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 Creditor's Interests and Director's Duties

1. Introduction
Where a company is insolvent in the sense that its liabilities exceed its assets, its
shareholders (and directors) have an incentive to continue trading as they have
everything to gain and nothing to lose. 1 Should the company trade out of its
difficulties this will benefit the shareholders whereas if it continues to decline they
will, because of the principle of limited liability, suffer no additional losses and
these will be borne by the company's creditors.2 Where an insolvent company
continues to trade the persons who make the decision that it should do so are not
the persons who will 'lose' if the company is unsuccessful. 3 Thus the principle of
limited liability creates a perverse incentive for an insolvent company to continue
to trade. This was an issue dealt with by the Cork Committee 4 in its report. In
particular, the Committee was concerned that the law failed to provide directors of
an insolvent company with appropriate incentives to take steps to avoid further loss
5
to the company's creditors from continued trading. The Committee concluded
that the fraudulent trading provisions of the Companies Act 19486 had not proved
to be particularly effective because of the need to show dishonesty on the part of
those responsible for the management of the affairs of the company. As a correc-
tive, it proposed that directors should be made liable for the debts of a company

1 If the company is insolvent in the sense that it cannot pay its debts as they fall due, it is not necessarily the case
that it is in the interests of the shareholders to continue trading as the break up value of the company may exceed its
liabilities. This, however, will seldom be the case.
2 Another way of looking at this is to view the effect of continued trading by an insolvent company as altering the
status of a company's creditors to that of 'equity' investors.
I On this see Jackson, The Logic and Limits of Bankruptcy Law, at 167. Insolvency law clearly recognizes that where
a company is insolvent the persons who have the primary interest in the company are its creditors: see Ayerst v C&K
(Construction) Ltd [1976] AC 167; Re InstrumentationElectricalServices Ltd [1988] BCLC 550 (an example of the well
established principle that a fully paid up shareholder must show that he will obtain some advantage or avoid some
disadvantage in order to have standing to present a winding up petition); Re Corbenstoke Ltd (No 2) (1989) 5 BCC 767
(shareholder of an insolvent company has no standing to seek the removal of a liquidator under section 172(2) of the
Insolvency Act 1986).
4 Report of the Review Committee on Insolvency Law and Practice (Cmnd 8558), chap 44. It must be conceded that
much of the debate on the misuse of the principle of limited liability has tended to be satisfied with assertion. If a
company has to compensate creditors through the price mechanism for undertaking the risk of dealing with an entity
whose members enjoy limited liability then there is in a sense no 'abuse' as the creditors are fully compensated.
However, it is problematical just how efficiently the price mechanism works in this situation and it simply has no
relevance to the claims of involuntary creditors (for example, tort claimants). For a discussion on this see Landers, 'A
Unified Approach to Parent, Subsidiary, and Affiliate Questions in Bankruptcy' (1975) 42 U Chi L Rev 589; Posner,
'The Rights of Creditors of Affiliated Corporations' (1976) 43 U of Chi L Rev 499; Landers, 'Another Word on
Parents, Subsidiaries, and Affiliates in Bankruptcy' (1976) 43 U ofChi L Rev 527.
5 Ibid, at para 1776. Since the Cork Report was published the courts have made it slightly easier to prove fraud by
the rejection of the 'sunshine doctrine' formulated in Re White and Osmond (Parkstone)Ltd (unreported, 30 June 1960):
R v Grantham [1984] QB 676; see also R v Kemp [1988] QB 645.
6 Section 332.

© Oxford University Press 1990 Oxford Journal of Legal Studies Vol. 10, No. 2
 OxfordJournalof Legal Studies VOL. 10

where the company incurs 'liabilities with no reasonable prospect of meeting

them'. 7 It was hoped that the effect of such a reform would be that 'if the directors
at any time consider the company to be insolvent, they [would] ... take immediate
8
steps for the company to be placed in receivership, administration or liquidation'.
The recommendations of the Cork Committee were given effect to in what is now
section 214 of the Insolvency Act 1986, 9 the so-called 'wrongful trading' section. 10
This section has recently been applied by Knox J in Re Produce Marketing
Consortium Ltd (No 2), 11 the first decision to subject section 214 to a detailed
analysis. It is a decision of considerable importance. It is proposed first to set out
the facts of the case and then to examine its impact on the application of section
214. The concluding part of the article will deal with common law developments
with respect to the duties of directors towards a company's creditors.

