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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:
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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.
The Supreme Court did not decide precisely how directors should comply with the special duty, when it is engaged.
It may be a ‘negative’ duty not to take any steps in the management of the company that harm the creditors; or it may be a ‘positive’ duty for the directors actively to give proper consideration to the creditors’ interests. Sometimes, the directors may even be obliged to treat creditors’ interests as paramount, and as outweighing those of the shareholders.
It was suggested that directors’ duties regarding creditors’ interests may lie on a sliding scale, so that “the more parlous the state of the company, the more the interests of the creditors will predominate, and the greater the weight which should therefore be given to their interests as against those of the shareholders”.
On that reasoning, if it becomes clear that a company’s insolvency is irreversible, maximising creditors’ returns becomes the overriding objective, and the directors should no longer treat the shareholders as having any residual interest.
However, directors should still be given a substantial margin of commercial discretion. It was said that the courts will be unlikely to criticise a director’s commercial judgment about the potential risk and reward of a particular transaction, so that “a reasonable decision by directors to attempt to rescue a company’s business in the interests of both its members and its creditors” is unlikely to breach the special duty.
While the Supreme Court upheld the existence of the special duty, it took a relatively restrictive approach to defining the trigger point – neither ‘a real risk’ nor the ‘probability’ of future insolvency is sufficient for the special duty to be engaged.
A company’s directors will often have to act as gatekeepers, deciding on whether the company can afford to pay dividends or not. While dividends made for the purpose of putting assets beyond the reach of creditors may be overturned under insolvency legislation, as long as the trigger point first engaging the special duty is not reached, the Supreme Court has given the green light for directors to declare dividends benefitting shareholders, instead of retaining funds in the company in case future liabilities turn out to be greater than estimated.
While the Supreme Court has confirmed the existence of the special duty regarding creditors’ interests, the application of that duty is more restrictive than it could have been, with the Court of Appeal having previously favoured a more expansive approach. The narrower scope may reflect the difficulty of deciding on a fixed trigger point, against the backdrop of the broad spectrum of actions, intentions, risks and rewards that directors face every day.
Comment
If the purpose of a limited liability company is to encourage entrepreneurial investment by generating a financial return for its shareholders, while at the same time protecting shareholders against any personal liability to creditors arising from the company’s actions, the Supreme Court has made only a limited incursion against that principle. It may be seen as incremental rather than radical in approach.
Fresh claims against directors will likely now be generated as the precise trigger point for the special duty is worked out through the courts. The relatively high threshold should discourage borderline claims, and may provide a defence depending on whether the risk of insolvency had already moved beyond probability to near-certainty.
Creditor-inspired claims against directors will increasingly focus on complex and costly analyses of the company’s financial position, and of the precise likelihood of future insolvency, at the time of the impugned transaction.
Our view is that insurers should on balance welcome the Supreme Court’s incremental approach, which has avoided opening the floodgates to such claims.
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Read other items in Professions and Financial Lines Brief – December 2022
Insurance and reinsurance
United Kingdom