Balancing Shareholder And Creditor Interests In Corporate Insolvency: A Global Perspective
Introduction
Corporate directors have fiduciary responsibility primarily to shareholders under company law. However, they are also subject to common law duties of loyalty and good faith that serve the corporate entity as a whole, largely excluding other stakeholders. Corporate insolvency grapples with a fundamental question: where does the primary duty of directors lie when a company approaches financial distress? Traditionally, directors must prioritize shareholder value but with insolvency looming round the corner, the interests of creditors gain prominence. This shift raises critical legal, and economic implications which shape corporate governance across various jurisdictions.
A sliding scale approach could be derived from the case of BTI 2014 LLC v Sequana SA (‘Sequana’) of the United Kingdom (‘UK’) Supreme Court where directors were required to consider creditor interests when the vicinity of insolvency was “imminent.” Alternatively, the Delaware Supreme Court in the United States (‘US’) case of North American Catholic Educational Programming Foundation, Inc. v. Gheewalla (2007) (‘Gheewala’) reinforced primacy towards shareholders, while simultaneously shielding directors from creditor claims until the occurrence of insolvency. India’s framework on the other hand remains ambiguous since the Companies Act (2013) requires adherence from directors to act in the company’s best interests, therefore lacking creditor-oriented protections before insolvency. Creditor rights, thus adopt a reactive approach which are derived through the Insolvency and Bankruptcy Code (2016).
This excerpt examines such divergent approaches, highlighting the various strengths and limitations of each. It is further argued that India’s non-reliance towards a more proactive framework leaves earlier financial distresses unaddressed. The necessity for a more proactive fiduciary duty regime that protects creditor interests without restricting business risk-taking is highlighted by a comparison with the US and UK models.
Global Legal Framework:
1. UK Law:
The UK Supreme Court in the Sequana Judgment was equivocal as to when directors are obligated to consider the interests of the creditors. Such a duty arises when the company is either insolvent, on the brink of insolvency or when insolvency is ‘highly probable;’ not when there is merely a mild risk.
This ruling sets in stone the concept of a “zone of insolvency,” which had also been discussed earlier in US judgements but never really materialized in Delaware, because it stemmed from a misread footnote in the case of Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp and generated legal uncertainty along conflicting duties that courts deemed unworkable. The UK Supreme Court was careful not to include any initial sign of financial trouble within this zone, to avoid excessive creditor actions against directors, or any situation where the financial distress is manageable. Directors, being seen as natural persons, must always act in the best interests of the company and an increase in any potential liability might affect their business judgment in navigating through challenging periods.
Similarly, under the Companies Act 2006, the existence of creditor duty is affirmed through Section 172(3) which reflects two dominant theories:
- Shareholder Primacy: Directors must maximize shareholder wealth (Friedman, 1970).
- Stakeholder Theory: Directors must balance all stakeholders’ interests (Freeman, 1984).
Even within shareholder primacy, scholars argue for creditor protection. Substantively, the ruling boils down to as Smith’s (2002) fiduciary theory posits, that directors as trustees of corporate assets, must prioritize beneficiaries with predominant economic interests. As insolvency looms, creditors replace shareholders as residual claimants, justifying fiduciary extensions involved.
Sequana brings in clarification beyond the purview of the Insolvency Act (1986) which dealt with wrongful trading, therefore the “lacuna in the law” was remedied by introducing a gradual ‘Sliding Scale’ approach for handling creditor interests. In its most elementary form, where the company is financially sound, directors have their traditional fiduciary obligations primarily to shareholders, creditor interests being secondary. As pressure on the finances develops and the company approaches the “zone of insolvency,” directors must begin to consider creditor interests in the decision-making equation, but shareholder primacy continues.
The point of insolvency is reached when insolvency is “imminent” – at which the directors’ fiduciary duties irretrievably shift towards safeguarding creditor interests at the expense of maximizing shareholder value. These may include persistent operating losses, inability to meet debt service obligations, suppliers demanding cash-on-delivery terms, or creditors issuing statutory demands for payment. This graduated framework is aware that the transition from shareholder-focused to creditor-centric duties should not be sudden but should be responsive to the level of financial distress. The model thus provides legal certainty without being insensitive to the experience of corporate financial deterioration.