2. Re ProduceMarketing Consortium Ltd

Produce Marketing Consortium Ltd (PMC) carried on the business of importing
fruit. PMC traded as a commission agent, charging a fixed commission on the gross
sale price of the fruit it imported and consequently, as its profit was linked to its
gross turnover, it could be computed without difficulty. From 1981 onward PMC
traded at a loss, depending on a substantial bank overdraft to finance its activities.
One of the directors of PMC guaranteed the overdraft up to the sum of £50,000.
PMC's annual accounts were regularly laid and delivered late. 12 By the summer of
1986 there were signs that the fortunes of PMC had deteriorated sharply; it
regularly exceeded its overdraft limit and there were substantial amounts of
cheques outstanding so that allowing for these cheques would have put it even
more in excess of its overdraft limit. At the end of 1986, PMC was exceeding its
overdraft by £16,000 and a number of its cheques were returned unpaid. In
January 1987 draft accounts for 1984/85 and 1985/86 were submitted to PMC by its
auditors. These accounts, signed in 1987, showed that PMC was in a parlous state
and the auditor's certificate for both sets of accounts stated that the company was
insolvent and could only continue its activities because of the overdraft facility
provided by the bank. In February 1987 the company's auditors wrote to the
directors of PMC pointing out that in the light of PMC's trading record there was a
possibility that the directors could be held liable for fraudulent trading on the
grounds that the company had continued to trade and incur debts at a time when
there was no reasonable prospect of these debts being paid. Although there was a
reduction in PMC's bank overdraft during 1986/87, to a large extent this was
7 Cork Report, at para 1783.
1 Ibid, at para 1786.
9 On the relationship between section 214 and the Cork Committee proposals see Sealy and Milman, Annotated
Guide to the 1986 Insolvency Legislation (2nd ed), at 229-32.
10 As has been pointed out by others, the phrase 'wrongful trading' does not appear in the body of the section but
only appears in the marginal note.
1' [1989] BCLC 520.
12 At 530. As PMC was a private company the reports should have been laid and delivered ten months after the end
of the accounting reference period: see section 242 of the Companies Act 1985. See now Companies Act 1989, section
11, introducing a new section 244 into the 1985 Act which deals with the period for laying and delivering of accounts.
SUMMER 1990 Creditor'sInterests and Director'sDuties

financed by PMC's increased indebtedness to its principal supplier of fruit.

Negotiations took place between PMC and its principal supplier of fruit (which had
no prospect of being paid in full) to try to work out a solution. These failed and
PMC went into a creditors' voluntary winding up in October 1987. The liquidator
sought an order under section 214 that the directors of PMC contribute £107,946 to
the assets of the company. Knox J ordered the directors to contribute £75,000.

3. The Effect of the Judgment on Section 214

It is proposed in this section to examine the structure of section 214 and analyse the
effect of the judgment in Re Produce Marketing ConsortiumLtd on the section.
13
The basis of liability: Section 214 empowers the court to order a director to
contribute to the assets of a company where the company has gone into 'insolvent
liquidation' and at some time before the winding up the director 'knew or ought to
have concluded that there was no reasonable prospect that the company would
avoid going into insolvent liquidation'. 14 For the purpose of the operation of the
section a company goes into insolvent liquidation at a time when the company's
assets are insufficient to pay its debts and other liabilities. 15 Thus the section only
comes into operation where there is a shortfall in the company's assets to meet the
claims of its creditors and its primary focus is the protection of the interests of
creditors.
Personspotentially liable under the section: The section imposes potential liability
on a person who is a director 16 or a shadow director 17 at the time when he formed
the opinion, or ought to have formed it, that the company could not avoid going
into insolvent liquidation. It is important to note that liability is dependent on
status, that is because a person is or was a director or a shadow director, and not
because of the extent to which a person is, or has been, involved in the
management of a company's affairs."' However, the extent of such involvement
may, as we shall see later, be a factor to be taken into consideration in determining
the amount (if any) a director should be obliged to contribute to the assets of the
company. The extension of liability to a 'shadow director" 9 is of considerable
importance for a number of reasons. For example, it entails that in many situations
a parent company will be liable for the debts of its subsidiary. And so also may
others who have been involved to a significant extent in the management of a
13 On this see the text accompanying notes 16 and 17.
14 Section 214(2)(a) and (2)(b). By section 214(4) the director is held to an objective standard of care and skill. This
will be dealt with later.
11 Section 214(6). The section would not apply if a company which goes into liquidation on the grounds of
insolvency turns out to have been solvent: see, for example, In re Islington Metal and PlatingWorks Ltd [1984] 1 WLR
14. It is also submitted that the same would apply in a case such as Re Joshua Shaw and Sons Ltd [1989] BCLC 362
where the claims of the creditors were statute-barred and as a result there was a surplus available for members.
16 Section 214(2)(c).
17 Section 214(7).
11 This is a condition precedent for liability under the fraudulent trading sections and can produce the bizarre result
that a director who does not take part in the management of the affairs of a company can escape liability: see Re Maney
and Sons De Luxe Service Station Ltd [1968] NZLR 624.
19 'Shadow director' is defined in section 251 of the Insolvency Act 1986 as a person in accordance with whose
instructions the board of the company is accustomed to act.
 Oxford Journalof Legal Studies VOL. 10

