Shoosmiths LLP
  September 13, 2023 - Milton Keynes, England

Schrödingers Liability - When does the duty to consider creditors’ interests arise if a liability is disputed?
  by Shoosmiths LLP

When does the directors' duty arise to consider creditors' interests in the face of insolvency if a liability is disputed? Hayley Capani and Kate Garcia consider the case of Hunt v Singh and conclude we still don't have all the answers.

When the decision in Sequana was handed down, commentators expressed both disappointment and (dare we say it) joy that a clear test had not been laid down as to when the creditor duty arose. There is no clear trigger as to when the creditors’ duty starts and advisors have since adopted the ‘sliding scale’ analogy - each case requires a consideration, on its facts, as to how far a company is into the zone of insolvency to see if/ when the creditor duty has arisen.

So how does this sliding scale operate where there is a disputed liability, especially a tax liability, which is likely to remain contingent throughout lengthy enquiries and court processes?

This was the issue that the Court had to grapple with in Hunt v Singh which laid down more helpful markers as to what to look for when advising in such a grey area.

What is the creditor duty? 

The ‘creditor duty’ is a common law duty of directors to take into account the interests of a company’s creditors when considering a company’s acts once the company is in the ‘zone of insolvency’. There is no clear divide as to when a director should take the interests of the company’s creditors into account, ahead of the company’s shareholders. Instead, it is a sliding scale, which will tip more in favour of one group depending on how far the company has entered into “the zone of insolvency”.

Applying that test alone is something of a minefield; its discretionary nature means there are always nuances and circumstances that have not previously been considered.

Disputed tax scheme

In the case of Hunt v Singh, the fact pattern involved a contingent tax liability, with a lengthy timeline:

The issue was that the company was only solvent during this eight year period on the assumption that the scheme was effective. Once the Upper Tribunal decided that the scheme was ineffective, the company was ‘substantially insolvent’ during the entire period. 

Throughout the period of dispute, the company had received advice from BDO that the scheme was ‘robust’ and that ‘no further action was needed by the company’ – but was that enough to engage the creditors’ duty? The short answer is ‘no’ – the court held that the duty had arisen in 2005, when the directors received the market-wide offer and knew there was a real risk that the scheme might fail.  

Given that tax disputes can be protracted – sometimes taking several years to resolve – this decision has significant implications for companies which face a ‘real prospect’ of insolvency should their challenge fail. 

‘A disputed liability is not a contingent liability’

When considering whether a company is balance sheet insolvent, any balance sheet prepared will need to include both contingent and prospective liabilities. 

Justice Zacaroli gave us a helpful reminder in Hunt v Singh that disputed liabilities are not contingent liabilities. It is binary: either the liability is owed or it is not. Whether the liability should therefore form part of the company’s balance sheet will involve considering who is more likely to win the dispute. If it is the company, the liability does not need to be included on the balance sheet. If it is the other party, then the liability should be included on the balance sheet.

However, even if the company is likely to lose the dispute, this does not always mean that the creditors’ duty is automatically triggered. In a nod to how tricky it is for company directors to know which decision to make when a company is in the zone of insolvency, Justice Zacaroli explained that, for the creditors’ duty to arise, the following tests will need to be met:

  1. the company faces a real prospect of  losing the dispute (i.e. having considered, as Lord Briggs put it, “the brightness or otherwise of the light at the end of the tunnel”); and
  2. the directors know, or ought to know, that this is the case.

Only once both of these two tests are met will the creditors’ duty arise.

Is the company’s challenge likely to succeed?

However, assessing who is more likely to ‘win’ in a tax dispute is notoriously tricky.

Given the costs involved in pursuing tax appeals, and the drain on management time, it would be rare for a company to dispute any liability if it did not consider there to be a real prospect of success. In Hunt v Singh, the company had BDO’s advice throughout the period of challenge that the scheme was ‘robust’, and it was not unreasonable to rely on that professional advice. The fact that there was a win in respect of Pay as You Earn at the First-Tier Tribunal in 2009 would also have buoyed the company’s view of likely success (at least in part). Yet the duty had nonetheless arisen. 

For directors, the key trigger point to keep in mind is the moment when they know there is ‘at least a real prospect of the challenge failing’. Once this happens, even if the company still believes the challenge could succeed, the liability should be included on the company’s balance sheet. If the company at that stage is balance sheet insolvent, the creditors’ duty is triggered. 

Directors cannot avoid triggering this duty by adopting the approach of wilful blindness. Whilst tax law is notoriously tricky, directors should be taking advice (and considering it appropriately) as to the merits of any argument. Directors who bury their heads in the sand risk falling foul of the test ‘ought to have known’, whereas, taking advice may alleviate them from liability in full.

What happens once the duty is triggered?

Whilst Hunt v Singh has helped apply a number of the theoretical points that were first raised in Sequana, the question of what happens once the duty is triggered is still up for debate.

The duty was never triggered in Sequana as the company was solvent throughout. By contrast, the duty was trigged in Hunt v Singh, although it has been remitted to the trial judge for further consideration.

We will wait to see whether there will be more guidance on this point from the trial judge. However, given Mr Singh is now bankrupt, it is possible that the case will not advance any further and this point will be left open, for the next case to pick up.

The need for active monitoring

Overall, how is the creditors’ duty developing? From a defendant director point of view, it is helpful that the Courts are willing to consider more contemporaneous documents and have emphasised the need to consider what the director knew (or ought to have known) at that moment in time: The Courts appear to be giving those directors facing applications a fair shot to explain why they acted in the way that they did.

However, from the point of view of those bringing claims, it may be difficult to get contemporaneous documents, which could make it harder to bring a successful claim. Insolvency applications are often brought without expansive contemporaneous documents - many years down the line these documents either no longer exist or may be too expensive or impossible to obtain. The need for more evidence on what the director knew, or ought to have known, makes cases more costly, and potentially causes the cost-benefit analysis (as to whether there would be an ultimate benefit to the company’s estate in bringing it) to fail.

Either way, with the Courts taking a more subjective approach to the test, the need for directors to document decisions is heightened, as is (of course) the need to take, and continue to take, legal advice along the way.




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