13 January 2023

A Balancing Act – when do directors owe a duty to creditors?

On 5 October 2022, the Supreme Court handed down its long-awaited judgment in the case of BTI v Sequana. The decision, described as “momentous” for company law, has provided much-needed clarification on the duty owed by company directors to creditors.

Understanding your duties as a director is a precondition of the role (for a general overview of your general duties, see here), but being aware of the transition between acting for the benefit of a company’s members and its creditors is even more significant given the current economic uncertainties.

In summary, the key points to come out of the recent decision are:

  • The creditors’ duty is engaged later in the insolvency process than previously thought.
  • Directors should weigh the interests of the company’s creditors against those of its shareholders, engaging in a balancing exercise where these interests come into conflict.
  • The closer a company is to insolvency, the more significant the interests of its creditors become.
  • It remains crucial that directors continue to keep themselves fully informed and up to date with company affairs, documenting the reasons for significant decisions affecting the company.
  • As soon as it becomes apparent that a company is facing financial difficulties, the directors should seek independent legal advice.

Background

In 2009 the directors of a company called AWA paid a dividend of EUR 135 million to its sole shareholder, Sequana SA (“Sequana”).

  • At the time the dividend was paid, AWA was solvent on both a balance sheet and cash flow basis but had a contingent liability of an uncertain amount which related to the clean-up costs of a Wisconsin river. Consequently, there was a real risk that AWA might become insolvent in the future, although insolvency was not imminent, or even probable, at the time.
  • The clean-up costs were much higher than anticipated and AWA entered insolvent administration, albeit almost ten years after the payment of the dividend. BTI (as assignee of AWA’s claims) sought to recover the dividend from AWA’s directors on the grounds that they had made the payment in breach of their common law duty to have regard to the interests of the company’s creditors.
  • Both the High Court and the Court of Appeal rejected this claim. The Court of Appeal found that the creditor duty was not triggered until a company was either insolvent, on the brink of insolvency or probably headed for insolvency. Since AWA was not insolvent or on the brink of insolvency in 2009, BTI’s claim failed.
  • BTI appealed this decision to the Supreme Court, arguing that the real risk of AWA’s future insolvency triggered the directors’ duty to act in the interests of the company’s creditors rather than its shareholders. They lost (again).

The Supreme Court considered whether such a creditor duty exists, the point at which the duty is engaged and how the duty operates once the trigger point has been reached.

What is the creditor duty?

Directors are subject to various statutory and common law duties, with the main statutory duties being set out in the Companies Act 2006 (CA 2006). Generally, these duties are owed to the company, and not to the shareholders. Possibly the most over-arching of the statutory duties is the duty for directors to promote the success of the company; directors must act in the way that they consider, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole.

So, where does the creditor duty come in? The creditor duty actually stems from a common law rule that a director’s duty to promote the success of the company is modified where the company is facing insolvency, such that the interest of the company’s creditors must be considered rather than the interest of its shareholders.

This common law duty is reflected in section 172(3) CA 2006, which states that a director’s duty to promote the success of the company is subject to any enactment or rule of law requiring directors to consider or act in the interests of the company’s creditors, i.e. in an insolvency situation, the directors must consider the creditors’ interests rather than just the shareholders’.

Although the existence of the creditors’ duty is not in doubt, uncertainty has arisen in the past as to when the creditor duty would be triggered and how this duty interplays with the duty to members. The Supreme Court has now shed some light…

When is the creditor duty triggered?

The majority decision of the Supreme Court found that the creditor duty arises when the directors know or ought to know that the company is:

  1. actually insolvent (either on a balance sheet or cash flow basis);
  2. bordering on insolvency, i.e. insolvency is both imminent AND inevitable; or
  3. likely to go into insolvent liquidation or administration.

