On 5 October 2022, the Supreme Court handed down its long-awaited judgment which confirmed the common law duty of directors to take into account and give appropriate weight to the interest of the company's creditors in certain circumstances (the “Creditor Duty”).
The court has also clarified the nature of the Creditor Duty and the time at which it arises.
The Facts
In May 2009, the directors of a company called AWA (now, Windward Prospects Limited) caused it to distribute a dividend (“the May Dividend”) to its only shareholder Sequana SA (“Sequana”). This extinguished almost the whole of a slightly larger debt which Sequana owed to AWA. At the time the May Dividend was paid, AWA was solvent on both a balance sheet and a cash flow basis. There was a real risk that in the future AWA might become insolvent, but insolvency was not probable. AWA had long-term pollution-related contingent liabilities of an uncertain amount and an uncertainty as to the value of an insurance portfolio.
AWA went into insolvent administration in October 2018. BTI 2014 LLC (“BTI”) is the assignee of AWA’s claims.
BTI pursued a claim to recover the amount of the May Dividend from AWA’s directors. It argued that the director’s breached the Creditor Duty. This was rejected by both the High Court and the Court of Appeal. The Court of Appeal decided that the Creditor Duty “arises when the directors know or should know that the company is or is likely to become insolvent…In this context, "likely" means probable”. BTI appealed to the Supreme Court.
The Decision – The Supreme Court dismissed BTI’s appeal
BTI argued that in declaring the May Dividend, the directors failed to have regard to the creditors’ interests. It argued that the Creditor Duty arises, even where the company is solvent, if there is a real but not remote risk of it becoming insolvent in the future.
The Supreme Court decided that the Creditor Duty did not arise in those circumstances and the appeal was dismissed. Some of the key points that emerged from the judgment are as follows:
The existence of the Creditor Duty
The Supreme Court rejected the contention that there is a Creditor Duty distinct from the directors’ duty to act in good faith to promote the success of the company under s.172, Companies Act 2006. However, the rule which the Court described as the “rule in West Mercia” after the leading case of West Mercia Safetywear Ltd (in liq) v Dodd [1988], has the effect of requiring the directors to consider creditors’ interest along with members’ interests. This is encapsulated in s.172(3), Companies Act 2006. The Creditor Duty essentially modifies the director duties to act in good faith to promote the success of the company.
What triggers the rule in West Mercia to apply?
The majority of the court found that the point at which directors should have regard to creditors’ interests is:
- when they know or ought to known that the company is insolvent or bordering on insolvency; or
- that an insolvent liquidation or administration is probable.
They further confirmed that insolvency is to be determined in accordance with the balance sheet or cash flow test.
The court rejected the argument that directors should have regard to creditors’ interests whenever there is a real rather than a remote risk of insolvency.
The content of the Creditor Duty
The Supreme Court commented on the content of the Creditor Duty although this issue was not directly relevant to the case. The Court stated that “prior to the time when liquidation becomes inevitable…the Creditor Duty is a duty to consider creditors’ interests, to give them appropriate weight, and to balance them against shareholders’ interests where they may conflict”. It was also suggested that generally as the company’s financial problems increase, “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”.
Where there is no prospect of avoiding insolvent liquidation or administration, the interests of creditors become paramount.
Other key points:
- When the Creditor Duty is triggered, it can apply to a decision to pay a dividend which is otherwise lawful; and
- Where the directors are under the Creditors Duty, the shareholders cannot authorise or ratify a transaction which breaches that duty.
What does this mean?
The Creditor Duty can arise as soon as insolvent liquidation or administration becomes probable. It is accordingly imperative that directors keep informed about the company’s affairs, regularly assess the company’s financial position and ensure they are documenting all their considerations. Those considerations should include the interests of shareholders and the creditors to varying degrees subject to the extent of the Company’s financial position.
Unfortunately it is not always easy for directors to be sure that insolvent liquidation or administration has become probable (i.e certain that the risk is over 50%) however, directors should follow the general rule of thumb that the greater the financial difficulties of the Company, the more weight should be given to the creditors’ interest. Ultimately, the particular circumstances of each case will need to be considered in determining whether the Creditor Duty arises and if so when it arises. Directors are advised to seek professional advice if their Company faces financial difficulty, to ensure that they are doing everything they can to protect themselves and the Company.
If you believe you may be affected by this decision, or require further advice, please do not hesitate to contact a member of our Insolvency and Restructuring Team.
