Since 1988, the ‘rule in West Mercia’ – so named after the West Mercia Safetywear v Dodd Court of Appeal case – has been the leading authority for when directors of financially stressed companies are subject to the so-called ‘creditor duty’, namely the duty to consider the interests of the company’s creditors. Now, in BTI 2014 LLC v Sequana SA & Others , the Supreme Court has considered the ‘rule in West Mercia’ for the first time, and clarified the existence, content and engagement of that duty.
In the current economic climate, it is more important than ever for directors to be aware of when the ‘creditor duty’ may be engaged and, if it is, to understand the lengths to which they are expected to balance the interests of the company’s creditors as against the company’s shareholders. The risks of getting this balancing exercise wrong can be severe given that a finding of personal liability for making creditor re-payments is within the scope of possible remedies.
The factual matrix in BTI 2014 v Sequana was complex but largely not a matter of dispute. In brief, in May 2009 the directors of a company called Arjo Wiggins Appleton Limited (‘AWA’) distributed a €135 million dividend to Sequana, who was its only shareholder. The payment was effected by way of a set off against an intra-group debt that was owed by Sequana to AWA. At the time of the dividend payment, AWA was solvent but there was a risk that AWA might become insolvent in the future , though such an insolvency event was not, in the opinion of the court, imminent nor even probable.
By October 2018 (some nine years later) AWA did, in fact, become insolvent and could not meet its duty to indemnify an entity called BTI with regards to historical liabilities (that pre-dated the 2009 distribution) for remediating the pollution of a river in the United States. BTI then tried to recover the amount of the dividend from AWA’s directors by advancing the argument that the dividend was in breach of the ‘creditor duty’ because AWA’s directors had not considered and balanced the interests of AWA’s creditors (such as itself) when making the 2009 distribution to Sequana.
Both the High Court and the Court of Appeal rejected BTI’s ‘creditor duty’ claim as it was advanced. It was held in the Court of Appeal that the ‘creditor duty’ does not arise until either: (i) a company was actually insolvent; or (ii) on the brink of insolvency or probably headed for insolvency. Given that AWA did not meet this threshold at the time of the dividend payment (that is, it was not insolvent nor on the brink of insolvency), BTI’s ‘creditor duty’ claim failed. BTI appealed to the Supreme Court.
Does a ‘creditor duty’ exist?
The first question the Supreme Court considered was whether the ‘rule in West Mercia’ was still applicable in light of the provisions of the Companies Act 2006 (the ‘Act’).
Section 172 of the Act requires directors to act in the way that they consider, in good faith, would be most likely to promote the success of the company, crucially, for the benefit of its members as a whole. The section sets out a non-exhaustive list of matters that the directors should have regards to when exercising that duty. Creditors are not mentioned. However, the section also specifies that ‘the duty imposed by this section has effect subject to any enactment or rule of law requiring directors […] to consider or act in the interests of creditors of the company’. The Supreme Court held that this demonstrated an intent by Parliament to preserve the rich tapestry of existing common law on when the ‘creditor duty’ arises, of which West Mercia is the leading authority.
Accordingly, the ‘rule in West Mercia’ remains relevant and, when properly engaged, applies to modify the duties imposed on directors so that they must be discharged only once they have considered the interests of the creditors. Although it is worth bearing in mind that this modification does not change the fact that, at all times, the duty is owed by the directors to the company itself and not to the creditors directly (nor, indeed, to the shareholders directly).
When does the ‘creditor duty’ arise?
The Supreme Court confirmed that the rule in West Mercia does not apply simply because a company has a real, rather than remote, risk of insolvency at some point in the future. In circumstances where a company remains financially stable, the interests of the shareholders will continue to dominate the interests of the creditors. It is rather at the point where a company is either insolvent as a matter of fact, which may only be determinable with reference to expert evidence, or is imminently insolvent that the duty arises. The Supreme Court considered various iterations of this test including “bordering on insolvency”; “doubtfully solvent”; “on the verge of insolvency”; and “potentially insolvent”. It was agreed that what was trying to be conveyed was a sense of imminence. Given that AWA was not actually insolvent, nor imminently insolvent, it was held that the ‘rule in West Mercia’ was not engaged on the facts and, accordingly, BTI’s appeal was dismissed.
In practice then, it is important for directors to consider, once it is determined that the ‘rule in West Mercia’ has been engaged, the weight which should be given to the interests of the company’s creditors, which will likely be at odds with the interests of the members. It is not a binary matter that members’ interests fall away entirely as soon as the ‘creditor duty’ is engaged. However, the weight that should be given to the interests of the creditors will increase as the financial health of the company worsens. Indeed, the Supreme Court held that ultimately, where insolvent liquidation or administration is inevitable, ‘the interests of the members cease to be bear any weight, and the rule consequently requires the company’s interests to be treated as equivalent to the interests of its creditors as a whole.’
Is actual knowledge required?
It should be noted that the Supreme Court did not consider whether the duty arises only in circumstances where directors had actual knowledge of the state of the company’s finances regarding potential insolvency (or, for example, whether it would be satisfied if they had ‘ought to have known’); but a fair warning was given, in any event, by way of a reminder that directors are under a duty to keep themselves informed about their company’s affairs and that they would be well served to keep the solvency of their company under careful review in today’s choppy economic climate.
The Supreme Court’s judgment in this matter should be a touchstone for directors that are looking to navigate the potentially turbulent times ahead. Directors should, in addition to ensuring that their existing duties are properly discharged, be kept aware of their company’s financial standing and consider, on an ongoing basis, whether that causes them to have reason to believe they are under a ‘creditor duty’. If so, it is crucial that directors seek advice on the matter and recognise that their existing duties have been materially modified so that it is no longer simply business as usual.