Supreme Court judgment offers guidance on director duties in event of insolvency

By Zelda Pitman ,

Retail Client Executive, Management Liability

18/10/2023 · 4 minute read

In this article we will consider the relevance of the 2022 Supreme Court judgement in BTI v Sequana^[1] to directors, which discusses their duties upon and before the insolvency of a company and the existence of the so called “creditor duty”

When a company becomes insolvent, directors and officers will often be in the firing line from various quarters. For example:

Insolvency practitioners appointed to liquidate the company will be on the lookout for any wrongful trading, transactions at an undervalue or preference transactions^[2], by the directors in the run up to the insolvency, with a view to recovering some of the losses suffered by the company on behalf of the creditors.
At the same time the Insolvency Service may investigate whether there are grounds for Directors Disqualification Proceedings; if directors’ conduct was unfit or in breach of their legal responsibilities.
HMRC can^[3] issue Joint and Several Liability Notices (JLNs) to individual directors, including shadow directors and former directors, meaning unpaid corporate tax liabilities can be enforced in full against these individuals if HMRC suspects the insolvency to be for the purpose of tax avoidance.

Therefore, insolvency is a particularly high risk time from a Directors and Officers (D&O) liability insurance perspective - leading to some of the most significant D&O claims. Consequently, D&O insurers will be very interested in the financial health of a company and how it is dealing with economic headwinds, when considering a risk.

Directors should ensure that D&O insurance is in place and the premiums are up to date, that they have sufficient protection in terms of limits and breadth of cover to protect them personally if the worst happens, and consider placing ‘run-off’ cover in the event of insolvency.

Introduction

Increasing energy prices, high inflation, worker shortages, supply chain pressures, and rising interest rates have all combined to create a perfect storm for UK businesses. The number of company insolvencies is increasing with Q2 2023 witnessing the highest numbers since the aftermath of the financial crisis^[4] of 2008. The rise in insolvencies increases risk for directors of insolvent companies. In 2022, the Insolvency Service launched 36% more investigations into directors of insolvent companies for alleged misconduct than in 2021. Additionally, during the same period, the number of corporate abuse cases referred to the Insolvency Service more than doubled^[5].

Directors need to be alert to their personal responsibilities and liability when their company is experiencing financial difficulties that may lead to insolvency. The recent Supreme Court judgment in BTI v Sequana illustrates the difficult balancing act that directors must manage, in determining at what stage their duty to act in the best interest of shareholders becomes secondary to a duty to act in the best interest of creditors.

The BTI v Sequana case

Directors have a fiduciary and statutory^[6] duty to act in the best interests of the company, which generally means the members, or shareholders, of the company. However, where a company is approaching insolvency or actually insolvent these duties change. The duty to the shareholders is not always paramount and it has also been understood that the directors’ duty to act in the best interests of the company should be taken to mean in the best interests of the company’s creditors, or both the creditors and the shareholders. In BTI v Sequana, the Supreme Court confirmed that this is indeed the case - directors do have a duty to act in the best interests of creditors. The case also sets out when that duty to creditors might be triggered, when it should take priority over the duty to shareholders, and its scope.

The facts

The company AWA distributed a dividend of €135M to its only shareholder, Sequana SA, in May 2009. At that time, the dividend was legally distributed; AWA was both balance sheet and cash flow solvent and a going concern, however it’s contingent liabilities for clean-up costs following pollution meant there was a risk - though not a probability - that it might become insolvent at some point in the future. Almost 10 years later, AWA did indeed become insolvent and BTI became an assignee of AWA’s claims. BTI sued AWA’s directors alleging that the dividend payment to Sequana was a breach of their duty to consider the best interests of the company’s creditors. Both the High Court and the Court of Appeal rejected BTI’s claims and they appealed to the Supreme Court.

