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Corporate update: the latest corporate law developments November 2022

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In this month’s update we:

  • review the Supreme Court’s decision confirming and clarifying the directors’ duty owed to creditors;
  • explain how restrictive covenants can fail if there’s no legitimate interest to protect; and
  • consider the validity of sole director decisions in the light of two recent cases.

Directors’ duties: Supreme Court confirms and clarifies ‘creditor duty’

In BTI 2014 LLC v Sequana SA and others [2022] UKSC 25, the Supreme Court has confirmed that directors have a fiduciary duty to consider the interests of the company’s creditors when the company becomes insolvent or is approaching insolvency. Although the case provides useful clarification on when this ‘creditor duty’ is triggered and what it entails, there are still aspects that remain unresolved, and directors will still face difficult decisions when trying to navigate periods of financial turbulence.

Directors’ statutory duties

Section 172(1) Companies Act 2006 requires directors to act in the way they consider, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole. The directors owe this duty to the company itself (rather than to its members) and in fulfilling it, they must have regard to the interests of other stakeholders, including employees and suppliers.

The section 172 duty is subject to any rule of law requiring directors, in certain circumstances, to consider or act in the interests of the company’s creditors. Case law has confirmed that directors of an insolvent company must have regard to creditors’ interests. There has, however, been much uncertainty as to when (if ever) creditor interests should be considered in the run up to insolvency and also, how the competing interests of members and creditors can be reconciled. The Sequana case is the first time that the Supreme Court has addressed these and other related issues.

Facts

The case concerned a dividend payment of €135m by a trading company, AWA, to its parent, Sequana SA. When the payment was made (May 2009), AWA was fully solvent on both a balance sheet and a cash flow basis and the dividend was fully compliant with the requirements of the Companies Act 2006 and relevant common law rules. However, AWA had long-term environmental contingent liabilities that made insolvency a real (though not probable) risk at some unknown point in the future.

AWA entered insolvency in 2018 as a result of the environmental liabilities. The claimant, BTI (as assignee of AWA’s claims), sought to recover the dividend from AWA’s directors on the basis that their decision to pay it had breached their duty to consider the interests of AWA’s creditors. BTI argued that this creditor duty was engaged whenever a proposal involved a real risk to the creditors of the company.

Both the High Court and the Court of Appeal rejected BTI’s claim. BTI appealed to the Supreme Court.

Supreme Court decision

When unanimously dismissing BTI’s appeal, the Supreme Court analysed the extent of any creditor duty and reached the following key conclusions:

  • Existence of creditor duty confirmed: Directors do have a duty to consider the interests of creditors, but this is not a separate duty owed directly to creditors. Instead, the creditor duty is a modification of the directors’ fiduciary duty to act in good faith in the interests of the company. There are circumstances in which the interests of the company should be understood to include the interests of its creditors as a whole.
  • Creditor duty arises when insolvency is probable or imminent: The creditor duty will be triggered when directors know or ought to know that a company is insolvent or bordering on insolvency (i.e. it is imminent) or that an insolvent liquidation or administration is probable. The fact that a company faces a “real risk” of insolvency (as opposed to a remote risk) is not sufficient to give rise to the creditor duty.
  • Sliding scale of creditor interests: Directors must balance the interests of shareholders and creditors, with creditor interests being given more weight on a sliding scale as the financial state of the company deteriorates. Once insolvency is inevitable, the interests of creditors become paramount and the members’ interests are no longer relevant.

The Supreme Court also usefully confirmed that once the creditor duty has been triggered, the shareholders cannot authorise or ratify a transaction which is in breach of that duty.

Comment

Although helpful in many aspects, the judgement in the Sequana case has not provided all the answers that many had hoped for. The Supreme Court recognised that the creditor duty is still a developing area of law and was reticent to make decisions about the duty that were not required on the facts of the case.

Confirmation of the trigger point for the creditor duty is helpful for directors, as is the knowledge that creditors’ interests are paramount when insolvency is inevitable. In practical terms, however, not much will change – when a company is facing financial difficulty, a board will still need to review continually the company’s financial position and should always have their legal duties at the forefront of their minds when making decisions. Directors may also now wish to consider where their company’s circumstances sit within the sliding scale framework established by this decision. Professional advice continues to be essential and should be sought at an early stage.

Restrictive covenant unenforceable as no legitimate interest to protect

In Credico Marketing Ltd v Lambert [2022] EWCA Civ 864, the Court of Appeal held that post-termination restrictive covenants amounted to an unreasonable restraint of trade and were, therefore, unenforceable. The case is a useful reminder that restrictive covenants must protect a legitimate interest throughout the period of the restriction in order to be valid.

Restraint of trade

Restrictive covenants are commonplace in commercial contracts and as the name suggests, they are designed to prevent and restrict a party from engaging in specified activities. 

The party imposing the restrictive covenant must ensure that it has a legitimate business interest to protect and also that the restrictive covenant is no wider than necessary to protect that interest. Failure to do so runs the risk that the covenant will be unenforceable under the common law doctrine of restraint of trade. It is, therefore, essential to identify the field of business, geographical area and period for restrictions required for the protection of the business interest and not to seek restrictions greater than those actually needed.

