Abstract
Two recent developments in the United Kingdom and Ireland have reignited the debate regarding the scope of the directors’ fiduciary duties during financial distress when the creditors’ economic interests in the company’s assets assume greater significance. This paper examines these developments and discusses the reorientation of the directors’ fiduciary duties that is necessary in near insolvency and insolvency scenarios from shareholder interest primacy to safeguarding the creditors’ interests. This paper further discusses the implications and workability of such position in the Indian context to examine how the directors’ fiduciary duties towards creditors can be formalised under the Indian regime.
While the directors of a company owe their fiduciary duties to the company, traditionally, the shareholders are considered to be the derivative beneficiaries of the fiduciary duties of the directors, as they contribute to the capital of the company. In this context, the primary responsibility of the directors is to seek maximization of shareholder value (Keay, 2005). However, the scope of the fiduciary duties owed by the directors becomes a vexatious legal issue during the phase of financial distress, as the creditors’ economic interests in the company’s assets assume greater significance (Barondes et al., 2007; Hu & Westbrook, 2007). In such scenarios, from the creditors’ perspective, the assets of the company require preservation for resolution and debt realization, which object can often be at loggerheads with the shareholders’ preference for riskier profit-making objectives. While the shareholders may prefer the company to undertake risk-prone decisions in order to redeem their investment, the creditors may prefer a risk-averse approach in order to ensure that the assets of the company are preserved and available for resolution and distribution during formal insolvency. Accordingly, as trustees of the assets of a company, the directors’ duties may need a reorientation by taking into account the creditors’ interests in near insolvency and insolvency scenarios, as the creditors’ economic interests in the company’s assets assume significance in such scenarios on account of their prospective entitlement to the company’s assets on formal insolvency (Atkins & Luck, 2021;
Two developments have reignited this debate (Quinn & Gavin, 2023; Shekerdemian, 2022). In October 2022, the Supreme Court of the United Kingdom (UK) affirmed the existence of a common law duty for the directors of the company to take into account the interests of the creditors when the company is insolvent or is likely to become insolvent, as the economic interests of the creditors in the company’s assets are enhanced when the company is insolvent or bordering insolvency ( BTI 2014 LLC v Sequana SA, 2022). Further, in July 2022, Ireland codified the directors’ duty towards creditors when the company is or is likely to be unable to pay its debts (Companies Act, 2014, § 224A).
This article examines these developments and discusses the reorientation of the directors’ fiduciary duties that is necessary in near insolvency and insolvency scenarios from shareholder interest primacy to safeguarding the interests of creditors. The implications and workability of such a position in the Indian context are discussed to examine how the directors’ fiduciary duties towards creditors can be formalized under the Indian regime.
This article uses the terminology ‘near insolvency’ to encapsulate various expressions such as ‘borderline insolvency’, ‘insolvency zone’, and ‘twilight zone’, which have been used by jurists and courts to broadly refer to the period where the company is on the verge of being insolvent. Further, the term ‘insolvency’ is broadly used to refer to the onset of cash-flow insolvency (i.e., the company is not able to settle its debts as and when they fall due) or balance sheet insolvency (i.e., the liabilities of the company exceed its assets) of a company rather than the admission of a company into formal insolvency process.
The next section discusses the theoretical and practical justifications for extending the directors’ fiduciary duty towards creditors in near insolvency and insolvency scenarios. Subsequently, this article examines the contents and contours of the directors’ fiduciary duties towards creditors, including the trigger for the duty towards creditors and the consequences for breach of such duty, as set out under the UK and Irish positions. Thereafter, the authors analyse the current framework for the protection of the creditors’ interests under the Indian corporate law and insolvency law frameworks. In the last section, the authors propose the changes to be introduced under the Indian regime to actualize directors’ fiduciary duties towards creditors in near insolvency and insolvency scenarios.
THEORETICAL AND PRACTICAL JUSTIFICATIONS FOR RECOGNITION OF DUTY TOWARDS CREDITORS
This section discusses the justifications for the extension of the directors’ fiduciary duties towards creditors in near insolvency and insolvency scenarios in theory with some practical insights and justifications. First, the conceptual notion of the term ‘fiduciary’ is examined. Thereafter, this section problematizes the current debate regarding the scope of the directors’ fiduciary duties and dissects the possible ‘shift’ in the dominant economic interests in the assets of the company from the shareholders to the creditors in near insolvency and insolvency scenarios. Subsequently, this section provides the theoretical basis for considering the interests of creditors in near insolvency and insolvency scenarios as well as the real-world justifications for adopting such an approach.
While there are two conflicting theories regarding the scope of fiduciary duties of directors, that is, the shareholder approach, requiring the directors to focus only on maximizing shareholder wealth and the stakeholder approach, requiring the directors to take into account the interests of all stakeholders (Rönnegard & Smith, 2019), this section contends that even in the paradigm of shareholder approach, there exists a strong theoretical justification for extending the directors’ fiduciary duties to protect the interests of the creditors.
Fiduciary Law and Directors
In legal philosophy, the term ‘fiduciary’, which is derived from the Latin term ‘
In the context of corporate law, the common law fiduciary duty of the directors of the company is expressed as being owed to the company itself rather than any particular constituency (BTI 2014 LLC v Sequana SA, 2022, para. 18). The core fiduciary duties of the directors are the ‘duty of loyalty’ and the ‘duty of care’. The duty of loyalty obligates the directors to act in the interest of the company rather than any self-interest, whereas the duty of care requires the directors to make prudent and informed decisions regarding the functioning of the company (Black, 2001).
The directors of a company act in distinct fiduciary capacities
Problematizing the Debate
In relation to insolvency and near insolvency scenarios, the primary focus remains on whether the directors have discharged their fiduciary duties while dealing with the assets of the company, that is, whether the decisions taken by the directors regarding the property of the company exhibit due care and fairness by the directors in accordance with the trust reposed in them. While the company remains the ‘primary’ beneficiary of the fiduciary duties given that the company is the legal owner of the assets, the key question for debate is as to who should be considered as the proper ‘derivative’ beneficiaries of the assets of the company managed by the directors, that is, the shareholders or the creditors, on the basis of such constituency’s predominant ‘economic interest’ in the assets of the company.
To determine this question, this article relies on the theory of fiduciary duty proffered by Professor D. Gordon Smith (2002). Professor Smith (2002) provides a mechanism for distinguishing a fiduciary relationship from a non-fiduciary relationship. Professor Smith (2002) posits that a fiduciary relationship is formed ‘when one party (the ‘fiduciary’) acts on behalf of another party (the ‘beneficiary’) while exercising discretion with respect to a critical resource belonging to the beneficiary’. Generally, property may constitute as a critical resource in many fiduciary relationships. In other instances, a critical resource may undertake the form of anything of value given by the beneficiary, such as confidential information in an attorney–client relationship (Smith, 2002).