The Supreme Court judgment

The Supreme Court dismissed BTI’s appeal. The Court confirmed that directors do have a duty to consider the interests of creditors in certain circumstances, and that this duty could be found in statute^[7]and case law^[8]. Indeed, one of the Supreme Court judges went further and said that the directors must not only consider creditors’ interests but must not materially harm them either^[9]. This duty also makes business sense, as creditors always have an economic interest in the company’s financial wellbeing, and this will likely become a very keen interest as a company nears insolvency.

The judges went on to consider when the directors need to start giving more weight to creditors’ interests and when those interests would take priority over shareholders’ interests. It was held that the duty did not arise when there was a real risk of insolvency nor even when insolvency was probable. The Supreme Court felt that this was too soon as even when insolvency was likely, there was a chance that the company could find a way back to solvency. Then the interest of the shareholders and the company, and indeed the creditors, would likely be aligned in working towards that goal.

The duty to consider the interests of creditors was engaged later, when insolvency was ‘imminent’. At that stage, directors would need to take into account their duty to shareholders as well as their duty to creditors, and if those were in conflict, make a judgment as to whose interests were paramount. The more financial difficulty a company was in, the more that the balance would shift in favour of a duty to creditors. However, when insolvency or administration “is unavoidable, the interests of shareholders drops out of the picture and the company’s interests can be treated as equivalent to those of the creditors alone”^[10].

Although the decision does give some comfort to directors it also leaves room for debate about the allocation of weight as between the creditors and the shareholders duties in the run up to an insolvency, and the point at which insolvency became inevitable. We may well see more case law on this in the future especially given the increase in reported insolvencies.

Takeaways for directors

Directors should take away the following lessons:

The creditors duty is part of the directors’ duty to act in good faith in the interest of the company.
It is triggered when directors know or ought to know that the company is insolvent, is bordering on insolvency, or insolvency is probable. It is not triggered by the real risk of insolvency.
It is a general duty to all creditors, not to one particular creditor.
Once insolvency is inevitable, the interest of creditors become paramount and should take priority over those of shareholders or other stakeholders.
When insolvency is probable or imminent, directors need to balance any competing interests by considering the degree of financial difficulty the company is in.

As always, it may be of limited evidentiary value if Boards consider these issues but fail to keep a record of it, so all these deliberations need to be properly minuted and it may well be prudent for professional advice to be taken at certain stages.

Directors must be mindful of their obligations to creditors from the moment that their company enters into financial difficulties and be sure to document their decision-making processes. A switch too soon to prioritising the creditor’s interests may put them at risk of shareholder action, but directors are also at risk of creditor claims if they move too late. This makes it very important that directors, including non-executive and shadow directors, stay on top of their company’s financial position at all times.

D&O insurance

It is also important that directors have appropriate D&O cover in place. Some D&O policies offer extensions for individual tax liabilities, which may cover suits by the HMRC for unpaid corporate taxes and/or national insurance in the event of insolvency. Directors should check if this cover is provided in their current D&O policy. Directors may also want to confirm whether the D&O policy provides cover for legal or expert fees incurred in responding to an investigation into the affairs of a company brought by an insolvency professional or the Insolvency Service, as well as confirming the run off provisions or discovery periods available in the event of insolvency.

Speak to a Marsh professional if you want to discuss further or you have any questions about your cover.

^{[1] BTI v Sequana [2022], UKSC 25 on appeal from [2019] EWCA Civ 112}

^{[2] The Insolvency Act 1986}

^{[3] Under The Finance Act 2021}

^[4]^{Commentary - Company Insolvency Statistics April to June 2023}

^{[5] City AM, Fraud Warning as insolvency surge sees more directors investigated for corporate misconduct, 15 May 2023, reporting on research by Reynolds Porter Chamberlain (RPC)}

^{[6] See Section 172 (1) of the Companies Act 2006}

^{[7] See Section 172 (3) of the Companies Act 2006}

^{[8] West Mercia Safetywear Ltd (in liq) v Dodd [1988] BCLC 250}

^{[9] Lady Arden at para. 250}

^{[10] Lord Reed at para. 77}