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Legal Strategies to Overcome Agency Problems, Shareholders, and Creditors
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Legal strategies to overcome agency problems, shareholders, and creditors
An agency problem is a challenge resulting from a disagreement between an
organization's shareholders and creditors. Therefore, the two sides aim to maximize their profits
at the other party's expense. Creditors want to protect their investments and get paid on time, but
stockholders seek to maximize their firm profits. As a result, the government has built a
legislative framework to ensure that no conflict emerges between these groups. This article will
examine the legal methods for settling shareholder and creditor issues.
Mandatory corporate disclosure legal strategy
Mandatory corporate disclosure is one technique used to alleviate conflict between
shareholders and creditors. All firms registered in the United Kingdom are required by law to
publish their financial statements, significant transactions, and other relevant information to
stakeholders and creditors1. The financial statement enables creditors to assess the company's
capacity to satisfy long-term and short-term loan obligations, income, costs, and profitability2.
Creditors can make informed judgments about whether to continue doing business with the
corporation if they can study this information.
Debtors who seek to exercise the court's jurisdiction to restructure their obligations
through schemes of the arrangement must also submit all essential information to all creditors in
the explanatory statements, according to UK legislation3. This is required so creditors have
enough information to make an educated choice during creditors' meetings. Please adequately
disclose this information to avoid the court declining to sanction the plan. As a result, the plan
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Council FR, UK Corporate Governance Code
Hasanaj P and Kuqi B, 'Analysis of Financial Statements (2019)
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Reiner Kraakman, et al.
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guarantees that creditors have enough information and can make informed judgments based on
the company's present performance.
Loan covenant legal strategy
Another strategy used is the loan covenant between the organization and its creditors. The
law has allowed creditors to protect their interests by including specific covenant and contractual
safeguard safeguards in lending agreements. In these agreements, the creditors can limit
dividends payments, capital expenditure, and debt issuance without the creditors' consent.4. This
strategy allows creditors to control their assets, limit managerial opportunism, and protect their
claims in the event of financial struggle.
This limitation gives the creditors a step ahead in protecting their financial assets invested
in the organization. For instance, many creditors limit the dividends paid to shareholders to
ensure that the company does deplete its fund while paying dividends. This would impact the
company’s ability to operate and generate enough income to pay its creditors. Moreover, the
creditors avoid the stress and time wasted in legal battles while reclaiming their loans from
insolvent or liquidated organizations.
The creditors can use the indebted limitations to protect them from potential losses due to
over-lending beyond the capacity to pay. The creditors will provide restrictions on the
organization to take any other loans beyond the current loan under the loan agreement5. The
central role of a covenant of this nature is to ensure that the organizations do not take more loans
and thus have creditors competing to be paid, which may be unsustainable. Therefore, the
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Reiner Kraakman, et al.
Staraci G and Pouraghdam M, ‘Chapter 11 Bankruptcy and Loan Covenant Strictness’
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organization will only take another loan once they clear their current debt. This will also ensure
the repayment burden is little, and the revenue generated for the company is used for growth,
which would help make a better repayment structure.
Another limitation that can be used under this legal provision is the lien limitation that
limits an organization from creating other additional liens or encumbrances on their assets other
than the liens held by the lender or other approved third parties6. Therefore the creditors ensure
that no other party can use the asset as collateral for another loan. This gives the lender an upper
hand over other creditors in case of defaulting or bankruptcy proceedings. Moreover, it helps
ensure that few creditors have used the same property as collateral which would reduce the
amount of money that creditors can collect in addition to the cost incurred in unnecessary legal
processes.
The creditor can also use the limitation of sales, transfer, or disposal of its assets outside
the ordinary cause of business. This provision allows the collateral to remain untouched during
the loan repayment period and ensures that the creditors7. In doing so, the limitation aims to
maintain the value and quality of the assets that secure the creditor's loan to the organization.
This is particularly important since the creditors want the investment to remain in good condition
to ensure that the assets can be sold and recover the amount the company owes the creditors in
case of bankruptcy.
Insolvency legal strategy
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7
Staraci G and Pouraghdam M, ‘Chapter 11 Bankruptcy and Loan Covenant Strictness’
Ibid
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The insolvency law plays a vital role in addressing the agency problems between the
shareholders and creditors if the company is deemed insolvent. The law provides a legal
framework on how the creditors will be paid by the organization when it becomes insolvent8.
This ensures that both creditors and stakeholders of the corporate get their investment back.
Furthermore, all shareholders in the corporate are treated fairly and do get not lose their
investment.
The insolvency law plays a vital role in protecting the creditors by establishing a
hierarchy of claims to establish the order in which stakeholders will be paid in case of liquidation
or restructuring of the company. The law prioritizes certain claims, such as secured creditors or
employee wages, to protect their rights and interests9. Therefore, creditors being in priority
claims they get their dues paid, thus avoiding potential problems with the other shareholders in
the organization.
The insolvency law also provides provisions on how a company can restructure itself to
normalcy. The law gives the company rescue and restructuring mechanisms that may include
administration reorganization procedures10. This aims to ensure that the company does not
collapse and that the stakeholders’ investments are safe. Moreover, it allows for negotiation and
compromises and thus encourages cooperation between stakeholders and creditors to achieve
mutually beneficial outcomes.
