The director's duty to take into

account the interests of company

creditors

PRESENTED BY :
FARHAN RIYAZ KHAN
 The director's duty to take into account the interests of company creditors: when is it triggered?

• Since the comments of Mason J in Walker v Wimborne, a strong line of judicial opinion has developed whereby in
certain circumstances it is mandatory for directors, in discharging their duties to their companies, to take into
account the interests of their companies' creditors. But there is uncertainty as to what the actual circumstances
are that will lead to directors being required to do this. It is a well-established principle in company law that
directors owe duties to their companies as a whole but not to any individual members or other persons, such as
creditors; in fact directors would be acting beyond the scope of their powers if they acted for the benefit of
creditors. Yet, by way of exception to this principle, and to the principle established in Salomon v Salomon, it has
been held in a significant number of cases that in certain circumstances it is mandatory for directors, in
discharging their duties to their companies, to take into account the interests of their companies' creditors.
However, this exception is ill-defined for there is a distinct lack of judicial unanimity as to the actual circumstances
which will cause directors to have to consider creditors' interests. The lack of precision in delineating the point at
which directors are to have regard for creditor interests, and may potentially become liable, is highly
unsatisfactory. While acknowledging the fact that establishing guidelines in this area of the law is not easy, it is
submitted that directors in undertaking their decision-making need to be guided by consistent and clear principles
so that they know the ground rules and at what point in time, if at all, they are subject to this duty. As a matter of
legal certainty and fairness, lines have to be drawn so that directors can be confident that when they act they are
taking into account the appropriate interests and that their action is safe from attack. If directors are unable to
ascertain, with a fair degree of certainty, what they can do and when they are potentially liable, then, from an
academic viewpoint, the law is unjust, and, from a practical perspective, directors will nearly always take the
safest option in order to prevent any possible lawsuits. In doing this, directors are likely to act defensively and
make decisions not on the basis of what is best for the company, but of what will avoid liability.
 THE RATIONALE FOR THE DUTY

• the predominant amount of case law in many jurisdictions has taken the view that if a company is in various
states of financial difficulty the creditors warrant some special consideration. Certainly if the company is
insolvent, in the vicinity of solvency or embarking on a venture which it cannot sustain without relying totally
on creditor funds, `the interests of the company are in reality the interests of existing creditors alone.' At this
time, because the company is effectively trading with the creditors' money, the creditors may be seen as the
major stakeholders in the company. The creditors are protected only by contractual rights, but when
companies are financially stressed perhaps it is only fair that their position warrants some form of fiduciary
protection, whereby the directors become accountable principally to the creditors. Unless this occurs, then
the directors have every reason, at this time, to engage in risky ventures that could bring in substantial
benefits, but could, if they fail, imperil the company. The shareholders have little or nothing to lose by such a
gamble as they have already lost the money that they invested in the company and they cannot be pursued
by creditors because of the concept of limited liability. A venture, however risky, could conceivably turn the
company around and provide the shareholders with some return, but such action, if it failed, would see the
creditors suffer an even greater loss as they would be the ones to lose out if the company collapsed. So, while
the doctrine of limited liability shifts the risk of failure from the shareholders to the creditors, the duty to
take account of creditors' interests seeks to mitigate the shift. Breach of the duty is usually claimed when the
company is in liquidation and the duty is a way of compensating unsecured creditors for whom liquidation is
frequently perceived as an empty formality. While most jurisprudence sees debtors as the weaker party in
the lending situation, the fact of the matter is that when a company is in financial distress it is the creditors
who often occupy a position of weakness.
 DEVELOPMENT OF THE DUTY
• The duty to creditors is seen as having its genesis in the leading judgment delivered by Mason J in Walker v
Wimborne. His Honour said:

• “ In this respect it should be emphasised that the directors of a company in discharging their duty to the
company must take account of the interest 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.”

