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.
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 a ‘reckless decision’ that ultimately harms the creditors. Finally, some countries also require that the directors take into account the interests of the creditors even if the company is solvent.
My paper starts by analysing the features, advantages and weaknesses of the primary regulatory models of directors’ duties in the zone of insolvency. It concludes that none of them is necessarily more desirable. Instead, 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.
First, in countries with many micro and small enterprises (MSMEs) as well as large controlled firms, as it happens in most countries around the world, 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. Examples of these forms of behaviour not only include when directors ‘gamble for resurrection’ (a hypothesis increasingly challenged by the empirical literature) but also a variety of economic and behavioural factors, including what Amit Licht has referred to as ‘escalation of commitment’. In one way or another, the truth is that creditors of MSMEs and large controlled firms are exposed to a higher risk of shareholder opportunism in the zone of insolvency. For this reason, a more interventionist approach, such as a duty to initiate insolvency proceedings, might be needed in countries with a significant number of these firms. By contrast, in countries like the United States and the United Kingdom, 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, a duty to maximise the value of the company or to take steps to minimise potential losses for the creditors will be more desirable. In principle, in companies with dispersed ownership structures, the directors will be less influenced by the shareholders. Hence, by being in a better position to preserve their independence, directors 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.
Second, 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 comprising 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.
Third, 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. By contrast, in countries with less experienced courts, as it is usually the case in many emerging markets and some advanced economies, this discretion should be reduced and 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.
Fourth, in many countries, the insolvency framework is not very efficient. Therefore, since the initiation of insolvency proceedings can be value destructive for both debtors and creditors, a duty to initiate insolvency proceedings may do more harm than good. As a result, these countries should adopt another model of directors’ duties in the zone of insolvency.
Fifth, in countries without developed financial systems, adopting a solution that does not credibly solve the risk of shareholder opportunism in the zone of insolvency can exacerbate the problems that many firms face to obtain credit even when they are solvent. As a result, by addressing the problem of shareholder opportunism in a more credible manner, the duty to initiate insolvency proceedings can serve as a more powerful mechanism to promote firms’ access to debt finance.
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 (eg, MSMEs, large controlled firms, etc). For this reason, my paper argues that different regulatory approaches may be required for different types of firms.
A modified version of this post was published on the Singapore Global Restructuring Initiative Blog.
Aurelio Gurrea-Martínez is an Assistant Professor of Law and Head of the Singapore Global Restructuring Initiative at Singapore Management University.