A real, as opposed to remote, risk of insolvency is not necessarily enough for the duties of a board of directors to switch from being owed to its shareholders to being owed to its creditors.
So ruled the Court of Appeal (“CA”) in its judgment in BTI 2014 LLC v Sequana SA & Ors, handed down on 6 February, on an appeal made by the parties to a dispute between a division of BAT Industries Pty Ltd, the listed French paper business Sequana S.A., and the directors of Sequana’s subsidiary at the time arising out of disputes relating to liability for the contamination of a river in the USA in the 1960s and 1970s.
The CA’s decision confirms that:
- it is possible, as a matter of law, for a dividend to be lawful (i.e. paid in accordance with the Companies Act) and yet be found to be a transaction defrauding creditors under the Insolvency Act (section 423); and
- there is ‘for good reason’, according to the CA, no single form of words that encapsulate the test for determining when a company’s financial position is such that the law requires that its directors act in the interests of creditors. The point arises, the CA held, when a company’s circumstances fall short of actual, established insolvency and at a point when there may need to be more than a ‘real risk’ of insolvency. Descriptions used in earlier cases, such as ‘on the verge of insolvency’ or ‘nearing insolvency’ or ‘of dubious solvency’ or ‘in a parlous financial state’ were considered, by the CA, to be too vague to serve as useful tests of general application for the important step of engaging the creditors’ interest duty.
Whilst warning that judicial statements should never be treated as if they were statutes, Richards LJ’s judgment is that the duty to creditors arises ‘when the directors know or should know that the company is or is likely to become insolvent’. Readers will recognise how closely aligned those words are to the statutory provision for wrongful trading (‘… knew or ought to have concluded that there was no reasonable prospect that the company would avoid … insolvent liquidation … or … administration’).
As a result of the CA’s decision, each party’s appeal was dismissed and accordingly:
- the payment of a dividend to Sequana by its subsidiary at the time (AWA) was upheld as a transaction that was caught by s423 of the Insolvency Act (transactions defrauding creditors), found on the facts to have been made with the requisite statutory purpose of putting assets beyond the reach of those who may make a claim against AWA; and
- BAT failed to establish that the directors had breached their legal duties as the creditors’ interest duty had not, on the facts, been engaged. This, in turn, meant that the shareholder (i.e. Sequana) could ratify the decision made by the directors of AWA so as to preclude any claim subsequently made by or on behalf of AWA against the directors, while leaving in place any claim under s423.
BTI 2014 LLC v Sequana SA & Ors ( EWCA Civ 112)
In the 1990s Appleton Papers Inc (“API”) was identified by US authorities as a party liable to contribute to the costs of cleaning environmental damage caused to the Lower Fox River in Wisconsin, USA. API was named because in the late 1970s it had acquired a paper business which carried on damaging environmental practices, and when API acquired that business it had agreed to indemnify the previous owner against environmental liabilities. At the time of that acquisition, API was a subsidiary of BAT Industries Pty Ltd (“BAT”).
In 1990, BAT demerged the holding company of API, and at that point was indemnified by API and its new holding company for the costs of the clean-up. API and its holding company were, a few years later, acquired by Sequana S.A. (“Sequana”) and the holding company of API was renamed Arjo Wiggins Appleton Limited (“AWA”).
API was sold by Sequana in 2001 and by reason of a complex series of corporate transactions, AWA was subject to contingent indemnity liabilities in respect of the clean-up costs and damages arising out of the pollution of Lower Fox River. AWA had the benefit of an investment contract which would pay out a maximum of US$250million, and certain historic insurance policies with an expected recovery, subject to litigation, of US$100million. It was found that the ultimate liability of AWA depended on a large number of ‘moving parts’, including several pieces of large-scale litigation in the United States.
In the very broadest of terms, at the time the dividends were paid, AWA:
- had ceased to trade;
- had only one material liability being the contingent liability for the clean-up costs and damages described above; and
- had, as material assets, only the investment contract and insurance policies mentioned above and a large intra group receivable (of EUR585million) it was owed by its parent company, Sequana.
In December 2008, AWA’s directors resolved to pay an interim dividend of EUR443million to Sequana and in May 2009, the directors of AWA resolved to pay a second interim dividend of EUR135million to Sequana. These dividends were paid following a reduction of AWA’s capital under section 642 of the Companies Act 2006 (the “Companies Act”) and in each case were supported by solvency statements from AWA’s directors. Further, each dividend was paid by the amount of the dividend being set-off against the receivable due to AWA from Sequana. The net effect of such dividends, therefore, was to remove this receivable as an asset of AWA (save for a balance for cEUR3million) and put it beyond the reach of BAT, who may make a claim against AWA for its liability for the clean-up costs and related damages.
