The point of no return: Supreme Court clarifies and recasts the duties of directors to creditors

Adam Chaffer
Associate, Dispute Resolution

The Supreme Court’s landmark decision of BTI 2014 LLC v Sequana SA [2022] UKSC 25 has heralded the most significant development in the role of duties of directors since the enactment of the Companies Act 2006. The decision of the court reflects the difficult balancing exercise between the interests of shareholders and creditors in a financially distressed business and provides some clarity and guidance on an important aspect of directors’ duties relevant to those managing and advising companies.

Background
In May 2009, the directors of AWA made a lawful dividend payment to its only shareholder, Sequana SA. In doing so it extinguished a significant part of a debt owed by AWA to Sequana SA. When the dividend was made AWA was both balance sheet and cash flow solvent, however, it had an outstanding liability of an unknown value in respect of remedial work associated with pollution. That liability posed a real risk of insolvency but when the dividend was made that risk was neither imminent nor probable. In October 2018, AWA went into administration with the pollution liability outstanding. BTI 2014 Ltd (‘BTI’), sought to recover the liability from the dividend payment.

Decision of the Supreme Court
The Supreme Court dismissed the appeal brought by BTI on the basis that while the decision of the directors of AWA to pay a dividend was otherwise lawful it could not have breached the creditor duty at the time because the company was neither in actual or imminent insolvency nor was insolvency even probable. The creditors duty only crystalises in a scenario where there is a real risk of insolvency whereas when the lawful dividend was made by AWA there was only a remote risk of insolvency which was not sufficient to trigger the decision creditor obligation.

Commentary
The overarching issue for the Supreme Court was to consider was the circumstances in which a company director must exercise their duties under section 172 of the Companies Act 2006, with regard to the creditors, in contrast to the normal position of the interests of the shareholders. On this point, the Supreme Court was asked to determine three substantive issues which are relevant to the question of directors’ obligations to creditors:

1. is there a common law creditor duty at all?

2. what is the content of the creditor duty?

3. when is the creditor duty engaged?

4. can the creditor duty apply to a decision by directors to pay an otherwise lawful dividend.

The statutory duty for directors is to act in a way which they consider, in good faith, would most likely promote the success of the company for the benefit of the collective shareholders. It is settled law that there is also a duty to have regard to the interest of creditors as set down in section 172(3) of the Companies Act 2006:

"subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company"

This obligation originates from the common law, and on this point the Supreme Court affirmed the earlier decision of West Mercia Safetywear Ltd (in Liquidation) v Dodd [1988] BCLC 25. It is further supported from the persuasive perspective in other common law jurisdictions including Australia and New Zealand. This creditor duty, however, is not a standalone duty but a modification of the wider directors’ duties to the company. This creditor duty obligation as a matter of economic policy increases when a company is nearing insolvency with the court observing:

"Where the company is insolvent or bordering on insolvency but is not faced with an inevitable insolvent liquidation or administration, the directors’ fiduciary duty to act in the company’s interests has to reflect the fact that both the shareholders and the creditors have an interest in the company’s affairs. In those circumstances, the directors should have regard to the interests of the company’s general body of creditors, as well as to the interests of the general body of shareholders, and act accordingly. Where their interests are in conflict, a balancing exercise will be necessary."

The Trigger Event
There is no precise wording as to when the creditor duty arises, however, it is accepted that the more significant the company’s financial difficulties the greater weight the directors should give the interests of the creditors over the interest of shareholders in striking the balance where their interests conflict with each other. Despite this acceptance, the opinions of the individual justices differed on the precise moment.

In this regard, Lord Briggs (with whom Lord Kitchin agreed) the moment arose when insolvency was ‘imminent’ (taken to mean, ‘just around the corner and going to happen’) or ‘probable’. Lord Reed took the view that it arose when the company was ‘insolvent or bordering on insolvency, or that an insolvent liquidation or administration is probable’ which Lady Arden concurred with and added that further applied when, ‘the directors plan to enter into a transaction in question would place the company in one of those situations.’

