Directors’ Duties in the Zone of Insolvency: The Offshore Impact of Sequana

Oct 31, 2022

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Key Takeaways:

Set the baseline for how directors’ duties evolve as regards shareholders and creditors’ interests when a company is in the zone of insolvency
In certain circumstances, the directors of a company do need to take into account the interests of creditors
The baseline for directors' duties when a company is in the zone of insolvency for Bermuda, BVI, Cayman Islands, Guernsey, Jersey and Ireland differs

After much anticipation, the UK Supreme Court has handed down its judgment in BTI 2014 LLC v Sequana S.A. [2022] UKSC 25 - and has authoritatively set the baseline for how directors’ duties evolve as regards shareholders and creditors’ interests when a company is in the zone of insolvency.

Background

The case arose because in May 2009, the directors of a company (“AWA”) paid nearly all of its net assets of €135 million as a dividend (the “May 2009 Dividend”) to its sole shareholder (“Sequana”). At the time that the May 2009 Dividend was made, AWA was solvent on both the balance sheet and cash flow basis, but it had long term contingent liabilities of an uncertain, but likely substantial, amount. Because of this, there was a real prospect of insolvency, but no certainty as to when, if at all, it might occur.

AWA subsequently went into insolvent administration in 2018.

Prior to AWA’s entry into administration, BTI, an assignee of AWA’s claims, brought a claim against AWA’s directors on grounds that the May 2009 Dividend had been paid to Sequana in breach of the directors’ duties to act in the best interests of the Company, which BTI alleged included an obligation to take into account the interests of creditors (referred to as the “Creditor Duty”) when there was a real risk of insolvency.

A separate claim by AWA’s main creditor was also brought in which it sought to have the May 2009 Dividend set aside as a transaction at an undervalue intended to prejudice creditors under section 423 of the Insolvency Act 1986.

The two claims were heard together in the High Court and whilst the May 2009 Dividend was held to fall foul of section 423, Sequana then went into insolvent liquidation and no part of it was repaid.

BTI was unsuccessful in its claim both in the court of first instance and before the Court of Appeal: both courts found that the Creditor Duty was not engaged at the time when the May 2009 Dividend was paid. David Richards LJ, giving judgment in the Court of Appeal, was of the view that a risk of insolvency in the future, however real, was insufficient to trigger the Creditor Duty unless the risk amounted to a probability.

BTI appealed this decision to the Supreme Court where it again argued, inter alia, that a real risk of insolvency (whether probable or not) was sufficient to engage the Creditor Duty.

Decision of the Supreme Court

The Supreme Court was unanimous in finding that in certain circumstances, the directors of a company do need to take into account the interests of creditors. The Supreme Court noted that (as a matter of English law) this duty was preserved by section 172(3) of the Companies Act 2006 (the “English Companies Act”). The Supreme Court also found that, once the duty was engaged, any breaches could not be ratified by a decision of the company’s shareholders.

However, like the Court of Appeal, the Supreme Court rejected BTI’s argument that the Creditor Duty could be triggered merely by a real risk of insolvency which is not imminent. The Supreme Court consequently found that the duty was not engaged on the facts of the case as AWA was not actually or imminently insolvent, and accordingly the appeal was dismissed.

The Supreme Court went on to provide some further analysis (albeit largely obiter) as to the point at which the Creditor Duty may become engaged and its content in any particular case.

In the leading judgment, Lord Briggs (with whom Lord Hodge and Lord Kitchin agreed) departed from the threshold identified by David Richards LJ and held that the duty is engaged at the point when directors know, or ought to know, that:

the company is insolvent;
the company is bordering on insolvency; or
an insolvent liquidation or administration (as opposed to mere insolvency) is probable.

The minority (Lady Arden and Lord Reed) preferred to leave the issue of the necessary degree of knowledge held by directors open, particularly as directors already have a duty to inform themselves of the company’s financial affairs. Lady Arden did suggest, however, that to the extent it formed part of the test, the burden would be on directors to prove a lack of knowledge.

As to content, the Supreme Court confirmed that where a company is insolvent or bordering on insolvency, but is not faced with an inevitable liquidation or administration, a balancing exercise must take place between the interests of creditors and shareholders – the closer to insolvency, the more weight that should be given to the creditors, because it is they who begin to assume the greater risk and have the greater economic interest.

However, once an insolvent liquidation or administration is inevitable and there is no way in which the company can redeem its financial affairs, the creditors’ interests are to be treated as paramount. In the judgment of Lord Reed, in such a case, shareholders’ interests would cease to bear any weight whatsoever.

Although this decision is strictly limited to English law, it is likely to be highly authoritative and applied in the offshore jurisdictions, even though they do not have the same express statutory recognition of a Creditor Duty as contained in section 172(3) of the English Companies Act.

This note explores the positions in the jurisdictions in which Walkers practises.

