The need for insolvency fail-safe in Cayman
First published in the Cayman Financial Review
Directors of Cayman companies owe fiduciary duties to the company to act in the interests of the company as a whole. When the company is able to pay all of its creditors, those interests are reflected in the interests of the shareholders, who stand to receive a share of its surplus assets. But when a company is no longer able to pay its creditors in full, as they fall due, the directors must treat the interests of the creditors as paramount. Where the solvency of the company is doubtful, in order to discharge their duty to the company, directors must put the interests of creditors as uppermost while remaining cognizant of the need to preserve the prospect of a return to shareholders. When a Cayman company is in troubled waters, the directors will often have to weigh the interests between those who stand to gain from continuing to pursue a risky venture (the shareholders) and those who may prefer to take a certain return on their current claim (the creditors).
The current legislation in Cayman prohibits directors of Cayman companies from presenting a petition for the winding up of the company, unless expressly authorized by a provision in the company’s articles or a special resolution of the shareholders of the company. This legislative position, affirmed by the Grand Court in the China Shanshui case, can be problematic. For instance, a winding up petition is currently the necessary first step in invoking a moratorium within which a formal restructuring can be pursued. Successful restructurings can increase the return to creditors but often will involve a dilution of shareholder interests in the company.
The necessity for shareholder consent for filing a winding up petition either provides a hostage to fortune, or a bar to the directors being able to achieve the best outcome for creditors; the directors can find themselves unable to act in the interests of creditors fettered at the very moment they need to exercise it.
This difficulty exists not only in the restructuring context (for which a legislative fix is under construction), but also when the clear and obvious need is for the company to be placed in official liquidation to preserve value and protect creditor interests.
While it is the case that the company’s creditors can initiate winding up proceedings on the ground that the company is unable to pay its debts (and other just and equitable grounds), it is a fundamental contradiction to have those appointed as the custodians of the company and imposed with duties to protect creditor interests can have their pathway to doing so blocked by parties (the shareholders) with little or no economic interest.
This article suggests a rethink to Cayman companies law and the inclusion of an “insolvency fail-safe” power for directors.
The Companies Law provides that the company may itself petition for its winding up but then limits the authority of the company to do so:
“Where expressly provided for in the articles of association of a company the directors of a company incorporated after the commencement of this Law have the authority to present a winding up petition on its behalf without the sanction of a resolution passed at a general meeting.”
The directors of a company are its agents and derive their powers from the governing documents of the company, from the company acting in general meeting or from statute. In that context, section 94(2) is really a tautology: directors have power to do something only if they have express power to do it.
This was the conventional common law position: the ordinary powers of the directors are to carry on and manage the business of the company on behalf of the person who brought the company into existence; it is anathema to that appointment that the directors would have the power to terminate the business without the consultation of the shareholders . The leading English case on the topic was Re Emmadart Ltd., which was approved by Justice Anthony Smellie (now Chief Justice Smellie) as applicable in the Cayman Islands in 1998.
The introduction of s94(2)
Sub-section 94(2) was introduced by the Companies (Amendment) Law 2007, which brought in changes recommended by the Law Reform Commission (LRC) between 2002 and 2006. The specific rationale for the amendment of this section can be seen in the bill introducing that law:
“The rating agencies normally require that special purpose vehicles have at least one independent director. Historically, this requirement has not applied to Caymanian companies because their directors had no power to present a winding up petition.
The ability to exclude this power in the articles will prevent Caymanian companies being put at a competitive disadvantage in the capital markets business. In order to avoid any adverse effect upon existing transactions, this amendment will only apply to companies incorporated after the commencement of the new law.”
The bill therefore entrenched the common law requirement that directors have express power delegated to them from the shareholder to seek to bring the company to an end.
Confusion in Cayman
It is inevitable that restructurings give rise to conflicts of interests between creditors and shareholders. In Cayman, the only formal means of imposing corporate rescue of a distressed and insolvent company is a scheme of arrangement. Schemes are an expensive and time-consuming process that do not, without additional steps, protect the company from potentially destructive creditor action. As such, the practice has developed for a scheme to be implemented in conjunction with the appointment of provisional liquidators. This enables the company to take advantage of the statutory moratorium on claims, so allowing the provisional liquidators and the company’s principal creditors to assemble the restructuring proposal.
It was in this context that section 94(2) came to be considered for the first time. China Milk was an investment holding company with shares listed on the Singapore Stock Exchange that raised finance through zero coupon convertible bonds. China Milk was insolvent and needed to restructure its debt. Its directors presented a winding up petition without the support of shareholders, to appoint provisional liquidators and pursue a restructuring. By a quirk of fate, the judge assigned to the proceedings was one of the authors of the reports recommending change.
The application was supported by the bondholders, and not opposed by the shareholders. Justice Jones construed section 94(2) within the context of the bill as a whole, but went further into recommendations that had been but not implemented in the bill, and held that:
- Directors of insolvent companies were allowed to present a petition whether or not authorized by the shareholders;
- the directors of solvent companies incorporated from 2009 onwards (the date of commencement of 94(2)) could present a petition if authorised by the articles (or by shareholder resolution); and
- the directors of solvent companies incorporated before 2009 could only present a petition to wind up the company if authorised by shareholder resolution.
