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Published on May 15, 2024
Creditors duty – taking stock

In this update we analyse recent developments in the UK and other common law countries to flesh out unanswered questions left by the Supreme Court following BTI 2014 LLC v Sequana and others [2022] UKSC 25 (“Sequana”). This update focuses only on case law developments. It does not delve into the significant commentary following Sequana.

In Sequana the Supreme Court recognised that a stage may be reached where the Creditor Duty is invoked. That is, the directors’ fiduciary duty to the company is modified to include a duty to have regard to the interests of creditors. This is said to arise where the directors know or ought to know that

  • (i) imminent insolvency is just round the corner and going to happen; or
  • (ii) there is a probability of an insolvent liquidation (or administration).

The Court, however, left a number of unanswered questions, for example (i) the directors’ requisite knowledge; (ii) what is meant by the ‘probability’ of an insolvent liquidation; (iii) which creditors are owed the duty; (iv) are creditors to be treated homogenously or individually; and (v) when and who can obtain the relief for a proposed breach. This is not an exhaustive list.

These questions will be answered by future cases in the usual way of the development of the common law: the underlying principle being refined or qualified over time to fit within the accepted rules and principles of the established law.

Requisite knowledge

Starting then with a recent English authority. The question arose in Hunt v Singh [2023] EWHC 1784 (Ch) (“Singh”) as to whether insolvency itself is sufficient to trigger the Creditor Duty irrespective of the directors’ state of knowledge as to the company’s solvency. The alleged insolvency in Singh arose where a tax liability arose but where the directors believed it had been avoided by a valid tax avoidance scheme. However, no sufficient assets were maintained during the scheme to satisfy any potential adverse tax liability.

The Court concluded that, upon the assumption that some form of knowledge is required, where a company is faced with a claim to a current liability of a size that its solvency was dependent on successfully challenging that claim, then the Creditor Duty arose if the directors knew or ought to have known that “there was at least a real prospect of the challenge failing” (see Singh [48]-[51]). It was not sufficient for the company to say there were “repeated assessments of HMRC’s status” in circumstances where assets were routinely distributed by way of dividend leaving nothing to repay the liability if it was later established to exist.

Turning to the Cayman Islands. Prior to the Supreme Court’s decision in Sequana but following the preceding Court of Appeal’s judgment, the Cayman Islands Court of Appeal in AHAB v Saad Investments Company Limited (21 December 2021, unreported, CICA (Civil) 15 of 2018) (“AHAB”) considered a number of factors (albeit, fact specific to that case) to satisfy the knowledge requirement. Relevantly, the evidence included (i) defaults in payment to the banks had already begun; (ii) the director had requested the general manager to produce a memorandum that the company was unable to meet its obligations; (iii) the director received that memorandum identifying the debt and that unless money was injected by shareholders the company would be in default (see AHAB at [685]).

Putting the factors together from Singh and AHAB the common thread is that the ‘knowledge’ element will not be a high threshold. A director will have knowledge where an overhanging debt is known with insufficient funds to cover that debt.

Probability

The Supreme Court left open what is a ‘probability’ of an insolvent liquidation.  Put another way, the use of the word ‘probability’ necessitates the question ‘how probable?’. There is a difference between saying insolvency is more likely than not (say a 51% likelihood) compared to very/highly probable (say a 95% likelihood).

It is likely that financial expert evidence will be key in this area. In simple terms, as stated in the recent English High Court decision of Re Lion House Portfolio Ltd (in liquidation) [2024] EWHC 610 (Ch) (“Re Lion House”), the enquiry will be by reference to the cases’ particular facts “beginning with the nature of the act which is under contemplation, and including the company’s existing financial state and the financial and other consequences of the act for it over time” (see [12]). However, the facts or expert opinion will need to form a reasonable basis for a definitive conclusion of which the Court may reasonably be satisfied (see, for example, Jones v Dunkel (1959) 101 CLR 298 at 305). That is, at a minimum, the Court will need to feel an actual persuasion based upon the evidence that insolvency is ‘likely’ by reference to the factors in Re Lion House.

A related question was raised in the Supreme Court of New Zealand in Yan v Mainzeal Property and Construction Limited (in liquidation) [2023] NZSC 113 (“Mainzeal”). That is, whether it is appropriate for directors of an insolvent company to continue to trade despite substantial risk of serious loss to the company’s creditors if the directors consider that continuing trading will create a possibility of reducing or eliminating such losses.

The argument was rejected. However, the basis for rejecting the argument was that New Zealand’s statutory regime was different to the UK’s statutory regime in Sequana. That is, the New Zealand statutory regime proceeds upon the premise that it is undesirable for a company to trade on irrespective of the potential benefit which trading on may confer to existing creditors. This is to be contrasted with Lord Reed’s observation in Sequana at [62] “[…] being on the brink of insolvency does not necessarily require an immediate cessation of trade […]” insofar as “[…] continuing to trade may be honestly believed to offer the best prospect of the creditors being paid, even if it also carries some further financial risk”.

To summarise, (i) there may be instances where the probability calculation shifts where there is a road out of insolvency; and (ii) the question of probability will likely be answered with factual and expert evidence by reference to the transaction and the company’s financial position at the time.

