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An Agency Cost Analysis of the Wrongful Trading Provisions: Redistribution, Perverse Incentives and the Creditors' Bargain

Published online by Cambridge University Press:  03 October 2000

Rizwaan J. Mokal
Rizwaan J. Mokal*
Affiliation:
University College London
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Abstract

Previous work on the wrongful trading provisions of the Insolvency Act 1986 (s. 214) has been content with description, or with statutory construction. This paper employs the tools of agency theory and the creditors' bargain heuristic to analyse the need for these provisions, their structure, role, and effect. It examines why those interested in the company's undertaking would demand and accept a s. 214-type duty. The analysis reveals that the duty would not be equally relevant for all types of companies, and that the influence of the market for managerial labour ensures most s. 214 actions are likely to be brought against directors of closely-held companies, and against shadow directors. The analysis, by pointing out that security plays a role similar to s. 214 itself, also justifies a recent Court of Appeal decision which precludes secured creditors from any recoveries under that section. Finally, the incentives created by the provisions for the managers of both healthy and distressed companies are examined. It is suggested that these incentives are generally socially efficient.

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Articles
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The Cambridge Law Journal , Volume 59 , Issue 2 , 29 June 2000 , pp. 335 - 369
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Copyright © Cambridge Law Journal and Contributors 2000

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Footnotes

I am very grateful to Alison Clarke for her helpful comments. Thanks are also due to Taimur Hyat for giving me his views on an early draft of this paper. Any remaining mistakes are of course my own.

References

1 Insolvency Act 1986 (hereafter, IA), s. 123.

2 The question whether this is commensurate with the aims of insolvency law is seldom asked in this jurisdiction. When asked, it is shrugged aside with the observation that security holders are merely seeking access to what in fact belongs to them. See e.g. James L.J. in Re David Lloyd & Co. (1887) 6 Ch.D. 339, 344-345. But as more thoughtful commentators have pointed out, this answer is far from satisfactory. See e.g.. Clarke, , “Security interests as property: relocating security interests within the property framework”, in Harris, (ed.), Property Problems from Genes to Pension Funds (London, 1997)Google Scholar.

3 IA, s. 239; see Re MC Bacon [1990] B.C.L.C. 325, per Millett J. (as he then was).

4 IA, s. 130(4).

5 IA, ss. 127, 128, 130(2).

6 Commentators accept that it might have other goals as well, for example, attempting to rescue the firm, and to penalise the management for acts or omissions harmful to the company and its creditors. See, e.g., Finch, , “The measures of insolvency law” (1997) 17 O.J.L.S. 227 for an overview of different visions of insolvency law, and Goode, Principles of Corporate Insolvency Law (London, 1997), 25–29Google Scholar.

7 As to the nature of these costs, see below.

8 The locus classicus is Jackson, , “Bankruptcy, nonbankruptcy entitlements, and the creditors’ bargain”, (1982) 91 Yale L.J. 857CrossRefGoogle Scholar. See also, by the same author, The Logic and Limits of Bankruptcy Law (London, 1986Google Scholar); Baird, and Jackson, , Cases, Problems and Materials on Bankruptcy (Boston, 1985)Google Scholar; Baird, and Jackson, , “Corporate reorganizations and the treatment of diverse ownership interests” (1984) 51 Univ. Chicago L.R. 97CrossRefGoogle Scholar.

9 Jackson, Bankruptcy, 16.

10 Note that involuntary creditors, e.g. victims of torts committed directly or vicariously by the insolvent, have little say in the voluntary ex ante bargain. Still, even they would presumably agree to an arrangement which maximised the value of the firm for all the claimants; see below.

11 One way that the relative value of pre-insolvency rights could be upset would be for the special insolvency law regime to create rights in some parties which did not exist under the general law; see Jackson, Bankruptcy, 22 and 93. But Jackson also cautions, in the first sentence of chapter 3 of Bankruptcy, 68, that “Bankruptcy law … should focus primarily on values, not rights.”

