A much-anticipated UK decision confirms directors' obligations to creditors, but changes little in practice
When directors should consider the interests of creditors is ultimately a judgment call which is only truly scrutinised in the sometimes harsh light of 20/20 hindsight in a subsequent administration or liquidation. So best practice for boards of stressed English companies is to manage the risks to directors by considering creditors' interests too soon (rather than too late). When boards consider the potentially different interests of creditors and shareholders early, it is also often the case that there is substantial alignment. Plus, having been through this exercise helps a board to formulate sensible and prudent contingency planning by identifying points in the future where interests may diverge.
Since March 2019, firms across the City have referred to the test used by Lord Justice David Richards in the Court of Appeal in BTI v Sequana that creditors' interests are engaged when it is likely (meaning probable) that a company will become insolvent. The majority in the Supreme Court has now:
- affirmed the existence of the duty to consider the interests of creditors;
- clarified that it is engaged where 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;
- explained that where interests of creditors are engaged and diverge from those of shareholders:
- if liquidation is inevitable, creditors' interests are paramount; and
- prior to that, there will be a fact sensitive balancing exercise to weigh up the competing interests by reference to the degree of distress.
Here, the decision is likely to mean little practical change for boards of stressed businesses following existing best practice. There may be scenarios where there is a practical difference between the Supreme Court and Court of Appeal tests. These are however likely to be rare. As before:
- Board decision-making around material transactions (for example, payment of dividends and mergers & acquisitions) should be properly documented even before the creditor duty is engaged (albeit taking care not to inadvertently overstate the proximity of insolvency).
- Close monitoring of the company's financial position will ensure directors are better positioned to respond to periods of turbulence and adapt to changing (and competing) stakeholder demands.
- Boards should consider engaging professional advice sooner rather than later. In the first place, the right advice may help to avert a distress scenario from ever arising (or from worsening); but failing that, since there is statutory relief for directors who have acted honestly and reasonably in the circumstances, evidence of reliance upon independent advice could make all the difference. It may also be relevant to the question of breach.
- Consider shareholder ratification – although shareholders cannot ratify director decisions once the creditor duty is engaged, it is available before that point. So in cases of uncertainty, it may be better to err on the side of caution.
- Directors should ensure appropriate insurance cover is in place and premium payments are all up to date – if all else fails, litigation can become very expensive and personal liability significant. The right directors and officers insurance policy, for example, may help to limit that potential exposure.
Sometimes, momentous decisions are most important for what they do not do. Directors can take some comfort that the Supreme Court has declined to hold that the duty to have regard to creditors' interests is engaged where there is only a risk of insolvency – since doing so would have increased the scope for potential personal liabilities where companies encounter distress.
We previously considered the background to this case here in the context of the Court of Appeal's ruling in these proceedings in early 2019. However, broadly, and as set out in the Supreme Court's judgment:
- In May 2009, the directors of a UK limited company, AWA, caused it to distribute a dividend of €135m to its only shareholder, Sequana SA ("Sequana"). It was common ground that the dividend was lawful (in the sense of complying with the applicable statutory regime regulating the payment of dividends) and was distributed at a time when AWA was solvent.
- At the time the dividend was paid, AWA had a contingent liability on its books in respect of clean-up costs relating to the pollution of the Lower Fox River in Wisconsin. The value of this liability was highly uncertain and, as such, this gave rise to a real risk, although not a probability, that AWA might become insolvent at some (uncertain but not imminent) point in the future. A third party, BAT Industries Plc ("BAT"), had agreed to guarantee that liability.
- It later transpired that AWA's clean-up costs were significantly greater than originally anticipated and it became insolvent as a result (some 10 years after the dividend).
- BAT, as AWA's main creditor, sought to have the dividend set aside under section 423 of the Insolvency Act 1986 on the basis that as a result of it being at an undervalue it constituted a transaction defrauding creditors. Although at first instance (and on appeal) BAT was successful, Sequana itself went into insolvent liquidation and no part of the dividend was repaid.
- In parallel, BTI 2014 LLC ("BTI"), an assignee of AWA's claims, brought proceedings against AWA's directors on the basis that their decision to pay the May dividend was a breach of their duty to consider the interests of the company's creditors.
- BTI failed against the directors at first instance and appealed to the Court of Appeal.
THE COURT OF APPEAL DECISION
As set out in our previous briefing, the Court of Appeal dismissed BTI's appeal.