Issues at first instance
BAT established BTI 2014 Plc (“BTI”) in order to challenge the decision of the board of AWA to make the two dividend payments to Sequana. The dividends were challenged on the following grounds:
- that the accounts on which the directors of AWA relied on when resolving to pay the two dividends had not been properly prepared, and as such, the dividends were not lawful dividends for the purposes of the Companies Act;
- that when AWA’s directors resolved to pay the dividends to Sequana, due to the financial position of AWA, the directors owed a duty to consider the best interests of the company’s creditors and, by paying the dividends, breached that duty; and
- that the dividends were transactions at an undervalue within the meaning of section 423 of the Insolvency Act 1986 (“IA”) entered into for the dominant purpose of putting assets beyond the reach of BAT as a potential claimant against AWA.
The High Court’s decision at first instance
On each of issues set out above, the High Court held as follows:
- that the dividends did not contravene the Companies Act i.e. the dividends had been lawfully made;
- that the directors’ duty to consider the interests of creditors had not, on the facts, been engaged when the directors authorised the payment of the dividends and therefore the directors of AWA had not breached their duties as directors; and
- that the payment of a dividend could, as a matter of law, be characterised as a transaction at an undervalue for the purpose of s423 of the IA. Further, it was determined that, in the case of the dividend paid in May 2009, the evidence was such that that the directors’ intention was to put assets beyond the reach of BAT as creditor of AWA and accordingly that dividend was a transaction at an undervalue within s423.
There were two principal issues raised in the appeal as follows:
- whether the payment of an otherwise lawful dividend is capable, as a matter of law, of being a transaction at an undervalue within the meaning of section 423 of the IA and, if it is, whether on the facts of this case the dividend in question was paid with the requisite statutory purpose. Sequana appealed these points which had been found against at first instance; and
- when and in what circumstances does the duty of directors to have regard to the interests of the company’s creditors (as opposed to its shareholders) arise. BTI appealed the decision on this issue at first instance.
First issue: can an otherwise lawful dividend be a transaction at an undervalue within the meaning of s423 of the IA?
Sequana argued that the High Court had erred in finding: (1) that payment of a dividend could be a ‘transaction at an undervalue’ within the meaning of s423(1) of the IA; and (2) that the May dividend was paid with the purpose of putting the dividend monies beyond the reach of BAT or prejudicing BAT’s interests within the meaning of s423(1).
Richards LJ rejected Sequana’s appeal on the first issue, holding that payment of a dividend is, as a matter of law, capable of being a transaction at an undervalue within the meaning of s423(1) of the IA, even if the dividend was paid in accordance with the Companies Act (i.e. lawfully). In so deciding, and by reference to the requirements set out in s423(1), the Court of Appeal held as follows:
- dividends are both commercially and legally a return on investment. Rights are conferred on shareholders as regards dividends by the terms of the issue of shares or by the articles and it is pursuant to those rights that shareholders receive dividends. Accordingly, a dividend cannot be characterised as a ‘gift’, made by a company to its shareholders (a requirement of the first limb of s423(1)(a));
- it cannot be said that a company receives consideration for the payment of a dividend because ‘the terms of [a] dividend do not provide for the company to receive any consideration [and] nor will it receive any consideration’ (it being a requirement of the second limb of s423(1)(a) that there is a transaction on terms that provide for the company to receive no consideration); and
- s423 is not confined to gifts, as the only unilateral acts capable of falling within s423, and only bilateral acts as transactions. It is not the right approach to regard dividends as unilateral acts of a company. A dividend is paid pursuant to and in accordance with the rights of the shareholders under the articles of association, as a return on investment. Therefore, the payment of a dividend is within the scope of s423 ‘even if it cannot be said to involve an agreement or arrangement between the company and shareholders’ (para 63).
Richards LJ, (who gave the leading judgment in the Court of Appeal) also rejected the argument that to construe s423 as applying to a dividend would cut across the statutory regime in Part 23 of the Companies Act. Section 423 is ‘wholly unrelated’ to the Companies legislation and there is ‘no conceptual difficulty in an otherwise lawful dividend being paid for the purpose of putting assets beyond the reach of actual or potential claimants …’ (para 62).
