UK SUPREME COURT – INSOLVENT TRADING IN THE TWILIGHT ZONE

With the Supreme Court decision in Mainzeal said to be imminent, there has been quite a bit of interest in a recent decision of the UK Supreme Court in case called Sequana about the duties of directors of a company in the twilight zone.  One UK commentator has said that Sequana represents the most significant ruling on the duties of directors of distressed companies in the past 30 years.

Whilst there are many similarities between the relevant law in the UK and that of New Zealand and existing (New Zealand) case law on the need for directors to consider the interests of creditors when a company is in the twilight zone approaching insolvency, there are also a few important points of difference.  As a result, there are mixed views about the extent to which Sequana will have an impact here.

It should also be noted that Goddard J., in the Court of Appeal decision in Mainzeal, described New Zealand’s insolvent trading regime as not fit for purposes and in need of reform.  Across the Tasman, the Australians have already started such a review.  As a result, Sequana and (in all likelihood) the Supreme Court decision in Mainzeal could buttress the calls for law reform.

Importantly, or perhaps unhelpfully, Sequana did not identify a ‘bright line test’ pointing to some sort of tipping point at which the interests of creditors must receive greater prominence than the other interests being juggled by directors.  Instead, it seems to reinforce the point already reached by the New Zealand courts that, once insolvency exists or is likely, the duty of directors to act in the best interests of the company must accommodate a consideration of the interests of creditors. 

Sliding scale

The UK Supreme Court sought to address what was seen as ambiguity regarding the contents of the “creditor duty” by seeking to make it clear that the way in which directors discharge the “creditor duty” differs as the company’s financial difficulties company become more acute.  

Some commentators have tried to characterise this as involving distinct stages (in the ‘twilight zone’), but it is clearly a sliding scale, ranging from:

• entry into the twilight zone – when approaching insolvency, the directors must consider creditors’ interests – which may require a balancing act (and inevitably, a greater level of financial distress points to the need for more attention to be paid to the interests of creditors); and
• to a point when insolvency (and a formal insolvency process) is “inevitable” – then the interests of creditors become paramount.

To repeat the point above, the “creditor duty” is not a separate (freestanding) duty owed directly to creditors.  Instead, it is permutation of the (primary) duty to act in the best interests of the company by having regard to the interests of the company’s creditors – when the company becomes insolvent or approaches insolvency.  The UK Supreme Court judgment refers to something labelled “modern corporate rescue culture” in the UK.  And, in doing so, it referred to the 1985 New Zealand Court of Appeal decision in Nicholson v Permakraft.

Importantly, when the “creditor duty” is engaged (triggered) the shareholders’ ability to ratify decisions and actions of the directors ceases to exist.

Sequana – background

The insolvency in question (of a company called AWA) was a long time in the making.  In 2009, AWA had paid its parent company (Sequana) a dividend of €135 million extinguishing a significant amount of inter-company debt.  At the time the dividend was distributed, AWA was solvent (on both limbs of the solvency test – balance sheet and cash flow).  However, AWA had a significant contingent liability in the form of pollution clean-up costs.  There was also uncertainty about the value of one of its major assets.  The amount and likelihood of those liabilities (and the question mark about the asset value) was uncertain.  Nonetheless, they gave rise to a real risk (but not then a probability) that AWA could become insolvent at some point in the distant future.

Nearly 10 years after paying the dividend, AWA went into administration.  BTI purchased AWA’s claim against its directors and sought to recover the amount of the dividend payment from AWA’s directors – arguing a breach of the “creditor duty” by failing to consider or act in the best interests of creditors at a time when AWA was insolvent or there was a real risk of insolvency.

Sequana – decision

The unanimous decision of the UK Supreme Court was that:

• The AWA directors were not subject to a duty to have regard to the consider the interests of creditors at the time that the dividend was paid.  At that time, AWA was not either insolvent or imminently insolvent, nor was insolvency even a probability.
• A director, as part of their (primary) duty to act in good faith in the best interests of the company, must also consider the interests of creditors in certain circumstances.  This is because creditors have the main economic stake in the outcome of a liquidation – pointing to the need to consider their interests at an earlier stage.

As noted above, the UK Supreme Court did not identify a bright line test for directors.  But, the majority found that the “creditor duty” would be engaged when directors knew, or ought to have known, that the company was insolvent or bordering on insolvency, or that a formal insolvency process is probable.

Relevance to New Zealand

The Sequana decision underlined the point that the “creditor duty” dovetails with the provisions in the UK Companies Act relating to wrongful trading (which are said to roughly equate to reckless trading regime under section 135 of the New Zealand Companies Act).

However, there are (as a result of recent New Zealand decisions – notably Debut Homes) a number of important points of difference between the present state of the law on insolvent trading in New Zealand with that in the UK.  For example, directors of a UK company (once there is no reasonable prospect of the company avoiding insolvent liquidation) have a duty to take every step that a reasonably diligent director would take to minimise potential loss to the company’s creditors.  

UK directors can continue to trade, prior to a formal insolvency process, if by doing so they will achieve a better return for existing creditors.  As a result, the majority decision in Sequana is seen as being careful not to apply the “creditor duty” too early in the cycle of distress – to support a “rescue culture”.  By contrast, if directors were to face an earlier, or vaguer, trigger point this would be seen as unduly burdensome – and (to paraphrase one of the drivers for reform in Australia) might lead to too many good businesses being subjected to formal insolvency processes because directors were unwilling to take the risk of a rescue mission.  This approach can be contrasted with the approach of the New Zealand Supreme Court in Debut Homes which pointed to the need for a director to cease trading once it was clear that the company would not recover, even if continued trading for a finite period would reduce the amount of the loss to stakeholders.

