taking the corporate contract more the economic cases

TAKING THE CORPORATE CONTRACT MORE SERIOUSLY The Economic Cases against, and a Transaction Cost Rationale for, the Insolvent Trading Provisions

Introduction Recent Australian corporate law scholarship1 uses economic analysis and the contractarian theory of the firm t o critique t h e insolvent trading provisions.' T h e principal critics conclude that the duties imposed o n directors t o prevent insolvent trading are inefficient and unjustifiable. T h e rhetoric of efficiency provides a new contribution t o a debate regarding laws about which many lawyers feel uneasy. This disquiet is instantiated b y the nightmare imagery used in the title of one of Bob Baxt's recent articles.'

T h e application of contractarianism t o produce such conclusions is no t surprising. In a salutary critique of American law-and-economics, Branson commented:

[Llaw and economics scholarship ... now seems totally outcome oriented. The outcome to be arrived at, and to justify, is what managers of Fortune 500 corporations want, whether it be the death of the derivative action, de facto elimination of the duty of care, or upholding management entrenchment devices ...4

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* Lecturer, Faculty of Law, Griffith University. I wish to thank Stephen Bottomley and John Devereux for helpful comments and suggestions.

1 M Byrne, 'An Economic Analysis of Directors' Duties in Favour of Creditors' (1994) 4 Aust J Corp L 275; J Mannolini, 'Creditors' Interests in the Corporate Contract: A Case for the Reform of Our Insolvent Trading Provisions' (1996) 6 AustJCorp L 14.

2 Corporations Law ('CL') 1991 (Cth) ss 588G-2. 3 R Baxt, 'Insolvent Trading: The Nightmare Continues' (1992) 62(5) Charter 24. 4 D Branson, 'A Corporate Paleontologist's Look at Law and Economics in the

Seventh Circuit' (1989) 65 Chi-Kent LR 745, p 746. See also V Brudney, 'Corporate Governance, Agency Costs, and the Rhetoric of Contract' (1985) 85 Colum LR 1403, p 1410. For the record, I do not accuse Byrne or Mannolini of responding to private interest groups.

Some contractarians pursue a research agenda which seeks to strip corporate law of anything resembling a mandatory term.' However, law- and-economics has been used no less convincingly to demonstrate why statutory law can be efficienthnd how it can lead to better private contracting.' In an important article on opting out of corporate law, John Coffee states that:

[olne ironic generalization seems justified about those economists who view the firm as a private contract: they often seem to ignore modern contract law in favor of an almost nineteenth century, stereotypical notion of what contract law permits. In fact, commercial law places some important boundaries on the ability of garties to a contract to limit the remedies available for its enforcement.

Coffee urges that contract be taken 'more seriously' than contractarians have done so far.' With this exhortation in mind, this article considers the possibility that law-and-economics supports a different conclusion about the efficiency of the insolvent trading provisions.

Part I of this article offers a description of the insolvent trading provisions, thus laying a basis for the theoretical analysis in the balance of the article. Part I1 examines the contractarian analyses of the insolvent trading

5 See, eg, FS McChesney, 'Economics, Law, and Science in the Corporate Field: A Critique of Eisenberg' (1989) 89 Colum LR 1530; W Carney, 'The ALI's Corporate Governance Project: The Death of Property Rights?' (1993) 61 Geo Wash LR 898; H Butler and L Ribstein (1995) The Corporation and the Constitution, AEI Press.

6 M Eisenberg, 'The Structure of Corporation Law' (1989) 89 Colum LR 1461. 7 J Gordon, 'The Mandatory Structure of Corporate Law' (1989) 89 Colum LR

1549. 8 J Coffee, 'No Exit?: Opting Out, the Contractual Theory of the Corporation,

and the Special Case of Remedies' (1988) 53 Brook LR 919, p 937. It is interesting that Professor Larry Ribstein describes the work of Coffee, (ibid), Eisenberg (1989) and Gordon (1989) as 'anti-contractarian': L Ribstein, 'Limited Liability and Theories of the Corporation' (1991) 50 Md LR 80, p 84. This is incorrect, as these authors (with the possible exception of Eisenberg) do not reject the contractual basis of the firm but rather the normative implications drawn from this positive assertion.

9 Coffee (1988) p 924; hence the title of this article. A search of Index to Legal Periodicals from 1981 to date revealed no fewer than 101 articles with Dworkinian derivative titles that take something seriously. The title of this article, however, draws from Coffee's comment, given the importance of his analysis to this paper, rather than chic imitation. Readers may judge the legitimacy of this differentiation for themselves.

WHINCOP: TAKING THE CORPORATE CONTRACT MORE SERIOUSL Y 3

provisions and provides a critique using economic method. The major themes of these authors are twofold. First, the remedy for creditors under the insolvent trading provisions overcompensates creditors, since the risk of credit is 'priced' by the contract. Secondly, the mandatory quality of the insolvent trading provisions inefficiently distorts creditor contracts. The analysis below exposes theoretical objections to both arguments and doctrinal problems with the second.

Part I11 demonstrates how the insolvent trading provisions can find an economic justification in a paradigm that regards corporations as contractual. The insolvent trading provisions create a default term - not, as the critics would have it, a mandatory tern1 - that is efficient where transaction and information costs are significant. In particular, the provisions have the ability to improve the accuracy of the pricing of debt because they create incentives for the release of private information. However, the rules that provide for sharing compensation obtained from the director amongst all unsecured creditors as part of the general fund are inefficient ones.

Part IV concludes by considering whether common law fraud principles and the criminal law can deal sufficiently with problems of creditor contracting.

I. A Short Account of the Insolvent Trading Provisions Comparison with fraudulent trading The insolvent trading provisions in Division 3 of Part 5.7B of the Corpora- tions Law 1991 (Cth) provide protection for creditors against directors of companies in financial difficulties, alongside the fraudulent trading prohibition. The fraudulent trading prohibition in s 592(6) applies to insolvent companies or those which have entered into some form of external admirii- stration."' The substantive grounds of the section are that the company does some act which is accompanied by a 'fraudulent' purpose or an intent to defraud creditors of the company or any other person." Where the substantive ground is made out, any person (the section is not restricted to directors or officers)" knowingly concerned in that fraudulent act contravenes the section and the court may impose personal liability on them for so much of the company's debts that the court thinks proper." Liability is not restricted to debts incurred in connection with the company's 'fraudulent' act.

10 CL s 589(1).

11 C L s 592(6)(a). 12 However, an ofliccr is likely to be subjcc~ to a criminal penalty under s 596.

13 CL s 593(2).

The right to apply for such an order is given to various persons, including creditors and the Australian Securities Commission." However, the liability of the person contravening the section is to the company and not, for instance, to a defrauded creditor." This compensation thus becomes part of the insolvent company's assets to be distributed in the manner required by the external administration regime.I6 While the creation of this type of liability is soundly based (because fraud needs to be deterred)," its form reduces its significance almost to vanishing point. First, it requires proof of f raud. '~econdly, its attractiveness as a remedy is compromised by a collective action problem. Creditors are important plaintiffs in these matters, but if they must share the benefits of their recovery with other creditors, the incentive of the latter creditors to 'free ride' on the litigation will deter creditors from becoming plaintiffs." A related problem in the compensation rules in the present insolvent trading provisions is analysed below.

The jurisdictional conditions of the insolvent trading provisions The present insolvent trading provisions are different from the fraudulent trading provisions both substantively and procedurally. These differences were enhanced by the 1993 amendments which created Part 5.7B.'"The

14 CL s 593(3). 15 CL s 593(2). 16 Australian Corporation Law: Principles G Practice (1996) Butterworths looseleaf,

s 5.8.0090; RC Williams, 'Fraudulent Trading' (1986) 4 C G S LJ14. 17 See, eg, F Easterbrook and D Fischel, 'Optimal Damages in Securities Cases'

(1985b) 52 UChi LR 611, pp 613,621-2. 18 Note the restrictive interpretation given in Hardie v Hanson (1960) 105 CLR

451. 19 For a discussion of collective action problems, see M Olson (1971) The Logic of

Collective Action: Public Goods and the Theory of Groups, 2nd edn, Harvard University Press. The collective action problem will be less, according to Olson, where there are a small number of creditors and the creditor who brings the proceedings 'owns' a large proportion of indebtedness.

20 Prior to the Corporate Law Reform Act 1992 (Cth) coming into effect, insolvent trading was governed by s 592(1), a provision carried over from s 556 of the Companies Act 1981 (Cth). The reforms were motivated by recommendations of the Australian Law Reform Commission (1988), General Insolvency Inquiry ('Harmer Report'), Report N o 45, Australian Law Reform Commission. The recommendations were that: (a) the legislation should oblige directors to prevent insolvent trading by the corporation; (b) breach of duty should primarily attract civil consequences, not criminal consequences; (c) actions for breach should be prosecuted by the corporation through the liquidator; and (d)


following exposition restates elementary propositions that are important to economic analysis. First, s 588G is restricted to directors." Predecessor provisions extended to persons who took part in the management of a company." Secondly, liability depends on the company incurring a debt." A director is not subject to liability in the event of, for example, the value of a company's assets dropping substantially below the value of its existing liabilities." Liability is contingent because it depends on incurring further debts in insolvency. This is important because it establishes that the insolvent trading provisions are not directly aimed at risk-taking.

