Directors’ Duties to Creditors in the Zone of Insolvency

 Directors’ Duties to Creditors in the Zone of Insolvency

Dissertation 

The Zone of Insolvency (ZOI) is a concept that appears in legal discussion, usually concerning creditors’ rights. No scrupulous attempt at defining the realm has been made however, though various jurisdictions allude to the existence of this period.

The company is a going-concern within regular solvency. Cash reserves exist, the company is able to comfortably repay creditors, and funds are available to finance future operations. Insolvency, on the contrary, has standards which can be judged by the tests laid out in Section 123 of the Insolvency Act. The ZOI is a transitionary period between the two phases, which may be best suited to seeing the creditors’ interest’s gain priority over those of the shareholders. The aim of this study is to indicate ways in which larger companies, through their directors, should approach the ZOI.

The expectation of shareholders to realise the value of their investment diminishes as the company approaches insolvency, upon which time this expectation vanishes. The opposite is the case for the creditors, however, wishing for a company to retain assets so that the company’s ability to repay debts remains. The ZOI could be a crucial stage which sees the creditor’s interests surpass those of the shareholders for the first time, and thus require an appropriate governance response.

The current situation within the UK shall be discussed. The negative impact which ambiguity has when wishing to govern corporate actors will be considered. Section 172(3), which details a time where directors may act to maximise creditor value, will be examined in light of this. Subsequently, case law reflecting the current view within the UK will be outlined. The analysis will extend to the US, hoping to draw from similar guidelines and approaches which exist there. Due to the highly regarded condition of company law within the State of Delaware, much of the conversation surrounding the US references this jurisdiction.

This discussion will consider warning signs which hint at the ZOI domain being entered. Responding to these red flags will be invaluable for any company who wishes to avoid becoming irretrievably insolvent. A subjective test, based on how rationale actors assign utility in response to these signals, will consequently be explored. It will be contested that failure to satisfy this standard ought lead to director’s being personally liable to the creditors. Naturally, there may be criticisms attached to implementing this test, which thereafter will be given consideration. 

It is important to note that although a precarious realm, the ZOI may still see a company return to comfortable solvency. When this is not possible, a company has entered irretrievable insolvency and director’s must act in the best interests of the creditors. Wrongful trading is covered under Section 214 of the Insolvency Act. The impact of this method of governance will be explored.

Thoroughly investigating the ZOI realm, and determining if it can be better governed, is of considerable importance, as there may be potential to add value to the market through increased efficiency.  

CHAPTER 1: RECOGNISING THE ZONE OF INSOLVENCY

1.1 Recognition Within UK Law:

1.1.1 Ambiguity and the Law

Unclear law fails the task of guiding those governed by it.Being unable to access comprehensive information for what is expected causes confusion. Concerning the ZOI, ambiguity is particularly troublesome if repercussions can be attached to a director’s actions. Attention should accordingly be given to the effect ambiguity has on the running of the company. Expense can be caused when a director finds it difficult to determine what ought be done and has to seek advice. This may prolong the perhaps doomed faith of the company while depleting already limited company resources. Shortcomings in company law should not hamper the survival of a firm through this needless dissipation of funds. Clear meaning of the law helps to avoid unnecessary distractions and allows resources be allocated more efficiently. 

When deciding the most attractive opportunity to follow, director’s must rely on the governance system to predict the outcome of their actions. The speed at which corporate events can evolve demands that there is a fluid decision making process. The ZOI needs clearer instructions within this realm, displaying a consistent spirit of guidance and protection. Director’s should be aware of the principles which they are bound to abide by within this realm. This in turn will benefit the market. Director’s who run a company into the ground without paying creditors create the knock on effect of those same creditors increasing the cost of credit to their future debtors. Without a sufficient understanding of what the ZOI consists of, directors may not be able to give creditors’ interests satisfactory consideration within an appropriate timeframe.

What constitutes good behaviour and bad behaviour on behalf of the director is subjective and duly difficult to define, especially where there is a conflict of interest between opposing stakeholder constituencies. Generally, that which is good for the shareholders may not be backed as strongly by the creditors, and vice versa. This reality makes an objective standard for the ZOI difficult to create. However, any rational individual viewing the corporate situation at it’s simplest form would be able to understand the situation quite swiftly. Simply, a creditor has allowed the borrowing company access to funds and wishes to benefit from being part of this arrangement. Creditor’s would not make finance available were they not expecting a return. Once a certain threshold is breached, director’s ought respect this rather than continuing a trend of assigning priority to the shareholders. Aiming to create value for the shareholders is suitable where the company is of sound financial position. Where the financial status of a company is in distress, promoting the interests of the shareholders ought be curtailed and replaced by an agenda of repaying debts. This frontier, the ZOI boundary, should be given consideration within the UK corporate landscape.  

1.1.2 Companies Acts 2006, section 172(3)

It is untrue to say that the director’s owe their duties to anybody but the company itself. However, referring to duties owed to specific constituencies is done as a means to express the function which the directors are aiming to maximise. The directors most notably promote the interests of the shareholders over all other stakeholder constituencies.

The codification of formal duties into statute sought to make the law more accessible, and advance the interests of non-shareholder constituencies. The general duties of directors is outlined in Part 10 Chapter 2 of the Companies Act, yet is done so in a puzzling manner. Section 172 contradicts that which is found at the introduction of this chapter. Section 170(1) outlines that duties are owed to the company, and this expectantly relates to creating value for it’s shareholders. Section 172(1) presents that director’s ought also act in good faith for the benefit of wider parties. It is Section 172(3), which is of importance to the discussion surrounding the ZOI, outlines a shift in function, towards creditors.

