A recent application to the British Virgin Islands courts has sought to blur the lines between directors’ general duties to act for the benefit of an insolvent company’s creditors, and the statutory clawback associated with unfair preferences entered into in the twilight period prior to a company going into liquidation.

It is trite law that where a company gives an individual creditor a preference at a time when it is insolvent, then that transaction may be unwound if the company subsequently goes into liquidation within a certain period thereafter. Although some people are caught out by the absence of a requirement for an “intention to prefer” under BVI law (in contrast to English law, for example), the concept of unfair preferences which violate the pari passu distribution between creditors is well known and understood. However, the remedy for an unfair preference operates as between the company (acting through the liquidator) and the preferred creditor. The court may, on the liquidator’s application, order that the preferred creditor restores money or assets to the insolvent company for distribution amongst the general body of creditors.

Similarly, most directors are generally familiar with the legal rules which provide that they must have regard to the interests of the general body of creditors where the company is in financial distress. If directors operate without regard to the interests of the general body of creditors and cause loss, they may be held liable for misfeasance or insolvent trading (similar to wrongful trading under English law). However, the BVI courts are now having opportunities to explore an area of law where the directors might potentially be held liable to the general body of creditors for entering into a transaction which is akin to an unfair preference but is not otherwise deleterious to the general body of creditors as a whole.

On the face of it, imposing liability in such a situation would create an unjustified windfall for the creditors overall. If the directors are ordered to contribute an amount to the company’s assets equal to the amount of the payment to a preferred creditor, then the creditors as a whole will have received more money than they would normally have expected in the company’s liquidation. To take an oversimplified example, assume a company has $100 in assets, and $200 in liabilities owed equally to two creditors, A and B. If the directors make an unfairly preferential payment to A of $100, B can justifiably complain that but for the directors action he would have received a $50 distribution in the liquidation but now he will get nothing. However, if the court orders the directors to contribute $50 to the company’s assets, then although B will then receive the same amount as he would have done originally, the general body of creditors as a whole have received $150 in total, whereas they were only entitled to $100 in the ordinary course of the company’s liquidation.

Nonetheless, there is clear case law that suggests in appropriate cases, the directors can be liable in such circumstances, see for example West Mercia Safetyware v Dodd [1988] BCLC 250 and Re Washington Diamond Mining [1893] 3 Ch 95.

The real question is, how far should this principle should be taken. The existing case law reflects extreme factual examples - directors who acted in a blatantly self-interested way when the companies were hopelessly insolvent. The court will need to explore how far the principle enunciated should be applied to companies where the directors are simply seeking to continue trading and paying outside creditors in good faith. Because under BVI law there is no requirement to show an intention to prefer for an unfair preference, potentially any payment made to a creditor made shortly prior to going into liquidation would be vulnerable, even if made in good faith to an arm’s length creditor. If the directors are potentially to be made personally liable for all such payments, then that would presumably create an intolerable burden for directors, and create huge pressure to put companies into liquidation at the first sign of trouble.

Similarly, there must be a real concern that liquidators may prefer to attack the directors as “soft targets” with directors’ liability insurance to swell the general assets for creditors rather than seeking to claw back assets from a hostile third party in order to secure a pari passu distribution.

The views of the court are eagerly awaited.