It is common knowledge that directors of companies owe a duty to the company to act in its best interests.

Less well understood is the principle that, when a company reaches a certain level of financial distress, the directors’ duties shift to include a duty to consider the interests of creditors of the company.

This topic is of crucial importance to directors of companies in financial distress but is also relevant to creditors of those companies, so that they can understand whether directors of their debtors are acting in accordance with their duties. It will also be relevant, of course, to professional advisers of both groups.

The rule that, on the eve of insolvency, directors owe duties to creditors, is relatively novel. The principle has been developed in parallel in a number of common law jurisdictions over the last 50 years or so.

This parallel development of the rule combined with a relatively small number of cases on this topic led to inconsistencies and open questions, including:

• Does the creditor duty exist at all?

• What is the duty?

• When does the duty apply?

The UK Supreme Court this month handed down a much anticipated judgment, BTI 2014 LLC v Sequana SA, which adds significant clarity to this topic and answers some of these questions.

Since there is no binding authority from the Bermudian court directly on this point, the BTI v Sequana decision will carry significant weight in Bermuda. The Privy Council - Bermuda’s ultimate appeals court - and the UK Supreme Court share judges, which adds to the significance of this decision in Bermuda.

The judgment involved Sequana, a company that became insolvent in October 2018. Almost ten years before its insolvency, in May 2009, Sequana had paid a dividend to its shareholder of €135 million.

BTI, a creditor of Sequana, claimed that Sequana’s board of directors had acted in breach of duty by failing to consider or act in the interests of Sequana’s creditors, when it paid the dividend.

In the UK, companies are not permitted to indemnify their directors for breaches of duty, unlike in Bermuda, and so the directors would have been personally liable had they been held to have breached their duty.

The court found that there had been no breach of duty. At the time that the dividend was paid, there was a real risk of insolvency in the future but it was not an imminent or even probable risk. The directors’ duties were therefore to act in the best interest of the shareholders.

Despite this conclusion, the court felt it appropriate to conduct a thorough review of the law in this area and to answer some questions that had been left open by previous cases.

The court found that a common law “creditor duty” exists. That duty is not, however, a duty owed to creditors. It is instead a facet of the duty that the directors owe the company to act in its best interest and thus the best interest of its economic stakeholders. Usually, those stakeholders are solely the shareholders but in times of financial distress the class expands to include creditors.

Regarding the nature of the duty, the court held that where the company is insolvent or nearing insolvency the directors should consider the interests of creditors, balancing them against the interests of shareholders where they may conflict. The greater the company’s financial difficulties, the more the directors should prioritise the interests of creditors.

This demonstrates that there is no simple, bright line point at which directors must disregard the shareholders’ interest and focus solely on the creditors. The court acknowledged that a company in financial distress will go through ups and downs and that any final deterioration may be sudden and unpredictable or slow but unavoidable. Once insolvent liquidation is inevitable, the creditors’ interests become paramount.

As the duty is part of the wider duties that directors owe to the company, creditors cannot directly enforce the duty to act in the creditors’ best interests. However, if the company has entered insolvent liquidation, various statutory remedies might apply and a liquidator may sue the directors for the creditors’ benefit.

Usually, shareholders can ratify directors’ breaches of duty to the company if they so choose. However, in the case of the creditor duty, shareholders cannot ratify breaches as they lack the necessary economic interest in the outcome of the decision.

Finally, in a crucial portion of the decision, the court sought to identify the time at which the creditor duty first arises. The formulation that the majority of the court preferred was that the duty applies when the directors know, or ought to know, that the company is insolvent or will probably become insolvent.

Insolvency in this context can mean cashflow insolvency (the company cannot pay debts currently due) or balance-sheet insolvency (looking at company assets and allowing for prospective and contingent liabilities, the company will not be able to pay its debts).

One question the UK Supreme Court left open was whether the objective “ought to know” portion of the test for engaging the creditors’ duty had been fully argued or was still open.

Directors who should but do not know that a company is insolvent with the consequence that they disregard the creditors’ interests may therefore unwittingly act in breach of duty: the point may be open for debate.

It may be, however, that a director who fails to realise that the company is insolvent - in circumstances when they ought to - is not exercising the skill and diligence expected of a director and would therefore be in breach anyway.

It remains to be seen how BTI v Sequana will be applied in a Bermudian context. Bermuda does treat directors differently to the UK, with company indemnities for directors being a notable feature of the landscape.

Nonetheless, this additional clarity provided by the decision on the existence, nature and timing of the creditor duty following BTI v Sequana may give litigants more confidence in bringing claims based on breach of duty in future.

Partner Hannah Tildesley and associate James Batten are members of the dispute resolution department at Appleby. A copy of this column can be obtained on the Appleby website at www.applebyglobal.com.

This column should not be used as a substitute for professional legal advice. Before proceeding with any matters discussed here, persons are advised to consult with a lawyer.