The word 'debt' narrows the section to obligations to pay ascertained sums. Unliquidated damages obligations or equitable compensation liabilities are outside the provision." This is important because it enables one to make the generalisation that ascertained sums are incurred in a voluntary (contractual) manner, such as borrowing money or buying goods on credit.'" Therefore, the act which invokes the section is, to a significant degree, a voluntary one and therefore avoidable." This conclusion is fortified by the courts' treatment of contracts which create continuing obligations to pay money but which are entered into when the company is solvent. For example, the accrual of obligations according to the terms of a lease contract is not regarded as the incurring of a debt.'"

directors should have defences that were consistent with modern expectations of responsible management. 'Director' is defined expansively in s 60 and will catch 'shadow' directors. See also Standard Chartered Bank ofAustralia Ltd v Antico (1995) 18 ACSR 1. For example, CL s 592(1). Insolvent trading liability is, however, extended to a holding company under similar circumstances: s 588V. See generally I Ramsay, 'Holding Company Liability for the Debts of an Insolvent Subsidiary: A Law and Economics Perspective' (1994) 17 UNSWLJ520.

Section 588G(l)(a). The director may be liable for negligence, however, or for breach of s 232(4). See, eg, Jelin Ptv Ltd v Johnson (1987) 5 ACLC 463 at 464-5; Geraldton Building Co Pty Ltd v Woodmore (1992) 8 ACSR 585 at 590. Cf Williams (1986) p 23, n 54. Rmell Halpern Nominees Pty Ltd v Martin (1986) 5 ACLC 393 at 396 per Burt CJ; at 398 per Olney J. See also L Proksch and R McKenzie, 'Guarantees and Section 592, Corporations Law: The Dynamics of Debt' (1993) 21 ABLR 212, p 214. Russell Halpern Nominees Pty Ltd v Martin (1986) 5 ACLC 393. See also John Graham Reprographics Pty Ltd v Steffens(1987) 5 ACLC 904 (liability to interest on a debt). Cf Leigh-Mardon Pty Ltd v Wawn (1995) 17 ACSR 741.

The principal factual matters that the section requires to be proved are that the company is (or as a result of incurring the debt, will become) insolvent and that there are reasonable grounds for suspecting this to be the case." The definition of insolvency is that the company cannot pay all debts (not just the debt in question) as and when they become due and payable."' This definition is supplemented by various presumptions.J' The test for the assessment of solvency is one of szlspicion, which contrasts with the previous use of expectation." It is said that a 'suspicion' of insolvency requires less than an 'expectation' of same, so increasing the obligations on a director." However, the exculpations in s 588H may offset the increased onus attribut- able to the new standard.

The section is contravened if the director is (or a reasonable person would be) aware of the grounds for suspicion of insolvency and fails to prevent the debt being incurred." Several defences are provided in s 588H. The defence in s 588H(2), that there are reasonable grounds to expect solvency, is a counterpart of the substantive ground of reasonable grounds to suspect insolvency." An important defence (explored below)" exculpates a defendant where, in essence, a competent person provides financial information that indicates solvency. Other defences relate to acting to prevent the debt from being incurred" and excusable non-participation in management at the relevant time.'"

Liability for contra vention Section 5886 is a civil penalty provision." Therefore, its breach exposes the director to liability to compensation, civil penalties (fines and management

CL s 588G(l)(b), (c). CL s 95A.

CL s 58%.

CL s 592(1)(b). Harmer Report, ss 287,303, 304. Section 588G(2). Harmer Report, ss 303, 304. When I describe it as a 'counterpart', I mean that the defence's use of the more onerous standard of 'expectation' of solvency is a logical concomitant of the more easily invoked 'suspicion' of insolvency as the ground of contravention.

See text accompanying nn 143-145 below. CL s 588H(5). CL s 588H(4). CL s 1317DA.

WHINCOP: TAKING THE CORPORATE CONTRACT MORE SER~OUSL Y 7 - - -

disqualification orders) and, if aggravating circumstances are present,"' criminal penalties. Because of its effect o n debt contracting, compensation liability is the focus of the article. Compensation liability is available under the civil penalty provision legislation in Part 9.4B, but also under provisions in Part 5.7B. Compensation orders under the civil penalty provisions can be made either 011 an application for a civil penalty order," when hearing a prosecut ion ei ther f o r a n offence" o r a t t h e corporat ion 's suit." I n this last case, s 1317HD effectively confers a cause of action o n the corporation where a civil penalty provision is contravened, independent of any prosecution. I n all three cases under Part 9.4B, the compensation payable t o the corporation depends o n establishing that the corporation has suffered loss and damage as a result of the insolvent trading." T h e compensation is divisible amongst the creditors of the corporation i n accordance with applicable priorities. Section 1317JA permits the court t o relieve the director f rom this liability where it is satisfied the director has acted honestly and ought fairly t o be excused. F o r these purposes, the court may consider the director's action t o appoint an administrator." This conforms t o the statutory policy that voluntary administration is a preferred 'next step' where insolvency problems emerge.

T h e compensation provisions in Part 5.7B confer a right t o compensation o n the liquidator, and in limited circumstances, individual creditors. These provisions are activated by the company incurring an unsecured debt and the creditor suffering loss o r damage as a result of insolvency." They

-

40 CL s 1317FA(1). 41 CL s 1317HA(l). 42 CL s 1317HB(l). See also ss 1317HB(2), 1317GF, 1317GG. 43 CL s 1317HD. 44 CL ss 1317HA(l)(b), 1317HB(l)(b), 1317HB(2)(b), 1317HD(l)(b). In s 1317HD,

the corporation also has a cause of action to recover any profit made as a result of the contravention by the officer or another person.

45 CL s 1317JA(2). 46 It has been pointed out that the wording of the legislation may support open-

ended, 'consequential' liability: A Herzberg (1995) 'Duty to Prevent Insolvent Trading' in J Corkery and J Lessing (eds) Corporate Insolvency Law, Taxation & Corporate Research Centre, p 20. No authority supports this prediction so far. Since a debtor's only obligation is to pay money, satisfying any test of remoteness in order to recover consequential loss would be very difficult. From an economic perspective, the creditor is likely to the better risk bearer of the consequential loss: R Posner (1992) Economic Analysis ofthe Law, 4th edn, Little Brown, pp 126-8. The Harmer Report, s 317, suggested that the director should be liable not only for the unpaid amount of the creditor's debt, but also for the amount of any benefit to the company from the provision of funds.

contrast with the general civil penalty provisions which depend on loss or damage to the corporation, not to the creditor. While these compensation orders may be made on hearing civil penalty applications" or prosecutions for offences," s 588M permits an application by the liquidator, independent of any prosecution. It entitles the liquidator to recover the amount of loss or damage suffered by the creditor as a result of the debt being incurred as a debt due to the company." It thus forms part of the general fund for creditors, although s 588Y excludes secured creditors from those eligible to share in it. This contrasts with the procedure under the old legislation which prevented the liquidator from bringing the action and permitted the relevant creditors to recover from the defendant the loss or damage that they had suffered." This was criticised in the Harmer Report as leading to a multiplicity of proceedings and discriminating against creditors for whom litigation was too ex~ensive." Under the current legislation, an individual

u u

creditor can sue onl; where a liquidator chooses not to bring proceedings" or consents to the action." The right is destroyed if the liquidator sues or intervenes in a civil penalty application."

These compensation provisions invite several comments. The company's rights under the civil penalty provisions are anomalous. It is difficult to conceive how an insolvent company could suffer loss in consequence of incurring a debt that is not repaid.- The loss is suffered by the

This, fortunately, does not appear in the legislation. This is just as well as it is an absurd proposal, which penalises directors for making best use of the company's finance.

47 CLs588J.

49 CL s 588M(2). 50 See CL s 593(1). 51 Harmer Report, s 279.

53 CL s 588R. The Harmer Report, s 314 proposed an even more restrictive procedure.

54 CL s 588U. See also s 588N. 55 The Harmer Report, ss 283, 286 frequently talks about civil liability 'to the

company' and that the duty to prevent insolvent trading is owed 'to the company'. However, the 'company' referred to here seems merely to reify the company's unsecured creditors. Given that insolvent trading authorises the 'piercing' of the corporate veil, it would simplify analysis of this area to dispense with separate legal personality and admit that the only relevant parties are the directors and creditors, since shareholders have no valuable interests in insolvent companies.

WHINCOP.' TAKING THE CORPORATE CONTRACT MORE SERIOUSL Y 9

creditor. Companies gain funds or goods by incurring debts. The scope for applying these provisions seems to be limited, although non-arm's length transactions may be an exception.

By contrast, the compensation provisions in Part 5.7B proceed on the more logical basis that incurring debts in insolvency harms creditors, not the company. The change in procedure to the liquidator-centred model has interesting policy implications. The new legislation benefits two categories of persons who were shut out of the old regime. First, it benefits persons whose debts were incurred during solvency. Secondly, it benefits persons to whom the company became indebted after insolvency as a result of circumstances that do not amount to incurring a 'debt', such as an unliquidated but provable damages claim or an obligation under a contract entered into during solvency." This rule, which requires that creditors whose debts were incurred in insolvency share with these other groups the benefits of the liquidator's recovery, is an inefficient one, as is explained in detail below."

