DIRECTORS DUTIES TO CREDITORS by SULETTE LOMBARD submitted in partial fulfilment of the requirements for the degree DOCTOR LEGUM in the FACULTY OF LAW UNIVERSITY OF PRETORIA PROMOTOR: PROF DR PA DELPORT Pretoria AUGUST 2006
VOORWOORD Met opregte dank en waardering aan die volgende persone vir die bydrae wat hulle tot hierdie proefskrif gelewer het: Prof Piet Delport, my promotor, vir sy deurlopende bystand, waardevolle advies en bekwame leiding. Prof Chris Nagel vir hulp met die redigering van die proefskrif. My familie, vriende en kollegas vir hul deurlopende belangstelling, aanmoediging en ondersteuning. n Besondere woord van dank aan my ouers, Isak en Erika Roos, vir hul liefde, geloof in my vermoëns en getroue ondersteuning met hierdie proefskrif en al my ander studies. Hierdie proefskrif word opgedra aan my man, Gerrit en ons kinders, Cara, Jeanne en Gerrit. n Spesiale woord van dank kom hulle toe vir volgehoue aanmoediging, ondersteuning, geduld, begrip en opoffering. Die proefskrif sluit relevante regsontwikkelings tot en met 30 April 2006 in. Sulette Lombard Augustus 2006
TABLE OF CONTENTS PART I: GENERAL ORIENTATION Chapter 1: Introduction...3 1.1 BACKGROUND...3 1.2 PURPOSE OF STUDY...5 1.3 EXPOSITION...5 1.4 LIMITATION OF SCOPE...7 1.5 METHODOLOGY...8 PART II: JUSTIFICATION OF A DUTY TO CREDITORS Chapter 2: Conceptual Justification...13 2.1 INTRODUCTION...13 2.2 THEORIES ON THE NATURE OF THE COMPANY...14 2.2.1 General...14 2.2.2 Contractual Theories...15 2.2.2.1 General...15 2.2.2.2 Legal Contractualism...16 2.2.2.3 Economic Contractualism...17 2.2.3 Communitarian Theories...17 2.2.4 Concessionary Theories...19 2.2.4.1 General...19 2.2.4.2 Dual Concession Theory...21 2.2.5 Associative Theories...22 2.2.6 Application to a Duty to Creditors...23 2.2.6.1 Contractual Theories...23 2.2.6.2 Communitarian Theories...24 2.2.6.3 Concessionary Theories...25 i
2.2.6.4 Associative Theories...25 2.3 CREDITORS CONTRACTUAL RELATIONSHIP WITH THE COMPANY...27 2.3.1 General...27 2.3.2 Freedom to Negotiate...28 2.3.3 Adequacy of Contractual Protective Measures...28 2.3.3.1 Risk Compensation...28 2.3.3.2 Guarantees and Loan Covenants...30 2.3.4 Efficiency Concerns...30 2.3.5 Conclusion...31 2.4 SHAREHOLDERS V CREDITORS AS PRIMARY CORPORATE CONSTITUENTS...32 2.4.1 General...32 2.4.2 Owners of the Company...33 2.4.3 Relative Strength of Bargaining Power...34 2.4.4 Residual Risk-bearers...35 2.4.5 Efficient Monitors of Managerial Performance...38 2.4.6 Differences Between Equityholders and Debtholders...41 2.4.7 Conclusion...43 2.5 EFFECT OF A DUTY TO CREDITORS ON DIRECTORS BEHAVIOUR...44 2.5.1 General...44 2.5.2 Fragmentation of Duties...44 2.5.3 Increased Risk Averseness...45 2.5.4 Reluctance to Serve on Company Boards...47 2.6 EFFECT OF A DUTY TO CREDITORS ON LIMITED LIABILITY...48 2.7 CONCLUSION...52 Chapter 3: Evaluation of Alternative Remedies...55 3.1 INTRODUCTION...55 3.2 STATUTORY MEASURES PROVIDING FOR DIRECTORS PERSONAL LIABILITY...57 ii
