A recurring issue concerning directors’ duties is the question whether or not directors have duties to their company’s creditors when the company is in the “zone of insolvency.” In an interesting recent decision, the U.K. Supreme Court addressed the duty of directors to creditors when their company becomes insolvent or when it approaches or is at risk of insolvency. In a case in which it decided that the directors for the company before the Court were not liable, the Court ruled that the creditor duty may arise not only when the company is insolvent but when it is “bordering on insolvency,” though the creditor duty does not become paramount until insolvency is “inevitable.” The Court’s October 5, 2022 decision in BTI 204 LLC v. Sequana SA can be found here. The Press Summary of the Court’s Judgement can be found here.
The dispute at the center of this action relates to a €135 million dividend paid in May 2009 by an English company, AWA, to its sole shareholder, Sequanna SA. In making the dividend payment, AWA’s directors considered certain long-term contingent liabilities AWA owed concerning historic pollution on the Fox River in Wisconsin. The AWA directors determined that AWA’s pollution liability was less than the value of its available insurance, and, accordingly, that the company was solvent and able to pay the dividend. The dividend was compliant with the statutory scheme regulation dividends in the Companies Act. At the time AWA paid the dividend, it was solvent on both a balance sheet and cash flow basis.
It later turned out that AWA’s pollution liabilities exceeded the earlier estimates. The company was unable to satisfy its environmental obligations. In October 2018, the company went into insolvency administration. BTI 2014 LLC, as assignee of AWA’s claims, filed an action against Sequanna and AWA’s directors seeking to recover the amount of the May 2009 dividend from AWA’s directors. BTI contended that the directors had a duty to consider the interests of AWA’s creditors when they paid the 2009 dividend. BTI argued that the duty arose because there was a real and not remote risk of AWA becoming insolvent.
Both the High Court and the Court of Appeal rejected BTI’s creditor duty claim. BTI appealed to the Supreme Court.
The October 5, 2022 Judgment
In an October 5, 2022 Judgment in which all members of a five-Justice panel of the Court joined or concurred, the U.K. Supreme Court rejected BTI’s appeal, holding that while the common law does provide that in certain circumstances directors are required to consider the interests of creditors, the “creditor duty” was not “engaged” on the facts of this case, because at the time of the May 2009 dividend, AWI was not actually or imminently insolvent, nor was insolvency even probable.
The Court began its analysis by considering the applicable legal principles with respect to whether or not there is a “creditor duty.” The Court considered Section 172(1) of the Companies Act 2006, which codifies the long-established common law fiduciary duty of directors to act in good faith in the interests of the company. The principles embodied in this provision are, the Court found, in certain circumstances modified by the common law rule that the company’s interests are taken to include the interests of the company’s creditors as a whole. The modifying principle is “in truth, an aspect of the director’s duty to the company, rather than a free-standing duty of its own.”
As to the question of when this “creditor duty” arises, a majority of the Court held that the duty arises when directors know, or ought to know, that the company is actually insolvent or bordering on insolvency, or that an insolvent liquidation or administration is probable.
Under this creditor duty, where the company is insolvent, or bordering on insolvency, but is not faced with an inevitable insolvent liquidation or administration, the directors should consider the interests of the creditors, balancing them against the interests of shareholders where they may conflict. The greater company’s financial difficulties, the more the directors should prioritize the interests of creditors. Where an insolvent liquidation or administration in inevitable, the creditors’ interests become paramount as the shareholders cease to retain any valuable interest in the company.
Applying these principles to the facts of this case, the Court unanimously found that the creditor duty was “not engaged” here, because at the time of the May 2009 dividend, AWA was not actually or imminently insolvent, nor was insolvency even probable. The Court specifically found that the duty does not apply, as BTI had argued, merely because the company was at a real and not a remote risk of insolvency.
An October 6, 2022 Skadden law firm memo discussing the Supreme Court’s ruling in the BTI 2014 LLC v. Sequana SA case (here) described the Court’s decision as a “significant milestone in the development of the English common law.” The significance of the Court’s decision is that, in addition to confirming that directors have duties to creditors that arise when the directors know, or ought to know that the company is insolvent, the Court also found that directors have duties to creditors when the directors know, or ought to know, that the company is “bordering on insolvency, or that an insolvent liquidation or administration is probable.”
The Court’s decision with respect to directors’ duties to creditors when their company is “bordering on insolvency” differs from the law generally applicable to directors’ duties in the United States. For example, as discussed at length here, under the law of Delaware (the state in which many U.S. companies are incorporated), directors’ duties do not shift from shareholders to creditors when a corporation is operating in the “vicinity” or “zone” of insolvency.
For example, in a 2007 decision, the Delaware Supreme Court said that when a solvent company is navigating in the zone of insolvency the “focus for Delaware directors does not change: Directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.” However, once a company becomes insolvent, directors’ obligations are altered, the creditors join the shareholders in the group of residual owners to whom the directors owe duties.
While the U.K Court recognized a director duty to creditors when a company is “bordering on insolvency,” the creditor duty does not become “paramount” until insolvent liquidation or administration is inevitable. In addition, the Court emphasized that the “appropriate course of action” for directors of companies faced with potential insolvency is “highly fact sensitive and requires a weighing of interests and the exercise of judgment.”
As the Skadden law firm memo to which I linked above put it, the Supreme Court’s emphasis on the necessity of balancing creditor and shareholder interests, and not on dissuading directors from seeking to achieve a restructuring or rescue, is consistent with the “rescue culture” which has been a “key focus on development in English corporate law” in recent years.
I will say that I find the Court’s ruling in the case to be unsurprising. The nearly ten-year gap between the dividend at issue and the Company’s eventual insolvency seems to make the “bordering on insolvency” analysis so temporally remote as to be almost unrelated. This was not at all a sympathetic case for the claimant/assignee – though in the end the Court was called upon to articulate principles that could be important in other cases.