Directors’ duties following the Supreme Court decision in Sequana

Published on
6 min read

The Supreme Court finally handed down its hotly anticipated judgment in Sequana last month. The judgment concerns the fiduciary duty of company directors and the effect on that duty of a company’s insolvency.

Supreme Court decision

  1. All five judges agreed in the result, but there were some differences in their reasoning. All five judges agreed that:
    • Company directors can be under fiduciary duties to act in the interests of creditors as a whole
    • A real risk of insolvency was not a sufficient trigger for the engagement of the duty
    • When arising, the duty is not a paramount duty necessarily trumping other stakeholders
    • The duty can apply to a decision by directors to distribute a dividend notwithstanding that the dividend is lawful under Part 23 to the Companies Act 2006 (CA)
       
  2. Lord Briggs (with whom Lord Kitchin agreed) gave the principal majority reasoning judgment, holding that as regards the Court of Appeal’s trigger for the duty (when the directors know or should know that insolvency is probable), Lord Briggs preferred a formulation for the trigger where:
    • Insolvent administration or liquidation is more probable than not and the directors know or ought to know of it
    • Either imminent insolvency (ie an insolvency which the directors know or ought to know is just around the corner and going to happen) or
    • Prior to the time when liquidation becomes inevitable and the section 214 wrongful trading duty is engaged, the creditor duty is not a paramount duty that trumps any other stakeholders, it is instead a duty to consider the creditors’ interests, to give them appropriate weight and to balance them against shareholders’ interests where they conflict
       
  3. Lord Hodge agreed with Lord Brigg’s reasoning and made some further points disagreeing with part of the reasoning of Lady Arden, which is discussed further below.
     
  4. As for Lord Reed:
    • Rather than referring as Lords Briggs and Hodge did to a “creditor duty”, he preferred the term “the rule in West Mercia”
    • He held that it arises when the company is insolvent or bordering on insolvent or where an insolvent liquidation or administration is probable or where the transaction in question would place the company in one of those situations
    • He also stated that he was inclined not to agree with the Court of Appeal’s view that it was sufficient that the company was likely to become insolvent at some point in the future
    • Lord Reed was however less certain than the majority reasoning Lords as to whether it was a requirement that the directors knew or ought to know that the situation had arisen for the duty to arise – he preferred to reserve any judgment on that question to a later case
       
  5. Lady Arden agreed with Lord Reed on the points made by him as set out at 4 (a), (b) and (d) above. She also held that the duty requires the directors to consider the creditors’ interests and not to materially harm them.
     
  6. She also goes on a somewhat “inside cricket” discussion of section 172(1), CA (the section that sets out the fiduciary duty to promote the success of the company for the benefit of its members) and section 172(3), which subjects the section 172(1) duty to any rule of law requiring directors to act in the interests of creditors. After a long discussion of the background legislative materials, she concludes that, in enacting section 172(3), Parliament was not confirming the existence of the rule in West Mercia but rather leaving the issue of whether the rule existed up to the courts. This then ties in with her more general point that the rule in West Mercia is not some free standing duty but can be incorporated into section 172(1) itself as an aspect of the broader enlightened shareholder duty enacted in that provision. Accordingly, even where the rule is triggered, the directors may make a decision that benefits shareholders and this would not be a breach of their duties provided the creditors would not be worse off than in a liquidation. Lord Hodge (agreed in by Lord Bridge) envisaged a potential for greater conflict between the interest of shareholders and creditors in certain scenarios requiring that the creditor duty in effect “do more work”, ie not operate through an enlightened shareholder duty alone.

    Commentary

    What is insolvency?
     
  7. The judgments do not definitively resolve the question of what constitutes balance sheet insolvency so as to give rise to the creditor duty. A distinction may be drawn here between balance sheet insolvency in section 123(2) of the Insolvency Act as elaborated on in Eurosail, in particular a more circumstantial test weighing up on a non-worst case scenario of the likelihood of long term liabilities in fact being paid, and the test for balance sheet insolvency under Part 23 CA for the purpose of effecting a lawful dividend, which is less concerned with future ability to pay and more concerned with accounting rules on what provisions need to be made in accounts.
     
  8. None of the judgments is absolutely clear which of these two tests is relevant to the breach of fiduciary duty claim. Indeed, while the court holds that Part 23 CA does not occupy the whole of the field on fiduciary duties, it would appear that this is not because the balance sheet test under Part 23 CA is any different from the balance sheet test for the purpose of a breach of fiduciary duty claim but because there may be other grounds militating against the directors approving a Part 23 CA compliant distribution, eg because cashflow insolvency may prevent a dividend even though the balance sheet test in Part 23 CA is met. This author is of the view however that such a conflation does not properly delineate the different provision/contingent liability rules for accounts from the Eurosail test which is specifically not an accounting test.
  9. This lack of clarity could be played up by a director in defending a future claim, ie by asserting that the breach of duty cannot arise where the company is balance sheet solvent under the accounting rules for Part 23 CA even though balance sheet insolvent on the Eurosail test.

    Possible resurrection of the Court of Appeal test?
     
  10. The Supreme Court clearly found against the existence of a duty to creditors where there was a real not remote risk of insolvency. Less clear, however, is whether the Supreme Court’s rejection of the Court of Appeal test, namely future insolvency being more probable than not, was part of the ratio of the judgment. It is arguable that it was not and that it could remain open to an insolvency officeholder to assert the duty in such a circumstance notwithstanding its seeming rejection by the Supreme Court.

    Preference
  11. The Supreme Court also discusses the issue of preferences. Early caselaw on this was to the effect that a director could not be in breach of fiduciary duty by making a payment that preferred a company creditor unless the specific criteria for a preference claim against the preferee under the Insolvency Act were satisfied; later caselaw raised the spectre of a director being in breach of duty for effecting a preference even where the Insolvency Act criteria for preference were not satisfied.
  12. The defendants had argued that the existence of the creditor duty had been used to reverse preferences where the section 239, IA criteria did not apply and that entailed both a wrongful circumvention of the section 239, IA criteria and potential overcompensation, such overcompensation arising because, had the company not made the payment, while the company’s assets would have included the amount of the payment, it would also have included the amount of the liability. Lord Reed rejected this argument holding that, whether or not the conditions of section 239, IA are met, cannot be determinative of whether there had been a breach of fiduciary duty. He was however more circumspect on the issue of overcompensation but referred provisionally with favour to the West Mercia case itself in which relief was granted but on terms that the director be subrogated to the rights of the paid off creditor.
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