We have recently published a few blogs on the hot topic of company insolvencies, including more specifically about:
- the increase in company insolvencies by Lucy McCann; and
- what the new case of Hunt v Singh means for the directors' creditor duty by Nicky-Ray Watson.
Here, we take a step back and provide a broader overview of recent developments and look at what those developments mean for directors' duties more generally.
Statutory and common law directorial duties
Most directors are aware of their statutory duties under sections 171 to 177 of the Companies Act 2006, including the general duty under section 172(1) to "promote the success of the company for the benefit of its members as a whole". This duty to promote the success of the company for the shareholders is modified by section 172(3) and the requirement for directors to consider or act in the interests of the creditors of the company in circumstances where an enactment or rule of law requires them to do so.
This is referred to as the "creditor duty". It engages when a company is or is verging on insolvency or is at real risk of insolvency. The "creditor duty" is a rule of law exception to the section 172 general duty and, notwithstanding its name, the duty is owed by the directors to the company and not creditors themselves. You might know it as the "rule in West Mercia", which is reference to the decision of West Mercia Safetywear Ltd v Dodd (1988) 4 BCC 30 which was the leading authority in this area for over 30 years.
The courts have however more recently been examining the scope of the "creditor duty" in a series of cases, including:
- Re Marylebone Warwick Balfour Management Ltd [2022] EWHC 784 (Ch) "Marylebone"
- the Supreme Court case BTI 2014 LLC v Sequana SA [2022] UKSC 25 "Sequana"; and
- the English High Court case Stephen John Hunt v Jagtar Singh [2023] EWHC 1784 (Ch) "Hunt v Singh".
Looking at each of these cases in turn we can see developments in what the "creditor duty" means for company directors and when it applies.
Development of the "creditor duty"
- Marylebone
In 2002, having taken professional advice, Marylebone entered into a tax avoidance scheme to pay its directors bonuses in addition to salary and reduce PAYE and NIC liability of the company. In 2004 HMRC advised Marylebone that it did not consider the scheme to be legitimate tax avoidance and that they would likely take action to recover the unpaid tax. In 2005 HMRC made an offer of settlement to Marylebone which, having received further professional advice that the scheme was "robust", was refused by the directors. At the time of the HMRC settlement offer the tax liability of Marylebone would have produced a net deficit for the company in excess of £3.5 million rendering it insolvent.
In 2011 the Court of Appeal held that PA Holdings Ltd, which operated a similar scheme to that of Marylebone, was liable for both PAYE and NICs. At this time Marylebone received professional advice that its position was not distinguishable from that of PA Holdings Ltd and any defence of the HMRC proceedings would likely fail. In 2013 Marylebone was placed into liquidation and subsequently dissolved from the Register of Companies. In 2017 the liquidator restored the company and brought claims against the former directors for breach of the "creditor duty".
The court determined that as the directors of Marylebone had taken professional advice throughout the lifetime of the scheme and whenever HMRC made enquiries into it (they had continually been advised that the scheme was "robust") the directors had considered the interests of creditors and had not therefore acted in breach of their duties. The liquidator was given leave to appeal this decision – see Hunt v Singh below. However, before the appeal was heard, Sequana - another case concerning the "creditor duty" - was determined by the Supreme Court which affected the outcome of the liquidator's appeal.
- Sequana
In 2009 Sequana received a dividend from its wholly owned subsidiary in the sum of Euro135 million. At the time the dividend was paid the subsidiary was solvent. However, due to some contingent liabilities there was a risk that it might become insolvent in the future, although this was not imminent. In 2018 the subsidiary company went into administration and certain rights of action of the subsidiary were sold by the administrator to BTI 2014 LLC ("BTI"). Using those rights, BTI sought to recover the dividend from the directors of the subsidiary claiming it had been paid in breach of the creditor duty i.e. when there was a risk of insolvency. Both the High Court and the Court of Appeal rejected BTI's claim, BTI appealed to the Supreme Court (who also dismissed BTI's appeal).
The significance of Sequana is the Supreme Court's recognition of the "creditor duty" and guidance about the nature of the duty and when it might apply. The Supreme Court determined that directors do owe a duty to consider the interests of creditors where a company is insolvent or is bordering on insolvency and that the duty operates on a "sliding scale" i.e. as the likelihood of insolvency increases the directors should increasingly consider the interests of the creditors to the point where insolvency is inevitable at which time the interests of the shareholders cease to bear any weight.
The Supreme Court judges did not, however, agree on everything about the requirements of the "creditor duty" leaving some elements of the duty remaining to be settled by future cases. Hunt v Singh - the High Court appeal of the liquidator in Marylebone - was one of the first opportunities for the courts to consider the application of Sequana and further clarify the "creditor duty".
- Hunt v Singh
In determining Hunt v Singh the appeal judge noted that one of the questions left unanswered by Sequana was where a company is actually insolvent at the relevant time is insolvency alone sufficient to trigger the "creditor duty" i.e. regardless of whether the directors believed the company to be solvent or not. In Hunt v Singh the company was insolvent, but the directors thought they had avoided insolvency because they disputed the company's tax liability on the basis of professional advice. In Sequana the company was solvent at the time of payment of the dividend. The appeal judge in Hunt v Singh assumed that some knowledge of insolvency on the part of the directors was necessary for the "creditor duty" to arise even where the company was insolvent. Based on that assumption it was held that if a company has a significant liability and its solvency depends on the successful defence of that liability then the "creditor duty" arises if the directors know or ought to know, that there is a real prospect of the defence failing. The judge concluded that in Marylebone the "creditor duty" arose at the latest in 2005 when HMRC made its settlement offer to the company and the duty continued until the company entered liquidation in 2013. Consequently, the appeal was granted overturning the decision of the first instance judge and the case was remitted to be reconsidered in light of judicial guidance provided in Sequana where on the facts of the case the duty had in fact been breached.
Consequences of a breach of director duties
Although the law around a director's creditor duty is still developing what is abundantly clear is that if a director is found to have breached their "creditor duty" the consequences can be serious, both financially and reputationally. Where breach is established the court has to power to allow the corporate veil to be pierced and for the director to be held personally liability to repay monies to the company. Further, depending on the conduct of the director they could also face being disqualified as a director.
Good board practice
Bearing all this in mind it would seem prudent for directors to be aware of their company's solvency status. To help them do so directors should:
- obtain regular legal advice regarding discharging their duties
- ensure they receive regular financial reports from the company
- consider and document in board minutes the purpose of any transaction and, if necessary, the interests of company creditors
- obtain specialist restructuring & insolvency advice if there are any signs that the company is or is likely to become insolvent
How can Brodies help?
The above outlines the main considerations to think about in relation to the "creditor duty".
Brodies Restructuring and Insolvency Team have extensive experience of working with company directors to advise them in relation to their duties and insolvency issues – if you have any queries in relation to either of these matters, please contact Lucy McCann or Nicky-Ray Watson or your usual Brodies contact.