On 5 October 2022, the UK Supreme Court confirmed that directors sometimes owe an extended duty to uphold the interests of a company’s creditors when solvency is in doubt.
The precise circumstances in which this special duty is triggered will be more fully developed in future cases, but the Court ruled that merely ‘a real risk’ of the company becoming insolvent is not enough to trigger it.
D&O insurers should brace for more claims alleging breach of this extended duty, as now endorsed by the Supreme Court.
The very existence of the special duty was at issue in this case. In what it described as a momentous decision going to the heart of company law, the Supreme Court unanimously agreed that this previously established principle should be upheld.
The rationale is that, as a company nears insolvency, the creditors’ real economic interests in the management of the company increasingly override those of its shareholders.
The Court confirmed that this special duty is a qualified version of the normal duties that directors owe to their company. It is not open to the company’s creditors to claim against directors. Instead, it falls to the company itself (often acting through administrators or liquidators) to pursue any claim.
Background – dividends declared when liabilities uncertain
The directors’ decision to declare dividends, which was criticised in this case, brings the potential for conflict between shareholders’ and creditors’ interests sharply into focus.
The directors declared substantial dividends of hundreds of millions of Euros, with the result that funds ceased to be available to pay company debts, and were instead transferred to the shareholders. However, the company faced known environmental liabilities, the timing and amount of which were uncertain. Subsequently, those environmental costs were much higher than had been estimated (or than had been provided for in the company’s accounts). Almost ten years after the dividends were paid, the company went into administration.
The first instance judge found that the purpose of the dividends had been to facilitate the sale of the company out of the group, so as to remove any risk of the company’s shareholders being required to meet the environmental costs.
While payment of the dividends was not dishonest, the decision was taken in full knowledge of the uncertainty over the ultimate level of the environmental costs, and that they could be higher than provided for in the accounts. The judge found that the dividends had been a transaction at an undervalue, entered into for the purpose of putting assets beyond the reach of the company’s creditors (in breach of s.423 of the Insolvency Act 1986).
Under accounting standards, a company may not be required to make provisions in its accounts for liabilities if it is not at least ‘probable’ that those liabilities will ultimately need to be paid. If provisions are made in the accounts, it is on the basis of an estimated value. So when the value of an uncertain future liability finally crystallises, a company will not always have provided for it fully in its accounts.
In the meantime, dividends may have been declared, so that the company is ultimately unable to pay that liability in full.
Trigger point when the duty is first engaged
At first instance it was held that, when the directors declared the dividends, there had been ‘a real risk’ of the company falling into insolvency, but not more than that. The Supreme Court ruled that merely ‘a real risk’ of insolvency was not enough to trigger the special duty, and so the directors successfully defeated the claim.
In considering what constitutes the trigger point, the Supreme Court considered a number of possibilities, but without settling on the precise threshold.
The trigger point(s) when the special duty is first engaged may therefore be:
- The company is actually insolvent.
- The company is ‘bordering on’ insolvency, or its insolvency is ‘imminent’, or ‘just round the corner’.
- Insolvent liquidation or insolvent administration of the company is ‘probable’.
- The directors take an action, or enter into a transaction, which places the company into one of the above situations.
Even the meaning of ‘insolvency’, when considering these trigger points, remains undecided. It is likely to mean ‘balance sheet insolvency’ (when a company’s liabilities exceed its assets) or ‘cashflow insolvency’ (when a company is unable to pay its debts as they fall due).
But both these tests for insolvency are themselves open to degrees of judgment, and the Court recognised that even successful companies can go through periods of balance sheet or cashflow insolvency, but when it remains appropriate for the directors to manage the company in the shareholders’ interests. The likelihood of liquidators or administrators being appointed in respect of an insolvent company will also depend on external factors, such as decision-making of creditors and potential funders, which may be hard for directors to predict.