Directors’ duty in the zone of insolvency

“If you put a religious person and a prostitute in one room, one’s necessity is likely to convert the other” – African Proverb.

By Ali Abdi

Mater artium necessitas. Necessity is the mother of invention, and the law is replete with theories and doctrines that are the outgrowth of necessity. Perhaps no area of law provides more opportunity and need for invention owing to necessity than does insolvency.  A simple view of insolvency is that it is a notorious murky area where legal space warps. The contours of this area are fuzzy, if not nebulous.

It is trite that the courts perform the herculean task of interpreting and ascertaining the true meaning of the statutes and other legal texts; therefore, in the myriad of judicial and legal understanding of company laws and insolvency laws, directors owe fiduciary duties of care and loyalty to their companies. In this situation, the shareholders are the residual claimants of the company. The directors, therefore,  are required to act in the best interest of the shareholders and the company.

However, The situation changes when the company has insufficient assets to cover its debts. That is when it approaches or enters insolvency. Courts have recently found that the fiduciary duty calculus may change towards recognising that creditors have financial interests similar to those of shareholders at or near insolvency, that is, when a corporation is still technically solvent but within what has been termed the “vicinity of insolvency,” or the “zone of insolvency.”

The shift in insolvent periods toward protecting the interests of creditors generates confusion regarding the nature of a company’s fiduciary duties when operating in the zone of insolvency.

It is fitting that, while it is a little disconcerting for those who require certainty in the law at all times, the uncertainty as to the circumstances which will provoke the duty shift is not unusual for a developing area of law. Whenever the judiciary embarks upon any new developments, a degree of uncertainty always eventuates. Therefore, at this juncture, a need arises to understand the question of what the triggers for the duty are.

Insolvency

To be effective, a duty must have a clear triggering point. If the trigger for the liability of directors to creditors is insolvency, one major problem arises: 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. For now, directors are left to grapple with determining when insolvency occurs.

Characterising and identifying its bright-line threshold becomes increasingly difficult as one comes within or near insolvency. Although it may be easy to define insolvency in the abstract accounting sense, i.e., when liabilities are in excess of assets, the law has, for some time, recognised a tension in defining insolvency for other purposes. Corporate and insolvency law has generally recognised two enigmatic dichotomy working definitions of insolvency: the balance sheet and cash flow tests.

Under the balance sheet test, a corporation is insolvent, with liabilities in excess of the reasonable market value of its assets. Conversely, the cash flow test considers a company insolvent where its “debts that are beyond the debtor’s ability to pay as such debts matured,” and this inability to pay may account for debts presently owed or debts that have not matured but whose repayment the company cannot meet at a future date.

It is, therefore, trite to say that a company can become insolvent under either test. However,  deciding what test applies is a complex issue. Given this myriad of standards, one cannot feasibly assert that they represent a singular material fact representative of “solvency.” Instead, they offer a means to derive conclusions from many underlying material facts.

The definition of insolvency is central to the operation of the law on directors’ duties to creditors. Under Kenyan laws, insolvency can be either an excess of liabilities over assets or a lack of liquidity. As stated by Justice Owen in Bell Group Ltd v. Westpac Banking Corporation. 2008,  “The central feature of the insolvency concept is clear: a person is insolvent if they cannot pay debts as they become due and payable. But, after that, the fog descends.”

Therefore, Notwithstanding the voluminous case law and judicial guidelines, the inherent complexity surrounding whether a company is solvent and the difficulties associated with this determination are captured by Justice Palmer in Southern Cross Interiors Pty Ltd v Deputy Commissioner of Taxation. 2001, whereby he noted the challenges of determining insolvency in the following situation:

“ There is conflict in the authorities as to whether, to ascertain insolvency, a trading debt is to be regarded as payable when it is required to be paid under the terms of the relevant contract or whether the Court can take into account normal or likely indulgences granted to the company by its creditors. The cases recognise that the former proposition may produce a test of unrealistic rigidity. In contrast, the latter may produce a test which is so imprecise as to be impossible for consistent and principled application. Many judges have, therefore, struggled to find some middle ground between the two competing views. The result, unfortunately, is that the law on this point is in a state of some uncertainty”.