12 Jackson, Bankruptcy, 21.

13 In addition to non-insolvency debt-collection mechanisms.

14 See above.

15 Jackson, Bankruptcy, 22; see also, Baird, “Loss distribution, forum shopping, and bankruptcy” (1987) 54 Univ. Chicago L.R. 815, 825-826.

16 Jackson, Bankruptcy, 93.

17 Ibid.

18 Section 214.

19 See Section III, below.

20 See Section V, below.

21 To take a specific example, Cheffins, , Company Law (Oxford, 1997), 537–548Google Scholar, argues that a section 214-type duty would not be offered and accepted by the interested parties in a hypothetical bargain.

22 Cheffins, 603-604.

23 See e.g. Re Barings plc and others (No. 5); Secretary of State for Trade and Industry v. Baker and others (No. 5) [1999] 1 B.C.L.C. 433.

24 IA, s. 214(5); see e.g. Re Brian D Pierson (Contractors) Ltd. [1999] B.C.C. 26.

25 IA, s. 251.

26 As to shadows, see Section IV, below.

27 Report of the Review Committee on Insolvency Law and Practice (Cmnd 8558, 1982), hereafter, the Cork Report, ch. 44.

28 See Oditah, “Wrongful Trading” [1990] L.M.C.L.Q. 205, 206.

29 Ibid.; see Re Patrick & Lyon Ltd. [1933] Ch. 786. But as Prentice points out, the courts shifted their position after the publication of the Cork Report, rejecting the so-called “sunshine doctrine” and making it somewhat easier to prove fraud; see “Creditor's interests and director's duties” (1990) 10 O.J.L.S. 265, 265 fn. 5.

30 Cork Report, paras. 1781-1806.

31 A Revised Framework for Insolvency Law (Cmnd 9175, 1984).

32 This weakening of the proposals has been criticised; see, e.g., Williams and McGee, “Curbing unfit directors”, Insolvency Lawyer, Feb 1993, 5.

33 Including shadow directors; see IA, s. 251.

34 The term appears, not in the section itself, but only in the marginal notes. It is in this potentially significant way that the section is wider than Cork's proposals; the debtor need not be trading for its directors to be rendered liable under section 214.

35 See text accompanying fns. 15-17, above.

36 [1998] Ch. 170; pet diss [1997] 1 W.L.R. 1197 (HL).

37 By IA, Sch. 4, para. 6.

38 Re Oasis, above, 177H.

39 Ibid., 181D.

40 Ibid., 181G.

41 Ibid., 181F.

42 Piercy v. S Mills & Co. [1920] Ch. 77; Hogg v. Cramphorn Ltd. [1967] Ch. 254. The statement in the text must be qualified; section 309 of the Companies Act 1985 imposes a subsidiary obligation on directors to have regard to the interests of the company's employees.

43 For examples, see Rackham v. Peek Foods Ltd. [1990] B.C.L.C. 895.

44 Baird, , “The initiation problem in bankruptcy” (1991) 11 International Review of Law and Economics 223, 228–229CrossRefGoogle Scholar.

45 Kinsela v. Russell Kinsela Property Ltd. (in liq.) (1986) 4 N.S.W.L.R. 722, 730, per Street C.J.; quoted with approval by Dillon L.J. in West Mercia Safetywear Ltd. (in liq.) v. Dodd and another [1988] B.C.L.C. 250, 252-253.

46 Oditah considers a similar argument in “Wrongful trading” [1990] L.M.C.L.Q. 205, 217-218.

47 [1998] Ch. 170, above.

48 See also Re Howard Holdings Inc. [1998] B.C.C. 549, 554G.

49 See e.g. Framework, above, para. 12; Goode, Insolvency, 472-473.

50 Davies, , “Directors’ fiduciary duties and individual shareholders”, in McKendrick, (ed.), Commercial Aspects of Trusts and Fiduciary Obligations (Oxford, 1992), 87Google Scholar.

