by Dr Saleem Sheikh

Balancing Shareholders’ and creditors’ competing interests: How BTI v Sequana modified the landscape of the Directors’ duties

The decision by the UK Supreme Court in BTI v Sequana [2022] UKSC 25 is a landmark judgment in setting out the circumstances when directors must have regard to shareholders’ and creditors’ interests, in discharging their functions within the corporate governance system.

Directors cannot serve two masters when considering the interests of the company’s shareholders and creditors. Traditionally, the dilemma for directors has been to identify in whose primary interests should they act and serve for the key dramatis personae of the company: the shareholders who provide capital and take the risk of investing in the company, or the creditors, who provide finance but also take commercial risks when lending to a company? Can directors strike a balance between these two competing interests? If so, how is balance achieved? What are the circumstances that can give rise to directors considering shareholders’ and creditors’ interests at the same time or at different times? Can shareholders ratify any breach by directors in their failure to consider creditors’ interests? Has the common law preserved directors’ duty to take account of creditors’ interests under the Companies Act 2006 (CA 2006) and the interrelationship with the Insolvency Act 1986 (IA 1986)[1]? These are some of the significant issues addressed by the Supreme Court in BTI v Sequana [2022] UKSC 25.

The traditional economic theory of the firm is based on the view that directors act in good faith in the interests of the company as part of their fiduciary duty to the company and to their shareholders,[2] meaning the shareholders’ interests collectively as a group.[3] Directors must exercise their powers bona fide for the company’s benefit.[4] This is a subjective duty based on what directors believe to be in the company’s best interests, and the courts will not second-guess directors’ decisions.[5] In so doing, the directors’ primary objective is profit maximisation for their shareholders,[6] while other stakeholders’ interests were relegated, and only engaged if these interests were for the company’s benefit, that is, for the benefit of shareholders as a general corporate body.[7] After all, the shareholders took the risk in providing the capital and investing in the company, and taking account of the fortunes and fluctuations of the company, shareholders want to be assured they will at least receive corporate dividends based on their capital injection into the company. As the company cannot act in vacuum, directors therefore serve the best interests of shareholders by maximising profits as part of enlightened shareholder value.[8]

Another perspective based on the managerialism and separation of ownership from control concept considers directors as having the freedom to manage the day-to-day operations of the company, which gives them some discretion to have regard to the interests of wider stakeholders, who include the employees, suppliers, customers, creditors and the wider public.[9] In so doing, this enables companies to engage in corporate social responsibilities on a voluntary basis. From this perspective, directors positively engage with creditors to ensure corporate survival, sustainability and growth.

The privilege of incorporation (which can sometimes lead to an abuse of the corporate form) signifies that the company has a separate legal personality distinct from its shareholders, who are shielded by the limited liability status. As the House of Lords in Salomon v Salomon & Co Ltd [1897] AC 22 stated that provided all the formalities are complied with in setting up the company, and it is not set up for an unlawful purpose,[10] creditors take the commercial risks in dealing with companies when providing finance. This creditors’ self-protection perspective means that creditors will therefore engage in a detailed due diligence of the company, assess its financial track record, where appropriate, take security by way of fixed or floating charges, seek personal guarantees from directors, and enter into contractual relations with the company. These mechanisms are used to protect creditors’ interests in the event the company defaults, or falls into an insolvency situation.

While all is well within the company, the directors’ primary focus will be to serve the company and to act bona fide in the company’s best interests. But what happens when the company’s financial fortunes fluctuate, and it encounters hard times because of the economy, slack in the business, excessive overheads, or inability to meet the wages of personnel thereby leading to an insolvency situation? Should the shareholders’ interests be displaced? Should creditors’ interests intrude thereafter - but at what stage?

In BTI v Sequana, the company’s directors of AWA distributed a dividend in May 2009, of €135 million to its sole shareholder, Sequana (May Dividend). The effect of the May Dividend was to extinguish a larger debt that was owed by Sequana to AWA. The May Dividend complied with all formalities for payment of dividends under CA 2006, pt 23 on maintenance of capital based on the common law rules. When the May Dividend was paid, AWA was solvent based on the balance sheet test and the cash flow test and was able to pay its debts as they fell due. However, AWA has long term pollution-related contingent liabilities of which amounts were uncertain, as well as an uncertain value for an insurance portfolio. Owing to these liabilities of an uncertain amount, there was a real risk AWA could become insolvent in the near future – though at the time AWA’s insolvency was neither imminent nor improbable. Subsequently after ten years, AWA went into insolvent liquidation. As assignee of AWA’s claims, BTI attempted to recover the amount of the May Dividend from AWA’s directors. BTI contended AWA’s directors’ decision to distribute the May Dividend was a breach of the creditor duty as the directors had neither considered nor acted in the interests of AWA’s creditors.