Delivering an extensive judgment following a thorough review of the authorities, Lord Justice David Richards (as he was then) posited four potential points in time at which the duty that directors owe to the company to have regard to creditors' interests (otherwise referred to as the "creditor duty") could in principle be engaged: (1) upon actual insolvency; (2) upon imminent insolvency ("on the verge of insolvency" or "near-insolvent"); (3) where insolvency is more likely than not ("likely to become insolvent" or "of doubtful solvency"); and (4) where there is a realistic prospect of insolvency ("as opposed to a remote risk").
Preferring the third of these tests, David Richard LJ concluded that the creditor duty is engaged when the directors know or should know that the company is or is likely to become insolvent, with "likely" meaning probable.
As such, since it could not be said that AWA was likely to become insolvent at the time it paid the dividend to Sequana in May 2009, the directors were not in breach of the creditor duty – that duty was never engaged. Notably, the Court of Appeal left open, for these purposes, whether, once the duty is engaged, creditors' interests are paramount or are merely one factor to be considered without being decisive.
BTI obtained leave to appeal to the Supreme Court.
THE ARGUMENTS BEFORE THE SUPREME COURT
Before a Supreme Court made up of five sitting justices, Lords Reed, Hodge, Briggs and Kitchin and Lady Arden, the appellant, BTI, argued that the Court of Appeal had erred in its conclusion as to the applicable test for when the creditor duty is engaged. The appellant argued that a "real risk" of insolvency is sufficient to engage that duty.
The respondent directors, on the other hand, argued that the Court of Appeal was wrong to conclude: (a) that a creditor duty existed at all; and (b) that, if it did, that duty (i) could apply to a dividend which was otherwise lawful; or (ii) could be engaged short of actual, or possibly imminent insolvency. In the alternative, the directors argued that the Court of Appeal was right to hold that a real risk of insolvency, falling short of a probability, would not engage the creditor duty.
There were therefore four issues before the Supreme Court:
- Is there a common law creditor duty at all?
- If so, when is the creditor duty engaged?
- What is the content of the creditor duty?
- Can the creditor duty apply to a decision by directors to pay an otherwise lawful dividend?
THE SUPREME COURT DECISION
The Supreme Court justices were unanimous in their dismissal of BTI's appeal on the grounds that, although a duty to consider the interests of creditors does indeed exist, a "real risk" of insolvency is not sufficient.
On the contrary (in the majority's view) the creditor duty is only engaged when 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.
We summarise below the Supreme Court's findings on each of the four questions before it:
(1) Is there a common law creditor duty at all?
Under section 172(1) of the Companies Act 2006, directors are required to act in a way which 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. It codified the long-established common law fiduciary duty to act in good faith in the best interests of company, implementing the recommendations of the Company Law Review Steering Group ("CLRSG") (an independent review body established in 1998 to make recommendations for the reform of company law).
According to Lord Reed (with whom the other justices agreed), although commonly referred to as the "creditor duty", there is in fact no duty owed to creditors, or any duty separate from the directors' fiduciary duty to the company. As to this, Lady Arden observed that there exists no rule of law which entitles creditors, either directly or derivatively though the company, to sue the directors if they do not comply with the creditor duty: "In fact, the creditors can neither sue for a breach of it nor recover any losses that ensue for breach. The remedies are those for a breach of the duty under section 172(1). Accordingly, any financial award resulting from a breach of the obligations owed in relation to creditors would inure for the benefit of the company, not for the creditors who were harmed by the breach..."
As Lord Reed went on to explain, there is a rule which modifies the ordinary position under section 172(1) such that, when it applies, the company's interests for the purposes of that section are to be taken to include the interests of its creditors as a whole.
The justification for this finding of the existence of the creditor duty was essentially threefold:
- Historic cases: although, as the Court observed, this was the first time it had been asked to decide whether there are circumstances in which directors must act in, or at least consider, the interests of creditors, the existence of the duty, it said, is supported by a long line of authority in the lower courts (and also from New Zealand and Australia). Among the cases considered, particular reliance was placed on the decision in West Mercia Safetywear Ltd (in liq) v Dodd  BCLC 250, being (as Lady Arden put it) the "only relevant decision at appellate level" (albeit it is worth also noting Lady Arden's further comment that: "Until this appeal, it was not clear what West Mercia does decide, and in some respects the Rule in West Mercia will remain unclear even after these judgments".)
