Supreme Court decision gives further clarity on claims by distressed companies against directors

INTRODUCTION

The key aspects affecting directors' liabilities presented in the Supreme Court ruling are that:

1. at least where unlawful preference rules are not engaged, loss to the company is a necessary element of the company's claims against its directors for misappropriation of the company's assets; and
2. building on the principles considered in Sequana, a company's losses for these purposes are not one and the same as those suffered by its creditors.

This means that, where other remedies are not available to recover sums paid out to third parties in breach of duty, insolvency practitioners and creditors alike should not assume that recourse will lie against defaulting directors to increase the amounts distributable upon liquidation.

This is the first reported judgment to consider the landmark BTI v Sequana decision which clarified the duties owed by directors of distressed and insolvent companies and was the subject of a recent briefing paper produced by our restructuring team.

BACKGROUND

The case of Stanford International Bank Ltd (In Liquidation) v HSBC Bank PLC [2022] UKSC 34 was heard before the Supreme Court and related to a claim brought by the liquidators of a Ponzi scheme against its correspondent bank, alleging that the bank breached its so-called Quincecare duty to take sufficient care that monies paid out from the accounts under its control were being paid out properly.  The Supreme Court decision upheld the previous ruling by the Court of Appeal to strike out the claim.

For the purposes of this opinion piece, we concentrate on the specifics relating to, and affecting, company directors. However, our banking litigation team has recently summarised the underlying issues in this case in their briefing note.

ANALYSIS

West Mercia – was there a loss?

For over three decades until Sequana, the Court of Appeal's decision in Liquidator of West Mercia Safetywear Ltd v Dodd (1988) 4 BCC 30 was considered authority for the proposition that where a company's insolvency is probable, the company's directors must have regard to the interests of its creditors in the discharge of their duty to promote the success of the company. Sequana has since confirmed the applicable test in this regard, but why in a case not involving allegations of breach of a director's duty but instead allegations of breach of duty by the company's bank were the principles in West Mercia considered to be relevant? Indeed, the only breach of which HSBC stood accused concerned its (alleged) Quincecare duty of care (which SIB said imposed on HSBC a duty to take sufficient care that monies paid out from the accounts under its control were being properly paid out).

The reason concerns Stanford International Bank's (SIB's) interpretation of the Court of Appeal's approach to the question of loss in West Mercia, by awarding damages against the offending director. In that case, the court found that the director of an insolvent company, Mr Dodd, had breached his fiduciary duty by causing £4,000 to be paid by the company to its parent. This payment had the effect of discharging the company's debt to its parent (as well as the director’s personal liability as a guarantor). Nevertheless, the Court of Appeal upheld the liquidator's claim to recover from Mr Dodd personally. The Court was in no doubt that the payment constituted an unlawful preference, but because the parent company itself had gone insolvent, there was no possibility of recovering the payment via that route.

Relying on West Mercia by analogy, counsel for SIB had argued that the Court of Appeal's decision showed that a payment can be treated as causing loss to an insolvent company even though it discharges a debt owed by the company so as to leave the company in the same net assets position. Accordingly, counsel argued, the fact that SIB may have discharged valid debts owed to its early creditors did not mean that the company had not suffered a loss by virtue of payments being wrongly paid out, and should not therefore be a bar to recovery from HSBC.

The justices in the majority in the Supreme Court disagreed that this was the correct interpretation of West Mercia. They did not accept that Mr Dodd had argued that no loss had been caused because the relevant payment discharged a valid debt. As Lady Rose explained, the argument which Mr Dodd raised was a different one; namely, that on the particular facts of that case, the payment to the parent company would not affect the amount available for distribution to creditors liquidation. It was said by Mr Dodd that, had the payment not been made and instead such sums were therefore available in the liquidation, the amount which the parent would have received by way of a distribution in that liquidation would have exceeded the amount of the payment. Mr Dodd therefore argued that, rather than requiring him to repay the relevant sums, they could be recouped simply by deducting them from the dividend ultimately paid out of the liquidation to the parent and none of the other creditors would therefore suffer any loss.

As Lady Rose explained, the Court of Appeal did not accept that Mr Dodd's argument was made out on the facts, largely because the estimated state of affairs on which that argument had been based had not taken account of the costs of the winding up. As such, the Court of Appeal had not been satisfied that there would have been sufficient assets to satisfy the company's other creditors simply by way of a dividend deduction and Mr Dodd was therefore ordered to pay back the relevant sums.

