Trading in the Twilight Zone – When does the Creditor Duty arise for Company Directors? A round-up of the recent cases applying the Supreme Court decision in Sequana.

Introduction:

On 5 October 2022, the Supreme Court delivered a landmark judgement in BTI 2014 LLC v Sequana SA [2022]. The decision is the first from the Supreme Court to address when, and in what circumstances, company directors owe a duty to consider the interests of the company’s creditors (‘’the creditor duty’’).

The creditor duty stems from the longstanding fiduciary duty of a director to act in a way they consider to be promoting the success of the company for the benefit of its members as a whole, as codified in section 172(1) of the Companies Act 2006. The duty has been modified by the common law rule, as recognised in section 172(3), to also consider the interests of creditors alongside those of shareholders in certain circumstances, namely when the company is approaching insolvency.  The Court considered when the duty arises, its scope, and in what circumstances the duty to act in the creditors’ interests entirely supersedes the duty owed to the company’s members.

Background:

In summary, AWA made payment of a £135m dividend to its only shareholder, Sequana, in May 2009. AWA went into insolvent administration in 2018, nine years later. BTI, as assignee of AWA’s claims, sought to recover the dividend from AWA’s directors, arguing that they had breached the creditor duty by distributing the dividend given that insolvency was a possible result of administering the payment.

The Court of Appeal and the High Court dismissed the claims against the directors on the basis that in May 2009 AWA was not insolvent or imminently facing insolvency. BTI appealed to the Supreme Court, arguing that the creditor duty was engaged when there was a real risk of insolvency. The directors argued that the creditor duty could not be engaged prior to the onset of actual insolvency.

Decision:

The Supreme Court upheld the Court of Appeal’s judgment in dismissing BTI’s appeal, but gave valuable guidance as to the nature and scope of the creditor duty, and the point at which the duty will arise.

The Court reaffirmed the existence of the creditor duty but explained the duty not on the basis of a freestanding duty but rather as an aspect of a director’s fiduciary duty to act in the best interests of the company as codified in s.172, which in certain circumstances would include the interests of the Company’s creditors.

Lord Briggs, writing for the majority, further stated:

1. The creditor duty is triggered upon imminent insolvency, insolvency or probable insolvent liquidation; all of which the directors would know or ought to know about.
2. Once the duty is engaged, it involves considering creditor interests by giving them “appropriate weight” and to “balance them against shareholder interests where they may conflict”. The balance between the two should be held in proportion and adjusted in weighting according to which of the interests the directors believe to be at risk of suffering from greater damage when executing transactions. However, this scale ceases to exist at the point of a company becoming “irretrievably insolvent“, at which point the interests of creditors supersede the interests of a company’s members altogether.

Comment:

This judgment represents an important development in English insolvency law, and as evidence of its significance it has already been cited in three further judgments in the approximately four months since it was handed down.

The judgment is particularly timely given the current economic downturn. Insolvency-related claims against company directors tend to be counter-cyclical, and in November 2022 the Insolvency Service reported a 38% increase in collapses year-on-year.

The judgment will likely alter the scope for insolvency practitioner claims against directors, as well as the way in which such claims are pursued. Where proceedings are brought against a director for favouring a member over a creditor in circumstances where a company was in financial difficulty, it will need to be considered to whom the director owed interests at the time of the relevant transaction. If a payment was made before the creditor duty has been engaged, as in Sequana itself (where there was a period of nine years between the payment and the insolvency), there will be no case for the directors to answer. On the other hand, if the company was at the point of “irretrievable insolvency”, then the position is straightforward because at that stage the interests of creditors supersede the interests of a company’s members. This was the basis for a finding of a breach of the creditor duty in the very recent decision in Kieran Looney & Co Ltd (In Liquidation), Re [2023] EWHC 197 (Ch), an ultimately straightforward decision on this issue because there was no evidence or even any assertion that the defendant had taken the creditors’ interests into account.