company's affairs, for example, a company's bank. 20 In many situations the

responsibility of individual directors for a company's insolvency will not neces-
sarily be the same. Where this is the case, there is no reason why the court's order
under section 214 should not reflect this fact. This to some extent happened in Re
ProduceMarketing Consortium Ltd. Although as against the liquidator the liability
of the directors to contribute the £75,000 to the assets of the company was held to
be joint and several, as between themselves one of them was held to be liable to
indemnify the other as to £50,000.21 This was partly because the director who was
ordered to pay the indemnity was the dominant figure in the management of the
company's affairs, and partly because he had guaranteed the company's overdraft
and would accordingly benefit from any contribution made under section 214.22
Persons entitled to bring section 214 proceedings: Section 214(1) provides that it is
only on 'the application of the liquidator' that a director can be obliged to
contribute to the assets of the company. This has important implications as it raises
the fundamental question as to whether liability to contribute under section 214
exists at the time a director commits the acts giving rise to liability under section
214, or whether it comes into existence later when the liquidator decides to bring
section 214 proceedings and obtains judgment. This point will be dealt with later in
connection with the question of whether or not contributions made pursuant to
section 214 are subject to a charge on the company's assets or, alternatively, form
part of the general assets available to meet the claims of unsecured creditors.
The defence provided to directors: A director will not be liable to contribute under
section 214 if the court is satisfied that he 'took every step with a view to
minimising the potential loss to the company's creditors as ... he ought to have
taken'. 23 This is a demanding test, particularly as it does not contain any provision
which limits the director's obligation merely to take reasonable steps to avoid loss
to creditors. 24 On the facts of Re Produce Marketing Consortium Ltd, there was
simply no basis on which such a defence could be argued as the court found that
the directors continued to trade at a time when they ought to have appreciated that
the company could not avoid going into insolvent liquidation and would not be in a
position to pay its creditors. 25 There remain unresolved problems with this
defence. For example, it is unclear whether the steps that need to be taken must
20 See, for example, Re a company (No 005009 of 1987), ex parte Copp [1989] BCLC 13 (allegation that a bank had
become a shadow director because the company had implemented various recommendations of the bank's officials not
struck out as showing no reasonable cause of action). A potential adverse and unintended but foreseeable consequence
of this aspect of section 214 is that banks will no longer try to nurse a company in difficulties through its problems but
will appoint an administrative receiver or put the company into liquidation.
21 At 554. Knox J also held that since the company's creditors had been kept out of their money interest at fifteen
per cent should be awarded from the commencement of the liquidation. In addition, Knox J held that the normal rules
as to costs would apply and that the directors would be liable to pay the costs of the liquidator (at 554-5).
22 Being able to make different orders would also deal with the situation where a director tries to persuade his fellow
directors to discontinue trading but is outvoted. Provided a director leaves a sufficient 'paper trail' evidencing his
position, this could provide him with some protection. It is of interest to note that one of the factors that the court has
to take into consideration under Schedule 1 of the Company Directors Disqualification Act 1986 in determining the
fitness of a person to act as a director is the extent of 'the director's responsibility for the causes of the company
becoming insolvent': see Schedule 1, Part II, para 6.
23 Section 214(3). The burden of proof is probably on the director.
24 As is pointed out by Sealy and Milman, op cit, at 231.
25 At 551.
SUMMER 1990 Creditor'sInterests and Director's Duties

provide the creditors with 'legal' protection; for example, a 'standard' letter of
guarantee rather than a letter of comfort. 26 It might be setting the standard too
high to require always that creditors have legal protection but anything 27
short of this
runs the risk of failing to satisfy the standard of taking 'every step'.
Standard by which director'sconduct to be judged: Section 214(4) sets out the stan-
dard by which directors will be judged in determining whether they should have
concluded that the company could not have avoided going into insolvent liqui-
dation (section 214(2)), or whether they took every step they should have taken to
minimize potential loss to creditors (section 214(3)). Section 214(4) provides:
For the purposes of subsections (2) and (3), the facts which a director of a company ought
to know or ascertain, the conclusion which he ought to reach and the steps which he ought
to take are those which would be known or ascertained, or reached or taken, by a
reasonably diligent person having both-
(a) the general knowledge, skill and experience that may reasonably be expected of a
person carrying out the same functions as are carried out by that director in relation
to the company, and
(b) the general knowledge, skill and experience that that director has.
This subsection is central to the section 214 scheme of liability. 28 In applying the
standard formulated in section 214(4), Knox J held that the court in having to have
'regard to the functions to be carried out by the director in question' should take
into consideration the 'particular company and its business'. 29 From this it follows
that the knowledge and skill required from a director of a company in a modest line
of business will be different from that of a company which possesses more elaborate
procedures. This relativity of standards is, however, subject to qualification.
Directors are presumed to possess a certain minimum standard of competence and,
more importantly, will also be presumed to possess the knowledge that they would
have acquired had the company complied with the financial reporting provisions in
the Companies Act 1985.30 Thus directors will be precluded from pleading
ignorance of what they should have known had the company complied with its
reporting obligations under the Companies Act 1985. On the facts in Re Produce
Marketing Consortium Ltd, Knox J held that had the results for the financial year
ending September 1985 been known when they should have been if the company
26 It seems reasonably clear that the standard letter of comfort will not give rise to any contractual liability on the
part of the issuer; see Kleinwort Benson Ltd v Malaysia Mining CorporationBerhard [1989] 1 WLR 799; noted Prentice
(1989) 105 LQR 346. There is no reason why a letter of comfort cannot be drafted to give contractual protection.
27 See Prentice (1987) 103 LQR 11; the Australian courts do not require legal certainty that the creditors' claims be
paid: see Flavelv Day (1984) 9 ACLR 502; Deputy Commissionerfor CorporateAffairs (WA) v Caratti(1980) 5 ACLR
119.
21 Also of relevance is section 214(5) which provides that any reference in subsection (4) to the functions carried out
by a director also refers to functions that have been entrusted to him and which he did not carry out. This avoids any
argument that a director is not in breach of duty for omissions as opposed to commissions: see, for example, Re
Denham & Co (1883) 23 Ch D 752; Marquis of Bute's Case [1892] 2 Ch 100. However, compare the judgment of Foster
J in DorchesterFinance Co Ltd v Stebbing [1989] BCLC 498 (decided in 1977).
29 At 550.
30 At 550. As Knox J points out, section 214(4) refers to facts which a director 'ought' to know. This also provides
an explanation as to how subsections (a) and (b) of section 214(4) can be operated in tandem; subsection (a) sets a
minimum standard and subsection (b) operates to increase that standard where a director ought to possess a level of
competence above this minimum.
 Oxford Journalof Legal Studies VOL. 10