In this regard, both Lady Rose and Lord Leggatt placed particular emphasis on the fact that, in granting relief against Mr Dodd, the Court of Appeal also gave a direction that in the liquidation Mr Dodd should stand in place of the parent as a creditor in the company's liquidation. This adjustment meant that the company was prevented from recovering £4,000 from the director while also benefitting from the discharge of its £4,000 liability to the parent. By substituting the director as the company's creditor, its balance sheet would have no net loss (or indeed gain), such that the company was put in the position it would have been in had the director not given the unlawful preference.

This, both Lord Leggatt and Lady Rose agreed, reflected the fact that the aim of the remedy ordered in West Mercia was to "achieve a just distribution of the company's assets and not to compensate the company for a loss which it had suffered". This was consistent with the policy of English law, embodied in the unlawful preference rule (section 239 of the Insolvency Act 1986) that "where a company has given a preference falling within the scope of that provision the position of the company ought to be restored to what it would have been if the company had not given that preference". It was:

"no answer to say that nothing needs to be done to achieve this aim as the transaction has not diminished the company's assets. The point of this element of the insolvency legislation is not to provide a means by which the company can recover compensation for loss; it is to enable a liquidator to reverse transactions which, even though they cause no loss to the company, have in eye of the law unjustly enriched the preferred creditor at the expense of the other creditors by depleting the pool of assets which ought to be available to distribute equally in the winding up….It is consistent with this policy of redistribution to require a director, who, in breach of fiduciary duty, has caused the company to give an unlawful preference to restore the company's position to what it would have been if the transaction had not taken place."

This, the court said, is what was done in West Mercia. The parent company was unable to repay the unlawful preference because it too was insolvent. However, by ordering Mr Dodd to repay the money and stand in place of that parent as a creditor, this achieved the remedial aim of putting the company into the position it would have been had the breach of fiduciary duty not occurred.

On this basis, SIB's attempt to draw an analogy with West Mercia failed. West Mercia was not a case which was decided in circumstances where no loss was suffered by the company, but based on reasoning, the Supreme Court said, which was specific to the policy aims of English insolvency law.

Where there is no unlawful preference

Consideration was also given to the position where there is no unlawful preference and those insolvency law policy aims are not engaged.

Until recently, there had been competing views as to the nature of a director's liability for causing payments to be made by the company in breach of his or her fiduciary duties. In re HLC Environmental Projects Ltd [2013] EWHC 2876 (Ch), like in West Mercia, a director had caused the company to make payments which discharged the company's debts at a time when the company was insolvent. In giving judgment against the director in that case, Mr John Randall QC said that "[t]he liability of a defaulting fiduciary who has, by his or her default, allowed the trust fund to become denuded is, or includes, a liability to restore the fund to what it should have been". As Lady Rose explained, this "traditional approach" was based on the orthodox view that this liability was not based on compensation for loss (or disgorgement of profits). It did not matter in that case that the payments made had reduced the company's debts by an equal amount and so therefore the breach had not caused the company to suffer loss (or enrich the director). The director was nevertheless required to restore the money wrongly paid out so as to ensure the distribution of assets in accordance with the order of priority on insolvency.

However, AIB Group (UK) plc v Mark Redler & Co Solicitors [2014] UKSC 58, determined that there exists no separate equitable remedy to account which is not based on a principle of compensation. In other words, a remedy is only available to the company (outside of a preference scenario) if it can demonstrate it has suffered a loss. It follows that, where a director is in breach of fiduciary duty, the company is required to demonstrate that the breach led to an actual loss in order to recover any amount dissipated. As Lord Leggatt put it, "there is no justification in terms of legal policy for ordering a defaulting trustee or other fiduciary to pay money to the trust fund which reflects neither any loss caused to the trust fund nor any gain made by the trustee. To do so… would be penal".