The balancing act in the treatment of the “creditor duty” adopted by the majority in Sequana (and the understanding of the need to promote a rescue culture) encourages considered risk taking, based on expert advice, to achieve a better outcome for creditors.  Perhaps, the Supreme Court will take the opportunity in Mainzeal to echo the comments of Goodard J. in the Court of Appeal about the need (for Parliament) to reconsider the insolvent trading regime.  Any such reflection may only be strengthened by developments in Australia.

The Sequana judgment suggests a sliding scale, that when a company is entering into the twilight zone (but it is not inevitable that a formal insolvency process will follow), the directors must undertake a balancing act for directors of creditors’ interests against those of shareholders’ interests.  When applying that scale, the weight to be given to each group’s interests will depend on what the directors reasonably regard as the likelihood that a proposed course of action will lead the company away from vs tip it over the brink.

As well as the need for evidence and expert advice, the application of the sliding scale may require directors to assess who has the most at risk.  For many companies in the twilight zone, this is likely to be creditors – as (typically) the prospect of a return on shareholders’ funds is very low.

In this regard, Debut Homes does not provide much assistance because the company was already beyond a point where it could have been brought back from the brink at the time that the critical decisions (to complete the remaining houses) were made.  To this I would also add that our leading cases seem to be those where large/lumpy transactions are under the spotlight – and not those affecting more bread & butter trading businesses where it is the trend or the compass bearing on which the business is headed with which directors must wrestle – and not single, identifiable, mission critical transactions.

The other question is what to make of the UK Supreme Court’s treatment of Permakraft.  A common view is that the comments (in technical terms – strictly obiter and a statement of opinion that was not essential to the judgment and therefore not binding as a precedent) by Cooke J. in 1985 left open the possibility that directors’ duties might be owed directly to creditors and not (in a dogleg) via the company.  In the intervening four decades those views have not received much support and are regarded as likely to be confined to special circumstances where the directors actively/deliberately assumed some responsibility towards specific creditors.

The majority decision in Sequana rejected the idea that Permakraft had led to New Zealand courts requiring the directors of companies teetering on the brink to consider the interests of creditors.  Instead, this was rationalised as part of the sliding scale approach – that the directors of a company on the brink should recognise that creditors have an economic stake in a formal insolvency process.  Obviously, the narrowing of the impact of Permakraft evidenced by references to the need for directors to conduct a balancing act narrows the scope of any duty to consider the interests of creditors.

Where does this leave directors?

Helpfully, the majority judgment in Sequana suggests that any duty to consider the interests of creditors only arises when a director knows or ought to know that the company is insolvent or bordering on insolvency, or that formal insolvency procedures are probable.  Contrast this with the situation in Debut Homes where the director knew and had been advised the company was incapable of being brought back from the brink. 

This might help limit the impact of Debut Homes – and not risk concerns about Debut Homes opening the floodgates for claims against directors based on arguments about the point at which a company was “unsalvageable”.  I also repeat my concern about the Courts needing to differentiate between a lumpy transaction that tipped the business over the brink vs the situation faced by a routine trading business with lots of small, regular, transactions.

Comments

The UK Supreme Court’s decision in Sequana reinforces and refines a trend that has been evident in New Zealand for some time – that directors of a company teetering on the brink have a duty (owed to the company) to consider the interests of creditors (generally).  This is consistent with the Law Commission’s formulation a director’s obligation under section 135 of the Companies Act (and the Law Commission’s specific rejection of the idea that the directors of a company teetering on the brink owed a specific duty to creditors that was directly enforceable by them). 

And whilst the focus of Mainzeal is on sections 135 and 136 of the Companies Act, it will be very interesting to see whether the New Zealand Supreme Court decision (which is said to be imminent) impacts further on the extent of directors’ duties – perhaps by echoing some of the comments of the majority in Sequana.  The approach that the directors of a company teetering on the brink need to have regard to the interests of creditors, as well as those of shareholders, when making critical decisions appears solidly based on the economic rationale that at that stage the creditors also have skin in the game.

Nonetheless, a number of questions remain unanswered, including:

• Absent a bright line test, it is not always easy to identify when the “creditor duty” is engaged.  There have been different formulations – such as “real risk of insolvency” or “imminent insolvency” (when the directors know or ought to know insolvency is just around the corner and going to happen) or the probability of a formal insolvency process or “bordering on insolvency”.

This leaves directors in a difficult position of (say) identifying a tipping point – when the risk of insolvency transitions from 49/51 – to that of being unsalvageable.

As noted, a number of times above, this may be much easier to identify for single/lumpy transactions.  Ultimately, it seems, the question needs to be considered on a case-by-case in light of the particular factual matrix affecting each specific company.

• There are some quirks in the majority decision.  And those affecting AWA itself (primarily a passive investment vehicle) which also call into question whether the trigger point must be viewed differently when dealing with an active trading business.

As a result, it is possible that the comprehensive review of the effectiveness of Australia’s corporate insolvency laws holds the key to sensible clarification in New Zealand.  The objective of the Australian review is that of protecting and maximising value for the benefit of all interested parties and the economy – in the face of a hybrid of 19th century companies’ legislation as well as a hotch-potch of more recent additions and amendments.