What does the ‘Sequana’ decision mean for directors’ duties?

Background

The claim arose following a €135 million dividend distribution by Arjo Wiggins Appleton Ltd (“AWA”) to its shareholder Sequana SA in 2009. The dividend was lawful in that the statutory procedure for quantifying the amount to be paid by way of distribution was complied with, and AWA was solvent on a cash flow and balance sheet basis.

Despite this, AWA had long-term pollution-related contingent liabilities of an uncertain amount, which gave rise to a real risk, although not a probability, that AWA might become insolvent at an uncertain but not imminent date in the future. AWA went into insolvent administration in October 2018.

AWA’s assignee, BTI 2014 LLC (“BTI”), sought to recover an amount equal to the 2009 dividend from AWA’s directors personally on the basis that the decision to distribute the dividend was a breach of the creditor duty. 

Before the Court of Appeal it was held that:

• they were bound by the decision in West Mercia that the directors owed a duty to consider the interests of creditors and that this duty was triggered when the directors knew or should have known that the company was insolvent (the creditor duty)

• the creditor duty was not engaged at the time of the 2009 dividend distribution as AWA was not insolvent, nor was a future insolvency either imminent or probable even though there was a real risk of it. It therefore did not arise simply because there was a real and not remote risk of insolvency

There was an appeal before the Supreme Court on the basis that a real risk of insolvency was sufficient to engage the creditor duty.

The extent of directors’ duties to creditors

While it is established law that directors owe a duty to promote the success of their companies (i.e. for the benefit of the shareholders) the Court made it clear that:

• directors of financially distressed companies must consider, as one of the relevant factors, the interests of creditors as a whole

• this duty to creditors is engaged when directors know, or ought to know, the company (1) is bordering insolvency or insolvency is imminent, or (2) is cash flow or balance sheet insolvent, or (3) insolvent liquidation or administration is probable (the creditor duty)

• this duty does not exist simply because there is a real and not remote prospect of insolvency

• directors must also not “materially harm” creditors’ interest, which protects creditors against “insolvency-deepening activity”

• at a certain point in time, the interests of creditors must have priority over any other interest (i.e. duties owed to the company). This point in time is not reached until the company becomes irreversibly insolvent and must enter liquidation or some formal insolvency procedure

• at no stage does there become a duty to “promote the success of the company for the benefit of creditors”, known as “a self-standing creditor duty”. However, if a company becomes irreversibly insolvent, directors must disregard the interests of shareholders if they conflict with those of creditors

In summary, the Court unanimously held that the ‘creditor duty’ was not engaged. This was because it was only after some years following a lawful dividend distribution that an environmental liability emerged to be much greater than originally estimated, and therefore the risk of insolvency was real and not imminent nor probable at that time.

This is a welcomed embrace by the Courts of the commercial realities of corporate governance and decision-making. After all, these are factors which keep companies competitive and dynamic.

The deeper into insolvency a company goes, the greater the directors’ duty to creditors

The judgment has clarified that the duties placed on directors to consider creditors’ interests increases the deeper into insolvency a company goes. This ‘sliding scale’ can be demonstrated by the follow pillars:

• Where there is a real risk of insolvency, directors have a duty to promote the success of the company for the benefit of the members
• Where a company is bordering insolvency or insolvency is imminent, or is cash flow or balance sheet insolvent, or insolvent liquidation or administration is probable, directors still have a significant duty to promote the success of the company for the benefit of the members, with a lesser, but increasing, duty to also consider and have regard to creditors’ interests.
• Where insolvency is irreversible and there is no prospect of a company avoiding liquidation or administration, the creditors’ interests are paramount.

• The reasons for this sliding scale include promoting the rescue of companies, and not seeking to discourage entrepreneurism. For example, insolvency legislation encourages the rescue of companies experiencing financial difficulty rather than liquidating them.
• Directors must be free to take some positive steps, such as raising funding, despite the fact that the position of the creditors is precarious; when making such commercial decisions in good faith, directors must be able to act in a way which they consider will most likely ensure the continued success of the company.
• Upon the creditor duty being engaged, it was one view in the Supreme Court that directors must ensure they do not engage in “insolvency deepening activities” – this is historically reflective of the director disqualification regime, particularly in respect of HMRC, where losses to HMRC during a period where there is a real risk of insolvency is considered misconduct by the director.

However, whilst this was a unanimous judgment it is noted that:

• There was a lack of unison between the judges in their rationale and / or minor differences; and
• The judgment made it clear that each case must be considered on its own facts. Despite this, the judges discussed hypotheticals.

The different reasoning reached by the judiciary may have the effect of creating uncertainty and be subject to future litigation, particularly when the lower courts come to interpreting the differing views expressed.

Tips for directors

Directors are expected to adhere to high standards which reflect the special duties they owe at different times within the lifecycle of a business. They must also, by the very nature of their role, exercise commercial judgement. It is therefore important that they are aware of these duties and able to demonstrate that they are not breaching them.

As discussed in the judgment of Sequana, directors should always have access to reasonably reliable and up-to-date information about the company’s financial position, ensuring they stay informed. “Directors can and should require the communication to them of warnings if the cash reserves or asset base of the company have been eroded so that creditors may or will not get paid when due.” This will assist in promoting the success of the company, considering the interests of creditors and protect directors from criticism as to why certain decisions were or were not taken.

• This is particularly important when considered against director safeguards, such as that at section 1157 Companies Act 2006 which offers protection in instances when directors act with honesty and integrity.

• This is also important where questions arise with respect to wrongful trading which provides for the losses suffered by creditors (as a result of continued trading at a time when such insolvency presented a risk), as well as fraudulent trading (which is more serious, usually requiring evidence of a deliberate or criminal intent).

Directors are of course human and cannot be sunk where the ship goes down despite their best efforts (as the insolvency regime provides for) and there are circumstances and defences available in circumstances where, for example, information was not available, the directors had a genuine commercial objective and/or where they acted with genuine honesty and integrity.

At Francis Wilks & Jones we have considerable experience of assisting directors to address these types of risk and also in supporting them when they are subject to claims for acting in breach of their fiduciary duties.

Contact our brilliant director defence team today for help.

FWJ were very hands-on, getting involved from an early stage in seeking to avert an expensive set of litigation proceedings. I am more than happy to recommend their services, particularly when it comes to considering complicated issues or complex proceedings.

A client who was facing a liquidator claim for the improper withdrawal of sums from a company. We had the claim dismissed