had complied with section 242 of the Companies Act 1985,31 namely at the end of
July 1986, the directors would have concluded that there was no reasonable 32
prospect that the company would avoid going into insolvent liquidation.
Accordingly, it was from this date that the directors' liability to contribute to the
assets of the company would be measured.
Amount the court would order to be contributed: Section 214(1) empowers the court
to declare anyone held liable under the section to make 'such contribution (if any)
to the company's assets as the court thinks proper'. 33 Knox J considered the court's
jurisdiction under section 214 to be primarily 'compensatory rather than penal' and
that prima facie the 'appropriate amount that a director is declared to be liable to
contribute is the amount by which the company's assets can be discerned to have
been depleted by the director's conduct which caused the discretion to be exercised
under sub-s (1) to arise'. 34 The way in which the court should approach its
jurisdiction under the section is to treat the extent of liability as one based on
'causation'; that is, to what extent has the conduct of the director caused loss to the
company's creditors? The upper limit a director should be made to contribute was
not to be determined by fraudulent intent as this would merely introduce the old
standard relating to fraudulent trading which section 214 was designed to depart 35
from, but fraudulent intent was not a factor that could be completely ignored.
Having taken the loss caused to the creditors as the starting point for measuring
the extent of a director's obligation to contribute under section 214, Knox J
proceeded to itemize the more specific factors in the case which had a bearing on
how he should exercise his discretion in a situation which he considered did not
involve a deliberate course of wrongdoing but rather a failure to 'appreciate what
should have been clear'. 36 Of the factors that Knox J considered relevant to the
determination of the amount that the directors should contribute probably the
most important were (i) that the warning of the auditors of the dangers of continu-
ing to trade was ignored, (ii) the fact that any contribution would go in the first
31 Accounts of a private company must be laid and delivered within ten months after the end of its accounting

