Will I have to repay my director dividend?
Will I have to repay my director dividend is a post focused on dividends paid by directors that in effect asset strip a company potentially leaving behind creditors who may go unpaid. This can be a particular problem when contingent liabilities are left unsorted.
Asset Stripping and repaying director dividends
An asset stripping dividend is a distribution of assets of a company via a dividend that will often leave nothing in the company other than its remaining liabilities.
When all material assets of a company are transferred out of the company creditors can potentially be left high and dry with limited recourse other than to put the company into liquidation and appoint a liquidator to see if the dividend can be clawed back as an unlawful dividend.
In normal circumstances if a dividend to strip a company of its assets was declared with known pre-existing creditors left behind, then it is likely that such conduct would be a breach of directors’ duty and it would need to be repaid. The reason being is that directors cannot usually enter into transactions which involves a transfer of assets out of a company that causes a predictable insolvency to arise.
However, what if the liabilities that are left behind have a degree of uncertainty about them? This is what is at the heart of this post.
A contingent liability is a liability that may be known about but it might never give rise to a liability that needs to be paid. An example me be a warranty provided when a product is sold. The seller may have a liability to the purchaser if the product develops a fault but then again it might not. Another example might be a creditor whose claim is subject to litigation whose outcome is materially uncertain.
Creditor Protection on Dividends
It is routinely suggested in the authorities that Part 23 of the Companies Act 2006 provides creditors with protection.
There arguably appears to be a gap between the requirements for a dividend declaration and the ability to pay the dividend in terms of safeguarding creditors because they are constrained by different legal concepts. To be clear it is best to avoid conflating a dividend declaration with the payment of the liability for that dividend, as I shall come onto explain.
The case of BTI 2014 LLC v Sequana S.A. & Ors  EWCA Civ 112 considered dividends in some detail as we shall see.
Will I have to repay my director dividend? Well the starting point is the mechanism of the dividend. Have the formalities been adhered to? There is reference in the judgment in BTI 2014 LLC v Sequana S.A. & Ors  EWHC 1686 (Ch) to the matter of the dividend “paid in contravention of Part 23”. The potential problem with this wording is that a dividend is declared; you pay the liability it creates. Each arguably have different rules to consider.
Just because a dividend has been declared does not mean it was paid. It is therefore unhelpful to conflate a dividend declaration with payment of the debt to the member that the dividend causes to sprout.
The point about the distinction between the dividend declaration and its consequential liability is perhaps illuminated when you look at the wording in Section 836 of the Companies Act 2006 which says “Whether a distribution may be made by a company…” [added emphasis]. That appears to suggest that a dividend (distribution) has to be considered before its becomes a creature that is created ie. its creation and payment are distinct and separate issues. The dividend declaration causes the liability and the creation of the liability legitimises the payment. It is no different from the payment of remuneration which can and indeed will be distinct from the liability that leads to such payment.
The whole thrust of the protection in Part 23 of the Companies Act 2006 is to in effect determine the legality of a distribution and therefore prevent it happening before it can do avoidable damage. The damage (if there is any) is of course the payment of the dividend rather more so than the declaration.
Therefore the question of the legality of the dividend can be traced back to its declaration. If the declaration is unlawful then the legitimacy of the consequential liability appears in doubt and subject to Section 847 of the Companies Act 2006.
The reason why the distinction between declaration and payment can be important is because when you examine a misfeasance position, you typically have to show a loss. The ‘declaration’ seemingly causes no apparent loss per se. It is the payment of the cash to discharge the liability caused by the declaration that may cause a loss.
What does a dividend do?
A dividend in effect when paid, takes money away from a company, not something that is likely to promote its success. A dividend promotes the wealth (perhaps arguably the success) of the members but not the company.
In a limited company it appears to me that in light of the duty in Section 172(1) of the Companies Act 2006, that a director ought to be able to demonstrate that the company is not just solvent for the purposes of its balance sheet ie. through deployment of reference to ‘relevant accounts‘ (see below) but the director should also be able to show that the company can pay its debts when they fall due.
A Director has a duty to promote the success of the company by virtue of Section 172(1) of the Companies Act 2006. The duty here refers to the long term, employees, commercial business relations, operations, corporate governance and to be fair.
In view of that in what way does a dividend promote the company’s success? I would say that it does not from the vantage point of Section 172(1). However, notwithstanding that Part 23 of the Companies Act 2006 specifically authorises distributions if the relevant rules are adhered to and in such instances a breach of Section 172(1) would not arise.
Relevant Accounts and Declaration
Will I have to repay my director dividend? Well did you refer to the ‘relevant accounts‘? These are those accounts which refer to relevant items to determine the legality of the dividend.
