generalisation, the Indian approach relies primarily on an objective test (whether a transaction was in the ordinary course of business) while the Singaporean approach incorporates subjective elements (whether a transaction was in good faith or actuated by proper commercial considerations).
Cases in both jurisdictions elucidate this distinction. In Anuj Jain Interim Resolution Professional for Jaypee Infratech Limited v Axis Bank Limited, Civil Appeal Nos. 8512-8527 of 2019, the Supreme Court of India, after undertaking a comprehensive analysis of the theory relating to avoidance of transactions in insolvency, gave guidance on the scope of the “ordinary course of business” defence under section 43(3)(a) of the Insolvency and Bankruptcy Code 2016 (“IBC”). The court held that for a transaction to constitute a part of “ordinary course of business” of a corporate debtor, it had to be part of “the undistinguished common flow of business done” and must not arise out of “any special or particular situation”. The inquiry is an objective one that focuses on the past practices of the debtor company’s business.
In contrast, in Coöperatieve Centrale Raiffeisen-Boerenleenbank BA (trading as Rabobank International, Singapore Branch) v Jurong Technologies Industrial Corp Ltd (under judicial management) [2011] 4 SLR 977, the Singapore Court of Appeal endorsed the predominantly subjective nature of the inquiry as to whether a transaction constituted an unfair preference. The court held that the assessment is whether the debtor had the desire (a subjective state of mind) to improve the creditor’s position. A transaction which is actuated by proper commercial considerations may not constitute a voidable preference. A noteworthy point is that the court even clarified that a genuine belief in the existence of a proper commercial consideration may be sufficient even if, objectively, such a belief might not be sustainable.
There are advantages and disadvantages to these different approaches. The objective approach has the advantage of delineating a clearer boundary as to what transactions are permissible when a company is in insolvency. In doing so, it gives the Independent Director greater certainty as to the confines within which he is permitted to act. It also makes it easier and clearer for a resolution professional or liquidator investigating the company’s transactions to objectively assess whether a transaction may be avoided or not. Whether a transaction was carried out in the “ordinary course of business” can be determined by examining the company’s established practices and is likely to be discernible from the company’s accounting records.
The subjective approach, which examines the intent of the parties to the transaction, suffers from the disadvantage of being difficult to prove and may make avoidance proceedings complex, unpredictable and lengthy (as noted in the UNCITRAL Legislative Guide on Insolvency Law at paragraph 179). However, the subjective approach might better serve to promote and foster a rescue culture. This policy consideration can be gleaned from the Singapore Court of Appeal decision of Liquidators of Progen Engineering Pte Ltd v Progen Holdings Ltd [2010] 4 SLR 1089, in which the court opined that commercially sensible transactions made with the objective of creating or extending a lifeline to a company suffering financial difficulty should not be questioned, and a court ought not to be too astute in taking directors to task when they appear to have been attempting in good faith to facilitate the preservation or rehabilitation of a company, and where they had reasonable commercial grounds for believing that the transaction would benefit the company. The subjective approach affords more freedom to the Founder and the Independent Director to explore and undertake restructuring options and transactions aimed at benefiting the company and its stakeholders even if such actions may be outside the ordinary course of business.
Neither approach is inherently preferable over the other. Giving greater latitude to the directors may help to promote corporate rescue attempts, but could come at the cost of more frequent incidences of good-faith but ill-advised risk taking. Giving less latitude may make the conduct of directors easier to police, but may discourage extraordinary value-preserving / value-enhancing measures. Again, harking back to the introduction in this article, the appropriateness of one approach over the other in a particular jurisdiction depends on the policy aims and societal values that undergird the insolvency regime of that jurisdiction.
Walking a tightrope under the wrongful trading regime
Under Singapore law, directors and officers of a company may face criminal sanctions and personal liability if the company engages in wrongful trading. A company engages in wrongful trading if it incurs debts without reasonable prospect of meeting them in full when it is insolvent or becomes insolvent as a result of incurring these debts. If a director knew or ought to have known that the company was trading wrongfully, the court may declare such a director personally responsible for all or any of the company’s debts.
The wrongful trading prohibition continues to apply even when a company is undertaking efforts to restructure (whether by way of a consensual out-of-court workout or a scheme of arrangement). This poses a challenge to any Founder or Independent Director seeking to restructure a company. A successful restructuring often depends on the continuation of the company’s business, so it is unavoidable that the company would have to continue incurring debts, yet the directors run the risk of attracting personal liability. They are forced to “walk a tightrope” and tread carefully when trying to restructure the company.
A director may be relieved from personal liability if he satisfies the court that he acted honestly, and, having regard to all the circumstances of the case, he ought fairly to be relieved from personal liability. However, although this defence gives some potential protection to an honest director, it does not provide a robust safety net as there is a significant degree of uncertainty in predicting whether a court looking at the matter after the fact will determine if the director “ought fairly to be relieved from personal liability”.