3.2.1 South Africa...57 3.2.1.1 Applicants...58 3.2.1.1.1 Question as to Whether Claim Should be Quantified...58 3.2.1.1.2 Effect of Implementation of Compromise in terms of Section 311 on Locus Standi of Creditor...59 3.2.1.2 Winding-Up, Judicial Management or Otherwise...60 3.2.1.3 Recklessly...61 3.2.1.4 Fraudulently...63 3.2.1.5 Consequences of a Successful Application...64 3.2.1.5.1 Liability for Which Debts?...64 3.2.1.5.2 Creditors Who Are Benefited...65 3.2.1.5.3 Punitive Element...66 3.2.1.6 Evaluation...67 3.2.2 Comparative Study...71 3.2.2.1 Australia...71 3.2.2.2 New Zealand...75 3.2.2.3 England...76 3.2.2.4 Canada...81 3.3 TYPICAL INSOLVENCY REMEDIES...83 3.3.1 General...83 3.3.2 Statutory Voidable Dispositions...84 3.3.2.1 Dispositions Not for Value...84 3.3.2.2 Voidable Preferences...84 3.3.2.3 Undue Preferences...85 3.3.3 Common Law Remedy: Actio Pauliana...85 3.3.4 Evaluation...86 3.4 PIERCING THE CORPORATE VEIL...90 3.5 CONCLUSION...93 iii
PART III: FRAMEWORK FOR A DUTY TO CREDITORS Chapter 4: Judicial Framework...97 4.1 INTRODUCTION...97 4.2 TYPE OF DUTY...100 4.2.1 Introduction...100 4.2.2 Australia...101 4.2.3 New Zealand...102 4.2.4 England...103 4.2.5 Canada...104 4.2.6 United States of America...105 4.3 POINT IN TIME WHEN THE DUTY ARISES...106 4.3.1 Introduction...106 4.3.2 Australia...106 4.3.3 New Zealand...108 4.3.4 England...109 4.3.5 Canada...110 4.3.6 United States of America...111 4.4 BENEFICIARY OF THE DUTY...114 4.4.1 Introduction...114 4.4.2 Australia...116 4.4.3 New Zealand...116 4.4.4 England...118 4.4.5 Canada...119 4.4.6 United States of America...121 4.5 PROTECTED CREDITORS...121 4.5.1 Introduction...121 4.5.2 Australia...122 4.5.3 New Zealand...123 4.5.4 England...124 iv
4.5.5 Canada...125 4.5.6 United States of America...125 4.6 POWER OF THE GENERAL MEETING TO RATIFY A BREACH OF THE DUTY.125 4.6.1 Introduction...125 4.6.2 Australia...126 4.6.3 New Zealand...126 4.6.4 England...127 4.6.5 Canada...128 4.6.6 United States of America...128 4.7 CONCLUSION...128 Chapter 5: Protection Afforded by Fiduciary Duties...132 5.1 INTRODUCTION...132 5.2 SOURCES AND FORMULATION...135 5.2.1 South Africa...135 5.2.2 Australia...136 5.2.3 New Zealand...137 5.2.4 England...138 5.2.5 Canada...142 5.2.6 United States of America...142 5.3 RELEVANT ELEMENTS...143 5.3.1 Acting in Good Faith in the Best Interests of the Company...143 5.3.1.1 General...143 5.3.1.2 Requirement of Good Faith...144 5.3.1.3 Defining the Interests of the Company...145 5.3.2 Maintaining an Unfettered Discretion...150 5.3.2.1 General...150 5.3.2.2 Nominee Directors...150 5.3.3 Avoiding a Conflict of Interests...155 5.3.3.1 General...155 v
