Insolvency law across the Commonwealth generally prescribes that when a company moves toward insolvency, the main economic stakeholder in the company shifts from its shareholders to its creditors. When this occurs, the law protects creditors by requiring the directors to have the interests of the company’s creditors as a significant, or even pre-eminent, consideration when acting. A failure to do so can result in the directors being found in breach of their duties to act in the best interests of the company.
The key question facing company directors then is when this requirement is engaged, and what the director is expected to do to fulfil his duties.
In its recent judgment in Foo Kian Beng v OP3 International Pte Ltd (in liquidation) [2024] SGCA 10, a five-member coram of the Singapore Court of Appeal has brought some much-needed clarity to this important issue of company law.
It has found that this requirement (which it termed the “Creditor Duty“) would be engaged in any transaction where (i) the company is imminently likely to be unable to discharge its debts and (ii) the company’s insolvency is inevitable (at the time of the transaction or as a result of the transaction) (see [103] to [105] of the judgment). The Court of Appeal further set out some factors that would be taken into account in determining whether or not the directors had complied with the Creditor Duty (see [106] of the judgment). We further examine the Court of Appeal’s analysis below.
The three financial stages of a company, and directors’ duties at each stage
The rationale underlying the Creditor Duty is the need to constrain directors from entering into trades while a company is financially distressed. At that stage, the company is trading using the creditors’ funds, and losses incurred will be borne by the creditors who will be entitled to a distribution in the company’s insolvency proceedings.
The law in Singapore in respect of when the Creditor Duty was to be engaged has not historically been uniform. It has been described in various cases as being when “the company is… perilously close to being, insolvent”, when the company is “in a parlous financial position” or when the company is “of doubtful solvency”.
In this judgment, the Court of Appeal categorised the life cycle of a company into three discrete stages:
The Court of Appeal then tied together the historical jurisprudence on the Creditor Duty by prescribing guidelines for directors at each of these stages:
On the other hand, any action that disproportionately benefits shareholders or directors (such as, for example, the payment of a dividend or repayment of a shareholder loan) should attract higher scrutiny. The greater the extent that shareholders and/or directors benefit from any given transaction, the more closely a court will scrutinise the decision of the director to determine if the Creditor Duty has been breached.
Excusing directors’ liability under Section 391 of the Singapore Companies Act
Section 391 of the Companies Act provides that if in any proceedings for breach of duty, it appears to the court that the director is or may be liable, but has acted honestly and reasonably and that having regard to all the circumstances of the case, the person ought fairly to be excused for the breach, the court may relieve the person either wholly or partly from the person’s liability.
In cases where the Creditor Duty appears to have been breached, the court will nonetheless retain the discretion to relieve a director on account of him acting honestly and reasonably. In such cases, the burden is on the director to prove these matters. One example would be proving that the director may have, in good faith, misjudged the financial state of the company and/or failed to consider the creditors in entering into certain transactions on behalf of the company.
However, the Court of Appeal also noted that such cases are likely to be few and far between.
Key takeaways for companies and directors
The starting point for the analysis is simple – when a company is in category two or category three, directors have to take extra care when entering into transactions on behalf of the company.
In category two, while directors may be keen to enter into deals that may provide liquidity or secure investment that results in eventual solvency, any downside (such as increased losses to creditors, or the taking on of more debt) should be considered with both the shareholders’ and the creditors’ interests in mind.
In category three, transactions that would breach the Creditor Duty by preferring shareholders or directors’ interests over creditors’ interests will be prohibited. In fact, the incurrence of further liabilities when the company is in a category three situation may also attract breaches of the Creditor Duty.
Directors who want to ensure they do not run afoul of the Creditor Duty would do well to look to the suite of restructuring tools under Singapore law such as (i) the moratorium and scheme of arrangement process, which stays claims against the company in favour of a debtor-led restructuring; and (ii) the appointment of judicial managers (i.e. administrators) over the company, who are court-appointed officers that will safeguard the company’s financial position in aid of an eventual restructuring, or simply for the betterment of creditors.
By electing to utilise these restructuring tools, directors can look to prevent their liability for potential breaches of the Creditor Duty. The moratorium process is characterised by full and frank transparency and disclosure to the company’s creditors, at all stages of the court-supervised process. The judicial management process involves the appointment of court-appointed officers to take over management, limiting the potential for breaches of the Creditor Duty.
A third option in category three situations is the liquidation of the company, under which the company’s business will cease and insolvency professionals are appointed to oversee the timely and fair distribution of the company’s property to its creditors and stakeholders.
As discussed earlier, the court retains the discretion to excuse a director’s breach of the Creditor Duty if the director can prove that he has acted reasonably and honestly. Directors of companies in Category two and Category three situations should therefore more carefully document their conduct and decision-making process.
Legal advice on possible transactions should be sought at an early stage, so that the directors may make such decisions on a fully informed basis. In addition, directors should keep proper records of the decision-making process, as evidence in defence of any allegation that the Creditor Duty has been breached.
What creditors should note
Creditors should be mindful that the Creditor Duty is a duty owed by the director to the company. The directors do not owe the Creditor Duty directly to the creditors – and as a result, the creditors cannot directly sue a director for a breach of the Creditor Duty. Instead, the claim must be brought by the company.
Any claim against a director for the breach of the Creditor Duty will likely have to be brought either by derivative action – as observed in the UK Supreme Court decision of BTI 2014 LLC v Sequana SA and others [2022] UKSC 25 – or through the appointment of liquidators who may bring the claim to further recovery for the liquidated company’s creditors.
How we can help you protect your interests
We are well-versed in acting for both debtor companies, creditors and insolvency professionals in various court-supervised restructuring and contentious insolvency proceedings and directors in defending claims for breaches of duty. We have, in multiple real-world situations, advised and represented clients on whether various transactions have breached or may breach the Creditor Duty.
If you want to find out more about protecting your interests in such proceedings in Singapore, please contact the lawyers below or your usual Herbert Smith Freehills Prolegis contact.
Prolegis LLC and Herbert Smith Freehills LLP (www.herbertsmithfreehills.com) are members of a Formal Law Alliance in Singapore marketed as Herbert Smith Freehills Prolegis (https://www.herbertsmithfreehills.com/content/herbert-smith-freehills-prolegis).
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| Yanguang Ker Deputy Head of Litigation, Singapore Prolegis LLC T +65 6812-1366 Yanguang.Ker@hsf.com |
Jonathan Tang Head of Restructuring & Insolvency, Singapore Prolegis LLC T +65 6812-1365 Jonathan.Tang@hsf.com |