[Rajat Maloo is a III year B.A., LL.B. (Hons.) student at the National Law School of India University, Bangalore]
Common law provides that those to whom duties are owed may release those who owe the duties from their legal obligations. In the corporate law context, this principle has been applied by courts in cases where shareholders ratified directors’ breaches of duties. However, various difficulties may arise in deciding to what extent and until when shareholders have the authority to ratify such breaches. One such scenario is when creditors’ interests interfere with shareholders’ interests when a company is nearing insolvency. In such a case, can shareholders ratify directors’ breach of duty? The answer to this question is in the negative as I explain by, first, understanding the nature of directors’ duties and the breaches which can be ratified by shareholders during solvency; secondly, analysing the shift in directors’ duty when the company is on the verge of insolvency; and lastly, explaining why shareholders cannot ratify breaches at that stage.
Directors’ Duties and Ratification in a Solvent Company
Ratification is a procedure through which an irregularity in the running of the company is sanctioned by the shareholders and a director is absolved from his or her personal liability to the company arising from a breach of duty. To appreciate the effect of shareholder ratification and when it is permissible under law, one has to understand the nature of the duty breached.
Traditionally, directors of a company in common law owe two kinds of duties, namely, fiduciary duties and duties of care. These duties entail that the directors act in the best interests of the company and its shareholders. In cases of breach, shareholders may absolve, by ratification, the directors of their liability. This is permissible because during solvency the interests of the company are equated with those of its shareholders. The proprietary interests of the shareholders entitle them to be collectively regarded as ‘the company’ when questions of the duty of directors arise.
Shareholders can ratify only certain kinds of breaches. This means adopting, where a director lacked authority to transact on behalf of the company, or affirming, where a transaction entered into by a director was voidable. Certain breaches such as fraud committed by directors, however, are non-ratifiable breaches. This post shall only be concerned with traditionally ratifiable breaches.
With developments in corporate law and the increasing need to protect other stakeholders, the duties imposed upon the directors have been widened. Unlike the erstwhile Companies Act, 1956 in India, the present Companies Act, 2013 under section 166 provides that the directors have a duty to act in the ‘…best interests of the company, its employees, the shareholders, the community and for the protection of the environment’. The Companies Act, 2006 in the United Kingdom (UK) also has a provision that codifies directors’ duties. Although the statute in India does not specifically provide for directors to act in the creditors’ interest, a question arises whether they have the duty to protect creditors’ interests when the company is nearing insolvency. In the next part, I will use principles emanating from common law cases to show that when the company is nearing insolvency, directors also owe a duty to take into account interests of creditors of the company.
When Company is Nearing Insolvency
Unlike in India, the Companies Act in the UK envisages the possibility that a director may have a duty to consider creditors’ interests in certain circumstances. These duties arise under section 172(3) of the Companies Act 2006 emanating from directors’ duty to promote the success of the company. Regarding solvent companies, the case of Multinational Gas v Multinational Services  Ch 258 in the UK established the view that directors do not owe duties to the creditors. However, difficulties arise when the company is at the verge of insolvency. When is the directors’ duty to take creditors’ interests into account triggered? What is the nature of such a duty?
Starting in the 1970s, the notion of a common law duty upon directors to take account of the interests of creditors when insolvency approaches has been widely accepted in the common-law world. The principle was adopted by the Court of Appeal in West Mercia Safetywear v. Dodd  BCLC 250 CA. The directors’ duty to act in the ‘best interests of the company’ has been interpreted to mean protecting creditors from potential losses if the company goes into insolvency. This shift in the directors’ duty is because creditors’ interest become ‘paramount’ at this stage when there is a ‘real risk’ of insolvency. In such a scenario, shareholders are no longer the major stakeholders in a company as the law steps in to protect the interests of the creditors if the company were to go insolvent. Essentially, the interests of the creditors coincide with the interests of the company.
In BTI v. Sequana  2 All E.R. 784 CA, the Court of Appeal acknowledged that it is difficult to lay down a clear test of when the directors’ duty to protect the interests of creditors is triggered. Richards LJ noted that the directors’ duty towards creditors is triggered when directors knew or should have known that the company is likely to become insolvent. This shift of focus from shareholders towards creditors is also recognised in India in the Insolvency and Bankruptcy Code, 2016. Section 66(2) thereof, which deals with fraudulent or wrongful trading, is designed to ensure that directors protect creditors from potential losses even before the insolvency commencement date – when a director ‘…knew or ought to have known’ that there was no reasonable prospect that the company can avoid insolvency.