Class of creditors

Two further questions were left open, to an extent, by the Supreme Court relating to whether (i) the creditors were to be treated as a class or as individuals; and (ii) the directors had to consider future creditors and/or secured creditors who are likely to substantially recover regardless of the outcome.

In Sequana Lord Reed and Lady Arden did provide obiter comments regarding these questions (see Sequana [48] and [256]). As Lord Reed explained at [48] creditors are to be considered as a “whole” given (i) individual creditors may be in different positions (e.g. secured and unsecured creditors); and (ii) the interests of the company cannot be confined to current creditors at the time of the decision. Since Sequana the English High Court has proceeded on, and adopted, the basis that the Creditor Duty is a duty to creditors as a whole in Tiuta International Limited (in liquidation) [2023] EWHC 3195 (Ch). The Singaporean Court of Appeal has added further credence to Lord Reed’s views in Sequana. In Beng v OP3 International Pte Ltd (in liquidation) [2024] SGCA 10 (“Beng”) the Court identified two reasons creditors are to be considered as a whole:

  • first, the identities of a company’s creditors constantly changes so long as debts continue to be incurred and discharged by the company (cf. Lord Reed Sequana at [48]); and
  • second, it is consistent with the underlying aim of the Creditor Duty in that it seeks to “redress the fact that the risks of continued trading of the company has shifted from the shoulders of one stakeholder (namely, the shareholders) to another (namely, the creditors)” (see [73] Beng).

Who and when

Does a liquidation operate as a condition precedent to the bringing of the action? The short answer is no.  The longer answer is that as a practical matter it is unlikely that a company will bring a claim for a breach of the Creditor Duty prior to liquidation. We say ‘the company’ bringing the claim because the Creditor Duty is a duty owed to the company meaning the company is likely the proper claimant to the proceedings (see Beng at [60]). As a matter of logic, the accused directors will still be in charge of the company at that time and therefore will not bring a claim against themselves.

In Mainzeal the New Zealand Supreme Court expressed the policy consideration under Sequana is that “as the financial affairs of a company deteriorate the economic stake (which is not a proprietary interest) that the creditors have in the company’s residual asset increases” (see [180]). While this is a good statement of principle, it is unclear whether the term “residual” here implies what is “leftover” at the time of liquidation. The better reading is likely that the New Zealand Court was not saying that a liquidation was a precondition. What the New Zealand Supreme Court was likely trying to get toward – as recognised by the New Zealand Court of Appeal in Kumar v Smartpay Limited [2023] NZCA 410 at [49] – is that it is a sliding scale of consideration with creditors’ interests being accounted for until they reach paramountcy upon entering into liquidation.

This approach appears consistent with the Australian position (see Kinsella v Russell Kinsella Pty Ltd (in liq) (1986) 10 ACLR 395 at 401-403 per Street CJ) and the UK position (see Sequana).

In Beng the Singaporean Court of Appeal developed a two-phase test to analyse the Creditor Duty

  • (i) first, the Court is to classify into one of three financial stages the company is in at the time the company entered into the transaction or that was likely to arise as a result of the transaction (see [105]); and
  • (ii) second, upon classifying the financial state of the company, the court should examine the intentions of the director and determine whether he or she acted in the best interests of the company (see [106]). 

This can be briefly tabulated as follows:

Financial positionRequired analysis
Category OneThe company is solvent and able to discharge its debts.A director typically does not need to do anything more than act in the best interests of shareholders to comply with their duty to act in the best interests of the company.
Category TwoWhere a company is imminently likely to be unable to discharge its debts.The Court will scrutinise the subjective bona fides of the director with reference to the potential benefits and risks that the relevant transaction might bring to the company.
Category ThreeWhere insolvency proceedings are inevitable.There is a clear shift in the economic interests in the company (from the shareholders to the creditors as the main economic stakeholders of the company) because the assets of the company at this stage would be insufficient to satisfy the claims of creditors.

In most cases categories one and three are not likely to be controversial.  It will generally be clear if a company is in a good, or incredibly poor, financial position.  Category two will therefore be the more arguable case (i.e. an ‘intermediate zone’).  In doing so, the Singapore Court noted two factors to consider as part of the analysis:

  • first, at stage one, the Court should assume the vantage point of that director and consider what the director knew or ought to have known in assessing whether the contemplated transaction would result in imminent insolvency.  Such factors include: the company’s recent financial performance, the industry in which the company operates, and any other external developments such as geopolitical factors.
  • second, at stage two, the Court should consider (i) whether the director, in good faith, is taking decisions to promote the continued viability of the company; and (ii) whether there is a way out of the company’s financial difficulties which will benefit shareholders and creditors.  To the extent the transaction appears to exclusively benefit shareholders it will attract additional heightened scrutiny of the Court.

Conclusion

The courts will continue to develop the Creditor Duty on a case-by-case basis tethered to the underlying principles arising from Sequana.  Based on case law to date it appears likely this development will continue as follows:

  • the ‘knowledge’ element will not be a particularly high threshold;
  • the ‘probability’ requirement will be a sliding scale requiring both subjective and objective analysis of whether a company is able to trade out of its position; and
  • it will be a useful exercise to classify the financial position of the company by reference to the contemplated transaction to determine when the Creditor Duty ought to arise in light of the directors’ intentions.
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