When do directors have to place creditors interests above shareholders?

In a recent ruling the UK Supreme Court confirmed that directors may need to take creditors' interests into account when a company is facing financial difficulties, particularly as insolvency becomes probable or inevitable.

Director duties to creditors

Most directors are aware that when a company is insolvent, the interests of creditors become increasingly important. But what happens in the months or years before a company becomes technically insolvent? In today’s fast-changing and difficult financial circumstances for many companies, directors need to remain vigilant about the company’s financial position and understand when creditor interests need to be given greater weight.

Background

Arjo Wiggins Appleton Limited (AWA)'s directors decided to give its only shareholder, Sequana SA, a dividend of €135 million in 2009.

The dividend was paid from distributable profits and, at that time, AWA was, in terms of accounting, both balance-sheet and cash-flow solvent.

However, AWA had assets with an undetermined value and contingent environmental liabilities with an unknown amount at the time of the dividend. As a result, there was a genuine (albeit improbable) chance that AWA would go bankrupt in the future.

AWA entered insolvent administration nine years after the dividend payment, which resulted in only partial payment of debts to creditors. Claims were then made that the directors of AWA had breached their duties by declaring the dividend without taking the interests of creditors into account.

How likely is it your company may become insolvent?

The Court unanimously decided that the Creditor Duty was not triggered on the facts merely because there was a "real and not remote" possibility of insolvency in the future.

The Court made it clear that directors must remain alert to the interests of creditors as a company’s financial position deteriorates. Where a company is insolvent or bordering on insolvency, but an insolvent liquidation or administration is not inevitable, directors should consider creditor interests and balance them against the interests of shareholders. The greater the company’s financial difficulties, the greater the weight that should be given to creditor interests.

Failure to take creditor interests into consideration can, on a company’s insolvency, result in directors potentially being personally liable under the "wrongful trading" provisions of the Insolvency Act 1986. These provisions apply where a director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation or entering insolvent administration and failed to take every step that they ought to have taken to minimise the potential loss to the company's creditors.

In addition, the Court ruled that a transaction entered into in breach of the creditor duty cannot simply be approved retrospectively by a majority of shareholders.

Tips for Directors of companies in financial difficulties

Some practical ways in which directors can proactively look to protect themselves include :

• At meetings, the board should take into account and record discussions about reliable and up-to-date financial and operational information, including short-term cash flow and creditor status. Over time, are creditors becoming increasingly "stretched"? Are any new creditors being added?
• Examine finance agreements and other significant business contracts for possible events of default and/or termination triggers that may impact solvency. Build and maintain confidence with lenders and other important financial stakeholders by engaging with them early and maintaining open, regular communication.
• Where a business is not trading profitably, it is important to exercise caution before choosing to pay some creditors while leaving others unpaid.
• Verify D&O insurance coverage to make sure it is appropriate for the situation, that premiums have been paid or renewed, and that any claims and conditions have been appropriately reported.
• Take appropriate specialist legal and financial advice on solvency and directors’ duties.