Supreme Court Rules on Directors’ Duty to Creditors
Supreme Court Rules on Directors’ Duty to Creditors
The Supreme Court of the United Kingdom (“SC”) has recently handed down a decision in the case of BTI v Sequana, dealing with the powers and duties of company directors. The appeal was expected to be of considerable importance.
This alert is especially relevant to companies, and directors of companies, in financial distress, as well as creditors and insolvency practitioners.
First, the court found that a director does owe a duty to the company’s creditors. The duty arises as the company’s insolvency becomes probable, and becomes paramount (i.e., supersedes the ordinary duty owed to shareholders) when insolvency is imminent. Additionally, it was held that even a lawful dividend payment to shareholders could breach this duty owed to creditors.
The existence of this duty to creditors means directors of companies in financial distress must be careful to consider the interests of creditors alongside shareholders and judge when the interests of the creditors become paramount. Advice from insolvency experts becomes increasingly important as the financial situation deteriorates. However, the SC’s apparent preference for analysing potential breaches on a case-by-case basis should give directors some breathing room. If a sensible and fact‑based argument for decision making can be made, directors’ decisions need not risk liability. Certainly, the interests of creditors will not supplant shareholders’ interests at the first hint of financial trouble.
This judgment was an appeal from a 2019 decision of the Court of Appeal. Read the Client Alert on that judgment; the broad range of questions dealt with by the Court of Appeal indicate that its judgment remains a relevant and important read. In contrast, the issues dealt with by the SC were far narrower in scope, focusing on the existence and substance of a potential duty to creditors owed by directors of distressed companies. A detailed explanation of the facts of the case can also be found in the linked Client Alert.
The SC agreed with the lower court and dismissed the appeal; however, the SC still provided an in‑depth analysis and consideration of the issues given their importance for directors and wider company law. Additionally, some of the distinctions between the reasoning of the SC and the Court of Appeal are important to understand.
In short, yes; there is a duty owed by directors of a company to its creditors as the company approaches insolvency. This is not a new duty, but rather a modification of the existing duty under s172(1) of the Company Act 2006 (“CA”) to ‘promote the success of the company for the benefit of its members as a whole.’ This means, in times of financial stability, the shareholders’ interests are paramount. However, as now confirmed by the SC, as insolvency approaches, the interests of the creditors become increasingly relevant.
Of course, while the clarity this provides is important, it is not necessarily groundbreaking. The existence of this so-called ‘creditor’s duty’ had already been all but confirmed in cases such as West Mercia. The SC decision therefore represents the culmination of this line of common law development. However, where the court provided less certainty and purposefully left room for future development was in deciding the substance and extent of the creditors’ duty.
At what point do the creditors’ interests become part of the s172 CA duty to the company? The SC’s decision on this issue was not reached unanimously, and even the majority appeared reluctant to frame the judgment as a final decision on the matter. Therefore, the below understanding of the SC’s decision should be read as guidance on likely judicial thinking, rather than a definitive conclusion.
The majority of the SC held that the duty to creditors arises in the following circumstances:
a) Where it is probable that the company will become insolvent;
b) Where the company’s insolvency is imminent; and
c) Where the company is currently involved in an insolvency process, such as insolvent liquidation or administration.
However, the substance of the duty to creditors is not the same in all of these circumstances. In the case of imminent insolvency or the company being involved in an insolvency process, the duty to creditors becomes paramount. Therefore, when acting in the best interests of the company, it is the creditors’ interests rather than the shareholders’ interests that must be considered.
In contrast, where insolvency is simply probable, creditors’ interests are relevant but not all‑important. Instead, their interests move on a sliding scale whereby they become ever more important as a company approaches imminent insolvency. During this time, where creditor and shareholder interests conflict, they must be balanced as appropriate.
Additionally, the majority held that any duty to creditors would only be engaged where the directors knew, or ought to have known, about the company’s insolvency position. Lord Reed and Lady Arden disagreed with the majority on this matter, preferring to leave such a conclusion to a later decision. Directors should therefore be cautious in relying on a lack of knowledge of their company’s insolvency as a defence, especially as that knowledge may be assumed given a director’s position and responsibilities.
While the SC’s approach does not seem to necessarily provide the absolute clarity of what company directors can and cannot do when their company is in financial trouble, it can be seen as helpful for several reasons. This sliding scale approach gives directors some leeway in the actions they take as a company approaches insolvency; even where insolvency is probable, shareholders’ interests are not automatically subordinate to creditors.
Additionally, the court indicated that each case should be considered according to its own circumstances. Therefore, if sufficient justification and reasoning can be provided for decisions, directors should still have some scope for manoeuvre.
The certainty of the existence of the ‘creditors’ duty’ is a welcome bit of clarity for directors running companies under financial pressure. While the SC’s decision may not have been as clear or decisive as some hoped, the flexible nature of the duty should provide reassurance to directors of companies approaching insolvency. Importantly, the duty to creditors does not arise where there is merely a real risk of insolvency. The higher standard of insolvency being ‘probable’ should come as some relief.
It remains imperative that directors in this situation receive financial and legal advice, and should contemporaneously record their decisions, the information they rely on, and their reasoning. Insolvency experts should be consulted to gain a clear understanding of a company’s financial position, bearing in mind that as soon as insolvency becomes imminent, creditors’ interests become paramount. While erring on the side of caution may seem advisable, this decision does not suggest it is strictly necessary for directors of companies approaching insolvency. Admittedly, the balancing of shareholders’ and creditors’ often opposing interests can be difficult, and directors may be disappointed that no checklist has been provided by the SC in this regard. However, by the same token, honest and diligent directors, taking advice and applying their minds, should be safe from personal liability.
Significant developments in this area of the law are bound to continue, given the SC’s reluctance to make a final decision on many of the key issues. Further Client Alerts will be issued when these developments arise—in the meantime, Morrison Foerster’s Restructuring Round-Up Blog provides in-depth analysis and insights on those areas of the law most relevant to our clients.
Kyle Howard, London Trainee Solicitor, contributed to the drafting of this Alert.
 BTI 2014 LLC v Sequana SA  EWCA Civ 112.
 S172(1) Company Act 2006.
 West Mercia Safetywear Ltd v Dodd  BCLC 250.