“Momentous decision” by UK Supreme Court impacts duty of Australian directors to creditors

This is an important update in the Australian corporate and insolvency law context because, in BTI 2014 LLC v Sequana SA and others [2022] UKSC 25, the UK Supreme Court (being the UK’s highest court) confirmed the existence of a duty owed by directors to creditors in certain circumstances (creditor duty). Under the common law and equity (together, general law), there is a gateway to applicability of the creditor duty in Australia.  

Before this decision, there was some uncertainty as to whether the directors of a solvent company owed any duties to creditors rather than solely to the company itself and its shareholders. This decision has provided much needed clarity – especially at a time of global economic uncertainty, and the forecasted increase in insolvency of Australian companies.

One implication of this case may be that creditors, who are not paid in full through the liquidation of the insolvent estate, may be able to pierce the corporate veil and sue directors for their loss.

The facts

The directors of a company, AWA, caused it to pay a dividend of €135m to its only shareholder at a time where, while the company was solvent, there was real risk that it might become insolvent at some point in the medium-to-far future.

The company became insolvent nine years later. The Appellant, BTI (2014) LLC, who was an assignee of the company’s claims, sought to recover the €135m dividend on the ground that the directors’ decision to distribute the dividend was a breach of their duty to take into account the interests of creditors.

The decision

Issue 1: The existence of a common law creditor duty

The majority held that the creditor duty is not only found in section 172(1) of the Companies Act 2006, but (and relevantly in the Australian context) is also a part of the general law duty to act in the best interests of the company. Put another way, since the “interests of the company …. should be understood as including the interests of its creditors as a whole”, this “creditor duty” is not separate from a director’s fiduciary duty to the company but is a constituent part of it.

Issue 2: The extent of the creditor duty

In this case the creditor duty was held to extend to the directors’ decision to pay a dividend, notwithstanding the distribution of the dividend was otherwise lawful. However, the precise nature of the duty is a question of fact and degree which needs to be “balance[d] … against shareholders’ interests where they may conflict”.

Factors that are relevant in this inquiry include but are not limited to:

• whether a proposed course of action will enable the company to return to a solvent state;
• who, as between shareholders and creditors, risk the greatest damage if that course of action does not succeed; and
• the interests of the general body of creditors as a whole, rather than of any individual creditors.

It is also important to note that the closer a company is to insolvency, the greater the weight that must be accorded by directors to the interests of creditors.

Issue 3: When is the creditor duty is engaged

On the facts of this case, the court held that the creditor duty was not engaged because the company was neither insolvent nor anywhere near insolvent at the time the dividend was paid – the company did not enter liquidation until nine years after the payment of the dividend.

However, the more significant principle of law which emerged from the judgment is that in the view of the majority, the creditor duty is enlivened where there is:

“either imminent insolvency (ie an insolvency which directors know or ought to know is just round the corner and going to happen) or the probability of an insolvent liquidation (or administration) about which the directors know or ought to know”.

Two Justices, Lord Reed and Lady Arden, went even further. Their Lordships queried whether it was even necessary that the directors “know or ought to know” that the company is insolvent or will imminently be insolvent. However, considering that their Lordships ultimately left this matter open and the majority of the Justices constrained themselves to the narrower test above, such a wide view is unlikely applied in future cases.

The creditor duty will not be enlivened in cases of mere temporary cashflow insolvency as opposed to balance sheet insolvency. In other words, the “trigger for creditors’ interests to override those of shareholders … [will not be pulled] where there is still ‘light at the end of the tunnel’”. However, in the Australian context, it must be noted that under s95A of the Corporations Act 2001 (Cth) the primary solvency test is based on cashflow, not balance sheet solvency. That is, a company which cannot pay its debts as and when they fall due is insolvent.

Comparison to other jurisdictions and future developments

The view taken by the UK Supreme Court that the creditor duty arises where insolvency is imminent (or that the directors know or ought to know that there is a probability of the same) marks a departure from other common law jurisdictions such as the US, where the scope of director duties remain firmly confined to the company and its shareholders until the point of actual insolvency (North American Catholic Educational Programming v. Gheewalla (Del. Supr. 2007).

In Australia, although there has been a line of authority for the existence of a creditor duty since Mason J’s judgment in Walker v Wimborne (1976) 137 CLR 1, it is still the subject of strident criticism including from a former Justice of the High Court of Australia (see K M Hayne, “Director’s Duties and a Company’s Creditors” (2014) Melbourne University Law Review 38 at 795). At any rate, the circumstances in which the duty is said to arise has been of particular confusion.

However, considering the weight that is accorded to judgments of the UK Supreme Court, especially when considering the scope of general law duties which often have their genesis in English law, it is likely that courts across the common law world (particularly in Australia) will adopt this approach, especially with regard to the majority’s test about the circumstances where the duty arises pre-insolvency (see Issue 3 above). This is particularly because of their Lordships’ explicit statement that the duty (and its attendant legal principles) arise even out of common law rather than a statutory duty, which makes them readily applicable in foreign contexts.

As the Justices found against the Appellant, the two important issues of the full scope of the duty and the nature of the remedies available for breach of the duty were expressly left open. That said, the remedies are likely to include all those remedies ordinarily available for a common law breach of director duties – in particular damages.  Such damages would likely be based on the creditor’s loss. 

Practical takeaways

1. Directors should always ensure that they are on top of their company’s financial health, as this will have a material impact on the weight to be accorded to creditors’ interests. The greater the company’s financial difficultly, the more important the interests of creditors become. A failure by directors to keep themselves informed of the company’s financial status may well itself be a breach of directors’ duties.

2. As a matter of good practice, make sure to be cautious and take creditor interests into account when making decisions. The fact-based nature of the inquiry means that a court may be more inclined to absolve a director who has directed his mind to the interest of creditors – even when the director does not suspect insolvency.

3. Directors should document the steps taken to evaluate the creditors’ interests, and how their decision took such interests into account. Board Minutes may be the best place to record this – but consideration should also be given as to whether documents would benefit from being shrouded in legal privilege.

4. Check that any D&O insurance policy is up-to-date and fit-for-purpose, as it may not have coverage for breach of the creditor duty.

5. Accountants, lawyers and insolvency practitioners should bear the creditor duty in mind when advising boards of companies in financial difficulty. An adviser who fails to advise a director about the creditor duty, may itself be liable to the director should the director suffer loss.

6. Creditors who suffer loss because of the insolvency of a company should consider whether they might have a claim against a director of the insolvent company.

7. Directors of companies benefitting from the insolvent trading safe harbour, may still be liable to creditors under the creditor duty. Specialist legal advice should be taken from corporate disputes and insolvency lawyers.