The Pain of Insolvency for Creditors – Can It Be Scaled?

Monday 24th October, 2022

The long-awaited Supreme Court judgment in the case of BTI 2014 LLC v Sequana SA and others [2022] UKSC 25 (“Sequana”) was handed down in early October. It is an important and extensive judgment for directors, insolvency practitioners and other stakeholders alike and is the first time the highest court in the land has considered and confirmed the existence, trigger point and meaning of the so-called “creditor duty”, which is also known as the “rule in West Mercia” after the case of West Mercia Safetywear Ltd v Dodd [1988] BCLC 250 (“West Mercia”).

Directors’ duties: the established position

Pursuant to section 172(1) of the Companies Act 2006 (“CA 2006”), a director must, among other things, act in the way they consider, in good faith, would be most likely to promote the success of the company for the benefit of its shareholders as a whole and, in so doing, have regard to a list of relevant factors. This duty is subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of the company’s creditors pursuant to section 172(3) of the CA 2006.

The West Mercia case confirmed that directors have a duty to consider the interests of creditors when the directors know, or ought to know, that the company is (or is likely to become) insolvent. However, it has always been unclear as to whether or not the interests of creditors become paramount at this point or if they merely have to be considered alongside the interests of shareholders.

Facts of the Sequana case

In 2009, the directors of a company called AWA declared, and caused AWA to distribute, a dividend to its sole shareholder, Sequana SA. This distribution was lawful (that is, declared and paid within the requirements of Part 23 of the CA 2006) and, at the time the dividend was declared and paid, AWA was solvent on both a balance sheet and a cash flow basis.

However, AWA also had existing contingent liabilities that were of an uncertain value, which the court found “gave rise to a real risk, although not a probability, that AWA might become insolvent at an uncertain but not imminent date in the future”. That risk became a reality nearly 10 years later in 2018 when AWA went into insolvent administration.

BTI 2014 LLC (“BTI“), as the assignee of AWA’s claims, sought to recover an amount equal in value to the dividend paid in 2009. BTI argued that the directors’ decision to declare and pay the dividend was in breach of their duty to consider (and act in accordance with) the interests of AWA’s creditors.

In the High Court, in the first instance, and later in the Court of Appeal, BTI’s argument failed. The case was appealed to the Supreme Court, the members of which considered the creditor duty in detail.

Directors’ duties: the decision of the Supreme Court in Sequana

The Supreme Court considered the existence of the creditor duty, the timing of the appropriate trigger of the creditor duty and its effect once triggered.

The existence of the creditor duty

The existence of the “creditor duty” was originally confirmed in the West Mercia case and later enshrined in statute by section 172(3) of the CA 2006. Sequana has further confirmed that the creditor duty exists, although not on a standalone basis, but rather as a modification of the ordinary fiduciary duty to act in good faith in the interests of the company under section 172(1) of the CA 2006. Where the duty under this section is engaged, the company’s interests are equivalent to the interests of the shareholders of the company as a whole. Specifically, this duty encompasses the interests of the creditors as a whole when the company is on the brink of insolvency or is in fact insolvent, but is not, as such, a duty owed directly to creditors.

Sequana also confirmed that the creditor duty can apply to the payment of a dividend that otherwise complies with Part 23 of the CA 2006 and/or the common law requirements in relation to the maintenance of capital, and a decision to make such a payment that is otherwise legal may nevertheless be in breach of the creditor duty.

The timing of the appropriate trigger of the creditor duty and its effect once triggered

As to when the creditor duty is engaged, there are two parts to the trigger:

  1. The first part of the trigger, where the company is:
    • insolvent (which refers to cash flow or balance sheet insolvency based on section 123 of the Insolvency Act 1986 (“IA 1986”)); or
    • bordering on insolvency; or
    • facing a probable, but not inevitable, insolvent liquidation or administration,

Means the directors should consider the interest of creditors, balancing them against the interests of shareholders where they may conflict. This has been described as a “sliding scale”, where the more serious a company’s financial distress, the greater the expectation will be for its directors to have regard for creditors’ interests.

  1. The second part of the trigger, where the directors know or ought to know that an insolvent liquidation or administration is inevitable (that is, the same basis for assessing whether directors have allowed their company to trade wrongfully pursuant to section 214 of the IA 1986), means the directors must treat the creditors’ interests as paramount.

The creditor duty is not engaged merely because a company faces a real (and not remote) risk of insolvency at some point in the future. Therefore, the creditor duty had not arisen on the facts of the Sequana case because, at the time when the dividend was declared and then paid, AWA was not actually or imminently insolvent, nor could its insolvency even be said to have been probable.

What does this mean for directors?

Although we expect that the Supreme Court’s findings will change little of the practical advice given to directors, this long-awaited judgment further substantiates the existence of the creditor duty under English law. It confirms the need for directors to be mindful of their company’s solvency position at all times to ensure that the interests of the company’s creditors and shareholders are balanced appropriately (or, moreover, that the interests of the creditors are prioritised where the financial troubles facing the company are more serious and imminent).

While key elements of the creditor duty arguably still remain unclear and open to interpretation (such as the meaning of “bordering on insolvency” and the meaning of other shades of insolvency risk on the “sliding scale”), on the plus side (for directors), it was clarified that the creditor duty is not triggered merely when a company faces a real risk of insolvency at some undetermined point in the future – this is now effectively just too remote.

However, the usual rules of caution arising from the duty to avoid wrongful trading should continue to apply. Directors should continue carefully to assess and analyse their company’s financial position on a regular basis and maintain a thorough, written record of their decision-making processes. The frequency of such assessments should increase as and when the concerns as to the company’s financial position deepen. Generally, the more serious a company’s financial distress, the greater the expectation will be for its directors to take steps in the interests of its creditors over and above the duty owed to its shareholders (whose ultimate interests inevitably decline the nearer it gets to insolvency). As ever, professional advice should be taken as appropriate.

 

The full judgment can be found here.

 

Should you have any questions concerning this case or require any advice in relation to any restructuring matter, please contact Brett Israel or Eleanor Mill of our Business Restructuring Group.