reference period.
11 At 552. On the facts in the ProduceMarketing case there was little doubt that the company would never be able to
pay its debts. But other cases are going to be less clear and the courts will have to decide what constitutes a 'no
reasonable prospect that the company would avoid going into insolvent liquidation' (section 214(2)(b), emphasis
added). For example, does this require that there must be at least a fifty-fifty chance that the company will survive?
Obviously the more certain that the directors have to be that the company will be able to pay its creditors, the greater
the pressure on the directors either to put the company into liquidation or to seek the appointment of an administrator.
There is thus a need for circumspection as this could force directors to take precipitate action. For a somewhat related
problem see Re Harris Simons Construction Ltd [1989] BCLC 202 (degree of probability needed that the purposes set
out in section 8(3) of the Insolvency Act 1986 will be achieved before an administration order will be made).
33 In earlier proceedings (Re Produce Marketing Consortium Ltd (1989) 5 BCC 399) Knox J held that the court's
jurisdiction under section 214 was not subject to section 727 of the Companies Act 1985 (power to excuse directors for
default). Given the very wide jurisdiction that the court has under section 214(1) with respect to the contribution order
that it can make, it is difficult to see what difference this in fact makes.
34 At 553.
31 At 553: 'The fact that there was no fraudulent intent is not of itself a reason for fixing the amount at a nominal or
low figure, for that would amount to frustrating what I discern as Parliament's intention of adding section 214 to
section 213 [the fraudulent trading section] of the Insolvency Act 1986 but I am not persuaded that it is right to ignore
that fact totally.'
36 At 598. Knox J ordered the directors to contribute £75,000 rather than the £107,946 requested by the liquidator;
the latter figure appears to have been the loss caused by the wrongful trading. It is unclear why the reduction was made
and the most plausible surmise is because there was no deliberate wrongdoing on the part of the directors.
SUMMER 1990 Creditor'sInterests and Director'sDuties
place to satisfy the claims of the bank as a secured creditor and correspondingly
reduce the liability of the director on his guarantee to the bank, and (iii) because
the bank as a secured creditor would be the first to benefit from any contribution,
the court should exercise its jurisdiction 'in a way which will benefit unsecured
37
creditors'.
An implicit assumption of Knox J's judgment is that the bank's charge would
attach to the contribution the directors were ordered to make under section 214(1).
There appears to have been little argument on this, but it is a point that is not free
from difficulty. There are two lines of authority that have a bearing on the question
as to whether a contribution ordered to be made under section 214 should be
subject to a charge on a company's assets. 38 The first relates to money recovered by
a liquidator because it constituted an improper preference. 39 The leading example
of this is Re Yagerphone Ltd. 40 In that case the court held that money recovered
from a creditor on the grounds that it had been paid out as a fraudulent preference
was not subject to a floating charge over the company's assets as the money at the
time the charge crystallized did not constitute property of the company. 41 The
court also reasoned that the right to recover money from a creditor who had been
fraudulently preferred was conferred for the purpose of benefiting the general body
of creditors and therefore should form part of the general assets of the company for
distribution to the general creditors. The reasoning in Re Yagerphone Ltd is open to
challenge. It is possible to argue that the right to recover assets paid out as a
preference is an asset of the company and the fact that the action is one vested in
the liquidator 42 is merely machinery designed to underpin the pari passu principle
of insolvency law. 43 As a preference constitutes a diminution in the assets of the
company which would otherwise be available to feed the charge, the court would
not be adjusting the respective rights of creditors by holding that the assets
recovered as an improper preference should be subject to the charge. However, the
Yagerphone principle does appear to be very firmly entrenched and it is probably
too late now to call it into question. 44 The other more general point underpinning
the decision in Re Yagerphone Ltd, that fraudulent preference law is designed to
assist the unsecured creditors, will be returned to later.
The second line of authority which has a bearing on the question of whether
money recovered under section 214 can as a matter of principle be caught by a
charge relates to assets or money recovered by a liquidator in misfeasance
proceedings. 45 Where an order is made in misfeasance proceedings, it is clear that
37 At 554.
11 This assumes that the charge as a matter of construction covers the contribution. Normally in the case of a
floating charge this would be the case as such a charge invariably covers all the assets of a company not covered by a
fixed charge having priority.
39 See Insolvency Act 1986, sections 239-41.
40 [1935] Ch 392.
41 The court also rejected the argument that it could constitute a 'contingent interest' (at 396).
42 See Willmott v London Celluloid Co (1886) 31 Ch D 425; affd (1886) 34 Ch D 147.
43 See Sellar, 1983 SLT 253.
44 See McPherson, The Law of Company Liquidation (3rd ed by J. O'Donovan), at 327; the Australian courts may
recognize an exception to it where specific property which has been the subject of a fraudulent preference is recovered
and it is covered by the terms of the charge: see NA Kratzmann Pty Ltd v Tucker (1970-71) 123 CLR 295, 301-2.
45 See Insolvency Act 1986, section 212.
 Oxford Journalof Legal Studies VOL. 10

the proceeds of the order are covered by a charge. 46 The courts reason that the
statutory provisions relating to misfeasance proceedings create no new liabilities
but merely establish a summary procedure for compelling directors to account for
any breach of duty. The right being vindicated is a right which inheres in the
company at the time the directors breach their duty and therefore the courts have
no difficulty in finding that it is capable of being caught by a suitably drafted
charge.
Although not free from doubt, it is submitted that the recovery under section
214 is governed by the reasoning in the Re Yagerphone Ltd line of authority. At the
time a charge is created, it is difficult to see how a right of action which may arise in
the future but which is not connected with any existing right (contingent or
otherwise) could be caught by a charge. Also, the courts will probably want to
protect the unsecured creditors who normally get a raw deal in insolvency. 47 If an
appropriately drafted charge were held to cover section 214 contributions, this
would entail that recovery for a loss suffered by unsecured creditors would feed the
charge; scarcely a meritorious result. This unmeritorious result can be avoided by
treating a section 214 claim as a right vested in the liquidator and as such it is not a
chose in action or entitlement inhering in the company which the company can
charge. This analysis also provides the means for distinguishing section 214 actions
from misfeasance proceedings. The latter proceedings are procedural, 48 designed
to vindicate a right of the company which exists at the time the misfeasance took
place. On this reasoning, as a matter of principle a charge could cover any sums
covered in misfeasance proceedings even though they accrue after a company has
gone into liquidation. 49 However, with section 214 claims the right only arises
when the liquidator brings the action and there can be no question of it being
subject to a charge created before the company went into liquidation. Accordingly,
it is submitted that should the point assumed by Knox J on the relationship of
section 214 contributions and a charge over the company's assets be expressly
argued, his decision would not be followed.
One other small point remains with respect to the entitlement to contributions
made under section 214 and that is whether they are available for the satisfaction of
the claims of all creditors or only those who were the victims of the wrongful
trading. For a number of reasons, a compelling argument can be made that they
should be available to meet the claims of all creditors.50 First, as a matter of
insolvency law principle the assets of a company in liquidation constitute a single
pool available for the claims of all creditors unless a creditor has a priority either by
46 See Re Asiatic Electric Co Pty Ltd (1970) 92 WN (NSW) 361.
47 Although paradoxically this could disadvantage unsecured creditors as in many situations the only source of
funds to finance the liquidation will be the charge holders and they will not be willing to finance section 214
proceedings if any contribution ordered to be made under that section does not feed the charge.
4' Re B Johnson & Co (Builders) Ltd [1955] Ch 634.
49 It is possible to create a floating charge over future assets and even though the assets are realized after the
company has gone into liquidation this does not constitute a 'disposition' caught by section 127 of the Insolvency Act
1986 as the disposition takes place when the charge is created: see Gough, Company Charges at 108-109; Re Margart
Pty Ltd [1985] BCLC 314 SC (NSW).
50 For the treatment of a similar problem in connection with the fraudulent trading provisions see Sealy and
Milman, op cit, at 228-9.
SUMMER 1990 Creditor'sInterests and Director'sDuties

