December 22, 2022

BTI v. Sequana – What’s new for directors in the zone of insolvency?

In BTI 2014 LLC v. Sequana SA and Others [2022] UKSC 25 (“Sequana”), the Supreme Court confirmed the existence of a duty owed at common law by company directors to consider the interests of its creditors, and also provided guidance on the timing of the duty’s application and its content. 

Ultimately, the Supreme Court found that directors do owe a duty to consider a 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. In other words, each member of the court in Sequana viewed the obligations of directors to shareholders and creditors as a balancing act, with the balance tilting towards the creditors’ interests as the likelihood of insolvency increases. At the point where insolvency is inevitable/irreversible/unavoidable, the interests of creditors become paramount and supplant the interests of shareholders, which cease to bear any weight.

In practical terms, however, the steps that should be taken by directors to protect themselves from liability remain, other things being equal, largely unchanged, and the “wrongful trading” regime, in addition to the common law creditor duty, will be their primary concern when they find themselves in the zone of insolvency.

Wrongful trading

Wrongful trading is a statutory claim of an administrator or liquidator under the Insolvency Act 1986 (the “Insolvency Act”) entitling them to apply for a court order that a director contribute personally to the assets of the insolvent company. Wrongful trading liability arises where a director of a company has allowed the company to continue trading -- prior to administration or insolvent liquidation -- in circumstances where the director knew or ought to have concluded at some point before the commencement of the insolvent liquidation or administration that there was no reasonable prospect that the company would avoid going into insolvent liquidation or administration.1

Liability arises when a director (including a de facto or shadow director) who concludes (or should have concluded) that there is no reasonable prospect of avoiding insolvent liquidation or administration, does not take every step to minimise loss to creditors. Accordingly, it is an important test for both individual directors and company boards when faced with doubtful solvency (i.e., during the twilight period and beyond), whether there remains a reasonable prospect of resolving the company's difficulties in a way that discharges all creditors' claims in full.

The court will not issue an order for wrongful trading if, knowing there was no reasonable prospect that the company would avoid going into insolvent liquidation or administration, the director took every step with a view to minimising the potential loss to the company's creditors. This is an absolute test (i.e. "every step" and not just "reasonable steps"), and recent case law suggests that the burden of proof is on the directors to demonstrate that they did so. 

Further, a director seeking to rely on this defence must be able to demonstrate that continuing to trade was designed not only (a) to decrease the company's net deficiency but also (b) to minimise loss to individual creditors whilst ensuring that any new creditors were paid in full. The court can, therefore, consider loss, or disproportionate loss, caused to individual creditors (so that, for example, where trading has continued and pre-existing creditors have been paid over the period but unpaid debts have been incurred to new creditors, the defence may not be available).

Difference between the Creditor Duty and the Wrongful Trading regime

Lord Reed’s judgment in Sequana (at [94]) highlights the main differences between the “wrongful trading” regime and the creditor duty:

  • The creditor duty arises at an earlier stage, when a company is bordering on insolvency or insolvency is imminent or probable rather than when the directors know or ought to know that there is no reasonable prospect of avoiding insolvent liquidation or administration.
  • Knowledge of the directors is not required to trigger the creditor duty (see further below the differing views of other members of the court on this point).
  • The subjective duty to act in good faith in the interests of the company is a far less onerous burden on the directors than the requirement to minimise losses to creditors, which is judged objectively.
  • The range of equitable remedies for breach of duty by directors is much broader than the order to contribute available in cases of wrongful trading.
  • Proceedings for breach of duty by directors do not need to wait until the company is in insolvent liquidation or administration.
  • Whereas a wrongful trading claim vests in the company’s liquidator or administrator (which could be assigned to a third party), breach of duty claims against directors could potentially be brought by the company, its assignee, a shareholder suing derivatively, or a creditor under section 212 of the Insolvency Act.
  • Remedies for breach of duty by directors can extend to persons other than directors (including recipients of payments made in breach of the duty).

Interests of shareholders and creditors in conflict

Lord Hodge in Sequana (at [238]) outlines an example of how the interests of shareholders and creditors may come into conflict in the zone of insolvency. In his example, the directors undertake a risky transaction in the hope of restoring equity value to an otherwise insolvent company, knowing that any loss will fall on the creditors if it fails. 

The key difference from the “wrongful trading” regime is that the breach of duty claim will arise when insolvency is more likely than not, rather than when there is no reasonable prospect of avoiding it.

Payment of a dividend

Another obvious case in which the interests of shareholders and creditors may conflict is when a dividend is paid, as was the case in Sequana. Directors may be liable for the payment of an unlawful dividend (Bairstow v. Queens Moat Houses [2001] EWCA Civ 712), and the Court of Appeal in Sequana ([2019] EWCA Civ 112) confirmed that, as against the recipient, a lawful dividend can be challenged as a fraudulent preference under section 423 of the Insolvency Act (see [38], [41], [50], [58]–[64], [66], [74], [75], [88], [89], [104], [237]–[239]). The effect of the Supreme Court’s decision in Sequana was to find that the directors were not liable in respect of the payment of the dividend, because the creditors’ duty had not yet arisen. An alternative argument, that a dividend constituting a fraudulent preference “involved for that reason alone a breach of duty” was not pursued in the Supreme Court – which Lord Briggs described as “an irony of the present case” (at [182]). It is possible that this point is still open, although the Court of Appeal, while refusing a belated attempt to plead this case, did indicate its view that such a case would fail, as it would be open the shareholders to ratify the dividend at a time when the creditors’ duty had not arisen (see from [126]).   

Knowledge and practical steps for directors

Lords Briggs, Kitchin, and Hogg indicated that the trigger was either an insolvency which the directors know or ought to know is around the corner and going to happen, or the probability of an insolvent liquidation or administration about which the directors know or ought to know (see [203], [231] and [238]). Lord Reed was less certain whether it was essential that 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 (from [90]). He noted that “It should be borne in mind that directors are under a duty to inform themselves about the company's affairs (In re Westmid Packing Services Ltd (No 3) [1998] 2 BCLC 646, 653); and the rule in West Mercia will itself incentivise directors to keep the solvency of the company under careful review.”

Lady Arden viewed the rule as comprising two parts [279]. At the point where a duty to consider the interests of creditors (and not to harm them) had arisen, the onus would be on the directors to show that they were not aware of the company’s position if they wished to be excused from liability. At the point where the interests of creditors become paramount, the level of knowledge required would be close to that under section 214 of the Insolvency Act 1986 [280]. In that context, Lady Arden had the following guidance for directors [304]:

Directors should always have access to reasonably reliable information about the company’s financial position. 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.

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

[1]See sections 214 and 246ZB of the Insolvency Act.
[2]See sections 170 to 177 and Chapter 2 of Part 10 of the Companies Act 2006, which generally preserve/codify the general law duties including this one.
[3]West Mercia Safetywear Ltd (in liq) v Dodd [1988] BCLC 250 - that the company's interests are taken to include the interests of its creditors as a whole. The duty remains the director's duty to act in good faith in the interests of the company.