Directors’ Duties at Common Law to Consider the Interests of Creditors (2017), by Sean Gabb

Critically Examine the Difference between Directors’ Duties at Common Law
to Consider the Interests of Creditors and the Protection
Afforded by Sections 213 and 214 of the Insolvency Act 1986

Note: One of my duties in the various places where I teach is to show students how to write essays – something most young people are not nowadays taught to do. What I like to do in class is to choose a question at random, discuss possible approaches, and then dictate an answer one paragraph at a time. Some of these answers are very short. Some amount to small dissertations. In this latter case, the students take turns at looking on-line for the information we decide is needed. It they cannot find it, I show them how to change the structure of what has already been written, or to strike out in a new direction.

It is a “writing masterclass” approach that makes use of my own strengths, and is often a welcome alternative to formal teaching. It fills up a long morning session. Everyone learns something, and the more attentive will improve their final grades by at least one step.

Here is an example of the finished product. Do not take it as a statement of personal opinion. It is an answer produced for a specific question, and it bears in mind what a possibly unknown examiner will appreciate, and what can be written to incorporate the sources found in class. SIG

PS – If anyone wants to engage my services as a teacher of these skills, please click on the image to the left. Though they are my niche subjects, Greek and Latin are not my exclusive focus as a teacher. I do much else besides.

PPS – If you are a student, and you have come across this in a frantic last minute search, I advise you not to copy and paste and submit. You will be found out in three clicks of a mouse. Examiners were not born yesterday.


The main purpose of the 19th century incorporation laws was to safeguard the personal assets of company shareholders and directors if the company failed. One of the greatest business scandals of that century was the Railway Mania of the 1840s. The British railway network was largely built by private enterprise. In the 1840s, there was a great speculative bubble. This burst in 1848, leaving many thousands of small investors jointly and severally liable for the debts of the companies in which they had bought shares. The Limited Liability Act 1855[1] was passed to establish the principle that shareholders were only liable to creditors of a failed company for the unpaid portion of their shares. From this Act and others of the same kind that followed, particularly the Companies Act 1862,[2] the doctrine emerged that a limited company was an artificial person that was separate from the personality of its shareholders and directors. A company had unlimited liability for its debts and tortuous actions and breaches of contract. But the shareholders had strictly limited liability.

This doctrine of separate personality was most fully established at common law in the judgement in Salomon v Salomon.[3] The High Court held that A Salomon & Co Ltd was a façade behind which Mr Salomon had sought to defraud his business creditors. In this case, the Company was held to be Mr Salomon’s agent, and he remained personally liable for his debts. This judgement was upheld by the Court of Appeal. The incorporation was described as a “myth” and a “fiction.” Lindley LJ added:

It is idle to say that persons dealing with companies are protected by s. 43 of the Companies Act, 1862, which requires mortgages of limited companies to be registered, and entitles creditors to inspect the register. It is only when a creditor begins to fear he may not be paid that he thinks of looking at the register; and until a person is a creditor he has no right of inspection. As a matter of fact, persons do not ask to see mortgage registers before they deal with limited companies; and this is perfectly well known to every one acquainted with the actual working of the Companies Acts and the habits of business men…. [U]ntil the law is changed such attempts as these ought to be defeated whenever they are brought to light They do infinite mischief; they bring into disrepute one of the most useful statutes of modern times, by perverting its legitimate use, and by making it an instrument for cheating honest creditors.

Mr. Aron Salomon’s scheme is a device to defraud creditors.

The House of Lords disagreed. According to Lord Macnaghten,

When the memorandum is duly signed and registered, though there be only seven shares taken, the subscribers are a body corporate “capable forthwith,” to use the words of the enactment, “of exercising all the functions of an incorporated company.” Those are strong words….. I cannot understand how a body corporate thus made “capable” by statute can lose its individuality by issuing the bulk of its capital to one person, whether he be a subscriber to the memorandum or not. The company is at law a different person altogether from the subscribers to the memorandum; and, though it may be that after incorporation the business is precisely the same as it was before, and the same persons are managers, and the same hands receive the profits, the company is not in law the agent of the subscribers or trustee for them. Nor are the subscribers as members liable, in any shape or form, except to the extent and in the manner provided by the Act. That is, I think, the declared intention of the enactment. [Emphasis added]

The meaning of this case was that a limited company was regarded in law as a wholly separate entity from its shareholders. It alone was responsible for its debts. There was a “corporate veil,” behind which the persons involved in a company were hardly ever taken to exist. From this, it followed that company directors were responsible in civil law only to the shareholders of their company. Since they could not be reached by any outside person, they had no duties to the creditors of a company. If the company failed, a creditor had a cause of action against the company, not against the directors.