The insolvency law, also in moratorium provision, allows the distressed organization a
particular timeline to explore potential restructuring options with no legal threat from creditors
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Reiner Kraakman, et al. The anatomy of corporate law
Reiner Kraakman, et al. The anatomy of corporate law
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Royston Miles G, ‘Corporate and Personal Insolvency Law
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for defaulting loan repayment within this timeframe. The moratorium is provided in the Part A1
of the IA of 1986, inserted by the corporate insolvency and Governance Act 202011. The
creditors are protected by buying the organization time to try and see whether they can recover
from their current situation and save the creditors' loan.
The law also allows the company's voluntary arrangement (CVA) with its creditors. The
CVA is an arrangement with the creditors to ensure that the company has a successful
restructuring or develops an appropriate recovery plan to prevent bankruptcy. A CVA is a formal
insolvency procedure governed by the Insolvency Act 1986 (IA 1986) in the United Kingdom12.
These proposals outline how the organization intends to repay the loans from its creditors over a
period. However, the CVA has to be approved by at least 75% of the organization's creditors.
Failure to meet the terms laid in the CVA will have the organization to suffer liquidation.
Director liability or disqualification
Another legal strategy to address these agency problems between creditors and
shareholders is the director's liability or disqualification. This legal framework holds the director
of any corporation accountable for their actions and imposes consequences for the breach of their
duties of care and loyalty. When making decisions on behalf of the company, the directors are
expected to use reasonable care, skill, and diligence. Their own interest should not be considered
at any one time in the organization.
This legal technique requires directors to prevent conflicts of interest,which is a
requirement by UK laws. The UK legislation is strict on such matters, and any breach of such
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Paul K and Preston L The Corporate Insolvency and Governance Act 2020
Tetyana B Insolvency Act 1986, Section 214
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laws will have legal action taken if directors are found to have violated the law. For instance, in
the case of Regal (Hastings) Ltd v Gulliver [1942], a cinema company that wanted to lease a new
property13. However, the firm only had $2000 to contribute, whereas the property owner required
a deposit of at least $5000. The director contributed $3000 from his personal funds, and the firm
and property were sold to a third party. The director profited significantly from his $3000
investment. However, the court concluded that the director must refund the profit since the law
prohibits any director from profiting in a scenario where there is a conflict of interest.
The company's directors are mandated to ensure that they act in ways that promote the
company's success. This is in line with the UK laws under section 172 of the companies act in
200614. Therefore, the cinema director, regardless of whether he used his own money or not, is
counted to be an action promoting the company's success. Thus, under this law, the directors can
only receive their investment back, not profits. The profits should be used to promote the success
of the company.
Another situation in which the directors must act in the best interests of the firm's
shareholders is when the company is bankrupt. Under Section 172(3) of the Companies Act and
Section 214 of the Insolvency Act of 1986 in the United Kingdom, directors must prioritize
paying creditors and avoid reducing the value of their assets, increasing the value of creditors,
and continuing to trade with people even if insolvency is apparent15. Any foregoing violation is
considered a breach of the directors' disqualification, and the directors may face legal action.
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NOLAN I [2012] Regal (hastings) ltd v gulliver (1942)
Williams R, ‘Enlightened Shareholder Value in UK Company Law’ (informit, 2012)
Ibid
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The director must also disclose any conflict of interest during company transactions. The
directors are required not to prioritize their claims over the other people in the company.
Therefore, any action that does not promote the company's interest is identified as a breach of
directors' disqualification and should face legal action. For instance, directors involved in any
fraudulent or sham transaction for their benefit should face legal proceedings.
The director is also seen as the company's trustee and thus liable for anything that
happens to any assets in the company. Therefore any misappropriation of the company's assets is
counted as the directors’ disqualification, and thus the director should face legal action for
such16. The director is expected to protect and ensure that all company property is not
mishandled or used for personal or family businesses. The law protects the shareholders and
creditors from organization assets being used in other personal business leading to its value
depreciation, where else it's collateral for some creditors who may feel that if an instance of
bankruptcy and liquidation were to occur, they would not be able to recover their loan repayment
value and making significant losses.
Conclusion
The creditors and shareholders conflict is an issue; if no proper measures are taken,
many companies would take advantage of the creditors to avoid repaying their loans. This would
significantly impact the economy, given the vital role that creditors play in the success and
survival of many organizations. Therefore, the legal strategy is essential in balancing the two
interested parties who could interfere with other people's pursuit of additional revenue and
profits. However, it should be noted that more legal framework is needed to protect further
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Williams M, 'Directors' Disqualification - International Journal of Disclosure and Governance
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loopholes that many organizations have exploited to take advantage of either their shareholders
or credit, thus leading to a massive loss of assets in an organization.
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Bibliography
Council FR, UK Corporate Governance Code (Financial Reporting Council 2012)
Hasanaj P and Kuqi B, 'Analysis of Financial Statements (2019) 2 Humanities and Social Science
Research
NOLAN I [2012] Regal (hastings) ltd v gulliver (1942)
Paul K and Preston L ‘The Corporate Insolvency and Governance Act 2020’, (2020)
Reiner Kraakman, et al. The anatomy of corporate law, chapter 5(OUP, 2017)
Staraci G and Pouraghdam M, ‘Chapter 11 Bankruptcy and Loan Covenant Strictness’ (SSRN, 3
July 2017)
Tetyana B Insolvency Act 1986, Section 214: A Model for the European Initiative on Wrongful
Trading (2005)
Williams M, 'Directors' Disqualification - International Journal of Disclosure and Governance
(SpringerLink, 1 September 2005) accessed 22 May 2023
Williams R, ‘Enlightened Shareholder Value in UK Company Law’ (informit, 2012)