Who is a Creditor?

Creditors of a company are those who, by their relationship with the company, advance credit or perform services for the company under a contract to whom the latter owe an obligation.191 However, this definition is not all encompassing as, within the context of company law, creditors include not only those who lend money or perform services to the company under contractual terms such as banks, trade creditors, customers and employees but also those who do not have any relationship with the company but are victims of corporate actions such as tort victims or innocent third parties. Thus creditors are broadly divided into two types. These are voluntary creditors representing those who have a relationship with the company based on contract and those generally referred as to as involuntary creditors i.e. victims of tort. The two combined together make up what is called company creditors. They include customers, consumers, and employees, lenders including banks and financial institutions and tort creditors.

189 _{P.Halpern, et al, n. 185 at 118.} 190

See Adams v Cape Industries Plc. [1990] 1 Ch. 433

191 _{A O’Sullivan & S.M. Sheffrin, Economics: Principles in Action, Pearson Prentice Hall, Upper} Saddle River, New Jersey, 2003, 204.

51 2.5.3.2 Voluntary Creditors

Three groups of creditors have emerged as those constituting voluntary creditor.192 The first are trade creditors who supply goods and services to companies and then advance credit by not requiring immediate payment. The second consists of institutional lenders such as banks who lend money to companies. A key method of bank lending is the overdraft, which allows a company to borrow by overdrawing on a bank account. The third class is composed of creditors whose right to payment is evidenced by a certificate the company has issued. This group of persons are called debenture holders. Creditors get returns on their investment by way of yield or interest and the contract it maintains with the company ultimately stipulates the terms of repayment or maturity of yield.193

The relationship between a company and its creditors as pointed out earlier is largely contractual in nature and gives the creditors different rights from those of the shareholders who are members of the company. Consequently, the debt owed them is by the company and not the shareholders. However, they rank ahead of any claims which the shareholders have against the company. This is particularly evident in times of liquidation when creditors have priority over shareholders since the debt owed must be paid before any assets can be distributed to the members.194

Since the creditors enter into contract with the company “in substantial awareness of the risk of injury involved”, it has been argued that they have to take the consequences of the risk involved if the company fails to meet its obligation. In view of the potential problem they face in contracting with the company, creditors have taken some protective or “self-help” measures to protect their interest by negotiating favourable terms in the contract, insisting on guarantee or security and other self- help mechanisms. These include getting adequate information about the financial stability of the company before initiating a transaction or exerting a premium payment in exchange for accepting the risk involved in the investment.195

192 _{B.R.Cheffins, Company Law, Clarendon Press, Oxford, 1997. 71} 193 _Ibid.

194

J. Charkham, Keeping Good Company: A Study of Corporate Governance in Five Countries, Clarendon Press, Oxford, 1994, at 36, 100-1, 299.

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For the big lenders such as banks, in particular, they can ask for higher interest rate as compensation for not only the money lent, but also for the risk they stand to face in the event of default in payment.196 Not only can they charge adequate interest rates, but they can also insert loan covenants. These agreements may for instance generally restrict the freedom of borrowers to distribute assets to shareholders197 or may prohibit distributions when financed by issuing debt.198 They may also require compliance with a specific debt-to-equity ratio or a particular cash flow development.199 Creditors can also include in the contract a requirement that would entail the company to furnish them with regular financial information.200 Over all, loan covenants tends to provide some control rights to creditors, so that the risk of default is not opportunistically higher than it was at the time of contracting. In addition to the above, creditors can still request for security in form of a charge or a floating charge which will crystallize due to the manner set out in the contract.201 Obtaining security for these big creditors has the tendency of reducing their financial exposure as they are given a privileged position if the debtor becomes insolvent. However, it is not a viable option for many creditors, especially the smaller ones, as the costs and time involved in organising security could well mean that their profit margins are grossly depleted.202 It is also most likely that they will not be familiar with the necessary arrangements for the taking, and the benefits, of security.

In terms of close corporation setting, where statutory limited liability may have only limited value, many creditors, especially banks and other lenders as well as many suppliers, require a personal guarantee from the corporation’s shareholders.203

For trade creditors who supply goods and services to the company in return for full or instalment payments at a later date, their position seems precarious as they do not request personal guarantees from shareholders and lack the skill and capacity like the

196 _Ibid.

