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An Agency Cost Analysis of the Wrongful Trading Provisions: Redistribution, Perverse Incentives, and the Creditors' Bargain


Riz Mokal


University College London (UCL) - Faculty of Laws; World Bank Global Initiative on insolvency and Creditor/Debtor Regimes; 3-4 South Square Chambers

July 1, 2000

Cambridge Law Journal, Vol. 59, July 2000

Abstract:     
This paper argues that the UK's wrongful trading provisions, enshrined in section 214 of the Insolvency Act 1986, are meant to ensure that hopelessly troubled companies enter the insolvency forum at the optimal time. This forum enables -- and forces -- those interested in the company's undertaking to forego aggressive and value-destroying individual action. Put differently, one of the functions of the collective insolvency regime is to minimise the co-ordination costs of the creditors of a firm threatened with insolvency. Section 214 is a tool enabling the regime to take over when these costs would be most acute. The existence of the collective regime might itself create motivation costs by producing incentives for parties who would lose out under it to try to prevent the company becoming subject to it. Directors would act for themselves and on behalf of shareholders to keep the firm out of the insolvency forum. The central insight offered into section 214 here is that the section assists in overcoming the co-ordination costs of creditors by controlling creditor/manager agency costs on the eve of insolvent liquidation.

The analysis in this paper operates on two levels. First, this paper shows that the wrongful trading provisions would be voluntarily accepted by all the relevant parties given the chance to bargain ex ante. Here, all the parties anticipate the incentives of managers to misbehave towards creditors when their firm is on the brink of insolvent liquidation. A provision like section 214 bonds managers to creditors when the firm is terminally distressed, and thus signals the credit and labour markets not to penalise shareholders and managers. On the other hand, where a market solution is available -- as it is in the shape of the discipline imposed by the market for managerial labour, and the existence of security -- the section 214 bond takes the back seat. On this basis, this paper suggests that wrongful trading claims would generally be brought against shareholder-managers of closely-held companies, and shadow directors, and examines "impressionistic" evidence which is not inconsistent with this hypothesis. It is shown that on this analysis, the English Court of Appeal's well-known decision in Re Oasis, directing section 214 recoveries away from secured creditors, is perfectly reasonable.

On another level, the well-established Law and Economics proposition -- that to redistribute in insolvency leads to perverse incentives -- is challenged. It is argued that the wrongful trading provisions are redistributive. They strip away the benefit of limited liability from the insolvent company's directors, making their assets vulnerable to a claim by the liquidator on behalf of the company's unsecured creditors. This takes place only within the specialised insolvency forum, and only because the distinct insolvency regime creates new rights and liabilities which are incapable of existing while the company is still solvent. Three types of perverse incentive which might potentially lead to unnecessary motivation costs are described. The analysis suggests that, far from creating perverse incentives, section 214 in fact encourages directors of troubled and healthy companies alike to operate with some much-needed regard for the company's unsecured creditors.

Note: This is a description of the article and not the actual abstract.

Number of Pages in PDF File: 35

JEL Classification: J24, J44, K12, K19, K22, K39, K42

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Date posted: May 9, 2002 ; Last revised: June 4, 2009

Suggested Citation

Mokal, Riz, An Agency Cost Analysis of the Wrongful Trading Provisions: Redistribution, Perverse Incentives, and the Creditors' Bargain (July 1, 2000). Cambridge Law Journal, Vol. 59, July 2000. Available at SSRN: http://ssrn.com/abstract=309583

Contact Information

Riz Mokal (Contact Author)
University College London (UCL) - Faculty of Laws ( email )
London WC1E OEG
United Kingdom
+44 - (0)20 - 7679 1406 (Phone)
+44 - (0)20 - 7679 1461 (Fax)
HOME PAGE: http://www.ucl.ac.uk/laws/
World Bank Global Initiative on insolvency and Creditor/Debtor Regimes
The World Bank
1818 H St NW
Washington, DC 20433
United States
3-4 South Square Chambers ( email )
3/4 South Square
Gray's Inn
London, WC1R 5HP
United Kingdom
HOME PAGE: http://www.southsquare.com/
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