The problem with this approach was that it enabled companies to be formed as instruments of fraud. By the 1920s, the problem had become notorious. In 1926, the Greene Committee on Company Law Reform accepted that there were large numbers of cases “where the person in control of a company holds a floating charge and, while knowing that the company is on the verge of liquidation, ‘fills up’ his security by means of goods obtained on credit and then appoints a receiver.”[4]

The Committee recommended a change in the law, so that where, during any winding up of a company, it appeared that any business of the company had been carried on with intent to defraud its creditors, the Court should have power, on application by the liquidator or any creditor, to subject the directors responsible to unlimited personal liability for the relevant debts. This became s.275 of the Consolidated Companies Act 1929. The section imposed both civil and criminal liability. It was carried over, with some strengthening, into s.332 of the Companies Act 1948.

From now on, the duties of directors were altered in law. While a company was trading solvently, their duty was to the company for the benefit of present or future shareholder. Once it became insolvent, their duties widened to acting in the interest of the company’s creditors, in order to minimise their potential loss.

However, while a significant breach in the Salomon rule, the provision was inadequate in a number of respects. First, any civil action against a director had to be made out on the criminal burden of proof, beyond reasonable doubt.[5] Second, the applicants in any action were required to prove “actual dishonesty, involving, according to the current notions of fair trading among commercial men, real moral blame.”[6]

In Bank of India v. Morris, Lord Justice Mummery discusses the scope of civil and criminal liability for fraudulent trading in the 1929 and 1928 Acts. He notes:

Those sections combined both compensatory and penal provisions. They were naturally regarded as penal legislation and, as such, were strictly construed so as to give the person charged the benefit of the doubt.[7]

The law made civil proceedings harder than they would otherwise have been. It was possible to pierce the corporate veil in the case of gross fraud. It might, for example, have allowed Mr Salomon to be forced to recompense his defrauded relatives. But it did little in the case of less obvious frauds on the creditors of a company. It did nothing about directors who, from negligence or misplaced optimism, misrepresented the financial state of their company to actual or potential creditors.

Therefore, the problem was looked at again in the late 1970s and early 1980s. The Report of the Review Committee on Insolvency Law and Practice[8] made further recommendations. One of these was that the insolvency laws should be regarded by the courts as “an instrument in the process of debt recovery.” For this reason, the duties of directors towards the creditors of failed companies should be more strictly defined and more easily enforced.

From this Report emerged Ss.213 and 214 of the Insolvency Act 1986. These create new civil offences of fraudulent trading and wrongful trading.

S.213 provides that if, when an insolvent company is wound up, it appears that any company business has been carried on with intent to defraud its creditors, or creditors of any other person, or for any fraudulent purpose, the court may, on application by the liquidator, make the people who knowingly carried on such business liable to make such contributions to the assets of the company as may be thought proper.

s.214 provides that if, when an insolvent company is wound up, it appears that a director of the company knew or ought to have known that the company had no reasonable prospects of survival, the court may, on application by the liquidator, make that director liable to make such contributions to the assets of the company as may be thought proper – unless it can be shown that he took “every step with a view to minimising the potential loss to the company’s creditors as he ought to have.”

These are important further breaches in the common law rule that emerged from Salomon and similar cases. Because they are civil offences, they have only to be made out on the civil burden of proof, on the balance of probabilities. In particular, s.214 separates negligence from fraud. Where fraud can be established beyond a certain level, there remains a criminal sanction, contained in s.458 of the Companies Act 1985. And so it can be said, to quote Mummery LJ, that

*[c]ompensation of those who have suffered loss as a result of the fraudulent trading is the paramount purpose of the provisions imposing civil liability to contribute to the loss suffered.[9]

With regard to fraudulent trading, we can see this in Morphites v Bernasconi.[10] In this case, the directors of a company assured a landlord that the company could pay its rent. At the time, they had already decided to stop paying rent after a certain date. The High Court tore aside the corporate veil and made the directors pay the rent owed at the time they made their dishonest assurance, plus interest. They were also made to pay an equal amount to the assets of the company in its liquidation, as a punishment for their dishonesty.

With regard to wrongful trading, we can see this in Re Produce Marketing Consortium Limited.[11] In this case, the directors did not know that the company was insolvent and continued trading. The court held that the directors should have known, or should have found out, that they were trading while insolvent. The late preparation of company accounts was no excuse. The court also held that the directors had failed to take steps to minimise loss to the creditors of the company. They were ordered to contribute personally to the assets of the company in its liquidation.

