Balancing members and creditors - the director’s perspective

11 October 2022

In a key judgment, the Supreme Court has confirmed that the directors of a company are under a duty to take the interests of the company’s creditors into account when it enters or approaches insolvency.

In BTI 2014 LLC v Sequana SA and others [2022] UKSC 25, the court examined when the duty arises and what it entails, as well as commenting on several aspects of company law that are of importance to companies with cashflow difficulties.

Three key take-aways for company directors
  • Directors must promote the success of a company for the benefit of its members as a whole (for most companies, its shareholders). But, when a company enters or is on the verge of insolvency, the directors must start to take the interests of the company’s creditors into account.
  • The more precarious the company’s financial state, the greater weight the directors must give to the creditors’ interests. If insolvent liquidation or administration becomes “inevitable”, the members’ interests give way completely to those of the creditors.
  • Directors should not pay a dividend while a company is insolvent. This includes where the company is “cash flow insolvent”, even if the company has sufficient distributable reserves to pay the dividend lawfully under the Companies Act.

What happened?

A trading company – AWA – paid a dividend to its parent company, Sequana.

When it paid the dividend, AWA was fully solvent on both a balance sheet and a cash flow basis. The dividend complied fully with the requirements of Part 23 of the Companies Act 2006 (the Act), which requires a company to have sufficient distributable profits to cover the amount of any dividend it pays, as well as with English common law principles relating to so-called “maintenance of capital”.

AWA had already made provision in its accounts for potentially significant environmental clean-up costs, which represented a long-term contingent liability. There was a risk that this liability could push AWA into insolvency. However, at the time of the dividend, insolvency was neither likely nor imminent.

AWA entered insolvency almost ten years later. It assigned its claims to BTI 2014 LLC (BTI).

BTI brought claims against AWA’s directors to recover the dividend. It alleged that, by paying the dividend, AWA’s directors had breached their duty to have regard to the interests of AWA’s creditors. It said they should not have paid the dividend while AWA had potentially significant long-term liabilities.

What is the duty to consider creditors’ interests?

The directors of a company owe a duty to promote the success of the company for the benefit of its members as a whole (section 172(1), Companies Act 2006). For a commercial company, “members” almost always refers to shareholders.

The directors owe this duty to the company itself. If they breach their duty, it is the company that has a right of claim against them, rather than the members (although, in some circumstances, the members can seize control of legal proceedings through a so-called “derivative claim”).

However, the duty to promote the company’s success is subject to any rule of law that requires the directors, in certain circumstances, to consider or act in the interests of the company’s creditors (section 172(3), Companies Act 2006).

It has long been assumed that, when a company is insolvent or approaching insolvency, the directors are under a duty to consider the interests of the company’s creditors, rather than its members. This is sometimes called the “rule in West Mercia”, after a case in which it was first explored. The scope of this duty, including when it arises, has been the subject of debate.

What did the court say?

The court examined the duty in great detail and came to the following conclusions.

  • There is a duty to consider creditors’ interests. However, this is a modification of the directors’ general duty to promote the success of the company. The modification arises when the company is in financial difficulty. There is no separate, free-standing duty owed directly to creditors.
  • The Act specifically recognises this duty. Section 172(3) of the Act specifically recognises that the duty to act in the interests of the members can be subordinated when the duty to consider creditors arises. The judges disagreed over whether section 172(3) confirms the rule in West Mercia, but it certainly gives that rule priority over the statutory duty to consider the members.
  • The duty arises when insolvency is probable or imminent. The court identified four situations where the duty arises: if the company is insolvent or bordering on insolvency; if an insolvent liquidation or administration is probable; and if a transaction would place the company in one of those situations. In all cases, insolvency must be “imminent” or “probable”. The duty does not arise merely if insolvency is a real but improbable risk.
  • But the directors still owe that duty to the company, not the creditors. This means creditors cannot bring direct action against directors who fail to take their interests into account. Instead, if the company enters insolvency, the liquidator or administrator will need to bring action against the directors on behalf of the company. However, any receipts should swell the pot for creditors.
  • For this purpose, there are two types of “insolvency”. A company will be “insolvent” if its liabilities exceed its assets (balance sheet insolvency) or it is unable to pay its debts as they fall due (cash flow insolvency). Either kind is capable of triggering the duty to consider creditors.
  • The duty increases as the situation worsens. The more serious the company’s financial problems become, the more weight its directors must give to creditors’ interests. Once insolvent liquidation or administration becomes “inevitable”, the members’ interests are no longer relevant and the interests of the company’s creditors become paramount.
  • The directors do not need to realise that insolvency is imminent. The duty applies if a “reasonably diligent and competent director” would know that there is no reasonable prospect of avoiding insolvency proceedings. This is different from other potential liabilities the directors may incur (such as wrongful trading under section 214 of the Insolvency Act 1986).
  • The members cannot ratify a breach of the duty. Normally, the members of a company can authorise (in advance) or ratify (after the event) a breach by the directors of their duties, including a breach of section 172. However, this is not possible once the duty to consider creditors arises. This flows from the broader principle that the members of a company cannot ratify a breach of duty by the directors if the company itself is insolvent or would become insolvent.

The court also confirmed that, when authorising a dividend, directors will not avoid a breach of duty merely because the dividend is paid lawfully under the Act.

The Act effectively mandates a balance sheet test of solvency when deciding whether a company can pay a dividend. But directors will breach their duty if they cause a company to pay a dividend when it is cash flow insolvent, even if the company satisfies the balance sheet solvency test in the Act.

What does this mean for me?

In many ways, the Supreme Court’s decision does not alter much. The existence of a duty to consider creditors’ interests has been considered by the courts several times and was never really in doubt. But the judgment does provide useful context that allows us to understand the duty a little better.

The court recognised the need to balance creditors’ interests with allowing a company’s directors flexibility to take risks and pursue commercial enterprise. In the words of Lord Briggs, “creditors of limited companies will get hurt from time to time”.

The result of this is that the stage at which the duty to consider creditors perhaps comes later than one might have thought. The mere possibility of insolvency at some point in the future (a so-called “real risk”) will not trigger the duty. This is welcome news for directors, who will want to concentrate on building their business and maximising growth, rather than constantly looking over one shoulder.

Rather, the duty is engaged once insolvency occurs or is on the verge. But even then, the creditors’ interests do not override all others. Directors of an insolvent company can still give thought to the members. They do not need to abandon the enterprise merely because the company may be temporarily insolvent. Many a start-up venture would fail ever to get off the ground were this the case.

In truth, we can perhaps think of the duty to consider creditors as a sliding scale.

At one end is the company that has a surplus of assets, healthy distributable reserves and the ability to pay its creditors when required – in other words, a healthy, solvent company. On a day-to-day level, directors should always consider the company’s creditors; no business should disregard its debts and liabilities. But the directors of a company in this situation are at liberty to concentrate squarely on the interest of its members. Of course, what is good for the members is likely to be good for the creditors.

At the other end is the company that has already entered, or will inevitably enter, formal insolvency proceedings. At this point, there is no place for the directors to act in the interests of the members; the interests of the company’s creditors are now “paramount”.

Between these poles are the many companies that move continuously or cyclically into and out of technical insolvency. The task for directors of these companies will be more difficult. They will need to balance the interests of the company’s members with those of its creditors, gauging its financial state on a regular basis to understand the degree of emphasis to give to each group of stakeholders.