The wording of Section 172(3) leaves a lot to be desired. The duty expects directors to act in the best interests of the creditors, when required to do so by other areas of law. This alludes to the fact that creditors gain prominence during insolvency. The obligation expands to realms such as wrongful trading, which shall be explored. Section 172(3) makes reference to “certain circumstances” which will lead to the triggering of this section. Further explanation is not forthcoming on what exactly these circumstances are, and directors could be left in a predicament due to this ambiguity. Directors will be aware that a point exists where their focus should shift, but they shall be unable to easily decode when exactly this is. Continuing to trade may be seen as negative, taking from the pool of assets which creditors’ claims draw from. However, criticism may also be apparent were directors to cease trading. It may be claimed that the business ceased prematurely and without a sufficient attempt to benefit the creditors. The Companies Act thus falls short in giving adequate instruction on how to navigate the ZOI.  

1.1.3 Case Law

The enigma which is the ZOI shows it’s face within UK case law. The terms ‘nearing’, ‘vicinity’ and ‘borderline’ are frequently peppered alongside the word ‘insolvency’, though judges do not go much further in explaining an exact time which should see creditors’ interests receive protection. The Wendy Fair case noted that a duty extends to the creditors “Given insolvency or near insolvency”. This case saw director’s allowing company debts to increase, while trade continued. The lender was aware of this, though seemed willing to discuss restructuring the agreement. The borrower would only be seen as insolvent were the liabilities to remain as per the original agreement. The director’s believed that there was no duty to consider the creditors as the company had “A reasonable prospect of negotiating relaxation of arrears”. The directors are caught within the ZOI and it is difficult to ascertain whose interests ought be pursued. The circumstance warranted consideration of the creditors’ interests, which may be mystifying to the director’s who believed the company would likely return to solvency. However, an earlier case put forth reasoning for ruling in favour of the creditors. West Mercia Safetywear v Dodd holds that a company expecting to return to solvency should be trading for the benefit of the creditors until it is back within comfortable confines. Attention was given to Section 172(3) in Eastford Limited v Gillespie. Lord Hodge comments that directors of a company facing “Borderline solvency…not act in such a way which would put creditors in a worse position”.

Another important UK case is that of Gwyer v London Wharf. This demonstrates that creditors have standing within the ZOI. “It is the creditors money at risk” and thus the thought process of directors should establish the interests of the creditor above any other stakeholder. An “Honest and intelligent” standard is mentioned, which simply reflects that of acting rational, that directors can use as guidance. This all occurs “Where a company is insolvent or of doubtful solvency or on the verge of insolvency”. Further guidance is presented in the US Healthco International case. Unreasonably small capital may be a test for entering the zone of insolvency. The suggestion here is that insolvency has not yet been reached, but the financial condition is certainly deteriorating. Directors may be expected to make allowance where there are likely to be economic downturns and other difficulties. However, this principle is very narrow and does not hold up in all situations.

The difficulty with the ZOI may not be determining whether creditors have standing, as much as at which point the ZOI commences. What ought constitute a close enough realm for the ZOI to initiate has not been defined. Multinational Gas, a leading UK case, highlights this. Directors made a decision to invest when the company was sufficiently solvent to do so. Ultimately, the investment caused the company to fail and become insolvent. Creditors claimed that a duty was owed to them at the time the decision was made, and that the investment posed the threat of insolvency.  However, as the company was of sound financial position, any approved decision carried out in good-faith was sanctioned. Had the company been close to insolvency, it would be expected that a duty is owed to the creditors. What exactly alludes to this threshold has not yet been put forward. The US Hellard case further muddles this, proclaiming that failing to satisfy the tests for insolvency is not the only prerequisite upon which the creditors’ interests derive standing. At the core of a company, directors ought make decisions which reflect their commitment to repaying debts, instead of advancing the interests of the company’s shareholders further.

Credit Lyonnais v Pathe offers the view that the US should see companies precariously close to insolvency adjust to recognising creditors. This is, after all, the constituency “Which sustain the corporation and allow it’s long-term wealth creating capacity”. The legitimate interests of creditors may be considered within this time, without the directors necessarily breaching their fiduciary duties to the shareholders. Again, a summary for what breaches the ZOI threshold went without description. The Gheewalla case takes a hard stance against this view. The Delaware courts vehemently disregarded the notion of the ZOI. Director’s are expected to continue focusing their judgement on how to best benefit the company and it’s shareholders. The rationale behind this concludes that directors ought navigate the ZOI with certainty as to who their duties are owed, and thus creditor claims should be unavailable within this period.

1.2Acknowledgment Within US Law

1.2.1 The Business Judgement Rule

In the US, directors are assumed to make business decisions which are informed, honest, in good faith, and in the best interests of the company. The Business Judgment Rule (BJR) will be applied once the courts are satisfied that the directors did not act in an unreasonable way. The BJR in part offers a means by which directors can avoid accountability. Directors are in place to act as conscientious actors, assigned the role of responsibly guiding a company towards success. Though the courts understand the relevance of the creditor constituency, it respects the director’s decisions through applying the BJR. The BJR developed alongside reasonable care standards, and courts will not examine these judgments as long as they are satisfied that this standard has been reached. Fundamentally, when applying the BJR, the courts do not feel obliged to deeply analyse how a director came to their decision. The courts will not commandeer the affairs of the company and will believe that the directors are acting in good faith. The same perception that leads to contracts being viewed as incomplete so too applies to management, and that the ability to make perfect decisions does not exist.

This rule has been recognised in the UK. A report addressing the ZOI issue suggested that any good faith assessment should focus on the question of whether it is more likely than not that a company would fail to satisfy it’s liabilities. Furthermore, a director’s conduct is seen as justified once they are not acting in self-interest and no explanation will be sought as to why an opportunity was pursued. 