The Court did not make a decision on the scope of the director’s knowledge or constructive knowledge as an indicator of the intention to trigger the obligation which is likely to lead to further judicial consideration in the future.

What does the scope of the duty to creditors entail
The content of the creditor’s duty was given some consideration by Lady Arden who considered that directors are not required to act for the benefit of creditors but rather the requirement was not to harm those interests. This point was not considered by the other justices in their judgments. The scope of the creditor duty remains a difficult question and which is clearly a subjective point turning on the facts of each case. It is also an issue which would warrant further judicial treatment at an appropriate juncture.

Was the creditors’ duty engaged in the facts on this case?
While the creditor duty can apply to a decision by directors to pay a dividend which is otherwise lawful, for two reasons. First, the provisions on distribution as contained in Part 23 of the Companies Act 2006 is subject to any rule of law to the contrary. The creditor duty is a common law principle and is enshrined in section 172(3) of the 2006 Act, and it is not excluded by Part 23. While a decision to pay a dividend is lawful under Part 23 it may still be taken in breach of the creditor duty since the rules on distribution identifies profits available for distribution on a balance sheet basis. Therefore it cannot be the case that directors of a company which is cash flow insolvent and in itself unable to pay its debts as they fall due could lawfully distribute a dividend.

Applying the rationale of the court to the case for AWA, the court unanimously took the view that the creditor duty was not engaged in AWA. This is because, at the time the dividend was paid the was neither actually nor imminently insolvent nor was insolvency even probable. The creditor duty was therefore not triggered and there can therefore be no breach of an otherwise untriggered duty.

Practical Considerations
The decision of the Supreme Court in practice means directors are likely to need independent advice in circumstances where the company is approaching a trigger event which crystalises the duty to have regard to the creditors’ interests.

From review the judgment of the Supreme Court, there are five commercial points which directors can take away from the decision which will assist businesses in who are facing financial distress:

1. all businesses would benefit from having ‘stress test review’ to monitor how the operations of the business will react in times of challenge. This review should map out the response to that moment when a director’s obligations may switch from acting in the best interests of the company to the creditor duty which was discussed in the Supreme Court decision.

2. holistically, the directors of a company which is facing financial stress need to be appraised of the financial position. A proactive board of directors may wish to monitor the situation through regular board meetings in which financial and operational information can be assessed and discussed. In an insolvency situation there is a likelihood that the decisions of directors will be retrospectively reviewed as such directors may wish to contemporaneously document why decisions were made so that this can be evidenced.

3. directors may wish to review key contracts taking into account any commercial risks which could add further pressure on businesses. A similar approach may be beneficial with the business’ financial instruments. Separate to the business those directors who have personal guarantees may wish to review these and seek legal advice on the risks associated with such obligations with a financially distressed company.

4. consider and where appropriate engage with stakeholders; including financial lenders, suppliers, landlords, customers and employees to ensure that there is a healthy, purposeful and regular dialogue.

5. the key consideration for a director is to be mindful of the opportunity and benefit of seeking specialist financial and legal advice. It is worth noting that this advice is likely to evolve as the circumstances in the business develop which may necessitate review and appraisal of the advice at appropriate junctures. This advice should be separate and distinct to the advice which could be given to a company.

Conclusion
The decision of the Supreme Court shows that the directors’ duties have become a spectrum from which the norm remains the requirement to act in the best interests of the members of the company to the need where applicable for directors to act in the best interests of the creditors rather than treating these as two separate isolated points of consideration. Although less helpful, it is important for directors to be aware that the Supreme Court made clear that this is a developing area of law with a significant amount of what was discussed being commentary rather than binding legal rules. This is an indicator that further cases will shape this area of law and with that further clarity and insight will be gained.

Additional Information
If you require further advice on the points discussed in this article in relation to your business or a company associated with your business then please contact Lucy Gray, Neil Harrold or Adam Chaffer.

The law contained in this article is up to date and accurate as of the 10 October 2022.