51 See also the decision of the House of Lords in Winkworth v. Edward Baron Development Company Ltd. [1986] 1 W.L.R. 1512, 1516F, which creates complications more apparent than real for the argument here.

52 That section 214 pierces the corporate veil has been recognised both judicially and academically. For example, see Yukong Lines Ltd. of Korea v. Rendsburg Investments Corp. of Liberia and Others (No. 2) [1998] 1 W.L.R. 294, 306-A, per Toulson J. quoting Lord Cooke delivering the 1997 Hamlyn lecture, and Williams and McGee, “Unfit directors”, 5.

53 This does no more than re-state the basic nature of the shareholders’ claims, while focusing on the fact that a firm is essentially a voluntary nexus of various contractual rights. Note that whatever lawyers may think, there is no inherent fundamental economic difference between debt and equity claims. Both sorts of claimant contribute to the firm's assets, and both bear some degree of risk. See the seminal work by Modigliani and Miller, “The cost of capital, corporate finance and the theory of investment” (1958) 48 American Economic Review 261.

54 Most relevant here is Jensen and Meckling, “Theory of the firm: managerial behavior, agency costs and ownership structure” (1976) 3 J. Financial Economics 305.

55 Pindyck, and Rubinfeld, , Microeconomics, (New Jersey, 1998) (4th ed.), at 632Google Scholar. See also Jensen and Meckling, “Theory”, at 308.

56 Jensen and Meckling, “Theory”, at 308.

57 This is because “the cost of full enforcement of [monitoring and bonding] contracts exceeds the benefits”; see Fama and Jensen, “Agency problems and residual claims” (1983) 26 Journal of Law and Economics 327, at 327.

58 Jensen and Meckling, “Theory”, at 308.

59 The assumption is reasonable, obviously for managers of closely-held firms, but to a degree, even for those of publicly-held ones. See Cheffins, 522: “In public companies, this alignment [of shareholder and manager interests] can occur because of a combination of contractual terms (e.g., managerial remuneration packages) and market factors (e.g., the market for corporate control)” [footnote omitted]. But of course it should never be forgotten that rational managers would actually seek to maximise their own utility, and this creates conflicts (i.e. agency costs) between them and shareholders. So the assumption made in the text here is relaxed in the next Section, when the differences between openly- and closely-held firms is considered, and in the final Section of this paper, where the incentives created by section 214 are examined.

60 Scott, “Relational theory”, at 624.

61 For an overview, see Drukarczyk, , “Secured debt, bankruptcy, and the creditors’ bargain model” (1991) 11 International Review of Law and Economics 203, 205-207CrossRefGoogle Scholar and Scott, “Relational theory”, 919-921.

62 Adler, , “An equity-agency solution to the bankruptcy-priority puzzle” (1993) 22 J. Legal Studies 73, 82CrossRefGoogle Scholar.

63 Ibid., at 80.

64 Drukarczyk, “Secured debt”, at 206-207.

65 Other types of agency costs include asset conversion and under-investment; ibid.

66 For a formal proof, see Jensen and Meckling, “Theory”, 338-339.

67 IA, s. 214 (3) reverses the burden of proof, requiring managers to demonstrate they took “every step” they ought to have taken (s 214 (4)) to minimise potential loss to creditors.

68 Jensen and Meckling, “Theory”, 325-326 and 338.

69 Scott, “Relational theory”, 927-928.

70 The ground-breaking work on this point is Fama, , “Agency problems and the theory of the firm” (1980) 88 J. Political Economy 288CrossRefGoogle Scholar.

71 Ibid., 292.

72 Ibid.

73 Ibid., 297-298.

74 Daniels, , “Must boards go overboard?” (1994-5) 24 Canadian Business Law Journal 229, 241Google Scholar fn. 43, quoting Shleifer, and Summers, , “Breach of trust in hostile takeovers” in Auerbach, (ed.), Corporate Takeovers (Chicago, 1988), at 40Google Scholar.