However, claims of this nature are rarely straightforward, and that remains the position notwithstanding the additional clarification provided in this judgment. A duty that arose on actual insolvency may have had the benefit of more certainty, although it can readily be understood why the creditor duty should arise before that point. However, in practice it will be difficult to distinguish between ‘a real risk of insolvency’, which will not trigger the creditor duty, and an ‘imminent insolvency’ which will. In any case where the financial situation fell short of irretrievable insolvency directors will argue they were balancing the interests of the members alongside the creditors, and assessing whether directors have weighed the often competing interests appropriately will be an extra layer of difficulty. For parties and their advisers, assessing the prospects of success of such claims will be fraught with uncertainty and risk, and in the short term at least there is likely to be an increase in claims that are difficult to resolve and that may therefore end up at trial. It remains to be seen whether courts may attempt to provide further guidance as to when directors will be considered to be in breach of the creditor duty, although in Sequana itself the Court noted many times throughout the judgement that this is a developing area of law. We can certainly expect further caselaw in this area in the not too distant future.

In the interim, directors of companies in financial difficulty should seek legal advice to determine whether the creditor duty has been engaged. Unsurprisingly, the court made clear the potential for directors to be liable not only where they know, but also where they ought to know, of an imminent insolvency or a probable liquidation. This places the onus on directors to stay up to date on the financial health of their companies to avoid unforeseen liabilities, since the situations in which the creditor duty can arise include when a proposed transaction would put the company into or close to a position of insolvency (a point made in the subsequent decision in Pickering v Hughes [2022] EWHC 3359).

D&O and Professional indemnity (“PI”) practitioners should heed this judgment when making or defending claims with an insolvency element. It is important to try to identify exactly where a director was situated on the sliding scale of duties owed to a creditor in the context of the financial health of the company. This will be critical for liquidators to avoid ‘throwing good money after bad’ by pursuing unmeritorious claims against directors.

In addition, the subjectivities and uncertainties in this area following this judgment could lead to professional indemnity exposures for liquidators once they have vacated office, if, for instance, the liquidator incurs significant fees in bringing unsuccessful preference payment proceedings in circumstances where the creditor duty was not engaged. This could lead to a misfeasance claim by disappointed creditors against the liquidator for misapplying company assets.

By way of postscript, the Supreme Court considered Sequana in Stanford International v HSBC [2022] SC 34. In brief, where HSBC had paid out sums from the Claimant’s (“C’s”) accounts held with HSBC to ‘early customers’ of a Ponzi scheme (ie those customers who were paid before the collapse of the scheme and suffered no loss), C’s claim against HSBC for breach of its ‘Quincecare’ duty (a tortious duty to refrain from executing an order for payment out where they had reasonable grounds to believe that the order was an attempt to misappropriate funds) was struck out by the Court of Appeal on the basis that C had suffered no loss. There was no suggestion that C’s overall balance sheet had been affected by the payment because it extinguished an existing liability. C had argued that it had suffered the loss of a chance to make lower payments to early customers (ie post-liquidation payments would have been lower), but these were offset by the fact that they would have had to pay the ‘late customers’ a higher amount.

The Court of Appeal’s decision to strike out the claim was upheld by the Supreme Court. The ultimate relevance of Sequana to the decision is somewhat tangential; in the 4:1 majority that upheld the appeal, the consolidated judgment of three of the majority did not address Sequana. However, Lord Sales, dissenting, said that Sequana was an example of corporate personality serving its own representative function, with a company having its own responsibilities separate from those of its shareholders. In his view, a fundamental change occurs as regards those responsibilities when a company is on the verge of, or enters, insolvent liquidation, as at that point the company’s own interests were equated with those of its creditors as a general body. Once viewed in that way, C (as a company) did suffer a loss; if HSBC had complied with its duty C would still have had the sum of £116m in its accounts at the point of liquidation. To suggest that payment out did not represent a loss was to treat the company as a pure abstraction whose interests are the same whether it is trading and solvent or whether it is in insolvent liquidation. Where a company is deprived of assets and thereby disabled from fulfilling its proper function in relation to those who have the relevant economic stakes in it and whose interests it exists to promote, that is a loss to the company.

One of the arguments raised by C was that a finding that C had suffered no loss in this type of scenario might affect the ability of the Court to award a remedy where directors had paid out sums to settle an existing liability in breach of the creditor duty. That was not an argument that found any favour, but it might be interesting to see whether any related arguments in relation to loss might be made in such claims in the future.