Moving away from a purely-theoretical perspective, the corporate landscape in the UK is largely dominated by Private Equity (PE) ownership; where leveraged buyouts (LBOs) are seen to saddle firms by acquiring them for much higher amounts while leaving them with unsustainable debt. This increases the risk of financial trouble early on as Sequana‘s creditor-centric obligations are only activated when there is “imminent insolvency.” Due to this, models which are only intended for short-term equity: where a company, which is already fragile in the initial stages, might have different thresholds for imminent insolvency and legal protections for creditors do not kick in until it is too late. This is exemplified through cases post-Sequana such as HLC Environmental Projects Ltd, where judicial struggles are evident to enforce such a duty. Here, shareholder payouts were given priority despite liquidity crises leading to creditor losses and judicial rebuke.
This is seconded by Lady Arden in her dissent in Sequana that while the gradual approach may be useful towards creditor duty, a corporation’s journey to bankruptcy might not always be gradual and linear; such could be brought upon by an unforeseen, noteworthy outside event- as seen in the scenario discussed regarding the prominence of PE firms in the UK. Thus, while Sequana does not discuss whether directors can be held liable for breaching their duty to creditors, an expansive reading of Section 178 of the UK Companies Act (2006) provides for such remedies available under common law and equitable practices.
2. US Law:
In contrast to the UK’s gradual approach, the US particularly through Delaware takes predominance due to its acclimated corporate environment. The Delaware Supreme Court made it clear in North American Catholic Educational Programming Foundation, Inc. v. Gheewalla (2007) that directors have a primary fiduciary duty to the company and its shareholders, which lasts until the company becomes insolvent.
Prior to Gheewalla, Delaware jurisprudence hinted at a ‘zone of insolvency’ concept, potentially analogous to Sequana, wherein directors’ duties might shift to consider creditors. However, this notion was subordinated to uphold shareholder primacy. This prioritization was then balanced against the existing protections afforded to creditors within the US legal framework, including contractual rights and remedies under fraudulent conveyance law. In addition, the following emphasized: Firstly, that upon insolvency, creditors become the residual beneficiaries and directors’ fiduciary duties are expanded to include their interests; and secondly that while creditors lack direct fiduciary duty claims, they acquire standing for derivative claims on behalf of the insolvent corporation. While tests like the ‘No Bright-Line Test’ and ‘Balance Sheet Test’ exist, insolvency is frequently ascertained retrospectively in litigation, with the advantage of hindsight.
Legal scholars have countered that corporate law practices were not significantly changed by Gheewalla. Delaware law is misinterpreted by some academics who upheld the pre-Gheewalla perspective, which holds that consideration is made in the best interests of creditors. These arguments are based on the premise that shareholder-centric approaches, while enabling creative risk-taking, inherently leave creditors exposed to losses from those risks well before a company is formally declared insolvent. However, later in Quadrant Structured Products Co. v. Vertin (‘Quadrant’), this misunderstanding was resolved. The ruling confirmed that while the ultimate objective is still maximizing overall value and directors of an insolvent company may employ aggressive (“risk-on”) strategies over more conservative (“risk-off”) ones, any possible “unfair treatment” of creditor claims here is subject to review based on the “entire fairness” standard. This, ultimately along with directors’ strategies to primarily benefit shareholders, negates any jurisprudence contrary to the precedent set in Gheewalla.
Thus, Gheewalla, reinforced by Quadrant, rests on the view that creditors are fully protected by contract and statutory remedies, but only once actual insolvency occurs. Because these protections arise post-insolvency, pre-insolvency “risk-on” transactions are addressed not through expanded fiduciary duties but by ardent reliance on the robust and equitable ex ante contractual and statutory safeguards – such as covenant protections and security interests, while preserving directors’ entitlement to Business Judgment Rule deference. This reliance, however, prompts the question of whether covenants and security interests alone can sustain creditor confidence and economic interests before insolvency occurs. Because the entire-fairness standard standard activates only after directors have executed risk-laden transactions, it functions as an ex post check rather than an effective ex ante constraint on risk-shifting. Consequently, creditors may remain under-protected until insolvency crystallizes.