75 Daniels, “Boards”, 241.

76 Or a lower return on their shares in the firm; see below on closely-held companies.

77 Generally on closely-held companies, see Easterbrook, and Fischel, , “Close corporations and agency costs” (1986) 38 Stanford L.R. 271CrossRefGoogle Scholar.

78 Ibid., 273; Farrar, et al., Farrar's Company Law (London, 1998), 519Google Scholar.

79 Easterbrook and Fischel, “Close corporations”, 276.

80 Jackson and Scott, “Bankruptcy”, 174.

81 IA, s. 251.

82 See Bhattacharyya, , “Shadow directors and wrongful trading revisited” (1995) Company Lawyer, 16(10), 313Google Scholar.

83 Farrar, 518-519; Carsberg, et al., Small Company Financial Reporting (Englewood Cliffs, 1985) at 79Google Scholar.

84 The brackets following the case citation indicate the proportion of the issued shares of the company held by the relevant director, where this information is available or can be surmised from the facts: Re Brian D Pierson (Contractors) Ltd. [1999] B.C.C. 26 (H and W between them held 100%); Re Fairmont Tours (Yorkshire) Ltd. (unreported) noted in Insolvency Litigation and Practice, July 1996, 12 (100%); Re Purpoint Ltd. [1991] B.C.L.C. 491 (100%); Re DKG Contractors Ltd.; Lewis v. DKG Contractors Ltd. [1990] B.C.C. 903 (98%); Re Produce Marketing Consortium Ltd. (No. 2) [1989] B.C.L.C. 520 (50%).

85 Re TLL, Secretary of State for Trade and Industry v. Collins and others (Ch. D, 27 November 1998) (Transcript) (5%, plus an option for another 5%); Re Leading Guides International Ltd. (in liq.) [1998] 1 B.C.L.C. 620 (100%); Re Sykes (Butchers) Ltd. (in liq.); Secretary of State for Trade and Industry v. Richardson and another [1998] 1 B.C.L.C. 110 (at least 20% of one relevant company by director against whom the application to disqualify succeeded); Secretary of State for Trade and Industry v. Laing and others [1996] 2 B.C.L.C. 324 (the disqualified de jure director held at least 51% shares at all material times); Re Living Images Ltd. [1996] 1 B.C.L.C. 348 (99%); Re Keypack Homecare Ltd. [1987] B.C.L.C. 409 (unclear, but seems to be closely-held); International Westminster Bank plc v. Okeanos Maritime Corporation [1987] 3 All E.R. 137 (again unclear, but again, seems to be closely-held).

86 Secretary of State for Trade and Industry v. Blake and others [1997] 1 B.C.L.C. 728 (seems closely-held); Re Grayan Building Services Ltd. (in liq.) [1995] Ch. 241 CA, [1995] B.C.C. 554 HL (100%); Re Farmizer (Products) Ltd.', Moore and another v. Gadd and another [1997] 1 B.C.L.C. 589 (CA), [1995] 2 B.C.L.C. 462 (HC) (100%); Re MC Bacon Ltd. [1991] Ch. 127 (again, seems closely-held); Re Sykes (Butchers) Ltd. (in liq.); Secretary of State for Trade and Industry v. Richardson and another [1998] 1 B.C.L.C. 110 (80% by director against whom the application to disqualify failed); Ward (liquidator of Span Technology Ltd.) v. Sellors and others (CA, 27 October 1997) (Transcript) (100%); Re Sherborne Associates Ltd. [1995] B.C.C. 40 (36%, 36%, and 3% of the initial shares issued).