agreement or by statute. 51 There is nothing in the wording of section 214 which

confers a special right on the creditors who are the victims of the wrongful trading
and therefore there is no reason for departing from this general principle.
Secondly, pragmatic considerations) relating to the mechanics of carrying out a
liquidation argue in favour of treating all creditors similarly. Thirdly, if it is only
the creditors who post-date the wrongful trading who benefit from any section 214
contribution, this would provide the directors of the company with an incentive to
pay off these creditors in preference to other creditors and thus reduce the extent of
their potential liability. Such an outcome has nothing to recommend it.

4. The Common Law Duties of Directors Towards Creditors2

It has long been a central tenet of company law that directors owe their duties to
the company and not to the company's shareholders or to its creditors. As was
stated more than a quarter of a century ago by the Jenkins Committee when
commenting on the effect of Percival v Wright53, 'no fiduciary duty is owed by a
director to individual members of his company, but only to the company itself, and
a fortiori that none is owed to a person who is not a member'. 54 This principle is
now under a considerable degree of strain. What is of interest is the conceptual
device used to undermine it: the courts have used the concept of the 'interests of a
company', one of the most problematical concepts in company law, as the basis on
which to build protection for the interests of a company's creditors. It is trite law
that directors in exercising their powers must do so bona fide and in the best
interests of the company. The concept of interests of the company is often
indeterminate (sometimes arguably incoherent 55) in many situations. It is clear that
by statute directors in discharging their duties must now consider the interests of
employees. 56 This duty is owed, however, to the company and is enforced in the
same way that other duties to the company are enforced and, while this gives rise to
difficulties, there are traditional (and arguably justifiable) reasons for adopting this
approach. In determining what constitutes the interests of the company, the courts
have recently held that in certain circumstances they can include the interests of a
company's creditors and thus indirectly have held that directors owe duties to a
company's creditors. 57 It is this development which I now wish to examine. There
are two English cases of importance.
The first case of relevance is Winkworth v Edward Baron Development Co Ltd. 58
The facts in the case have an all too familiar ring to them. A husband and wife
51 Pickering, 'The Problem Of The Preference Share' (1963) 26MLR 499, at 508.
52 For a full treatment of this see Sealy, 'Directors' "Wider" Responsibilities-Problems Conceptual, Practical and
Procedural' (1987) 13 Mon LR 164.
53 [1902]2 Ch 421.
54 Cmnd 1749 (1962), at para 89.
55 See Howard Smith Ltd v Ampol Petroleum Ltd [1974] AC 821, at 835; Peter's American Delicacy Co Ltd v Heath
(1938) 61 CLR 457, at 481.
56 Section 309 of the Companies Act 1985.
17 The courts are much more guarded and uncertain as to whether directors owe duties to shareholders: see Dawson
Internationalplc v Coats Paton plc [1989] BCLC 233.
51 [1986] 1 WLR 1512; see also Lonhro Ltd v Shell Petroleum Co Ltd [1980] 1 WLR 627, at 634.
 Oxford Journalof Legal Studies VOL. 10

acquired control of a company, appointed themselves directors, plundered it of its

