When Dividends Don’t Pay
The common-place practice of directors paying themselves dividends and a nominal salary has never been more risky. While doing so offers tax savings in terms of income tax, the credit crunch means that more companies are trading close to insolvency. Can dividends still be paid out? Now is an opportune time to review the practice, highlight the possible pitfalls and consider the consequences in the event of formal insolvency.
When can Dividends be Drawn?
When considering the lawfulness of drawing a dividend, the first step is to check the company’s own memorandum and articles. In general, most provide that a company’s shareholders must approve distributions, but that directors can approve the drawing of interim dividends, subject to approval at the next AGM.
While the memo and arts cover if dividends can be paid, section 830 of the Companies Act 2006 (“the Act”) covers when they can be paid. The Act is quite clear that a distribution may only be made out of “profits available for distribution”. Determining that is generally an accounting issue, and many directors will look to their company accountant for appropriate advice. What is clear is that dividends should not be paid out unless there are available profits.
Such profits are defined as the accumulated, realised profits of the company less its accumulated, realised losses. These will be determined by looking at the company's last annual accounts, or interim accounts where necessary. The accounts must allow reasonable judgment to be made of the company's profits, losses, assets and liabilities and include appropriate provisions and details of the company's share capital and reserves (including undistributable reserves).
Where the accounts legitimately show a profit, a dividend can be paid. Where more than one distribution is proposed in the one accounting year, each subsequent distribution should only be authorised if the total distributions so far, including that proposed, would be allowed under the last annual accounts.
Consequences of a Breach?
Where dividends have been paid out in breach of the Act, the consequences can be severe. Recovery of illegal dividends can be sought from both the directors and shareholders.
Shareholder Liability
Shareholder liability arises on payment of the illegal dividend – there is no requirement for the company to be in formal insolvency for this liability to occur. Section 847 of the Act provides that if a shareholder knows, or has reasonable grounds for believing, that a dividend was paid in contravention of section 830, then that shareholder is liable to repay the dividend (or indeed the “illegal” part of it, if it can partially justified).
So, an “innocent” shareholder is not liable. Innocence in this sense is a lack of knowledge of the availability of distributable profits, and not ignorance of the law itself – a line of argument tried unsuccessfully in the case of It’s a Wrap ([2006] EWCA Civ 544). Director shareholders, who should have intimate knowledge of the workings of their company, will rarely be able to successfully argue that they did not know there were no distributable profits.
Director Liability
Before deciding whether to make a distribution, the directors must consider their own duties. These include the statutory duty to promote the success of the company for the benefit of its members, taking into account the long term consequences of the decision and subject to any rule which requires the directors to act in the interests of the company's creditors. They also include the common law duty to ensure that a company is able to pay its debts as they fall due. For this, directors must be satisfied that the company will remain solvent following the distribution. Directors can be held personally liable for distributions which don't take proper account of future liabilities and cash flow requirements, and be forced to repay the company.
While drawing a dividend illegally will mean that a director is in breach of his fiduciary duties, and brings about an obligation to repay, the heat on directors is only likely to really come about following the appointment of an insolvency practitioner (“IP”). Note that an IP can take action on behalf of the company as against the directors or the members. In small or family run companies the same people will often act as both shareholders and directors.
An action may be raised under the Insolvency Act 1986 section 212 to force that repayment. The basis of the action is misfeasance – an argument that the director misapplied company funds. A finding against a director under this type of challenge can lead to a personal liability to repay funds. The action can be raised by the liquidator of the company or by any creditor.
If the directors have acted on the advice of an accountant or other professional adviser then there is an argument that the directors should be granted relief under section 1157 of the 2006 Act. However, in the case of Marini the judged opined that he had difficulty in seeing that it was ever likely that a defaulting director should be excused if the result is that the director will be entitled to a benefit he would not have had but for the default.
Other angles of challenge on insolvency
It is important to note that unlawful or unjustified distributions may also amount to a challengeable transaction. The declaration of a dividend creates a creditor of the company – the shareholder. It follows then that payment of a dividend may constitute an unfair preference. That is, the practice of preferring one creditor above all others. Alternatively, the distribution may still constitute a gratuitous alienation: disposing of an asset at undervalue.
In either of these cases an action may be raised by the liquidator, or a creditor (in a liquidation), or by the administrator (in an administration). The remedy sought will usually be restoration of funds, failing which payment, although it is open to the IP to also seek decree for reduction of the distribution.
So…
Directors and especially shareholding directors would be well advised to think twice before drawing dividends. They should ensure that the company is in necessary profits and take advice where necessary. In the event of insolvency, IP’s will most certainly review the circumstances in which dividends were paid, and the prospects for recovery of any paid illegally.
For further information please CONTACT: DOUGLAS GOURLAY OR FIONA CARLIN