87 Burgoine and another v. Waltham Forest London Council and another (Transcript), 95 L.G.R. 520, The Times, 7 Nov. 1996 (The Council here was clearly a shadow director, as well as owning 50% shares in the company); Re Oasis [1998] Ch. 170 (very inadequate information on the subject, but some directors were shadows); Re Hydrodam (Corby) Ltd. [1994] 2 B.C.L.C. 180 (on the facts, claim against the parent company as shadow failed); Re Latreefers Inc., Stocznia Gdanska SA v. Latreefers Inc. [1999] 1 B.C.L.C. 271 (Court thought a section 214 claim might exist); Re a Company (No. 005009 of 1987), ex p. Cropp and another [1989] B.C.L.C. 13; International Westminster Bank plc v. Okeanos Maritime Corporation [1987] 3 All E.R. 137 (seems shadows were involved); Secretary of State for Trade and Industry v. Laing and others [1996] 2 B.C.L.C. 324 (held that directors of the company which had abortively tried to purchase the now-insolvent firm were not shadows); Re PFTZM Lid [1995] 2 B.C.L.C. 354 (Bank was major creditor of closely-held company; its officers were held not to be the insolvent company's shadows).

88 Hughes and another v. Beckett and others (CA, 6 April 1998) (Transcript) ( public company, but no information as to whether any director had substantial shareholdings, or whether a shadow was involved); R v. Millard (CA Criminal Division) (unreported) noted in [1994] Crim. L.R. 146 (conviction for fraudulent trading; issue was length of disqualification).

89 Re Chancery plc [1991] B.C.L.C. 712.

90 The one exception is Re Howard Holdings Inc.; Norton Coles and Others v. Thompson [1998] B.C.C. 549. An interesting feature of this case is the fact that, while the three directors subject to the present claim were not shareholders of the company or shadows, neither did they exercise any real control over the company's affairs. The company's management was actually undertaken by E, who was either a de facto or a shadow director (550F; Millett J's dictum in Re Hydorodam [1994] 2 B.C.L.C. 180 emphasising the mutual exclusivity of the two relationships is duly noted here, but there is not sufficient information to ascertain which label better describes E's position). Proceedings against the three nominal directors seem to have been initiated because E had been adjudged bankrupt, and his whereabouts were uncertain (551E).

91 Discussion here has been restricted to directors of closely-held firms and shadows. But the prediction generated by the agency analysis of the wrongful trading provisions applies wherever the labour market's influence is weak. This is truer for older directors than younger ones, and for non-executive directors who are not professional managers than career managers, etc.

92 See e.g. Jackson, and Kronman, , “Secured financing and priorities among creditors”, (1979) 88 Yale L.J. 1143CrossRefGoogle Scholar; Levmore, , “Monitors and freeriders in commercial and corporate settings”, (1982) 92 Yale L.J. 49CrossRefGoogle Scholar; Scott, “Relational theory” (1986); Drukarczyk, “Secured debt” (1991); Adler, “Equity-agency” (1993); LoPucki, , “The unsecured creditor's bargain” (1994) 80 Virginia L.R. 1887CrossRefGoogle Scholar.

93 For a persuasive argument and evidence that “new money” secured credit has benefits for secured and unsecured creditors, see Schwarcz, , “The easy case for the priority of secured claims in bankruptcy” (1992) 47 Duke L.J. 425CrossRefGoogle Scholar.

94 See e.g. Adler, “Equity-agency”, at 77.

95 Ibid., 78 and 82. Of course the debtor can still do so, but only with the secured creditor's consent.

96 Scott, “Relational theory”, 927-928.

97 [1998] Ch. 170, 181A-185H.

98 This question is posed by Cheffins, 547, as a possible objection to viewing section 214 as mirroring the agreement interested parties themselves would strike.

99 Re MC Bacon [1990] B.C.L.C. 325. The debtor's desire to prefer would be obvious from the actions of its managers in having contracted ex ante to do so.

100 Companies Act 1985, s. 14; Bratton Seymour Service Co. Ltd. v. Oxborough [1992] B.C.L.C. 693, CA.

101 Eley v. Positive Government Security Life Association (1876) 1 Ex.D. 88.

102 Hickman v. Kent or Romney Marsh Sheep-Breeders’ Association [1915] 1 Ch. 881; Beattie v. Beattie [1938] Ch. 708; see generally Farrar, 118-124.