The above understanding illustrates that the legislative definition of insolvency, while apparently simple, is notoriously tricky to implement in complicated
factual situations.

In the case of  North American Catholic Education Programming Foundation, Inc. v. Gheewalla 2007, the court recognised that upon insolvency, what is in the best interests of the corporation often departs from what is in the best interests of stockholders, noting that ‘when a corporation is insolvent, its creditors take the place of the shareholders as the residual beneficiaries of any increase in value.’ Thus, the directors’ duty is ‘to maximise the value of the insolvent corporation for the benefit of all those having an interest in it’ — whether creditors or stockholder

Zone of insolvency

What happens when a company is somewhere between bright line solvency and insolvency? Loosely known as the amorphous zone of insolvency. If the practical realities of using basic insolvency to trigger the duty are difficult, then expanding that triggering event to the zone of insolvency is practically impossible. Nevertheless, many courts have supported the view that the duty is triggered before technical insolvency. Assuming arguendo that insolvency is amenable to practical demarcation, how far does its zone extend?

Defining this zone is particularly vexing. For instance, if the zone’s frontier is too close to insolvency, the rule offers little protection at the margins compared to using insolvency. However, setting the duty’s frontier too far away from insolvency undercuts the entire stated purpose of the rule.

The zone of insolvency does not have a generally accepted definition, and the judiciary provides limited guidance on its definitional scope. ‘Ill-defined’ seems to be the closest we can get to describing it, and the notion of a ‘zone of insolvency’ is quaint at best. An appropriate simile may be that of a blind man in a dark room looking for a black cat that isn’t there.

In re Healthco International, Inc. 1997, the bankruptcy court suggested that a company is in the zone of insolvency if the company has “unreasonably small capital,” which is “a condition of financial debility short of insolvency but makes insolvency reasonably foreseeable. Therefore, the point at which a corporation becomes insolvent is of tremendous significance to directors, officers, and their corporate constituencies. Yet the point of insolvency can also be extremely difficult to determine with precision.

While there are no precise definitions of when a solvent company enters the zone of insolvency, the directors’ fiduciary duties are primarily to the company’s shareholders. The court in North American Catholic Education Programming Foundation, Inc. v. Gheewalla 2007, believed that the ambiguous concept of the “zone of insolvency” runs counter to its attempt to establish “clear signal beacons’’ for directors’ fiduciary duties. The case did not provide directors or creditors with a clear method of determining when actual insolvency starts.

It is from the above understanding that one can state that there are no conclusive definitions of the beginning and end of a zone of insolvency period that would trigger the redirection of directors’ fiduciary duties to the creditors or how the scope of directors’ fiduciary duties during this zone of insolvency period are determined.

Therefore, there is no uniform method to gauge the zone of insolvency. Courts and commentators have tried to define its contours but have simply been unable to capture a practical and objective test for the zone. For this reason, the zone of insolvency continues to exist as an uncertain, problematic, and operationally undefined legal area, which requires further elucidation and strictly construed legal standards.

The problem with the current judicial morass is its undefined boundaries of the fiduciary duty per se – that is, when a company is in dire financial problems, at what exact time does the zone of insolvency begin and end? Further, when and where does the trigger for the bright line shift in fiduciary duties arise? Equally important is that, during the shift in the zone of insolvency, to whom are fiduciary duties owed?

When does the duty arise?

Uncertainty surrounding the determination of insolvency has contributed to a reluctance to recognise a threshold triggering the point at which a corporation enters the even vaguer zone of insolvency. It has been argued that the difficulties in defining the scope of this zone and using such a vague trigger to determine when directors’ duties can shift has created a conundrum as to precisely when the obligation arises.