Two Critiques The Byrne thesis Mark Byrne states that the appropriate duties imposed on directors must be considered as part of a wider question about the allocation of risk between the parties. 'We starts from a premise that in perfect markets, in which all participants have complete information, creditors will be compensated for the risk that they assume. In an imperfect market, however, creditors may not obtain complete information in order to accurately price the risk. Following Easterbrook and Fischel," Byrne argues, however, that creditors need not be undercompensated for risk in imperfect markets. Creditors can price protect themselves by charging a higher interest rate or by taking security, so shifting the incentive to corporate borrowers to eliminate information asymmetries. Borrowers can bond themselves in a way that reduces agency costs."' Therefore, the most important inquiry is whether the creditor was compensated (through the 'price' charged for credit) for the ex ante risk of insolvency of the borrower." If a creditor makes an informed decision about the risk of a company on the brink of solvency, there is no case for a further remedy." Byrne's argument that creditors make informed

56 See text accompanying n 28 above.

57 See text accompanying nn 99-115 below.

58 Byrne (1994) p 278.

59 F Easterbrook and D Fischel, 'Limited Liability and the Corporation' (1985a) 52 UCbi LR 89.

60 Byrne (1994) p 277. 61 Ibid, p 280.

62 Ibid, p 281.

decisions to protect themselves by contract is an important insight that must be considered in light of the legal rules. However, section 1I.C shows that focusing on overcompensation opens up extremely problematic inquiries.

The Mannolini thesis Applying contractarian theory, Mannolini recognises explicit and implicit contracts between creditors and managers (acting on the shareholders' behalf)." Mannolini asserts that implicit contracts may protect creditors and that such protection may be preferred to that offered by mandatory law." Companies that take high risks after loans are agreed will find credit hard to find subsequently." The validity of this 'ex post settling up'" effect is an empirical question needing examination in a variety of 'markets' for debt. Made in the context of insolvent trading, however, the argument collapses under its own weight. It is palpable that this is the one situation where ex post settling up will not occur. Post-contractual opportunism occurs in a 'final period'. The company will never borrow again; the directors may never manage again."

The other analyses of implicit contracts also seem illogical. Mannolini suggests that managers are motivated by their implicit contracts with shareholders not to incur excessive agency costs of debt." The market for managerial labour and the market for corporate control are used to support the argument. While these markets are important to economic analysis, they seem little more than rhetorical flourishes here. First, the market for corporate control is irrelevant to closely held companies with restrictions on share transfer. Secondly, both market influences are minimised by the final period problem that insolvency presents, as noted in the last paragraph. Thirdly, the argument is premised on the assumption that shareholders and

63 Mannolini (1996) p 23. These are contracts the law does not recognise. For a critique of the concept of the implicit contract, see Eisenberg (1989) pp 1487-8.

64 Ibid, pp 24-5. 65 Ibid, p 24. 66 See E Fama, 'Agency Problems and the Theory of the Firm' (1980) 88 J Pol

Econ 288, for a discussion of this theory which Fama offers in the context of managerial labour markets. For criticism of the concept, see 0 Williamson (1996) The Mechanisms of Governance, Oxford University Press, pp 173, 178.

67 Similarly, Corey et a1 state that 'market forces are only effective if more [debt is] offered in the future': G Corey et al, 'Are Bondholders Owed a Fiduciary Duty?' (1991) 18 Flu St ULR 971, p 978. See also C Frost, 'Organizational Form, Misappropriation Risk and the Substantive Consolidation of Corporate Groups' (1993) 44 Hustings LJ449, p 483.

68 Mannolini (1996) pp 24-5.

WHINCOP: TAKING THE CORPORA TE CONTRACT MORE SERIOUSLY 1 1

creditors have common interests, when the opposite is likely to be true. In the USA, the late 1980s were characterised by greatly increased borrowing in the face of pressures from takeovers.

The case of Nabisco is a classic example, where millions of dollars of bonds were pushed into junk bond status by the company's massive new borrowings." Shareholders gained from this but existing creditors were often the losers as they had underestimated financial risk.'" An implicit contract argument supports fundamental antagonism between shareholders and creditors."

Mannolini then considers the problems with the form of the provisions. The first criticism is that the insolvent trading provisions effectively prohibit the possibility of 'trading out' of insolvency." This, he argues, causes profitable projects to be foregone."

Secondly, Mannolini argues that the insolvent trading provisions are unnecessary as creditors are compensated for the risk they assume. Insolvent trading therefore overcompensates creditors." '[Plrovided there is no active misrepresentation, the rational creditor will be either protected (to an optimal extent) from divergent behaviour or at least adequately compensated for the risk that it will occur.'.'

Byrne also stresses the overcompensation point but in a different way." Mannolini seems to assert that creditors are price protected, as if it were axiomatically true, whereas Byrne says merely that courts must look for overcompensation. Mannolini does not seem to be bothered by the empirical nature of his extravagant claim.'. For now, it is worth noting its curt dismissal by Victor Brudney, apropos of what should be the most efficient of all debt markets: the US bond market.

Metropolitan Life Ins Co v RJR Nabisco Inc 716 F Supp 1504 (1989). See, eg, L Light (1993) 'Bondholder Beware: Value Subject to Change Without Notice', Bwinm Week (US), 29 March, p 34. J Coffee, 'Shareholders Versus Managers: The Strain in the Corporate Web' (1986) 85 Mich LR 1, pp 48-52,68-70. S Schwarcz, 'Rethinking a Corporation's Obligations to Creditors' (1996) 17 Cardozo LR 647,p 649. Mannolini (1996) p 29. Byrne (1994) p 283. This argument is demonstrated below to be incorrect (Section 111, 'The Social Cost Counterargument').

Mannolini (1996) pp 30-1. Ibid, p 25. See text accompanying nn 61-62 above. Its speciousness is demonstrated in Section 11, 'The Overcompensation Argument'.

There is no empirical evidence to support the notion that the market prices all protective provisions, and little to suggcst that it prices any but the most significant ones - that is, those addressed to contingencies that come to be thought of (from time to timc) as having, a large impact on pricc. "

Thirdly, Mannolini argues that even if the insolvent trading provisions had advantages, such as screening good and bad quality debtors, this would not justify the mandatory quality of the rules. It should be possible to opt out.-' The mandatory/enabling balance in the insolvent trading provisions is indeed a crucial issue. However, Mannolini's analysis is rendered nugatory due to elementary legal errors and because he ignores important issues that the complex provisioris raise."'After establishing the transaction cost rationale for the insolvent trading provisions, the analysis will turn to whether the term is one that should be opted into or out of.

Fourthly, Mannolini argues that the conduct that contravenes the insolvent trading provisions goes beyond fraud and deliberate wrongdoing and includes some cases of simple errors of judgment." If there have been cases in which the laws were misapplied, the fault would seem to lie with the judge. Under the present provisions, a judge who considered a director had made an honest commercial misjudgment could hold that the director had reasonable grounds to expect the company was solvent and would remain so after incurring the debt." There is also a business judgment defence to actions under Part 9.4B." Given such defences, these sorts of judicial 'errors', if that is what they are, eclipse Mannolini's advocacy of the courts and the common law as superior controls in this area, an issue revisited in the conclusion of this article.

Fifthly, Mannolini accepts that some creditors may not assess commercial risks properly but that the director and not the creditor must be

78 V Brudney, 'Corporate Bondholders and Debtor Opportunism: In Bad Times and Good' (1992) 105 Harv LR 1821, pp 1851-2.

79 Mannolini (1996) p 31. 80 See Section 11, 'The Mandatory Argument' below. 81 Mannolini (1996) p 32. Only one is cited. This is John Graham Rtprogfphics

Pty Ltd v StefJem (1987) 5 ACLC 904. However, Connolly J at 910 regarded the defendant's conduct as going an unacceptable distance beyond a bona fide error of commercial judgment.

82 CL s 588H(2). 85 CL s 1317JA(2), (3). The general defence in s 1318 may also be available: Byrne

v Southern Star Group Pty Ltd (1995) 13 ACLC 301; cf Commonwealth Bank of Australia v Friedrich (1991) 9 ACLC 946.

WHINCOP: TAKING THE CORPORA TE CON TRACT MORE SERIOUSL Y 13

preferred in order to favour 'entrepreneurial risk-taking'." To begin with, it is unclear why directors should be regarded as entrepreneurs but lenders should not, since both are in the business of risk-taking. The first part of the argument is inconsistent with the earlier premise that creditors are price protected. Something more than bare assertion is needed to support the second part of the argument that entrepreneurial risk-taking is promoted by permitting the directors of insolvent companies to incur further debts. There are many issues involved in the standard insolvent trading case, amongst which entrepreneurial risk-taking is only one. These include the costs of transacting, the costs of producing information concerning solvency, the cost of verifying that information and the locus of comparative advantage in bearing these costs."

The overcompensation argument Mannolini makes a strident case that creditors can protect themselves completely by contract. For him, and perhaps also for Byrne, creditors are not undercompensated. The risk of insolvency or opportunistic wealth transfers would be impounded into p r i ~ e . ~ Mannolini says that 'if such a creditor is then permitted to recover the debt from a manager, then on a risk adjusted basis, the creditor is effectively over~om~ensated' .~ '

Mannolini cites Byrne as authority for that proposition. However, it has been noted that this may be incorrect, as Byrne seeks to examine whether overcompensation would occur; he does not assert that it must have occurred.

Mannolini's analysis is theoretically incorrect. The insolvent trading rules are known and their impact on the allocation of risk between the parties can be ascertained and 'priced'. If parties can price-protect in the absence of the rules, they are capable of price-protecting when they are present. Polinsky states that: '[iln general, the parties [to a contract] will take any distributional effects of breach of contract remedies into account when they negotiate the contract price'.

84 Mannolini (1996) p 32.

85 An elementary model of some of these factors is provided below in Section 111, 'The Effect of Positive Information and Contracting Cos~s'.

86 This view also seems to be held in J Farrar (1987) 'The Obligations of a Company's Director to its Creditors' unpublished paper, New Zealand, p 32, quoted in J Dabner, 'Trading Whilst Insolvent - A Case for Individual Creditor Rights Against Directors' (1994) 17 UNSWLJ546, p 574.

