Competing Approaches to Director Liability in the Zone of Insolvency

When should directors be held liable for their company’s distressed financial condition? In a recent article, we show that the answer varies widely across legal regimes. We focus on the zone of insolvency, a phase in the company’s life when its financial condition is unstable and deteriorating, but it has yet to enter a formal bankruptcy proceeding (and theoretically may never enter such a proceeding).

There are two main approaches to dealing with directors’ actions when their company is in this zone. Under the American and Canadian approach, directors are generally held to the same corporate law standards that apply when the company is solvent and profitable. The directors are expected to maximize the company’s profits and work for its best interests. In contrast, a  second approach imposes a new standard of behavior unique to the precarious circumstances the company faces. This approach has been adopted by the United Kingdom, Australia, Hungary, Israel, Malaysia, and New Zealand. Generally, it requires directors to consider the interests of the company’s creditors and minimize their losses and not just look out for the interests of the company itself.

Our article examines the costs and benefits of these regimes, ultimately concluding that applying an independent behavioral standard for directors in the zone of insolvency leads to inefficient results. Such a doctrine is problematic for at least two reasons. First, from a practical point of view, it creates legal uncertainty and generates unnecessary and harmful competition between bankruptcy law and corporate law. This approach may distort directors’ considerations when deciding whether the company should file for bankruptcy. When directors are exposed to personal liability for not promoting creditors’ interests and minimizing the scope of insolvency,  they have an incentive to commence bankruptcy proceedings early. This is troublesome because ideally, they should initiate these proceedings for economic reasons rather than personal ones: They should pursue  the course of action that is best for the company rather than the one that is less risky for them.

Second, more broadly, such an arrangement does not acknowledge a basic, though somewhat neglected, insight: Corporate law and bankruptcy law are intertwined and based on similar goals – even though, in the United States, the former is largely a matter of state law and the latter a matter of federal law. On a theoretical level, they share similar foundations and core principles. On a practical level, market players take them both into account when making business decisions. When considering this bond between these two areas of law, we conclude that a company’s operations should be examined along a single extended spectrum. The overall legal framework governing companies’ activities should aim to reflect the shared foundations of corporate and bankruptcy law and attempt to form consistent definitions and criteria.

The approach of maintaining corporate law standards when insolvency occurs or is near is preferable because it generates more efficient results and better reflects the shared theoretical foundations of corporate law and bankruptcy law. Furthermore, we posit that the concern that creditors’ interests will not be sufficiently considered under this approach is unfounded. First, in the last few decades, directors’ duties were expanded to include the interests of constituents beyond just shareholders. The law now acknowledges stakeholders as players whose interests are relevant to the company and, in effect, to its directors. Second, creditors normally have other means of protecting themselves from directors’ opportunistic behavior. For example, they may use contract provisions to mitigate the risks associated with their transactions with the company. Contracts also enable creditors to develop solutions tailored to their concerns, minimizing uncertainty and unpredictability for creditors and directors alike. We conclude that legal systems that aim for more efficient results should refrain from enacting laws that create two different standards for directors’ liabilities. Efficiency will benefit both corporations – whether they are healthy or in financial distress – and creditors.

This post comes to us from Odelia Minnes, an associate professor of Law and academic director at Ono Academic College, and Dov Solomon, an associate professor of law and head of the Commercial Law Department and the LL.M. program at the College of Law and Business, Ramat Gan Law School. It is based on their recent article, “Game of Thrones: Corporate Law and Bankruptcy Law in the Arena of Directors’ Liability,” available here.