Director Duties to Creditors of the Company
Problem: Lawfulness of dividend amounts paid to shareholders 10 years before liquidation
Outcome: The dividend was lawful as at the time of making the dividend payment the company’s assets exceeded its liabilities, and the reiterated the director’s duties towards creditors of a company.
Brief Summary of the Insolvency Claim
In October 2022, the Supreme Court handed down its judgment in BTI 2014 LLC v. Sequana S.A. [2022] UKSC 25 and provided vital guidance in which directors must have regard to the interests of creditors under s.172(3) of the Companies Act 2006 (also commonly known as the “creditors’ interests duty”).
The judgment raises important considerations for directors in evaluating the solvency of their company, especially those facing significant liabilities.
In May 2009, directors of a company named Arjo Wiggins Appleton Limited (“AWA”) distributed a dividend in the amount of €135 million to its only shareholder, namely Sequana SA (“the May Dividend”), which extinguished by way of set-off almost the whole of a slightly larger debt which Sequana owed to AWA.
It is important to note that at the time of the dividend payment, AWA was solvent (pursuant to its cash flow and balance sheet), its assets exceeded its liabilities and it was able to pay its debts as they fell due. As such, it is common ground that the May dividend was lawful, in the sense that it complied with the statutory scheme regulating payment of dividends in Part 23 of the Companies Act 2006 and with the common law rules about the maintenance of capital.
However, AWA had a long-term pollution-related contingent in place of an uncertain amount relating to the need to clean up a polluted river together with an uncertainty as to the value of one class of its assets (an insurance portfolio). This gave rise to a ‘real’ risk that AWA might become insolvent in the future, although insolvency was not ‘probable’. After almost a decade, this risk materialised and on or around October 2018, AWA went into administration.
An assignee of AWA’s claims, namely BT1 2014 LLC, sought to recover this dividend payment from the directors of AWA on the basis that they did not act in the best interest of its creditors. Meanwhile AWA’s main creditor applied to have the May dividend set aside as a transaction at an undervalue intended to prejudice creditors, under section 423 of the Insolvency Act 1986.
The Supreme Court Judgment
This appeal provided the first opportunity for the Supreme Court to address the existence, scope and engagement of an alleged duty of company directors to consider, or to act in accordance with, the interests of the company’s creditors when the company becomes insolvent, or when it approaches, or is at real risk of, insolvency.
The Supreme Court held that directors, as part of their duty to act in good faith in the interests of the company, must also consider the interest of creditors (section 172(3) of the CA 2006 applied). However, it was unanimously found that although the duty exists, it cannot be triggered merely by a real risk of insolvency. Therefore, at the time of the dividend payment, the directors were not under any duty to consider the interests of the company’s creditors because AWA was neither imminently insolvent nor was insolvency probable.
The Judges noted that there is a rule which modifies the ordinary rule whereby, for the purposes of the director’s fiduciary duty to act in good faith in the interests of the company, the company’s interests are taken to be equivalent to the interests of its members. Therefore, where the modifying rule applies – a rule described as the rule in West Mercia in the Judgment, after the leading case of West Mercia Safetywear Ltd (in liq) v Dodd [1988] BCLC 250 – the company’s interests are taken to include the interests of its creditors.
Lord Hodge in particular dismisses the appeal in paragraph 247 of his Judgment and summarises the position as follows:
- The fact that a company faces a real risk of insolvency is not sufficient to give rise to the West Mercia duty.
- The West Mercia duty can apply to a decision to pay a lawful dividend.
- The West Mercia duty is a recognition of the economic interests or stakeholding in the company of its creditors when the company is bordering on insolvency or is insolvent.
- Where a company is insolvent or bordering on insolvency the West Mercia duty involves a fiduciary duty of the directors to the company to take into account and give appropriate weight to the interests of the company’s creditors as a body. Where the company is irretrievably insolvent, the interests of those creditors become a paramount consideration in the directors’ decision-making.
What does this mean for directors?
Directors are personally subject to statutory duties in their capacity as directors of a company. In addition, the company as a separate legal entity is subject to statutory controls and the directors are responsible for ensuring that the company complies with such statutory controls.
The Companies Act 2006 codified certain common law and equitable duties of directors for the first time and sets out the general duties of directors, which are:
- to act within powers in accordance with the company’s constitution and to use those powers only for the purposes for which they were conferred
- to promote the success of the company for the benefit of its members
- to exercise independent judgement
- to exercise reasonable care, skill and diligence
- to avoid conflicts of interest
- not to accept benefits from third parties
- to declare an interest in a proposed transaction or arrangement
What practical steps should directors consider?
There are several practical steps that directors can take in order to reduce the risk of claims being brought against them:
- It is good practice to hold frequent board meetings and keep detailed minutes of these meetings, which ultimately is required for an audit trail.
- It is good practice to prepare up-to-date, reliable financial and operational information, for example, a cash-flow prediction, details in relation to any potential bad debts and a list of creditors in advance of any board meetings. These will provide a clear financial picture of the company and are in the interest of transparency.
- Be mindful when prioritising payments, especially any payments pursuant to a director’s loan. Directors should be cautious of honouring and prioritising payment obligations to certain creditors over other creditors.
- The directors should frequently review commercial contracts, consider any potential breaches and terminations, and take note of any events which may be triggered in the current circumstances.
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If a company has gone into insolvent liquidation and before that liquidation took place a director knew, or ought to have known, that there was no reasonable prospect that the company could avoid the liquidation, then the court may declare that the director makes a personal contribution to the company’s assets.
However, the director will not be made personally liable in circumstances where the director can show that every step was taken prior to the liquidation to minimise the potential loss to the company’s creditors.
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