5.3.3.2 Unwarranted Personal Benefit...156 5.3.3.3 Contracts with the Company...156 5.4 CONSEQUENCES OF BREACH OF DUTY...157 5.4.1 General...157 5.4.2 Setting Aside of Transaction...157 5.4.3 Civil Personal Liability...158 5.4.3.1 Extent of Personal Liability...158 5.4.3.2 Basis of Personal Liability...159 5.4.3.3 Defendant...161 5.4.3.3.1 Definining Director...161 5.4.3.3.2 De Facto Directors...163 5.4.3.3.3 Non-executive Directors...165 5.4.3.3.4 Puppet, Dummy or Stooge Directors and Shadow Directors...166 5.4.4 Pecuniary Penalty Orders...168 5.5 APPLICATION TO A DUTY TO CREDITORS...169 5.5.1 Sources...169 5.5.2 Formulation...171 5.5.3 Relevant Elements of Fiduciary Duties...174 5.5.3.1 Acting in Good Faith in the Best Interests of the Company...174 5.5.3.2 Maintaining an Unfettered Discretion...177 5.5.3.3 Avoiding a Conflict of Interests...181 5.5.4 Consequences of Breach...182 5.5.4.1 Remedy...182 5.5.4.1.1 Personal Liability...182 5.5.4.1.2 Pecuniary Penalty Order...183 5.5.4.2 Basis of Liability...183 5.5.4.3 Defendant...184 5.6 CONCLUSION...185 vi
Chapter 6: Protection Afforded by the Duty of Care and Skill...189 6.1 INTRODUCTION...189 6.2 SOURCES AND FORMULATION...191 6.2.1 South Africa...191 6.2.2 Australia...194 6.2.3 New Zealand...195 6.2.4 England...196 6.2.5 Canada...199 6.2.6 United States of America...199 6.3 RELEVANT ASPECTS...200 6.3.1 Elements of Care, Skill and Diligence...200 6.3.1.1 Duty of Care...200 6.3.1.2 Duty of Skill...200 6.3.1.3 Duty of Diligence...202 6.3.2 Required Standard...203 6.3.2.1 South Africa...203 6.3.2.2 Australia...204 6.3.2.3 New Zealand...206 6.3.2.4 England...208 6.3.2.5 Canada...208 6.3.2.6 United States of America...209 6.3.3 Distinction Between Executive and Non-Executive Directors...211 6.3.3.1 South Africa...211 6.3.3.2 Australia...213 6.3.3.3 New Zealand...214 6.3.3.4 England...215 6.3.3.5 Canada...215 6.3.3.6 United States of America...216 6.3.4 Reliance on Others...216 6.3.4.1 South Africa...216 vii
6.3.4.2 Australia...217 6.3.4.3 New Zealand...218 6.3.4.4 England...218 6.3.4.5 Canada...219 6.3.4.6 United States of America...219 6.4 CONSEQUENCES OF BREACH...220 6.4.1 South Africa...220 6.4.2 Australia...221 6.4.3 New Zealand...222 6.4.4 England...222 6.4.5 Canada...222 6.4.6 United States of America...223 6.5 APPLICATION TO A DUTY TO CREDITORS...225 6.5.1 Sources...225 6.5.2 Formulation...228 6.5.3 Relevant Aspects...229 6.5.3.1 Required Standard...229 6.5.3.1.1 Duty of Care...229 6.5.3.1.2 Duty of Skill...233 6.5.3.2 Distinction Between Executive and Non-executive Directors...234 6.5.3.3 Reliance on Others...234 6.5.4 Consequences of Breach...236 6.5.4.1 Basis of Liability...236 6.5.4.2 Suitability of Remedy...238 6.5.4.3 Inadequate Information...238 6.5.4.4 Judicial Reluctance...241 6.6 CONCLUSION...243 viii
Chapter 7: Point in Time When the Duty Arises...248 7.1 INTRODUCTION...248 7.2 DEFINING THE TRIGGERS...250 7.2.1 Insolvency...250 7.2.1.1 General...250 7.2.1.2 Definition of Insolvency in Cases dealing with Directors Duties to Creditors...251 7.2.1.2.1 Australia...251 7.2.1.2.2 New Zealand...252 7.2.1.2.3 England...252 7.2.1.2.4 United States of America...253 7.2.1.3 Definition of Insolvency in Context of Application of Section 424(1)...254 7.2.1.3.1 Commercial or Factual Insolvency?...254 7.2.1.3.2 Debt Subordination...256 