Professor Smith’s account of fiduciary duty will serve as a useful guide in determining: (a) who acts as the derivative beneficiaries of the company’s critical resources (i.e., assets); and (b) whether there is a creation of a fiduciary relation between the directors and such beneficiaries.
Economic Interest in the Assets of the Company
Before delving into the conceptual justifications for requiring the directors to take into consideration the interests of creditors in the discharge of their fiduciary duties, it is imperative to examine the nature of the economic interests of the shareholders and the creditors in the assets of the company.
While the company remains the legal owner of its assets, the shareholders have economic interests in the assets of the company owing to their embedded ownership of the company on account of their contribution of capital to the company (Hu & Westbrook, 2007). On the other hand, the creditors of the company also have economic interests in the assets of the company as well as its continued solvency so that the debts of the creditors can be satisfied (BTI 2014 LLC v Sequana SA, 2022, para. 246). Thus, the economic interests of the shareholders as well as creditors are mediated through the company.
In times of financial solvency, the economic interests of the company are aligned with the interests of the shareholders, as the shareholders primarily bear the commercial risks of the enterprise. However, as the company approaches near insolvency or insolvency scenarios, the relative importance of the economic interests of the creditors enhances
Theoretical Justifications for Extension of Directors’ Fiduciary Duties Towards Creditors
All of the above theories provide some justification for extending the directors’ fiduciary duties towards creditors during insolvency and near insolvency scenarios. However, there are some limitations and criticisms to some of them. For instance, while the trust fund theory may work in most insolvency scenarios, it may not provide an adept framework for near insolvency scenarios, as the economic interests of the shareholders in the company’s assets may still persist. Thus, in such circumstances, there is no strong justification for completely relegating the shareholders’ economic interests and for treating the creditors’ interests as paramount. Similarly, the subrogation theory also overestimates the value of the economic interests of the creditors in near insolvency and insolvency scenarios and disproportionately discounts the economic interests of the shareholders. Further, a mere change in risk incentives does not provide a strong enough rationale for the imposition of fiduciary duties, as a mere change in risk incentives does not in itself create a trustee–beneficiary relationship between the directors and the creditors.
The economic interest theory, which forms the underlying rationale of the UK Supreme Court in BTI 2014 LLC v Sequana SA & Others (2022) (‘Sequana Case’), provides the apt justification for reorientation of the fiduciary duties of the directors to encompass the interests of the creditors in near insolvency and insolvency scenarios, as the relative importance of the economic interests of the creditors enhances in comparison to the shareholders’ economic interests when the company approaches insolvency. The underlying tenet of this theory also aligns with the theory of fiduciary duty propounded by Professor Smith. On account of the prospective entitlement of the creditors (beneficiaries) to the company’s assets (critical resources) as the company borders insolvency, the directors are imposed with a fiduciary obligation while exercising their discretion in respect of the company’s assets. Additionally, in contrast to other justifications, which provide for static treatment of the creditors’ interests, as will be discussed in detail in the next section, the economic interest theory enables a dynamic and gradient approach to the treatment of the creditors’ interests in accordance with the relative importance of their economic interests. Thus, the economic interest theory aptly encapsulates and reflects the practical realities of the swing and dynamism in the relative economic interests of the different constituencies of the shareholders and the creditors of the company.
It is also pertinent here to discuss and examine the general theoretical justifications provided against extending directors’ fiduciary duties towards creditors in near insolvency and insolvency scenarios. The said justifications are primarily based on an unwavering recognition of the ownership rights of the shareholders juxtaposed with the purely contractual relations of creditors with the debtor company. It is argued that the shift of duty towards creditors in near insolvency and insolvency scenarios undermines the ownership and voting rights of the shareholders that are immutable to the financial conditions of the company (Hu & Westbrook, 2007). It is also contended that the relation between the company and its creditors is purely contractual in nature, and the creditors cannot be afforded any protections outside the realm of the contracts between the parties (Hu & Westbrook, 2007).
However, these contentions fail to take into account that the economic interests of the shareholders in the company’s assets arising on account of their embedded ownership of the company are distinct from the economic interests of the creditors arising due to their prospective entitlement of the creditors to the company’s assets upon formal insolvency. Once insolvency becomes imminent for the company, the interests of the creditors, who stand above the shareholders in law in formal insolvency, must be recognized and given due consideration by the trustees of the company’s assets, that is, the directors of the company.
Practical Justifications for Extension of Directors’ Fiduciary Duties Towards Creditors
In addition to the theoretical reasons set out above, there exist strong justifications for extending the directors’ fiduciary duties towards creditors in near insolvency and insolvency scenarios on the basis of the international policy framework on insolvency law as well as India’s peculiar corporate finance and insolvency law frameworks.
UNCITRAL Legislative Guide on Insolvency Law
The United Nations Commission on International Trade Law’s (UNCITRAL) Legislative Guide on Insolvency Law, which is a crucial international policy framework intended to guide policymakers across nations in devising optimal insolvency systems (Atkins & Luck, 2021), recommends the incorporation of a regulatory framework pertaining to the directors’ fiduciary duties when the company is bordering insolvency (United Nations Commission on International Trade Law [UNCITRAL], 2019). The Legislative Guide states that the cardinal motivation for incorporating such a framework is to generate ‘adequate incentives’ for the directors for early recognition and resolution of financial stress as well as preventing the directors from ‘externalising the costs’ of financial distress upon the creditors (UNCITRAL, 2019, para. 7). However, the Legislative Guide cautions that such regulations should not result in directors, with an intent to avoid liability, being dissuaded from undertaking reasonable commercial risks to enable successful resolution of the company or discouraging the participation of experienced personnel in the management of companies experiencing financial stress (UNCITRAL, 2019, recommendations 255-256). Thus, the framework should aim to balance the conflicting interests of the stakeholders by preserving the independence of the directors to take reasonable commercial risks while disincentivising excessive risk-taking that is detrimental to the interests of the promoters (UNCITRAL, 2019, para. 14).
RBI Framework
The Reserve Bank of India (RBI) has devised a comprehensive regulatory framework to mitigate credit risk and develop a resilient corporate finance system, including stipulating provisioning requirements for banks for non-performing assets (NPAs). As per the present regime, a loan account is deemed to be an NPA if a payment default remains outstanding for more than 90 days (Master Circular - Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances [Master Circular], 2023, para. 2.1.2). While the United States follows a discretion-based provisioning system based upon the anticipated credit losses linked to the loan accounts (Bandyopadhyay & Ghosh, 2023), the Indian system imposes a stringent requirement of mandating banks to follow an incremental, age-wise provisioning norm, commencing from 15% of the outstanding amount in the first year of the asset being NPA and escalating to 100% by the fourth year in case of secured exposure, without making any allowance for the available collateral (Master Circular, 2023, paras. 5.4.1 and 5.3.2). In case of unsecured exposure, a provisioning requirement of 25% is mandated in the first year and 100% in the second year (Master Circular, 2023, paras. 5.4.2 and 5.4.3).