The Supreme Court held that, upon the occurrence of one of these trigger events, the board should become mindful of the interests of the company’s creditors alongside the interests of the shareholders. Prior to the judgment, it had been suggested that the duty to creditors, once engaged, would completely override the interests of the shareholders, i.e. the interests of the shareholders and creditors were mutually exclusive. The Supreme Court however did not consider this to be the case; instead, the interests of the creditors should be weighed against the interests of the shareholders, with the directors engaging in a balancing exercise where these interests come into conflict. However, the nearer towards insolvency the company tips, the more significant the interests of the creditors become.

This creates, in effect, a sliding scale following the point of engagement of the creditor duty. The more serious a company’s financial difficulties become, the more weight the directors should place on the interests of the creditors until such time as insolvency becomes inevitable and the creditors’ interests override those of the shareholders entirely.

Practical implications

The Supreme Court’s judgment makes clear that the creditors’ duty is engaged later in the insolvency process than previously thought, i.e. when insolvency is imminent AND inevitable, not simply likely to happen. Given this later point of engagement, the board must continue to focus on the shareholder interest and even when the creditors’ interest comes into play, the shareholders’ interest may still be of relevance on the sliding scale basis. Directors should remain mindful of the need to reasonably consider the interests of both creditors and shareholders and undertake a balancing exercise where they begin to differ.

Such a balancing act will need to be undertaken throughout the insolvency process. One can envisage, for example, that when the creditor duty first kicks in near the start of the process, that the interests of creditors and shareholders may well be fairly equally aligned, whereas the nearer the company moves to actual insolvency, the wider apart they may become. What may be a sensible and reasonable step for all stakeholders early on, may not be so further down the insolvency line.

The judgment also raises an important issue in relation to the significance of a directors’ knowledge at the point of insolvency. Although refusing to reach a definitive conclusion as to whether directors are to be judged on whether they knew (or ought to have known) that the threshold for engaging the creditor duty has been reached, it was observed that directors are obliged to keep themselves fully informed and up to date with company affairs. This should not come as a surprise to any director, but a gentle reminder is always worthwhile. While directors cannot run a business single-handedly and will need to delegate certain aspects, this is not an excuse for a director to deny all knowledge.

The Supreme Court also acknowledged that insolvency is not a straightforward process and that the financial position of a company can fluctuate significantly before insolvency becomes inevitable. It is advisable to make and retain a written record of decisions made and why, including any key points of debate and the conclusions reached. This should be standard protocol at any board or board committee meeting, including when the financial position of the company is strong, but becomes even more important when times for the business are not so good.

Further considerations:

  • Ratification – Shareholders, acting unanimously, can usually ratify the directors’ breach of duty but they cannot do so if the company is insolvent. As such, shareholders cannot ratify a breach of the creditor duty.
  • Groups of creditors – The Supreme Court emphasised that it is the general body of creditors whose interests must be considered by the directors. How this will pan out where there are different creditor groups (e.g. secured and unsecured creditors) remains to be seen and further case law may be needed to resolve the potential conflict here.
  • Start-ups – Often, start-ups will be balance sheet insolvent simply because they need to spend a lot of capital. Although it is arguable that the creditor duty will apply to this type of technical insolvency, the balancing act concept should help here. We consider it unlikely that the courts will view the test as meaning that start-ups can’t take risks, always assuming that decisions have been made properly.

Summary:

Although the Supreme Court decision clarifies that the duty to creditors kicks in later down the line than previously thought and potentially enables directors to try and “rescue” the company without having to be too cautious about falling foul of the creditor duty, the practical implications for company directors do not appear to have changed too much. It remains the case that directors should:

  • continue to pay close attention to the operation, including the financial position, of the business
  • document significant decisions made by the company and the reasons for them
  • obtain independent legal advice as soon as it becomes apparent that the company is facing financial difficulties

Disclaimer

This note reflects our opinion and views as of 13 January 2023 and is a general summary of the legal position in England and Wales. It does not constitute legal advice.

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