As for Sequana’s second ground of appeal, the statutory purpose, this was essentially a question of fact. Sequana argued that the High Court had failed to make a finding that the intention of the May 2009 dividend met the requirements of s423(3) of the IA, namely, that the transaction was entered into for the purpose of (a) putting assets beyond the reach of a person who is making, or may at some time make, a claim against him, or (b) of otherwise prejudicing the interests of such a person in relation to the claim which he is making or may make. Sequana’s arguments were rejected by Richards LJ as, in his view, the High Court had examined the facts at hand, had made clear findings and had correctly identified the legal issue. Richards LJ cited, in support, the following comment from para 516 of the judgment of Rose J of the High Court:
‘Here there is no doubt that the subjective intention of the directors at the time of the May dividend and the sale was to prevent claims. After the declaration of the dividend and the sale to TMW, the creditors were prejudiced because the assets of AWA had been depleted and it no longer had any call on Sequana to that extent.’
Second issue: at what stage is the directors’ duty to creditors engaged?
BTI’s position was that, when the AWA board resolved to pay the May 2009 dividend, the board owed a duty to AWA’s creditors. BTI argued that the duty for directors to consider the interests of creditors is engaged when a company faces a real, as opposed to a remote, risk of insolvency.
As a reminder of the relevant statutory provisions: under section 172 of the Companies Act, directors have a duty to act in a way that they consider, in good faith, would be the most likely way to promote the success of the company for the benefit of its shareholders as a whole, with regard to a number of non-exhaustive issues set out in s172(1). Section 172(3) provides that such a general duty ‘has effect subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interest of creditors of the company’. It was BTI’s submission that the common law duty to creditors had been engaged at the time the dividend in May was paid.
When this point was argued by BTI in the High Court, Rose J had not been persuaded. Rose J found that to set the test at the level of ‘a real as opposed to remote risk of insolvency’ would appear to be a much lower threshold than a test set at the level of being ‘on the verge of insolvency’ or of ‘doubtful’ or ‘marginal’ solvency. In her judgment, Rose J said:
‘Having reviewed the authorities, I do not accept that [BTI had established] that whenever a company is ‘at risk’ of becoming insolvent at some indefinite point in the future, then the creditors’ interest duty arises unless the risk can be described as ‘remote’. That is not what the cases say and there is no case where, on the facts, the company could not also be accurately described in much more pessimistic terms, as actually insolvent or ‘on the verge of insolvency’, ‘precarious’, ‘in a parlous financial state’ etc.’
Having considered the evidence of AWA’s financial position at the time, Rose J concluded that AWA could not be described as on the verge of insolvency or of doubtful insolvency. As such, the High Court held that the duty to creditors had not been engaged at the time that AWA’s directors resolved to pay the May 2009 dividend.
In his leading judgment for the Court of Appeal, Richards LJ undertook a thorough review of how this issue has been considered in previous reported cases. He held:
‘The precise terms in which the duty is said to arise differ but a frequently used formulation is that it arises where the company “is insolvent or of doubtful solvency or on the verge of insolvency and it is the creditors’ money which is at risk”, in which case the interests of creditors are paramount…’
Having examined previous judicial pronouncements on the issue, Richards LJ considered BTI’s submission that the duty arises when there is a real risk of a company’s insolvency and found that that would set a lower test than one which requires asking whether the company’s solvency is ‘doubtful’ or if the company is ‘on the verge of insolvency’ or ‘likely to become insolvent’ (para 214 of the judgment). Richards LJ observed that the trigger for when directors are required to consider the interests of creditors had, in a few instances, been expressed as a question of whether there is a real risk of insolvency, for example, in the Australian decision of Kalls Enterprises Pty Ltd v Baloglow ( NSWCA 191), it was said:
‘It is sufficient for present purposes that, in accord with the reason for regard to the interests of creditors, the company need not be insolvent at the time and the directors must consider their interests if there is a real and not remote risk that they will be prejudiced by the dealing in question.’
Richards LJ concluded that in the vast majority of cases, the trigger for when directors must consider the interests of creditors has not been expressed in these terms, and that the test of a real, as opposed to a remote risk of insolvency is not part of the present law and that it would not be appropriate for the test to be expressed in this way.
In considering how the test should be described, Richards LJ acknowledged that the precise moment at which a company becomes insolvent is often difficult to pinpoint. In some cases it may occur suddenly, whereas equally, the descent into insolvency may be more gradual. Each case will depend on the particular facts and circumstances. Further, Richards LJ observed that the adoption of any legal test to identify the point at which the duty owed to creditors is engaged involves ‘a difficult amalgam of principle, policy, precedent and pragmatism’, as stated by Richardson J in Nicholson v Permakraft (NZ) Ltd ( 1 NZLR 242).
