Company directors’ duty to creditors
In this guest article, Tim Matthews, Partner and general counsel for Moore Barlow, discusses the duty of a Company’s director and the legal circumstances to be upheld by the directors.
In the UK, directors have a duty to act in the best interests of the company and its creditors. This means that they must manage the company’s finances responsibly and ensure that the company meets its obligations to its creditors, such as paying debts in full and on time.
If a company is facing financial difficulties, company directors’ duties include taking appropriate steps to minimise the losses to creditors, such as seeking professional advice or restructuring the company’s finances.
If the company is unable to pay its debts, the directors must take steps to inform creditors and initiate insolvency proceedings, if appropriate. It’s important to note that directors can be held personally liable for failing to meet their duties to creditors, so it’s crucial for them to be aware of their responsibilities.
Supreme Court Case
There has been a very important case decided by the Supreme Court in relation to the issue of the duty of directors to creditors in relation to a company in an insolvency situation and whether the authorisation by directors of a substantial dividend was a breach of duty by the directors. The Supreme Court, in BTI 2014 LLC v Sequana SA  UKSC 25, have considered for the very first time:
- Whether a rule of law exists that gives rise to a duty requiring directors to consider or act in the interests of a company’s creditors, as contemplated by s 172(3) Companies Act 2006 (CA 2006); and
- If such a duty does exist, what is the precise scope and application of the duty?
The Supreme Court confirmed that directors indeed owe such a duty to their company in certain insolvency related situations (known previously as the rule in the West Mercia Safetywear case).
The court held that the creditor duty (owed to the company) applies 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.
However, in the absence of these two specific situations a position close to insolvency or which creates a risk of insolvency is not enough for the creditor duty to apply. As it turned out, although the duty has been acknowledged by the Supreme Court, the applicant, in this case, failed to prove that the duty applied on the facts of this case.
The background to the case
The facts were that during 2009, Arjo Wiggins Appleton Limited (AWA) paid an interim dividend of 135 million euros to its parent, Sequana SA, in order to extinguish an intra-group debt due from Sequana to AWA. At the time the dividend was paid, AWA had long ceased trading. Immediately after it was paid, AWA was both balance sheet and cash flow solvent. The assets of AWA exceeded its liabilities and the company was able to pay its debts as they fell due.
However, AWA had very large long-term contingent indemnity liabilities. The scale of its liabilities might only become clear after certain litigation in the US courts. The dividend in effect distributed all of the profits lawfully available for distribution under Part 23 CA 2006 on the basis of accounts which included a provision for those indemnity liabilities based on a best estimate at the time. However, if that best estimate in future proved too optimistic, AWA would become insolvent. As a result, there was a real risk that AWA might become insolvent at some point in the future.
AWA did in fact go into insolvent administration in 2018, nearly 10 years after payment of the dividend. BAT and BTI (the corporate vehicle of BAT, to whom AWA assigned its claims) together made claims in respect of the dividend on the basis that, among other things:
- It was not lawfully paid in accordance with Part 23 CA 2006.
- The directors’ decision to pay the dividend was in any event in breach of the creditor duty as the directors had not considered, or acted in accordance with, the interests of AWA’s creditors.
- The May dividend payment constituted a transaction that contravened s 423 Insolvency Act 1986.
In effect, BTI’s appeal to the Supreme Court raised the issue of the trigger for the creditor duty and the content of the duty. The courts below the SC had in fact dismissed the claim on the basis that the duty had not been triggered. In response to the appeal, the directors of AWA argued that there was in fact no common law duty under English law for directors to act in the interests of creditors.
They submitted that the decision of the Court of Appeal that first recognised the duty in West Mercia Safetywear Ltd v Dodd  BCLC 250 was wrongly decided and contrary to settled principle.
If the court accepted that such a duty did exist, they contended in the alternative that a lawful dividend could not be challenged on the basis of a breach of the creditor duty. They also contended that, in any event, the creditor duty was only triggered when a company’s insolvency was actual or imminent – neither a real risk of insolvency, nor likely insolvency, was sufficient to engage the creditor duty.
Supreme Court decision
The SC dismissed BTI’s appeal, holding that whilst the creditor duty does exist in English law in the facts of this case, it was not in fact engaged when the dividend was paid. Then on the key issues discussed by the SC there is essentially a majority view on the application of the duty, to be found largely in the judgment of Lord Briggs.
The SC did however unanimously hold that directors do under English common law in certain circumstances owe a duty to the company to consider and act in the interests of the company’s creditors as a body, rejecting the submission that no such duty exists. All members of the SC agreed that, although the creditor duty was a relatively recent arrival, it was firmly established by a line of English authorities beginning with West Mercia Safetywear.
A majority of the court further considered that the existence of the creditor duty at common law was affirmed by the wording of s 172(3) CA 2006, which provides that the duty of a director to promote the success of the company for the benefit of its members as whole under s 172(1) has effect subject to any enactment or rule of law requiring directors to consider or act in the interests of the company’s creditors.
In particular Lord Briggs took the view that: “Parliament must be taken to have understood the general statement of the common law at that time, which by the binding Court of Appeal authority of the West Mercia case did clearly recognise a creditor duty, even if the precise content of that rule of law may have had fuzzy edges, and might thereafter be subject to further judicial development.”