103 Cheffins, 547, also points out that lenders do not usually seek such protection when dealing with public companies. Adopting the analysis in this Section, this is easy to understand: contractual protection against eve-of-insolvency misbehaviour by managers of publicly-held companies is generally superfluous because of the stronger influence of the market for managerial labour.

104 Adopted with some modification from White's insightful modelling of bankruptcy costs in “The costs of corporate bankruptcy: a US-European comparison” in Bhandari, and Weiss, (eds.), Corporate Bankruptcy (New York, 1996), 467CrossRefGoogle Scholar.

105 Aghion, et al., “The economics of bankruptcy reform” (1992) 8 J. Law, Economics, & Organization 523, 531 (footnote omitted)Google Scholar.

106 See generally Pindyck and Rubinfeld, Microeconomics, ch. 5.

107 White, “Costs”, at 481, citing Jensen, and Murphy, , “Performance pay and top-management incentives” (1990) 2 J. Political Economy 225CrossRefGoogle Scholar.

108 White, “Costs”, at 481.

109 Ibid., fn. 36.

110 The use of the word “penal” in relation to section 214 in this paper should be taken to mean no more than that it compensates the insolvent company's creditors for a particular category of loss at the expense of its managers. But see the text later in this sub-section as to the primary role of the provision.

111 Section 214(3).

112 Section 214(4).

113 White, “Costs”, 467; see also 496.

114 Ibid., 491.

115 Criticism on this basis has come for example from Cheffins, 545, and the sources cited therein (fn 269).

116 The ratio of recoveries to claims should rise as knowledge of the section and the duties it imposes becomes more widespread.

117 See e.g. Baird, “Initiation”, 223, and Williams and McGee, “Unfit directors”.

118 For the view that lack of litigation under the section might be undermining its ability to influence manager behaviour, see Cheffins, 545.

119 See Section I, above.

120 White, “Costs”, 485.

121 Subject to the remarks about risk aversion, above.

122 White, “Costs”, 485. As has already been noted, firms might be distressed for industry- and economy-wide reasons and not because of any management shortcoming.

123 Ibid., 486.

124 Ibid.

125 That is, the excess in the firm's value, had its resources been applied to U2, over the value of the firm with its resources sunk in U1.

126 Ibid., 487.

127 Because it punishes directors for their acts or omissions by making them personally liable for the resulting harm to creditors.

128 Re Produce Marketing Consortium Ltd. (No. 2) [1989] 5 B.C.C. 569, 597.

129 Re Oasis [1998] Ch. 170, 181G.

130 Section IV, above.

131 White labels these as Type-II costs; ibid., at 489.

132 Sealy, and Milman, , Annotated Guide to the 1986 Insolvency Legislation (Bicester, 1987), 223Google Scholar.

133 Finch, , “Directors’ duties: insolvency and the unsecured creditor”, in Clarke, (ed.), Current Issues in Insolvency Law (London, 1991), 96Google Scholar.

134 See again e.g. A Revised Framework for Insolvency Law (Cmnd 9175, 1984), above, para. 12; Goode, Insolvency, 472-473.

135 Sealy and Milman, above, 224.

136 The latter relying in part on IA, s. 43, which empowers the court to authorise disposal of property subject to a prior charge.

137 White, “Costs”, 490.

138 Aghion et al., “Bankruptcy reform”, 528-9.

139 See again e.g. Re David Lloyd & Co. (1887) 6 Ch. D. 339, 344-345, per James L.J.

140 This exaggerated deference to the property rights of security-holders is difficult to justify: see Clarke, “Security interests as property”.

141 See Section I, above.

142 Jackson, Bankruptcy, 74.

143 Ibid., commenting on McCoid, “Bankruptcy, the avoiding powers, and unperfected security interests”, (1985) 59 Am. Bankr. L.J. 175.