On the one hand,  In the case of Colin Gwyer and Associates Ltd v London Wharf (Limehouse) Ltd, 2002, It was held that the creditors’ interest were to be seen as paramount where there is a shift in the directors’ duties. The duty was expressed as arising where the company was ‘insolvent or doubtful solvency or on the verge of insolvency, and the creditors ‘money is at risk.

On the other hand,  in the case of Re MDA Investment Management Ltd, 2003, it was held that the directors’ duties owed to the company are extended to include the interests of the company’s creditors as a whole and those of the shareholders. Park J said that the duty arose where the company ‘whether technically insolvent or not, is in financial difficulties to the extent that its creditors are at risk’.

It is, therefore, important to note that the law is still unclear, and there is a certain ambiguity as to when precisely this shift in interests from shareholders to creditors occurs. Identifying at what point the creditors’ interest duty arises is significant because it can have important practical consequences for the conduct of companies’ business. Setting the trigger point too early may stifle entrepreneurial activity.

It is also important and appropriate to set the trigger prior to actual insolvency, given that it is difficult to pinpoint the exact moment of insolvency and that it may then be too late to protect creditors. This can be seen in the judgment of Owen J in Bell Group Ltd (in liq) v Westpac Banking Corporation in 2008, who stated that the obligation could arise in situations outside of actual insolvency and might propel the company towards an insolvency administration. And this is where creditors come to the fore.

In my view, the nearer a company gets to being insolvent, the more likely the duty will be triggered. However, the circumstances identified by the courts do lack pinpoint precision.

Therefore, The lack of precision when the shift in duty is to occur might manifest the fact that the law cannot be too prescriptive here. There is a need for a balance involving consideration for the fact that directors must be permitted to manage companies commercially, but the law must ensure that it does not permit directors to disregard the position of the creditors when a company is in the vicinity of insolvency.

To whom are fiduciary duties owed?

Directors in the vicinity or zone of insolvency often face decisions that leave them, if loosely put, at a Russian roulette standoff between Shareholders and Creditors. The question of directors’ fiduciary duty in the zone of insolvency is blurry or left nebulous. 

It is true that when a few words are accorded the status of a golden passage constituting a canonical statement of the law, and in their understanding if they are divorced from the context in which they were made, they may readily provide a foundation for a theory. However, statements made in reasons for judgment should never be divorced from their context.

In Walker v Wimborne [1976], Mason J. stated that “the directors of a company in discharging their duty to the company must take into account the interests of its shareholders and creditors. Any failure by the directors to consider the interests of creditors will have adverse consequences for the company and them.”

From the above, If directors owe at least a duty of imperfect obligation to creditors, the substance and extent of the duty remain uncertain. Therefore, as indicated at the outset, it is plain that the duty should not arise until the company is suffering some degree of financial difficulty; however, there is no unanimity on the question of when the obligation is triggered.

If the fiduciary duty is imposed at one extreme of the financial spectrum, namely insolvency, there is a significant danger that creditors will not benefit. If the responsibility were to apply at the other extreme, namely when the company is solvent, it would unreasonably interfere with directors’ decision-making, hamper the company’s business, and likely lead to over-cautious directors.

Shifting directors’ duties from shareholders to creditors

Uncertainty surrounding the determination of insolvency has contributed to a reluctance to recognise a threshold triggering the point at which a corporation enters the even vaguer zone of insolvency. It has been argued that although insolvency may suffer from imprecision, prescribing the triggering of the duty when the company is near insolvency suffers even more from that problem, for it is impossible in many situations to say from what point a company is nearing insolvency.

Pinpointing the shift when a director begins to be subject to the obligation to take into account the interests of the creditors is a weighty debate. This is because the current jurisprudence, although well-intended, has made ambiguous guidelines with regard to the zone of insolvency by creating uncertainty for directors and officers about to whom their duties are owed.

