Are directors under a duty to consider the interests of creditors?

BTI 2014 LLC (Appellant) v Sequana SA and others (Respondents) [2022] UKSC 25 (5 October 2022)

The United Kingdom Supreme Court has delivered a significant judgment on the issue of a director’s duty to consider the interests of creditors as a company approaches insolvency.

Whilst the current Australian authorities handle the issue differently to this judgment, it can be expected that as the Australian law evolves, this authority will be considered.

The outcome of the case was that the Court dismissed an appeal by a party who: (a) took an assignment of a company’s rights against its directors for breach of their duties; and (b) argued that the directors failed to adequately consider the interests of creditors when paying a dividend.

Though no breach of directors’ duties was found in this case, the decision is significant because the Court also held, as a matter of principle, that directors have a statutory duty to consider the interests of creditors when a company is either insolvent or imminently so.

This decision – which should be of interest to insolvency practitioners and directors alike – may be compared with the Australian position. Only lower and intermediate Australian courts have considered the question, and none have formulated a principle suggesting that the time at which a duty to consider the interests of creditors is enlivened only as late as when a company is either insolvent or imminently so.

A company known as “AWA” did not trade. It existed solely because it was liable to pay pollution clean-up costs, in respect of claims notified under United States environmental compensation legislation.

However, by 2009 those claims had not been determined and quantified, though a third party, “BAT”, had guaranteed AWA’s liabilities in respect of those claims.

AWA’s directors approved accounts for the previous 2008 year on the idea that AWA’s insurance policy would be sufficient to cover a best estimate of AWA’s environmental liabilities and that there was otherwise a distributable reserve.

In May 2009, AWA’s directors caused it distribute a €135 million dividend to its only shareholder, “Sequana”. That dividend was lawful in that it complied with the statutory scheme relating to payments of dividends. At the time of paying the dividend, AWA was solvent on both a balance sheet test and a cash flow test.

Almost 10 years later, it transpired that the environmental liability was greater than estimated, and so AWA became insolvent and went into liquidation.

AWA’s claims against its directors were assigned to “BTI”, an entity set up by BAT. BTI commenced proceedings against AWA’s directors, claiming that in paying the dividend, they failed in their duty to take into account the interests of AWA’s creditors. BTI lost in the High Court and then in the Court of Appeal. BTI appealed to the Supreme Court.

In dismissing the appeal, four of the five judges delivered lengthy reasons. Nuances aside, those reasons mostly arrived at the same conclusions.

The traditional approach?

Each of the judges commented on aspects of the traditional approach to directors’ duties in relation to the interests of creditors.

Directors owe duties to act in the best interests of the company. Accordingly, the company may have a claim against its directors for breaches of those duties, and so whom may be liable to compensate the company.

The interests of the company are equivalent to those of the company’s shareholders as a whole, that is, its members or corporators.

Creditors transact with a company at their own risk. They may charge interest on their debt or take a security. In becoming creditors, they are not in any contractual relationship with the directors. They have a statutory right to share in the company’s assets upon liquidation, save that they can only enforce that right to the extent that the company acts on its own motion, or through a liquidator.

In this sense, directors are to consider the interests of creditors no more so than they might consider the interests of employees as vital to the success of the company’s business. If creditors are not paid, the company risks litigation and reputational damage.

This idea is codified in section 172(1) of the Companies Act 2006 (UK), which states:

(1) A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to—

(a) the likely consequences of any decision in the long term,

(b) the interests of the company's employees,

(c) the need to foster the company's business relationships with suppliers, customers and others,

(d) the impact of the company's operations on the community and the environment,

(e) the desirability of the company maintaining a reputation for high standards of business conduct, and

(f) the need to act fairly as between members of the company.

(2) Where or to the extent that the purposes of the company consist of or include purposes other than the benefit of its members, subsection (1) has effect as if the reference to promoting the success of the company for the benefit of its members were to achieving those purposes.

(3) The duty imposed by this section has effect subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company.

The equivalent Australian provisions are in ss 180 – 181 of the Corporations Act 2001 (Cth) which sets out the duties of directors to act with care and diligence, and in good faith in the best interests of the company. The Australian provisions, unlike the UK provisions, do not prescribe the considerations that directors must take into account when so acting.

The reasoning in the UK Supreme Court

The questions before the Supreme Court were whether a duty to act in the interests of creditors existed, and if did, what was its content, and when did it arise?