The judgment was a pragmatic outcome that allowed the restructuring to proceed, but it was criticised for giving directors a discretion that was not apparent in the legislation.
The First Report of the LRC of April 2006 supports Justice Jones’s rationale that there should be a distinction between the liquidation of solvent and insolvent companies (“In practice this is the critical distinction”). However, the LRC focused on the distinction only once in liquidation, and codified the “current best practice” of a voluntary liquidator of an insolvent liquidation applying for court supervision. Crucially, the 2007 Bill did not implement any distinction pre-liquidation – applying only the broad rule that directors could only petition if authorised. The ruling had consequences in practice, and empowered directors to take into account creditors’ interests at the appropriate time.
That pragmatic approach was reversed by Justice Ingrid Mangatal four years later, reverting to a literal interpretation that restricted directors’ ability to present a petition in any circumstances if not expressly authorised in the articles or by shareholder resolution. In that case, the restructuring was opposed by the shareholders who succeeded in striking out the petition as an abuse of process brought without authority.
Although China Shanshui was undoubtedly a technically correct decision, the result was that directors of troubled companies without shareholder support were (and still are) often left in the invidious situation of choosing between being forced to remain in office for a hopelessly insolvent company or resigning and letting the company eventually be struck off without proper realisation and distribution amongst the remaining assets. This can arise when shareholders are:
- Disinterested: there is no prospect of a return to them and so no incentive to participate further;
- Dysfunctional: parent companies in their own foreign insolvency process unable to take decisions;
- Disparate: widely held small shareholdings; or
- Dishonest: where the appointment of a liquidator may enable a liquidator to investigate the actions of the parent that a board could not do.
In each of these situations, it may be in the creditors’ interests to bring the company to an end or secure the appointment of provisional liquidators to promote a restructuring, but the creditors themselves may be unable to present a petition through contractual arrangements or other prohibitive factors.
The restriction appears to have been driven by a commercial concern regarding one specific use of corporate vehicles but had wider consequences to all insolvent companies.
The legislature should reconsider the imposition of an insolvency fail-safe: permitting the board of an insolvent company to present a petition for its winding up. Providing for an express ability for directors to petition on the insolvency of the company will better accord to their fiduciary duties. A director’s duty is clearly owed to the company but as the solvency of the company shifts, the directors must begin to take into account the best interests of the creditors; the receding tide of solvency reveals the interests of the creditors that the directors must navigate.
The LRC recognised this in their report, suggesting a codification of directors’ duties in future revisions, and separately that there should be a distinction between solvent and insolvent liquidations but section 94(2) is anathema to this – permitting the shareholder to fetter the directors’ fiduciary duties in the shareholders’ own selfish interest beyond the point at which the shareholder no longer has a fiduciary duty.
Providing an insolvency fail-safe would not mean bestowing on boards of directors an indiscriminate power to bring the company to an end:
- Active shareholders could simply take steps to change the constitution of the board;
- The board would need to establish their standing to petition – they would need to satisfy the court that the company was indeed insolvent;
- A board would be acting in breach of duty if they did not objectively and subjectively hold the view that the course of action that they were following was in the company’s best interests; and
- Any winding up would still be at the discretion of the court – and shareholders or creditors have standing to appear at the hearing of the petition.
Given those protections, the inclusion of an insolvency fail-safe may actually improve corporate governance and shareholder responsiveness. There seems little harm in confirming that a director must act independently (as may be required in some contexts for ratings), but much detriment by removing their ability to do so at a time of crisis for the company.
Such an insolvency fail-safe would also be in line with much of the rest of the common law world:
- In England and Wales, the legislature overturned Emmadart in 1986 by legislating for directors (not just the company acting by the board) to have standing to petition for the winding up of the company;
- In Bermuda, the courts have held that in the absence of requirement for express shareholder approval, given the civil and criminal consequences for directors of insolvent trading, the directors could present a petition if the interest of the creditors dictated that a winding up petition should be filed, the wishes of the shareholders at that point being irrelevant;
- In Jersey, the directors of a company, upon showing that it is insolvent on a cash flow test, but with realisable assets, may have the court declare the company “en désastre”;
- In Guernsey, any director is entitled to make an application that the company be wound up, although the exercise of this power will be influenced by the directors’ fiduciary duties;
- In the Isle of Man, the directors do not have express power to present a petition in their own name, but the courts have held that, where the “interests of justice” requires it, they are at liberty to make law where there are indications that the English common law are superseded by statute and so, although untested, may in the appropriate case, be persuaded to accept that the directors have power to present a petition on behalf of the company;
- In BVI, the company has authority to present a petition, but there is no express provision that the directors may only do so if authorised by the shareholders. It is therefore unclear how the BVI courts will deal with an unauthorised petition, but the absence of a clear restriction leaves the matter more open to judicial discretion.
It is inconsistent with the fiduciary duties of the board of a Cayman company to be constrained from taking steps that are likely to significantly benefit the company’s creditors. Other safeguards exist to protect the interests of shareholders from over-zealous director action. The introduction of an insolvency fail-safe to permit directors to petition in appropriate circumstances would prevent insolvent zombie entities from being perpetuated and allow for a more efficient resolution than requiring directors to abandon ship. The issue cannot be resolved by more judge-made law but should be reconsidered by the legislature.