197

Luca Enriques & Jonathan Macey, ‘Creditors versus Capital Formation: The case Against the European Legal Capital Rules’, Cornell Law Review, 86, 1172.

198 _{Ibid at 1188.}

199 _{Wolfgang Schon,‘The Future of Legal Capital’, (2004) European Business Organisation Law}

Review 5, 439.

200 _{Halpern, et al . n.189 at 135.}

201 _{P. Davies, ‘Legal Capital in Private Companies in Great Britain’, Aktiengesellschaft, 1998, 386.} 202 _{V. Finch, ‘Directors’ Duties: Insolvency and the Unsecured Creditor’, in A. Clarke (ed), Current}

Issues in Insolvency Law, Stevens, London, 1991.

203 _{W.A. Klein & J.C. Coffee Jr., Business Organisation and Finance, Oxford University Press,} Oxford, 2002, 142.

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big lenders to gather enough information about the transaction before bargaining and spreading risk. Again, they do not have an incentive to spend considerable time and resources for exhaustive negotiations with a company, since they do not extend huge amount of credit. Competitive pressures can even cause them to shy away from demanding the contractual protection they might value.204 And because they provide goods and services to a great number of customers, trade creditors do not negotiate terms with each of them separately. Instead, they make use of standard forms of contract.205 In consequence, therefore, what emerges is the use of standard forms of uniform terms which apply to all contracts in order to save transaction costs. Following these inadequacies of lack of bargaining skills and widespread use of standard for contracts, trade creditors rarely embark upon an investigation of the creditworthiness of a particular company.206 To this extent, trade creditors remain the most vulnerable group among the voluntary creditors.

In view of the above, the question whether trade creditors are voluntary or involuntary creditors has been a subject matter of debate among commentators with no agreement on their status. For Blumberg, trade creditors “are simply not in business to bargain for credit”.207

On the contrary, Easterbook and Fischel regard them as voluntary creditors able to demand compensation for the risk that they face.208 Since the trade creditors have a clear relationship with the company in terms of goods and services supplied, it is difficult to put them in the class of involuntary creditors. It is submitted that trade creditors are voluntary creditors notwithstanding the perceived anomalies in their transactions with the company.

Nonetheless, some form of protection still exists for trade creditors. This may come in the form of higher prices for goods supplied or the inclusion of retention of title clauses in their contracts with the company.209 The retention of title clauses meant, in effect, that goods supplied to the company are subject to the reservation of title to the seller until the payment of the price thereof. Although this procedure is widely in use in most of continental Europe and in the US for a long time, it became an acceptable

204

Cheffins, n.192 at 540.

205 _{See R. Goode, Commercial Law, Sweet & Maxwell, London. 1982.}

206 _{For issues relating to standard form of contracts, see J.M. Landers,’ Another Word on Parents,} Subsidiaries and Affiliates in Bankruptcy’, 43 Univ. of Chi. L.Rev., 1976, 527 at 530.

207

Blumberg, n.36

208 _{Easterbrook & Fischel, n.160, at 104} 209 _{Cheffins, n.192 at 82.}

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feature in the UK in 1975 following the decision in Aluminium Industries Vaassen Bv v. Romalpa Aluminium Ltd.210 Thereafter, such clauses became known as “Romalpa clauses”. In Nigeria, such clauses are not readily available in the absence of any authority. However, there is an implied term in the contract that the reversionary interest in the goods supplied still remains with the seller until payment is made. In any event, the perceived protection afforded by retention of title clauses to trade creditors is neither comprehensive nor always effective. Its operation seems to be in favour of sellers of goods and not those who perform some services to the company. Besides, their validity is not always upheld.211 This is largely because, in most cases, the courts treat them like charges with the effect that their non registration renders them valueless, as against a Receiver or a liquidator.212

From the above, it is submitted that creditors, particularly trade or small creditors, bear enormous risk from the effects of limited liability who lack the capacity to negotiate and elicit favourable terms from the company. The risk of a company’s failure is shifted to them and the likelihood that they will take enough measures to avoid such risk remains largely remote. To this extent, limited liability remains a potential source of danger to this class of creditor.