As the current model is hinged upon an ‘incurred loss’ approach (i.e., the provisioning requirement is triggered after the occurrence of default), the RBI (2023) has proposed to transition to an ‘expected credit loss’ (ECL) framework, which would require banks to ‘estimate expected credit losses based on forward-looking estimations rather than wait for credit losses to be incurred before making corresponding loss provision’. The discussion article floated by the RBI in this regard in January 2023 states that ‘default’ is a lagging indicator of financial stress and that banks should be able to anticipate the rise in credit risk and make provisions for the same before the actual default. In October 2023, the RBI constituted an external working group for suggesting a suitable ECL framework (Gopakumar, 2023).
Thus, with an increasing emphasis on banks recognising stress at an early stage (i.e., even prior to actual default), the necessary corollary of the same is that the directors of a company should have a corresponding duty to consider the interests of creditors when the company is bordering insolvency in order to enable the development of a robust credit risk management ecosystem.
Insolvency Model Followed by India
As will be discussed in detail subsequently, India follows a creditor-in-possession model on the commencement of the insolvency resolution process under the Insolvency and Bankruptcy Code, 2016 (Code), reflecting that the interests of the creditors are treated as paramount
As long as debt obligations are met, equity owners have complete control, and creditors have no say in how the business is run. When default takes place, control is supposed to transfer to the creditors; equity owners have no say.
With this ‘paradigm shift’ ushered in by the Code, a recalibration of the director’s fiduciary duties towards creditors in near insolvency and insolvency scenarios only seems logical. The essence of a creditor-in-possession model requires the recognition of the creditors’ interests by the company when the company is in a near insolvency or insolvency scenario and is prone to committing a default, as a shift of control to creditors may be imminent in such a scenario.
THE CONTENTS AND CONTOURS OF DIRECTORS’ FIDUCIARY DUTIES TOWARDS CREDITORS
This article focuses on the UK Supreme Court’s decision in the Sequana Case, and the codification of the directors’ fiduciary duties towards creditors under the Irish Companies Act, 2014 as the key legal developments on the subject. In the Indian context, these developments are significant and need to be examined, as the Indian company and insolvency law and jurisprudence draw and adopt several principles from the UK. Further, Section 224A under the Irish Companies Act, 2014 represents an attempt to codify the complex and intricate fiduciary obligation of the directors towards creditors. These developments can provide the conceptual basis for envisaging a proposed framework for creditor duty under the Indian law.
Before proceeding to analyse the contents and contours of creditor duty, a brief overview of these legal developments is provided below.
Summary of the Sequana Case
In May 2009, AWA made a dividend payment of €135 million, which was nearly the entirety of its net assets to its parent company, namely Sequana SA. This dividend payment, coupled with another dividend payment made in December 2008, decreased Sequana’s debt to AWA from €585 million to around €3.1 million through a set-off arrangement. While the dividend distribution was in accordance with the provisions of the law, at the time of the payment of the dividend, AWA had ceased trading and was subject to a contingent liability of an uncertain amount arising on account of clean-up costs and damages due to river pollution caused in the United States. Further, at the time of the payment of the dividend, AWA was also considered to be solvent on the basis of the balance sheet test (i.e., AWA’s assets exceeded its liabilities) and the cash-flow test (i.e., AWA had the ability to settle its debts as and when they fell due). Thus, when the dividend payment was made, there existed a ‘real risk’ that AWA may become insolvent in the future, that is, a ‘remote possibility’ of insolvency at some point in the future (BTI 2014 LLC v Sequana SA, 2022, paras. 115, 193 & 350; BTI 2014 LLC v Sequana SA, 2019, paras. 7-20).
However, later, the actual environmental liability turned out to be much larger than estimated, resulting in AWA becoming insolvent. AWA, which was subsequently replaced by BIT as an assignee of AWA’s claims, brought an action against AWA’s directors to recover the amount equivalent to the dividend pay-out in May 2009 on the grounds that the dividend pay-out was in breach of the directors’ fiduciary duties to creditors (BTI 2014 LLC v Sequana SA, 2022, para. 115, 350;
In its judgement, the UK Supreme Court affirmed that the directors of a company are required to take into account the interests of the creditors when the company is insolvent or is likely to become insolvent. It primarily based its reasoning on the creditors’ enhanced economic interests in the company’s assets when the company is insolvent or bordering insolvency. However, on facts, it,
Codification of Creditor Duty Under the Irish Law
In July 2022, Ireland codified the directors’ fiduciary duties towards creditors when the company is or is likely to be ‘unable to pay its debts’ (i.e., insolvent). The relevant provision under the Irish Companies Act, 2014 has been reproduced below:
224A. (1) A director of a company who believes, or who has reasonable cause to believe, that the company is, or is likely to be, unable to pay its debts (within the meaning of section 509(3)), shall have regard to –
the interests of the creditors,
the need to take steps to avoid insolvency, and
the need to avoid deliberate or grossly negligent conduct that threatens the viability of the business of the company.
The duty imposed by this section on a director shall be owed by them to the company (and the company alone) and shall be enforceable in the same way as any other fiduciary duty owed to a company by its directors.
The Irish law requires the directors to not only take into account the interests of the creditors but also take steps to avoid insolvency as well as any ‘deliberate’ or ‘grossly negligent’ conduct that jeopardises the viability of the company (Companies Act, 2014, § 224A). The Irish law further clarifies that this duty owed by the directors shall be enforceable in the same manner as any other fiduciary duty of the directors (Companies Act, 2014, § 224A).
In light of these two developments, this section focuses on the key aspects in relation to the contents and contours of creditor duty in near insolvency and insolvency scenarios as set out under the Sequana Case and the Irish regulation, namely: (a) the class of creditors to whom duty is owed; (b) the trigger for the engagement of creditor duty; (c) the nature and content of creditor duty; (d) the non-applicability of the principle of shareholder ratification; and (e) the liability of directors for breach of creditor duty. The determination of these aspects has critical practical ramifications for the directors managing the affairs of the company.
Class of Creditors to Whom Duty is Owed
The Sequana Case has endorsed the position that the directors’ duties extend to creditors ‘as a whole’ on two grounds. First, creditors may have divergent interests and occupy distinct positions, such as secured and unsecured creditors (BTI 2014 LLC v Sequana SA, 2022, para. 48). Second, the entire body of creditors has a distinct interest in the affairs given that they are reliant upon the remaining assets of the company for the satisfaction of their debt claims (BTI 2014 LLC v Sequana SA, 2022, paras. 48 & 256). The Sequana Case also held that akin to the shareholders, the company’s interests cannot be limited to consider the interests of the contemporaneous creditors of the company during the period of a specific decision taken by the directors and must encompass the collective interests of the creditors ‘as a class’ instead of a ‘fixed group of individuals’ given that there is a continuous change in the creditors of the company (BTI 2014 LLC v Sequana SA, 2022, para. 48).
