Directors duties to shareholders and creditors when faced with insolvency | Winston Solicitors UK Skip to main content

In “Sequana” dividends had been declared reducing the indebtedness of Sequana SA to AWA, its parent, by EUR578m. AWA potentially owed BAT a very significant sum in respect of the clean up of its operations in USA. The sums in issue were large and the players significant.

At the time the dividends were paid AWA:

  • had ceased to trade;
  • had only one material liability being the contingent liability for the clean-up costs and damages resulting from its activities which would fall to BAT to pay if AWA could not; and
  • had, as material assets, only the investment contract and insurance policies and a large intra group receivable (of EUR585million) it was owed by its parent company, Sequana.

The dividends were supported by solvency statements from AWA’s directors. Further, each dividend was paid by the amount of the dividend being set-off against the sum due to AWA from Sequana. The effect of the dividends was to remove this asset, save for a balance for cEUR3million, and put it beyond the reach of BAT.

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The action went to trial and subsequently both parties appealed the decision of the trial Judge, Rose J.

One of the issues to be determined by the Court of Appeal was when the director’s duty to creditors was engaged.

Under section 172 of the Companies Act, directors have a duty to act in a way that they consider, in good faith, would be the most likely way to promote the success of the company for the benefit of its shareholders as a whole. Section 172(3) provides in certain circumstances, that the Directors should act in the interest of creditors of the company. It was BTI’s submission that the common law duty to creditors was engaged by the time the dividend was paid in May 2009.

There was significant legal argument debating how the Court should decide when the duty to creditors became engaged. On this issue Rose J said that to set the test at the level of ‘a real as opposed to remote risk of insolvency’ would appear to be a much lower threshold than a test set at the level of being ‘on the verge of insolvency’ or of ‘doubtful’ or ‘marginal’ solvency. In her judgment, Rose J said:

‘Having reviewed the authorities, I do not accept that [BTI had established] that whenever a company is ‘at risk’ of becoming insolvent at some indefinite point in the future, then the creditors’ interest duty arises unless the risk can be described as ‘remote’. That is not what the cases say ……...’

Having considered the evidence of AWA’s financial position at the time, Rose J concluded that AWA could not be described as on the verge of insolvency or of doubtful insolvency. As such, the High Court held that the duty to creditors had not been engaged at the time that AWA’s directors resolved to pay the May 2009 dividend.

In his leading judgment for the Court of Appeal, Richards LJ undertook a thorough review of how this issue has been considered in previous reported cases. He held:

‘The precise terms in which the duty is said to arise differ but a frequently used formulation is that it arises where the company “is insolvent or of doubtful solvency or on the verge of insolvency and it is the creditors’ money which is at risk”, in which case the interests of creditors are paramount…’

Richards LJ considered BTI’s submission that the duty arises when there is a real risk of a company’s insolvency and found that that would set a lower test than one which requires asking whether the company’s solvency is ‘doubtful’ or if the company is ‘on the verge of insolvency’ or ‘likely to become insolvent’.

Richards LJ acknowledged that the precise moment at which a company becomes insolvent is often difficult to pinpoint. In some cases it may occur suddenly, whereas equally, the descent into insolvency may be more gradual. Each case will depend on the particular facts and circumstances. Further, Richards LJ observed that the adoption of any legal test to identify the point at which the duty owed to creditors is engaged involves ‘a difficult amalgam of principle, policy, precedent and pragmatism’, as stated by Richardson J in Nicholson v Permakraft (NZ) Ltd ([1985] 1 NZLR 242).

Richards LJ considered that in his view ‘for good reason’ judges have shied away from prescribing a single form of words to encapsulate the test for determining when a company’s financial position is such that the law requires that its directors owe a duty to act in interest of creditors. In considering when the point before actual insolvency arises such that the duty is engaged, Richards LJ stated:

‘Judicial statements should never be treated and construed as if they were statutes but, in my judgment, the formulation used ….. in Bilta v Nazir, and by judges in other cases, that the duty arises when the directors know or should know that the company is or is likely to become insolvent accurately encapsulates the trigger. In this context, “likely” means probable, and not some lower test…’

BTI’s appeal, based on its argument that the applicable trigger for the creditors’ interests duty was a real, as opposed to remote, risk of insolvency, was rejected by the Court of Appeal. Accordingly, BTI’s appeal as regards all claims for breach of duty by the directors of AWA in paying the May dividend was dismissed.

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This issue wasn’t the only issue appealed but this case is probably be of most interest for what the Court of Appeal said about directors’ duties and specifically what it said about the legal test is for when directors ought to be taking decisions that are in the interests of creditors rather than shareholders.

In looking at what can be taken from this case, it must first be emphasised that it arose out of exceptional circumstances. The company had ceased to trade. It had one potentially huge liability in the form of indemnity obligations linked to the outcome of litigation in the US which, if it became an actual liability, may or may not be covered by its insurance policies. It otherwise had no material liabilities or assets, aside from the EUR585 million receivable owed to it by its parent company.

The fact that the facts were exceptional does not meant that the test will not apply in more routine circumstances. This is a case with real practical consequences for directors in all business’ in financial difficulty.

What we do know in the light of this case is that:

  • the creditors’ interest duty is engaged at some stage that is close to insolvency and before actual, established insolvency (either on a cash flow or balance sheet basis);
  • it may not be engaged when the risk of insolvency is real as opposed to remote;
  • a company being ‘on the verge of insolvency’ or ‘in financial difficulties’ or ‘approaching insolvency’ may be apt to describe particular circumstances that meet the test but none of these sets of words can be relied on to be the legal test for all situations;
  • the duty arises when the directors know or should know that the company is or is likely to become insolvent (which probably means cash flow insolvent and not just balance sheet insolvent) and ‘likely’, for these purposes, means more probable and not some lower test; and
  • the directors’ decision as to whether the creditors’ interest duty has arisen is best taken on an informed basis as to the practical consequences. Directors who seek and act on professional advice are likely to be in a stronger position.

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