Directors duties: When should directors take creditor interests into account?

Directors’ duties are a hot topic at the moment, especially as we await the New Zealand Supreme Court decision in Mainzeal. One question that directors need to consider is whether—and, if so, when—they need to take the interests of creditors, rather than just shareholders, into account.  

Our Dentons colleagues in London have written an article about the recently released Sequana decision from the UK Supreme Court, which deals directly with this question and confirms that:

• the trigger point for when directors must have regard to the interests of creditors—under section 172(3) of the UK Companies Act 2006—is when the directors know or ought to know the company they control is insolvent, or insolvency is probable;
• the closer to insolvency the company is, the more directors must take the interests of creditors into account; and
• once insolvency is inevitable, creditors’ interests become paramount.

The Sequana decision

The directors of a company, AWA, paid a significant dividend (€135m) to its sole shareholder (Sequana) in 2009 when AWA was clearly solvent, but had a contingent environmental liability that gave rise to a real risk (but not a probability) of future insolvency at an uncertain date. The risk was insured, but the cover was insufficient, and in 2018 AWA entered insolvent administration. A claim was brought against AWA’s directors for breach of their obligation to consider the interests of creditors when making the earlier dividend. The UK Supreme Court found in favour of AWA’s directors because, at the time the dividend was paid, AWA was not insolvent, nor likely to become insolvent in the near term.

As Lord Reed of the Supreme Court said, the issues in Sequana “…go to the heart of our understanding of company law, and are of considerable practical importance to the management of companies.” So, how does this decision apply to New Zealand? Is our law on this point the same? Sequana goes further than the New Zealand courts have up to now. While UK Supreme Court decisions are not binding on the New Zealand courts, Sequana will be persuasive and may point to how the law may develop here.

Accounting for creditor interests when insolvency is probable

Section 172 of the UK Companies Act is similar to section 131 of the Companies Act 1993, which requires directors to act in good faith and in the best interests of the company they control. Traditionally, it has been considered that directors only had to take into account shareholder interests to comply with section 131, and did not need to consider the interests of creditors. Sequana confirms that this view remains the case when a company is solvent.

The position is different if a company enters the ‘twilight zone’: the UK Supreme Court ruled that the closer a company is to insolvency, the more a director must consider the interests of creditors. The duty to act in the best interests of the company is still owed to the company, but the interests of creditors become paramount.

The New Zealand position

The need for directors to take into account the interests of creditors was first recognised in New Zealand in the mid-1980s. In 2020, the New Zealand Supreme Court in Debut Homes (without reference to any of the earlier Sequana judgments) acknowledged that the focus of section 131 was on the interests of creditors where a “company is insolvent or nearly insolvent”. Sequana goes further in setting the trigger point for when directors should begin to take creditor interests into account as when insolvency becomes “probable”, which is arguably an earlier point in time than that recognised in Debut Homes.

We anticipate that the New Zealand courts will need to return to the question of when and how directors should consider the interests of creditors. Sequana confirms that creditor interests take precedence when a company is in financial distress, but the wider debate between the shareholder primacy model of corporate governance and a more contemporary model that encompasses the interests of employees, creditors, and community interests, is far from settled.  

Practical tips

Directors confronted by difficult trading conditions should seek early legal and financial advice about their position, and should closely monitor the financial situation of the companies they are involved with.

In the article linked to above, our London colleagues have listed 10 practical tips for directors to comply with their duty to act in good faith. We encourage you to read these tips which have equal application in New Zealand.   

Our thanks to Law Graduate Ossama Mohamed for his assistance with this article.

About the authors

James McMillan is a litigator who specialises in insolvency law, helping creditors and insolvency practitioners with businesses in financial distress. He leads the restructuring and insolvency team based in Auckland. James brings many years of experience to his work. 

Gerard Dale is a partner in Dentons Kensington Swan’s Corporate and Commercial team. He specialises in corporate and commercial law, including mergers, acquisitions, and major contract negotiations, across a wide range of industry sectors.

Patrick Glennie is a senior associate in our Litigation and Dispute Resolution team in Auckland. His practice covers a broad range of commercial litigation with a particular focus on insolvency matters and contractual disputes. Patrick’s insolvency experience has included advising liquidators and administrators on their duties and liabilities as well as the legislative framework governing their appointment.