On the other hand, the Irish regulation appears to be silent on the question of the class of creditors to whom fiduciary duties are owed by the directors (Companies Act, 2014, § 224A).
Trigger for Engagement of Creditor Duty
The Sequana Case broadly discusses four plausible triggers for the engagement of creditor duty: (a) real risk of insolvency; (b) probability of insolvency; (c) imminent insolvency; and (d) actual insolvency. Before discussing the nature and scope of these triggers, it is important to discuss how the UK Supreme Court understood the term ‘insolvency’. Although there were no submissions heard on the meaning of insolvency, Lord Reed expressed that ‘insolvency’ should be understood to mean cash-flow insolvency (i.e., the company is not able to settle its debts as and when they fall due) or balance sheet insolvency (i.e., the liabilities of the company exceed its assets) (
In this context, a ‘real risk’ of insolvency denotes a ‘remote possibility’ of insolvency at some point in the future (
In the Sequana Case, there was a ‘real risk’ that AWA may become insolvent in the future on account of its contingent environmental liabilities. The UK Supreme Court held that a mere ‘real risk’ of insolvency is not adequate to trigger the engagement of the directors’ creditor duty – as a ‘real risk’ of insolvency, when the company is otherwise financially solvent, cannot result in the engagement of creditor duty. During the period of financial solvency, the shareholders will continue to exercise the principal economic interest in the company and their interests generally will be in unity with the creditors’ interests (
The UK Supreme Court held that creditor duty is triggered when ‘insolvency’ is ‘imminent’ or ‘actual’ or when administration or liquidation is ‘probable’ (
The Sequana Case also comments on the contentious issue of whether the directors are required to have actual or constructive knowledge of insolvency or borderline insolvency for the engagement of creditor duty, or whether the duty will be triggered on account of the mere fact of onset of insolvency or borderline insolvency of the company. In respect of the knowledge requirement, Lord Briggs, Lord Kitchin, and Lord Hodge considered that creditor duty should be applicable when directors ‘
The creditor duty under the Irish regulation is not triggered by the mere onset of actual or borderline insolvency and is only engaged when the directors, ‘believe’ or have ‘reasonable cause to believe’ that the company is or is likely to be insolvent (i.e.,unable to pay its debts) (Companies Act, 2014, § 224A).
Further, the Irish regulation provides an express meaning of insolvency (i.e., when the company is ‘unable to pay its debts’). In terms of Section 509 of the Irish Companies Act, 2014, a company is ‘unable to pay its debts’,
Nature and Content of Creditor Duty
While discussing the scope and content of creditor duty, the UK Supreme Court held that the content of creditor duty remains a fact-sensitive question and depends on the financial position of the company (
In near insolvency or insolvency and as long as there is ‘light at the end of the tunnel’ (i.e., there exists a reasonable prospect that the company can trade out of insolvency), the directors’ fiduciary duties to act in the company’s interests entail considering the interests of the shareholders as well as the creditors and not treating the creditors’ interests as paramount (
The Supreme Court further distinguished that in instances where formal liquidation or administration is inevitable or the company is irretrievably insolvent (i.e., there is no light at the end of the tunnel), the interests of the shareholders in the company come to an end and the interests of the creditors become paramount (
Thus, the UK Supreme Court has laid down a gradient or sliding scale from near insolvency to irretrievable insolvency in the context of the content of creditor duty. In near insolvency and insolvency scenarios and as long as there is scope for a turnaround in the financial position of the company, the directors are required to consider the interests of the shareholders and the creditors and to balance their interests in case of any conflict. In instances of inevitable formal administration or irreversible insolvency, the economic interests of the creditors become completely dominant and their interests are to be treated as paramount by the directors. However, in this regard, Lady Arden has cautioned that while a ‘sliding scale’ approach to the content of creditor duty may be useful, a company’s path to insolvency may not always be linear and incremental and may arise due to an unexpected and significant external event (
In principle, the Irish regulation also embodies a preference for according weightage to and balancing the interests of the creditors. The content of fiduciary duty under the Irish regulation requires the directors to take into account the interests of the creditors along with the interests of the shareholders and the employees in near insolvency and insolvency scenarios (Companies Act, 2014, § 224 & § 224A). Further, the requirement to take into account the creditors’ interests under the Irish regulation is coupled with the obligations to take steps to ‘avoid insolvency’ and ‘avoid deliberate or grossly negligent conduct that threatens the viability of the business of the company’. However, the jurisprudence in respect of creditor duty under the Irish regulation is yet to evolve.
Non-applicability of Shareholder Ratification
The Sequana Case dealt with the important question of whether the shareholders of the company can ratify any breach of directors’ fiduciary duties towards creditors. The UK Supreme Court held that the shareholders cannot ratify any action when the company is insolvent, or which action may result in insolvency or loss to the creditors (
Liability Framework
While the Sequana Case does not have any specific discussion on the liability of the directors for breach of creditor duty, Section 178 of the UK Companies Act, 2006 provides that the remedies available for breach of the directors’ fiduciary duties are those provided under the common law or equity. The remedies for breach of fiduciary duties generally include damages, injunction, restoration of property, restitution, and account of profits (Squire Patton Boggs, 2007). A similar provision exists under the Irish law regarding the remedies available for breach of fiduciary duties (Companies Act, 2014, § 232).
As the directors owe their fiduciary duties to the company in principle rather than any particular constituency, it is only the company that can initiate action against breach of fiduciary duties by the directors (Companies Act, 2006, Explanatory Notes, para. 485). However, when the board of directors and the controlling shareholders fail to bring any action against a director (or a former director) for breach of fiduciary duties, then an individual shareholder can bring a ‘derivative action’ on behalf of the company to enforce the right vested in the company for breach of fiduciary duties (Companies Act, 2006, Explanatory Notes, paras. 484 & 485).
While the shareholders of a company are enabled to initiate a derivative action in certain circumstances to remedy a wrong on behalf of the company under the UK legislation (Companies Act, 2006, § 260) and the Irish position (Ahern, 2019), there is no enabling provision to allow a creditor to file a derivative action on behalf of the company for breach of directors’ creditor duty.
CURRENT INDIAN FRAMEWORK FOR PROTECTION OF CREDITORS’ INTERESTS
In the Indian context, the Code recognizes the paramount interests of the creditors on the commencement of formal insolvency by stipulating a creditor-in-possession model. While setting out the creditor-oriented scheme under the Code on the commencement of formal insolvency, this section examines the recognition provided to the creditors’ interests in near insolvency and insolvency scenarios under the Companies Act, 2013 as well as the Code.
