Introduction
In Foo Kian Beng v OP3 International Pte Ltd (in liquidation) 1 (Foo Kian Beng), the Singapore Court of Appeal had the opportunity to rule on the important issue of when a director comes under a duty to consider the interests of creditors (Creditor Duty). Prior to this case, descriptive terms such as ‘financially parlous’ and ‘on the verge of insolvency’ were used, but they did not give directors clear guidance as to when the Creditor Duty first arises.
In that case, Mr Foo Kian Beng (Foo), was the sole director and shareholder of OP3 International Pte Ltd (OP3). OP3 was sued by its customer for breach of contract, as OP3 was late in completing certain works and the works done were defective (Suit 498). Between 2015 and 2017, while suit 498 was still ongoing, Foo caused OP3 to pay to himself a significant dividend and to repay its loan to him.
OP3 was subsequently wound up by its customer. OP3’s liquidator brought an action in OP3’s name against Foo, arguing that Foo was in breach of his director’s duty to act in the interests of the company, and sought to recover the dividend and loan repayment.
The High Court found Foo to have breached the Creditor Duty. Foo appealed to the Court of Appeal.
Preliminary points
To whom is the duty owed?
The Court of Appeal emphasised that the director’s duty to consider the interests of creditors is part and parcel of the duty which he owes to the company to act in the interests of the company. The director does not owe an independent duty to the creditors, which means the creditors cannot sue directors directly for breach of duty. Although commonly referred to as ‘Creditor Duty’, it is not a duty owed to creditors as such and it is for the company, and where the company is in liquidation – the liquidator, to bring an action against the director for breach of this duty.
How does the Creditor Duty modify the duty to act in the interests of the company?
According to the Court of Appeal, it is not the case that the interests of creditors are relevant only when the Creditor Duty is engaged. A director’s duty to act in the interests of the company would ordinarily require them to have regard to the interests of different stakeholders, including the creditors. While the company is doing well as a going concern, directors treat the interests of the company as aligned to the interests of shareholders, without considering the interests of creditors. This is because a solvent company has sufficient assets to pay all its creditors, and amongst them, the secured creditors would have already taken steps to protect themselves by obtaining security. It is in the shareholders’ interests, and concomitantly the interests of the company, to pay the company’s debts as they fall due in order to lower its credit risk and ensure access to future credit.
The Court of Appeal explained the Creditor Duty emphasises the fact that the interests of creditors become significant and must be considered separately only at certain stages of a company’s life cycle.
Why the Creditor Duty?
The Court of Appeal also explained the rationale for the Creditor Duty. Where the company is solvent, the main economic stakeholder of the company is the shareholders in that they are the primary bearers of risk of loss. Where the company is insolvent, the main economic stakeholder is the creditors, and they are the primary bearers of risk of loss because the company is essentially trading with the creditors’ money. In the latter case, although the creditors bear the risk, they unfortunately do not have control over the directors who run the company’s business. The law therefore must constrain the directors by imposing the Creditor Duty on them in order to prevent them from externalising the risks onto the creditors.
Are creditors treated as a single class?
The Court of Appeal clarified that the Creditor Duty regards creditors as a class, even though the identities of creditors change over time as the company incur new debts and discharge old ones.
What is the test to be applied?
The duty to act in the interests of the company requires an assessment of whether the director made a decision in good faith in what he considered, and not what the court considers, to be the best interests of the company, given the financial circumstances of the company at the time of the decision. Although the duty is subjective in that it focuses on what the director considers, the Court of Appeal stated it may draw an inference that a director was not acting honestly if the transaction cannot objectively be regarded as one which is in the interests of the company.
To allay concerns that such an inference will be readily drawn, the Court of Appeal stated that where the decision is one of business judgement, the court will be slow to interfere; and the court is cognizant of the fact that directors do not operate with the benefit of hindsight.
Does the Creditor Duty coexist with other duties?
The Court of Appeal observed that the Creditor Duty is one of many duties that a director is subject to. The significance of this observation is that while the Creditor Duty focuses on the subjective intentions of the director, and he may honestly believe that he had acted in the interests of the company, thereby not breaching the Creditor Duty; he may however concurrently breach other duties, for example, the duty of care and diligence.
Contours of the Creditor Duty
Prior to Foo Kian Beng, courts have used various formulations to describe when the Creditor Duty is engaged. These terms are descriptive but difficult to apply in practice because it is not clear what exactly these situations entail.
The Court of Appeal envisaged a two-step approach in the following manner: first, whether the Creditor Duty has arisen; second, whether the director has breached the duty.
With regards the first step, the court examines the financial situation the company was in at the time of the disputed transaction, in order to determine who the company’s primary economic stakeholder was at that time.
With regards the second step, the court determines if the director subjectively believed he was acting in the interests of the company, bearing in mind the court may draw an inference the director was not acting honestly if the decision was objectively unreasonable.
Ascertaining the company’s financial situation
The Court of Appeal indicated that it was not concerned with whether the company was technically insolvent, and while the ‘going concern’ test and ‘balance sheet’ test are useful, the court would engage in a broad assessment of the circumstances, taking into account all claims, debts, liabilities and obligations of the company.
According to the Court of Appeal, a company may enter the disputed transaction in one of these three financial stages:
‘Category one: Where all things, including the contemplated transaction, having been considered, the company is solvent and able to discharge its debts.