Nevertheless, unlike the persistent uncertainties in Sequana, Delaware law offers a clear framework for allocating creditor and shareholder rights. This clarity, however, spotlights the enduring Directors’ Dilemma: balancing shareholder protection against preserving enterprise value under financial distress. As Willett observes, reconciling these competing priorities remains a core corporate-governance puzzle beyond the scope of this excerpt.
3. Indian Law:
When individuals invest in a for-profit corporation, they enter a contractual relationship by purchasing equity, aligning their interests with the company’s profit-driven objectives. Consequently, directors’ duties of loyalty is to prioritize actions that enhance shareholder value, reflecting the company’s fundamental purpose. In contrast, creditor protection in India is engaged only when formal insolvency proceedings commence under the Insolvency and Bankruptcy Code (IBC). This section will thus examine the two distinct regimes: the Companies Act (2013) and the IBC, due to a markedly different distribution of directors’ duties.
Companies Act, 2013
1. Fiduciary Duties and the Subjective Duty Approach
Section 166 of the Companies Act (2013) charts directors’ fiduciary duties by prioritizing a stakeholder approach, where directors are required to act in the best interests of the company. This theoretically includes balancing the interests of the shareholders and other stakeholders; however, this is a purely textual perspective. The provision establishes that directors “shall act in good faith to promote the objects of the company” and such “in the best interests of the company” and its stakeholders. However, the Act imposes this duty in purely subjective terms, requiring only that directors honestly believe their decisions further corporate objects and stakeholder welfare in accordance with its legislative history. Because the statute conditions the duty on directors’ own bona fides, it provides no objective guarantee that creditor confidence or interests will be protected; any consideration of creditor welfare remains entirely within directors’ discretion rather than a mandated legal obligation.
Notably, Section 166 does not list creditors among the specified stakeholder categories. In the absence of any objective guidance, the broader legislative scheme – including linking managerial remuneration to profitability and granting shareholders specific remedies against oppression, mismanagement, and for class actions, impels directors to focus on wealth maximization and shareholder protection. Legal scholars argue that the absence of objective duties stems from regulatory challenges in balancing the multifaceted interests of various parties. This ambiguity leaves significant discretion to directors, which can result in inconsistent judicial outcomes regarding creditor-centric interests.
2. Inadequacies in Enforcement Mechanisms
Due to the lack of jurisprudence in India compared to foreign jurisdictions, there is more emphasis on redressal mechanisms. For instance, shareholders are the primary initiators of derivative actions under the Companies Act. They are not explicitly codified for creditor claims, which means that non-shareholder constituencies lack a clear pathway for redress. Class Action Suits, on the other hand, are encompassed within Section 245, which can be resorted to if a company’s affairs are prejudiced by the interests of shareholders or depositors. However, these remedies do not extend to other stakeholders, which include creditors, nor do they directly address the breaches of fiduciary duty by directors.
Although directors, whose gain benefits are obligated to compensate the company for their gains – this remedy is only limited to the account of profits and does not incorporate any other common law remedies, such as damages or injunctions, which may have better implications for protecting creditor interests.
A sharp jurisdictional contrast highlights the regulatory gap in India’s corporate governance framework. The UK’s post-Sequana framework clarifies a proactive common law duty, giving rise to actionable claims against directors before insolvency takes hold. Conversely, India’s legal architecture offers no comparable pre-insolvency mechanism. Under Indian law, creditor interests remain unprotected during this critical phase, as directors face no equivalent duty, and non-shareholder constituencies lack a clear pathway for redress. This absence of both direct and indirect proactive protections underscores the reactive nature of India’s system.
Insolvency and Bankruptcy Code (2016)
The IBC represents a significant shift in India’s insolvency regime by prioritizing creditor interests once formal insolvency proceedings have been initiated. The Committee of Creditors (CoC) assumes control of the company, which effectively suspends the board of directors, whilst empowering resolution professionals to oversee and manage asset distribution (Section 17). In Bhushan Steel (2018), the CoC-approved resolution plan was said to maximize the creditors recoveries, demonstrating the IBC’s effectiveness in balancing creditor interests.
Some of the mechanisms for director accountability include Sections 43, 45 and 50 of the IBC, which provide for avoidance transactions. These mechanisms, which are designed to reverse preferential or undervalued deals, are entered into during a defined “look-back” period. An alternative remedy envisages directors to be held accountable under Section 66 for neglecting to reduce creditor losses when insolvency is unavoidable. However, rather than proactively addressing financial distress, these provisions are reactive, addressing misconduct after insolvency is underway rather than pre-emptively mitigating financial distress.