Facts

Credico provided marketing campaigns for its clients. It did so by entering into standard form ‘trading agreements’ with marketing companies and those marketing companies would then provide the required services to the clients. The trading agreements set out the terms under which Credico would supply the marketing companies with services, including sales training, knowhow and backroom support.

The trading agreements also contained two restrictive covenants preventing the marketing companies from competing with Credico. The first covenant restricted the marketing companies from engaging in similar work for anyone else during the course of the agreement, while the second restricted those activities for six months after the trading agreement ended. The owners of each marketing company were also required to give the same restrictive covenants on their own behalf as well as guaranteeing the obligations of their company.

Credico claimed that one of the marketing companies, S5, and its owner, Mr Lambert, had breached both restrictive covenants and this claim was upheld by the High Court. S5 and Mr Lambert appealed.

Court of Appeal decision

The Court of Appeal held that the restrictive covenant that applied during the term of the trading agreement was valid. Credico had invested time and money to help the marketing companies become successful and the restrictive covenant protected this investment by providing Credico with an exclusive pool of agents – there was a legitimate interest to protect.

In contrast, the Court ruled that the post-termination restriction was unenforceable. Essentially, Credico did not have a legitimate interest to protect once the trading agreement had terminated as it could no longer expect to have exclusive access to the available work force. Credico had no goodwill, knowhow or confidential business information to protect and the knowledge and skill that the marketing companies had gained while working with Credico did not amount, without more, to a legitimate interest.

Commentary

This judgment should act as a warning that a clause restricting competition, particularly one imposed after any contractual arrangement has ended, will not automatically be justified merely because one party has invested time or money or because one party has gained general (as opposed to market or client specific) knowledge from the arrangement.

That said, the Court of Appeal did recognise that equality of bargaining power could be a crucial, if not decisive, factor in the reasonableness of a restriction. Where there is inequality (as there was in the Credico case) the court will examine the restrictive covenant more critically to ensure that it is reasonable between the parties in all the circumstances.

The crucial issue for the party imposing the restriction is to identify the legitimate interest it is seeking to protect. This interest will often be obvious during the term of an agreement, but less so once the agreement has terminated. It may, therefore, be helpful to include an express reference in the contractual documents to the business interests that any restrictions are attempting to protect (for example, goodwill or confidential business information). Ultimately, however, it will be a matter for the court to decide whether any such legitimate interest, in fact, exists.

Decision-making by sole director

Earlier this year in Re Fore Fitness Investments Holdings Ltd, Hashmi v Lorimer-Wing [2022] EWHC 191 the High Court held that a requirement in a company’s articles of association for a quorum of two directors prevented a sole director from acting on behalf of the company. The case cast into doubt decisions made by the sole director of many companies.

Now another High Court decision has taken a different approach holding, on the facts, that the requirement in the Model Articles for a quorum of two directors did not override the decision-making powers of a sole director.

The Fore Fitness decision

This case involved a company which had bespoke articles of association, that adopted the Model Articles for private companies but with various amendments. In particular, a bespoke provision had been added which required a quorum of two for any directors’ meeting.

But the articles also incorporated Model Article 7(2) which provides that for so long as the company has a single director, the general rule about directors’ decision-making by majority decision at a board meeting doesn’t apply and the sole director may take decisions without regard to any of the provisions of the articles relating to directors’ decision-making.

Market practice had been to interpret Model Article 7(2) as taking precedence over any quorum requirement, but the judge in Fore Fitness took a different view. He held that the quorum requirement was effectively a provision requiring the company to have two directors meaning any decision of a sole director was invalid.

The new decision

In the latest case, Re Active Wear Limited [2022] EWHC 2340 (Ch), the sole director of a company had executed documents appointing joint administrators in April 2022. But, when the Fore Fitness case cast doubt on decisions taken by a sole director, the administrators applied to court for a declaration about the validity of their appointment.

Crucially in this case, the company had always had a sole director and had always had as its articles of association the unamended version of the Model Articles. Nonetheless, those articles still contained a provision stating that the quorum for any directors’ meeting was two (Model Article 11(2)).

The judge held that, applying the normal rules of contractual interpretation to the Model Articles, it was clear that those articles permitted a sole director to take, on their own, any decision relating to the company’s affairs. He said that the articles had to be read as a whole and that interpreting Model Article 11(2) as requiring the company to have at least two directors for effective decision-making would deprive Model Article 7(2) of any practical meaning.

The judge distinguished the earlier decision in Fore Fitness on the grounds that:

  • in Fore Fitness the company had adopted a bespoke article requiring a quorum of two directors (which the judge then interpreted as requiring the company to have at least two directors) – in Active Wear the company had simply adopted the unamended version of the Model Articles; and
  • in Fore Fitness the company had previously had multiple directors before reducing that to a sole director – in Active Wear the company had only ever had a sole director.

Comment

The decision in Fore Fitness was controversial and did not reflect the practical application and interpretation of the Model Articles since they were introduced in October 2009. The subsequent decision in Active Wear will be helpful for many sole director companies. But, for a company that has amended the Model Articles or that has previously had multiple directors, there is still a risk that a quorum provision in its articles will be interpreted as a provision requiring more than one director meaning a sole director may not take decisions on their own. Such a company would need to appoint another director or amend its articles to be clear about the decision-making powers of a sole director. It would also be well advised to pass shareholder resolutions to ratify historic decisions taken by a sole director which might otherwise be void.

First published in Accountancy Daily.

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