Sequana: implications for directors in the zone of insolvency

The Supreme Court handed down its long-awaited judgment in BTI 2014 LLC v Sequana SA on 5 October 2022. This important case addresses the duties of directors to consider the interests of creditors as a company approaches insolvency.

While the judgment will be welcomed by many as providing some useful guidance on a number of issues, there still remain some key areas of uncertainty which, as we consider in further detail below, will present clear challenges for directors seeking to navigate their way through a company’s financial difficulties. 

The full judgment can be found here. 

The facts

Arjo Wiggins Appleton Limited (AWA) paid a dividend to its sole shareholder, Sequana SA (Sequana), in 2009 by way of set-off against an intercompany debt owed by Sequana to AWA.  At the time the dividend was paid, AWA was solvent on a cash flow and balance sheet basis. AWA had certain long-term contingent liabilities relating to historical pollution and, although there were a number of insurance policies in place which would have paid out in relation to these liabilities, it was uncertain whether the insurance portfolio would be sufficient to cover the liabilities in full. 

While not insolvent at the time the dividend payment was made to Sequana, AWA faced a real risk of future insolvency given the nature of the potential liabilities and uncertainty in relation to the insurance cover (particularly since AWA was also not trading at the time). The dividend to Sequana was approved and paid lawfully in accordance with the provisions of Part 23 of the Companies Act 2006 (CA 2006).  AWA subsequently entered administration in 2018.

A breach of duty claim against the directors of AWA (being the individuals that had authorised the payment of the dividend) was brought by BTI (as assignee of AWA’s claim) on the basis that the dividend had been paid in breach of the directors’ duty to consider the interests of AWA’s creditors. 

Existence of the creditor duty

Unsurprisingly, the court’s judgment confirmed the existence of a duty to consider the interests of creditors as a company nears insolvency (referred to throughout the judgment as the “creditor duty”), noting that this was well-established by the time of the CA 2006. In the court’s view, section 172(3) CA 2006 was a clear reference to the creditor duty, making it plainly apparent that this common law rule survived the codification of the wider directors’ duties set out within the CA 2006. 

However, the court clarified that the creditor duty did not constitute a separate standalone duty owed to creditors, but rather modified directors’ existing duty owed to a company to act in good faith to promote the success of the company for the benefit of its members. When a company’s circumstances were such that it was insolvent or bordering on insolvency, the duty to promote the success of the company is extended by virtue of the common law so as to encompass the interests of a company’s creditors.

When is the duty triggered?

In a divergence from the Court of Appeal’s earlier decision, the court’s view was that the creditor duty was engaged when a director knows, or ought to know, that a company is insolvent or is bordering on insolvency, or that an insolvent liquidation or administration is probable. In dismissing the appeal, the court held that a “real risk” of insolvency at some point in the future is insufficient to trigger the creditor duty, thereby pushing back the point in time at which directors were obliged to consider creditors’ interests.

The decision provides some useful guidance for directors of struggling companies on this issue – not least because it effectively delays the point at which creditors’ interests must be considered by directors when taking corporate actions, thereby providing them with greater scope to seek to trade through financial difficulties having regard only to the interests of a company’s members. 

Balancing the interests of creditors and members

Where the creditor duty is triggered, but a company has not yet reached the stage where an insolvent liquidation or administration is inevitable, the court held that directors will be required to conduct a balancing exercise between the interests of the company’s members and those of its creditors where those interests might exist in conflict. 

The weight given to each group’s interests will depend upon the financial state of the company and its proximity to insolvency at a particular point in time. As the solvency of a company deteriorates, the greater the weight that should be ascribed to the creditors’ interests as the party with the increasing economic interest in the company and its assets.

The court’s decision on this aspect represents a departure from earlier authorities which had established that once the creditor duty was triggered, the creditors’ interests were paramount - establishing a metaphorical “cliff edge” which, once reached, meant that the interests of shareholders would immediately fall away. In reaching its decision in this case, the court held that creditors’ interests will only become paramount at the point at which insolvent liquidation or administration becomes inevitable. Until this point is reached, the directors will be required to conduct the balancing exercise between the interests of creditors and those of the members, which will be informed by the financial state of a company and its proximity to insolvency at the relevant time.

Dividend payments

The court’s decision also confirmed that an otherwise lawful dividend payment could nonetheless still constitute a breach of the creditor duty. While the court ultimately held in Sequana that the creditor duty had not been triggered at the time the dividend payment was made, the extension of the duty in this manner will mean directors will need to consider more than simply the rules relating to distributions (set out within Part 23 of the CA 2006) when contemplating the payment of any future dividends. Another point to note is that once the creditor duty has been engaged, a company’s shareholders cannot ratify a breach of that duty.

Matthew Padian, partner in the Finance, Restructuring and Insolvency department at Stevens & Bolton LLP comments:

"While the Sequana decision certainly provides some helpful clarity for directors, the crucial question remains as to the point at which directors should begin to balance the interests of creditors against those of members. This remains uncertain and will always be a very fact specific analysis in each case – particularly since the road to insolvency is often not linear and companies are capable of recovering from the point of “probable” insolvency in the short term.  Directors will no doubt welcome the Court’s confirmation that the lower threshold of a “real risk” of insolvency (as opposed to insolvency being imminent or probable) is insufficient to trigger the creditor duty on the basis that this will provide them with greater scope to seek to trade through financial difficulties.

As such, the decision reinforces the critical need for directors to seek professional advice at an early juncture – not only to assess the point at which the creditor duty has been (or is likely to be) triggered, but also to assist with the balancing exercise they must undertake between the interests of creditors and those of a company’s members.  It will clearly be more imperative than ever that directors have access to up-to-date financial information and fully understand a company’s position when contemplating corporate actions, including the payment of dividends to shareholders".