- Affirmation in Statute: according to the majority, Parliament confirmed the existence of the creditor duty by enacting sub-section 172(3) of the Companies Act 2006, which states that the duty in section 172(1) "has effect 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". Notably, Lady Arden, who had been a member of the CLRSG but was nevertheless in the minority on this point, rejected the majority's contention that Parliament had intended to legislate for such a duty by virtue of section 172(3): "If it had done so, it would have to have defined the content of the duty and the time when it arose" (which it had not).
- Commercial Justification: in ordinary circumstances where the company is stable and is able to pay its creditors in a timely manner, then the interests of the company's shareholders as a whole can be treated as the company's interests for the purposes of the duty under section 172(1). Indeed, as Lord Reed put it, in those circumstances "it is the shareholders whose interests are affected by fluctuations in its profits and reserves, as they are the persons entitled to share in its distributions and its surplus assets". For so long as the company remains stable, the interests of creditors should in principle be more or less aligned with that of the company's shareholders since both have a vested interest in the continued financial performance of the company; the former, insofar as the company remains able to pay its debts as they fall due, and the latter insofar as the company's continued profitability optimises shareholder value. The directors, Lord Reed observed, will also need to be mindful of the creditors in any event if they are going to act in the company's interests, since if the company is not able to pay its debts as they fall due, its reputation and creditworthiness will suffer, in turn inhibiting its ongoing ability to do business. However, as Lord Reed went on, where financial stability persists "the creditors' interests do not require to be considered as a discrete aspect of the company's interests for the purposes of the directors' fiduciary duty to the company." That position, on the other hand, changes in an insolvency scenario – in this case, "the company's creditors as a whole become persons with a distinct interest…in its affairs, as they are dependent on its residual assets, or on the possibility of a turnaround in its fortune, for repayment" (per Lord Reed at para 48). This – namely the shift in relative economic interests where the company is insolvent or nearing insolvency – provides the commercial justification for acknowledging a creditor duty.
Notably, all justices agreed that the shareholder authorisation or ratification principle (namely, that outside of insolvency, the shareholders are entitled to authorise or subsequently ratify the conduct of the directors) does not prevent the recognition of the creditor duty. Where the directors are under a duty to act in good faith in the interests of the creditors, the shareholders cannot authorise or ratify a transaction which is in breach of that duty. This is because there can be no shareholder ratification of a transaction entered into when the company is insolvent, or which would render the company insolvent. The Court also held that there is no conflict between the creditor duty and section 214 of the Insolvency Act 1986, which deals with wrongful trading and only applies in circumstances where the director knew or ought to have concluded that there was no reasonable prospect that the company would avoid insolvent liquidation (per section 214(2)(b)). Indeed, in the view of Lord Hodge, "there may be more egregious circumstances in which the absence of a remedy beyond section 214 would appear to be a lacuna in our law".
(2) When is the creditor duty engaged?
As noted above, the majority held that the creditor duty is engaged where 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.
As Lord Briggs explained, the idea that a real risk of insolvency is an appropriate trigger for the creditor duty "rests upon an unsound principle" – namely, "it assumes that creditors of a limited company are always among its stakeholders, so that once the security of their stake in the company (i.e. their expectation of being repaid in full) is seen to be at real risk, there arises a duty of the directors to protect them…The true principle by contrast is that creditors (or at least unsecured creditors) are not the main stakeholders in the company at any earlier date than when it goes into insolvent liquidation".
Although Lord Reed and Lady Arden agreed with the majority's characterisation of the relevant threshold, they were prepared to leave open the question of whether knowledge on the part of the directors is an essential element of the test. In the event, that question did not arise on the facts since it was clear that AWA had not met the relevant threshold.
In terms of what is meant by the word "insolvency" for the purposes of the foregoing test, it was accepted that the Court had heard no submissions on this point. However, Lord Reed was of the view that it means balance sheet and/or cash flow (or commercial) insolvency. There is also scope for argument following comments of Lady Arden and (potentially) Lord Briggs that "insolvency" for these purposes excludes what is referred to as a form of "temporary commercial insolvency" (giving the example of what directors may consider to be a temporary cash-flow shortage as the result of an unexpected event, like the covid-19 pandemic).
(3) What is the content of the creditor duty?
Although the content of the creditor duty did not need to be determined because, on the facts, it was held not to have been engaged, the following principles (albeit obiter) emerge from the Supreme Court's consideration of that content:
- Where the company is insolvent, or bordering on insolvency, but is not faced with an inevitable insolvent liquidation or administration, the interests of creditors should be balanced against the interests of shareholders where they may conflict. Per Lord Reed, the more "parlous" the state of the company, the more the interests of the creditors will "predominate" and the greater the weight which should therefore be given to their interests as against those of the shareholders.