87 Mannolini (1996) p 31 (original emphasis). 88 M Polinsky (1989) An Introduction to Law and Economics, 2nd edn, Little

Brown, pp 122-3. There is a passage in Byrne's article that seems to

Byrne seems to say that courts should inquire whether lenders are overcompensated by invoking the insolvent trading provisions. As soon as we admit the possibility of overcompensation expost in particular cases, then ex post undercompensation seems likely in other cases." Only a naive assumption about market efficiency will require a nil 'error' term for all observations. Most analyses of market efficiency merely require the error term's mean value over many observations (that is, the arithmetic mean) to be nil."' Thus, overcompensation and undercompensation are both inevitable in imperfect markets. Admitting that possibility, however, initiates a new line of inquiry. If overcompensation and undercompensation are both possible in credit contracts, is there any reason to expect that systematic overcompensation prevails? A reasonable null hypothesis seems to be that in a world with insolvent trading provisions, lenders are overcompensated as frequently as they are undercompensated. While this is speculative, long-run competitive effects would tend towards this result." The likely economic response would therefore be: ignore overcompensation in particular cases, as lenders are as likely to win as lose. The long term arrives 'one day', so default rules must be oriented towards issues with greater importance to efficiency, such as reducing transaction costs."

The second, more fundamental objection to inquiring into overcompensation is its indeterminacy. For a court to assess whether a creditor has been overcompensated in a particular case requires the following: (i) a model for pricing debt; (ii) information about how interest rates are set in the relevant industry; (iii) the information about the borrower available at the time of the loan; and (iv) knowledge of how lenders trade off contractual protections in the debt contract and price protection. It may be technologically impossible, given the state of financial economics, to even obtain this information; the costs of an attempt to apply it would be prohibitive and it is difficult to have any confidence in the result." If one

acknowledge this: Byrne (1994) pp 278-9. 89 Insolvent trading is not a perfect solution, given that some directors will be

insolvent, and others may flee the jurisdiction. The transaction costs of suing insolvent trading directors is significant. Thus, ex post undercompensation is inevitable.

90 E Fama, 'Efficient Capital Markets: A Review of Theory and Empirical Work' (1970) 25 JFin 383.

91 The insolvent trading provisions apply to all creditors, so the legislation does not establish any barrier to entry.

92 For a parallel argument applied in a different context, see F Easterbrook and D Fischel, 'The Corporate Contract' (1989) 89 Colum LR 1416, pp 1432-3.

93 As Brudney states, '[wlhatever may be the pricing miracles that the market can perform, registering the appropriate equilibrium between gains and losses from

WHINCOP: TAKING THE CORPORATE CONTRACT MORE SERIOUSL Y 1 5

were to use the Capital Asset Pricing Model, for instance," one would need to know the beta of the debt. A beta measures the risk of a security attrib- utable to variability in the market as a whole. Betas (for shares) are estimated by analysing the movements of share prices and an index of stock price behaviour." While conceivable for traded debentures, such estimation would be impossible for the majority of debts to which the insolvent trading provisions apply. The process of determining overcompensation would resemble the game of 'pin the tail on the donkey'. The law must surely have a more secure foundation than this."

Overcompensation is therefore theoretically and practically empty of significance to the law. Economic analysis and particularly contractarian theory must concentrate on transaction costs. Before attempting this task, the article first addresses whether or not the insolvent trading provisions are 'mandatory'.

The mandatory argument Mannolini argues that the insolvent trading provisions were mandatory. However, his analysis is undermined because he applies the wrong law to reach his conclusion. Mannolini quotes the provision which was repealed by the Corporate Law Reform Act 1994." Section 241(1) now reads:

A company or a related body corporate must not: (a) indemnify a persbn who is or has been an officer or an auditor of

the company against a liability incurred by the person as such an officer or auditor; or

(b) exempt such a person from such liability.

Section 241(2) provides:

loopholes in protective covenants is not one of them': Brudney (1992) p 1875. 94 The original statements of the theory can be found in J Lintner, 'Security

Prices, Risk and Maximal Gains from Diversification' (1965) 20 J Fin 587; and W Sharpe, 'Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk' (1964) 1 9 j F i n 425.

95 See generally R Roll, 'A Critique of the Asset Pricing Theory's Tests, Part I: O n Past and Potential Testability of the Theory' (1977) 4 JFin Econ 129.

96 See also Brudney (1992) pp 1825-6 97 Mannolini (1996) p 30, n 74. That provision is no longer effective after 14

April 1994, about two years before the publication of the article.

Subsection (1) does not prevent a person from being indemnified against a liability to another person (other than the company or a related body corporate) unlq2s the liability arises out of conduct involving a lack of good faith.

Neither section prevents any creditor from contracting out, provided the insolvent trading liability does not involve a lack of good faith. However, the combined effect of this law and the 1993 amendments to the insolvent trading provisions create difficult questions in need of analysis.

It was noted above that, prior to the 1993 amendments, the main plain- tiff in insolvent trading cases was the creditor whose debt was incurred at a time when the company was insolvent (hereafter, such a creditor is described as an 'insolvent trading creditor')." The insolvent trading provisions thus served as a form of guarantee by the directors that the company was solvent. That is no longer the case. The essence of the current provisions is that compensation is payable where (i) the company suffers damage or (ii) an insolvent trading creditor suffers damage. So far as case (i) is concerned, I have indicated that it is difficult to imagine situations (apart from some non- arms length transactions) in which the company suffers damage by incurring the debt.'" Case (ii) is the important one. However, despite the fact that incurring a debt to an insolvent trading creditor is the ground that invokes insolvent trading liability, the compensation becomes part of the general fund and is distributable among all unsecured creditors. The only other author to criticise this rule is Justin Dabner, whose arguments are different (but generally complimentary) to mine.'" However, he focuses on the lack of an individual right in the creditor, whereas my concern is with conferring an interest in the compensation on all unsecured creditors.

The change in the scheme was influenced by the Harmer Report, which considered that the old legislation permitted 'queue jumping' by insolvent trading creditors who were prepared to sue. "" Permitting the liquidator to

98 Because the Corporations Law contains an express provision concerning opting out and release, it is unnecessary to deal with the general law concerning waiver of rights under a statutory provision: see generally Wilson v Mclntosh [I8941 AC 129; Toronto Corporation v Russe11[1908] AC 493; Davies v Davies (1919) 26 CLR 348; Brown v R (1986) 160 CLR 171. Under the general law, statutory rights may be waived if the provision was introduced for their benefit, rather than for the benefit of the public.

99 See text accompanying nn 50-51 above. 100 These debts could probably be avoided as voidable transactions: see ss 588FA--

F F . See also text accompanying n 55.

101 Dabner (1994) pp 566-75.

102 Harmer Report, s 313.


bring an action which benefits all creditors seems a fair solution.'" This procedural model overcomes the unwillingness of small lenders to sue and the collective action barriers to co-operation between these lenders.'" How- ever, the proceeds of recovery benefit all unsecured creditors, not just the insolvent trading creditors. The contrast is thus between sharing compensation (a 'sharing rule') and reserving it for the insolvent trading creditors (a 'reserving rule'). A reserving rule is preferable to a sharing rule for reasons of logical consistency and economic efficiency.

A sharing rule is inconsistent with the nature of the insolvent trading rules. First, the insolvent trading rules are not motivated by reducing the losses of unsecured creditors but instead by deterring insolvent trading. N o compensation is available under these rules in the absence of insolvent trading, whatever the magnitude of the asset deficiency. I t therefore seems strange for damage to the insolvent trading creditor to be the basis for making any compensation order if that compensation must be shared with creditors who contracted at a time when the corporation was able to pay its debts. Using a sharing rule in the insolvent trading provisions severs the nature of the cause of action (insolvent trading) from the remedy, by denying the insolvent trading creditor anything more than any other unsecured creditor obtains.

Secondly, the illogicality of a sharing rule is intensified when one considers the entitlement of an insolvent trading creditor to sue to recover debts where the liquidator consents to, or fails to bring, an action."" In this case, one returns to the reserving rule. This combination of rules creates the possibility for antagonism between the liquidator and those insolvent trading creditors who would be prepared to sue. If the liquidator sues, their recovery decreases. Encouraging the liquidator to bring an action is, in the language of game theory, a strictly dominated strategy; such a co-operative strategy has no merit for these creditors, whatever the liquidator does.'" The insolvent trading creditors for whom co-operation is not a dominated strategy are those who lack incentives to sue themselves."" If the rule were to return to a reserving rule (for all insolvent trading creditors), it would be a

103 Corporate Law Reform Act 1992 (Cth), Explanatory Memorandum, para 101.

104 This collective action problem was recognised in Ross McConnel Kitchen G Company Pty Ltd (in lid v Ross(1985) 3 ACLC 326 at 328 per Young J.

105 CL ss588M(3), 588R-U. 106 Baird et a1 define a strictly dominated strategy as the strategy for a player that is

always worse than another choice: D Baird et a1 (1995) Game Theory and the Law, Harvard University Press, p 306.

107 The fact that these insolvent trading creditors with small debts will receive less than the amounts of their debts under a sharing rule reinforces the collective action problems they face: see n 19 above.

dominant strategy"" for these creditors to co-operate with and assist the liquidator in the action if, as the legislation assumes, there are procedural cost savings where the liquidator brings a single application on behalf of all insolvent trading creditors. The more applications for compensation, the greater the deterrence of insolvent trading.""