A counterargument can be made that, even at that stage, the directors can pursue the interests of both the shareholders and the creditors. Davies and Worthington (Gower & Davies’ Principles of Modern Company Law, (Paul L. Davies, 10th edn., 2018), 571) say that the courts have carried out a case-by-case examination in such situations. However, when a company is hopelessly insolvent, creditors’ interest must be protected. Hence, directors owe a duty to take into account the interest of the creditors when the company nears insolvency. Now, how does this affect the shareholders’ capability to ratify directors’ breaches?
When Shareholders Cannot Ratify?
The underlying assumption of ratification has been that the shareholders constitute the appropriate expression of ‘the company’. However, this is not always true. When the company is in the vicinity of insolvency, the common law takes the view that the creditors are the persons with the primary economic interest in the company and its assets. An important consequence of this is that the shareholders in such a situation may no longer be able to ratify breaches of the directors’ duties.
When this question was posed before the New South Wales Court of Appeal in Kinsela v Russell Kinsela Pty Ltd  4 N.S.W.L.R 722, it held that “…where directors are involved in a breach of their duty to the company affecting the interests of shareholders, then shareholders can either authorise that breach or ratify it in retrospect. Where, however the interests at risk are those of creditors I see no reason in law or logic to recognise that the shareholders can authorise the breach.” The Court, while according an interesting interpretation to the issue, also said that on the verge of insolvency, the creditors become prospectively entitled to displace the power of the shareholders and directors to deal with the company’s assets. It observed: “It is in a practical sense their [creditors’] assets and not the shareholders’ assets that, through the medium of the company, are under the management of the directors.” Thus, as the shareholders are not the ones primarily interested in the company’s assets and do not constitute ‘the company’, they cannot ratify directors’ breaches.
Cook J had in an earlier New Zealand Court of Appeal case of Nicholson v Permakraft (NZ) Ltd  1 NZLR 242 held that “every conduct of the directors that could deprive creditors of timely recourse to the property which would otherwise be applied to their benefit is fraud, the honesty of the directors in such a case is immaterial”. Therefore, the Court of Appeal interpreted any breach when the company is nearing insolvency to be a fraud on the part of the directors as they failed to protect creditors’ interests and, ergo, directors’ frauds become a non-ratifiable breach.
Although, the two judgments reach the same conclusion – that is, shareholders cannot ratify directors’ breaches when the company is on the verge of insolvency – their reasonings are slightly different. From an Indian perspective, I submit that the directors’ duty to consider creditors’ interests arise from their duty to act in the ‘best interests of the company’ under section 166(2). Directors’ duty to protect the interests of the creditors has been recognized by Indian courts as well. At the verge of insolvency, the creditors instead of the shareholders become a manifestation of ‘the company’ because of their interest in the assets, if the company were to go insolvent. Hence, shareholders cannot ratify directors’ breaches at that stage.
It might be argued that sometimes shareholders’ decisions can get the company out of insolvency and, hence, they should be able to ratify such decisions of directors. However, the directors have the duty to protect the creditors from further harm rather than the duty to promote the interests of creditors in a general sense. Hence, in such an event when the company is nearing insolvency, shareholders must not be permitted to ratify breaches made by the directors as their interests are no longer ‘paramount’ in the company.
The defence of ratification is not applicable to directors’ breaches when the company is on the verge of insolvency. This signifies how corporate law, in recent decades, has shifted its focus from protecting primarily shareholders’ interests towards also protecting the interests of other stakeholders’ such as creditors. A company is no longer merely its shareholders’ concern and directors are legally obligated to cater to other non-shareholder constituencies of a company which has been recognised by statutes and courts across jurisdictions. Although it can be argued that the focal shift is not significant, but law at least now recognises that a corporate entity has far reaching impacts and affects others apart from its shareholders. However, as presently the directors’ duty to take into account creditors’ interests emanates only out of their duty to act in the ‘best interests of the company’ and no cause of action is conferred on the creditors by a breach of the duty, there is a long way to go in enforcement of these protections by creditors themselves.
– Rajat Maloo