The Supreme Court was required to address two competing interests in the company – those of the shareholders (Shareholder Interest) and the creditors (Creditor Interest). It has long been recognised in common law that directors owe their duties to the company, but who is the ‘company’? This has been interpreted to mean to the shareholders collectively.[11] This common law Shareholder Interest has been preserved under various sections of the CA 2006. First, CA 2006, s 171, where the general duties specified in sections 171 to 177 are owed by a director of a company to the company. Second, to reinforce the Shareholder Interest principle, CA 2006, s 172(1) provides that a director of a company must act in the way they consider, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole. At this stage, the Creditor Interest is not the primary concern for directors, because the six factors under section 172(1) do not specifically require directors to consider Creditor Interest.[12] However, the Creditor Interest is implied in some of the six factors because section 172(1)(a) highlights that ‘directors must have regard to the likely consequences of any decision they make in the long term’. Directors must also take into account the need to foster the company's business relationships with suppliers, customers and others: CA 2006, s 172(1)(c).

Suppliers can also be creditors in this situation. It could also be contended that the term ‘others’ opens up a wide range of community interests, some of whom could be classified as creditors, even though creditors are not specifically mentioned in this subsection. The decisions that directors make now about the company could later impact on creditors, where for example, directors venture into activities beyond the company’s objects, and the venture becomes a financial failure, which could impact the Creditor Interest.

Third, the Creditor Interest becomes specifically relevant under CA 2006, s 172(3), which provides that the duty imposed by this section has effect, subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company. Therefore, the rule that directors must act in good faith in promoting the company’s success is modified for directors to also have regard to the Creditor Interest, namely the creditors’ interests as a whole as well, and not to harm those interests (West Mercia Rule)[13] in ‘certain circumstances’. Section 172(3) preserves this common law principle of the Creditor Interest, and is further supported by cases from other jurisdictions and judicial attitudes which support the Creditor Interest principle.[14]

What are the ‘circumstances’ in which the Creditor Interest will intrude to which directors must have regard? The Supreme Court highlighted that creditors have an economic interest in the company’s assets. While the company is financially secure and trading profitably, the Creditor Interest resides in the background as important, but not paramount, as the Shareholder Interest prevails at this stage. The Creditor Interest is not a free-standing interest that is continuously owed to the creditors. However, the Creditor Interest increases on a spectrum of importance and significance where the company is insolvent or near insolvency. At this stage, the Shareholder Interest is relegated, and modifies the rule, so that directors’ duty to the company includes a duty to consider the Creditor Interest as a whole, so as not to prejudice their interests. In this situation, the Creditor Interest becomes paramount because shareholders cease to retain any valuable interest in the company. Directors are not required to consider the interests of particular creditors in a special position, though this rule is modified to some extent by the IA 1986. Therefore, where the company is insolvent or bordering on insolvency, but is not in an inevitable insolvent liquidation or administration, the directors are required to have regard to Creditor Interest, balancing this against the Shareholder Interest, where they may conflict. The greater the company’s financial difficulties, the more directors should prioritise the Creditor Interest. The Creditor Interest does not apply where a company is at a real and not a remote risk of insolvency. It is only engaged when the directors know, or ought to know, that the company is insolvent or bordering on insolvency, or where an insolvent liquidation or administration is probable.

