Supreme Court confirms that creditor duty exists

Does a creditor duty exist?

Yes, there is a creditor duty owed by directors of a company. A director’s duty to act in good faith in the company’s interests is modified in certain circumstances so that the company’s interests are taken to include the interests of its creditors as a whole. Directors, under certain circumstances, must have regard to and consider the interests of a company’s creditors and prospective creditors. The duty is not a free-standing duty owed directly to the creditors. The duty is owed to the company and arises by virtue of common law, preserved by s172(3) Companies Act 2006.

When does the creditor duty arise?

The duty is triggered at a point short of actual insolvency (which in this context means ‘cash flow’ or balance sheet insolvency as referred to in the Insolvency Act 1986). The particular triggers referred to by the Supreme Court include ‘imminent insolvency‘ or the ‘probability of an insolvent liquidation or administration‘, which the directors ‘know or ought to know about‘ and when the company is ‘insolvent or bordering on insolvency‘. A potentially earlier trigger of ‘a real and not remote risk of insolvency’ was rejected. This is helpful to directors in that the judgment confirms that the creditor duty can be said to arise at a later date than could previously be argued.

What is the content of the creditor duty?

The content of the creditor duty, when triggered, is that the interests of the company’s creditors as a whole should be considered in respect of a particular decision. This means that decisions such as paying a dividend, even when the dividend is lawful, need to be taken very carefully if the financial state of the company means that the duty could be triggered. There is ‘sliding scale’: the greater the company’s financial difficulties, the more the directors should prioritise the interests of creditors.

Where an insolvent liquidation or administration is inevitable, the creditors’ interests become paramount in directors’ decision making as the shareholders cease to retain any valuable interest in the company. The shareholders’ right to ratify decisions and actions of the directors will cease to exist when the creditor duty is engaged.

So what does this mean in practice?

Although the judgment makes it clear that a creditor duty definitely exists, there is still not total clarity as to the precise timing or trigger point for the engagement of the duty: it will be fact specific. With this in mind, directors and their advisers are likely to continue to take a cautious approach as to when the duty is engaged.

It is crucial that you seek legal advice as soon as possible. One thing is clear, the trigger is not a ‘real risk of insolvency’ which many have previously tried to argue. Here are our top five tips to stay on the right side of the duty:

• Hold frequent board meetings to keep track of the financial position of the business.

• Make sure that up-to-date, reliable financial and operational information is available at the meetings.

• Hold additional meetings between scheduled meetings if there are material developments in relation to the financial health of the company.

• Ensure a written record is made of all discussions and meetings with detailed reasons given for why decisions have been made.

• Make sure that directors understand their legal duties, this becomes even more important at times of financial stress.

How we can help

The key to all of this is to come and talk to one of us in the Restructuring & Insolvency team as early as possible. We can help you navigate the challenges that you face running a business in a difficult market at the same time as complying with your legal duties as directors.