assets, the wife leaving the management of the company to the husband. The
company had purchased property (the Hayes Lane property), the title deeds of
which were held by the company's solicitors to the order of the company's bank to
secure the company's overdraft with the bank. Subsequently the husband and wife
sold their matrimonial home, held on a joint tenancy, and both authorized the net
proceeds of sale to be paid into the company's bank account in order to reduce its
overdraft. The company 'declined' into insolvency and the wife, with more
boldness than sense, claimed to be entitled to an equitable interest in the Hayes
Lane property arising, it was argued, from the fact that the proceeds from the sale
of the former matrimonial home had been used to reduce the company's overdraft
with the bank. Lord Templeman, who gave the only judgment, had no difficulty in
dismissing this 'bold and astonishing' claim: the payment of the money into the
company's bank account was not referrable to the acquisition of the Hayes Lane
property and there therefore was simply no basis for finding that the wife had
acquired an interest in the property. Lord Templeman also considered that there
was an alternative ground for defeating the wife's claim even if the money from the
sale of the matrimonial home had been used in such a manner as to give the wife an
interest in the company's property. He reasoned that the wife's failure to carry out
her duties as a director 'to ensure that the affairs of the company were properly
conducted' and resulting in the ensuing prejudice to the company's creditors
disbarred her from claiming an equitable proprietary interest 'in priority to the
claims of creditors'. 59 Lord Templeman formulated the duty which 60
the wife as a
director owed to the company's creditors in the following terms:

[A] company is not bound to pay off every debt as soon as it is incurred, and the
company is not obliged to avoid all ventures which involve an element of risk but the
company owes a duty to its creditors to keep its property inviolate and available for the
repayment of its debts. The conscience of the company, as well as its management, is
confided to its directors. A duty is owed by the directors to the company and to the
creditors of the company to ensure that the affairs of the company are properly
administered and that its property is not dissipated or exploited for the benefit of the
directors themselves to the prejudice of the creditors.
There was in the Winkworth case strictly no need to formulate a director's
fiduciary duty so as to include the interests of a company's creditors since the wife's
claim to possess an interest in the company's property arising by way of a
constructive trust failed in limine. However, in the second case of importance, West
Mercia Safetywear Ltd v Dodd,6 1 it was necessary to find the existence of a fiduciary
duty to enable the claim of the liquidator to succeed. In that case the plaintiff
company owed its parent company over £30,000. Both of the companies were
insolvent. D, a director of both companies, had guaranteed with a bank the debts
of the parent company. D was instrumental in having the plaintiff company pay
59 [1986] 1 WLR 1512, 1517A-B.
60 Ibid, at 1516E-G.
61 [1988] BCLC 250.
SUMMER 1990 Creditor'sInterests and Director'sDuties
£4,000 into the bank account of its parent company purportedly in part payment of
the debt which the plaintiff company owed to the parent. The liquidator of the
plaintiff company brought an action to recover the £4,000 from D on the grounds
that the payment constituted a breach of duty on his part. The claim was unsuc-
cessful at first instance, the court reasoning that since the payment was made in
part payment of a debt which the company owed it could not constitute a breach of
duty. This decision was reversed on appeal. Dillon LJ held that, since the plaintiff
company was insolvent, the 'company' was for all intents and purposes the
creditors and that D in carrying out his duties as a director had to consider their
interests. In making the transfer D had patently failed to do this as all he was
interested in was his own position as guarantor of the parent company's debts;
accordingly D had breached his duty and was obliged to account to the company
for the £4,000. In reaching this conclusion, Dillon LJ cited with approval the
following dictum of Street CJ in Kinsela v Russell Kinsela Pty Ltd (in liq)62:
In a solvent company the proprietary interests of the shareholders entitle them as a general
body to be regarded as the company when questions of the duty of directors arise. If, as a
general body, they authorise or ratify a particular action of the directors, there can be no
challenge to the validity of what the directors have done. But where a company is
insolvent the interests of the creditors intrude. They become prospectively entitled,
through the mechanism of liquidation, to displace the power of shareholders and directors
to deal with the company's assets. It is in a practical sense their assets and not the
shareholders' assets that, through the medium of the company, are under the manage-
ment of the directors pending either liquidation, return to solvency, or the imposition of
some alternative administration.
A number of questions arise with respect to the operation of this doctrine:
(i) first, what is its juridical basis? Although there are other views, 63 for example,
liability in tort, the view of Lord Templeman in the Winkworth case that this is
merely a development of the fiduciary duties imposed on directors is the one that is
to be preferred. The fiduciary duties of directors constitute a clearly established
cluster of rules in company law which can without difficulty be pressed into service
to protect the interests of creditors.
(ii) secondly, do the directors owe the duty to the creditors directly or has it to be
mediated through the company? There are strong reasons for arguing that the duty
should be one that is mediated through the company-in other words in certain
circumstances the interests of a company will embrace the interests of the
company's creditors. There are at least three reasons for this. First, it eliminates
any problems of double recovery. If the duty is not mediated through the
company, then in many situations where the acts of the directors constituting a
62 (1986) 4 NSWLR 722, at 730. Dillon LJ had to distinguish his own decision in Multinational Gas and
PetrochemicalCo v MultinationalGas and PetrochemicalServices Ltd [1983] Ch 258 in which he had held that directors
'owe fiduciary duties to the company though not to the creditors, present or future . . .' (at 288). He distinguished the
Multinationalcase on the grounds that the company in that case was 'amply solvent' and the directors had made a good
faith business decision at the bidding of its shareholders. This was to be contrasted with the West Merciacase where the
company was insolvent to the knowledge of the director.
63 See Nicholson v Permakraft(NZ) Ltd [1985] 1 NZLR 242 (Cooke J); Sealy, op cit, footnote 52; Dawson, 'Acting
in the Best Interests of the Company-For Whom are Directors "Trustees"?' (1984) 11 NZLR 68.
 Oxford Journalof Legal Studies VOL. 10