Companies Act, 2013
From the perspective of creditor duty, this segment focuses on the prevailing provisions under the Companies Act, 2013 dealing with the directors’ fiduciary duties, the remedies available for breach of such duties, and the liability of the directors for breach of such duties.
Directors’ Fiduciary Duties
Section 166 of the Companies Act, 2013 sets out the directors’ fiduciary duties and ostensibly follows a stakeholder or pluralist approach by casting a positive duty on the directors to treat the interests of shareholders as well as other stakeholders equally. Section 166(2) of the Companies Act, 2013 reads as follows:
166(2) A director of a company shall act in good faith in order to promote the objects of the company for the benefit of its members as a whole, and in the best interests of the company, its employees, the shareholders, the community and for the protection of environment.
In contrast, Section 172 of the UK Companies Act, 2006 adopts an ‘enlightened shareholder value’ (ESV) approach, whereby the directors are required to have regard to the interests of non-shareholders only as a means of maximizing the shareholder value (Naniwadekar & Varottil, 2016). Thus, the UK has adopted a hierarchical model that prioritises shareholders’ interests rather than requiring the directors to consider the interests of the shareholders and other stakeholders at the same level (Naniwadekar & Varottil, 2016).
Despite the apparent textual differences, it has been argued that the stakeholder approach under Section 166 is illusive and it embodies the shareholder approach in effect (Mukhopadhyay & Mandal, 2020; Naniwadekar & Varottil, 2016). First, Section 166 poses an interpretational issue of whether the usage of the terms, ‘shall act in good faith’ qualifies the requirement to ‘promote the objects of the company’ as well as the obligation to act in the ‘best interests of the company and its stakeholders’. If the requirement to act in good faith is applicable only to the requirement to ‘promote the objects of the company’, then the directors, while being required to ‘subjectively believe’ that their acts will promote the objects of the company, are supposed to ‘objectively determine’ whether their acts are in the best interest of the company and the stakeholders (Naniwadekar & Varottil, 2016). An objective duty to consider the interests of the stakeholders will cast a higher burden on the directors. However, Naniwadekar and Varottil (2016) have contended that in accordance with its legislative history, Section 166 only casts a subjective duty on the directors to promote the objects of the company as well as to act in the best interests of the company and its stakeholders and that there is no objective requirement to act in the interests of the stakeholders. Thus, the directors are only required to ‘subjectively believe in good faith’ that their actions are in the interests of the stakeholders (Naniwadekar & Varottil, 2016). The assessment above is justified, as providing an objective meaning to the obligation to act in the ‘best interests of the company and its stakeholders’ will require the directors to balance the competing ‘best interests’ and not merely ‘interests’ of various stakeholders, which may not be feasible and practicable. Further, as the categories of stakeholders, such as community and environment set out in Section 166, are ambiguous in nature and represent the larger public interest, it is unlikely that in the absence of explicit language, the legislature intended to create such a duty towards the public, failure of which would result in damages (Naniwadekar & Varottil, 2016). Notably, Section 166 does not specify creditors within the categories of stakeholders. In the absence of any objective guidance under Section 166 of the Companies Act, 2013, the legislative scheme, by including provisions that link managerial remuneration with profitability and conferring specific remedies upon shareholders against oppression and mismanagement and for initiating class action, impels the directors to focus on the maximization of wealth and the protection of the shareholders’ interests (Mukhopadhyay & Mandal, 2020).
Remedies for Breach of Fiduciary Duties
While the Companies Act, 2013 provides for consideration of non-shareholder constituencies, no corresponding remedies are made available to non-shareholder constituencies to enforce the directors’ fiduciary duties.
While derivative action has not been codified under the Companies Act, 2013, it has been recognized under common law as being available to shareholders (Jha & Misra, 2023; Naniwadekar & Varottil, 2016). The use of derivative action in India is not widespread, and till date, only shareholders have brought derivative actions on behalf of the company (Khanna & Varottil, 2012). Further, the Indian jurisprudence lacks consistent development on this issue (Jha & Misra, 2023; Varottil, 2021) 1 and is inadequate to enable non-shareholder constituencies, such as creditors, to initiate any action for breach of directors’ fiduciary duties.
Further, Section 245 of the Companies Act, 2013 provides class action remedy to shareholders or depositors if the company is being run in a manner that is ‘prejudicial to the interests of the company or its members or depositors’. The scope of Section 245 of the Companies Act, 2013 is specific and cannot be interpreted to entail directors’ fiduciary duties. Further, it is pertinent to distinguish here that the class action remedy is only available on behalf of shareholders or depositors as a constituency rather than on behalf of the company itself.
Thus, non-shareholder constituencies, including creditors, have not been provided with any effective remedy to initiate an action on behalf of the company for breach of directors’ fiduciary duties towards non-shareholder constituencies.
Liability of Directors
Section 166(5) of the Companies Act, 2013 provides for the remedy of ‘account of profits’ by stipulating that a director guilty of obtaining any undue gain shall be required to recompense a sum equivalent to the gain to the company. Conspicuously, Section 166(5) only provides for a personal remedy of ‘account of profits’ against the directors for breach of fiduciary duties and fails to specify other remedies or incorporate common law remedies through specific reference in the provision (Naniwadekar, 2013). The UK law, on the other hand, provides that the remedies available for breach of directors’ fiduciary duties are those provided under the common law or equity (Companies Act, 2006, § 178), which include damages, injunction, and restoration of property (‘The duties and liabilities of directors’, 2007). In light of Section 166(5) only providing for ‘account of profits’ as a remedy and in the absence of any specific language in Section 166(5) preserving the common law remedies, it may be difficult to contend that Section 166(5) is only a partial codification and other common law remedies remain available to the company (Naniwadekar, 2013). Thus, in instances, where the directors do not make any undue gain yet cause losses to the company due to their precipitous decision-making, no remedy of damages will be available against the directors. This is likely to be the case in instances of breach of creditor duty, as such claims may arise due to the loss caused to the company due to the incautious decisions of the directors rather than any personal gains made by the directors. In such scenarios, recourse may be limited to the penal provision under Section 166(7) of the Companies Act, 2013, which provides that in case of any contravention of Section 166, the directors shall be liable to pay a penalty of a minimum of one lakh rupees and a maximum of five lakh rupees.
Thus, this segment highlights that the prevailing framework is inadequate on each of the counts of creditor duty, remedy, and liability, and fails to provide any effective mechanism for the protection of the creditors’ interests.
Insolvency and Bankruptcy Code, 2016
The Code not only includes provisions for the protection of the creditors’ interests on the commencement of formal insolvency proceedings but also provides for the mechanisms to examine the decisions undertaken by the directors prior to the commencement of formal insolvency proceedings, which are deemed detrimental to the creditors’ interests. However, as will be discussed below, the scope of the Code is largely aimed at restoring financial equilibrium by reversing certain transactions that are prejudicial to the creditors’ interests rather than actively considering the creditors’ interests.