What do we learn from Sequana? Practical Points for Directors

  • There is still some lack of clarity as to the actual trigger point for directors to have regard to Creditor Interests. Some of the Law Lords referred to the trigger point as when the insolvent liquidation or administration is ‘inevitable’; others referred to the company being insolvent or ‘bordering insolvency’; or where an insolvent liquidation or administration is ‘probable’; where an insolvent liquidation or administration is ‘unavoidable’; where the company is in the ‘vicinity of insolvency’; where the company is insolvent or ‘facing insolvency’; where the company is insolvent or ‘nearing insolvency’; where the insolvent liquidation or administration is ‘unavoidable’; ‘insolvent or even doubtfully solvent’; ‘insolvent or of doubtful solvency or even on the verge of insolvency’; insolvent or ‘potentially insolvent’; ‘actual’ insolvency; ‘onset of liquidation’; where the company is ‘irretrievably’ insolvent; ‘material harm’; ‘irreversibly insolvent’; where the company is ‘financially distressed’. The ‘real risk’ of insolvency test is however rejected and has no application. The definition of ‘insolvency’ is established by the tests established under IA 1986, s 123(2) and s 123(1)(e).[15]
  • Directors are under a duty to inform themselves about the company’s affairs which includes its financial matters.[16]
  • Directors are under a duty to keep the solvency of the company under careful review under the West Mercia
  • The company’s shareholders cannot authorise nor ratify an act by directors which is in breach of the Creditor Interest. There can be no shareholder ratification of a transaction entered into by the directors, where the company is insolvent, or which would lead to the company’s insolvency.[17]
  • Directors must always be alert with regular information of the company’s financial position at any one time.
  • The Shareholder Interest and Creditor Interest applies to both executive and non-executive directors in a de jure or a de facto capacity.
  • There should be frequent meetings between the directors and the CFO/finance director highlighting any financial issues or challenges, with a solid action plan on resolving these issues, and how this may impact on the company’s business plan and financial forecasts and budget expenditure.
  • At other scheduled meetings addressing financial issues, the company should keep a written record of matters addressed, with responsibilities and timelines for resolution.
  • Directors should take legal and accountancy advice on the trigger point where the company reaches the insolvency or bordering insolvency stage. They should address if there are any mechanisms to avert such insolvency, and if not, engage the Creditor Interest.
  • The Supreme Court decision leaves open the issue of whether it is essential that the directors know or ought to know when the company is insolvent or bordering insolvency, or when an insolvent liquidation or administration is probable. It is suggested that in these circumstances, directors must do all that is practically possible to determine when this stage is attained, through regular interaction with its finance department and external professionals. It pays to be proactive as reticence or inactivity may bring about the company’s and its directors’ downfall through certain provisions under the IA 1986.[18]
  • Directors should engage with the company’s creditors at an early stage long before reaching the trigger point of insolvency or bordering insolvency, to identify financial issues and how creditors may assist in overcoming the company’s financial challenges to the extent practicable. The objective should be transparency, while still maintaining trust in directors managing the company and engaging in regular communications with creditors and other key stakeholders.
  • Directors should familiarise themselves with all financial and commercial contractual documentation entered into by the company; the terms of security provisions; financial obligations; effect of termination provisions on the company and any other liabilities. The objective is for the directors to be fully aware of its financial obligations and to be up to date on how this may impact the company if the company encounters financial problems.
  • Consider whether directors have given any personal guarantees as collateral security to creditors and how this may impact a financially troubled company.
  • Review the D&O insurance coverage, maintain renewals and be aware of the exclusions from the policy and inform insurers of any significant issues arising that affect the insurance coverage.
  • Directors should try to minimise financial liability by engaging in dialogue with other stakeholders to support the company including suppliers, landlords and shareholders to determine how they may assist the company during hard times.
  • Where an action is brought against a director, consider CA 2006, s 1157 (relief from liability). If in proceedings for negligence, default, breach of interest or breach of trust against an officer of the company, it appears to the court that the officer or person is or may be liable, but that they acted honestly and reasonably, and that having regard to all the circumstances of the case (including those connected with their appointment) they ought fairly to be excused, the court may relieve them, either wholly or in part, from their liability on such terms as it thinks fit: Royal Brunei Airlines Sdn Bhd v Tan [1995] 3 All ER 97.

 

 

[1] See too Corporate Insolvency and Governance Act 2020.

[2] Re City Equitable Fire Insurance Co Ltd [1925] Ch 40; Aberdeen Railway Co v Blaikie Bros (1854) 1 Macq 461. See too Re Wincham Shipbuilding, Boiler & Salt; Poole, Jackson and White’s Case (1878) 9 Ch D 322; and Kuwait Asia Bank EC v National Mutual Life Nominees Ltd [1991] 1 AC 187. However, see, Gaiman v National Association for Mental Health [1971] Ch 317, which considered the interests of shareholders both ‘present and future’ as a whole.