Inevitably, stakeholders may wish for a review on the director’s conduct when they are unhappy with the outcome. It is easy to criticise a director’s strategy with hindsight, what is difficult is determining what constitutes an acceptable risk to have taken. The courts do not intend to act as a business expert. It would be foolish to regard the courts as possessing the knowledge to run the company better than those in charge. In any case, it would not be viable for there to be a system which allows constant analysis each time a director acts. Therefore, the BJR is a mechanism through which the courts impose that an action was made with good conscience and without the intent to cause the company harm. The BJR will impact creditors as it leads to cases against the directors being difficult to win. Even where creditors believe a transaction had foreseeable risk attached, the courts will likely be of the opinion that the director operated intelligently. There can always be honest errors, and circumventing the BJR would be problematic. Removing the protection offered to the directors’ judgment would promote an environment of severely risk averse behaviour.

Rather than assuming the director implemented the best business judgment, it could instead be beneficial if the onus was to make a balanced judgment. This would require directors to actively weigh up the interests of constituencies involved with the company. The BJR accepts that a director acted with good faith to benefit the company through raising finance, while the balanced judgment accepts that a director acted with good faith to determine whose interests ought be prioritised. A balanced judgment could impede on the company however, as directors may effectively stop running a going concern prematurely. It may be hard for a director to determine whether or not a company can meet it’s liabilities, as the extent of any risk is hard to quantify, and any director airing on the side of caution would choose to protect the creditors’ interests.

Any method of challenging the application of the BJR ought be based off determining a more precise and meaningful standard for what exactly the BJR consists of. The courts too often respect and implement the BJR without giving regard to the deeper circumstances, which of course are further amplified in the ZOI. It would be fruitful to analyse the method by which the directors formed a judgment within this realm, expecting the process to uphold the same standards of attention as when there is solvent decision making. Decisions made in the ZOI may not have been approved were the company solvent and in a strong financial position. In the ZOI, decisions may be carried out as the company is under pressure and the directors look more kindly at riskier undertakings than they did when the company had more to lose. If the director’s standard of research decreases in the ZOI, then their conduct is perhaps negligent and should not satisfy the BJR. To make a negligent judgment would see the decision made with bad faith, or disloyalty influencing the path followed. A director, acting with intelligence and honesty, would show good faith by taking the creditors into account. The creditors could press to have the company enter liquidation prior to the company going insolvent if the BJR could be bypassed, or personal liability could be attached as shall be discussed in Chapter 2.

In the US case of Logue Mechanical Corp, a major failing on the director’s behalf saw the business judgement rule revoked. No additional business activity occurred after filing for Chapter 11 Reorganisation, though directors continued paying their own wages. The asset pool available to the creditors was therefore depleted, showing a complete disregard to claims and a failure by director’s to meet the appropriate standard expected of them. A similar approach would expectantly be taken under Section 172(3) within the UK, as the director’s fail to act in the best interests of the creditors.

The reality of the corporate world sees creditors as large contributors, enabling directors access finance in order to help the company grow. It is necessary to accept that directors rely on creditors, and the introduction of special duties may be necessary for times where the creditors’ interests are under threat. Indicators are required to give guidance to the directors when they feel they are within the ZOI, in order to extend duties to creditors within this time. A stringent test is technically difficult to establish, though will be deliberated in due course.

1.2.2 Debtor-In-Possession Financing

In the US, director’s can file for bankruptcy protection on behalf of the company and carry on the regular course of business, having received additional loans. The protection given over this new finance may be granted super priority over pre-existing claims. This is known as debtor-in-possession (DIP) financing. 

DIP financing respects the notion of repaying the creditors. This protective realm can be entered prior to a company being wound up. Similar to the cash-flow insolvency test in the UK, the company ought show that is unable to pay debts as they fall due. Wealth may be tied up elsewhere, however, and when this is realised the prospects of the company are deemed likely to improve. DIP financing gives the company time to obtain future earnings. Therefore, a distressed firm may continue if financially it is still viable to do so, creating value for the creditors rather than gambling the remaining health of the company on risky ventures to benefit the shareholders.

DIP financing facilitates recovery through recontracting. At worst, the creditors will suspend the pursuit of their claims in order to give the company time to execute undertakings more effectively. The company can reassure creditors that it is seeking to restructure it’s business strategy in order to give them the best return. Credibility is attached to the company’s outlook, directors understanding that this is a method through which capital can be obtained. The US system has benefitted through this, empirically a stock rise is usually seen as strong signals are sent to the market. 

Upon DIP occurring, specific statements must be filed which can help understand what got the company into the dire situation. Major events which led to filing are required, and monthly operating reports must be supplied on a continuing basis. These reports contain all the financial data relevant to the company, which will be operated in the best interests of the creditors at this time. Strategies are put in place to extract as much value within this period, whether or not this leads to the company regaining it’s full health. Court approval is required for any operations outside the regular scope of the business. This assures the creditors that the lifeline will not be exploited, but sensibly put to use. 

This scheme has been discussed in the UK, though the existence of floating charges and other technicalities distorts the applicability of a similar approach. The period reflects the ZOI as the company recognises that the future outlook is precarious, though the opportunity to recover remains possible. The reality of DIP suggests that US courts are aware that the threshold between solvency and insolvency is not so clear cut, and that offering guidance and potential solutions within this time may benefit the company. Specifically, DIP financing respects the situation which the creditors are in. The directors are given the option to seek help at an earlier stage, before running the company completely into the ground. Thus, the presence of DIP financing exhibits that directors are aware of warning signs which exist within the corporate landscape.