Therefore, in Identifying Commencement of Twilight Zone, There is no straight jacket formula to determine when there is a shift in directors’ duties and the commencement of the twilight zone. Being a potentially imprecise concept, there are various possibilities for determining the time it might commence.

One such possibility is when the company’s financial stability deteriorates to an extent it cannot pay its debts. Another possibility may be when any application has been filed with the adjudicating authority to initiate the corporate insolvency resolution process against the company.

If a fiduciary duty towards creditors exists, the time it is triggered must be established. Demarcating such a point involves the dubious presumption that such a situation can be legally defined. As Major and Deschamps JJ wrote in Peoples Department Stores (Trustee of) v. Wise (1998), the “vicinity of insolvency” is a “nebulous” term which is “incapable of definition and has no legal meaning.” Further, supposing that such a situation can be properly defined, imposing a legal test for when this ought to be done would involve a judicial usurpation of directorial discretion.

Existing position under Kenyan Insolvency laws

As in actual insolvency, the Kenyan courts and legislature have not expressly accounted for a shift in fiduciary duties on the company, having breached the zone of insolvency.

However, the Kenyan Insolvency Act 2015 applies a “wrongful trading” standard favouring creditors’ fiduciary duties in the zone of insolvency.  Section 505 (1) of the insolvency act 2015 states that (a) in the course of the liquidation of the company, the liquidator forms the view that a business of the company has been carried on with intent to defraud creditors of the company or creditors of any other person, or for any fraudulent purpose, and (b) the liquidator believes that specified persons participated (directly or indirectly) in the business with the knowledge that the business was being carried on in that manner.

This provision contemplates the director’s duties towards the company’s creditors prior to the commencement of insolvency (where there was knowledge of, or there ought to have been knowledge of, the company’s impending insolvency). It employs an objective test of “knew or ought to have known”, which enables the courts to adopt a more scientific approach to determining the breach of the duty.

Way Forward

Kenya must recognise the existence of the zone of insolvency and its interplay with directors’ fiduciary duties. Whether it does this through a statutory amendment or by deferring to common law must be left to the wisdom of the legislature. The question is whether we should follow the approach adopted in the U.S. or the U.K.

The U.S. approach would involve steering clear of creditors’ interests pre-insolvency, as was held in Gheewala and would require a continued focus on the interests of the corporate enterprise from the perspective of shareholder rights. On the other hand, by deferring to common law on this point, the U.K. approach provides for a shift towards creditors’ interests as the company enters the zone.

Now that the genie is out of the bottle, should we regard this duty-shifting principle as a desirable addition to the legal tools for the governance of insolvent companies? Its economic justification is to reset the balance between creditors and shareholders, which, arguably, is both presumptuous and cavalier. If something so fundamental requires adjustment, it can hardly be appropriate for this to come about as a deeply uncertain principle both as to scope and incidence.

The need for risk-taking

In determining what the trigger for the duty should be, one must consider several factors. First, companies need, at times, to take risks to prosper. Without risks being taken, we would not enjoy what we want in society today, such as the Kenyan Railway to nowhere – the SGR.

The corollary of this, indeed from a theoretical perspective, is that one of the functions of the directors who manage a risk-taking enterprise is to oversee the very action of risk-taking.[ The argument of those who question the existence of a duty to creditors is, among other things, 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.

It has been said that the duty results in the inability of directors to take risks with corporate assets to extinguish or minimise the firm’s temporary financial distress and that it changes the role of directors from an ‘active management mode to one of passive asset-preservation.

It is submitted that too much is often made of the argument that the duty will stifle the development of a company’s business. Requiring directors to take into account the interests of creditors does not automatically mean that directors are hamstrung, unable to take some risks and liable if things do not work.

However, the best counsel is that there are times to take high risks, there are times to take calculated risks, and there are times when few risks or actions involving little risk should be taken.