7.2.1.4 Definition of Insolvency in Other Statutory Measures Aimed at the Protection of Creditors...258 7.2.1.5 Suggested Definition of Insolvency...259 7.2.1.5.1 Balance Sheet and/or Commercial Insolvency?...259 7.2.1.5.2 Objective Test...261 7.2.1.5.3 Under-capitalized Companies and Debt Subordination...262 7.2.1.5.4 Insolvency in Fact...262 7.2.2 Doubtful Solvency...264 7.2.2.1 General...264 7.2.2.2 Definitions and Guidelines Provided by Commentators...264 7.2.2.3 Suggested Definition of Doubtful Solvency...267 7.2.3 Actions Causing Insolvency...267 7.2.3.1 General...267 7.2.3.2 Suggested Formulation of Actions Causing Insolvency...268 7.3 FACTORS INFLUENCING PREFERENCE FOR A TRIGGER...268 7.3.1 General...268 ix
7.3.2 Need for Precision...269 7.3.3 Need for Risk-taking...270 7.3.4 Director Reaction...272 7.3.5 Increase in Cost...274 7.3.6 Role of the Judiciary...274 7.3.7 Reconciling Triggers with Conceptual Justification for a Duty to Creditors...276 7.3.7.1 General...276 7.3.7.2 Insolvency and Doubtful Solvency...276 7.3.7.3 Actions Causing Insolvency...278 7.4 PRACTICAL APPLICATION OF THE TRIGGERS...279 7.4.1 Insolvency and Doubtful Solvency...279 7.4.2 Actions Causing Insolvency...282 7.4.3 Summary...284 7.4.3.1 Insolvency or Doubtful Solvency as Triggers...284 7.4.3.2 Actions Causing Insolvency as Trigger...285 7.5 CONCLUSION...285 Chapter 8: Beneficiary of the Duty...291 8.1 INTRODUCTION...291 8.2 ORTHODOX VIEW...294 8.2.1 Interest of the Company...294 8.2.2 Enforcement of Directors Duties...296 8.2.3 Ratification of a Breach of Directors Duties...297 8.2.3.1 Distinction between Ratifiable and Unratifiable Wrongs...297 8.2.3.2 Ratification by Directors as Shareholders...300 8.2.3.3 Ratification by Unanimous Consent...303 8.3 JUDICIAL METHODS FOR EXTENDING DIRECTORS DUTIES TO CREDITORS...305 8.3.1 Indirect Duty Method...305 8.3.1.1 Beneficiary of Duty...305 x
8.3.1.2 Right of Action...306 8.3.1.3 Power of Ratification...307 8.3.2 Direct Duty Method...306 8.3.2.1 Beneficiary of Duty...308 8.3.2.2 Right of Action...308 8.3.2.3 Power of Ratification...309 8.4 EVALUATION OF JUDICIAL METHODS...309 8.4.1 Indirect Duty Method...309 8.4.1.1 Perceived Advantages...309 8.4.1.2 Perceived Problems...311 8.4.2 Direct Duty Method...313 8.4.2.1 Perceived Advantages...313 8.4.2.2 Perceived Problems...314 8.4.3 Summary...316 8.5 SUGGESTED METHOD...318 8.5.1 Beneficiary of Duty...318 8.5.2 Classes of Creditors...319 8.5.3 Right of Action...321 8.5.3.1 Creditors Derivative Action...322 8.5.3.2 Flexible Definition of Membership...324 8.5.3.3 Summary...326 8.5.4 Power of Ratification...327 8.6 CONCLUSION...329 Chapter 9: Relief from Liability...332 9.1 INTRODUCTION...332 9.2 RELIEF BY THE COURT...335 9.2.1 Introduction...335 9.2.2 Statutory Provisions Empowering Courts to Grant Relief...336 9.2.2.1 South Africa...336 xi