Richards LJ considered that in his view ‘for good reason’ judges have shied away from prescribing a single from of words to encapsulate the test for determining when a company’s financial position is such that the law requires that its directors owe a duty to act in interests of the company’s creditors. Expressions such as being in a ‘parlous financial state’ or ‘in financial difficulties’ may, Richards LJ found be apt to describe a company’s situation in particular cases but they are ‘too vague to serve as a useful [general] test’. Richards LJ confirmed that the duty may be triggered when a company’s circumstances fall short of actual, established insolvency. In considering when the point before actual insolvency arises such that the duty is engaged, Richards LJ held as follows (at para 220):
‘Judicial statements should never be treated and construed as if they were statutes but, in my judgment, the formulation used by Sir Andrew Morritt C and Patten LJ in Bilta v Nazir, and by judges in other cases, that the duty arises when the directors know or should know that the company is or is likely to become insolvent accurately encapsulates the trigger. In this context, “likely” means probable, and not some lower test…’
BTI’s appeal, based on its argument that the applicable trigger for the creditors’ interests duty was a real, as opposed to remote, risk of insolvency, was rejected by the Court of Appeal. Accordingly, BTI’s appeal as regards all claims for breach of duty by the directors of AWA in paying the May dividend was dismissed.
Richards LJ went on to recognise that an important related issue which is ‘not straightforward’, is whether, once the duty to creditors is engaged, the interests of creditors are paramount or are to be considered ‘without being decisive’. Richards LJ declined to express a view other than to say that: ‘where the directors know or ought to know that the company is presently and actually insolvent, it is hard to see that creditors’ interests could be anything but paramount’ (para 222).
This case is important for establishing that a dividend which has been made in accordance with the requirements of the Companies Act can nevertheless be a transaction at an undervalue under s423 of IA. This is a point that directors will need to bear in mind when assessing whether they ought to declare a dividend, as with assessing any other transaction or business decision at a time when the company may be in some degree of financial difficulty.
This case will probably be of more interest, however, for what the Court of Appeal said about directors’ duties and specifically what it said about the legal test is for when directors ought to be taking decisions that are in the interests of creditors rather than shareholders. Richards LJ’s judgment contains a useful overview of the authorities on this important point of law.
In looking at what can be taken from this case, it must first be emphasised that it arose out of exceptional circumstances. The company had ceased to trade. It had one potentially huge liability in the form of indemnity obligations linked to the outcome of litigation in the US which, if it became an actual liability, may or may not be covered by its insurance policies. It otherwise had no material liabilities or assets, aside from the EUR585 million receivable owed to it by its parent company. The directors’ assessment was that the insurance policy was sufficient to cover the best estimate of the liability and that therefore it was not necessary to include a provision in the accounts for the year that preceded the dividends being paid.PwC audited the accounts and gave an unqualified certificate that they gave a true and fair view of the company’s affairs in accordance with GAAP. The auditors added an emphasis of matter to the accounts which drew attention to the uncertainty relating to the potential liability and which, PWC stated, was not necessarily under the control of the company.
The prospect of the company becoming insolvent - meaning unable to pay its debts as they fall due which would in turn also presumably result in due course in commencement of a formal insolvency proceeding - was considered on the facts to be a real risk and more than a remote risk. Those circumstances were found to fall short of what was required as a matter of law to engage the directors’ duty to creditors in place of shareholders.
Some might say that this was a missed opportunity for the Court of Appeal to bring clarity to an issue that boards of directors and their advisers wrestle with whenever a company encounters financial difficulties. But, this would be unfair in the light of the policy decisions taken by the Governments of the day repeatedly to decline to include a clearer statutory statement as to the law on this point. To recap what we do know in the light of this case and earlier authorities:
- the creditors’ interest duty is engaged at some stage that is close to insolvency and before actual, established insolvency (either on a cash flow or balance sheet basis);
- it may not be engaged when the risk of insolvency is real as opposed to remote (as was found in this case);
- a company being ‘on the verge of insolvency’ or ‘in financial difficulties’ or ‘approaching insolvency’ may be apt to describe particular circumstances that meet the test but none of these sets of words can be relied on to be the legal test for all situations;
- the duty arises when the directors know or should know that the company is or is likely to become insolvent (which probably means cash flow insolvent and not just balance sheet insolvent other than in exceptional circumstances) and ‘likely’, for these purposes, means more probable and not some lower test; and
- the directors’ decision as to whether the creditors’ interest duty has arisen is best taken on an informed basis as to the practical consequences.
Richards LJ’s comments as to the consequences of the creditors’ interest duty arising- specifically, whether there is any scope for directors to have regard to the interests of stakeholders other than the company’s creditors- were obiter. His obiter comments confirm that the debate is still alive, although in most cases it will likely be challenging to argue successfully, after the creditors’ interest duty has arisen, that creditors’ interests are anything other than paramount.
Sequana has announced that it intends to seek permission to appeal to the Supreme Court.