Creditor-oriented Scheme of the Code
The Code provides for a creditor-in-possession model, as the Code stipulates a shift in control to the creditors on the initiation of the insolvency resolution process. The Code mandates that on the commencement of the insolvency resolution process, the board of directors of the company shall be suspended and its power shall be exercised by the insolvency professional, that is, the resolution professional (Insolvency and Bankruptcy Code, 2016, § 17). While the resolution professional is required to manage and conduct the affairs of the company during the insolvency resolution process, Section 28 of the Code provides that the resolution professional is required to take the requisite approval of the committee of creditors (CoC) in respect of certain key financial decisions, including raising of any interim finance, changing of capital structure, and undertaking related party transactions. Further, Section 30 of the Code requires that a resolution plan in respect of the debtor company should be approved by the requisite majority of the CoC. Thus, the scheme of the Code reflects that the interests of the creditors are treated as paramount
Examination of the Directors’ Decisions Prior to Formal Insolvency
The Code also intends to protect the interests of the creditors in respect of unjust transactions or directors’ misconduct or lack of care prior to formal insolvency through the mechanisms of ‘avoidance transactions’ and ‘fraudulent or wrongful trading’. The provisions on avoidance transactions enable the resolution professional or the liquidator (as the case may be) to make an application to the National Company Law Tribunal (NCLT) to avoid and reverse the transactions undertaken by the company prior to the commencement of formal insolvency, which are prejudicial to the interests of the creditors by diminishing the company’s assets available to the general body of creditors and which unjustly enrich some at the expense of others. Whereas the provision on ‘fraudulent or wrongful trading’ enables the resolution professional to pursue action against the directors of the debtor company for conducting the business of the debtor in any fraudulent manner or for the directors’ failure to undertake reasonable care to minimise the losses to the creditors when formal insolvency is unavoidable.
Avoidance Transactions
The Code sets out extensive provisions to deal with the following species of avoidance transactions: preferential (Insolvency and Bankruptcy Code, 2016, § 43), 2 undervalued (Insolvency and Bankruptcy Code, 2016, § 45), 3 and extortionate (Insolvency and Bankruptcy Code, 2016, § 50). 4 The provisions on avoidance transactions have a look-back period, which refers to the timeframe in respect of which the transactions made by the debtor can be scrutinised by the resolution professional or the liquidator for potential avoidance. 5
The purpose of avoidance transactions is distinct from the purpose of the directors’ fiduciary duties towards creditors in near insolvency and insolvency scenarios. In principle, avoidance transactions are oriented towards reversing specific forms of transactions undertaken during the look-back period to ensure that the desired insolvency equilibrium is restored. Whereas the concept of creditor duty imposes an overarching duty on the directors to actively consider and accord appropriate weightage to the interests of the creditors in near insolvency and insolvency scenarios in accordance with the degree of their economic interests in the assets of the company. Further, the applications for avoidance transactions can only be brought once the company is admitted into formal insolvency, and such applications can only be preferred by the resolution professional or the liquidator.
Fraudulent or Wrongful Trading
Section 66 of the Code adopts the provision on fraudulent or wrongful trading. Section 66(1) of the Code stipulates that if it is found during the resolution process that any business of the company is being run with the ‘intent to defraud creditors’ or any other ‘fraudulent purpose’, then the NCLT, on an application by the resolution professional, may require any persons knowingly involved in the conduct of the business to be liable to make contributions to the assets of the company as deemed appropriate by the NCLT. As Section 66(1) focuses on the liability of persons (including directors) for fraudulently conducting the affairs of the company, it is evidently distinct from the notion of creditor duty, which is concerned with the directors’ fiduciary duties towards creditors (mediated through the company) in near insolvency and insolvency situations.
Section 66(2) of the Code adopts the provision on ‘wrongful trading’ from the UK Insolvency Act, 1986 (Insolvency Act, 1986, § 214), by imposing liability on the directors of the company to make contributions to the assets of the company, if, on an application by the resolution professional, it is found that such director, prior to the insolvency commencement date, ‘knew or ought to have known’ that there was no ‘reasonable prospect’ of avoiding the initiation of the insolvency resolution process and such director failed to demonstrate ‘due diligence’ in reducing the ‘potential losses’ to the company’s creditors. Section 66(2) does not prescribe a look-back period, and thus, this duty can extend to the period when the company is bordering insolvency.
It may appear that there are certain convergences between the conceptions of wrongful trading and creditor duty, particularly considering that they are oriented towards the protection of the creditors’ interests. However, in essence, the two conceptions vary in the content and nature of the obligations to the creditors embodied in them. Section 66(2) does not contemplate imposing a fiduciary duty on the directors to take into consideration the interests of the creditors. Section 66(2) is limited in scope, as the content of the duty provided under Section 66(2) merely requires the directors to exercise due diligence to minimise the potential loss to the creditors to avoid the imposition of personal liability on the directors. Further, the two conceptions are also at variance in respect of the trigger for the engagement of their respective duties. Section 66(2) is only applicable when formal insolvency is inevitable. In contrast, the Sequana Case held that creditor duty is engaged even when ‘insolvency’, understood as cash-flow or balance sheet insolvency (and not formal insolvency) is on the borderline, that is, insolvency is ‘probable’ or ‘imminent’. Thus, creditor duty comes into play even when there is ‘light at the end of the tunnel’, that is, there exists a reasonable prospect that the company can trade out of insolvency. Whereas the duty under Section 66(2) is only engaged when there is there is no light at the end of the tunnel (i.e., formal insolvency is inevitable). Additionally, in terms of the Sequana Case, where there is no light at the end of the tunnel, the interests of the shareholders in the company come to an end and the interests of creditors become paramount (
PROPOSED INDIAN FRAMEWORK FOR DIRECTORS’ FIDUCIARY DUTIES TOWARDS CREDITORS
This section outlines a preliminary conceptual framework for the directors’ fiduciary duties towards creditors in near insolvency and insolvency scenarios under the Indian regime, delineating the underlying principles and structural components of the Indian framework with the purpose of laying the groundwork for a broader dialogue and stakeholder discussion on the subject.
Explicit Recognition of Creditor Duty Under the Companies Act, 2013
The first question that arises is whether the Indian framework, akin to the Irish law, should provide for an explicit recognition of creditor duty. As discussed above, Section 166 of the Companies Act, 2013 in effect reflects an inherent inclination towards the shareholder primacy approach. The Code, while providing for some caution to directors to minimise the loss of creditor value, is largely oriented towards restoring financial equilibrium by reversing certain transactions that are prejudicial to the creditors’ interests. Thus, there exists a compelling case to explicitly legislate the directors’ fiduciary duty to take into account the creditors’ interests in near insolvency and insolvency scenarios to preserve the creditors’ interests at the time of decision-making by the board. A precise framework outlining the directors’ obligations towards creditors in near insolvency and insolvency scenarios will promote a transparent and clear understanding of the director’s duties towards creditors. In this regard, the Indian framework should aim to answer the following aspects in the context of creditor duty: (a) class of creditor to whom duty is owed; (b) trigger for the engagement of creditor duty; (c) nature and content of creditor duty; (d) non-applicability of shareholder ratification; (e) liability of directors and remedies for breach of duty; and (f) scope for derivative action by creditors.
