The dangers of an unlawful dividend

7th July 2016

There have been a number of recent instances, including this year, of quoted companies calling general meetings to seek shareholder approval to remedy dividends that were paid unlawfully. Invariably these have been for non-compliance with a statutory formality rather than because the company did not have sufficient distributable profits to make the dividend.

Why are companies prepared to suffer the embarrassment and expense of going to their shareholders to fix the breach rather than simply doing nothing?

A shareholder who has reasonable grounds to believe that a dividend is unlawful is liable to repay it (with interest). There is no requirement that the company be insolvent for this to apply. In the case of quoted companies, where there may be many shareholders who may have little knowledge of the company’s financial position, securing repayment of the unlawful dividend will often be impractical. However, for companies with a small shareholder base, it is more reasonable to assume that the shareholders will know whether group companies have sufficient distributable profits to declare/pay a dividend and, in practical terms, it is likely to be easier to effect a repayment by the relevant shareholders.

The likelihood of shareholders being required to repay dividends is greatest in the insolvency context where liquidators and administrators may challenge the dividend as a transaction at an undervalue or as a preference.

Case law has established that the directors involved may be personally liable for the amount of the unlawful distribution. Further, the courts have shown a marked reluctance to relieve directors who have authorised payment of an unlawful dividend from personal liability under the Companies Act 2006 (the Act), however honestly they may have acted.

The consequences for shareholders and directors of receiving or authorising an unlawful dividend are therefore potentially draconian.

This would matter less if it were not so easy to make an unlawful dividend. Unfortunately, the law in this area is beset with pitfalls for the unwary.

The starting point, set out in statute, is that distributions may only be made out of distributable profits, being, broadly speaking, accumulated realised profits less accumulated realised losses. (Public companies have some further requirements in order to ensure that their net assets do not fall below the aggregate of their called up share capital and undistributable reserves, e.g. share premium account).

The formalities are strictly enforced by the courts (and scrutinised by liquidators and administrators). The courts have found directors liable for declaring a dividend despite the existence of profits elsewhere in the corporate group and it is also settled law that a dividend may be unlawful in circumstances where the directors have acted with the best of intentions and the error is only a “technical” one.

The most commonly encountered form of distribution is the cash dividend but dividends may take the form, for example, of a transfer of an asset or the writing off of a book debt. “Disguised” dividends are particularly dangerous as company directors may not even recognise that the Act’s requirements regarding distributions (dividends) apply at all.

Under the statutory regime relating to distributions, the directors must refer to the “relevant accounts” to determine the existence of distributable profits, which will be the last statutory accounts for the financial period immediately preceding that in which the distribution is to be made, unless these cannot justify the distribution (or there are no previous statutory accounts) in which case more up to date “interim accounts” will be used. For private companies, interim accounts must enable a reasonable judgement to be made be made as to the company’s profits and losses, assets and liabilities, provisions, share capital and reserves. The accounts do not need to be filed. For public companies, interim accounts must be properly prepared under the Act and filed with Companies House prior to the distribution. It is this latter (filing) requirement which apparently keeps tripping up quoted (and therefore public) companies.

The directors also need to be alive to their statutory duties set out in the Act, including the duty to act in a way that is considered by them to be most likely to promote the success of the company for the benefit of the members as a whole. A dividend may comply with the statutory formalities noted above regarding distributions (and there is more detail on top of this not discussed in this article) but nonetheless the directors may be acting in breach of their statutory duty by paying/declaring a dividend. A breach of statutory duty may be ratified by the shareholders. However, this will not be possible where the company is insolvent or facing the threat of insolvency: in this situation, the duty owed by the directors to consider the interests of creditors becomes paramount.

It is not strictly correct to talk of “ratification” of a technical breach as it is not possible to ratify an unlawful action. In fact, the remedial action will generally involve:

• the entry by the company into deeds of release under which it releases those shareholders who received the dividend from any liability to repay any amounts received
• the entry by the company into further deeds of release releasing those company directors who approved the dividend from any right the company may have to pursue those directors in respect of that decision. In the case of quoted companies, this release will constitute a related party transaction under the Listing Rules and the AIM Rules and, as such, will require approval of the company’s shareholders (who are not themselves interested related parties) and/or an opinion from the sponsor/nomad.

Remedying an unlawful dividend can be costly and time-consuming. Any distribution of assets by a company needs to be approached with caution to ensure that it is done correctly.