The starting point was a 1988 English decision known as West Mercia. That case concerned a director who had authorised a preferential payment. It was not worthwhile for the liquidator to pursue the recipient of the payment under the legislative clawback provision, so the liquidator claimed against the director, applying for a declaration under old legislation that the director was guilty of misfeasance. It was held that the director breached his fiduciary duties when he authorised the payment in disregard of the interests of the general creditors.

West Mercia had been followed in subsequent UK and Commonwealth decisions and established the rule that a director’s statutory duty to act in the interests of the company could in some circumstances be modified to take into account the interests of creditors.

All the judges agreed that this common law rule was affirmed or preserved by s 172(3) of the Companies Act 2006 referred to above.

Any references to this rule in West Mercia as giving rise to a “creditor duty” might be a convenient label. However, all the judges agreed that the rule did not give rise to any freestanding duty, rather it was simply an aspect of a director’s duty owed to the company.

All the judges agreed that the rule gives rise to a duty in which the directors, when exercising their powers, are required to consider the interests of the general body of creditors. Though Lady Arden went further to say that the content of the duty also required directors, not just to consider creditors, but also not to exercise their powers in a way that would harm them.

BTI had argued that the requirement to consider the interests of creditors would arise when the company faced a real and not remote risk of insolvency in the future.

However, all the judges agreed that was not sufficient to engage the rule in West Mercia in this case; rather the company must be actually insolvent or imminently or bordering on insolvency. Lords Briggs (with whom Lord Kitchin agreed) and Lord Hodge each said that the requirement to consider creditors would only be triggered when directors know, or ought to know, that the company is insolvent or imminently so. Lord Reed and Lady Arden each left open the question of whether knowledge was essential.

All the judges agreed that once the rule is engaged at the point that insolvency is imminent, then the more serious the company’s financial difficulties, the more the interests of creditors should be considered paramount, above the interests of shareholders.

The judges also agreed that the acceptance of this rule was coherent with the ratification principle in Duomatic, allowing shareholders to authorise breaches of directors’ duties, as that principle would not allow shareholders to ratify insolvent transactions or that would cause a loss to shareholders. Further, the rule was coherent with other legislative remedies such as the insolvent trading and unfair preference provisions.

Importantly, the judges also agreed that the rule in West Mercia could be breached even if a dividend was lawful.

A comparison with the (more flexible) Australian position

By way of contrast, in the Australian context, the trigger point for the commencement of the duty to consider the interests of creditors may be earlier in the path to insolvency. The most relevant judgments have not, however, been considered by the Australian High Court (the ultimate court of appeal in Australia).

In Termite Resources NL (In Liquidation) v Meadows, In the Matter of Termite Resources NL (In Liquidation) (No 2) [2019] FCA 354, (2019) 135 ACSR 45, White J at [200]-[209] noted the various circumstances in which Courts have found the duty to consider the interests of creditors to arise. These have included doubtful solvency and there being a real but not remote risk of insolvency (that is, the trigger point that was rejected by the UK Supreme Court in Sequana). His Honour also noted in the Australian cases, there was some hesitancy to formulate a general test of the degree of financial instability that would trigger the duty.

In the well-known decision of Bell Group Limited (In Liquidation) v Westpac Banking Corporation Limited (No.9) [2008] WASC 239; (2008) 70 ACSR 1, Owen J at [4445] said that the interests of creditors may come to the fore during a state of adversity short of actual insolvency.

In Palmer v Parbery; QNI Metals Pty Ltd v Parbery [2019] QCA 27; (2019) 136 ACSR 26, the Court of Appeal at [47], in identifying the trigger point to consider the interests of creditors referred to “doubtful solvency with the potential for the transactions to cause prejudice to creditors or a group of creditors”.

In the Bell Group decision, Owen J at [4439] did however caution that, once triggered, the directors’ duty to consider the interests of creditors does not rise to the extent of treating creditors’ interests as paramount, because to do so would “come perilously close to substituting for the duty to act in the interests of the company, a duty to act in the interests of creditors”.

Finally, it is observed that in Sequana, the UK Supreme Court gave little attention to whether a cash flow test, versus a balance sheet test, would produce different results in engaging the rule. This may be an issue in the Australian context where the cash flow test may be regarded as a generally more appropriate test of insolvency.