How close is close enough? Considering creditors' interests
Insolvency Bitesize - March 2019
The Court of Appeal has held that directors do not have a duty to consider the interests of creditors until the company is probably insolvent. But, the precise scope of that duty and how directors should then balance shareholder and creditor interests remain unclear.
Directors of English companies must comply with a range of statutory duties, as well as various common law and fiduciary duties. If a company is facing financial difficulties, directors will need to focus on two concerns in particular:
- the “wrongful trading” risks (under s214 IA 1986); and
- the duty to consider or act in the interests of the company’s creditors (arising under s172(3) CA 2006).
In BTI 2014 v Sequana  EWCA Civ 112, the Court of Appeal considered the second of those concerns in the context of a company that had declared two substantial lawful dividends at a time when it had ceased to trade and had one material liability. That liability took the form of contingent indemnity liabilities that the company had inherited through a series of complex corporate transactions for clean-up costs and damages claims arising out of river pollution in the US in the 1950s and 1960s.
The Court of Appeal was faced with deciding whether something short of actual insolvency could trigger the creditors’ interests duty. While there were several authorities assuming that was the case, on examination in all of them the company had been actually insolvent, so there was no conclusive decision on what such a trigger might be.
The Court of Appeal considered 4 possible triggers suggested in the authorities and submissions:
- Actual insolvency (cash flow or balance sheet) – this was a well-established proposition and the Court of Appeal made clear that this would trigger the creditors’ interests duty;
- Imminent insolvency (being on the verge of or nearing/approaching insolvency) – the Court of Appeal thought that such formulations were problematic as they suggested a very short temporal test. They might describe situations where the duty was triggered but would not, for example, catch a company which was currently cash flow solvent but nonetheless likely to become insolvent and whose decisions now could prejudice creditors when the likely insolvency occurs. The Court of Appeal accordingly rejected these formulations as useful to establish whether the duty had been engaged;
- Likely insolvency (when the directors know or should know that the company is or is likely to become insolvent) – the Court of Appeal considered this accurately encapsulated the trigger. In this context, likely meant probable; and
- Real risk of insolvency (not just remote) – the test suggested by the applicant in this case. The Court of Appeal rejected it as too low a threshold. Such a trigger would be inappropriate as it could have a "chilling effect" on business activity leading to directors having to be too cautious.
Clearly if the company is “presently and actually insolvent” then creditors’ interests become paramount because of their quasi-proprietary prospective interest in the assets of the company. But, as clarified by the Court of Appeal, directors will also need to consider creditors’ interests if the company is probably insolvent. Do creditors’ interests entirely displace shareholders’ interests at that point? Or, are they to be considered without being decisive? How do directors strike the right balance?
The Court of Appeal acknowledged that those questions were not straightforward, but on the facts, they did not arise and so did not look to answer them. The creditors’ interests duty was not triggered as the company was not insolvent or likely to become insolvent at the time the dividends were paid.
Of course, the wrongful trading test in s214 IA 1986 homes in on a broadly similar timeframe – namely, when a director knew or should have known that the company had no reasonable prospect of avoiding a future insolvent administration or liquidation. In Grant v Ralls  EWHC 243 (Ch) (and as recently confirmed in Johnson v Beighton  3 WLUK 380), the focus here is whether insolvency is “inevitable”. While similar, there could well be a gap between when insolvency is “likely” and when it is “inevitable” and this period will require careful navigation.
However, directors – and IPs looking to investigate their actions – may be left wondering whether this decision really changes anything, as the test has always been hard to pin down. Recognising precisely where a company sits on the solvency-insolvency scale is more easily done after the event and, in practice, the emphasis to be placed on protecting creditors’ interests grows as the company’s financial position deteriorates. But, in settling on likely insolvency as a trigger for the creditors’ interests duty, it does seem directors will need to exercise caution at an earlier stage, although identifying whether their actions fall short of the required duty is no clearer. We will have to wait to see if the decision is appealed to the Supreme Court and further guidance becomes available.