Bermuda

In Bermuda, the shift in focus from shareholder interests to creditor interests has been recognised for some time[i], and a failure to act accordingly could lead directors to fall foul of the provisions of the Companies Act 1981 (in particular, section 246). However, the nature and scope of this duty has not yet been the focus of detailed consideration by the Bermuda courts, and so the Sequana decision (which, while not binding in Bermuda, will be highly persuasive) provides welcome clarification of this established principle.

British Virgin Islands (BVI)

The duties of a director of a BVI company are derived from a combination of common law and local statute. The overarching duty of a director of a BVI company is to act honestly, in good faith and in what s/he believes to be in the best interests of the company. A director’s duties are owed to the company, taking account of the interests of the shareholders as a whole. However, where a BVI company enters the “zone of insolvency”, the common law requires that the directors consider and act in accordance with the interests of the company’s creditors. In this, the BVI Courts are likely to follow the analysis of the Supreme Court in Sequana which, though not binding, is highly persuasive authority, on the existence, application and content of the common law duty.

There are no reported BVI decisions in which the Courts have analysed the precise circumstances in which the Creditor Duty is engaged, and it will be interesting to see how they approach this question as and when it arises for decision. However, it is unlikely that the BVI Court would depart materially from the approach that the Supreme Court has adopted and the likelihood is that it would follow the majority in Sequana in requiring that the directors either know, or ought to know, that the company is insolvent or bordering on insolvency, or that an insolvent liquidation or administration is probable before the duty is engaged.

Cayman Islands

The Cayman Islands Companies Act (2022 Revision) does not codify directors’ duties, and the Cayman Islands have imported the duties arising under English common law, which include the duty to act in the best interests of the Company. It is well-established under Cayman Islands law that this duty will, in certain circumstances relating to insolvency, engage the Creditor Duty.

Prior to the Supreme Court’s judgment, the Cayman Islands Court of Appeal followed the decision of the English Court of Appeal in Sequana (see AHAB v Saad 21 December 2021, CICA No. 15 of 2018 at 638) regarding the point at which the Creditor Duty is engaged; it is therefore likely that the Supreme Court decision will be highly persuasive in future Cayman Islands decisions. That said, there are a number of material differences between the English and Cayman Islands corporate insolvency regimes (for example, the absence of a wrongful trading remedy under Cayman Islands law) that may leave scope for argument as to the precise manner in which the Creditor Duty ought to apply.

Guernsey

Directors do not have codified duties under the Companies (Guernsey) Law, 2008 and the jurisdiction has imported the English common law position (as it existed prior to the introduction of statutory duties via the English Companies Act). The duty to have regard to the interests of creditors was considered in detail in Carlyle Capital Corporation Limited v Conway Others (Royal Court 38/2017). As a matter of Guernsey law, that duty has been held to arise when it can be seen that “decisions about the company’s actions could prejudice creditors’ prospects of recovering their debts in a potential liquidation” and that, once recognised that a company is on the “brink of insolvency”, directors are required to give precedence to creditors’ interests where necessary in the particular circumstances. Notwithstanding, the formulations in Sequana as to the balancing exercise to be undertaken by directors and the majority view on when the Creditor Duty arises may prove persuasive in future Guernsey cases.

Ireland

In Ireland, the common law duty of directors to have regard to the interests of creditors when a company is in the “zone of insolvency” was codified in statute this year following the coming into force of the European Union (Preventative Restructuring) Regulations 2022. This duty is also now included as an express fiduciary duty owed by the directors to the company in respect of which they stand appointed.

While the extent of this common law duty is well established in Irish jurisprudence, its placing on a statutory footing is to be welcomed. In that regard, the Sequana judgment, while not binding in Ireland, will likely be referenced in future cases before the courts of Ireland where the conduct of directors is challenged in a “zone of insolvency” scenario.

Jersey

In Jersey, the directors’ core duties (provided by article 74 of the Companies (Jersey) Law 1991) (the “Companies Law”) are to act in good faith in the best interests of the company and with the skill and care of a prudent person. Although the Companies Law does not go on to contain the same wider codification of directors’ duties as the English Companies Act, the Jersey court routinely looks to English cases in respect of company law principles.

The Supreme Court judgment in Sequana identified the Creditor Duty as being part of the duty to act in the best interests of the company, and so the decision is likely to be accepted as entirely consistent with the directors’ core duty as expressed in article 74 of the Jersey statute.

Conclusion

The decision in BTI 2014 LLC v Sequana S.A. [2022] UKSC 25 is strictly limited to English law, but it is likely to be highly authoritative and applied in the offshore jurisdictions, even though they do not have the same express statutory recognition of a Creditor Duty as contained in section 172(3) of the English Companies Act.

[i] Justice Kawaley commented that: “It is safe to say that once a company is in danger of becoming insolvent, the directors have to consider the interests of creditors, weighing the gravity of the company’s financial predicament against the realistic prospects of the company solving its financial problems.” ‘Offshore Commercial Law in Bermuda’ [at 9.32], edited by Ian R.C. Kawaley