Unlawful Dividends BRIEFING This briefing note is intended to provide guidance to insolvency practitioners who wish to consider whether to seek repayment on behalf of the company of dividends paid to shareholders. It addresses the legal requirements to be met before a dividend can be paid, under the Companies Act 2006 ( the 2006 Act ), and the company s articles of association, as well as at common law. It explains what can be done where dividends are found to have been paid unlawfully, and considers the limited circumstances in which the court will grant relief to shareholders who have received dividends in contravention of the law. The distribution of cash or assets of a company prior to its demise is not a rare occurrence. Where an insolvency practitioner, in the course of their investigations, uncovers such a distribution, they will wish to be satisfied that it is lawful. The courts are known to adopt a strict line when considering compliance with the legal requirements for distributions. This note considers some of the key features of the statutory rules, common law and case law relating to the most common form of distribution, namely a dividend to shareholders. The statutory provisions The relevant statutory provisions to consider are those in force at the date of the declaration and payment of dividend. This note considers the position under the statute currently in force, the 2006 Act, where the relevant provisions are to be found in Part 23. The general rule is that a company may only pay a dividend out of profits available for the purpose 1, namely its accumulated, realised profits (so far as not previously utilised by distribution or capitalisation) less its accumulated, realised losses (so far as not previously written off in a reduction or reorganisation of capital) 2. There are specific and more onerous restrictions in relation to distributions by way of dividend by public companies and investment companies, which are not covered by this note. 1 Section 829 Companies Act 2006 2 Section 830 Companies Act 2006 Page 1 of 6
The question of whether a company contravenes Part 23 in declaring and paying a dividend is determined by reference to the following items as stated in the relevant accounts: (a) Profits, losses, assets and liabilities; (b) Various provisions 3 ; and (c) Share capital and reserves (including undistributable reserves), together the Accounting Factors. The relevant accounts are the company s last annual accounts 4 but where those accounts would result in the dividend contravening Part 23, its payment may be justified by reference to interim accounts, or to initial accounts where the distribution is proposed to be declared during the company s first accounting period. Last annual accounts In the case of reliance upon the last annual accounts, the accounts are the company s individual accounts that (i) were last circulated to members in accordance with the company s duty under s.423 of the 2006 Act; or (ii) formed the basis of a summary financial statement (if that was provided to members under s.426 of the 2006 Act). The accounts must have been prepared properly, or prepared subject only to matters not material for determining whether the distribution would contravene Part 23. If the accounts are required to be audited, and they are qualified in any respect, the auditor must have stated that in writing either at the time of his report or subsequently, whether those qualifications are material for determining whether a distribution would contravene Part 23 and his report must have been circulated to members. Interim and initial accounts Where interim or initial accounts are relied upon, they must contain sufficient information to enable a reasonable judgement to be made of the amounts of the Accounting Factors. Directors general duties A director is not excused from exercising judgement, even when relying upon the last annual accounts, however. Directors have a general duty to act in the interests of the company; exercise reasonable care, skill and diligence; to promote the success of the company and safeguard its assets. Combined with the duty to take reasonable steps to ensure that the company is able to pay its debts as they fall due, and the prohibition at common law against making a distribution out of capital, means that whatever position is shown by the last annual accounts, a director must re-assess the company s financial position before making any previously recommended distribution and be prepared to reverse that decision if the financial position of the company has deteriorated since the date of the last annual accounts. Articles of association The 2006 Act is only one factor governing the declaration and payment of dividend. It is supplemented by the company s own articles of association, which regulate the management of a company. Where a company has bespoke articles of association, these should be registered at Companies House. If no bespoke articles have been drawn up, no articles are registered, or they are silent in relation to dividend, then model articles will apply by virtue of 3 Section 396 Companies Act 2006 4 Section 836(2) Companies Act 2006 Page 2 of 6