9.2.2.2 Australia...337 9.2.2.3 England...338 9.2.2.4 Evaluation...338 9.2.2.4.1 Applicability of Relieving Provisions in Case of Statutory Liability...338 9.2.2.4.2 Uncertainty Regarding Proceedings to which Relieving Provisions Will Apply...341 9.2.2.4.3 Anomaly in that Person who Acted Negligently Is Entitled to Relief if He Acted Reasonably...342 9.2.2.4.4 Extent of the Court s Discretion...344 9.2.3 The Business Judgment Rule...345 9.2.3.1 United States of America...345 9.2.3.2 Australia...349 9.2.3.3 Evaluation...352 9.2.3.3.1 Arguments in Favour of a Statutory Business Judgment Rule...352 9.2.3.3.1.1 Judiciary s Stance on Pronouncing on Business Decisions...352 9.2.3.3.1.2 Encouragement of Risk-Taking...352 9.2.3.3.1.3 Need for Protection at the Moment When Directors Take Business Judgments...353 9.2.3.3.1.4 Arguments from Fairness and Expediency...353 9.2.3.3.2 Arguments against a Statutory Business Judgment Rule...354 9.2.3.3.2.1 Superfluity of a Statutory Business Judgment Rule...354 9.2.3.3.2.2 Limited Application of and Protection Afforded by the Rule...355 9.2.3.3.2.3 Creation of Formalism...356 9.2.3.3.2.4 Realism About Shareholder Litigation Risk...356 9.2.3.3.2.5 Effect of a Statutory Rule On the Content of a Duty of Care...356 9.2.3.3.2.6 Doctrinal Conflicts...358 9.2.3.3.2.7 Uncertainty Regarding Parameters of the Business Judgment Rule...358 9.2.4 Application to a Duty to Creditors...359 9.3 INDEMNIFICATION...362 xii
9.3.1 Introduction...362 9.3.2 Statutory Regulation...362 9.3.2.1 South Africa...363 9.3.2.2 Australia...364 9.3.2.3 New Zealand...366 9.3.2.4 England...368 9.3.2.5 Canada...369 9.3.2.6 United States of America...369 9.3.3 Application to a Duty to Creditors...374 9.3.3.1 General Indemnity and Exemption...374 9.3.3.1.1 General...374 9.3.3.1.2 Section 247(1) and Modifying or Releasing Provisions in Articles of Association...376 9.3.3.1.3 Application of Section 247(1) in a Group Context...379 9.3.3.2 Indemnity against Liability for Legal Expenses...381 9.4 DIRECTOR LIABILITY INSURANCE...382 9.4.1 Introduction...382 9.4.2 Statutory Regulation...383 9.4.2.1 South Africa...383 9.4.2.2 Australia...384 9.4.2.3 New Zealand...385 9.4.2.4 England...386 9.4.2.5 Canada...387 9.4.2.6 United States of America...387 9.4.3 Application to a Duty to Creditors...388 9.4.3.1 General...388 9.4.3.2 Statutory Regulated Access...389 9.4.3.3 Consequences of Non-compliance with Statutory Requirements...391 9.5 CONCLUSION...392 xiii
PART IV: CONCLUSION Chapter 10: Conclusion...396 10.1 BACKGROUND...396 10.2 JUSTIFICATION OF A DUTY TO CREDITORS...397 10.2.1 Conceptual Justification of a Duty to Creditors...397 10.2.2 Need for a Duty to Creditors...398 10.2.2.1 Statutory Personal Liability...398 10.2.2.2 Typical Insolvency Remedies...400 10.2.2.3 Piercing the Veil...400 10.3 FRAMEWORK FOR A DUTY TO CREDITORS...401 10.4 DEVELOPMENT OF A DUTY TO CREDITORS...406 10.5 CONCLUDING REMARKS...407 APPENDICES Summary...411 Opsomming...413 Bibliography: Books and Theses...417 Bibliography: Law Journals...423 Bibliography: Bills and Reports...441 Table of Cases...445 Table of Statutes...457 xiv