Directors’ duties prior to insolvency: the creditor duty

The general rule of thumb is that directors owe their duties to act in the interests of the company and its members as a whole or, where the company has a purpose other than the benefit of its members, the duty is to act in a way to pursue that purpose. The latter will apply to social enterprises and charitable companies and many schools. This can cause difficulty and uncertainty when the company is in financial difficulty. The issue has been clarified recently and the importance of the directors’ duty to the creditors of a company potentially facing insolvency, known as the creditor duty, has recently been reaffirmed by the Supreme Court.

BTI 2014 LLC v Sequana SA [2022] UKSC 25

In this particular case the directors of Arjo Wiggins Appleton Limited (AWA) paid a dividend of €135 million in May 2009 to its parent company Sequana. AWA met both solvency tests at the time i.e. its balance sheet showed that assets exceeded liabilities and it was paying its debts as and when they fell due. However, there were some long-term contingent liabilities which meant that there was a real risk of future insolvency.

Fast forward to October 2019 and AWA went into insolvent administration. Some of AWA’s rights to actions were sold to BTI. BTI then sued AWA’s directors claiming that their decision to pay the dividend in May 2009 went against the creditor duty. They claimed that the duty started when there was a real risk to creditors.

The creditor duty is a duty to consider creditors' interests, to give them appropriate weight, and to balance them against shareholders' interests where they might conflict. The Supreme Court reaffirmed the existence of the creditor duty under section 172(3) Companies Act 2006 and section 214 of the Insolvency Act 1986.

The majority of the judges were of the opinion that when the creditor duty comes into force depends on the severity of the company’s financial difficulties, known as the paramountcy question. A definitive conclusion was not reached on the paramountcy question. However, it was suggested that when a company is insolvent or bordering on insolvency, the duty is to give the creditors’ interests appropriate weight and balance them against members’ interests, which may result in the members’ interests sitting below the creditors’ interests. The creditors’ interests are paramount if insolvent liquidation or administration is inevitable. Therefore, the creditor duty will come into action when the directors of a company know, or ought to know, that the company is or is on the verge of insolvency; or, there is a possible insolvent liquidation or administration.

The court also agreed that just because a company faces a real risk of insolvency in the future that does not mean the creditor duty has come into force.

What does this mean in practice?

Therefore, whenever a company is facing financial difficulty, even where the directors have reasonable confidence that they can manage the situation and resolve the issues, they need to consider matters that could be challenged and overturned if the company were to end up in liquidation or administration. There is also the potential for personal liability. Relevant matters can include whether dividends should be paid; salaries increased; whether any payment may be a preference; or a transaction at an undervalue. Taking professional advice early will not only help to manage the circumstances but should also substantially reduce the associated risks.

Charities and social enterprises:

The creditors’ duty applies to charitable companies as well as to non-charitable companies. It is therefore critical for the trustees or governors of any charitable company to consider the interests of creditors whenever the charity is, or is likely to find itself, in financial difficulty. For example, if a charity is struggling to pay its debts as they fall due or the cash flow forecasts show that it will have difficulty in discharging liabilities as they arise. Another test is whether the value of the charity’s assets is less than all of its liabilities, including contingent liabilities.

Trustees or governors will need to consider what weight to give to creditors interests, balancing them against the interests of the beneficiaries of the charity. This can seem extremely hard for a charity that provides support, makes gifts or provides donations to its beneficiaries for little or no financial reward.

Each of these would be transactions at an undervalue and may need to be avoided (or at least substantially reduced) until the social enterprise or charity is on firmer financial ground. The distribution of profits to a parent charity should also be very carefully considered in these circumstances.