section 20 of the 2006 Act. The articles of association, in whatever form, should therefore be considered carefully. There have been various versions of Table A, the model form of articles, and the version which applies is that which is in force at the date of the company s incorporation. New Model Articles apply to private companies which were incorporated after 28 April 2013 (replacing a version applying to companies incorporated on or after 1 October 2009) but since the majority of dividend declarations or payments that are currently under investigation will relate to companies incorporated before 1 October 2009, this note refers to Table A effective as at 1 July 1985. Although there have been a series of amendments to Table A from 1985 5 none impact on the regulations concerning payment of dividend. Table A Under regulation 102, the company may by ordinary resolution declare dividends in accordance with the respective rights of the members but the amount should not exceed that recommended by the directors. The directors may pay interim dividends if it appears to them that they are justified by the profits of the company available for distribution, but this question should be considered in conjunction with sections 829 and 830 of the 2006 Act (see above). Regulation 104 provides that all dividends should be apportioned and paid proportionately to the amounts paid up on the shares during any portion or portions of the period in respect of which the dividend is paid. Payment alleged to be of dividends, but which corresponds, for example, to the outstanding balance of a director s loan account or which does not reflect share ownership may point strongly to contravention of the 2006 Act and Table A regulations. Non-compliance with the strict legal requirements It can be seen from the above that the law must be strictly complied with for a declaration and distribution by way of dividend to be lawful. The courts will not hesitate to declare unlawful a distribution by way of dividend that has not been made strictly in accordance with the rules. What can be done when unlawful dividends have been declared/paid? Where a distribution, or part of one, made by a company to one of its members is made in contravention of Part 23 of the Act and, at the time of the distribution the member knows or has reasonable grounds for believing that it is so made, he is liable to repay it to the company, or in the case of a distribution made otherwise than in cash, to pay the company a sum equal to the value of the distribution at that time 6. In Bairstow v Queens Moat Houses Plc 7, which was concerned with a distribution to which the Companies Act 1985 ( the 1985 Act ) (and section 277 of that Act) applies, the court held, obiter, that the statutory remedy... is available only against a shareholder with actual or constructive knowledge of the unlawfulness of the dividend, however, the Court of Appeal overturned this decision and found that a shareholder should be required to return a distribution if he knew or ought reasonably to have known that the distribution contravened the requirements of the Companies Act. 5 As a result of the Companies (Tables A to F) Regulations 1985, the Companies Act 1985 (Electronic Communications) Order 2000, the Companies (Tables A to F) (Amendment) Regulations 2007 and the Companies (Tables A to F) (Amendment) (No. 2) Regulations 2007 6 Section 847 of the Companies Act 2006 7 [2001] EWCA Civ 712 Page 3 of 6
In It s a Wrap (UK) Limited v Gula & Anor 8, the court considered this question further. There were two shareholders, Mr and Mrs Gula, who each received 28,000 as dividends, in two financial years in which the company made a loss on ordinary activities before tax. In neither year were there profits available for distribution. This was in breach of the general rule 9 that a company may only make a distribution out of profits available for the purpose. Mr Gula explained to the liquidator of the company that the payments appeared in the accounts as dividends but were merely a tax efficient way of drawing a salary. The court accepted that this was true; that the classification of the payments as dividends was a deliberate decision for the purpose of gaining a proper tax advantage; that the directors were aware the company had made only losses; and that they were unaware that paying dividends in the circumstances involved contravention of the Act. The court also accepted the classification of the payments as dividends. In considering the meaning of section 277 of the 1985 Act (now section 847 of the 2006 Act) the court examined section 44(1) of the Companies Act 1980 (the successor to section 227) and Article 16 of the Second Council Directive of 13 December 1976 (77/91/EEC) ( the Second Council Directive ), the former having been enacted to give effect to the latter. The recitals to the Second Council Directive included: Whereas in order to ensure minimum equivalent protection for both shareholders and creditors of public limited liability companies, the coordination of national provisions relating to their formation and to the maintenance, increase or reduction of their capital is particularly important;... Whereas Community provisions should be adopted for maintaining the capital, which constitutes the creditors security, in particular by prohibiting any reduction thereof by distribution to shareholders where the latter are not entitled to it and by imposing limits on the company s rights to acquire its own shares;... Article 15 dealt with prohibitions on distribution and Article 16 provided: Any