Supreme Court rules on nature and timing of directors’ duty to consider creditors

The Supreme Court’s long-awaited decision in the Sequana case (handed down on 5 October 2022)[1] is the first time that the UK’s highest court has been asked to consider the proposition that directors are, in certain circumstances, under a duty in respect of creditors’ interests as distinct from shareholders’ interests.

The key takeaway points from this ‘momentous decision for company law’ (the words of Lady Arden who gave one of the leading judgments) are:

1. English law does recognise a so-called “creditor duty” (also referred to as the “rule in West Mercia”).
2. This rule does not create a free-standing duty on the part of directors: it merely adjusts the long-established fiduciary duty of directors to act in good faith in the interests of the company.
3. When the rule applies, directors are required to have proper regard to the interests of creditors and prospective creditors, along with those of shareholders. The weight to be given to creditors’ interests, in so far as they may conflict with those of shareholders, will increase as the company’s financial problems become more serious.The creditors’ interests will not be paramount until insolvent administration or liquidation is inevitable.
4. As for when the rule is engaged, it is not enough for there simply to be a “real risk of insolvency”.Rather, the company would need to be insolvent or “bordering on insolvency”, or an insolvent administration or liquidation is probable.

Background

In May 2009, the directors of AWA resolved to pay a dividend to AWA’s shareholder, Sequana, which extinguished by way of set-off a substantial part of a debt owed by Sequana to AWA. The dividend was distributed at a time when AWA was solvent, on both a balance sheet and cash flow basis. However, AWA had pollution-related contingent liabilities which gave rise to a risk that AWA might become insolvent at some point in the future. AWA entered administration in October 2018, nearly 10 years after paying the dividend to Sequana. BTI took an assignment of AWA’s claims and 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 its creditors.

The Court of Appeal considered that although the directors had not taken into account the interests of AWA’s creditors, the ‘creditor duty’ had not become engaged by May 2009. AWA had not then been insolvent, nor was a future insolvency either imminent or probable even though there was a real risk of it. The Court of Appeal considered that the creditor duty did not arise until the directors know or should know that the company is likely to become insolvent, where ‘likely’ means probable.

BTI appealed to the Supreme Court.

The issues for the Supreme Court

Because the Supreme Court is not bound by the decisions of lower courts, Sequana was able for the first time to dispute whether or not the so-called “creditor duty” exists at all in English law. It was first introduced into the common law tradition in the Australian case of Kinsela v Russell Kinsela Pty Ltd (in liq)(1986) 4 NSWLR 712 before being adopted in an English judgment in West Mercia v Dodd [1988] BCLC 250.

The Supreme Court was therefore called upon to decide:

1. whether or not the creditor duty exists;
2. if it did exist, whether or not it applied to the payment of a dividend that was lawful under the Companies Act; and
3. if it did exist, whether or not it was engaged at a stage prior to actual or imminent insolvency.

It was acknowledged in the Supreme Court’s judgment that a principled analysis of these questions could not sensibly be carried out without also considering the content and consequences of the duty, if it were found to exist. It was therefore necessary for the Supreme Court to express a provisional view about some issues which did not call for a final decision and therefore do not, strictly speaking, form a part of the ruling for the purposes of binding precedent.

(1) Is there a “creditor duty” under English law?

Yes.

The Supreme Court held unanimously that a director's duty under section 172(1) of the Companies Act 2006 (“CA 2006”), to act in good faith in a way that would most likely promote the success of the company for the benefit of its shareholders as a whole, is modified in certain circumstances by the common law, expressly reserved by section 172(3) CA 2006, such that the company’s interests are taken to include the interests of its creditors as a whole. This is not a new free-standing duty, but a modification to the existing duty directors owe to the company which is triggered in certain instances.

Lord Briggs noted that section 214 of the Insolvency Act 1986 (wrongful trading) creates an obligation on directors to treat creditors’ interests as paramount when, but only when, there is “no light at the end of the tunnel [for a company]”. He further noted that this statutory obligation is not to be understood simply as the recognition of a common-law creditor duty, given that (a) first, section 214 merely gives the court a discretionary power to require a director to make a contribution to the assets of a company in the stated circumstances; and (b) secondly, the statutory liability is not to account or to make equitable compensation for loss caused by an assumed breach of fiduciary duty, but to make such contribution to the assets of the company as the court thinks fit. Section 214, Lord Briggs explained, is a “central plank” in the statutory regime of creditor protection, which has been in force during the whole period in which the West Mercia case has stood as binding authority for the existence of a common law creditor duty.

He found that a common law duty was justified by:

• an increasing trend in legislation and case law of viewing a company as a distinct entity with interests and responsibilities separate from those of its shareholders;
• a principle going back to Roman law that insolvent persons or persons on the verge of insolvency have a responsibility to consider the interests of their creditors;
• the fact that it is creditors who have “the main economic stake in the liquidation process that may be triggered by insolvency”; and
• the reference in section 172(3) CA 2006 to “any… rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company” suggesting that Parliament proceeded on the basis that some such rule of law existed and, in the words of Lord Hodge’s concurring judgment, had “a purpose of preserving [it] as it had been developed” at the time the CA 2006 was passed.

Lord Reed, while agreeing with Lord Briggs on the above, stressed that the common law creditor duty should not be understood as separate from the directors’ fiduciary duty to the company, but as an aspect of it that comes to the fore “as the company’s financial problems become increasingly serious.” He explained that this rule modifies 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 the equivalent of the interests of its members as a whole. Where the rule applies, the company’s interests are taken to include the interests of the creditors as a whole.