It may be said that the reserving rule unfairly prefers insolvent trading creditors to others. However, it seems reasonable to assert that because creditors will not know that they are dealing with an insolvent company,"" the rule will not systematically favour any group of persons. Many insolvent trading creditors will be traders who may also have debts incurred during solvency. This counts against its unfairness. Another objection may be that if one cannot easily distinguish between a solvent company and an insolvent company, drawing a line, as a reserving rule does, between those permitted to recover and those not, is arbitrary. However, incurring debts in insolvency is exactly the line that the legislation draws, beyond which the director is liable.

Thirdly, a reserving rule achieves the outcome the legislature seeks to bring about. The insolvent trading provisions are intended to achieve a result where no insolvent trading occurs by putting pressure on directors to appoint an administrator or not to trade. Once that happens, putative insolvent trading creditors will not extend credit to the company, and therefore lose no money; however, other unsecured creditors will lose money from asset deficiency. A reserving rule in the insolvent trading provisions creates precisely that result by leaving the uncharged company assets to the unsecured creditors and by the director indemnifying the insolvent trading creditors.

A key economic objection to the sharing rule concerns contracting out. Contracting out describes a situation where a creditor agrees or, if more than one, creditors agree to waive a breach of the insolvent trading rules and to take their risks with the company's solvency. The reader should assume for the moment that contracting out by creditors may be desirable in circumstances where the director knows the corporation is close to insolvency but is not sure whether a court would hold the corporation to be

108 Baird et a1 define a dominant strategy as that which is a best choice for a player in a game for any possible choice by the other player: Baird et a1 (1995) p 306.

109 This conclusion may be slightly modified, as the Corporations Law permits the preferential payout to a creditor who indemnifies a liquidator against costs: see s 564. However, this depends on the ratio of insolvent trading creditors' debts to other unsecured creditors. Cf S Worthington, 'Liability for Insolvent Trading: Routes and Rules in Reform' (1992) 10 Company E. Sec LJ214, p 215.

110 In any event, if they do, they will be denied recovery: s 588Y(2).


insolvent."' If one adopts a reserving rule, only the insolvent trading creditors have claims against the director. If one adopts a sharing rule, however, all unsecured creditors have (indirect) claims. Some creditors may be prepared to deal with corporations close to insolvency. For instance, creditors may prefer an attempt to trade out of insolvency to taking their chances with the liquidator. If a sharing rule is adopted, however, contracting out would be very difficult, since every creditor would have to consent. If a reserving rule is adopted, the only contracting out would have to be with each new creditor on a prospective basis.

Returning to s 241 (quoted above), nothing there is inconsistent with informed creditors agreeing not to assert their insolvent trading rights. The policy of s 241 is that officers may not contract out of their duties to their corporations. This is explicable on the ground that the officer would be motivated to act opportunistically. Thus, contracting out of, say, s 232 would not be permitted. However, contracting out with creditors is different."' A creditor's contract is not fiduciary but adversarial."' The moral hazard argument applicable to the shareholder situation thus has less force, provided the creditor is fully informed."* Since the liquidator acts for the benefit of creditors in a winding up, it is clear the liquidator should be bound by the contracts of the interested creditor or creditors."' However, the transaction costs of contracting out under a sharing rule will be prohibitive because of the greater number of contracts (that is, all creditors). This problem, together with the logical deficiencies of a sharing rule, form arguments in favour of limiting the distribution of compensation to insolvent trading creditors.

Contracting out is certainly difficult under the present rule but it is not conceptually or legally impossible if the number of debtors is small. The more important question of whether or not contracting out should be permitted is considered next. However, it must first be clear that the insolvent trading provisions represent efficient default rules.

111 See text accompanying nn 155-164 below. 112 There is nothing in the report of the Companies & Securities Law Review

Committee on indemnification and release from duties which suggests any reason a creditor should not be able to contract out of insolvent trading protection: Companies & Securities Law Review Committee (1990) Company Directors and Officers: Indemnifcation, Relief and Insurance, Report N o 10, Companies & Securities Law Review Committee.

113 Brudney (1992) p 1839. 114 I discuss this proviso in text accompanying nn 155-164. 115 It would be absurd if the creditor agreed not to assert a right under the

insolvent trading provisions but the liquidator retained a cause of action. The company would have had the benefit of the debt, as well as compensation the creditor agreed not to seek.

Ill. A Transaction Cost Analysis The effect of positive information and contracting costs Like Mannolini, my aim is to analyse the effect of directors' duties in favour of creditors from a contractarian perspective. A different perspective is offered which is not inimical to statutory law if it produces better private contracting. An essential part of this analysis is to consider the economics of contracting out and the choice of default rule.

Over the last decade, law-and-economics scholars have developed theories of default rules; that is, they have considered the content of the legal rules articulated by courts and parliaments that apply, unless varied, to all or a subset of contract^."^ In the present situation, if the above analysis is correct and the creditor and the corporation are capable of agreeing not to enforce the insolvent trading provisions, they can be regarded as a default rule. The issue is whether the insolvent trading provisions are an appropriate default rule. Ian Ayres and Robert Gertner introduce the idea of a 'penalty default', a rule that is not what one party would choose."' A penalty default gives that party an incentive to contract around the rule. That process of contracting around the rule causes that party to reveal information to the other. That information may not otherwise be revealed for strategic reasons, because the party who possesses it gains from nondisclosure. The insolvent trading provisions fit this description.

A crucial consideration to selecting default rules are the costs of both producing information concerning the financial condition of the company and of verifying and processing the information furnished to the prospective creditor. If it was costless to produce and verify information regarding a corporation's solvency, an opt-out term like the insolvent trading provisions would create unnecessary transaction costs. Creditors would always seek

116 The notion of law as a means of filling incomplete contracts has its origin in R Coase, 'The Problem of Social Cost' (1960) 3 j L G Econ 1. An economic theory of default rules is developed in I Ayres and R Gertner, 'Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules' (1989) 99 Yale LJ 87; 1 Ayres and R Gertner, 'Strategic Contractual Inefficiency and the Optimal Choice of Legal Rules' (1992) 101 Yale Lj729; R Craswell, 'Contract Law, Default Rules, and the Philosophy of Promising' (1989) 88 Mich LR 489; M Gergen, 'The Use of Open Terms in Contract' (1992) 92 Colum LR 997; C Gillette, 'Commercial Relationships and the Selection of Default Rules for Remote Risks' (1990) 19 JLegal Stud 535; A Schwartz, 'Relational Contracts in the Courts: An Analysis of Incomplete Agreements and Judicial Strategies' (1992) 21 ]Legal Stud 271; and R Scott, 'A Relational Theory of Default Rules for Commercial Contracts' (1990) 19 JLegal Stud597.

117 Ayres and Gertner (1989) pp 95-100.


and verify information. They would use that information to 'price' the debt competitively. An opt-in term would be of no value.""

If information was costly to produce but is costless to verify, creditors would expect to. be provided with information. In these circumstances, a company borrower would pay the risk adjusted rate of return. The borrower gains nothing from misrepresentation since verification is costless. Again, the social optimum will obtain. Because verification is costless, borrowers have no incentive to waste resources in producing fraudulent information. Again, an opt-out term would produce unnecessary transaction costs; an opt-in term would be of no use. Thus, there would be no need for a penalty default because there are no gains from withholding information.

Where information concerning one of the parties to an exchange is important to the bargain but is costly to produce and verify, it is not always possible to assume that the less informed party will be disadvantaged. Under the unravellingprinciple (a principle of information economics), a party who lacks information may 'unravel' it from the other party's silence."' Thus, if Z seeks a loan from a bank, with which Z has not dealt before, Z will be treated as a bad risk unless Z supplies sufficient information to convince the bank to the contrary.

Can we assume, as Mannolini and Byrne do,"" that debtors bear the risk of the unravelling principle? We cannot, for several reasons. First, if the marginal cost of verifying information provided is substantial relative to the gains from trade, the creditor may not seek information as a rule; thus, the borrower's failure to disclose has no implications. Secondly, one must examine the unravelling principle across time and in the context of the relation between borrower and lender."' A failure to supply information before an exchange may provide no basis for the unravelling principle where there is a prior sequence or relation of exchange between the parties, as there may be with a trade creditor. The lender will draw inferences regarding creditworthiness from the relation. The creditor's silence before an

118 This analysis is consistent with the Coase theorem generally: if transaction costs are nil, the initial allocation of risk by legal rules will be irrelevant because the parties can contract around the rule to an efficient allocation: Coase (1960).

119 For a discussion of this principle, see Baird et a1 (1995) pp 89-109. 120 Byrne (1994) p 277; Mannolini (1996) p 25.

121 Studies of 'relational contract' treat contract in a way that regards exchange as being embedded in relations between the contracting parties rather than as sharply defined, discrete promises that are fully specified at the time of the contract. See generally I MacNeil, 'Contracts: Adjustments of Long-Term Economic Relations Under Classical, Neoclassical and Relational Contract Law' (1978) 72 Nw ULR 854; Schwartz (1992).

insolvent trade cannot be unravelled to form an adverse inference if obligations have been met in the past. The fact that trade credit transactions are frequently the subject of insolvent trading cases tends to bear this analysis out.

What is the consequence of an inability to distinguish risks? The natural response is for lenders to raise the price of debt across the board, except for borrowers who can credibly distinguish themselves as solvent. Many solvent borrowers may not attempt this given transaction costs. This is a form of 'external' effect, as insolvent traders raise the cost to all traders, although the creditor should on average be price protected.