• While his Honour's statement may have been of a rather casual nature, the impact of the dictum is not to be
diminished as it has been either acknowledged or eagerly taken up by many other courts . By the 1980s, the
idea of directors owing some duty to take into account the interests of creditors had been regarded as
providing a real protection for creditors of companies. Notwithstanding the robust criticisms of the duty, or
aspects of it, by some leading academic commentators, and the rather ambiguous remarks of Hayne JA in the
Victorian Court of Appeal decision in Fitzroy Football Club Ltd v Bondborough Pty Ltd concerning the
existence of the duty, the duty has been referred to and applied in recent cases in jurisdictions which have
traditionally embraced it,as well as being accepted for the first time in an appellate court in the Republic of
Ireland.Only last year the High Court in Spies v The Queen,in obiter comments, implicitly acknowledged the
existence of the duty. So, while there remain misgivings concerning the time from which it operates, the duty
has been supported widely as an important protection for creditors in certain circumstances.
• The courts have, in general, preferred to found the duty on a traditional basis in that they have said that the duty
is owed to the company to take into account the interests of creditors, that is the duty is mediated through the
company, rather than holding that the directors owe a duty directly to the creditors.Nonetheless there have been
some who have taken the view that directors should owe a duty to creditors directly. It has been pointed out that
Mason J in Walker v Wimborne did not exclude a direct duty to creditors, and one can perhaps read the
judgments of Lord Templeman in Winkworth v Edward Baron Development Co Ltd and the Full Court of the
Supreme Court of Western Australia in Jeffree v National Companies and Securities Commission as providing
some support for an independent duty being owed to creditors. However, recent judicial comments are set
against such a duty. First, Gaudron, McHugh, Gummow and Hayne JJ of the High Court in a joint judgment in
Spies v The Queen said by way of obiter that `it is extremely doubtful whether Mason J intended to suggest that
directors owe an independent duty directly to creditors.' Second, in the English case of Yukong Lines Ltd of
Korea v Rendsburg Investments Corporation, Toulson J clearly rejected the notion of a direct duty being owed to
creditors. However, there are indications in the United States, which has seen different avenues being followed in
the development of its law in the area, that, while no duty is extended to creditors in general, there is a direct
duty owed in certain limited circumstances, such as when the company is insolvent.
• An important point to note is that hitherto all of the cases where a director has been found to be in breach of the
duty have involved closely-held companies in which the director is also a shareholder. Directors in these sorts of
companies are more likely to be the subject of attack as it is in their interests as shareholders to take on risky
ventures. Perhaps in cases involving larger companies, courts might be more reluctant to impose the duty. This
remains to be seen.
 THE TRIGGER FOR THE DUTY: The issues and problems surrounding the points in time at which courts have found that the duty arises.

1. Insolvency :
It is almost non-contentious to say that directors have a duty to take account of the interests
of creditors when the company is insolvent. While Mason J in Walker v Wimborne did not
limit the duty to cases of insolvency or even of financial distress, several of the cases in the
1980s introduced insolvency as a requirement. A majority of the High Court in Spies v The
Queen approved of the comments of Gummow J in Re New Worm Alliance Pty Ltd when
his Honour said that insolvency created a duty to creditors.
Certainly it is possible to say that when insolvency exists the notions of corporate ownership
and creditors' rights converge. The creditors then are the real owners of the company, the
ownership rights of the shareholders having been expunged as there is nothing over which
they have a claim. Hence, if a company is insolvent, directors act improperly if they employ
funds that are payable to creditors in order to continue the activities of the company.
If the trigger for the liability of directors to creditors is insolvency, one major problem is:
what definition of insolvency applies? Some have said that insolvency is a broad and
ambiguous term, while others have focused on the indefinite nature of the concept.
 TEST FOR INSOLVENCY
IN AUSTRALIA
• In the Corporations Act 2001 (Cth) there is a definition,
albeit a little convoluted. Section 95A provides that `[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.' This is followed in s 95 with the rather
redundant statement that `[a] person who is not solvent is
insolvent.‘
• This section provides for commercial or, as it is more
frequently known, cashflow insolvency. It is clear that the
test is not without its problems. The main difficulties with
the cash-flow test have been said to be that it is vague in
meaning, and the decision as to whether a company, on a
particular day, is insolvent is often a difficult and imprecise
one.While these comments continue to hold some water,
it is fair to say that in recent years, especially in Australia,
there has been greater certainty in assessing whether or
not a company is insolvent (on the cash-flow basis) at a
particular point of time.
IN UK
• The United Kingdom also provides in its
insolvency legislation for a definition. For
instance, in relation to preferences and
transactions at an undervalue, insolvency
means either cash-flow or balance-sheet
insolvency.Hence, in Yukong Lines Ltd of
Korea v Rendsburg Investments
Corporation, Toulson J applied the balance
sheet test and said that in the case before
him there was a clear breach of duty
because the liability to a creditor was well
in excess of the company's assets.
• In the United States, the balance-sheet test
is invoked.
 CRITICISMS
Professor Len Sealy raises, in his attack on the use of insolvency as the trigger for the advent of the duty, the fact that a company may move
in and out of insolvency as its fortunes fluctuate, and that the duties of directors should be evaluated from a broad perspective and not on
the basis of technicalities. Undoubtedly the riposte to this view is that, if a company does move in and out of insolvency, obviously indicating
that it is highly unstable from a financial point of view, then it is exactly the type of company whose affairs should be run with consideration
for the creditors' interests; it is likely to collapse without much warning. In fact, the point Professor Sealy makes may well be a good reason
for having a less definite point at which the duty is triggered. Professor Ross Grantham has similarly commented that:

[I]nsolvency is the most obvious indication that the residual risk is no

longer borne by the shareholders. Thus the question posed by the court is
not simply whether the company is insolvent, but that given the
distribution of risk does it continue to be appropriate to regard the
interests of shareholders as exclusively erecting the corporate interest.

Another important point to note is that insolvency rarely occurs overnight, save where there are events like the share collapse in October
1987, and where there are telltale signs of a company's demise well before the point that technical insolvency occurs.
If the trigger for the duty to creditors is insolvency, should the duty apply strictly or only when it is, or should have been, clear to the
directors that the company is insolvent? In Liquidator of West Mercia Safetywear Ltd v Dodd, Dillon LJ found against the director who was
being pursued for breach of duty because that director knew that his company was insolvent when he gave a preference payment to a
related company. While his Lordship did not specify knowledge of insolvency as a prerequisite for the duty to arise, it is worth considering
whether knowledge should be taken into account.
There are two concerns that may be voiced in relation to the identification of insolvency as the trigger-point for the duty. First, there is the
problem of establishing insolvency, which is encountered by liquidators pursuing directors for breach of duty. Proving insolvency is not
infrequently onerous, and consequently this may mean that directors are being given the benefit of the doubt. Second, a goal of creditors
usually is the avoidance of insolvency, so the point when the company becomes insolvent is too late for the duty to creditors to arise.
 2. Near or in the Vicinity of Insolvency
A majority of the High Court in Spies v The Queen approved of the comments of Gummow J in Re New World
Alliance Pty Ltd, when his Honour said that if a company is nearing insolvency directors have a duty to creditors.
In New Zealand in Permakraft, Cooke J included near insolvency, along with insolvency or doubtful solvency, as
the trigger for the imposition on directors of a duty to creditors. But perhaps the most important developments
in this regard have occurred in the United States and particularly in Credit Lyonnais Bank Nederlander NV v Pathe
Communications Corporation. In this case, Chancellor Allen of the Delaware Court of Chancery stated that `At
least where a corporation is operating in the vicinity of insolvency, a board of directors is not merely the agent of
the residual risk bearers [the shareholders], but owes its duty to the corporate enterprise.' The corporate
enterprise to which the learned judge refers clearly comprises both shareholders and creditors.

While Chancellor Allen failed to explain exactly what he meant by `in the vicinity of insolvency', he seemed to be
suggesting that the duty to creditors arises when the company is nearing insolvency. This requirement means
that, if a company is in the vicinity of insolvency, directors should take stock of the company's position to
ascertain whether the company will remain solvent after the action which is contemplated.