Conclusion on West Mercia and subsequent authorities

Ultimately, much of this analysis was obiter since, as the Supreme Court acknowledged, it was not necessary to determine the precise nature of director liability in order to determine SIB's appeal. SIB v HSBC was not a case concerning a claim for breach of a trustee-like (or indeed any) fiduciary duty. Nor had equitable remedies of accounting or equitable compensation been claimed by SIB. It was therefore not necessary to decide whether the remedy in West Mercia was justified, or how it reconciled with subsequent decisions. However, as Lady Rose went on to conclude, "[e]ven if there are circumstances in which a defaulting fiduciary who has misapplied trust money can properly be ordered to replace the money when no loss has been caused to the trust estate (and no gain made by the fiduciary), there is no justification for importing such an approach into a claim for damages for breach of contract or in the tort of negligence."

Instead, the compensatory principle underlying awards for damages for breach of contract and in tort requires:

"a comparison to be made between the claimant's net asset position following the disputed payments and what its net asset position would have been if the payments had not been made. The aim of an award of damages is to compensate the claimant…for any net loss represented by the difference between these amounts. Considerations of reversing unjust enrichment or reconstituting a trust fund play no part in the assessment."

Are the company's losses the same as those of its creditors?

In his dissenting judgement, Lord Sales took the view that by substituting the director as a creditor for £4,000, the Court of Appeal in West Mercia had made it possible for the creditors as a class to recover their share of the payment to the parent which they otherwise would not have been able to had the company not been successful in its claim against the director. In Lord Sales' view, the order clearly sought to “shift the benefit of the £4,000... from being wholly for one of [the company's] creditors... to being for the general body of the creditors, on a pari passu basis”. In doing so, he said, the remedy granted in West Mercia reflected that the company's loss was aligned with that of its creditors.

Lord Sales concluded, “SIB’s own interests as a legal person were fully aligned with, and the same as, those of its general creditors as a class. To harm SIB's general creditors as a class was to harm SIB”. Relying on the recent Supreme Court decision in Sequana, his reasoning was as follows:

• “[C]orporate personality is not a pure abstraction, but has substantive content by reference to the interests which it exists to represent”. At the point of insolvent liquidation, a company exists to represent the interest of its creditors.
• Where a company is hopelessly insolvent, its interests are "fully aligned with those of its creditors as a general body." In those circumstances "the purpose of the company, and the function to be served by its having corporate personality as the vehicle by means of which it holds assets so that they can be used for fulfilling that purpose, is to protect the interests of the creditors as a general body".
• "The interests of the creditors as a general body, and hence the interests of the company, are prejudiced and damage is suffered if in those circumstances money under the control of the directors… is paid out to satisfy in full the debts of some creditors out of that general body, ie in a way which disregards the principle of equality which applies within that body. When that occurs, the trust fund has become "denuded"… because it has been misapplied for the wrong purposes and the proper beneficiaries have been made worse off as a result".

Lady Rose agreed with Lord Sales that the abstract nature of a company as a separate legal person does not mean that a company is regarded as having interests which are independent of the interests of those who have actual or prospective entitlements to its assets. However, in her view (and in the view of Lord Leggatt), that does not detract from the fact that a company's losses and gains are nevertheless distinct from those of the persons who have economic interests in the company's fortunes.

As the Supreme Court in Marex Financial Ltd v Sevilleja [2020] UKSC 31 has recently made clear, although where a company is solvent there may be a correlation between losses suffered by a company and by its shareholders, nevertheless they are not the same losses. The same reasoning applies vis-à-vis creditors where the company is insolvent. As Lady Rose put it: "when a company is insolvent, loss suffered by the company may result in future loss to creditors of the company by affecting the amount that they will be entitled to receive in a subsequent liquidation. But loss suffered by the company and loss suffered by its creditors are different losses and, if the law is to be coherent, it is important not to blur the distinction between them".

Sequana clarifies for directors at which point in time they are required to have regard to the interests of creditors and when those interests become paramount. However, that has no bearing, Lady Rose explained, on whether a payment which a director causes to be made out of the company's assets in breach of his fiduciary duty gives rise to a loss to the company.

IMPLICATIONS FOR DIRECTORS

Although again, much of the foregoing reasoning must be regarded as obiter, it seems clear that, outside of an unlawful preference context, the company must establish its own loss (or a gain made by the defaulting director) in order to maintain a claim against a director in respect of payment away of the company's assets in breach of his or her duties. That loss is not the same as the loss of its economic stakeholders, be they shareholders or creditors, but must be independently incurred for any claim to succeed.