Directors' duties: when the pendulum swings in favour of creditors

Directors' duties: when the pendulum swings in favour of creditors

New rules on section 1 statements from 6 April 2020

A recent Court of Appeal case, Sequana S.A. v BAT Industries Plc and others [2019] EWCA Civ 112, considered two important issues:

  1. when a payment of a dividend can breach s423 Insolvency Act 1986, i.e. by deliberately putting assets beyond the reach of creditors; and
  2. when directors have a duty to consider the interests of creditors rather than shareholders

s423 Insolvency Act 1986

The Court affirmed the decision of the High Court that a dividend (by way of set-off against a significant parent company debt) was, on the facts, a transaction at an undervalue for the purposes of s423, made with the intention of putting assets beyond the reach of creditors. Therefore there was a liability to restore the dividend payment even though made lawfully and not in breach of directors’ duties.

Directors and shareholders need to be careful of section 423 Insolvency Act. This case makes it clear that it covers dividend payments, and also that it can apply even where the dividend is otherwise lawful. In this case, it was held that the decision to pay the dividend could not be separated from the broader context of ultimately selling the subsidiary and removing any risk of the parent having to meet the subsidiary’s liabilities. There was evidence of the directors being motivated by a desire to remove the parent company debt as an asset of the subsidiary, so putting it beyond the reach of its creditors. So s423 may catch any dividend distribution where there is evidence that the directors are motivated to put assets beyond the reach of creditors. What is more, there is no insolvency requirement for this section. Section 423 focuses on the directors’ subjective intention and not the financial health of the company.

When directors have a duty to consider the interests of creditors rather than shareholders

Directors are subject to statutory duties under the Companies Act 2006 in taking decisions. In particular, they have a duty under section 172 of the Companies Act to act in a way they consider, in good faith, would be most likely to promote the success of the company for the benefit of its shareholders as a whole, and have regard to a number of non-exhaustive factors. So the basic rule is that shareholder interests are of paramount importance when directors take decisions, but this is subject to section 172(3) which reflects the common law rule that directors must consider the interests of creditors as well as or instead of that of shareholders where the company’s solvency is in doubt. The Court considered four possibilities when the duty to creditors may arise:

  1. on actual insolvency;
  2. when the company was on the verge of insolvency;
  3. when the company was likely to go insolvent (i.e. it probably would go insolvent); or
  4. when there was a “real” risk of insolvency as opposed to a remote risk.

After considering all the previous cases on the point, the Court was hesitant to offer a clear test, saying it was for Parliament to decide as a matter of policy, but on balance it favoured the third formulation, i.e. the duty arose when insolvency was probable. The Court was clear that the duty arose before actual insolvency but should not arise just because insolvency was a real risk.

The case is moderately helpful to directors, in dismissing the argument that a duty to creditors arises whenever there is a “real” risk of insolvency. It must be more than that, and a company must be likely to go into insolvency before the duty can be said to arise. But the Court was tentative – as a practical matter, in our view, directors of a company that fear a company could go insolvent should take advice before making any decision that may damage creditors’ interests.

Facts

Arjo Wiggins Appleton Limited (AWA) made two substantial dividend payments (by way of set-off against receivables owed to it by its parent company Sequana) at a time when it had ceased to trade and was effectively in run-off, with the benefit of 2 insurance policies and with one significant contingent liability (an indemnity provided to another company concerning contamination of a river in Wisconsin).

In the High Court, the judge dismissed claims that the directors “could not pay” the dividends (i.e. because they were unlawful under the Companies Act). She found that the directors had undertaken a proper assessment of the value of the contingent liability in accordance with accounting principles. She also rejected the claim for breach of duty (i.e. that the directors “should not pay” the dividends because the duty to creditors had arisen). But she did find that the dividends had been paid in breach of s423 Insolvency Act, i.e. the payment of dividends was a transaction at an undervalue for the purpose of putting assets beyond the reach of creditors.

There was an appeal and a cross-appeal. BAT, as the potential creditor of AWA and thus the “victim” of the dividend payment, appealed against the finding that the payment was not in breach of directors’ duties, and Sequana appealed against the s423 finding.

The Court of Appeal decided that a dividend is a transaction for which no consideration is received and therefore falls within s423. It was also satisfied that as a matter of fact the directors of AWA had been motivated by a desire to put assets beyond the reach of creditors by eliminating the inter-company receivable so that Sequana would have no liability in AWA’s insolvency.

On the breach of duty cross claim, the Court referred to s172 of the Companies Act setting out duties of the directors to their company, and to s172(3) which states that in certain circumstances directors owe those duties to creditors.

AWA had insurance policies to cover the potential risk under the indemnity, and had acted correctly in accordance with accounting policies in estimating the potential liability and distributing the surplus. But there was a risk that the contingent liabilities would exceed the provision made and therefore a risk of insolvency.

It was in this context that the Court examined when the duty to creditors arose, and concluded that in this case the mere risk of insolvency was not sufficient for it to arise. The duty to creditors may arise at a point short of actual, established insolvency, and, according to Richards LJ, that point is where the directors know or should know that the company is or is likely to become insolvent (“likely” meaning probable). But just because a company has provisions and contingent liabilities reflected in its accounts does not mean that directors have to run it in the interests of creditors rather than shareholders, unless at the time of the relevant decision the company is insolvent or likely to become so. Advice should be taken in cases of doubt on the company’s solvency prospects.

Comment

Tim Carter, restructuring and insolvency partner at S&B, comments:

“This case does not add a huge amount to the first instance decision, and means that directors of companies that are solvent may sometimes owe duties to creditors. When that duty arises is arguable and directors would be prudent to take advice in case of doubt. The case also highlights that dividends, even if lawful, can sometimes breach s423 of the Insolvency Act, though clear evidence of an intention to put assets beyond the reach of creditors will be required.”

Contact our experts for further advice

Search our site