Sequana: Syntax, Semantics and the Sliding Scale

The much-anticipated Supreme Court judgment in BTI 2014 LLC v. Sequana S.A. [2022] UKSC 25 was handed down on 5 October 2022. Seventeen months in the waiting; directors, investors, shareholders, insolvency practitioners and lawyers have all been eager to receive the latest ruling in the ever-uncertain area surrounding a company’s “twilight zone” and the trigger of the “creditor duty” – or is that “the West Mercia duty”?!

Creditor Duty

Directors of a company owe a common law fiduciary duty 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 members as a whole. This duty is codified by section 172(1) of the Companies Act 2006 (“the 2006 Act”).

The “creditor duty”, also referred to as “the West Mercia duty” (so named after the leading case, West Mercia Safetywear Ltd v Dodd [1988] BCLC 250)), is a common law principle that requires directors to shift their focus away from shareholder interests and towards creditor interests, when a company is in financial distress (otherwise known as being in the “twilight zone”). This modification to the general fiduciary duty is codified in section 172(3) of the 2006 Act.

 

Facts of Sequana

In May 2009, the directors of AWA caused it to distribute a €135m dividend to its sole shareholder, Sequana SA (“Sequana”), thereby extinguishing almost the whole of a debt owed by Sequana to AWA. The dividend complied with the statutory scheme regulating dividend payments (Part 23 of the 2006 Act) and with the common law rules. AWA was also, at the time, solvent on both a balance sheet and cash flow basis. It did however have long term contingent liabilities of an uncertain, but likely substantial, amount. Even though insolvency was not imminent, or even probable, there was a real risk that AWA might become insolvent in the future.

In October 2018, AWA went into insolvent administration. BTI, assignee of AWA’s claims, sought to recover the value of the dividend from AWA’s directors, arguing that the dividend had been declared in breach of the directors’ duties to consider and act in the creditors’ interests, those interests representing the interests of AWA at that time given its real risk of future insolvency.

 

High Court and Court of Appeal

The High Court and Court of Appeal both rejected BTI’s argument. The Court of Appeal held that the creditor duty was not triggered until “the directors know or should know that the company is or is likely to become insolvent… In this context, “likely” means probable“. BTI appealed to the Supreme Court.

 

Supreme Court

On appeal, the Supreme Court considered three main points:

1. Whether the “creditor duty” existed at all?

Whilst there appeared to be some dissent as to the description of the relevant duty (with Lord Briggs (supported by Lord Kitchin) preferring the “creditor duty” and Lord Reed, Lord Hodge and Lady Arden preferring “the rule in West Mercia”), all members of the Court agreed that the duty existed. In doing so, they pointed to established case law which supported the obligation to consider creditor interests in the context of the onset of insolvency, as well as the intentions of Parliament in endorsing common law through the enactment of section 172(3) of the 2006 Act.

It was further agreed that directors in fact owe their duties to the company, rather than directly to shareholders or creditors and accordingly that the creditor duty is not a free-standing duty owed to creditors; it merely adjusts the long-established fiduciary duty of directors to act in good faith in the interests of the company.

2. Can the “creditor duty” apply to payment of an otherwise lawful dividend?

The Supreme Court held that the creditor duty can apply to a decision by directors to pay a dividend which is otherwise lawful, for two reasons. First, Part 23 of the 2006 Act is subject to the common law creditor duty, as codified by section 172(3) of the 2006 Act. Secondly, a decision to pay a dividend that is lawful under Part 23 may still be taken in breach of duty, as Part 23 identifies profits available for distribution on a balance sheet basis only – it does not require a cash flow calculation.

3. What is the content of the “creditor duty” and when is it triggered?

The climax of the Supreme Court’s judgment went to the content of the creditor duty and the point at which it is triggered. Practically speaking, how and when are directors required to shift their focus to creditor interests.

It was held that directors are required to balance the interests of creditors, as against those of shareholders, depending on the stage of the company’s insolvency. The greater the company’s financial difficulties, the more the directors should prioritise the interests of the creditors; and where an insolvent liquidation or administration is inevitable, creditors’ interests become paramount as shareholders cease to retain any valuable interest in the company. In Lord Briggs’ judgment, this is the same point at which section 214 of the Insolvency Act 1986 (wrongful trading) is also triggered.

Members of the Court went on to affirm that the interests of creditors are the interests of creditors as a general body, rather than the interests of particular creditors in a special position. In her judgment, Lady Arden held that the content of the rule in West Mercia is not limited to a consideration of creditors’ interests; but that directors are also required not to harm those interests. Lady Arden further held that the progress towards insolvency may not be linear, and that directors should stay informed of the company’s financial position.

In dismissing the appeal, the Supreme Court held that the creditor duty had not been engaged in May 2009 when there was only a “real and not remote risk” of insolvency. Instead, Lord Hodge, Lord Briggs and Lord Kitchin held that the creditor duty is engaged when the directors know, or ought to know, that the company is insolvent or bordering on insolvency, or that an insolvent liquidation or administration is probable. Lord Reed and Lady Arden agreed that the duty applies when the company is insolvent or bordering on insolvency, or when an insolvent liquidation or administration is probable, however, they did not address the question of whether it is essential that the directors know or ought to know that this is the case.

The effect of the individual judgments was to establish a creditor duty trigger point sliding scale, such that when the risk of insolvency is too remote, so too is the creditor duty. As insolvency becomes more acute, so too does the creditor duty. And once insolvent administration or liquidation is inevitable, or indeed a company is insolvent, creditors’ interests are paramount.

 

Pertinent Points

The Supreme Court unanimously dismissed BTI’s appeal. What is apparent from the judgments is that the routes taken by the members of the Court in reaching the decision were not entirely consistent.

Indeed, the nomenclature of the relevant duty – “creditor duty” or “West Mercia duty” – remains open for debate.

The syntax of how and when the creditor duty is triggered however appears to have been settled, in part, by the Supreme Court’s sliding scale with:

• a “real and not remote risk of insolvency” falling short of the trigger point; and
• the duty becoming more acute as a company progresses through the following states of insolvency: “insolvency is imminent”, “bordering on insolvency”, “cash flow or balance sheet insolvent” and “insolvent liquidation or administration being probable”; and
• the creditor duty becoming paramount when there is “no prospect of avoiding liquidation or administration”.

What the Supreme Court has clarified in terms of syntax, it has kept open in terms of semantics. What is the practical or quantifiable equivalent of “insolvency being imminent”, as compared to, say, “bordering on insolvency”? At what point does a “real risk of insolvency” tip into the relevant period for which the creditor duty applies? And if, as Lady Arden identifies, insolvency is not linear, is there an expectation for directors to continuously switch between creditor and shareholder interests throughout the life of a company? This being so, the clarification of the relevant stages becomes all the more important.

The law was calling out for clarity and certainty. Directors need to know the parameters of their duties and should be confident as to the circumstances in which they can legitimately declare dividends, trade a company and act in the interests of shareholders as a whole. The Supreme Court’s sliding scale goes some way in clarifying the theoretical parameters; however the corresponding practical day-to-day triggers seem to be shrouded in syntax v. semantics.

If you have any questions regarding this subject please contact Sophia Bompas or any member of the Restructuring & Insolvency team.

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