Shearman And Sterling

Royal Courts of Justice in London

October 07, 2022

Directors’ Duties in an Insolvency Context: Where Creditor and Shareholder Interests Collide

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DIRECTORS’ DUTIES IN AN INSOLVENCY CONTEXT: WHERE CREDITOR AND SHAREHOLDER INTERESTS COLLIDE

UK Supreme Court gives important judgment on directors’ “creditor duty”

The UK Supreme Court in BTI 2014 LLC v Sequana SA and ors [2022] UKSC 25[1] has given an important judgment clarifying the nature of the so-called “creditor duty.”  The “creditor duty” is an aspect of the fiduciary duty of directors to act in the interests of their company which requires the directors to take into account the interests of creditors in an insolvency, or borderline insolvency, context.

The creditor duty is a relatively recent development in English common law[2] and Sequana now confirms beyond any doubt that the duty exists. The decision’s greater significance, however, may come from the guidance it provides directors and insolvency practitioners on how close to insolvency the company needs to be for the duty to be engaged.  That is a difficult issue that has received conflicting attention in the case law and presents a potentially wide margin for error for directors.

It is now clear from Sequana that the ‘creditor duty’ is engaged only when the directors know, or ought to know, that the company is insolvent or bordering on insolvency, or that an insolvent liquidation or administration is probable. It remains to be seen whether that still rather general test will in fact provide directors with greater comfort in practice.

Background

In May 2009 the directors of a company called AWA caused it to declare a dividend of €135M (the "May Dividend"), which was distributed to its sole shareholder, Sequana SA ("Sequana") by way of set-off against a broadly commensurate intercompany debt owed by Sequana to AWA. The May Dividend was distributed at a time when AWA was solvent, on both a balance sheet and a commercial (or cash flow) basis. 

At the time the distribution was made, AWA held an unknown but potentially significant long-term pollution-related contingent liability, and an insurance portfolio of uncertain value. In light of this, there was said to be a real risk that AWA may become insolvent in the future, even if insolvency was not at that time imminent (or even probable).

When AWA entered administration almost a decade later, BTI 2014 LLC ("BTI"), to whom AWA's claims had been assigned, sought to recover the amount of the May Dividend from AWA's directors, including on the basis that the directors had, by causing the May Dividend to be distributed, acted in breach of their common law duty to consider, or act in accordance with, the interests of the company's creditors when the company becomes insolvent or when it approaches or is at real risk of insolvency (the so-called "creditor duty").

The directors having successfully defended this claim in both the High Court and Court of Appeal, BTI appealed to the Supreme Court, which dismissed the appeal. Lord Briggs, giving the Court's leading judgment, considered the following four issues:

  • Issue 1: Is there a common law creditor duty at all?
  • Issue 2: Can the creditor duty apply to a decision by directors to pay an otherwise lawful dividend?
  • Issue 3: What is the content of the creditor duty?
  • Issue 4: When is the creditor duty engaged? Was it engaged on the facts of this case?

This was the first time that the creditor duty had been considered at Supreme Court level. 

The Supreme Court’s Decision

Issue 1: Is there a common law "creditor duty" at all?

The Court unanimously affirmed the existence of the duty, noting in particular that:

  • The creditor duty is firmly established in the common law and supported by extensive domestic authority in the lower courts, as well as authority from other common law jurisdictions, such as Australia and New Zealand.
  • Section 172(3) of the Companies Act affirms (per Lords Briggs, Kitchen and Hodge) or expressly preserves (per Lord Reed and Lady Arden) the creditor duty. This means the duty in section 172(1)—to act in the way the director considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole—is subject to the creditor duty, where it arises.
  • The creditor duty has a coherent and principled justification: the relative importance of a creditor's economic interest in a company increases as its financial difficulties deepen and it eventually enters insolvency, whereas the shareholders' economic interest in the company correspondingly diminish. In such circumstances, it is right that creditor interests should be taken into account in discharging the directors' duties to the company and the directors should avoid prejudicing those interests.
  • The creditor duty is not a 'standalone' duty as such[3] or one owed by directors to a company's creditors. Rather, it is one strand of the directors' fiduciary duty owed to the company, to act in its interests. Therefore, the creditor duty is a recognition of the fact that, once the duty is triggered, the interests of the company increasingly become the interests of creditors as the company approaches insolvency.
  • The shareholder ratification/authorisation principle does not preclude the existence of the creditor duty nor is it inconsistent with the consequences for wrongful trading under the Insolvency Act. That is because shareholders cannot authorise or ratify a transaction entered into while the company is insolvent, or which would make it insolvent.

Issue 2: Can the creditor duty apply to a decision by directors to pay an otherwise lawful dividend?

The Court said that it can, because:

  • The provisions of the Companies Act (Part 23) regulating the payment of dividends are subject to any "contrary rule of law" (see section 851(1) of the Companies Act), including the creditor duty, which is part of the common law, and recognised by section 172(3).
  • While the Companies Act defines profits on a balance sheet basis for the purposes of making a distribution, it could not be the case that such profits could be lawfully distributed even where a company was cash flow insolvent. Therefore, a decision to distribute a dividend that is otherwise lawful under Part 23 may still be taken in breach of the duty.