Category two: Where a company is imminently likely to be unable to discharge its debts. This category encompasses cases where a director ought reasonably to apprehend that the contemplated transaction is going to render it imminently likely that the company will not be able to discharge its debts. It is, in other words, no excuse for a director to claim that he did not appreciate how dire the company’s financial state was if he ought reasonably to have done so.
And in this latter regard, the court should assume the vantage point of that director and consider which factors he ought reasonably to have then taken into account in assessing whether the contemplated transaction would result in imminent corporate insolvency.
A non-exhaustive list of relevant factors includes: (a) the recent financial performance of the company, in particular whether the company’s financial performance has been improving or deteriorating as well as the duration and extent of any such improvement or deterioration; (b) the industry that the company operates in, including its recent and future prospects; and (c) any other external developments, such as geopolitical ones, which may have an impact on the company’s business. These are all factors which may affect the financial performance of a company. They are also capable of being known to directors at the point they undertake decisions for the company, and there is therefore little risk of the court holding directors to unrealistic standards by its determination of whether and when the Creditor Duty has arisen on the facts of a particular case.
Category three: Where corporate insolvency proceedings are inevitable. …[A] clear shift in the economic interests in the company (from the shareholders to the creditors as the main economic stakeholders of the company) would occur where insolvent liquidation or administration (or judicial management under Singapore law) is inevitable. We adopt this as the third possible classification of a company’s financial state. In our view, even at this relatively earlier stage, the shift in who may be said to be the main economic stakeholder of the company would be apparent.’ 2
Ascertaining the subjective bona fides of the director
Once the court has ascertained the financial situation of the company at the time of the disputed transaction, it will test the bona fides of the director against the financial stages as set out above in the following manner:
‘Category one: Where a company is, all things considered, financially solvent and able to discharge its debts, a director typically does not need to do anything more than act in the best interests of the shareholders to comply with his fiduciary duty to act in the best interests of the company. …In short, the Creditor Duty does not arise as a discrete consideration in these circumstances. That said, we reiterate that the underlying fiduciary duty is owed to the company and acts that a director undertakes to defraud creditors will suffice to ground a breach of his duty to act in the best interests of the company even at this juncture.
Category two: In this intermediate zone, the court will scrutinise the subjective bona fides of the director with reference to the potential benefits and risks that the relevant transaction might bring to the company. The court will be slow to second-guess the honest, good faith commercial decisions made by a director to afford the company the best possible chances of revitalising its fortunes. We reiterate that if a director considers in good faith that he can and should take action to promote the continued viability of the company, and that there is a way out of the company’s financial difficulties which will benefit shareholders and creditors, he is not obliged to treat creditors’ interests as the exclusive or primary determining factor in determining what the company should do next.
Conversely, transactions undertaken at this time which appear to exclusively benefit shareholders or directors will attract heightened scrutiny…[T]he declaration and payment of dividends or the repayment of shareholders’ loans during this period of time will weigh heavily against a director as shareholders are, in the usual course, the exclusive beneficiaries of these transactions. We add that the greater the extent to which the transaction is one which exclusively benefits shareholders or directors (and does not benefit the company as an entity), the more closely a court will scrutinise the decision of the director to determine whether he had breached the Creditor Duty.
Category three: Lastly, where corporate insolvency proceedings are inevitable, there is a clear shift in the economic interests in the company (from the shareholders to the creditors as the main economic stakeholders of the company) because the assets of the company at this stage would be insufficient to satisfy the claims of creditors. In the context of liquidation, shareholders as residual claimants will stand to recover little or nothing. Consequently, the Creditor Duty operates during this interval to prohibit directors from authorising corporate transactions that have the exclusive effect of benefiting shareholders or themselves at the expense of the company’s creditors, such as the payment of dividends.’ 3
Applying to the facts
Foo could not have honestly believed that OP3 would face no liability in respect of the lawsuit. Given that OP3’s contingent liability in Suit 498 was reasonably likely to materialise to the tune of $1 470 000, it had to be taken into account in assessing OP3’s financial situation at the time the payment of dividend and loan repayment was made to Foo. OP3 had $87 747 cash as at 31 Dec 2016 and a negative net asset value of $545 568 as at 31 Dec 2017. OP3 had also experienced a sharp decline in business, wherein its profits fell from $996 894 in 2015 to losses of $79 299 in 2016 and $703 251 in 2017. The Court of Appeal, after taking a holistic view of OP3’s financial situation, was satisfied that the Creditor Duty was engaged when Foo authorised the payments to himself.
The Court of Appeal went on to find Foo had breached the Creditor Duty when he failed to consider the interests of OP3’s creditors. The payment decisions were not commercial decisions intended to revive the fortunes of the company, wherein the creditors could enjoy an upside if the commercial judgment paid off. The payments were instead intended to benefit only Foo at the expense of OP3’s creditors.
Conclusion
Prior to this decision, directors could have been hampered in making commercial decisions to turn around their company in financial distress, for fear that those decisions could cause them to breach the Creditor Duty.
This case is significant because of the clarifications the Court of Appeal made as to the scope and nature of the Creditor Duty. This is a welcome development because there are now practical working principles by which a director may use to help him determine if, in making a particular decision for the company, at a specific stage of the company’s life cycle, he has discharged his duty to act in the interests of the company.
References
- [2024] SGCA 10
- [2024] 1 SLR 361 at [105]
- [2024] 1 SLR 361 at [106]
Written by a member of the LW examining team