Class of Creditors to Whom Duty is Owed
Akin to shareholders, the company may generally have different kinds of creditors with conflicting interests and subject to different legal treatments. For instance, the company may have secured or unsecured financial creditors, operational creditors, employees, etc. The risk appetite of and the bundle of contractual rights available to a financial creditor with a charge on the company’s assets may be substantially different from those of unsecured operational creditors (Keay, 2005). In addition, it may be possible that even creditors within the same class may have different interests (Keay, 2005). In such circumstances, it becomes moot to determine how the directors should resolve the conflicting interests of different creditors while exercising their fiduciary duties towards creditors. Should directors attempt to balance the conflicting interests
In our view, from the directors’ perspective, it would be unfeasible and impractical to balance the conflicting interests of various creditors given that they are not a homogenous class. Accordingly, the directors should focus on achieving the convergent interest of various creditors, that is, maximization of the value of the assets of the debtor so that the assets available to the ‘general body’ of creditors in the case of formal insolvency are enhanced. Thus, the directors’ fiduciary duties should extend to the ‘general body’ of creditors to ensure that the economic interests of the creditors ‘as a whole’ in the assets of the creditors are not hampered. Further, as held in the Sequana Case, the general body of creditors should be understood as creditors as a ‘class’ instead of a ‘fixed group of individuals’ given that there is a continuous change in the creditors of the company (
Trigger for Engagement of Creditor Duty
Determining the trigger for the engagement of creditor duty in near insolvency and insolvency scenarios requires defining ‘insolvency’ as well as ascertaining whether the directors should have the knowledge of the actual onset or possible onset of such insolvency.
Defining ‘Insolvency
Lord Reed’s judgement in the Sequana Case expressed that ‘insolvency’ should be understood to mean cash-flow insolvency or balance sheet insolvency. The Irish creditor duty also incorporates,
In this regard, it is pertinent to note that neither balance sheet insolvency nor cash-flow insolvency is perpetual or detrimental to the success of the company in the long run. A start-up company may be balance sheet insolvent prior to the roll-out and scaling up of the new product. The directors of such a start-up company may have a reasonable belief that the company may become balance sheet solvent once the product has captured the requisite market share. Thus, creditor duty should not be engaged in such a company as long as it is paying its debts even though it is balance sheet insolvent (
Thus, in our view, the Indian framework should adopt a twin test and only engage creditor duty when the company is or is imminently going to be both ‘cash-flow insolvent’ and ‘balance sheet insolvent’.
Engagement of Creditor Duty
The UK Supreme Court held that creditor duty is triggered when the ‘insolvency’ is ‘probable’, ‘imminent’ or ‘actual’ (
In our view, the ‘probability’ requirement casts a wide and onerous duty on the directors, and at this stage, the trigger for the engagement of creditor duty should be narrowly construed to avoid any rescue and revival paralysis among the Indian corporates. Accordingly, the Indian framework should provide for creditor duty to be engaged only when the ‘insolvency’ is imminent, that is, when the insolvency is around the corner and the insolvency will arise in a short period of time or when the insolvency is actual, that is, when the company is both ‘cash-flow’ and ‘balance sheet’ insolvent.
Knowledge Requirement
It is also crucial to determine whether creditor duty should be engaged when the directors have actual or constructive knowledge of imminent or actual insolvency, or on the mere onset of imminent or actual insolvency irrespective of actual or constructive knowledge of such onset.
The majority in the Sequana Case considered actual or constructive knowledge to be essential (
In our view, while the directors are required to stay abreast of the affairs of the company, the framework should stipulate a knowledge requirement in order to provide an objective basis for the engagement of creditor duty and to enable the directors to function with certainty. The knowledge requirement has also been endorsed by the UK High Court (
Thus, the Indian framework should only engage creditor duty when the directors know or ought to have known that the company is or is imminently going to be cash-flow insolvent as well as balance sheet insolvent.
Nature and Content of Creditor Duty
While the fiduciary duty of the directors to act in the interests of the company is understood and extended to include the economic interests of the creditors of the company as the company borders insolvency, the content and nature of creditor duty remains a contentious issue. Are directors required to consider the creditors’ interests as paramount? Or are directors merely required to take into account the creditors’ interests as a relevant factor? A duty to merely take into account the interests of the creditors is substantially distinct from a duty to consider the creditors’ interests as paramount. A duty to merely take into account the creditors’ interests provides a discretion in assessing the weight to be accorded to the creditors’ interests, often entailing striking a balance with the conflicting interests of other constituencies, such as shareholders. On the other hand, a duty to consider the creditors’ interests as paramount requires prioritization of the creditors’ interests when they conflict with the interests of other constituencies (
In our view, in accordance with the holding of the Sequana Case, the scope of the content of creditor duty (i.e., balancing of the creditors’ interests or treating the creditors’ interests as paramount) should be based on the financial position of the company, that is, depending on whether the insolvency is curable or irretrievable.
In near insolvency or insolvency scenarios and as long as there is light at the end of the tunnel, that is, there exists a reasonable prospect that the company can trade out of insolvency, the creditor duty should entail taking into consideration and according appropriate weightage to the interests of the general body of the creditors and should not extend to the requirement of treating the creditors’ interests as paramount. Such a stance is supported in theory as well as practice. Theoretically, as discussed earlier, the economic interests of the shareholders subsist in near insolvency and insolvency scenarios as long as there is a reasonable prospect of a viable turnaround in the position of the company, resulting in the economic interests of the shareholders again occupying a prominent position in the affairs of the company. Thus, in such scenarios, the creditor primacy approach is not tenable, as it results in completely disregarding the economic interests of the shareholders in near insolvency and insolvency scenarios. From a practical perspective, it is pertinent to appreciate that risk-taking is inherent in a commercial enterprise. The creditor primacy approach is not practically viable if there exists a reasonable prospect of a turnaround, as it may have the effect of completely stymieing the efforts for rescuing and reviving the company. Thus, in such scenarios, creditor duty should only entail according appropriate weightage to the interests of the creditors.
In this regard, it also becomes important to discuss how the directors should balance the interests of the creditors. As aptly held in the Sequana Case, the weightage to be accorded to the interests of the creditors
It becomes pertinent to discuss here whether our proposal pertaining to the ‘prospect of reasonable success of the proposed revival measures’ can also be understood in the context of the obligations of ‘avoiding deliberate or grossly negligent conduct that threatens the viability of the business of the company’ and ‘taking steps to avoid insolvency’ as stipulated under the Irish regulation.