CHAPTER 2 APPROACHING INSOLVENCY: DEFINING THE ZONE OF INSOLVENCY

2.1 Entering the Zone of Insolvency: Warning Signs

It would be beneficial to create a standard through which the ZOI can be measured. There is a realm where continuing the company is harmful to it as an entity. At this time, directors should disengage with trying to create value for the shareholders. Extending duties passed shareholders has been discussed within the UK system, contemplating the time it becomes appropriate for the corporate picture to consider the creditors.

There is a high degree of confusion as to what constitutes entering the ZOI. Throughout the life of the company, the desires of it’s shareholders are in stark contrast to those of the creditors. An axiomatic threshold for where directors’ duties shift would expectantly be easy to determine, given that it must be the place where the creditors have more to lose than the shareholders have to gain. It may be sensible for creditors to receive protection within this realm. At this point, the actions of the creditors are directly impacted by how the directors decide to run the company. There is no objective way to define the beginning of this period however, as there is no specific event which can be seen as triggering the ZOI. Where exactly creditors should gain preference is duly tough to discern. Applying an accurate boundary becomes difficult in reality due to the different business plans which companies opt to follow. 

The ZOI includes any company which is not irretrievably insolvent. In other words, company’s are at the brink of going to insolvent liquidation but the potential to survive this hardship still exists. Therefore, trading with no hope of recovery will be discussed under the wrongful trading standard. 

The ZOI is harder than insolvency to define. It could seem logical to integrate the current tests for insolvency into a definition for the ZOI. The distance from failing the insolvency tests could loosely characterise how deep a company is into the ZOI. Problems quickly arise with this method. Firstly, any quantitative financial figure which warrants being “close” enough to the ZOI could fluctuate alongside the market and risky investments. This precarious state does not offer any clarification to the directors, instead promising to leave them confused as to who duties are owed. Secondly, by extension, the problem with how long a company must stay in this state is hard to justify. The UK does not have a specific timeframe requiring directors to file as insolvent, unlike other European jurisdictions. Thirdly, even the tests for insolvency do not always agree with each other on the status of the company. Thus, determining a zone close enough to insolvency based on these tests is impractical.

Mathematical models designed to predict whether a company will enter the ZOI do not yield many exciting prospects. The weight attached to specific figures may lead to different outcomes regarding the company’s status, and may not supply consistent results when different company’s finances are compared. As a result, other factors must be considered.

Subjective indicators that the ZOI has been entered may be useful when forming a test. If there is a specific horizon which signals the point of no return for a company, deemed to be insolvency, then warning signs must exist that hint at this event approaching. The fact that circumstances do not necessarily concede insolvency, but instead warn of distress, should cause them to be greeted as viable indicators when forming a test for the ZOI. Approaching insolvency may see the gravity of any negative situations spiral to such an extent that it is increasingly unlikely that the company will be able to avoid death. Injuries or weaknesses within the company may be a tool to express that the company is in a fragile state, close to the end of it’s life, thus supporting any ZOI claim. These subjective indicators are elusive, changing alongside the state of the market and nature of the company.

Signs do exist which can indicate that a company is performing badly. Dealing with these appropriately will likely see the company recover. These signals must be severe enough that ignoring them will lead to the company entering an irreparable state. At minimum, directors can be anticipated as understanding the business model the company follows, and have a basic awareness of operations. A basic professional demeanour should lead the directors to understand the strength of the company’s position within the market it engages in. Awareness of company finances is a crucial prerequisite in order for directors to fulfil their role and recognise these signals. Directors should reliably be able to answer questions around the company finances. Inability to do this may be worrying, as the absence of this suggests that the company’s position is not fully understood. Director’s ought take positive steps to confirm the position of the company and settle any concerns. Responsible director’s could help themselves by obtaining such information as cashflow projections and regular financial accounts. Furthermore, seeking risk analysis reports will allow threats to assets be identified. 

The accounting practices used by a company may amplify profits and thus lull director’s into a false sense of security, having masked the company’s true position. At best, financial figures consistently shift and there may be a lag between compiling, processing and acting on the data. A greater awareness can be gathered through seeking reports on an ongoing basis. Adequate auditing schemes will give a better reflection of the company. Financial information should be as thorough as possible and not regularly have qualifying notes attached.

An increase in sales ought lead to greater profits. Failure for this to occur should lead director’s to understand that the operating costs of the company are too high. Operating costs, including sales techniques and a growing workforce to match demand, may remain more constant over time in comparison to sales. If the volume of sales does not continue, the company may find itself in difficulty due to money leaving the company faster than it is brought in. Cash exiting in this way may hint at an underlying financial problem. Losses may be sustainable short term, if it is believed that the market has merely hit a rough patch. A reasonable director ought be competent enough to determine whether this is the case or if continuing under performance has deeper complications. There is very little room for error in this situation. A dip in sales will create difficulty in paying debts. This is a common characteristic in markets where the value attached to the good or service is susceptible to fluctuations. This erosion of profits can be further hampered by a decrease in demand, outdated technology, increased competition, and so forth.

The response from creditors could help the director’s ascertain how the company is seen by outsiders. The creditors are set to lose out if the company is performing badly, and their behaviour towards the company speaks volumes. Realistic plans ought be discussed when receiving credit, and director’s should put programs in place in order to maintain these. The inability to keep up with these commitments suggests that the company is not performing how it was originally anticipated, and the company may be in a quandary. A change in how creditors behave may signal that faith in the company is diminishing. Lack of confidence in the company’s ability to continue repaying debts may be shown by trade creditors refusing to ship goods before payment has been made. This is especially significant if the relationship does not usually rely on this occurring. Of course, the company should be worried when creditors refuse to extend deadlines and instead threaten legal action. Pressure from the creditors may progressively grow, wishing to influence the board into winding up. Having to pay interest due to late payments on debt is not a positive situation to be in. This in itself compellingly expresses that the company is not functioning correctly. 

