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07 Oct 2022

Directors' duties prior to insolvency

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The Supreme Court has handed down its long-awaited judgment in BTI 2014 LLC v Sequana SA [2022] UKSC 25.

Basic facts

  • In May 2009 the directors of a company called AWA caused it to distribute a dividend to its only shareholder, Sequana (which extinguished by way of set-off a large part of a debt owed by Sequana to AWA). The May dividend complied with the statutory scheme regulating the payment of dividends in Part 23 of the Companies Act 2006 and with the common law rules on the maintenance of capital.
  • At the time of the declaration of a dividend there was no imminent insolvency threat on a balance sheet or cash flow basis. However, AWA had long-term pollution-related contingent liabilities of a very uncertain amount (relating to needing to clean-up a polluted river), which gave rise to a real risk, although not a probability, that AWA might become insolvent at an uncertain but not imminent date in the future.
  • AWA went into administration in October 2018.
  • BTI (as assignee of AWA's claims) brought a breach of duty claim against the directors of AWA (who authorised the dividend payment) arguing that it had been paid in breach of their duty to have regard to the interests of the company's creditors.
  • Both the High Court and the Court of Appeal rejected the creditor duty claim. In the judgment of the Court of Appeal, the creditor duty did not arise until a company was either actually insolvent, on the brink of insolvency or probably headed for insolvency. Its provisional view was that the creditor duty became paramount as soon as the company became insolvent. Since AWA was not insolvent or on the brink of insolvency in May 2009, BTI’s creditor duty claim failed.

A reminder of the so-called "creditor's interest duty"

The 'creditors' interest duty', as it has come to be known, stems from the long-established fiduciary duty of a director to act in a way they consider, in good faith, would be most likely to promote the success of the company for the benefit of its shareholders as a whole (as codified by section 172(1) of the Companies Act 2006).

However, there is a common law rule (as recognised by section 172(3) of the Companies Act 2006) that this duty is modified in certain circumstances, namely the company's insolvency, such that the company's interests are said to equate to those of its creditors. This means that when the company's insolvency comes into contemplation it is the creditors' interests that the directors must consider.

Therefore, in practice, if, due to the company's financial situation, it is no longer in the interests of the general body of creditors for the company to keep trading, the directors should instead put the company into an insolvency process. This is so that the then appointed office-holder can do his best to get back as much of what is owed to the creditors as he or she can, rather than allowing the company to keep on trading and rack up even more debt (that cannot be repaid).

The key issues and what the Supreme Court has said

Is there a creditor's interest duty at all and, if there is, what is it? 

The Supreme Court has now confirmed that the duty exists.

The Supreme Court also confirmed that directors owe their duties to the company rather than directly to the shareholders or its creditors, so the creditor duty is not a "free standing" duty owed to creditors. (As a result, not all the judges thought creditor duty was the right label to use, albeit we expect that commentators and practitioners will continue to refer to "creditor duty" or "creditor's interest duty" as shorthand – albeit recognising that use of the term doesn't mean it is a "free standing" duty).

The Supreme Court also raised the point that the duty is owed to the general body of creditors (not the interests of particular creditors in a special position), but unhelpfully didn't go onto explore this in any particular detail. This seems likely to raise some interesting/challenging issues to grapple with going forward.

When is the creditor's interest duty engaged and how does it operate, once triggered?

The majority of the Supreme Court held that the duty arises when the directors know or ought to know that the company is insolvent or bordering on insolvency, or that an insolvency liquidation or administration is probable. (However two of the judges left open the question of whether it is essential that the directors know or ought to know that the company is insolvent or bordering on insolvency.)

Importantly, this does not operate as a "cliff edge" trigger. Where the company is insolvent, or bordering on insolvency, but is not faced with an inevitable insolvent liquidation or administration, the Supreme Court held that the directors should consider the interests of the general body of creditors, balancing them against the interests of shareholders where they may conflict. So, the greater the company’s financial difficulties, the more the directors should prioritise the interests of creditors.

All members of the Supreme Court agreed that, where an insolvent liquidation or administration is inevitable, the creditors’ interests become paramount as the shareholders cease to retain any valuable interest in the company.

So, in effect this means that there is a sliding scale after the creditor duty is engaged - as a company moves closer to inevitable insolvency a greater weight will be given to creditor's interests - until such time as insolvency is inevitable, at which point the creditor's interests are "paramount".

This nuanced approach no doubt reflects the commercial reality, but obviously in practice it tends to be hard to operate tests like these with certainty.

Was the creditor's interest duty engaged on the facts of BTI v Sequana?

All of the members of the Supreme Court agreed that the creditor's interest duty was not engaged on the facts of BTI v Sequana. This is because, at the time of the May dividend, AWA was not actually or imminently insolvent, nor was insolvency even probable. The duty does not apply merely because the company was at a real and not remote risk of insolvency.

What does this mean in practice?

It appears that the Supreme Court has in effect suggested that the so-called creditor's interest duty kicks in a little later than was previously thought. That said, each case will of course turn on its specific facts.

As was the case before the Supreme Court's decision, it is of paramount importance that the directors take legal advice as soon as it becomes clear that financial difficulties are on the horizon. This will help them to navigate both the challenges facing their business as well as the need to comply with their own personal duties.

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