The need for precision

Another factor to consider is that concern has been voiced about the difficulty of precisely stating when the shift in duty will occur. The law does not seem to have a problem requiring courts to do this in other areas. For instance, under Kenyan laws, a director is liable for 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.

It is submitted that there must be a balance. On the one hand, the law must not unduly hamper directors. It must allow companies to be governed in a commercial manner for, as Lockhart J said in Australian Innovation Ltd v Petrovsky, ‘it is important that the courts do not impose burdens upon directors which make their task so onerous that capable people would be deterred from serving as directors.

But, on the other side of the coin, the law must ensure that it does not permit directors to do whatever they like so that the position of the creditors is ignored. Limited liability is a privilege, and it must not be forgotten that it can work to the disadvantage of creditors.

Therefore, although it becomes very difficult to identify with precision the exact circumstances that trigger insolvency, a reasonable expectation of insolvency, coupled with the knowledge that insolvency may be near, will cause this shift in directors’ duties. After all, at this point, the directors are also responsible for acting per insolvency laws and not arbitrarily.

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?

Therefore, a company must not be deemed to be in the zone simply because its directors have made “a sizeable enough bet.” Such a test would be akin to the one established in Brandt v. Hicks, Muse & Co. (In re Health co International) 1997. It would be very easily triggered without any probability of the company being financially unstable.

In this regard, Kenyan courts may consider the holding in BTI 2014 LLC v. B.A.T. Industries PLC [2016] to ensure that a company is not inappropriately deemed to be in the zone. This test can best be supplemented by a trigger like the one in Charterbridge Corp. Ltd. v. Lloyds Bank Ltd. [1970] to grant it greater objectivity.

Further, Kenya might also consider revisiting its wrongful trading standard as prescribed under Section 505(1) of the Insolvency Act 2015. In terms of providing clarity, what must be done to minimise potential loss to creditors is still unclear. Does this mean that the effect of this Section is to ensure that directors do not make any decisions that involve an element of risk? No such clarity has been provided.

However, questions remain in understanding the nebulous zone of insolvency. First, the level of knowledge required of directors to trigger the duty is still uncertain. Second, although clearly creditors’ interests prevail when insolvency is inevitable, personal liability will still weigh heavily on the minds of directors during the period prior to “inevitable insolvency”, when a nebulous “sliding scale” seemingly applies and creditor and shareholder interests must be “balanced”.

Finally, when the requirement has been triggered, considering the interests of the creditors as a general body can create challenges when, for example, directors borrow new money to pay off old money. Given that creditors are often not a homogenous group and may have conflicting interests, it may be unclear how directors should proceed in such a situation.  The sagacity of some fiduciary duty elements remains uncertain.

Conclusion

Shareholders cannot be said to be the primary risk bearers of a company in the zone of insolvency. This is because their behaviour is bound to change at the slightest hint that the company’s insolvency is imminent. It is then inappropriate to contend that shareholders can be trusted to have the company’s best interests in mind, even when it has reached a financially precarious state.

Protections favouring creditors have no bearing on the incentive structure or the risk matrix in the zone, and contractual protections cannot be assumed to be the norm, especially given the preponderance of unprotected and vulnerable creditors in today’s business scenario.

The challenges highlighted above have resulted in a lack of understanding regarding trigger shifting of duties, nature, beneficiaries of such shifting at different stages, and the applicability of specific corporate governance norms during the borderline zone of insolvency. The ease of doing business can be amplified by clarifying and, to a certain extent, modifying the extant framework on director fiduciary duties in the zone of insolvency.

The Kenyan legal framework in this regard is still in a nascent stage and is in desperate need of a more nuanced approach towards fiduciary duties. Today, the Kenyan framework only expressly provides for fiduciary duties owed in financial solvency. It is silent on what will happen when the company enters the zone of insolvency or finally becomes insolvent. As has always been, we are bound to look at more developed jurisdictions in the West for answers.