The long awaited Sequana Supreme Court judgment[1] has provided some welcome clarity around the duties of the directors of a company in the "twilight zone" – i.e. where the company is facing financial difficulties.
Section 172(1) of the Companies Act 2006 requires that the directors of a company act in a way they consider, in good faith, would be most likely to promote the success of the company for the benefit of its members (i.e. shareholders) as a whole. The Supreme Court's decision in the Sequana case is the first time that the highest court has been asked to consider whether this duty includes, or is replaced by, a requirement that directors consider or act in the interests of the company's creditors; when that duty arises; and its scope.
The nature of the rule outlined by the Court
The Supreme Court affirmed the rule in West Mercia Safetywear v Dodd[2], namely that directors of a company must consider the interests of creditors alongside those of shareholders in certain circumstances. The Supreme Court was clear that this rule does not represent a separate duty owed to creditors, but rather a modification of the directors' statutory duty (owed to the relevant company) requiring the directors to take into account the creditors' interests as well as the shareholders' interests.
The Supreme Court considered at length the rationale behind this rule and generally considered that it recognises the reality of the economic interests in a company in financial distress.
When is this duty triggered?
The appellant in Sequana argued that the directors' duties to prioritise the interests of creditors ought to apply where a company is at a real (as opposed to remote) risk of insolvency.
The Supreme Court disagreed that the duty could be triggered merely by a real risk of insolvency which is neither probable nor imminent. The Supreme Court instead held that the trigger point is:
- when the company is insolvent or bordering on insolvency[3];
- where an insolvent liquidation or administration is probable; or
- where the transaction in question would place the company in either of the foregoing two situations.
This is likely to result in the modified duty being engaged at a later point than argued by the claimants (and, indeed, earlier than the trigger point identified in the Court of Appeal judgment, namely a "probability of insolvency"). This part of the judgment does bring welcome and sensible clarification to the sometimes conflicting judicial and academic commentary on the trigger point.
Having reached that conclusion, this was sufficient to decide the appeal on its facts. But the Supreme Court did go on to provide some obiter dicta observations and guidance.
What is the scope of the duty to creditors?
The earlier Court of Appeal judgment had held that, following the trigger point, the creditors' interests were paramount (sometimes referred to as a "cliff edge" analysis). However, the Supreme Court disagreed with this and, instead, preferred what might be termed a "sliding scale". In other words, the weight to be given to the interests of creditors will increase as the company's financial difficulties become increasingly serious.
The Supreme Court was of the view that the creditors' interests will only become paramount at the point where insolvent liquidation or administration is inevitable. At this point the shareholders will cease to have any economic interest (because their rights to a return on their capital invested in the company are subordinated to creditor claims in a notional insolvent liquidation or administration). Consequently, the company's interests should be interpreted as being equivalent to the interests of its creditors in those circumstances.
In practice, therefore, if an insolvent liquidation or administration is not inevitable, the shareholders' interests will remain relevant and the directors will need to balance the interests of creditors and shareholders and act accordingly. The more precarious the financial position of the company, the more the directors should prioritise the interests of the creditors. Clearly this is likely to depend on the facts as they develop, and directors should ensure that they have the benefit of detailed legal advice on these matters.
The Supreme Court emphasised that the duty to creditors is to the creditor body "as a whole". Whilst, on the face of it, this makes sense as a principle and such equality is mirrored in other parts of insolvency law, its application in practice could be problematic. For example, it is common for the directors of a company in financial distress to prioritise payments to certain critical creditors and the existing law does provide safe harbour for this in the right circumstances. A blanket rule that compels directors to treat all creditors the same would conflict with this, as would a suggestion that the directors are not obliged to consider the impact of their actions on individual creditors or classes of creditors. Presumably this was not the intention behind those references, but further judicial clarification may be required.
What standard of knowledge should be attributed to directors?
The Supreme Court declined to reach a definitive opinion on whether the directors should be judged on whether they knew (or ought to have known) that the trigger point had been reached, perhaps unsatisfactorily leaving this point for future submissions and consideration.
However, it was noted that directors are generally under a duty to inform themselves as to the company's affairs. In the absence of a judicial decision to the contrary, it remains essential that directors keep a very watchful eye on the solvency of the company, with the benefit of up to date financial information and professional advice.
Can an otherwise lawful dividend constitute a breach of the directors' duties to creditors?
The Sequana case involved a number of shareholder dividends which were made some years before insolvency, but were determined to be lawful under the provisions of the Companies Act 2006. Whilst the Supreme Court was not required to determine this point, as it had already decided that the duty shift had not been triggered on the facts, the Supreme Court did indicate that an otherwise lawful dividend (i.e. one made in accordance with the Companies Act 2006) could be made in breach of duty if the trigger point has occurred and the company’s directors have failed to act in accordance with their modified duties, as described above.
The interaction with other insolvency law principles
The Supreme Court held that there is no inconsistency between the modified duty to consider creditor interests and the existing insolvency law creditor protections. Therefore, directors must continue to be mindful of the other statutory provisions such as the wrongful trading regime (which is likely to apply in parallel once an insolvent liquidation or administration is probable) as well as the transaction voidance provisions such as preference and transaction at an undervalue claims. Different trigger points and remedies will apply to a number of these provisions, emphasising the need for proper professional advice when in a distressed situation.
Implications of the judgment
The Supreme Court's judgment represents an important development in English insolvency law and is particularly timely, given the current uncertain economic climate in the UK. It provides directors and their advisors with further clarity on the framework under which directors should be making potentially critical decisions.
The Supreme Court was careful not to apply the modified duty too early in the cycle of distress, recognising the need to support a rescue culture and the burden that directors may face if an earlier, or vaguer, trigger point was adopted. Further, the judgment clarifies that creditors' interests only become paramount at the point where insolvent liquidation or administration is inevitable, recognising that shareholders retain a valid economic interest prior to this point whilst there is a potential for the company to be rescued.
Perhaps less helpfully, the Supreme Court noted many times that this is a relatively new and developing area of law with much of their commentary being obiter dicta (i.e. observations rather than legal rulings as such). So future appeals may be required to provide clarity on some aspects of this important area of law.
References
[1] BTI 2014 LLC (Appellant) v Sequana SA and others (Respondents) [2022] UKSC 25
[2] West Mercia Safetywear Ltd v Dodd [1988] BCLC 250
[3] With insolvency being taken to mean cash flow or balance sheet insolvency under Sections 123(1)(e) and (2) of the Insolvency Act 1986.