breach of duty to the creditors also constitute a breach of duty to the company,
both the creditors and the company could sue. 64 This would obviously present the
court with the difficulty of sorting out the respective rights of the company and the
creditors so as to avoid the directors having to pay damages twice over with respect
to a single wrong. Secondly, by mediating the duty through the company it
preserves what is a firmly entrenched principle of insolvency law, the pari passu
principle that all creditors should be treated equally since no one creditor will be
able to steal a march on his fellow creditors. 65 Thirdly, and somewhat related to the
previous point, mediating the claim through the company preserves the procedural
monopoly of liquidation proceedings for dealing with the claims of creditors
66
against an insolvent company.
(iii) the third question is what is the content of the duty, or to put it slightly
differently, in what circumstances will it arise? Normally the company will have
gone into insolvent liquidation, but probably the duty arises before this point when 67
it is, or should have been, clear to the directors that the company was insolvent.
There is no reason why insolvency should not mean either that the company was
unable to pay its debts as they fell due or, alternatively, that the company's
liabilities exceed its assets. 68 It is important to note that this merely establishes the
grounds which trigger off the existence of the duty. Where a company is wound up
on the grounds of insolvency but it ultimately transpires that it has sufficient assets
to pay its liabilities, 69 there can be no question of the directors being in breach of
any duty that they might owe the company's creditors; as there are no outstanding
creditor claims the issue of breach of such a duty simply cannot arise.
(iv) lastly, is there any need for this duty in the light of section 214 of the
Insolvency Act 1986? Obviously section 214 greatly diminishes the need for the
common law doctrine as formulated in the West Mercia case. There are a number of
ways, however, in which the common law doctrine still has a role to play:
(a) It prevents a director from proving in the liquidation for any claim he might
have against the company; this, for example, would have been its effect in a case
like Winkworth.
(b) If there is a breach of the common law duty there will be no question of the
court exercising its discretion to reduce the amount that the company is entitled to
recover. This is because the claim being made by the liquidator is proprietary in
nature and the court has no jurisdiction to deprive the company of what it owns.
(c) The court's power to grant relief under section 727 of the Companies Act

64 Compare the problems that arose in Nurcombe v Nurcombe [1985] 1 WLR 370; noted Sterling (1985) 5 OJLS
475.
65 See Re Gray's Inn ConstructionLtd [1980] 1 WLR 711, at 718: 'Since the policy of the law is to preserve so far as is
practicable rateable payments of the unsecured creditors' claims ... '
66 See Prentice, The Effect of Insolvency on Pre-LiquidationTransactionsin Company Law in Change (ed Pettet 1987)
at 69-70; Butler v Broadhead [1975] Ch 97; Abrahams v Nelson Hurst and Marsh Ltd (23 May 1989, Evans J) (claims
against brokers in a firm of insurance brokers in liquidation would have to be pursued against the liquidator, and the
liquidation proceedings could not be leapfrogged by bringing a direct action against individual brokers).
67 See Dawson, op cit, at 70-1.
68 See Insolvency Act 1986, section 123. At the minimum it would cover insolvency in the latter sense.
69 See, for example, Re Islington and Metal PlatingWorks Ltd [1984] 1 WLR 14.
SUMMER 1990 Creditor'sInterests and Director'sDuties
1985 would apply to breach of the common law duty whereas it has no application
70
to section 214 liability.
(d) Perhaps the most important aspect of the development of this doctrine is the
way in which it will restrict the power of the shareholders to ratify a breach of duty
by directors. Shareholders in certain circumstances can ratify a breach of duty by
directors which has the effect of insulating the directors against a subsequent action
by the company; 7 1 for example, an action by the liquidator against the directors for
misfeasance. However, where a company is insolvent the shareholders, as the West
Mercia case clearly states, no longer have an interest in the company and there
should be no question that the breach can be ratified by the shareholders.

Conclusion
The above two developments, particularly section 214, have greatly altered the
topography of company law. The threat to directors that they will be made
personally liable for the debts of a company which has continued to trade at the
expense of its creditors has significantly eroded the principle of limited liability.
This, in many ways, is unquestionably
72
one of the most important developments in
company law this century.
D. D. Prentice*

7 See footnote 33 above.

71 For a recent example of a case dealing with the limitations on the power of a company to ratify a transaction see
Aveling Barford Ltd v PerionLtd [1989] BCLC 626.
11 I am grateful for discussions on this topic with Fidelis Oditah of Merton College and Nick Segal of Allen and
Overy. I am responsible for any faults.
* Pembroke College, Oxford.