Directors’ duties in hard times: When exactly do directors’ duties shift from acting in the best interests of the company as a whole, to acting in the best interests of its creditors?

Introduction

Every director has a duty to act in the best interests of his or her company. But how are the best interests of a company, an inanimate legal person, to be understood? Further, which stakeholder’s interests (i.e. company’s shareholders, the creditors or the employees) take precedence at any given point in time?

As elegantly put by the Singapore Court of Appeal in Foo Kian Beng OP3 International Pte Ltd (in liquidation) [2024] SGCA 10 (“Foo v OP3”), there is no “single and unchanging answer.”

The interests of the company and all its stakeholders row broadly in the same direction when a company is in the pink of health. Indeed, there is little reason for a divide where a company is thriving and can pay its employees, distribute dividends to shareholders and repay their loans to creditors on time. The interests of creditors are sufficiently protected, and directors may be entitled to treat the interests of shareholders as a sufficient proxy for those of the company.

Time and time again however, we have seen a drastic divergence in the interests of these various stakeholders when a company’s financial position weakens:

1. The management can be tempted to make risky “bet-the-company” deals in an attempt to improve the company’s financial position.
2. Shareholders (who may also include management) may on the other hand, be inclined to extract as much value from the company before an impending collapse.
3. Finally, there are the creditors who are determined that there should not be any non-essential outflows from the company or even any further trading at all, because these would eat into the company’s estate.

The position across the Commonwealth countries is consistent: when a company is on the brink of insolvency, the interests of that company’s creditors come to the fore, and a director’s duty to the company’s creditors becomes his pre-eminent duty (the Creditor Duty). The shift lies in who may be said to be the main economic stakeholder of the company and the asymmetry in corporate governance:

1. Shareholders are the primary bearers of the risk of loss arising from the exercise of directors’ duties when a company is solvent.
2. When a company is insolvent however, creditors become the primary bearers of the risk of loss because an insolvent company effectively trades and conducts its business with creditors’ money. At the same time, these creditors have no control over the conduct of the company’s business.

Justice therefore, tips its scales in favour of creditors when a company falls on hard times. After all, shareholders usually have nothing to lose and everything to gain, and creditors, contrastingly, have everything to lose and nothing to gain by the continued trading of a company which is on the cusp of insolvency.

What has always been less clear, however, is this: when exactly does this shift take place? What is the inflexion point at which the Creditor Duty comes to the fore? Up until recently, the courts across the Commonwealth had not been uniform in describing when the Creditor Duty first arises. Vague and ambiguous terms such as “bordering on insolvency” and “financially parlous” were used as thresholds, leaving directors and those who advise them with uncertainty.

The parameters of the Creditor Duty was thoroughly considered by the Singapore Court of Appeal in Foo v OP3 as we elaborate below.

Facts

Foo was the sole director and shareholder of OP3, a construction company. OP3 was engaged, sometime in 2013, to provide construction services to a company running dental clinics (Smile Inc). OP3 and Smile Inc eventually ended up in a legal dispute over the services rendered by OP3. Amongst other things, Smile Inc alleged that the construction works conducted by OP3 led to the growth of mould and the flooding of its clinic.

In May 2015, Smile Inc sued OP3 for damages of S$1.8 million. While these proceedings were ongoing, Foo (as the sole director of OP3) caused OP3 to: (i) pay him dividends; and (ii) repay his shareholders loans (collectively, the Impugned Payments). As a result, OP3 paid a total of S$2.8 million to Foo between December 2015 to 2017.

OP3 was found to be liable for damages to Smile Inc by way of a decision of the High Court rendered in October 2017. These damages were subsequently quantified to be in the sum of S$534,189.19 in a decision handed down in November 2019.

OP3 failed to satisfy the debt owed to Smile Inc and was wound up on 3 April 2020. A liquidator was appointed, and in February 2021 an action was commenced in OP3’s name against Foo to recover the Impugned Payments. Amongst other things, the liquidator alleged that in authorizing such payments to himself, Foo had breached his duty to act in the best interests of OP3 because OP3 was already in a financially parlous position at the time.