Accordingly, the effect of substantial production and verification costs is to create significant votential for insolvent trades. Creditors may be able to protect thimselves 6ut this will be a cost shared by borrowers generally. Another way of stating this so as to accord with the earlier analysis of overcompensation is that the market for lending is 'speculatively' efficient."' Over the long term, lenders will earn normal returns (that is, be compensated) for risks assumed. However, a speculatively efficient market need not be 'allocativelv' efficient. Allocative efficiencv describes a market in which factors of production are priced in a way that leads to their allocation to uses in which their value is maximised. The Coase theorem, the cornerstone of law-and-economics, asserts that transaction costs may prevent resources moving to the most allocatively efficient use."' Thus, I have indicated that a price for credit that reflects positive information and transaction costs will exceed the price for credit in a world otherwise identical but where these costs are nil. Some borrowers would transact at the latter mice but not at the former.

The issue, therefore, is whether the insolvent trading provisions are an efficient means of reducing the transaction costs associated with insolvent trades. To assess this requires comparative study against other alternatives. A provision 'protecting7 the creditor in the credit contract with the company will be useless in insolvent trades. The efficacy of such a provision depends on the company's solvency, the very matter in contention."" Insolvent trading is a classic final period problem, where such controls founder."' A proprietary protection in the form of a security will protect

122 J Gordon and L Kornhauser, 'Efficient Markets, Costly Information and Securities Research' (1985) 60 NYULR 761, pp 766-70.

123 Coase (1960).

124 See W Bratton, 'The Economics and Jurisprudence of Convertible Bonds' [I9841 Wisc LR 667, p 733; and J O'Donovan, 'Corporate Benefit in Relation to Guarantees and Third Party Mortgages' (1996) 24 ABLR 126. Some writers are chary of the value of debt contracts even where the borrower is solvent; see M McDaniel, 'Bondholders and Corporate Governance' (1986) 41 Bm Law 413.

125 See text accompanying n 67 above.

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creditors more effectively than a non-proprietary provision. However, such a remedy for the problem we are looking at is not necessarily viable. First, viable security may be hard to offer even for solvent companies. Prior charges may exist. Assets may be highly 'specific'; that is, their value in alternative uses is l o w . " T h i s decreases the value of pre-emptive claims against them. Secondly, the transaction costs of offering security are high. Negotiating a security agreement, investigating prior charges and valuing the security asset are costly. The legal system creates additional difficulties for a lender who takes a security proximately to insolvency." The security is potentially voidable. This decreases the inherent value of the security and may also increase the costs the lender must bear to check the solvency of the creditor. Thus, security is unsuitable as a default, 'opt-out' term and is a costly opt-in term.

An alternative protection for the lender is a personal guarantee. A guarantee is conceptually akin to the insolvent trading provisions' effect. However, a normal guarantee is not an attractive proposition for company directors."Vf the term of the guarantee is of any significant duration, the guarantee imposes a substantial part of the risk of the residual cash flows of the company's assets on the guarantor. There are problems with this situation because directors are inherently risk averse and a guarantee would merely increase this risk aversion.'" H o w then is the implicit guarantee in the insolve~lt trading provisions an efficient solution? In the case of a standard guarantee, the risk is unrestricted: the liability is invoked by subse- quent insolvency during the period the guarantee subsists. O n the other hand, the implicit insolvent trading guarantee is 'conditional' on the director knowing or having reason to suspect insolvency. It thus imposes on the director only the risk that the company is insolvent at that relevant time and not beyond. It is a 'close-ended' guarantee. In relation to this risk, the director is the logical bearer. The director is likely to have the lowest costs of producing information regarding the company's solvency at that point. This is why there is an inherent adverse selectio~l problem in insolvent trading situations.'"' Because of the consensual quality of the phrase

126 0 Williamson, 'Corporate Governance and Corporate Finance' (1988) 43 J Fin 567.

127 See, eg, CL, Pt 5.7R, Div 2. For a discussion of the implications of these rules, see O'Donovan (1996).

128 Where one embraces a sharing rule for compensation, the insolvent trading provisions become less of a guarantee to irlsolvent trading creditors since they are unable to recover the full amount of damage where there are unsecured creditors who are not also insolvent trading creditors.

129 See n 149 below and accompanying text for a more extensive discussion of this point.

'incurring a debt', the director can avoid the transaction (and the risk) by entering voluntary administration. It therefore makes sense to impose this risk on the director via an opt-out default term."'

This analysis accords with Ayres and Gertner's analysis of penalty defaults. Generally, the majority of borrowing companies are solvent, so the insolvent trading provisions would lie dormant. However, making the insolvent trading provision as a penalty default compels a relatively informed party to disclose information about impending insolvency. In the absence of that rule, the information would not be voluntarily disclosed because of the obvious strategic advantage. The rule therefore compels disclosure; a side effect is that solvent companies no longer borrow at a rate which reflects the possible presence of insolvent buyers. This eliminates an inefficient cross-subsidisation."'

I therefore disagree with Ramsay's analysis that directors are the least efficient bearers of the risk of loss resulting from the insolvency of a subsidiary to the extent that argument applies to the non-corporate-group insolvent trading situation."' Ramsay's analysis seems cogent if one is considering risks generally. However, the risk of the insolvent trading provisions is not a general risk but a very specific type of risk that depends on establishing insolvency at the relevant time. The director can avoid that risk given that the director is liable only when the company incurs a debt.'"

The costs of the duty to be informed The analysis above seems correct in cases where the insolvent trading provisions are predicated on the director knowing that the company is or, as a result of the transaction, will be insolvent. However, the insolvent trading provisions are activated by a lower standard of knowledge. The relevant grounds are that:

130 Adverse selection is a term used in the insurance literature to refer to the condition that obtains where the insured knows his ex ante risk better than the insurer; it contrasts with moral hazard, which refers to the insured's ex post change of incentive to act efficiently with respect to a risk. Insolvent trading is an adverse selection problem.

131 The analysis in this section resembles Coffee's analysis that it is logical for limits to be imposed on director's duty of care violations, but not on duty of loyalty violations, since the director are poor risk bearers of the former, but the lo.: ,>L cost avoiders of losses deriving from the latter: Coffee (1988) pp 951-2.

132 Ayres and Gertner (1989) pp 99-100.

133 Ramsay (1994) pp 539-40.

1-34 It is for this reason that a different analysis is needed of bearing the risk of 'transactions' creating involuntary creditors, such as torts. Ramsay gives an insightful discussion: see ibid, pp 542-3.


(b) the company is insolvent at that time, or becomes insolvent by incurring that debt, or by incurring at that time debts including that debt; and

(c) at that time, there are reasonable grounds for suspecting that the com an is insolvent, or would so become insolvent, as the case may ?,> y be ...

Compared to an actual knowledge ground, these provisions require the director to be informed of the corporation's solvency because a failure to do so can attract significant liability. What effect does this implicit duty to be informed have on the analysis above?

This obligation to be informed conforms to trends in modern corporate law requiring a considerably stronger duty to be informed than the law has normally recognised. The foundations of these developments were in fact laid in insolvent trading cases.'" I have argued elsewhere that imposing a duty to be informed as part of the director's general duty of care is rnis- specified because of the difficulty a director faces in assessing the marginal benefit of acquiring an incremental piece of information. In a world of business uncertainty, the equation of the marginal costs and benefits will be a difficult task. Courts that sit in ex post judgment are likely to err in this complex, costly process.". That analysis endorsed the application of a gross negligence standard to substantive and information acquisition decisions:"" were the directors cognisant of circumstances of such a plain and simply appreciated character that no reasonable person would enter into the transaction?"' Such a rule catches decisions that are irrational or clearly wrong and so minimises the chance of errors in adjudication. The rule imposes business risk of other decisions on shareholders who can bear it more efficiently than directors, given their capacity to diversify company specific risks.'"'

Gross negligence rules will catch cases where directors fail entirely to be informed. T o extend this analysis to insolvent trading cases, the marginal cost of acquiring basic information concerning company solvency is likely to

-

135 CL s 588G(1). 136 See, eg, J Hill, 'The Liability of Passive Directors: Morlq v Statewide Tobacco

ServicaLtd (1992) 14 Syd LR 504. I have provided a theoretical critique of these developments elsewhere: M Whinco~, 'A Theoretical and Policy Critique of the Modern Reformulation of Directors' Duties of Care' (1996b) 6 Awt J Gorp L 72.

137 Ibid, pp 85-7.

138 Ibid, p 86. 139 Overend and G u r n q Company v Gibb (1872) LR 4 HL 480 at 487. 140 Whincop (1996b) p 86.

be low for a 'minimally functioning' director."' A decision to do nothing or to ignore credible signals of serious trouble (which one would expect to see in companies approaching insolvency) will be irrational and therefore grossly negligent."'

These arguments inform analysis of the requirements of the insolvent trading provisions for directors to be informed. Section 588H provides that it is a defence if at the time the debt was incurred, the defendant:

(a) had reasonable grounds to believe, and did believe:

(i) that a competent and reliable person ('the other person') was responsible for providing to [the defendant] adequate information about whether the company was solvent; and

(ii) that the other person was fulfilling that responsibility; and

(b) expected, on the basis of information provided to [the defendant] by the other person, that the company was solvent at that time and would remain solvent even if it incurred that debt and other debts that it incurred at that time."'

Several points should be noted. First, a court need form no judgment about the marginal benefit of the information acquisition, so avoiding the difficult judgments that the general duty to be informed requires. A court need only be satisfied that an adequate process exists to inform directors and that the director takes heed of the information produced. Secondly, the marginal cost t o acquire the information that is needed to make out the defence intuitively seems low. While the total costs of installing an internal accounting control system o r retaining an accountant to provide similar information may be significant, it would seem reasonable to speculate that most companies would engage in this activity for management and external reporting reasons anyway."* If so, the marginal cost (the important statistic in economic analysis) of fulfilling the statutory defence would not seem especially high by the standards of the hypothetical 'minimally functioning' director."' If this analysis is accurate, it is difficult to object to the extension of liability from cases of actual knowledge of insolvency to cases where

141 Ibid, p 87. 142 Ibid. 143 CL s 588H(3). See also s 588H(2). See text accompanying n 36 above. 144 Cf Harmer Report, s 307 (the defence encourages the establishment of such

monitoring). Note also that the insolvency presumption in s 588E(4) encourages the installing of an accounting system.