Failure to meet any of the criteria in Section 123 of the Insolvency Act of course warrants being able to trigger Section 172(3) of the Companies Act. Warning signs may come in the form of barely satisfying these measures. For example, were a creditor to issue a written demand for repayment under Section 123(1), it may be a significant indicator that the company is in trouble even where the company manages to repay the debt.

There are certain valuable assets which a company has that ought be viewed as extremely necessary for the continuance of the company along the same business model. The loss of a major customer may spell trouble for the company, and ought be given serious reflection. Loss of important patents may cause both a contraction of annual revenue while also pressuring the company into spending more on research. The exit of important actors may outline that the company is deteriorating, suggesting that senior individuals have given up hope that the company will experience success. This syndrome may be coupled with other attitudes, demonstrating how insiders feel the company is performing. Poor employee morale poses the threat of strikes. This impediment could present serious exposure to the usual course of business, and ultimately sound the death knell for a company. The additional dilemma connected with a strike is the ominous impact which it has on potential finance. The appeal of the company diminishes, making it less probable that investment can be attracted. 

Naive director’s could harm the company. Those who refuse to accept the faith of the company may be acting negligently. Company’s are indeed artificial systems. Unlike biological entities, it is unnecessary to prolong their existence through any means. Prolonging the life could increase debts. Were the directors to be in denial about the reduction in market share, the company may spiral into a deficit. The share price says a lot about the company. Director’s, wishing to blame the market for a decline, ought look at competitors and other similar businesses. A drop in share price may act as a major indicator of tough times, notably if competitor share prices do not follow the pattern of the failing company. Were directors to read further into these signals, they may learn that the company is in a downturn. It is irresponsible if directors’ ego’s cause them to be unable to accept the reality of the company.

Other indicators can also strongly reflect that a company is not performing in a desirable way, such as dividend’s not being paid out or being used to finance the company. Additional debt ought be used to finance further development, rather than paying off current debts. A company becomes very susceptible to failure when short term financial options are relied upon to fund future investment. Furthermore, a company with large investments could be more susceptible to entering the ZOI due to a lack of diversification. The company is more exposed to any downturn in the market it operates.

These subjective indicators may individually demonstrate a failing company, and combined likely spell out disaster. A specific threshold for the ZOI is tough to determine, but a rationale director ought be able to decipher the magnitude of any implications. Extending from this, a director ought respond appropriately to the situation and do that which is in the best interest of the company.

2.2 What is Expected in the Zone of Insolvency

Law and economic theories stem from the idea that the company is a nexus of contracts, fulfilled by rational actors. Gaps in contracts are filled through reasonable expectations being attached to the actions of rationale individuals. The director’s behaviour must be studied in order to judge what is justifiably “rationale”, and deserving of protection. It should be expected that any rationale actor acts consistently rationale. The following section aims to build a subjective test for how these actors ought perform, wishing that a steady objective standard of rationality is not simply imposed from the outset when dealing with directors. The subjective attitude of directors towards risk is how the creditors create their reasonable expectations. It is submitted that should remain dependable, as opposed to being allowed fluctuate with the health of the company and ZOI warning signs. 

Obtaining finance requires the borrower to display elements of economic rationality and moral responsibility. When looking at the governance of firms, it is important to assess the natural persons who possess the ability to implement decisions on the company’s behalf. Economists understand that directors do not draw facts solely from the situation itself, but also assert individual preferences and inclinations. The underlying thought processes these individuals follow, and the varying approaches between them, is scarcely looked at, yet the outcome shall represent the corporate body as a separate legal entity. The input and flow of information between actors at the decision making level leads to shared understanding and agreement when making a decision. The organisational intelligence of the firm will be reflected. Creditors will be the ones who bear the cost of risky activity, due to companies acting with limited liability. The prevailing attitude of risk which the directors have should not exceptionally oscillate. This would see the market dealing with capricious actors, as opposed to rationale ones.

Directors are represented as being rational actors. Merely placing an individual into the role of being a company director does not mean they are rational however, this stems from individual social interactions and an understanding of duties. Director’s themselves rarely have much training or professional qualifications, instead they learn through doing. Perfect knowledge does not exist when making decisions, but this is not particularly relevant to the discussion surrounding the ZOI. Imperfect knowledge will be reflected through lower confidence in pursuing the opportunity, directors with less information should likely feel a lower degree of reliability and attractiveness towards investing. Directors should be wise in analysing all opportunities individually when determining which route ought be followed. Any shortcomings with the information available will increase risk and uncertainty. Risk can be judged as the likelihood of a positive or negative outcome, that is, the promise of success or failure. Risk can be apportioned to any circumstance where absence of information can still allow a calculable future position, whereas uncertainty forebodes an indiscernible outcome. 

Director’s will attach value to an opportunity: Positives and negatives are derived from the available knowledge. The weight attached to both positive and negative attributes of an opportunity ought remain consistent with those of the directors when the company was in a more comfortable position.

Being a rational actor, the director’s degree of certainty should stem from the credibility of evidence used when forming an opinion. In reality, there is clear variance between directors who are risk-averse and those who look at risk in a friendlier manner. Utility is a term which reflects the preference an actor shows for a particular venture. Analysing the value of a director’s utility requires observing behaviour. Exceptional divergences from any business model likely do not exist, as these would require an overhaul in an actor’s utility.

