At what point should company directors consider the risk of litigation to be an insolvency issue?

Insight

10.10.2023

Company directors have a duty to act in the best interest of creditors (the creditor duty). But at what point is that duty engaged? Put another way, when should directors start worrying about the duties they might owe to creditors? In this briefing, Jolyon Connell, David Fletcher and Oliver Blundell explain how the recent case of Hunt v Singh [1] has provided further guidance on what this means for company directors faced with significant litigation.

The case

Hunt concerned a company’s use of a tax avoidance scheme which, when challenged by HMRC, caused the company to owe £36m in unpaid tax liabilities; that, in turn, led the company to enter into insolvent liquidation. The liquidators brought numerous claims against the company’s former directors, including for breach of the creditor duty.

The background to Hunt is the Supreme Court’s decision in Sequana [2] which confirmed that for the creditor duty to be engaged the company must be insolvent, bordering on insolvency, or that an insolvent liquidation is probable. One point left undecided by the Supreme Court was whether the directors had to have knowledge of insolvency for the creditor duty to apply and, if so, should this test be judged on both a subjective and objective basis.

Hunt is one of the first opportunities for the Courts to provide guidance on these highly significant points. In Hunt the company had implemented a tax scheme based upon professional advice and subsequently made various distributions based on that advice. They then faced the threat of a claim from HMRC challenging the tax scheme and the value of HMRC’s potential claim significantly exceeded the value of the company’s assets. The board contested the claim and sought advice on the strength of their defence and were told that this was “robust”. They therefore refused to agree to HMRC’s settlement proposals and in the interim, whilst on notice of the risk of a claim from HMRC, continued to distribute the company’s assets. This continued until it became apparent that HMRC’s claim would be successful.

The company subsequently entered liquidation and the liquidator sought to challenge the payments made by the company from the time it became aware that HMRC intended to challenge the validity of the scheme.

The Court was therefore asked to consider whether the creditor duty applied in this scenario (where a company faces the prospect of a claim with a value in excess of the value of its available assets). Some very practical issues arise in this scenario, including how the claim should be valued in determining the company’s solvency and whether the subjective views of the board were relevant or determinative.

According to the Judge in Hunt:

the company was clearly insolvent on a balance sheet basis for the entire period being considered. In a fairly black or white viewpoint, the Court held that “a disputed liability is not a contingent liability”. The logic being therefore that it was not open to the board to argue that, in assessing solvency, the company had provided for the likelihood of the contingent liability becoming an actual liability (ie by assessing solvency by making a provision for part of the value of the claim, based upon its likelihood of success). Instead the Judge made clear that “at the time there either was an actual liability to HMRC or there was not….In fact as we now know there was an actual liability”. This meant that based on these facts “there is no doubt that the Company was indeed insolvent (indeed substantially insolvent) throughout the relevant period”;
that for the creditor duty to apply some state of knowledge of insolvency on behalf of the board was required (although it was noted that the opposing argument, that no knowledge of insolvency by the board was required, was not put to the Court for determination);
that the knowledge of the board as to the company’s solvency should be tested on both a subjective and objective basis (preventing the company relying solely on the argument that it had subjectively concluded that the claim would fail); and
on the basis that some element of knowledge is required: “where a company is faced with a claim to a current liability of such a size that its solvency is dependent on successfully challenging that claim, then the creditor duty arises if the directors know or ought to know that there is at least a real prospect of the challenge failing” (our emphasis added).

What this means for directors

What is clear from Hunt is that company directors must think carefully about the creditor duty whenever a company is faced with litigation, or some other form of claim, which has a value that could outstrip the company’s assets. Equally, this is a potential heading of claim that insolvency practitioners should investigate keenly if a company does fall into insolvency following the bringing of a successful claim which the company cannot discharge and it is apparent to the IP that, whilst the claim was being defended, the board continued to act without sufficient regard to the creditor duty.

Beyond that, the decision in Hunt perhaps raises more questions than answers. In the case the Judge was only asked to determine is the creditor duty applied and the implementation of that duty to the facts was left for future proceedings. Chief among the outstanding questions are the following:

What does “a real prospect of the challenge failing” mean? Strictly speaking, any claim against the company which has a real prospect of success would be sufficient to mean that the company’s defence to the claim would have a “real prospect” of failing. Only the most fanciful or speculative claim is likely to fail to meet that (low) threshold. As such, any claim large enough that, if successful, would tip the company into insolvency would arguably therefore be sufficient to trigger the creditor duty.
If the creditor duty could arise in the face of a very large (and not fanciful) claim, how should directors deal with that duty?

As noted in Sequana, if the company is insolvent then there is a shift in focus of the duties towards the creditors of the company – either in conjunction with the interests of the shareholders or in competition with them. As to that, the directors are asked (poetically) by the Court to consider the “brightness of the light at the end of the tunnel” – ie how likely is it that the company will emerge from the claim unscathed (or at least, solvent). The less light, the more the directors should prioritise the interests of the creditors. By analogy, presumably the weaker the company’s defence to a claim, the more the directors should consider the creditor duty?

However, the position is not clear: Hunt still leaves open to interpretation – perhaps deliberately – how directors faced with large claims should see the “sliding scale” of their obligations towards the potentially conflicting interests of shareholders and creditors.

In this regard the Judge in Hunt, echoing similar comments in Sequana, made clear that each case turns on its specific facts but indicated that the Courts may have more sympathy to a situation where the board is managing a trading company and is seeking to carry out a turnaround plan whilst incurring new liabilities and making payments out in the ordinary course as opposed to a non-trading company facing a claim, where the board just has to consider whether to provide for such liabilities before deciding whether to make a voluntary distribution of the company’s assets

What Hunt does mean is that where a company is facing a claim for a value that exceeds the value of their assets then, unless the board can have a very high degree of certainty that the claim is highly unlikely to succeed, the prudent policy is to assume the creditor duty is engaged. It is far better to be cautious in advance.

In practical terms this at the very least means taking appropriate professional advice, which in addition to advice on the merits of the claim should include advice from a restructuring professional. In addition, companies should carefully minute the board’s decision contemporaneously. Beyond this, the steps to be taken will vary depending on the specific facts, including the strength of the claim, the solvency of the company and the proposed actions of the company whilst the claim continues to be contested. What Sequana and Hunt both indicate is that the Courts are still at an early stage in developing the scope and application of the creditors duty: during this period, where there is any question mark regarding a company’s solvency, it is better to take a prudent approach before acting.