145 See also S Pollard, 'Fear and Loathing in the Boardroom: Directors Confront New Insolvent Trading Provisions' (1994) 22 ABLR 392, p 407.

WHINCOP: TAKING THE CORPORA TE CONTRACT MORE SERIOUSL Y 2 7

reasonable grounds exist to suspect insolvency. The duty to be informed is not obviously inefficient and also overcomes the evidentiary problem of proving actual knowledge.

The social cost counterargument . A caveat must be added to this analysis. Where a director pleads the information defence, a court must ascertain whether the director expected, having regard to information, that the company was solvent and after incurring the debt, would remain so. The italicised requirement involves extrapolating from the circumstances in which the debt was incurred to the future. Accounting information cannot supply a definitive answer to this extrapolation since the answer may depend on what is done with the proceeds of the credit transaction. There are business judgment issues here. This jurisdiction should be exercised by a court in a way that does not impose unreasonable barriers to honest directors relying on this defence. A reasonable foreseeability test - would a reasonable director foresee that the company could be rendered insolvent by incurring the debt? - might limit the usefulness of the defence for honest directors. The balance is hard to strike.

Whether courts should take a sanguine view of the applicability of a generous business judgment rule at every point up to and including the brink of insolvency is a question where we have little useful t h e ~ r y . " ~ In the absence of theory, the issue threatens to be resolved by useless dogma about the merits of entrepreneurship versus creditor protection.

Consider an example. Mannolini criticised the effect which the insolvent trading provisions would have on projects that are risky, but profitable. Social costs would apparently be suffered by abandoning these projects mid- way, or by never taking them up."' The proposition is valid as far as it goes but that is not very far. The issue is clearly in need of empirical evidence. In particular, what needs scrutiny is the adequacy of the voluntary administration procedure for companies that have assets needing both

146 See L Lin, 'Shift of Fiduciary Duty upon Corporate Insolvency: Proper Scope of Directors' Duty to Creditors' (1993) 46 Vand LR 1485, p 1494; B Nicholson, 'Recent Delaware Case Law Regarding Director's Duties to Bondholders' (1994) 19 Del J Corp L 573, pp 589-91; Schwarcz (1996) pp 672-3 (suggesting a dual loyalty in insolvency). In a leading American case on the duties directors of an insolvent company owe, decided in the important corporate jurisdiction, Delaware, Chancellor Allen refused to consider the business judgment question: see Credit L~onnals Bank Nederland NV v Pathe Communications Corp (1991) WL 277613, reprinted in (1992) 17 Del J Corp L 1099.

147 Cf Byrne (1994) p 283.

discretionary investment and the expertise of incumbent d i r ec to r s . "We may need more innovative alternatives so that valuable projects are not left moribund.

At a broader level, the significance of the 'social cost' of the insolvent trading provisions also needs comparative examination in a real world of transaction costs. The economic literature targets the director's risk aversion as a key problem for shareholders in corporate law."' This phenomenon exists in large companies, in which executive directors and managers make significant investments of their human capital.'" It also exists in closely held companies in which officers usually make large financial (equity) investments."' I t therefore seems strange to assert that the insolvent trading provisions prevent the exploitation of all valuable projects when inherent risk aversion led to the same result when the company w a solvent.'j2 The correct analysis is that when insolvency is imminent, directors become risk neutral because they realise that profitable projects, or even negative value projects with some chance of profit, are all that stand between them and the loss of their undiversified investments in the firm."' Losses from these projects are borne by creditors. Limited liability thus distorts pay-offs in insolvency, so leading to potential allocative inefficiency.

Contracting out These issues converge in an analysis of the merits of contracting out of the insolvent trading provisions. A theme of this article has been that these provisions are a transaction cost efficient means of reducing information asymmetries between companies and their creditors. This increases the accuracy of pricing debt, so leading to the use of debt finance in a more allocatively efficient way. Sharing rules in dividing compensation are, however, inefficient.

148 See generally S Myers, 'Determinants of Corporate Borrowing' (1977) 4 J Fin Econ 147.

149 K Arrow (1991) 'The Economics of Agency' in J Pratt and R Zeckhauser (eds) Principals and Agents: The Structure ofBusiness, reprint edn, Harvard University Press, pp 37, 44-5; R Kraakman, 'Corporate Liability Strategies and the Costs of Legal Controls' (1984) 93 Yale LJ857, pp 858-67; Coffee (1986).

150 Coffee (1986). 151 E Fama and M Jensen, 'Separation of Ownership and Control' (1983) 26 J L G

Econ 301. 152 R Rao et al, 'Fiduciary Duty a la Lyonnais: An Economic Perspective on

Corporate Governance in a Financially-Distressed Firm' (1996) 22 J Corp L 53, pp 54-5.

153 Schwarcz (1996) p 674.


I mentioned above that, in the abserice of the insolvent trading provisions, applying the unravelling principle is difficult.'" The silence of the company is too ambiguous to permit inferences to be drawn, given positive costs of transacting, i~rforrnation production and information verification. If the default provision is liability for insolvent trading, that problern disap- pears where the creditor seeks to opt out of insolvent trading liability. Alarni bells start ringing. At the risk of pushing metaphors too far, any sensible creditor can work out what song the chimes are playing. This is exactly what one would expect where a penalty default is used.

I explained above that there are substantial differences between the implicit guarantee under the insolvent trading provisions and a general guarantee of iridebtedness."' The former is only activated by incurring a debt under circumstances of actual or deetned knowledge of insolvency, whereas a guarantee of any significant duration iniposes on the guarantor much of the risk of residual cash flows. Comrnencitig negotiations to contract out of insolvent trading provisions carries a single rnessage: the director has some reason to suspect insolve~lcy and is uncertain whether a court would regard the corporation as being insolvent. The unravelling principle causes the creditor to assume the worst. The insolvent trading provisions place the onus on the conipariy to provide information that perrriits the creditor to refine the assessrrietlt of risk that war ut~ravelled from the cotnrnencernent of opting-out negotiations.

With this in rriind, reconsider the arguments that the irisolvent trading provisioris cause conlparlies to forego profitable projects. By this logic, they need not do so, provided the net present value of the project exceeds the transaction costs of opting out. Information is disclosed, the debt is accurately priced and the director is released frorn personal liability.'* The rnost important point is that in order to be released, the directors have incentives to provide irlformation to creditors that is relevant to the risk the creditor must bear. Of course, some profitable projects may still he lost. However, this is inevitable in a world characterised by significant contracting costs and risk aversion.

We nlay conclude that the insolvent trading provisions act as a perlalty default that coerces the party whorn iriformation asyrnriietries will favour to feed that information into negotiations. 111 a discussion of opting out of

154 See text accompanyirig nn 120-121 above

155 Cf n 128 above.

156 In credit transactions critered into i n the shadow of insolvency, marly creditors would seek a personal guarantee from a director. The insolvent tradir~g provisions create this situation by dclault, so showing their transaction cost efficiency.

default rules applying in the shareholder-manager contract,"' Coffee states that:

the optimal default rule is not the rule that either maximizes wealth or reflects what rational parties would have intended, but rather the rule that best compels each party to reveal to the other its intended use of discretionarv Dowers. The rationale for such a 'coercive'

2 1

default rule is that it forces those possessing private information to disclose it to the market - and hence results in more accurate

i 5" pricing.

While the creditor-corporation contract differs to that between shareholders and managers, this analysis applies cogently to the insolvent trading provisions. They compel private information to be disclosed. Consistently with another theme in Coffee's article,"' they apply in a way that makes opting out a highly specific exercise confined to particular debts (ie each insolvent trade). The more specific the 'opt-out' transaction, the more likely it is that the creditor will price the debt accurately and replace the protection of the insolvent trading rules with other rules and compensations that suit the creditor.'"'

It follows from the earlier analysis that reserving rules are to be preferred to sharing rules. Opting-out negotiations place directors at a disadvantage which they must overcome by providing information. The reserving rule decreases unnecessary transaction costs of opting out and is to be preferred. Contracting out under a sharing rule creates difficulties. It means rhat the directors of solvent companies must seek releases of possible future insolvent trading liability from their creditors at the time they transact. Alternatively, they could seek to opt out of liability with these creditors once insolvencv becomes likelv. It is obvious that under most circumstances, opting out would be a dominated strategy for these creditors. Under a sharing rule, they have everything to gain by holding out. Note also that the consent of evervunsecured creditor has to be obtained. which is , costly. The provisions should be changed accordingly.

Can it be said that a sharing rule is necessary because the risks that are created by the company in incurring a new debt have the possibility of jeopardising the existing assets available to the unsecured creditors in liqui- dation? My inclination is to answer negatively. First, if, as I argue, the

157 J Coffee, 'The Mandatory/Enabling Balance in Corporate Law: An Essay on the Judicial Role' (1989) 89 Colum LR 1618.

158 Ibid,p1624. 159 Ibid, pp 1667-72.

160 See n 156 above.

WHINCOP: TAKING THE CORPORATE CONTRACT MORE SERIOUSL Y 3 1 - - 'insolvent' trade is an informed one in the presence of insolvent trading liability, it is most unlikely to be value decreasing since the consent of the insolvent trading creditor must first be obtained. Transactions with expected positive values are in the interests of all creditors.'" Secondly, non- opportunistic trades of this character are in the nature of normal business risks that creditors expect to be undertaken. Thirdly, the voidable transaction provisions of the Corporations Law will deprive the insolvent trading creditor of any genuinely unfair advantage the creditor seeks."'

