Directors’ duties – when does the duty to creditors take priority over the duty to the shareholders?

Last week saw a landmark judgment from the Supreme Court in the case of BTI 2014 LLC v Sequana SA [2022] UKSC 25, which gave valuable guidance to directors on the balance between their duties to shareholders and to creditors at the point when their company is facing financial difficulties. Our Insolvency Solicitor Eleanor Stephens summarises.

What are the issues?

Traditionally, directors duties have been reasonably clear. While a company is solvent and trading well, then the majority of the duties that directors must abide by are primarily to the company’s shareholders.  However, once the company is ‘insolvent’, the duty shifts so that the primary duty is owed to the creditors of the company rather than the shareholders.

Where there is often confusion however, is when the company is in financial difficulties and it is not clear whether the company will recover, or whether it will end up in a formal insolvency process such as liquidation or administration.  At that point, how are the duties to shareholders and creditors to be balanced? This period is often referred to as ‘the twilight zone’. 

In the twilight zone the company may not have the cashflow to pay all creditors as and when they are due, but it is often hard to be clear on whether the situation might be temporary, or whether it could lead to irreversible insolvency.  The directors will need to keep a close eye on the financial position of the company during this time to be able to ensure that they make the right decisions for the company, its creditors and its shareholders.

When is the trigger point that tips the duty from shareholders to creditors?

The court in this case gave some firm guidance on the trigger point.  This is important because it is notoriously difficult for directors to be objective in determining the point at which their duty shifts.

Even when the position is relatively clear, what has not been clear is whether, during the twilight zone, the directors’ duties are solely to protect the company’s creditors, or whether some duties to the shareholders remain, and where this cross over might be? 

The case of BTI v Sequana has given some much needed guidance on these points.  In particular, the court has addressed what is the ‘trigger point’ when the duty shifts from shareholders to the company’s creditors?  The court also provides guidance on what is the scope of the duty to creditors when the duty shifts during this time.

Clarification on when the duty moves to creditors – when is the ‘trigger point’

The court clarified that the duty to creditors arises:

• not just when the company is very likely to move into formal insolvency, but when it either is insolvent or bordering on insolvency;
• or where an insolvent liquidation or administration is probable;
• or where a transaction in question would place the company in either of these two situations.

What is ‘insolvent’ in this context?

Insolvent means that the company is either balance sheet insolvent, i.e. it has more liabilities than assets; or if it is cashflow insolvent, i.e. it is unable to pay its creditors as and when they fall due. 

What duties are owed to shareholders once the ‘trigger point’ has been reached?

Previous caselaw has followed the rule that following the ‘trigger point’, the creditors' interests are paramount and take precedence over the shareholders’ interests.  However, this latest judgement states that there can in fact be a sliding scale, where depending on the circumstances, creditors’ interests become more important than shareholders’ interests the closer the company moves to the point of no return and inevitable liquidation or administration.

The court found that creditors' interests will only become wholly paramount at the point where it is clear that formal insolvency is inevitable, because by that time the shareholders will no longer have any financial interest in the company, having little or no chance of any return on their capital investment in a formal insolvency situation.

However, until that happens, the shareholders potentially still have an interest in the decisions made by the directors, and so their interests remain as a concern for the directors until the company becomes irreversibly insolvent.  Shareholders’ interests deplete on a sliding scale the closer the company moves to formal insolvency.

What does this mean in practice for a director of a company in financial difficulties?

This case means that until a formal insolvency is inevitable, the interests of shareholders should still be taken into consideration by the directors, who will need to balance the interests of creditors and shareholders during times of financial instability. However, if and when the financial position gets worse, the interests of creditors increasingly take priority over shareholders, so that when formal insolvency is inevitable, the creditor’s interests become paramount.   

To determine when this point is, directors will need to be fully aware of the company’s financial position at all times.  This means that directors:

• must ensure they have regularly updated financial information at all times to enable them to make informed decisions;
• should hold regular board meetings to discuss the financial position of the company, record all decisions taken and why, in case these are later questioned; and
• take professional advice if they are unsure on their position.

For more guidance for directors during times of financial instability see: Directors duties: what are they on insolvency, and how can a director avoid personal liability for breach?