- As Lord Briggs put it, before liquidation becomes inevitable, how to balance the relative interests of creditors and shareholders is a fact sensitive question: "Much will depend upon the brightness or otherwise of the light at the end of the tunnel; i.e. 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, or back out of actual insolvency. It may depend upon a realistic appreciation of who, as between creditors and shareholders, then have the most skin in the game; i.e. who risks the greatest damage if the proposed course of action does not succeed."
- The position changes on the other hand where an insolvent liquidation or administration is inevitable (or the company is "irretrievably insolvent"). In that case, the creditors' interests become paramount as the shareholders cease to retain any valuable interest in the company. According to Lord Briggs, this happens at the same point that section 214 of the Insolvency Act 1986 (wrongful trading) becomes engaged.
- Notably, Lord Briggs offered the following illustration in opposition to the suggestion that creditors' interests should be treated as paramount at any earlier moment in time: "Why should the directors of a start-up company which is paying its debts as they fall due but is balance sheet insolvent by a small margin abandon the pursuit of the success of the company for the benefit of its shareholders? And why should the directors, faced with what they believe to be a temporary cash-flow shortage as the result of an unexpected event, like the present pandemic, give up the pursuit of the long-term success of a fundamentally viable, balance sheet solvent, business for the continuing benefit of shareholders?"
- Going further than the others, in Lady Arden's view, where the creditor duty is engaged, "directors must not only consider creditors' interests but not materially harm them either (and this protects against 'insolvency-deepening activity')."
- The interests of "creditors" are the interests of creditors as a general body; indeed, the directors are not required to consider separately the interests of particular creditors in a special position (e.g. because they are subordinated or long-term or contingent creditors). While there is nothing new about this particular proposition, it nevertheless does little to resolve the question we have raised elsewhere (see here) regarding the challenges of reconciling the duty to consider the interests of the company's creditors as a whole with the new offences introduced in 2021 by the Pensions Regulator concerning conduct materially detrimental to defined benefit pension schemes. As we have previously suggested, there presently exists a clear tension in how directors will consider creditors' competing interests in circumstances where the prospect of regulatory sanctions will mean that directors may pay closer attention to the impact of their decisions on a defined benefit pension scheme than how those decisions impact other creditors.
(4) Can the creditor duty apply to a decision by directors to pay a lawful dividend?
Again, this question did not need to be determined since the creditor duty was found not to have been engaged. However, the Supreme Court noted that, in principle, the creditor duty can apply to a decision by directors to pay a dividend which is otherwise lawful, for two reasons:
- First, Part 23 of the Companies Act 2006 (which regulates the payment of dividends) is stated as being subject to any rule of law to the contrary (see section 851(1)). Given that the creditor duty is part of the common law, it is therefore not excluded by Part 23.
- Second, under Part 23 whether profits are available for distribution is determined on a balance sheet basis. However, it is possible for a company to have a balance sheet surplus while at the same time being cash flow (or "commercially") insolvent. Per Lord Briggs: "It cannot be the case that directors of a company already unable to pay its debts as they fall due could distribute a dividend, or do so if the consequence of the payment was to bring about cash flow insolvency. To do so in those circumstances would be to take a foolhardy risk as to the long-term success of the company, by exposing it to the real risk (or at least a gravely increased risk) of being wound up."
The latest formulation of the test set out by the Supreme Court will see an amendment to model forms in many law firms across the City – and has already seen a considerable amount of electronic ink spilt on LinkedIn.
Directors can take comfort that the Supreme Court recognises the inherent risk taken by creditors of limited liability companies and has not sought to protect creditors by extending directors' personal liability to an earlier point in time (i.e. where there is only a mere risk of insolvency). In this sense, the decision is likely most significant for the submissions it rejected.
Directors' judgment calls however remain difficult where they are required to assess where on the "sliding scale" of insolvency the company is presently positioned so as to determine where the balance of competing interests between the company's various stakeholders should lie. As Lady Arden noted in her judgment: "the progress towards insolvency may not be linear and may occur not as a result of incremental developments but as a result of something outside the company which has a sudden and major impact on it." Indeed, despite best-laid plans, directors may still face significant challenges when it comes to identifying and responding promptly and effectively to circumstances which may threaten the existence of the company so as to minimise the risk of personal liability. But at the very least, the Supreme Court has declined to increase the load on directors in those circumstances.