These considerations provide a framework for a court confronted by an attempt to opt out of the insolvent trading provisions. Research does not indicate anv cases decided under the new s 241 in which this has been in point.'" First, a court must decide whether it should permit the variation. In the above critique of Mannoli~li, it was argued that s 241 is not inimical to creditors contracting out of the compensation rights against directors. The liquidator should be prevented from suing for debts incurred in the context of a transaction in which a creditor chooses to o ~ t out. If an informed creditor judges that other types of protection are of more value than the insolvent trading provisions, that creditor is likely to be the best judge of their utility and certainly a better one than a court. One cannot contract out of the penalty provisions. However, there have been only a small number of prosecutions and it is difficult to imagine a conviction where directors have dealt fairly and candidly with creditors. I have also pointed out that few insolvent trading cases will present a case of injury to the corporation. Therefore, while the corporation cannot contract out of its rights, it is difficult to imagine these rights arising in the opt-out transactions I have mentioned.

Secondly, courts must consider some aspects of the bargaining process leading to an opt-out provision. A court should be satisfied that information regarding insolvency flowed from the company to the creditor. Beyond being satisfied that this took place, a court must largely defer to the matters, if any, arising out of the bargaining process that the parties choose to plead. An important issue is misrepresentation by the directors. While this article cannot dwell on these issues, as yet unadjudicated, courts must take a robust view of materiality and not strike the provision down merely because some fact can be identified as undisclosed. A stringent view of misrepresentation would increase the costs of contracting out, which is not desirable. Parties

161 See also Lin (1993) p 1498. Lin advocates a standard of value maximisation as a benchmark of directors' behaviour in this period; cf Whincop (1996b) pp 84-5 (rejecting value maximisation as a meaningful standard of expost judicial review in a world of uncertainty).

162 CL s 588FB.

163 See generally Miller v Miller (1995) 16 ACSR 73.

d o no t expect every fact t o be disclosed. T h e parties may make their o w n contractual provisio~is regarding the consequences of 11011-disclosure. Given the virtual impossibilities of usi~ig substarltively specified rules of disclosure in this area, one irlteresti~lg issue that needs attention is whether a du ty t o negotiate in good faith (that duty falling short of a strict fiduciary disclosure rule) might be a useful standard.'" T h e concept of good faith as a test of opting ou t is specifically part of the indemnification provisiori i11 s 241."'

T h e direction that courts should take o n this u~ l t rodden path is the facilitation of private ordering, in light of a default tern1 that should force the disclosure of private information and improve debt pricing. T h e analysis has suggested w h y we can have confidence in the default rule. It follows that we can have confidence in most of the deviatio~ls from the default rule agreed to by rational parties.

IV. Conclusion In his 1991 Nobel Lecture. Ronald Coase said:

O f course, it [the Coase theorem] does not imply, when transaction costs are positive, that government actions . . . could not produce a better result than relying on negotiations between individuals in the market. Whether this would be so could be discovered not by studying imaginary governments but what real governments actually do. My conclusion: let us study the world of positive transaction

Ihh costs.

164 As to duties of good faith in corporate situations, see Coffee (1989) pp 1654-65; Schwarcz (1996) pp 656-65. See also P Finn, 'Good Faith and Nondisclosure' in P Finn (ed) (1989a) Essays on Torts, LBC, p 150; P Finn (1989b) 'The Fiduciary Principle' in T Youdan (ed) Equity, Fiduciaries and Trusts, Carswell, p 1; M Whincop, 'Precontractual Disclosure by the Insiders of Closely Held Corporations: The Economics of Restrained Self Interest' (1997) 11 JCL 177.

165 See text accompanying n 98. The concept of good faith was recently considered in a different context in corporate law in State ofSouth Australia v Marcus Clark (1996) 19 ACSR 606. Perry J thought good faith had a more restrictive meaning than a lack of bad faith. However, the main reason he held good faith to be lacking in the case before him was a director's deliberate abstention from taking due precautions in the context of a transaction in which he had a serious conflict of interest.

166 R Coase (1993) '1991 Nobel Lecture: The Institutional Structure of Production', reprinted in 0 Williamson and S Winter (eds) The Nature (if the Firm: Origins, Evolution and Development, Oxford University Press, pp 227, 232. This was in reference to his 1960 article, 'The Problem of Social Cost'


The Coase theorem implies that in a world of transaction and information costs, the default legal rules are important matters. The criterion for selecting those rules is the minimisation of transaction costs which should in turn lead to a more allocatively efficient use of resources. The analysis in this article has been concerned to show how the duty to prevent insolvent trading can be justified by these standards. Clearly, this analysis is not immediately obvious, since contractarianism is inextricably linked to the normative analysis that mandatory terms are inefficient.

One must first admit that the insolvent trading provisions are not obviously mandatory. Doctrinal analysis of the Corporations Law supports the view that the term can be excluded by some form of indemnity or release in the credit contract, provided the director acts in good faith. The one problem is the use of the compensation sharing rule, which makes opting out costly but not impossible.

Are the insolvent trading provisions efficient default terms? It has been argued that they are because they operate by compelling a director who would seek to avoid the provisions to disclose information to the creditor. This is desirable as it should lead to better, more informed private contracting. While there are arguments to the contrary, the implicit guarantee operates effectively, since most minimally functioning, honest directors will be able to invoke the defence in s 588H(33. This decreases the

\ ,

cost of complying with the duty to be informed and the courts need not make difficult balancing decisions required in other duty of care cases. The risk that is imposed on the director - that the company is insolvent - is a 'precise' one that can be avoided by not incurring a debt or by entering voluntary administration. It is also one that the director knows more about than anyone else.

Perhaps the most desirable feature of the provisions is that they achieve these benefits through a role for courts as the enforcer of bargains and private contracts, rather than as a forum for ex post judicial review. I t is difficult to comprehend why Mannolini, who professes to be a contractarian, advocates that instead of legislative default terms in contracts, the courts should 'be entrusted with the task of identifying fraud on traditional common law principles''6- or, alternatively, matters should be left to the criminal law. So far as the former, he in effect invites courts to engage in the indeterminate and confused principles of fraud, such as the relevance of intentions to deceive, the problems with half-truths and omission to speak and the obscure application of common law tests of materiality. It is also not clear whether a director would have personal or some form of accessorial

(Coarse 1960), for which the Prize was awarded, together with the 1937 article, 'The Nature of the Firm' ((1937) 4 Economics 386).

167 Mannolini (1996) p 33.

liability for a fraudulent statement made within their actual corporate authority which does not directly benefit them. If there is no personal liability, the only remedy would be the exiguous one against the corporation.

The cost of errors by courts are not obviously smaller when the court applies common law than when it applies a statute. It is incomprehensible that Mannolini should cite the American rule lob-5 (an anti-fraud rule applying to securities cases) as an example of the ability of courts to deal efficiently with fraud.'" The repeated calls in the United States for legislative redefinition of insider trading demonstrate that 'generally framed' rules (including those in trade practices legislation) which Mannolini advocates often apply inefficiently in an area needing certainty.'" Mannolini's article is silent on the merits of the judge-made rules that protect creditors from opportunistic directors. That analysis would provide an interesting test of his hv~othesis.""

i l

The criminal law, while a necessary backdrop to corporate 1ax.v and present in sections like s 232 of the Corporations Law,"' is an even poorer alternative. We know that history reveals a strong aversion to holding white-collar defendants to be fraudulent or havine acted criminallv. " Moreover, criminal laws operate with indifference to compensation"' and depend on the efficacy of state enforcement. Mannolini seems unique among contractarians in subscribing to a view that state enforcement of private law matters is efficacious. The only way one can agree with such a view is if we reach the normative judgment that creditors should not have rights in

168 (1995) 17 CFR s 240.10b-5; this is part of the Code of Federal Regulations, pursuant to s 10(b) of the Securities Exchange Act 1934 (US).

169 See, eg, J Cox, 'Choices: Paving the Road Toward a "Definition" of Insider Trading' (1988) 39 Ala LR 381; D Langevoort, 'Setting the Agenda for Legislative Reform: Some Fallacies, Anomalies, and Other Curiosities in the Prevailing Law of Insider Trading' (1988) 39 Ala LR 399; J Fisch, 'Start Making Sense: an Analysis and Proposal for Insider Trading Regulation' (1991) 26 Ga LR 179; M Kenny and T Thebaut, 'Misguided Statutory Construction to Cover the Corporate Universe: The Misappropriation Theory of Section 10(b)' (1995) 59 Alb LR 139, pp 167-8.

170 Brudney indicates his doubts that fiduciary doctrine can ever be an adequate protection for lenders: Brudney (1992) pp 1841-3.

171 CL ss 232(5) and (6) have been directed against a number of opportunistic transfers of wealth from corporations to directors that have prejudiced creditors: M Whincop, 'Developments in Directors' Statutory Duties of Honesty and Propriety under the Corporations Law' (1996a) 14 C & S LJ 157, pp 161-2, 164-5.

172 Harmer Report, s 322.

WHINCOP: TAKING THE CORPORA TE CONTRACT MORE SERIOUSL Y 3 5 - . -

insolvent trading cases.''' This argument needs a greater defence than any its proponents have so far offered. I believe that such a defence does not exist.

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