In contrast, the “safe harbour” regime under Australian insolvency law, which was introduced to discourage companies from entering administration or liquidation prematurely, is more well-defined in delineating when a director is exempted from wrongful trading liability. Under the Australian safe harbour provisions, directors will not be personally liable for debts incurred while the company was insolvent where it can be shown that they were developing or taking a course of action that at the time was reasonably likely to lead to a better outcome for the company than immediately proceeding to administration or liquidation. A number of factors are considered in this assessment, including whether the company's directors obtained advice from an appropriately qualified adviser and had been taking appropriate steps to develop or implement a plan to restructure the company.
To the extent that promoting a rescue culture is a desired policy aim, adopting the Australian safe harbour reforms may be appropriate in order to give directors a stronger safety net when walking the tightrope of wrongful trading liability. However, affording greater protection to the directors will conversely weaken the protection of creditors and counterparties that are continuing trade with the insolvent company in question. This again requires consideration of the competing policy interests of promoting corporate rescues and safeguarding the interests of creditors.
Building an effective framework for enforcement
Building an effective framework for enforcement is as important as designing a legal framework that best fits the country’s needs and objectives. Otherwise, the law is nothing but a paper tiger – it appears threatening but has no real bite. This is a particularly pertinent problem in the realm of enforcement of cross-border insolvency-related judgments.
In the realm of cross-border insolvency, no man is an island (although, unhelpfully for this metaphor, Singapore is an island). For a country to carry out an effective restructuring or insolvency proceeding under its laws, it depends on other countries to recognise and give effect to it.
In relation to avoidance actions, one can easily see why a robust framework for cross-border enforcement is necessary. Imagine a scenario where a wrongdoer siphons off assets from a company and stashes them away in a foreign jurisdiction. The wrongdoer then disappears and the liquidator seeks a default judgment against the wrongdoer to clawback the misappropriated assets. The liquidator then takes the judgment to the foreign courts in the jurisdiction where the assets are located and seeks the courts’ assistance to recognise and enforce the judgment. Will such a judgment be recognised and enforced?
This was, in a nutshell, the situation that confronted the UK Supreme Court in Rubin v Eurofinance SA [2013] 1 AC 236 (“Rubin”). The UK Supreme Court, applying well-entrenched English private international law rules governing the enforcement of in personam judgments, held that the default judgment against the wrongdoer could not be enforced. This was because at common law, a foreign judgment in personam could be enforced only if the judgment debtors had been present or resident in the foreign jurisdiction or if they had submitted to its jurisdiction, but neither requirement was satisfied on the facts of the case. The court also held that the UNCITRAL Model Law on Cross-Border Insolvency (“MLCBI”) (adopted under the UK Cross-Border Insolvency Regulations 2006) offered no panacea either, as the MLCBI says nothing about enforcement of judgments against third parties.
It is not certain how the Singapore courts would rule on a case which involves the same facts. The common law rules for enforcement of in personam judgments in Singapore remain fundamentally the same as the traditional English position, and that appears to be the case in India as well. That said, the Singapore courts have not shied away from departing from English law (most notably in the reformulation of the Gibbs principle in Re Pacific Andes Resources Development Ltd [2018] 5 SLR 125).
Legislation offers the clearest path forward. The UNCITRAL Model Law on Recognition and Enforcement of Insolvency-Related Judgments (“MLREIJ”) was formulated, in part, as a response to the uncertainty engendered by Rubin. The MLREIJ is intended to complement the MLCBI to further assist the conduct of cross-border insolvency proceedings.
Under the MLREIJ, avoidance judgments are among the various insolvency-related judgments that may be recognised and enforced. The MLREIJ provides more expansive grounds on which a foreign in personam judgment can be recognised and enforced compared to the traditional English law rules. Like English law, under the MLREIJ, a foreign judgment can be recognised if the judgment debtor explicitly consented or submitted to the jurisdiction of the court. However, the MLREIJ provides that it suffices if the foreign court either exercised jurisdiction on a basis on which the recognising court could have exercised jurisdiction or on a basis that was not incompatible with the law of the recognising state.
The MLREIJ provides various safeguards to protect the interests of the recognising state. This includes a public policy exception under which the recognising court may refuse to take action if doing so would be manifestly contrary to the public policy of the state, and the discretion to refuse recognition and enforcement if the judgment is inconsistent with a judgment of the recognising state in a dispute involving the same parties.
The MLREIJ is likely to represent the next step in the evolution of cross-border insolvency and will help to establish an effective international regime for the enforcement of avoidance judgments.
Conclusion
We conclude by borrowing a quote used in Dr. Sahoo’s introductory message in the IBBI’s 2021 report, Quinquennial of Insolvency and Bankruptcy Code, 2016: “It does not matter how slowly you go as long as you do not stop.” This message rings equally true in Singapore. Despite substantial reforms having been made, there are areas for refinement and improvement.
India and Singapore have embarked on parallel paths in recent years to revamp and revitalise their restructuring and insolvency regimes. In time, those paths may intersect as laws in the region harmonise and converge.
*This post summarises a chapter contributed by the author in “Insolvency: Now & Beyond - A Thought Leadership Document On Insolvency Regime” jointly published by the Insolvency and Bankruptcy Board of India (IBBI) and the Foreign Commonwealth Development Office of the United Kingdom. The full publication can be found here.