Foo’s position was that the Creditor Duty was not engaged at the time, because OP3 was not in fact insolvent or on the brink of insolvency when he authorized the Impugned Payments. Amongst other things, he also argued that his contingent liability arising from the lawsuit commenced by Smile Inc need not have been accounted for as this liability was not one that was likely to materialize.

The crux of the dispute thus centred on whether the Creditor Duty was engaged at the time Foo authorised the Impugned Transactions.

First instance decision of the High Court

The High Court determined that the Creditor Duty was engaged when the Impugned Payments were authorized by Foo, as OP3 was in a “financially parlous” state. Even though OP3 was technically solvent at the time, the contingent liability arising from the lawsuit commenced by Smile Inc had to be accounted for because Foo could not have reasonably believed that OP3 would not face any liability in the lawsuit. Taking this contingent liability into account did in fact place OP3 in a financially parlous state.

Accordingly, the Creditor Duty arose; Foo had an obligation to consider the interests of OP3’s creditors as part of his fiduciary duty to act in the best interests of the company. The High Court held that Foo had breached that duty because there was no legitimate reason to pay himself in preference to the other creditors.

Foo appealed against the High Court’s finding that he had breached the Creditor Duty.

Singapore Court of Appeal decision

The key issues before the Court of Appeal were as follows:

1. When, as a matter of law, is the Creditor Duty first engaged?
2. Had the Creditor Duty in fact been engaged when Foo authorized the Impugned Transaction?

In addressing issue (i), the Court of Appeal also took the opportunity to reiterate and clarify the nature, scope and content of the Creditor Duty. These foundational points are set forth below.

1. The Creditor Duty is a fiduciary duty that directors owe to the company. This duty is not one that directors owe directly to creditors. The proper plaintiff is therefore the company, and the creditors cannot sue for breach.
2. Liquidation is not a condition precedent to the bringing of an action for breach of the Creditor Duty (obiter dicta).
3. It is not the case that the interests of creditors only become relevant when the Creditor Duty is engaged or that those interests are immaterial at other times. The predicate duty is a duty to act in the best interests of the company, and this requires directors to have regard to the interests of different stakeholders, including creditors, at all times.
4. Creditors ought to be understood as a class for the purpose of the Creditor Duty. Even as the respective positions of individual creditors may differ, it is sensible to consider the interests of creditors as a body where the Creditor Duty is at issue because the identities of the company’s creditors constantly change so long as debts continue to be incurred and discharged by the company.
5. In an action for breach of the Creditor Duty, the relevant question is whether the director exercised his discretion in good faith in what they considered (and not what the court considers) to be in the best interests of the company, as understood with reference to the financial state of the company prevailing at the material time. Although the duty is a subjective one in that sense, the court will assess a director’s claim objectively, by asking whether the view the director claims to have formed was one that is credible or was reasonably open to them, given the information available at the time.
6. The courts will take a practical and broad assessment of the financial health of the company to decide when the Creditor Duty should arise, and assess the company's solvency in a flexible manner, including a consideration of all claims, debts, liabilities and obligations of the company. The courts will not apply a strict and technical application of the “going concern” test or “balance sheet” test.
7. The Creditor Duty is just one of a panoply of duties that a director is subject to. For instance, a director is also subject to a duty to act with reasonable diligence in the discharge of their office. This encapsulates the director’s common law duty to exercise due care, skill, and diligence.

As to when the Creditor Duty is engaged, the Court of Appeal broadly endorsed the decision of the UK Supreme Court in BTI 2014 v Sequana SA and Ors [2022] UKSC 25: Where the company is insolvent or bordering on insolvency but is not faced with inevitable insolvent liquidation or administration, the directors should consider the interests of creditors and balance them against the interests of shareholders where they may conflict. Once the liquidation or administration is inevitable however, the creditors’ interests become paramount. Both courts also spoke in one voice as to the nature and doctrinal basis of the Creditor Duty.

The Singapore Court of Appeal went further and provided guidance as to the applicability of the Creditor Duty based on its financial state based on a three-category approach: