UK Supreme Court instructs supporting Directors in Seminal Case on Directors' Duties in 'Zone of Insolvency'

UK Supreme Court instructs supporting Directors in Seminal Case on Directors' Duties in 'Zone of Insolvency'

The United Kingdom Supreme Court has established that there are conditions in which company directors are supposed to consider the interests of creditors. Accordingly has given directions on when the duty gets up.

The Supreme Court approved that the necessity to consider the interests of creditors may arise preceding insolvent administration or liquidation becoming unavoidable. The consent came in while delivering judgment in BTI 2014 LLC v Sequana SA and ors [2022] UKSC 251 (Sequana) on 5 October 2022.

But it was made clear that till insolvent liquidation or administration was inevitable, creditor interests would not essentially be supreme.

As long as the existence of such duty in English law and the circumstances in which it arises are concerned, this judgment has addressed long standing uncertainties

The Supreme Court's acknowledgement will provide comfort to directors and those advising them. It's regarding the importance of not disturbing the director determinations to naturalise troubled companies by imposing an excessively firm standard, or one which will be too easily activated.

Background

Directors and advisers have extensively assumed that there are situations where the economic interest in a board's decision-making process sits, however in part, with the creditors as a company nears bankruptcy.

Recently in England, (in West Mercia Safetywear Ltd v Dodd [1988] BCLC 250 and the cases that followed it), Courts have recognised that such a requirement exists. When it arises, however, what exactly is required and how the requirement interacts with the statutory protections applicable in insolvency have remained unclear.

The uncertainty and particularly the possibility that a duty may arise as early as when there is a "real, as opposed to a remote" risk of insolvency (as the appellant contended in Sequana), had the probability to leave directors and their advisers to assume the worst potentially hampering the efforts to assimilate or rearrange companies to the benefit of all stakeholders, or leading to excessively careful, hence fruitless, decision-making.

The Issues in Sequana

The litigation concerned dividends an English company (AWA) paid to its sole shareholder Sequana SA (the first respondent), which it was argued impacted AWA's ability to satisfy certain indemnities in relation to historic pollution in the Fox River in the state of Wisconsin, in the United States.

In 2009, the directors of AWA (the second to third respondents) determined that the most likely quantum of AWA's liability under such indemnities was less than the value of the insurance it held, and accordingly, that it was solvent and able to pay dividends. A dividend of €135 million was paid to Sequana in May 2009. That dividend complied with the statutory scheme regulating the payment of dividends in Part 23 of the Companies Act 2006 (the 2006 Act) and with the common law rules on the maintenance of capital. At the time it was paid, AWA was solvent on both a balance sheet and a cash flow basis.

The environmental liabilities, however, ended up being substantially greater than estimated, with the result that AWA was not able to satisfy its indemnity obligations and went into insolvent administration almost 10 years later, in October 2018. The shareholder Sequana and AWA's directors were sued by BTI 2014 LLC as an assignee of AWA's claims.

The claimant argued at trial and in appeals to the Court of Appeal and the Supreme Court that the directors had a duty to consider the interests of creditors when they paid the 2009 dividend, because at that point there was a real and not remote risk of AWA becoming insolvent. In the Court of Appeal, David Richards LJ rejected the proposed test of "real, as opposed to a remote" risk of insolvency but concluded that such a duty exists when a company is more likely than not to become insolvent. The claimant appealed to the Supreme Court.

Is There a Duty To Consider the Interests of Creditors?

Section 172(1) of the 2006 Act needs directors to act in the way they reflect, in good faith, would be most likely to promote. In doing so to consider a list of specific factors, the success of the company for the benefit of its members as a whole. The section is a codification of the long-established common law fiduciary duty and embodies the concept of "enlightened shareholder value." The list of additional factors to be considered does not, however, include creditors. Rather, section 172(3) expressly preserves any existing common law rule requiring directors to consider the interests of creditors, if such rule exists.

The Supreme Court consistently agreed that in certain conditions, the common law does provide that the directors are required to consider the interests of creditors. The Supreme Court confirmed the underlying concept in doing so, as developed in the line of lower court cases commencing with West Mercia.

However, there is no independent "creditor duty." Rather, the Supreme Court described the rule as merely a modification of the directors' fiduciary duty to the company. It extends the scope of the interests which are taken into account when considering the company's interests to include creditors' interests and shareholders as well.'

When Is the Duty Activated?

To consider the interests of creditors, a vital issue for directors of companies facing financial inconveniences has been to know when they are required. The Court of Appeal's decision in Sequana held that the duty was triggered when it became more likely than not that at some point. In the future the company would become both cash flow or balance sheet bankrupt, left directors and their advisers taking a risk-averse attitude to the valuation of such prospect.

The Supreme Court consistently forbidden that trigger point, with a majority (Lord Briggs, with whom Lord Kitchen agreed, and Lord Hodge) holding that the duty arises when directors know, or ought to know. The company is actually bankrupt or bordering on insolvency, or that an insolvent liquidation or administration scheduled is feasible. The Supreme Court emphasised that the duty would arise where insolvency was forthcoming and that striking a bond on director decision-making at an earlier point should be forbidden.

What Is the Creditor Duty Content?

The Supreme Court acknowledged that the appropriate course of action for directors of companies faced with potential insolvency. It is highly fact sensitive and requires a weighing of interests and exercise of judgment.

According to Lord Briggs, the duties of directors have to reflect "both the shareholders and the creditors have an interest in the company's affairs [and that in] those circumstances, unless insolvent liquidation or administration is inevitable. The directors should have regard to the interests of the company's general body of creditors, to the interests of the general body of shareholders as well." He further stated that a balancing exercise will be needed where those interests encounter.

Majorly it's clear also that creditor interests do not become dominant, at least till an insolvent liquidation or administration is predictable. According to Lord Briggs specifically it would be wrong for the common law to recognise an obligation. It will result in directors deciding, or being advised for their own protection, to immediately terminate trading when there remains a light at the end of the tunnel.

In a statement which should provide noteworthy pledge for directors of troubled companies, Lord Hodge said:

A reasonable decision by directors to attempt to rescue a company's business in the interests of both its members and its creditors would not in my view involve a breach of the common law duty.

Conclusion

The Supreme Court's decision is a significant milestone in the development of the English common law in relation to directors' duties and provides welcome certainty to directors and their advisers. The Supreme Court's emphasis on the necessity of balancing creditor and shareholder interests, and on not dissuading directors from seeking to achieve a restructuring or rescue, is consistent with the "rescue culture" which has been a key focus of development of English corporate law since the Enterprise Act 2002 and which has been furthered by the creation of the "Restructuring Plan" procedure under Part 26A of the 2006 Act and other recent reforms.