(2) The application of the creditor duty to a lawful dividend

Sequana argued that the creditor duty could not apply to a lawful dividend because Parliament had chosen in the CA 2006 and the accounting standards to which is refers to delimit the scope of the directors’ discretion with regard to dividends by reference to, amongst other things, “probable future liabilities”. To require the directors to take into account contingent future liabilities that in their view were unlikely to materialise would go against this statutory scheme.

Lord Briggs disagreed with this argument because:

• the relevant portions of the CA 2006 were expressly subject to any rule of law to the contrary, which would include the common law creditor duty; and
• the CA 2006 rules were designed to prevent a dividend from being paid when a company is balance sheet insolvent and did not address cashflow insolvency. Those rules therefore could not provide a complete code as to the circumstances in which dividends could be paid.

(3) When is the creditor duty engaged?

Previous case law had suggested a wide range of different triggers for the point at which the creditor duty was engaged, ranging from a “parlous financial condition” or “real risk of insolvency” via a number of intermediate concepts such as “probable” or “imminent insolvency” to “actual insolvency”.

Lord Briggs considered that a “real risk” trigger would often be too remote to require directors to take into account the interests of creditors. Since there was no question in this particular case of insolvency being “probable” or “imminent”, at the time the dividends were paid, he did not have to go on to determine which trigger would in fact be sufficient.

He indicated, however, that in his view any trigger other than actual insolvency would require “clear justification”, which he would consider to be present where the directors knew or ought to have known that insolvency was either “imminent” or “probable”.

Lord Reed preferred the formula “insolvent or bordering on insolvency” and cautioned against making it a requirement that the directors should have known of this state of affairs.

Lady Arden for her part suggested a trigger of “irreversible insolvency”, a view which Lords Briggs and Reed impliedly rejected by emphasising that even formal insolvency procedures in modern times are designed to allow a company to trade out of insolvency wherever possible. If this criterion were adopted, the creditor duty would very rarely arise.

Both Lord Briggs and Lord Reed cited with approval the comment by Lt Bailiff Hazel Marshall QC in the Guernsey case of Carlyle Capital Corpn Ltd v Conway (Judgment 38/2017) (unreported) 4 September 2017 that it was necessary to adopt a fact-specific approach which was flexible enough to:

“take account of differences, according to particular circumstances, in what it may be reasonable and responsible for directors to do when they find that the company is in a sufficiently weak financial situation that a conflict of interest between its creditors and its shareholders appears to arise.”

The earlier Court of Appeal judgment had held that, following the creditor duty being engaged, the creditors’ interests were paramount (sometimes referred to as a “cliff edge” analysis). However, the Supreme Court disagreed with this and, instead, preferred what might be termed a “sliding scale” approach. In other words, the weight to be given to the interests of creditors will increase as the company's financial difficulties become increasingly serious.

The Supreme Court was of the view that the creditors’ interests will only become paramount at the point where insolvent administration or liquidation is inevitable or irreversible. At that point, the shareholders will cease to have any economic interest.

Comment

The UK’s highest court has put an end to the argument that a so-called “creditor duty” may not exist under English law. Such a duty does exist and it can apply to the declaration of a dividend in addition to the requirements of the CA 2006.

We also know from this judgment that the creditor duty is not engaged simply by there being a risk of insolvency which is not remote: a company would need to be closer to or at greater risk of insolvency for the creditors’ interests to intrude. Precisely how much closer to insolvency or at how much higher risk of insolvency remains open to argument, as is whether the directors’ knowledge of the company’s financial position is a key factor.

Although not strictly part of the ruling in this case, the Supreme Court has given helpful guidance (obiter dicta) as to certain aspects of the creditor duty and its effect: it is not a self-standing rule which creates any obligation on the part of directors to creditors. Instead, it modifies the fiduciary obligation owed at all times by the directors to act in the best interests of the company, with the effect that the interests of the company are no longer regarded as solely those of its shareholders but also those of its creditors as a whole. It may be also that directors are under a duty, when the creditor duty is engaged, not to materially harm creditors (to protect creditors against “insolvency deepening” activity).

This judgment leaves very little scope for debate as to the circumstances in which the creditors’ interests are paramount, to the exclusion of the shareholders’ interests. There is strong obiter dicta that this does not occur until the point in time when a company is irreversibly insolvent. Until that point, directors ought still take into account the interests of shareholders, although with a lot less weight than the interests of creditors when the company’s risk of insolvency is high.

Overall, the Supreme Court has provided some welcome guidance for directors of companies in financial difficulties, which is timely given the current uncertain economic environment in the UK. As identified above, however, the Supreme Court consciously left scope for debate about certain key points that it was not necessary or appropriate for it to answer in this case. As Lord Reed acknowledges, this is “an area of law which is in the course of development, and many aspects of which remain controversial …” There therefore remains a degree of uncertainty for directors and much will depend on the particular circumstances. Directors who are concerned about the financial position of a company should seek specialist advice on the discharge of their fiduciary duties, in parallel with identifying the options available for resolving or easing the financial difficulties being experienced by the company.

For further information, please email the authors or your usual CMS contact.

[1] BTI 2014 LLC v Sequana SA and others [2022] UKSC 25