The Supreme Court has handed down a long-awaited judgment concerning the duties of directors of insolvent companies in BTI V Sequana. The Supreme Court itself described its decision as ‘momentous’, noting that this was the first time it had considered an area of the law which is in the course of development, and many aspects of which are controversial.
The decision is particularly timely as businesses face unparalleled economic uncertainty with rising interest rates, energy costs and other inflationary pressures.
The facts of the case are stark – enough to strike fear into the hearts of many a director. It involved a claim against the directors of AWA. In May 2009, the directors approved a EUR139 million dividend to be paid to AWA’s parent Sequana. The dividend was set off against and extinguished a larger debt owed by Sequana to AWA.
At the time the dividend was paid, AWA was apparently solvent on both a balance sheet and a cash flow basis (i.e. the value of its assets exceeded its liabilities and it was able to pay its debts as they fell due). However, the value of AWA’s assets, consisting primarily of an insurance portfolio, was also uncertain. Further, AWA had long-term contingent liabilities relating to an indemnity it had given in respect of environmental clean-up costs, whose amount would depend on the outcome of litigation in the US.
Before approving the dividend to Sequana, the directors of AWA had estimated the likely exposure under the indemnity and made provision in AWA’s accounts for the contingent liability. It was common ground that the directors had complied with relevant statutory provisions concerning the maintenance of share capital in causing the dividend to be paid and the accounts had been signed off by PwC as auditors.
Nevertheless, in view of the uncertain value of both its assets and contingent liabilities, there was a real risk that AWA might ultimately become insolvent by the time of the payment of the dividend to Sequana.
Many years later, AWA entered insolvent administration and the provision in AWA’s accounts turned out to be a significant underestimate of its liability under the indemnity. BTI (as assignee of AWA’s claims) then sought to recover an amount equivalent to the dividend from AWA’s directors on the basis that their decision to pay the dividend had breached their duties to creditors.
Section 172(1) of the Companies Act 2006 requires directors to act in the way they consider would be most likely to promote the success of the company ‘for the benefit of its members as a whole’. However, where the company is insolvent or potentially insolvent, the duty to act in the interests of the company is to be exercised not exclusively in the interests of shareholders, but also to consider creditor interests.
The notion that directors of insolvent or potentially insolvent companies owe duties to consider creditor interests has been a feature of company law in England and throughout common law jurisdictions for several decades. However, the existence and parameters of the ‘creditor duty’ (as we shall refer to it in this article) have long been uncertain and controversial.
Particular controversy arose in BTI v Sequana as to when the duty to creditors arises (or the ‘trigger’ for the creditor duty). BTI had argued that the ‘real risk’ of insolvency described above was sufficient to engage the duty. AWA’s directors argued that no duty to creditors existed at all but if such a duty did exist, it arose only when insolvency was actual or imminent.
The Supreme Court’s decision
The Supreme Court’s decision on the case was unanimous and straightforward. A real risk that AWA would become insolvent was not sufficient to engage a duty for its directors toward their creditors. Some higher threshold would need to be reached before that duty, if it existed, were triggered.
That finding was sufficient to dispose of the claim against AWA’s directors. However, the Supreme Court recognised that the issues arising on the appeal were of considerable significance to company law and that its decision was an opportunity to provide broader guidance. A few key takeaway points from the judgments for directors to be aware of:
Is there a duty to creditors?
The four judgments were unanimous in finding that a form of ‘creditor duty’ does exist.
The duty is not one which is owed to creditors directly and is not a freestanding duty, separate from the ordinary fiduciary duty which directors owe to a company. Instead, it is a modification of the ordinary rule whereby, for the purposes of the director’s fiduciary duty to act in good faith in the interests of the company, the company’s interests are taken to be equivalent to the interests of its member as a whole. There are circumstances in which the company’s interests are taken to include the interests of its creditors as a body.
When is the duty triggered?
Again, the panel were unanimous in concluding that a ‘real risk’ of insolvency was insufficient to engage the creditor duty. However, there was less clarity as to precisely when the duty would be engaged.
All members of the Supreme Court panel concluded that the threshold for engagement of the creditor duty was relatively high. While their reasoning was provisional and non-binding, it provides useful insight to directors who are concerned about when liability may be triggered. The panel seemed to agree that the creditor duty is triggered when a company is ‘insolvent or bordering on insolvency’ or when an insolvent liquidation or administration is probable. Further, it is insufficient that the company is ‘likely’ to become insolvent at some unknown future date.
There was some disagreement about whether it was necessary that directors ‘knew or ought to have known’ that the relevant threshold had been met before the creditor duty was triggered. In practice, as Lord Reed and Lady Arden both pointed out, directors have a duty to inform themselves as to the financial position of the company. Put simply, if a company is bordering on insolvency, it would seem axiomatic that its directors who are properly performing their duties with appropriate care and skill should be aware of that fact.
What is the content of the duty to creditors?
Finally, there was a range of commentary as to the effect of the rule and what obligations it imposes on directors in practice. There was general agreement that the duty required directors to take into account creditor interests and to give them appropriate weight in taking decisions concerning the management of the company. However, directors are not required to treat creditor interests as ‘paramount’ over conflicting interests of shareholders.
In balancing conflicting creditor and shareholder interests directors would need to particularly consider:
1. The prospects that any action they are proposing to take will lead the company toward insolvency, or back out of actual insolvency (i.e. the brightness or otherwise of the light at the end of the tunnel);
2. Who, between creditors and shareholders, has the greatest economic interest, or who has the most ‘skin in the game’ if a proposed course of action does not succeed.
Whether and when creditor interests will outweigh and take priority over interests of shareholders will be fact sensitive. Indeed, Lord Reed noted that weight to be given to competing interests of creditors as opposed to shareholders (if there is a conflict between their interests) will increase as the company’s financial problems become increasingly serious. Lady Arden took the view that the interests of creditors could only supplant the interests of shareholders altogether when the company becomes irreversibly insolvent, making insolvent liquidation or an administration unavoidable.
For creditors, the decision brings welcome confirmation that directors of insolvent or imminently insolvent companies are required to consider their interests. This confirmation, and the guidance as to when the creditor duty applies, will assist creditors and insolvency officeholders (i.e. liquidators and administrators) in holding directors accountable for creditor losses in appropriate cases.
The decision will be of particular interest to directors – and it is generally a positive development from their perspective. Although the Supreme Court did not pronounce conclusively on all the issues, a key message was that the threshold for triggering the creditor duty was relatively high – and likely does not arise until insolvency is imminent. Further, even when the creditor duty does arise, directors are entitled to continue to take account of shareholder interests and to balance those competing interests. Directors are not necessarily required to treat creditors as paramount, at least until insolvency becomes irreversible.
In the circumstances, directors should continue to be circumspect when a company is in financial difficulty. We recommend directors seek professional advice at an early stage when confronted with doubts about a company’s solvency.
Directors would also do well to heed Lady Arden’s admonition in her judgment:
“ the message which this judgment sends out is that directors should stay informed. The company must maintain up to date accounting information itself though it may instruct others to do so on its behalf. Directors can and should require the communication to them of warnings if the cash reserves or asset base of the company have been eroded so that creditors may or will not get paid when due. It will not help to resign if they remain shadow directors. In addition, directors can these days without much difficulty undertake appropriate training about their responsibilities, and about the penalties if they disregard them”.