Our proposal aligns with the requirement of taking steps to avoid gross negligence that threatens the viability of the business, as the measures for proposed rescue and revival should be ‘reasonable’ and cannot be based on grossly negligent conduct. Further, the notion of gross negligence is not a novel concept and is jurisprudentially well-established. It sets a high threshold of culpability and provides the necessary latitude to the directors to undertake reasonable commercial risks and measures for corporate rescue (Quinn & Gavin, 2023).
While there is no clarity under the Irish law or jurisprudence regarding the scope of the obligation to ‘take steps to avoid insolvency’, this obligation can be in consonance with our proposal if this obligation is construed in accordance with the judgement of Lady Arden in the Sequana Case, which holds that the directors should avoid ‘insolvency-deepening activities’, such as risky decisions which have a slim chance of success and its failure will only deepen the insolvency of the company (
Thus, as long as there exists a reasonable prospect of a turnaround, the Indian framework should require the directors to consider the creditors’ interests by undertaking a balancing exercise and according appropriate weightage. This requirement to undertake a balancing exercise and provide appropriate weightage should be adjudged against the objective standard of determining the ‘prospect of reasonable success of the proposed revival measures’.
In instances where the company is irretrievably insolvent or formal insolvency under the Code is inevitable (i.e., there is no light at the end of the tunnel), the interests of the shareholders in the company come to an end and the interests of the creditors become paramount. Thus, in such instances, the directors of the company should prioritize the interests of the creditors. While the factual assessment of these situations (i.e., where there is a chance of a turnaround and where there is not) would be a matter of degree and would rarely be straightforward, the sliding scale approach will allow the directors to take reasonable and legitimate rescue efforts till the possibility of a turnaround exists.
Shareholder Ratification
The shareholders of the company can authorize the company to undertake any action within its corporate capacity as well as ratify any decisions taken by the directors without authority to thwart any action against the directors for breach of fiduciary duties (
In our view, the holding of the UK Supreme Court aligns with the underlying rationale that only the beneficiaries of a fiduciary duty can excuse any breach of a fiduciary duty owed to them (Liew & Mitchell, 2018). Thus, the Indian framework on creditor duty should clarify that the shareholders can only ratify any breach of the directors’ fiduciary duties owed to the shareholders as the beneficiaries of such duties and not any breach of directors’ fiduciary duties towards creditors.
Liability of Directors and Remedies for Breach of Creditor Duty
The liability framework for breach of directors’ fiduciary duties under the Companies Act, 2013 is inadequate. Section 166(5) only provides for a personal remedy of ‘account of profits’ against the directors for breach of fiduciary duties and fails to specify other remedies or incorporate common law remedies through specific reference in the provision. Accordingly, in line with the UK Companies Act, 2006 (UK Companies Act, 2006, § 178), a provision should be introduced under the Companies Act, 2013 clarifying that the remedies available under the common law or equity, including damages, injunction, and restoration of property, can be availed for breach of directors’ fiduciary duties.
The conceptualization of a liability framework for breach of directors’ fiduciary duties will also require the determination of the contentious questions of whether the liability should be limited to executive directors or should also extend to non-executive and independent directors, whether dissenting directors can also be subject to liability, and whether the liability of directors should be joint and several or should be apportioned on the basis of their level of involvement (UNCITRAL, 2019, paras. 17-28).
The Companies Act, 2013 limits the scope of liability of independent and non-executive directors for any regulatory breaches on the part of the company by providing that they shall be liable ‘
However, the same rationale is not specifically applicable to the breach of fiduciary duties owed by the directors to the company. First, fiduciary duties towards the company are imposed upon all directors, as is also evident from the language of Section 166. Second, in instances involving the breach of fiduciary duties, the decisions taken at the board level are generally impugned rather than the actions involving the management of day-to-day affairs of the company by the directors. Third, in such instances, the breach is not committed by the company with the breach being attributable to the directors. Rather the directors are in breach of their fiduciary duties owed to the company. Accordingly, the directors should be jointly liable for breach of fiduciary duties. However, in order to ensure fair treatment, the framework should provide for the exemption of liability in case of dissenting directors or where the necessary information for a decision was not provided to such directors and the same could not have been reasonably obtained by them.
Derivative Action
At the outset, this article proposes that derivative action by shareholders should be codified in order to prevent inconsistent judicial developments in this regard. In respect of derivative action by creditors, this article proposes that the creditors should be vested with the right to initiate derivative actions. A failure to confer such a right upon the creditors may render the framework on creditor duty ineffective, as there is a high likelihood that the company or the shareholders may not file an action for breach of creditor duty. However, in order to prevent the misuse of derivative action, a preliminary threshold can be imposed that a creditor must obtain the permission of the court to file such an action by establishing a
THE WAY FORWARD
This article sets out a conceptual framework for the directors’ fiduciary duties towards creditors in near insolvency and insolvency scenarios based on the recognition of the creditors’ predominant economic interests in the assets of the company in such scenarios. The recognition of creditor duty becomes further imperative in the context of the Indian insolvency framework. While the Code recognizes the paramountcy of the creditors’ interests in formal insolvency by providing for a creditor-in-possession model, it becomes crucial for the corporate governance framework to incorporate the requirement for the directors to consider the interests of the creditors during decision-making when such formal insolvency may be on the horizon.
This article also aims to develop a comprehensive perspective on the NPA crisis in India. After 2011, the Indian financial system witnessed a substantial rise in the quantum of NPAs, posing wider systemic risks (Kumar et al., 2022). The central government and the RBI have undertaken a series of measures to alleviate the NPA crisis and enable better credit risk management by banks and financial institutions (Mohan & Ray, 2022). However, the regulatory focus has been unidimensional, as it is predominantly focused on bringing reforms in the financial sector without adequately examining the need to reimagine corporate governance frameworks and corporate culture in the context of creditor duty. In this regard, this article intends to provide a more nuanced understanding of the bad loan crisis, by underscoring the need for a broader consideration of the directors’ fiduciary duties towards creditors to reduce the potential losses faced by creditors in near insolvency and insolvency scenarios.
In this light, this article intends to initiate a broader academic and regulatory discourse and encourage wider stakeholder participation on the subject with an earnest hope to develop robust corporate governance frameworks for fostering a sustainable and robust credit ecosystem.
Footnotes
AUTHOR NOTE
This paper was presented at the Annual Research Workshop on Insolvency and Bankruptcy, 2024 held at IIM Ahmedabad and was awarded as the ‘Best Practice and Policy Relevant Paper’.
DECLARATION OF CONFLICT OF INTERESTS
The authors declared no potential conflicts of interest with respect to the research, authorship and/or publication of this article.
FUNDING
The authors received no financial support for the research, authorship and/or publication of this article.
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