Due to directors being perceived as prudent and logical actors, there ought be consistency shown for how a conclusion was reached and relative firmness with opinions on risk. Expanding on this, the director ought consider the financial position of the company and consider the efficiency of any investment. The path chosen should reflect the anticipated outcome as being more desirable than any of the alternatives. Rather than reacting to a shock when an opportunity deteriorates, adequate research and caution should be displayed from the outset. Actors who look kindly at risk are justified as being rational as long as they remain sensible when calculating the extent of the risk. Choices ought show consistent preference or bias to a particular utility, with the aim of maximising this utility.  

The director’s preference is considered to remain stable, due to their rational approach to assigning utility. Thus, the value placed on an income (in relation to the risk attached to it) should remain stable. In particular, this utility should not change towards the end of the company’s lifecycle when the ZOI has been entered. Should this be the case, the indication may be that the director understands the depth of the situation through gauging the warning signs, and is willing to gamble the company assets. This will be to the detriment of creditors.

It is possible to apply the above information when looking at how company director’s may act when inside the ZOI. A director may find it attractive to alter their value of certain utilities, increasing their tolerance for risky ventures. Looking at investment opportunities at the upper end of a risk matrix may seem alluring due to the prospect of saving the company from insolvency. With the position of the company being unstable, the effect of any failed investment may not be as discouraging as when the company was healthy. This could be especially true if the calculated risk of the investment is similar to the likelihood that the company enters insolvent liquidation. Simply, declining to invest could lead the company to the same miserable faith as a sour venture may, though partaking in a venture at least offers hope. Discomfort will be minimal in the ZOI, whereas the same hazardous course could previously have had unacceptable results. Risk is usually a large contributing factor when calculating whether an investment opportunity is viable or not, breaking down as being a burden. Risk can contribute to transaction costs. Logically it can be assumed that without this transaction cost, investment becomes more feasible. Even to a risk-averse actor, developments in the ZOI offer such change in circumstances that attitudes towards risk may diminish. Naturally, at this stage, there may be insufficient incentives to refrain from risk.

Behavioural studies use empirical evidence to conclude that a numerical value can be assigned to an individual’s preferences. One option is deemed to hold priority over any alternative. This is done after comparison is conducted between two distinct preferences. Actors are viewed as operating as if this regular preference exists, with utility as the numerical value. From this, a model can be constructed to seek if director’s act consistently, and in line with the value they place on risk. It can be expected that a greater risk will have a higher return. In the ZOI, a risk-averse actor ought not follow a high risk situation for having deemed it safer due to the precarious position of the company’s finances. Put differently, the value placed on risk should not increase as the company’s position decreases solely because the impact of a failed risky opportunity will not be felt. Any model attempting to hold the directors accountable should focus on the change in their stance towards risk over time. There ought be a correlation between the value attached to risk both within the ZOI, and within solvency. Any risky opportunity in the ZOI should not be justified by the company’s lessened concern for risk due to it’s doubtful future. If this could be drawn from the circumstances, then it is clear that the director’s acted in disregard to the company’s obligation to pay it’s debts.

Were this to be the case, it could only be described as the directors failing to act rationally. The legitimate expectations made by the creditors when entering into the contract are suppressed, as the corporate actor is not acting in good faith. Individuals who fail to act in good faith should have a penalty attached to their misconduct. Although the company is not irretrievably insolvent (and therefore does not fall under wrongful trading standards), personal liability should be imposed on directors. Allowing direct claims for this breach would act as a strong deterrent.

Of course, there are criticisms to be made of this model. Any attempt to implement this test will only work for risk-averse actors who delve into risky ventures towards the company’s death. The more risk-averse the director originally was, the easier it is to satisfy this test. Risk-averse individuals are entitled to act this way, however, and it is unfair to treat them to a higher standard than their risk-friendly counterparts. Some corporate actors may have a tendency to choose certainty over risk, accepting the lower expected return. Failure may not be as great of a concern to individuals who value the prospect of success highly, and thus are willing to take greater risks in anticipation of a higher return. There is no appropriate threshold to determine what is too severe a divergence from the original assigned utility. This would be unfair as risk allows profit to be possible. 

Director’s may also act with more leniency towards risk at the beginning of the company’s lifecycle, in order to grow and please the shareholders. This same spirit may exist towards insolvency. Human error becomes tougher to evaluate once the performance cannot be compared to normal routine. Identifying errors during atypical situations does not see any evidence to compare what may be unusual behaviour, as it is likely the director’s first time to be in this situation. 

Utility must have some spectrum of change. Perhaps agency theory can resolve this, alluding to the fact that director’s may value their position within the firm and wish to provide attractive results. Risk may not be essential to take when the company is going well, as reliable and consistent earnings may be enough to please shareholders. Towards the death of a company, the director’s may wish to satisfy this ambition by increasing their tolerance for risk.

If a director is consistently familiar with risk, the model will not determine them to have acted inappropriately. Perhaps this is justified however, as the creditors would have known this to be the case when entering into any dealing with the company. Nevertheless, this ought not relieve the responsibility of having to repay debts, as the creditor has asserted trust in the company.

It can be tough to ascertain expected return, even where risk has been calculated. Evidently there is a gap in understanding how expectations come to be, and what the impact of these expectations are on the decision making process. Additionally, utility is hard to understand at times. The disparity emanates from a lack of understanding in sociology and psychological knowledge when trying to assess the concept.

2.3 Troubles with Allowing Zone of Insolvency Expectations

Implementing ZOI rules which at all make risk-taking less attractive may greatly impact the director’s decision making ability. Penalties for taking risks presumably lead to director’s acting with extreme caution. In a reality where directors are personally liable for failed risk-taking, the benefits for maximising the shareholder’s utility in a large company would be minuscule. In a situation where it is possible to return to the comfortable realms of solvency, timid actions may lead to the company failing to reach it’s potential worth. Value is prevented from being added to the company, as risk-taking drives profits. There would not be a large enough incentive for the directors to leave themselves vulnerable to personal liability should their risk fail and they have not satisfied the requirements of the law. Trying to obtain value for the shareholders only returns potential bonuses and job security. UK law promotes entrepreneurship, and ZOI restrictions would impede this. This is neither good for the shareholders nor the creditors. 