Issue 3: What is the content of the creditor duty?

While the content of the duty was not an issue the Supreme Court had to decide (and therefore may be subject to further attention from the Court in due course), the Court considered that, once the creditor duty is triggered, directors must seek to balance the interests of creditors with those of the shareholders (to the extent they differ). The relative weight which must be given to the interests of the company's creditors will increase as a company's financial difficulties deepen. In this context, the Supreme Court also held that the interests of creditors mean the interests of the creditors as a general body and directors are not required to consider the interests of particular creditors who are in a special position.

Once insolvent liquidation or administration becomes inevitable, the interests of the company's creditors become paramount. At this point, the shareholders cease to retain any valuable interest in the company.

Lady Arden would have gone further than the rest of the Court in holding that the duty was not limited to requiring creditors' interests to be considered, but also requires directors not to harm those interests.

Issue 4: When is the creditor duty engaged? Was it engaged on the facts of this case?

This is perhaps the most interesting issue from the decision and was the key battleground in the Court of Appeal. It had been noted by the Court of Appeal that the extensive authorities on the creditor duty did not provide any clear, definitive guidance on the question of when the creditor duty arises. The Court of Appeal ultimately concluded that the authorities provided sufficient justification for a trigger which was pre-insolvency, arising when the directors "know or should know that the company is likely to become insolvent".

The Supreme Court considered the concept of "likelihood" of insolvency to be a relatively vague test. It found that many of the authorities on the trigger point, in cases decided since West Mercia, conveyed a sense that insolvency must be "imminent" and therefore that mere likelihood was not sufficient. The majority settled on the duty arising when the directors know, or ought to know, that the company is insolvent, is bordering on insolvency or insolvent liquidation or administration is probable.[4] Lord Reed and Lady Ardern (in the minority) did not decide whether directors’ knowledge as to insolvency was necessary.

Applying the above test, the Court unanimously held that the creditor duty did not arise at the time of the May Dividend, which was roughly ten years before AWA eventually entered into insolvent administration. In doing so, the Court also confirmed unanimously that the creditor duty does not apply merely because a company is at a "real and not remote risk" of insolvency (a rule found in some English cases and derived from certain Australian authorities).

Comment

While the fact pattern in the present case, which concerned the distribution of a dividend many years prior to the company entering an insolvency process, did not engage the creditor duty, the detailed and clarificatory guidance that has now been provided, at the highest level, as to the existence and scope of the creditor duty and when it is engaged, will undoubtedly have wider application, including in cases where the solvency of the company is less certain at the relevant time.

Given that the existence of the duty itself has not seriously been in doubt, it is likely to be the question of when the duty is engaged, and to what extent, that most concerns company directors and insolvency practitioners. The Supreme Court has made clear the creditor duty is not engaged merely because there is a "real and not remote" risk of insolvency (as had been the test referred to in some earlier cases).  The Court’s requirement that insolvency must at least be “imminent” shifts (at least in theory) the point at which the duty is engaged closer to the point of insolvency than the tests used by the Court of Appeal and previous authorities had suggested.  In doing so, the Court has provided a settled formulation of the relevant trigger, albeit one which still allows for a relatively wide field of operation.

This is because determining when a company is “bordering” on insolvency or that an insolvency process has become “probable” may be no less difficult a task than determining when insolvency is “likely” or “real and not remote.” Directors may therefore have some difficulty discerning the practical implications of the Court's refinement of the test for when the creditor duty is engaged.  We may need to await further cases which apply Sequana to a range of fact patterns (particularly those involving a more imminent onset of insolvency than in Sequana itself) to gain a better understanding of precisely how the test needs to be applied in practice.

It follows that the question of when the duty is engaged is highly fact dependent, according to the financial circumstances and factual context applying to the company at the relevant time. It is therefore important that directors receive the information necessary for them to make an informed assessment as to the financial position and operational prospects of the company and that processes are in place for that information to be prepared in a timely manner (and for material issues to be immediately escalated to the Board in cases where the company's financial health is threatened). Board minutes should also record the factors that the directors have considered and the reasons why they have reached their decisions.

Once engaged, the creditor duty requires a careful exercise of balancing creditor, member, and company interests, which will modulate according to the financial health of the company in question. Only once the members' interests are largely diminished or extinguished at the point when an insolvency process becomes “inevitable,” do creditor interests become paramount (the precise meaning of “inevitable” in this regard being another point the courts may well need to grapple with in due course). That is a salutary reminder that companies are, at their heart, vehicles for risk-taking, a notion borne out by the Supreme Court’s apparent wish in this case to avoid unnecessarily stifling such risk-taking by adopting an excessively ‘early’ trigger point for the creditor duty.

Special thanks to counsel Karla Dudek who co-authored this publication.

Footnotes

[1]  A copy of the judgment may be found here.
[2]  Having first been definitively established in English law in
West Mercia Safetywear Ltd (in liq) v Dodd [1988] BCLC 250.
[3]  The term “creditor duty” was used by the Court in
Sequana merely as a convenient shorthand.
[4]  That had been adopted by the Supreme Court in
Bilta (UK) Ltd v Nazir (No 2) [2015] UKSC 23; [2016] AC 1.

Authors and Contributors

Jonathan Swil

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Alexander Wood

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