Comparative Insights with UK and US frameworks
The UK approach, as exemplified by Sequana, introduces a more proactive sliding scale or gradual approach mechanism for creditor protection. As a company nears “imminent insolvency,” the legal framework is mandated to be more creditor-oriented. Alternatively, it is noted that the UK tends to diverge from an approach dependent on the Insolvency, whereas India adopts a more reactive approach which leaves systemic gaps in addressing early financial fragility, which depends on the commencement of proceedings under IBC.
The US approach, particularly under Delaware law, places a stronger emphasis towards shareholder primacy. This draws similarities with Section 166 of the Companies Act (2013), focusing towards a ‘subjective’ duty pre-insolvency. This is based around the Business Judgement rule model in the US, which provides directors with considerable discretion, unless proven irrational. This is provided with the certainty of creditors being provided with several recourses to recover their debts post-insolvency.
The Indian approach exhibits a dual nature where: Firstly, under the Companies Act (2013), directors are expected to act in the company’s best interests with a subjective duty which ultimately results in a de-facto prioritization of the shareholders over the creditors and secondly, the IBC shifts creditor protection to a reactive mechanism, leaving the early financial fragility unaddressed.
A critical distinction emerges when comparing these frameworks is between India and UK’s models, where the UK’s proactive Enlightened Shareholder Value (ESV) model is designed to protect creditors during an early stage. In contrast India’s system, while theoretically embedded in a ‘Stakeholder Approach,’ operates under the IBC more reactively only after commencement of proceedings. Given the dearth of established alternative mechanisms like those in Delaware, this contrast strongly favours taking a more proactive approach akin to that of the UK. This approach is likely more feasible in India. By putting such a structure into place, directors’ fiduciary duties would improve creditor protection and guarantee a fair handling of financial difficulties.
Conclusion
India’s corporate insolvency framework, although advanced in form, is plagued by long-standing structural flaws calling for reform. This comparative study discloses a core thesis: India’s default approach to the protection of creditors jeopardizes systemic weaknesses that a proactive regime could manage effectively.
Although section 166 of the Companies Act (2013) was introduced to foster heightened consciousness of directors’ fiduciary responsibilities, this awareness still has not yet translated to a more forwarded approach. Evidence confirms why proactiveness is normatively superior and practically feasible in India. Normatively, the UK Sequana model offers stakeholder protection that is balanced and does not annihilate entrepreneurial risk-taking, while the US Gheewalla method, although predictable, exposes creditors to risk for a lengthy period of financial distress. Practically, India’s current institutional framework under the Companies Act (2013) offers the platform on which graduated creditor responsibilities can be introduced without upsetting current corporate governance frameworks.
Specific Recommendations
- Modify Section 166 of the Companies Act (2013) to specifically encompass creditor interests in the event of “incipient financial distress” of companies, i.e., chronic liquidity issues or covenant defaults, thereby initiating early intervention measures before insolvency in the offing.
- Adopt a calibrated judicial test for ‘financial distress’ drawing on the factors such as cash-flow projections, covenant breaches, or market confidence indicators to give directors clear guidance while preserving flexibility for firms with non-linear distress paths. This hybrid bright-line/factor test can limit abusive litigation without the pitfalls of a one-size-fits-all rule.
India’s corporate law development necessitates this evolutionary change to safeguard creditor interests without suppressing business acumen. The present dualistic model – mixing shareholder-focused duties with passive insolvency procedures – falls short for both constituencies. A graduated creditor-duty framework would make India a leader in equitable corporate governance, ensuring directors act on financial distress before it translates into formal insolvency procedures.
Thus, India’s framework, while progressive in its formal insolvency provisions, remains inherently reactive, falling short of the UK’s proactive creditor-duty model and the predictability offered by Delaware. In order to achieve a more balanced consideration of both interests, it is essential that the Companies Act evolves to enact early intervention measures. This is to ensure that directors address financial distress before it culminates in Insolvency.
About the Authors
Pranava Kapur and Garrv Jain are fourth-year B.B.A LL.B (Hons.) students at Jindal Global Law School, O.P. Jindal Global University.