October 10, 2022

Do Directors Have a Duty to Consider the Interests of Creditors Prior to Insolvency?

On 5 October 2022, the English Supreme Court handed down its decision in BTI 2014 LLC v Sequana SA and others.

This (as described by Lady Justice Arden) “momentous” decision principally concerns whether directors are under a duty to consider creditors’ interests prior to insolvency and, if so, at what point in time does the duty arise. In reaching its decision, the Supreme Court considered whether there is, in fact, a duty owed by directors to consider the interests of the company’s creditors when a company is insolvent or is facing insolvency (often referred to as the “creditor duty”). Furthermore, the Supreme Court went on to consider the scope of and trigger for the creditor duty and set out some “provisional” views on a number of other questions of company law.

Ultimately, the Supreme Court found that directors do owe a duty to consider the company’s creditors interests prior to insolvency and that this duty is subject to a sliding scale, based on the financial position of the company. It was held that, where insolvent liquidation or administration is probable (as opposed to a real risk) the directors should consider the interests of the creditors and balance these against the interests of the shareholders where there is a conflict. However, where insolvent liquidation or administration is inevitable the interests of the creditors should be prioritised (particularly ahead of the interests of the shareholders).

The reason why this judgment is highly significant is because it is the first time that the Supreme Court has had the opportunity to address these issues which have practical implications for the management of businesses and, as Lord Reed observed, go “to the heart of our understanding of company law”.

What was the case about?

The dispute arose out of dividends that Arjo Wiggins Appleton Ltd (“AWA”) had paid to its parent company, Sequana SA, in 2008 and 2009. These dividends were paid at a time when AWA had stopped trading and was subject to contingent indemnity liabilities of an uncertain amount in respect of clean-up costs and damages claims generated by the historic pollution of the Lower Fox River area in Wisconsin.

By the time the case had reached the Court of Appeal, the dispute was focused on the dividend of €135 million which had been paid in May 2009. At the time of this dividend, AWA was (as described in the judgment) “not a trading company: it existed solely because it was liable to meet future environmental clean-up costs, which could not be precisely estimated but for which it had provision in its accounts”. AWA was solvent on both the balance sheet and cash flow bases and in making the dividend, it had complied with the statutory and common law maintenance of capital rules relevant to the payment of dividends. Due to the uncertainty over the quantum of its future liability and the value of AWA’s assets, there was a real risk that AWA might become insolvent in the future but, at that time, the Court held that such insolvency was not a probability nor was it imminent.

In October 2018, AWA entered into administration. Claims were subsequently brought against AWA’s directors seeking to recover the amount of the dividend. The allegation against AWA’s directors was that the payment of the dividend created a real and not remote risk of AWA becoming insolvent at some point in the future (because the ultimate liability in respect of the environmental claims may have been considerably more than had been provided for) and that the directors failed to have regard to the interests of creditors in deciding to declare the dividend, thereby breaching the creditor duty.

At first instance, the court did not consider that the creditor duty had arisen in May 2009 because AWA was not then insolvent and nor was its insolvency either “imminent or probable”. The Court of Appeal also considered that “the creditor duty did not arise until a company was either actually insolvent, on the brink of insolvency or probably headed for insolvency” and that a “risk of insolvency in the future, however real, was insufficient unless it amounted to a probability”.

Before the Supreme Court, the claimant argued that a “real risk” of insolvency (which was the position in May 2009) was sufficient grounds for the creditor duty to arise. The directors, on the other hand, argued that the Court of Appeal had been wrong to decide that the creditor duty existed and that, even if it did, it was incorrect that it could apply to a lawful dividend or arose before actual or possibly imminent insolvency. The directors also argued that the Court of Appeal was correct to hold that a real risk of insolvency, falling short of a probability, was not enough for the creditor duty to arise.

What did the Supreme Court conclude?

The Supreme Court unanimously dismissed the claimant’s appeal because, it found that at the time of the dividend, the directors of AWA were not under a duty to consider, or act in accordance with, the interests of AWA’s creditors.

In reaching its decision, the Supreme Court found that there is a “creditor duty” which is sufficiently established and well founded (although there was no consensus reached as to the use of this term, with two of judges preferring to use the phrase “the rule in West Mercia”, after the 1988 leading case). As to when the creditor duty arises, the majority view of the Supreme Court was that this occurs when the directors know, or ought to know, that the company is (i) insolvent, or (ii) bordering on insolvency, or (iii) there is a probability of an insolvent liquidation or administration.

The Supreme Court was clear that the creditor duty is not a free-standing duty owed to creditors (rather than the company) as distinct from the directors’ duty (as codified in Section 172(1) of the Companies Act 2006) to act in a way that the directors consider, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole. Rather, when the creditor duty arises, the directors’ duty to act to promote the success of the company is modified and extended so as to include the interests of the company’s creditors as a whole.

The relevant weight that the directors ought to give to the interests of the shareholders on the one hand and the creditors on the other, will depend on the circumstances. Where the likelihood of insolvency is understood to be only temporary (for example, in a cash flow shortage expected to be resolved promptly), the balance is likely to weigh more heavily towards the shareholders than creditors. By contrast, where the financial situation is so severe that there is no “light at the end of the tunnel” and insolvent liquidation or administration is unavoidable and inevitable, then the interests of the shareholders will fall away entirely and the interests of creditors will become of paramount concern. This reflects the economic reality of the situation that, on insolvency, the creditors’ interests diverge from those of the shareholders and it is the creditors who, per Lord Briggs, “have the most skin in the game”. This balancing exercise will be fact sensitive and will depend upon “what the directors reasonably regard as the degree of likelihood that a proposed course of action will lead the company away from threatened insolvency”.

What does this mean for directors?

While the company is financially stable and solvent and there are no known future events or circumstances which may jeopardise this, the directors owe their primary duty to the body of shareholders. That is not to say that the position of creditors can be ignored. The need for directors to give consideration to the position of creditors on a day to day basis is, to a certain degree, woven in to the fabric of section 172(1) CA 2006 in that the provision imposes a duty on directors to promote the success of the company for the benefit of its members as a whole and in doing so, have regard (amongst other things) to the needs of its employees and the need to foster the company’s relationships with its suppliers and customers, all of which may be creditors. The success of the company for the benefit of its members therefore naturally requires some consideration of creditors, in addition to the company’s other stakeholders.

However, at the point at which a company is financially distressed, insolvent or is bordering on insolvency, or where an insolvent liquidation or administration is probable, the creditor duty arises and the directors must consider creditors’ interests. The degree of weight to place on the creditors’ interests must be driven by the directors’ assessment of the company’s current and likely future financial position.

It is important that directors are aware that the creditor duty, once triggered, cannot be overridden or removed by a resolution of the company’s shareholders.

The practical message, said Lady Justice Arden, is that directors need to ensure they have access to reliable information as to the company’s financial health: “The company must maintain up to date accounting information itself although it may instruct others to do so. 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… In addition, directors can these days without much difficulty undertake appropriate training about their responsibilities, and about the penalties if they disregard them”.

More than ever, it is important that the directors carefully manage the interests of each of the company’s stakeholders, and where those interests conflict (or potentially conflict) the directors will need to determine, based on the facts of each case and the current and anticipated future financial position of the company, whose interests should be given higher regard and prioritised.

In addition, directors should ensure that, where a company is experiencing financial distress or future uncertainty, they obtain appropriate professional advice.