Lord Biggs reached his conclusion on the basis of the language of s 172(3) CA 2006.
The nature of the duty
A majority at least held that the creditor duty is not freestanding, but rather a modification of the primary duty owed by directors to the company to promote the success of the company for the benefit of its members as a whole under s 172(1) CA 2006.
In common with the general duties of directors under ss 171 to 177 CA 2006, and as was already well established, the creditor duty is owed to the company itself and is not a duty owed by directors directly to creditors or other stakeholders. Lord Briggs acknowledged that his use of the term ‘creditor duty’ was merely a convenient (but imprecise) label.
At what point is the director’s duty to creditors engaged?
A majority of the SC held that the creditor duty is triggered when the directors know or ought to know that:
- The company is actually insolvent.
- Its insolvency is imminent, that is to say a state of insolvency is effectively just around the corner and going to happen and not just imminent but inevitable.
- It is probable that the company will go into insolvent liquidation or administration.
What is the content of the creditor duty?
A majority of the SC agreed that once the creditor duty is triggered, directors are required to consider the interests of creditors along with those of members, balancing these interests against each other where they diverge. The priority to be given to creditors’ interests will depend on the company’s particular financial situation and increase as a company’s financial position worsens. There is therefore a ‘sliding scale’ of increasing priority for creditors’ interests as a company gets more deeply insolvent and/or closer to insolvent liquidation or administration.
A majority held that at the point at which an insolvent liquidation or administration is inevitable, so that there is no longer any so called light at the end of the tunnel, members’ interests will cease to have any weight and the company’s interests are to be treated as equivalent to those of creditors generally.
The court made it clear that the creditor duty focuses on the interests of the company’s creditors as a body, not on those of individual creditors, as individual creditors’ interests may differ and their identities change over time as a company incurs and discharges its debts.
Dividends, the creditor duty and can shareholders ratify acts?
All members of the court agreed compliance with the common law and statutory regime governing distributions to members in Part 23 CA 2006 does not insulate directors from liability to the company for breach of the creditor duty. Having affirmed the existence of the creditor duty as part of the common law, preserved by s 172(3) CA 2006, the court held that the duty is not excluded by Part 23 CA 2006.
Generally, shareholders, at least if acting unanimously, can authorise or ratify a transaction in breach of directors’ fiduciary duties so as to cure such breaches – described by the court as “the ratification principle”. A majority of the court approved the proposition that the ratification principle cannot apply when the creditor duty has been engaged. Lord Hodge for example noted that the trigger for the engagement of the creditor duty “must sensibly coincide with the moment when the ratification principle ceases to apply”.
The court cited earlier authorities for the proposition that there is a limit on the ratification principle by reference to the company’s solvency, which adopted formulations of the degree of insolvency or proximity to insolvency required that do not coincide completely with the trigger for the creditor duty identified by the SC. It is, however, clear now that the test for the disapplication of the ratification principle is the same as the test for the application of the creditor duty.
The way forward
The main changes to the law, as a result of the SC judgment are that:
- The content of the creditor duty has now been firmly identified; and
- The trigger for the duty has also been identified, creating a test that is differently focused and more demanding than some of the tests suggested by earlier authorities so that it is clear that the creditor duty will be engaged less frequently than before.
Lawyers in future advising directors in difficult financial situations for a company will now have to consider new questions . First – is the company in a state of insolvency or is such a state imminent and inevitable, or, regardless of that, has it become likely that the company will go into insolvent liquidation or administration?
The first element will still be subject to the inherent practical difficulties that sometimes arise in understanding the company’s financial position sufficiently to be confident as to whether or not it is insolvent. That is particularly so if the issue is balance sheet insolvency. Cash flow insolvency is usually much easier to detect, since the persistent inability to pay any significant debt on time is enough.
Second, advisers and directors acting bona fide may tend to prefer a precautionary approach, erring on the side of assuming the creditor duty has been triggered. This would seem sensible, since the trigger test has an objective element, in that directors who do not know but ought to have realised that the trigger conditions are satisfied, will be subject to the duty.
On the other hand, the duty is subjective once triggered and so directors who are genuinely trying to comply with it do not breach it. Therefore, directors wishing to minimise their risk of liability would be well advised if in doubt to assume that the duty applies and to try to comply with it.
Third, that approach is also facilitated by the content of the duty itself, in particular the fact that when the duty is initially triggered and insolvent liquidation or administration is not inevitable, creditors’ interests only have to be taken into account alongside shareholders’ interests.
Therefore, complying with the duty does not require a complete change of focus from shareholder to creditor interests. Fourth, the existence of the second trigger point at which the creditors’ interests completely exclude the shareholders’ interests, where insolvent liquidation/administration is inevitable, does create an extra question for directors and their advisers.
When that point is reached directors must exclude shareholders’ interests from their deliberations, which may necessitate a significant shift in approach in practice, and an enhanced risk of liability if that shift is not made. The second trigger point is (and was intended by the SC to be) very similar to the trigger for liability for wrongful trading under s 214 Insolvency Act 1986.
This is that the director ought to have concluded that there was no reasonable prospect that the company would avoid insolvent liquidation/administration. So whether the second creditor duty trigger is subjective or has an objective element, directors and their advisers should in effect be considering that second trigger test on an objective basis for considering liability under s 214 IA 1986.