The Rule In West Mercia Blake-Turner Solicitors
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The Rule In West Mercia

The Supreme court handed down its long-awaited judgment in BTI 2014 LLC v Sequana SA on 5 October 2022 (the rule in West Mercia) where it affirmed the existence of directors’ Creditor Duty.

Since 1988, the Court of Appeal rulings in West Mercia Safetywear Ltd (in liq) v Dodd [1988] BCLC 250 (popularly known as ‘the rule in West Mercia’) has been the leading authority subjecting directors of financially stressed companies to a duty to consider the interest of the company’s creditors, or Creditor Duty. Now in BTI 2014 LLC v Sequana the Supreme Court has considered the rule in West Mercia for the first time, and confirmed the existence of a Creditor Duty, its content and when that duty is engaged.

In the current economic climate, it is more important than ever for directors (and insolvency practitioners) to be aware of when the Creditor Duty is engaged, and from the time it is, to strike the right balance when considering the interests of the company’s creditor’s as against the company’s shareholders.

Background

In May 2019, the directors of AWA, a UK limited company, cause it to distribute a dividend of €135m to its only shareholder, Sequana SA (“Sequana”). The dividend complied with the applicable statutory regime regulating the payment of dividends and was distributed at a time when AWA was solvent.

However, at the time the dividend was distributed, AWA had a contingent liability on its books regarding clean-up costs for pollution of the Lower Fox River in Wisconsin, which was highly uncertain. This gave rise to a real risk, although not a probability, that AWA might become insolvent at some point in the future. A third party, BAT Industries Plc (“BAT”), has agreed to guarantee that liability.

It later transpired that AWA’s clean-up costs were significantly greater than originally anticipated. As a result, it became insolvent, but some ten years after the May 2009 dividend.

As AWA’s main creditor, BAT sought to have the dividend set aside under section 423 of the Insolvency Act 1986 on the basis that it constituted an undervalue transaction defrauding creditors.

An assignee of AWA’s claims, BTI 2014 LLC (“BTI”) also brought proceedings against AWA’s directors on the basis that its directors’ decision to pay the dividend was a breach of their duty to consider the interests of the company’s creditors.

The two claims were heard before the High Court and the Court of Appeal.

BTI was unsuccessful in its claim. The High Court and Court of Appeal ruled that the Creditor Duty had not been engaged by May 2009. As for the BAT claim, the May dividend was held to have fallen foul of section 423, although Sequana went into insolvent liquidation, and no part of the dividend was repaid.

The Court of Appeal Decision

Lord Justice David Richards, delivering an extensive judgement, put forward four potential points in time at which the duty that directors owe to the company to have regard to creditors’ interest, i.e. when the Creditor Duty is engaged:

  1. upon actual insolvency;
  2. upon imminent insolvency;
  3. where insolvency is more likely than not; and
  4. there is a realistic, and not remote, prospect of insolvency.

David LJ concluded that the Creditor Duty is engaged when the directors know or should know that the company is likely to become insolvent, likely meaning probable.

As such, AWA was not likely to become insolvent when the May 2009 dividend was paid. Accordingly, the directors were not in breach of the Creditor Duty as the duty was never engaged.

For company directors, notably, it remained unclear whether, once the Creditor Duty is engaged, creditors’ interests are paramount or are merely one factor to be considered.

Supreme Court Decision

BTI obtained leave to appeal to the Supreme Court, where they argued that a real risk of insolvency was sufficient to engage the Creditor Duty. There were four questions before the Supreme Court:

  1. Is there a common law Creditor Duty at all?
  2. If so, when is the Creditor Duty engaged?
  3. What is the content of the Creditor Duty?
  4. Can the Creditor Duty apply to a decision by directors to pay an otherwise lawful dividend?

The Supreme Court ruled, unanimously, that BTI’s appeal should be dismissed on the grounds that, although a duty to consider the interests of creditors does exist, a “real risk” of insolvency does not suffice. The Creditor Duty is only engaged when the directors know, or ought to know, that the company is insolvent or bordering insolvency, or that an insolvent liquidation or administration is probable.

The Supreme Court’s response to the each of the above questions is summarised below:

Is there a common law Creditor Duty at all?

  • Section 172(1) of the Companies Act 2006 codified the long-established common law fiduciary duty owed by directors to act in good faith in the best interest of the company.
  • According to Lord Reed (and agreed by the other justices), there is no duty owed to creditors, or any duty separate from the directors’ fiduciary duty to the company.
  • There is, however, a rule which modifies the ordinary position under section 172(1) such that, when it applies, the company’s interests for the purpose of that section are to be taken to include the interest of its creditors as a whole. This finding was justified as follows:
    1. The existence of the Creditor Duty is supported by a long line of authority in the lower courts of England and Wales, as well as from New Zealand and Australia. Particular reliance was placed in West Mercia Safetywear Ltd (in liq) v Dodd [1988] BCLC 250 (the rule in West Mercia) which was decided at appellate level.
    2. Parliament confirmed the existence of the Creditor Duty by enacting sub-section 172(3) of the Companies Act 2006, which states that the duty in section 172(1) “has effect subject to any enactment of rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company”.
    3. In ordinary circumstances where the company is stable and is able to pay its creditors on time, then the interest of the company’s shareholders as a whole can be treated as the company’s interest for the purpose of the duty of the company’s shareholders as a whole can be treated as the company’s interests for the purposes of the duty owed under section 172(1). This position changes in an insolvency scenario when the company’s creditors as whole become persons with a distinct interest and dependent in the company’s residual assets, or a change in its fortune, for repayment.

If so, when is the Creditor Duty engaged?

The Creditor Duty is engaged where the directors know or ought to know that the company is insolvent or nearing insolvency, or that insolvent liquidation or administration is probable. A potential earlier trigger of a real and not remote risk of insolvency does not suffice.

What is the content of the Creditor Duty?

  • Where the company is insolvent, or nearing insolvency, but is not faced with an inevitable insolvent liquidation or administration, the Creditor Duty requires directors to have regard to the interests of the company’s general body of creditors, as well as the general body of shareholders. In these circumstances, the more “parlous” the state of the company, the more the interests of the creditors will predominant.
  • Where insolvent liquidation or administration is inevitable, the creditors’ interests become paramount as the shareholders cease to retain any valuable interest in the company. As put forward by Lord Briggs, this happens when section 214 (wrongful trading) of the Insolvency Act 1986 becomes engaged.

Can the Creditor Duty apply to a decision by directors to pay an otherwise lawful dividend?

Although this question did not need to be determined in relation to the case before it, the Supreme Court gave two reasons for which, in principle, the Creditor Duty can apply to a decision by directors to pay a dividend which is otherwise lawful:

  1. Part 23 of the Companies Act 2006, which regulates the payment of dividends, is stated as being subject to any rule of law to the contrary. It follows that as the Creditor Duty is part of the common law, it is therefore not excluded by Part 23.
  2. Under Part 23 availability of profits for distribution is determined on a balance sheet basis. A company can, nonetheless, have a balance sheet surplus while being cash flow insolvent.

Conclusion

Although directors can take some comfort that the Supreme Court clarified that there must be an imminent risk of insolvency or the probability of an insolvent liquidation or administration, this judgment reinforces that a prudent approach to corporate governance is essential.

This decision is equally important for insolvency practitioners when determining whether directors of an insolvent company have acted in breach of their duties and the potential claims which might arise against them.

 

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