Although insolvency may suffer from imprecision, prescribing the triggering of the duty when the company is
near to insolvency suffers even more from that problem, for it is impossible in many situations to say from what
point a company is nearing insolvency, except where one is viewing the company's dealings ex post facto.
 3. Doubtful Solvency

• While some commentators have been concerned about prescribing insolvency as

the trigger for the duty to creditors because, inter alia, the company may move in
and out of technical insolvency and the directors may not be aware of the
company's insolvent state, providing that doubtful solvency is the trigger allows
for more leeway for liquidators in proving cases and means that directors do not
have to ascertain whether their companies are in fact insolvent. Several cases
have held that directors may be under a duty when doubtful solvency exists.
• The argument that may be levelled at doubtful solvency as the trigger-point is
that it is also imprecise. Unlike insolvency, which is now defined in the insolvency
legislation of most common law countries, there is no definition of doubtful
solvency. Who must doubt the solvency of the company? Directors could
probably ascertain when the solvency of their company is doubtful more easily
than when insolvency has occurred. Insolvency occurs at one point. Doubtful
solvency is broader. Yet, as with `near insolvency', from what point is a court
going to say that a company was doubtfully solvent?
 4. Risk of Insolvency
Moving further away from the point of insolvency, some cases suggest either expressly or implicitly that directors have a duty to
creditors once there is a risk of insolvency. For instance, Cooke J in Permakraft stated that directors owed a duty where a
`contemplated payment or other course of action would jeopardise solvency.' In Liquidator of West Mercia Safetywear Ltd v
Dodd, Dillon LJ referred to his earlier judgment in Multinational Gas, a case in which the Court of Appeal rejected the argument
that the directors owed a duty to take into account creditors' interests after the directors made a bad decision and this led to the
company becoming insolvent. His Lordship said that the reason for his decision in that case was the fact that the company was
amply solvent and the decision of the directors was made in good faith. His Lordship implied in Liquidator of West Mercia
Safetywear Ltd v Dodd that, if the company in Multinational Gas had not been amply solvent, and there was a risk of insolvency
as a result of the directors' decision, then he would have held there to have been a duty. The same approach has been employed
in relation to the avoidance of preferences in England. In Katz v McNally, the Court of Appeal upheld the reasoning of the judge
at first instance that it was not necessary for it to be established that the directors knew that the company was insolvent when
giving a preferential payment before the payment could be avoided under the Insolvency Act 1986 (UK) c 45; it was enough that
the directors knew that there was a real risk of insolvency if they made the payment.
 
Taking up what Cooke J said in Permakraft, one is moved to ask whether the directors must know either that there is a risk of
insolvency or that the action could lead to insolvency. Again, as with the case where insolvency is the trigger, requiring
knowledge is leaving the creditors too exposed. Such a requirement could too easily favour the indigent director who has not
sought to apprise himself or herself of the state of the company's affairs and, as a result, did not know that there was a risk of
the company becoming insolvent. Consequently, in addition to prescribing knowledge of the risk of insolvency, an objective test
has to be employed. Therefore, the trigger for the duty would be either where the directors knew of the risk of insolvency, or
where they ought to have known of the risk of insolvency or that one of the reasonably expected consequences of their action
could be insolvency.
 5. Financial Instability

• Other cases have not sought to identify with any precision

how close to insolvency the company must be before the
duty arises. They have been content to say that the
company must be in a dangerous financial position or
financially unstable. These phrases can mean a number of
things and can be regarded as indefinite, but it is fair to
say that for the most part, from a financial economist's
viewpoint, they mean that the company is facing
insolvency, and this appears to have been the meaning
given in the cases. Therefore, the trigger point is probably
close to `doubtful solvency' or a `risk of insolvency'.
 AN ASSESSMENT
• Perhaps the first thing to note is that the preponderance of authority favours the
view that a duty to take into account the interests of creditors does not arise
where a company is clearly solvent. But there is a significant amount of judicial
opinion that supports the view that the duty is triggered before a company
actually becomes technically insolvent. That said, it is plain, as indicated at the
outset, that, while there is significant agreement amongst judges both on the
need for a duty to creditors and the fact that the duty should not arise until the
company is suffering some degree of financial difficulty, there is no unanimity on
the question of when the duty is triggered.
• If the duty is imposed at one extreme of the financial spectrum, namely
insolvency, there is a significant danger that creditors will not benefit. If the duty
was to apply at the other extreme, namely when the company is clearly solvent,
then it would have the effect of unreasonably interfering with the decision-
making of directors, hamper the business of the company, and would be likely to
lead to directors being over-cautious.
• The New South Wales Court of Appeal in Linton v Telnet Pty Ltd
recognised that the time when directors should pay attention to the
interests of creditors was dependent on the facts. In Kinsela, Street CJ
said, `I hesitate 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.'

