Dangerous Dividends?

Dividends: the statutory requirements

The law regarding the declaration and distribution of dividends is set out in the Companies Act 2006 ('the Act'). It's important that company directors understand their statutory duties in relation to the distribution of declaration of dividend. Of particular significance is section 830 of the Act which provides that "a company may only make a distribution out of profits available for the purpose."

It's important therefore, that dividends are only issued in accordance with the statutory regime and on the basis that there are adequate distributable profits available in the company.

This can be an area of risk where, as is commonplace, director / shareholders of small/medium enterprises are remunerated at least in part by dividends to reduce their tax liabilities.

The distribution of dividends in circumstances where the company's financial position is precarious could have serious consequences if the company subsequently enters an insolvency procedure.

A distribution of unlawful dividends could potentially give rise to a misfeasance claim against a director. An unlawful distribution of dividends is likely to mean that, at the very least, a director has either misapplied funds belonging to a company and/or breached their fiduciary duties. Under Section 212 of the Insolvency Act 1986, a liquidator could issue a variety of claims against a director personally. There's no time limit regulating when a liquidator must bring a claim for breach of duties and/or misfeasance. Section 21 (1)(a) and Section 21(1)(b) of the Limitation Act 1980 states:

There's no limitation period for a fraudulent breach of trust. This in turn includes breach of a fiduciary duty by a Director (Gwembe Valley Development Co Ltd and another v Koshy and others (No3) [2003] EWCA Civ 1048).

There's no limitation period for an action to recover from a trustee property or the proceeds of trust property in the possession of the trustee. This can also encompass a claim against a director (JJ Harrison (Properties) Ltd v Harrison [2001] EWCA Civ 1467).

Powers to pursue shareholders

Insolvency practitioners also have the power to pursue shareholders personally where a shareholder has received an unlawful dividend payment.

Section 847(2) of the Act provides that a shareholder who knows or has reasonable grounds to believe that a distribution may be illegal may have to repay the dividend. In the case of It's a Wrap (UK) Ltd (In Liquidation) v Gula & Anor [2006] EWCA Civ 544, the Court held that it is not strictly necessary for a shareholder to understand all of the relevant statutory provisions and their consequences. It's simply enough that the shareholder had knowledge of certain facts that resulted in the distribution contravening statutory provisions.

Shareholders may be requested to repay a dividend where liquidators and administrators seek to challenge a dividend as a transaction at an undervalue or a preferential transaction. The time limits regulating when an insolvency practitioner may challenge a preferential payment or a transaction at an undervalue are contained within section 240 of the Insolvency Act 1986. The time limits are as follows:

1. A claim may be brought against a party associated/connected with the company in relation to transactions that took place up to two years prior to the onset of insolvency (in most circumstances).

2. In the event that the receiving party is not connected or associated to the company, the time period within which a dividend could be challenged is 6 months prior to the onset of insolvency.

The Dangers

Where dividends are declared whilst a company is in financial trouble, both directors and shareholders leave themselves open to potential litigation from insolvency practitioners where the company ultimately enters a formal insolvency procedure. At the time the dividends are declared, there must be sufficient distributable profits. However, the responsibility does not stop there. When declaring dividends, a Director must also have regard to:

1. Events that have taken place since the latest accounts had been produced that could affect the level of distributable reserves.

2. Future solvency of the business. Directors have a duty to safeguard assets of the company and act in a way that is most likely to promote the success of the company for the benefit of its members as a whole (Section 172 of the Act). Directors have a duty to consider the impact the declaration of dividends will have upon the business financially. Furthermore, if the company may be considered insolvent, the duty under section 172 of the Act is displaced and directors must also have regard to the interest of its creditors.

Court of Appeal reiterates no-nonsense approach to dividends

The Court of Appeal's decision to overturn the decision of Global Corporate Ltd v Hale [2017] EWHC 2277 (Ch), has been welcomed by many. The Court of Appeal handed down its judgment on the 27 November 2018.

The case involved a director/shareholder of the company PowerStation UK Ltd (the Company). The director faced a claim in relation to the liquidation of the Company.

The Company had sought advice from their accountants in relation to the payment and distribution of dividends. The director had been paid regular monthly payments up to a personal allowance limit. Further payments to the director were declared as dividends thereafter. The dividends had been recorded as dividends in the Company's books and records. Dividend tax vouchers had also been prepared and filed at HMRC.

During the proceedings, it became apparent that the accountant would review the payments made to the director and if there had been insufficient distributable reserves the dividend payments would then be transferred or altered to remuneration. The necessary tax would then be paid. The transactions had been recorded as 'restructured management adjustments'.

It was argued by those acting against the director that given there were insufficient distributable reserves, the dividend was unlawful pursuant to section 830 of the Act.

The judge at first instance considered that the dividend payment was only provisional and was subject to review. The judge determined that the dividends did not have to be repaid and that the director could be compensated on a quantum merit basis.

The Court of Appeal over-turned this decision on the basis that the amounts paid were undeniably dividends. The following factors were considered:

1. The sums paid were expressly declared as a dividend

2. The payments were distributions within the meaning of the Act. The timing of the payments was key. Any subsequent treatment of the dividends is irrelevant and cannot overturn the previous illegality

3. The quantum meruit rule did not apply. The Court of Appeal had confirmed that a director cannot set off a quantum meruit claim against unlawful dividends. This judgment highlights that insolvency practitioners have extensive powers to pursue repayment of an unlawful dividends on behalf of the Company and that an attempt to disguise a dividend as some other form of payment will likely fail if challenged.

Practical advice:

Directors should be prepared to explain the reasons why dividends have been declared and distributed. Any dividends declared will be heavily scrutinised in the event that a company subsequently enters an insolvency process. Directors must always ensure that:

1. Dividends are only be declared if there are adequate distributable profits within the company

2. Directors must be able to show the basis on which they have concluded that they are sufficient profits having consideration to the current and future position of the business

3. The directors must be confident with the figures that they have relied upon in declaring the dividend evidencing that there is sufficient profit in order to award the dividend payment. If a director relies on improper or inaccurate information, they could still face personal consequences even if that information had been completed by an external professional.

For more information, please contact Rhian Davies in our Dispute Resolution and Litigation team.

Insight article byHugh Hitchcock

Hugh Hitchcock

Partner

+44 (0)7545 702 212
[email protected]

 

Insight article byRhian Davies

Rhian Davies

Solicitor

+44 (0)7773 635 133
[email protected]