distribution made contrary to Article 15 must be returned to the shareholders who have received it if the company proves that these shareholders knew of the irregularity of the distribution made to them, or could not in view of the circumstances have been unaware of it. The Court of Appeal held that section 277(1) of the 1985 Act must be interpreted as meaning that the shareholder cannot claim that he is not liable to return a distribution because he did not know of the restrictions on the making of distributions under the 1985 Act. The shareholder will be liable if he knew or ought to have known of the facts which mean that the distribution contravenes the relevant requirements. There is nothing in the wording or purpose of Article 16 to oust the general principle that a person is deemed to know the law. This therefore avoids any requirement to show knowledge on the part of the shareholders of the provisions of Part 23 of the 2006 Act and the law generally. The court considered It s a Wrap in Re. Snelling House Limited 10, in which dividend payments were made in the knowledge of a lack of distributable profits. In that case also, the court had no hesitation in ordering repayment of the dividends. 8 [2006] EWCA Civ 544 9 in section 829 of the 2006 Act 10 [2012] EWHC 440 (Ch) Page 4 of 6
Relief It is worth remembering, however, that the court has the ability to grant relief. Under section 1157, if in proceedings for negligence, default, breach of duty or breach of trust against an officer of the company, it appears to the court that the person acted honestly and reasonably, then having regard to all the circumstances of the case if he ought fairly to be excused, then the court may relieve him, either wholly, or in part, from his liability on such terms as the court thinks fit. (An officer of the company who has reason to apprehend that a claim may be brought against him may apply for relief). In Bairstow v Queens Moat Houses plc, the court at first instance found that nine dividends had been unlawfully paid, but granted relief in respect of seven of them, under section 727 of the 1985 Act, which provision is reflected in section 1157 of the 2006 Act. The court rightly recorded that the burden of proving honesty and reasonableness was on those asking for relief. In this case, the judge at first instance concluded that the former directors had placed reliance on the auditors in relation to sufficiency of reserves and were neither dishonest or unreasonable in being unaware that there were insufficient reserves available in the parent company to pay the dividends on the basis of the... accounts, and that this rendered them unlawful under the Act and granted relief. This was overturned on appeal, the Court of Appeal finding that the court should not exercise its discretion under this section and excuse directors from liability at the expense of creditors of the company 11. The court considered whether relief should be granted in the case of In the matter of Marini Limited 12. In that case, where dividends were paid in sums in excess of the available profits for distribution, the three directors were ordered to repay the sums received to the extent that they exceeded the available profits. Although the directors had acted honestly and reasonably in seeking the advice of an accountant before the dividend was paid, the court refused to grant relief, considering that it was unlikely ever to be appropriate for the court to excuse a defaulting director for his breach of duty if the consequence would be to leave the director receiving benefits that he would never have received but for the default and at the expense of creditors. In Brocks Mount v Beasant 13, the court made clear that where there has been a misapplication of the company s assets, the onus on satisfying the requirements of section 727 of the 1985 Act (or section 1157 of the 2006 Act) is a particularly heavy one. Summary In examining dividends paid, consider these few points: The statutory provisions are contained in Part 23 of the Companies Act 2006 The general rule at common law is that a company may only pay a dividend out of profits available for the purpose 11 Inn Spirit v Burns [2002] BCLC 780 12 The liquidator of Marini Limited v Dickenson & ors [2003] EWHC 334 (Ch) 13 [2003] All ER (D) 39 Page 5 of 6
Where the last annual accounts are relied upon these are the company s individual accounts that were circulated to members or that formed the basis of a summary financial statement Where interim or initial accounts are relied upon, these must enable a reasonable judgement to be made of the company s financial position The company s articles of association supplement the Companies Act 2006 The company may declare dividends, which should not exceed the amount recommended by the directors All dividends must be apportioned and paid proportionately to the amounts paid up on the shares A dividend paid in contravention of Part 23 can be reclaimed under section 847 of the 2006 Act The court may grant relief under section 1157 of the 2006 Act, only if doing so does not benefit the shareholder at the expense of creditors For further details or if you have any questions please contact: Marie-Louise King Partner Commercial Litigation T: 020 7593 5192 E: mlking@wslaw.co.uk John Hiscock Partner Commercial and Corporate T: 020 7593 5075 E: jhiscock@wslaw.co.uk Page 6 of 6