• While the comment in Linton v Telnet Pty Ltd is undoubtedly true, and
the latter comment in Kinsela understandable, some guidelines are
needed in order to be fair to directors so that they can plan and know
when they must exhibit some loyalty to creditors. Also, guidelines must
be identified if this development of the law is not to suffer further
criticism on the basis that it is imprecise and produces uncertainty.
 Factors to Be Considered
The Need for Risk-Taking
• In determining what should be the trigger for the
duty, one must take into account a number of factors.
First, undoubtedly companies need, at times, to take
risks to prosper. One can even say that without risks
being taken we would not enjoy some of the things
that we do enjoy in society today, such as the
railways. The corollary of this, certainly from a
theoretical perspective, is that one of the functions of
the directors, being the persons who manage a risk-
taking enterprise, is to engage in overseeing the very
action of risk-taking.The argument of those who
question the existence of a duty to creditors is, inter
alia, that directors are placed under greater pressure
when making decisions and the company's
development might be stifled as directors become
extremely cautious and refuse to take risks. This is
the point on which Vladimir Jelisavcic focuses when
discussing the Delaware decision of Credit Lyonnais
Bank Nederland NV v Pathe Communications Corp
An Increase in Costs
• It must be acknowledged that the existence of a duty
to creditors might, in some cases, produce an
increase in a company's costs as directors may well
have to undertake investigations to ascertain whether
their contemplated actions could precipitate
insolvency. Such investigations, it may be argued,
could occupy inordinate periods of time and perhaps
even limit the company's profitability. This might
entail, by way of protection for the directors, the
securing of more expert opinions than is normal,
undertaking copious checks, and even some
valuations of the company's assets -- all of which
would add to the company's operating costs. While
this must be seen as a cost of doing business, courts
must surely take into account the costs that are
associated with undertaking inquiries and realise that
companies' finances cannot be used for every check
possible and that directors must act quickly in some
situations.
The Need for Precision
• A third factor to consider is that concern has
been voiced about the difficulty of stating
with precision when the shift in duty is to
occur. But the law does not seem to have a
problem with requiring courts to do this in
other areas. For instance, a director is liable
for the English equivalent of insolvent
trading, wrongful trading, if he or she knew
or ought to have concluded that there was
no reasonable prospect of the company
avoiding going into insolvent liquidation.
This is imprecise, and the provision does not
set out the kind of conduct which will
constitute wrongful trading, but there has
been relatively little criticism of the test.
A Cause for Panic?
• Is the existence of a duty, when a
company is subject to financial
distress, likely to make directors
panic and place their company into
administration or even liquidation
prematurely, thereby ensuring that
all stakeholders lose out? It is
more likely that directors will take
the decision to appoint an
administrator or liquidate because
of fear of liability for insolvent
trading or liability
 MALAYSIA
Duty to act for proper purposes and in good faith

The new amendment (2007)repeals the current statutory provision on directors’

duties that requires a director to act honestly and use reasonable diligence in the
discharge of his duties in s. 132(1) of the Companies Act 1965. This is replaced by a
new s. 132(1) which requires a director to act for proper purposes and in good faith.
Although the new provision retains the statutory requirement that directors must
act in good faith in the interests of the company, it does not specify for whose
benefit the company should be managed, and whether directors can properly take
into account the interests of employees, creditors and other stakeholders. The
Malaysian High Level Finance Committee on Corporate Governance took the long
term shareholder value approach (now is more elegantly stated as the “enlightened
shareholder value”) that companies should be managed “with the ultimate
objective to enhance long term shareholder value, whilst taking into account the
interests of other stakeholders”
• In Malaysia, it should also be mentioned that the
common law position of directors’ duties to creditors is
underdeveloped and inadequate; the same extends to
creditors statutory provisions under the Companies Act
1965.Additionally, Malaysia’s corporate restructuring law
gives much room for corporate abuses which may be
used to deny creditors their rightful claims as “creditors
are kept from enforcing security for unduly long periods
by the use of temporary restraining orders, which do not
rest on sound conceptual ground or precedent”.
 THANK YOU

"Anyone who has never made a

mistake has never tried anything
new.“ Einstein