Apart from this attractive side to risk, creditors may not require additional protection as routes already exist to shelter them. The current belief is that sufficient methods are in place to guard the creditors. Creditors can include methods of protection within their contracts, which gives an element of control over their fate. Further ZOI protection may not be necessary were the creditor to merely allocate more resources in overseeing the company’s progress. Keeping in check with the financial affairs, through monitoring statements and otherwise exercising supervision, will allow the creditor spot any warning signs that the borrower is in distress. If these methods show any alarming signs, a contractual clause may have been included from the outset to allow for the appointment of a receiver. 

Creditors willingly enter into business with the company, and need not contract with a company if they so wish. Creditors wishing to counteract carrying the burden of risk may contract for an increased risk premium to be paid, in the form of higher interest payments. The creditors must themselves be wise as to who they decide to supply finance to. It would be unfair to see methods of protection extend to creditors who knowingly entered into a contract with a party it considered quite likely to cause problems. This would be counterintuitive, allowing the creditors risk be protected while the director’s risk is punished. Either way, creditors may just rely on negotiating debt restructuring as a way to gain more control when a company is failing. Risky ventures may then be influenced through overseeing the investments and financial opportunities.

CHAPTER 3: THE IMPACT OF WRONGFUL TRADING

Statutory regulation in the UK demands that director’s do not engage in irresponsible conduct when insolvency is inevitable. The distinction between this and the ZOI is that wrongful trading occurs when there is no legitimate way of escaping insolvent liquidation and returning to operating on a going-concern basis. The legal obligation to avoid wrongful trading is aimed at protecting the creditors. Section 214 of the Insolvency Act implements rules which allow a director be held personally liable where their actions lead to an increase in company debts. The director allowed this to occur even though they knew or ought to have known that the company continued to trade when insolvent liquidation was unavoidable. The standard is thus not in place to evaluate the level of a director’s culpability, but to definitively assert whether or not they acted when the reality of the company should have seen the creditors’ interests prioritised.

As has been noted, creditors are most easily recognised as being contractual claimants prior to insolvency, and this generally offers satisfactory protection. However, there is good reason for the wrongful trading provision. Creditors are the ones who are most exposed to the harshness of insolvency proceedings, and thus deserve the consideration of the directors. At this time, the assets remaining in the company will not be substantial enough to cover the pool of claims which will remain upon the inevitable death of the company. The protection creates a civil standard through which creditors can make claims, not needing to reach the onerous levels required by criminal claims of fraudulent trading. The wrongful trading provision deals with directors who should be punished for creating debts that it is not possible for the company to deal with. Additional debt adds to the dire condition of the company and further worsen the creditors’ prospects. 

The financial position of the company should be relevant in the minds of the directors. The wrongful trading provision goes a long way in helping to create this consideration. Limited liability is an invaluable feature which is crucial to allowing companies operate as they currently do. This phenomenon has the drawback of acting as a shield through which directors can feel free from burden. Section 214 therefore sees the director’s thoughts align with those of the creditors. A level of consistency is attached to what is expected of director’s when they make decisions that impact creditors. The director’s ability to blindly pursue an objective without considering the effect this will have on the creditors is negated. The desire for growth is superseded by the need to act responsible and appreciate the agreement with creditors.

Directors are therefore motivated to respond to threats of insolvency in a swifter manner.

Deterrence is a major factor for introducing the wrongful trading provision. The measure facilitates in governing director’s behaviour, discouraging undesirable conduct by the attachment of consequences. Directors do not want to be personally liable, it is instead more attractive to guard the creditor’s stake. The provision is ex ante in this sense, predictably there will be a curtailment of negative actions in the future due to it’s existence.

The point at which Section 214 becomes relevant is the moment where a director knows or ought to have known that the company was experiencing such financial distress that there was no reasonable prospect of avoiding insolvent liquidation. In order for a director to be held accountable,  evidence must show that the decision to continue trading had a negative impact on the creditor constituency. This relates to the asset shortfall which exists within the company, which should not increase after the director realises the intensity of the situation. To cause further debt would collide with the wishes of the creditors.

Wrongful trading is viewed by either an objective or subjective standard. Objectively, the director is judged as a reasonably diligent person, one with sufficient skill, knowledge and experience for the role. This is the basic standard for any individual who fulfilled the position of director. If, in reality, the director is more proficient, creditors will see an increased subjective standard attached to the director.

When arguing that wrongful trading occurred, a relevant date must be considered as the point at which the company should have stopped trading. This date requires that the company’s net deficiencies be more attractive than when the director was found trading. This shift occurs at the point that the debtor experiences financial distress beyond any means of recovery. It remains that assets were unable to cover all claims at this date, but the depleted pool was still more valuable than what the director’s conduct led to. Of course, it may be more onerous to determine this timeframe in practice. The extent to which a guilty director will be penalised is a matter for the courts to resolve.

The rule is in place for good reason. Directors usually create value for the benefit of the shareholders. This constituency, though essential, puts a finite amount of finance at risk when investing. Creditors also only contribute a fixed amount of capital, yet do not seek to make the unrestrained earnings which are possible for the shareholders. The creditor-focused protection is thus justified, similar to the fact that shareholders can enjoy the fiduciary duties protecting their investment when the company is a going-concern. Upon the real likelihood of insolvency approaching, the interests of the creditors closely align with those of the company. It may be fair that this element of fiduciary duty, that of loyalty, shifts to the creditor as their equitable interest in the company exceeds that of the shareholder. It is therefore reasonable that a director be held liable when they have decided to continue trading, as this loyalty is absent.