[3] Greenhalgh v Arderne Cinemas Ltd [1951] Ch 286.

[4] Allen v Gold Reefs of West Africa Ltd [1900] 1 Ch 656.

[5] Re Smith and Fawcett Ltd [1942] Ch 304.

[6] Percival v Wright [1902] 2 Ch 421.

[7] See for example, the position of employees: Hutton v West Cork Railway Company (1883) 23 Ch D 654; and Parke v Daily News Ltd [1962] Ch 927; and previously CA 1985, s 309. See Sheikh, S, Corporate social responsibilities: Law and practice (1996).

[8] Friedman, M, The social responsibility of business is to increase its profits (1977) Issues in Business and Society p.168; Friedman, M, The responsible corporation: Benefactor or monopolist? (1973) Fortune. Vole 88 p.56. See too Schumpeter, J, Capitalism, Socialism and Democracy (1942); and Hayek, F. A, The corporation in a democratic society: In whose interest ought it and will it be run? In Anshen, M and Bach, G (eds), Management and Corporation in 1985 (1985).

[9] Anthony, R.N, The trouble with profit maximisation (1960) 38 Harvard Business Review p.133; Smith, An inquiry into the causes of the wealth of nations (1937); Berle, A, and Means, G, The modern corporation and private property (1933).

[10] CA 2006, s 7(2). R v Registrar of Joint Stock Companies, ex parte More [1931] 2 KB 197.

[11] Salomon v Salomon & Co Ltd [1897] AC 22.

[12] It has for a long time been established that directors do not owe a duty to creditors except where there are special circumstances giving rise to such duty: Re Horsley & Weight Ltd [1982] Ch 442; and Multinational Gas and Petrochemical Co v Multinational Gas and Petrochemical Services Ltd [1983] Ch 258; Law Commission, Company directors: regulating conflicts of interest and formulating a statement of duties (Law Com no. 261, 1999); Company Law Review Steering Group, Modern company law for a competitive economy: developing the framework (March 2000); and  Modern company law for a competitive economy: completing the structure (November 2000).

[13] West Mercia Safetywear Ltd (in liq) v Dodd [1988] BCLC 250. The West Mercia Rule is summarised by Dillon LJ when quoting Street CJ in Kinsela v Russell Kinsela Pty Ltd (1986) 4 NSWLR 722 as: ‘In a solvent company the proprietary interests of the shareholders entitle them as a general body to be regarded as the company when questions of the duty of directors arise. If, as a general body, they authorise or ratify a particular action of the directors, there can be no challenge to the validity of what the directors have done. But where a company is insolvent the interests of the creditors intrude. They become prospectively entitled, through the mechanism of liquidation, to displace the power of the shareholders and directors to deal with the company's assets. It is in a practical sense their assets and not the shareholders' assets that, through the medium of the company, are under the management of the directors pending either liquidation, return to solvency, or the imposition of some alternative administration.' See too Bilta (UK) Ltd v Nazir (No 2) [2015] UKSC 23.

[14] See Winkworth v Edward Baron Development Co Ltd [1986] 1 WLR 1512; Nicholson v Permakraft (NZ) Ltd [1985] 1 NZLR 242; Kinsela v Russell Kinsela Pty Ltd (1986) 4 NSWLR 722; Rolled Steel Products (Holdings) Ltd v British Steel Corporation [1986] Ch 246; Moulin Global Eyecare Holdings Ltd v Lee Sin Mei [2014] HKCFA 63; and Re Frederick Inns Ltd [1993] IESC 1. See too Cork Committee’s report, Insolvency Law and Practice (Cmnd 8558, 1982).

[15] The first test is the ‘balance sheet insolvency’ where the value of the company’s assets is exceeded by the value of its liabilities. The second is the ‘commercial insolvency’ test, where the company is unable to pay its debts as they fall due.

[16] Re Westmid Packing Services Ltd (No 3) [1998] 2 BCLC 646.

[17] Ciban Management Corp v Cito (BVI) [2021] AC 122. Kinsela v Russell Kinsela Pty Ltd (1986) 4 NSWLR 722; Official Receiver v Stern (No 2) [2001] EWCA Civ 1787. See too CA 2006, s 239 and the ‘Duomatic’ principle: Re Duomatic Ltd [1969] 2 Ch 365.

[18] See IA 2006, ss 213, 214 and 423.