The 1929 and 1948 Acts were made less effective than they would otherwise have been, because of decisions by the courts. But the 1986 Act has been clearly accepted by the House of Lords. The recognition of the existence of directors’ duties to creditors has received the endorsement of the House of Lords. In Winkworth v Edward Baron Development Co Ltd, Lord Templeman explained that directors owe a fiduciary duty to the company and its creditors, present and future, to ensure that its affairs are properly administered and to keep the company’s “property inviolate and available for the repayment of its debts.”[12]

None of this means, however, that creditors can easily enforce the duties that directors have towards them. In the first place, the new law is much more restrictive than the old as to the right of action. The 1929 and 1948 Acts allowed creditors to sue directly. The 1986 Act confines that right to a company liquidator. On this point, Anthony Reeves of Pinniger Finch & Co wrote in 2008:

From cases I am involved with there seems to be a large number of situations where creditors need a better mechanism by which they can hold directors to account if there has been wrong doing, such as “wrongful trading”. This where a company continues to trade while it is insolvent.

As the law stands at present, only the liquidator can make an application to the court for the directors to be made to contribute personally to the debts of the company. In reality, this does not happen. Rather than the creditors having to persuade the liquidator to make an application I believe that there ought to be an amendment to the Insolvency Act 1986. This would permit creditors to be able to make the application. It would require a very simple two clause Act of Parliament.[13]

Furthermore, it is in the nature of things that most companies that are wound up have no assets. When an insolvent company has no assets to fund an action, an action cannot easily be taken. Then there is the probability that the directors themselves have no assets, or have effectively concealed their assets. In that case, any action for recovery will only result in further costs of winding up. This does not effectively protect the interests of creditors.

In the second place, it still needs to be established, in the case of s.213, that there has been clear intent to defraud. There are many cases on this point. But it is worth quoting an Australian case on the general difficulty. According to Pincus JA,

[it is a] legal curiosity that after 400 years of judicial exposition of the statutes {governing bankruptcy and insolvency fraud] there remains room for argument as to the nature of the fraud which must be proved, under such provision in order to set aside a transaction.[14]

In the third case – and this applies in the case of wrongful trading – it may be that the law often harms the interests of creditors. In Re Continenal, Park J [XXX] J commented that the directors of a company in financial difficulties need to decide whether to go into liquidation or to continue in the hope that the company is in temporary difficulties. He adds:

A decision to close down will almost certainly mean that the ensuing liquidation will be an insolvent one. Apart from anything else, liquidations are expensive operations, and in addition debtors are commonly obstructive about paying their debts to a company which is in liquidation. Many creditors of the company from a time before the liquidation are likely to find that their debts do not get paid in full. They will complain bitterly that the directors shut down too soon, they will say that the directors ought to have had more courage and kept going. If they had done, so the complaining creditors would say, the company probably would have survived and all of its debts would have been paid.[15]

In conclusion, it can be said that, while the common law, as it developed from the rule in Salomon, treated creditors rather poorly, the various statutory remedies that culminate in the Insolvency Act 1986 may not in practice guarantee that the interests of creditors will be effectively protected in the event of an insolvent liquidation.

2360 words

Notes

[1] 18 & 19 Vict c 133

[2] 25 & 26 Vict. c.89

[3] Salomon v A Salomon & Co Ltd [1897] AC 22

[4] Report of the Company Law Amendment Committee, Cmmd 2697, London, 1926, p.61.

[5] Re Maidstone Buildings Ltd [1971] 1WLR 1085.

[6] Re Patrick and Lyon Ltd [1933] Ch 786.

[7] Bank of India v Morris [2005] 2 B.C.L.C. 328 CA

[8] Report of the Review Committee on Insolvency Law and Practice, Cmnd 8558, London, 1982

[9] Bank of India v Morris [2005] 2 B.C.L.C. 328 CA

[10] Morphites v Bernasconi [2001] 10 Current Law 312

[11] Re Produce Marketing Consortium Limited [1989] 5 BCC 569

[12] Winkworth v Edward Baron Development Co Ltd [1986] 1 WLR 1512

[13] Blog comment 14th September 2008 – http://www.ukbusinessforums.co.uk/forums/archive/index.php/t-79925.html

[14] World Bank Expo Park v EFG (1995) 129 ALR 685.

[15] Re Continental Assurance Company of London plc [2007] 2 BCLC 287

 

© 2017, seangabb.

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