Director’s owe it to the creditors to halt additional debts, and it is fair that a sum be payable as punishment for disregarding this. Furthermore, it is sensible to attach the penalty to any director in a position where they knew or ought to have known to cease trading. A director may not claim ignorance to the reality of the situation if they were in a position where it was appropriate that they were informed about the company’s position. If a director legitimately cannot discern how to perform, the expectation is that professional advice shall be sought. It is apparent that all possible measures must be taken in order to constrict the loss the creditors could experience. The courts will look kindly at directors who show initiative and seek advice on how best to deal with the unpleasant situation. Rather than sit idly by, directors ought take information on board and use it to aid the creditors.

Under the tort of deepening insolvency, the US has a standard which mimics that of the UK. This is not supported in the state of Delaware, however, which much of the previous discussion regarding the US stems from. Deepening insolvency punishes prolonging the life of a company, as it has a negative impact on creditors’ claims. Any remaining finances within the company will be depleted and inaccessible for claims, where this occurs. Specific actions are carried out purely in hope of reviving the company. This does not assist the creditors claims in any way, negligently draining resources from the corporation. Creditors ought therefore be allowed to seek damages due to the director’s attempting to undermine the company.

Upon discovering that there is no reasonable prospect of recovery, it would be wise for a director to inform the creditors about the position which the company is in. In the normal course of business it may not be relevant to divulge such information. This proactive behaviour benefits the creditors, allowing them keep track of this change within their own records while also allowing them influence any further decisions the company makes. The director will be inclined to do this in order to avoid being personally liable. Furthermore, documenting all information on how the creditors interests were considered is beneficial. At board meetings, discussing the financial state of the company and raising any concerns shall show that attention was given to the creditors. It is good practice for director’s to keep track of their input to company so that the “knew or ought to have known” standard can be debated. This is particularly relevant if minutes of board meetings are used as evidence under Section 249 of the Companies Act.

The impact of Section 214 has been limited since it’s first inception. Though a lot of promise still remains, many drawbacks to the section are evident. A large criticism is that the claim can only be brought through insolvent liquidation, and thus protection is narrowed. The wrongful trading mechanism cannot be applied for any other form of winding up, or prior to winding up. The creditors may be better served if this approach was available prior to insolvent liquidation. The directors would be governed in a stricter manner through this, fearful that the creditors could assert a claim whenever there are hints that there is wrongful trading conduct. Creditors themselves would be able to fund this action, this in itself will not cause the company any additional expense.

As it currently stands, the creditors cannot bring a claim under Section 214. Instead, there is reliance on the liquidator to do so. The weight of evidence shall determine whether the liquidator believes that success is likely. Due to using finances from the asset pool owed to the creditors, the liquidator may not feel that pursuing a claim is the best option as it drains assets from the creditors’ pool of resources.

The extent of protection by the wrongful trading standard is quite narrow when compared to other jurisdictions. Applying the tests for insolvency may not strictly lead to Section 214 applying if judged through the standard of “knew or ought to have known”. Simply, being unable to pay debts when they fall due does not necessarily mean the directors ought to have known to stop trading. This standard is ambiguous, and cases which see success are normally a lot more straightforward. In reality it is very tough for a director to know what constitutes being insolvent, and if insolvent liquidation is unavoidable. Of course, a company may be insolvent but still reasonably assume that a return to positive dealings is acceptable. It is a lot easier to look at the facts retrospectively when wishing to attach liability, though the test itself is not black and white 

CONCLUSION

The ZOI is of crucial importance when discussing the rights of stakeholders. The unclear approach which the UK takes with the ZOI has been investigated in this research. It is apparent that ambiguity within UK legislation will create problems, when director’s wish to discern to whom they owe their duty. The “certain circumstances” referred to in Section 172(3) are puzzling. Fixing this uncertainty would allow resources be allocated more beneficially.

The approach which the US takes when governing director’s business decisions reflects that which is expected from the UK. The attitude of protecting director’s judgment was analysed, in order to understand why the courts refrain from imposing their own view.

This research has put forward indicators which may be used to assess whether a company is operating within the ZOI. Various factors have been listed and discussed, in order to expand the knowledge past that which is offered by current insolvency tests. A high degree of confusion may still exist due to there being no specific event which triggers the ZOI by itself. This would be expected to be clearer, as directors’ duties will shift from maximising the wealth of the shareholder to instead protecting creditor interests.

A test proposed that director’s behaviour ought be scrutinised at a deeper level than is currently witnessed. A rational actor’s utility is expected to remain constant, and any large deviation from this may appropriately see an individual as failing to act in good faith. Altering the utility of how much value is attached to risk should not correspond with the diminishing health of the company. Upon determining this, it is deemed to be fair that a director is held as being in breach of duty. Personal liability should stem from this.

Perhaps there is a more accurate test, though creating this appears troublesome. Criticisms of the proposed test were raised. Risk was identified as being valuable, as it enables profits to be made. Furthermore, it was proposed that adequate methods already exist, through which creditors can gain protection. 

The purpose of the wrongful trading provision was explored. This is distinct to the ZOI, as it only occurs when the company is irretrievably insolvent. Methods through which a director can avoid liability were recommended, and shortcomings of the section were confronted.

Realistically, the ZOI may just rely on the facts of each individual case. As it currently stands, the ZOI will not expectantly be of much help to creditors wishing for their interests to be promoted. Creditors will find it difficult to have specific duties attached to directors within this timeframe. Improvements will only occur when greater clarity is offered within the UK corporate landscape. Were it to be regulated in a more constructive way, efficiency could be created which would generate value within the market.

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