#5298 - Creditor Protection - Company Law

Creditor Protection

The capital rules provide limited protection for creditors on some views. There are other measures outside the capital rules through which also try to protect creditors.

There is a general shift towards ex-post facto regulation to protect creditors. This was an approach also preferred by the Cork report. I agree that ex-post facto rules are the best way forward. They allow the flexibility for companies to develop effectively but provide punishments and try to sort the situation if it goes wrong or if there is improper behaviour.

The ex-post rules are particularly aimed at small over managed companies, and the particular problems that this type of company poses with the director and shareholder being the same any breach of directors duty is more likely to remain undetected for longer.

The Cork Report asserted that sanctions on directors are necessary to prevent abuse of the limited liability. This would be consistent with focusing the rules on small owner managed private companies; there can be no doubt that these pose the greatest likelihood for limited liability abuse.

There are generally two types of regulations:
Private recovery rules

These enable liquidators to seek a remedy against a wrongdoing director in respect of particular actions; this is solely for the benefit of the creditors.

Public interest regulations

These are not particularly for the benefit of creditors; they are more focussed on putting protection in place in the public interest so as to prevent bad behaviour of directors generally, e.g. disqualification from being a director.

There are various statutory protections for creditors; they are of varying degrees of effectiveness.

Wrongful trading: Insolvency Act 1986 s.214

A director commits an offence of wrongful trading if the company is insolvent but the director continues to trade despite the fact that he knows or ought to know that there was no reasonable prospect of avoiding insolvency. (Insolvency Act 1986 s.214)

The wrongful trading rule is intended to prevent directors from being reckless. It only applies which have gone into liquidation (this is the most serious form of insolvency). It can be difficult to work out what a director knew or ought to have known, but the courts seem to take a generous approach.

Re Hawkes Hill

• Mr Justice Lewiston: the determination of what the directors knew or ought to have concluded with regards to the company’s prospects of insolvency should not depend on a snapshot at any given time. It depends on rational expectations of what the future might hold. The fact that directors were not clairvoyant and failed to foresee what would eventually come to pass does not make them guilty of wrongful trading.

West Mercia

• From the point at which the company goes insolvent, the directors’ duties flip to be to protect and promote the best interests of the creditors.

There have been very few cases under Insolvency Act 1986 s.214. This could show it was ineffective because of uncertainties. Liquidators may feel they don’t have a convincing chance of recovery; liquidities are personally liable if they waste assets on frivolous liquidation.

Another reason for so few IA1986s.214 cases, only about 30, could be that generally a director in a small company is already bankrupt himself anyway due to the personal guarantee which banks extract.

Fraudulent Trading: Insolvency Act 1986 s.213

A director commits the offence of fraudulent trading if he continues to trade in insolvency with the intention to defraud creditors.

There is a very high measure requirement. Very difficult to prove.

Transactions at an under value: Insolvency Act 1986 s.238

A director enters into a transaction at an under value if:

1. The company enters into a transaction or makes a gift for no consideration. Or

2. The company enters into a transaction in which it receives consideration significantly less than the true value.

(Insolvency Act 1986 s.238(4))

There shall be no liability if the company entered into the transaction in good faith for the purposes of carrying out its business and there were reasonable grounds to believe that the transaction would benefit the company. (Insolvency Act 1986 s.238(5))

Phillips v. Brewin Dolphin

• Lord Scott said that consideration paid is to be valued at the date of the transaction. The value of the asset being transferred by the company should not be less than the amount a reasonable person would be willing to pay. If a specific valuation is possible then the court may accept a valuation range.

The transaction must have happened at the relevant time. Defined in Insolvency Act s.240 see below.

Preferences: Insolvency Act 1986 s.239

An unlawful preference is when a person receives preference and:

• That person is a creditor of the company. And

• The company does anything which put that creditor in a better position on insolvency than it would be if it had not been done.

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