Such ‘relevant accounts‘ must show a true and fair view. What is interesting is that in Sequana it appears to have been held that a dividend can be declared with reference to the numbers alone and in effect ignore the notes to the accounts:
The wording of section 836 focuses on the numbers used in the accounts as opposed to the other narrative parts. Thus, section 836(1) provides that the lawfulness of a distribution is determined ‘by reference to the following items as stated in the relevant accounts’. For our purposes, these items are those in section 836(1)(a), that is profits, losses, assets, liabilities, those in paragraph 88 of Schedule 4 to the Companies Act 1985 (namely provisions relating to depreciation or diminution in the value of assets) and those in paragraph 89 of Schedule 4 (namely references to any amount retained as reasonably necessary for the purposes of providing for any liability the nature of which requires provision for accounting purposes). This focus on amounts rather than narrative is apparent too from section 837(2) which qualifies the requirement that the accounts must be properly prepared by stipulating that this is ‘subject only to matters that are not material for determining (by reference to the items mentioned in section 836(1)) whether the distribution would contravene this Part’. This requirement that any defects in the accounts must relate to material items is further reinforced by section 837(4) which envisages that even a report qualified by an auditor can support a lawful distribution if the auditor states in writing that the matters in respect of which his report is qualified are not material for determining whether a distribution would contravene Part 23.BTI 2014 LLC v Sequana S.A. & Ors  EWHC 1686 (Ch)
The problem this presents is what happens when there is a massive contingent liability, either in the accounts only disclosed as a note or perhaps not even mentioned in the accounts because it is deemed by the Directors to be a remote prospect?
A classic example of such a problem might be for instance a company involved in litigation. It is well known that there is a risk with any piece of litigation. It is well known that lawyers rarely give unequivocal advice – see my post reliance upon legal advice. This means that a dividend could theoretically be declared notwithstanding that such litigation could cause the company in the future thereafter to go into liquidation. Shouldn’t the dividend await the outcome therefore of litigation so that creditors are protected?
However, it appears that such a dividend declaration might (I stress might) not be unlawful but could the payment of it be and if so would it make sense for that to prevail?
The notes to the accounts are not incidental i.e. they are part of the accounts as a whole and without them the accounts arguably would not show a true and fair view. So why does Section 836 of the Companies Act 2006 exclude the numbers that might appear in a contingent liability note?
How can you ratify a breach if you do not take account of a prospective liability? You might be home and dry on the requirements for the dividend declaration but as to the potential misfeasance of paying a dividend when you might not be able to afford to do so, how can you ignore significant prospective and contingent liabilities?
Creditor Provisions in Accounts
The contingent creditor presents a problem because the Accounting Standards have a degree of flexibility in how you record provisions. The relevant Accounting Standard is Financial Reporting Standard 12
If there is a liability which is ‘probable’ and it can be estimated, then it should be recognised in the accounts.
Where a liability is a contingent liability, then unless its likelihood is deemed ‘remote’, it has to be disclosed only as a note to the accounts. Even so, it is not recognised on the balance sheet or profit and loss account. Who determines what is ‘remote’? The answer is the Director(s) who sign off the accounts. They are the party who makes this determination and for many businesses that are not subject to an audit, there can be no independent oversight here. Where a contingent liability is material but deemed by the Directors to be remote, it is also not recognised on the balance sheet or the profit and loss account.
In either case the contingent liability therefore appears to bypass the calculation of distributable reserves for the purposes of Section 836 of the Companies Act 2006. This risks enabling a company to be in effect asset stripped by way of a dividend and contingent creditors are at risk of being left high and dry. Will you have to repay your director dividend if challenged by a liquidator? The answer as ever is it depends! What does it depend upon? Have a look at the section below on breach of duty.
Members Voluntary Liquidation Distributions
Creditor dividend protection from the vantage point of asset stripping does not have much connection to cases of Members Voluntary Liquidation (“MVL”). However, what is interesting is the difference of approach to an MVL distribution from a distribution of a trading entity. In the case of an MVL, the liquidator will be conceivably at risk of negligence and misfeasance if he or she distributes a dividend to the members without having ensured that all creditors were paid in full and furthermore that clearance had been obtained from HMRC.
An MVL Liquidator generally has to be comfortable that the creditors have been paid in full before distributing the cash to the members. Should Directors be able to adopt a different position?
Granted that a liquidator is not running a trading company but in effect is finalising the end of its life. In the case of a limited company there appears few differences (ignoring the tax implications) between what is actually happening when there is a dividend to the members by the directors and a dividend by the liquidator to the members, yet there arguably appears a somewhat more rigorous approach to dividends where the MVL is concerned.
When an MVL liquidator pays a dividend to creditors, he or she has the backing of not just the last accounts and a Statement of Affairs but also a Statutory Declaration of Solvency. Why do directors only have to rely upon ‘relevant accounts’ as prescribed by Section 836 of the Companies Act 2006? Where is the consistency?
A dividend appears to be a key payment that can be lawfully entered into which has no real benefit for the company itself and yet the protection afforded to creditors appears conceivably troubling if material contingent liabilities could be in effect overlooked. Will you have to repay your director dividend if challenged by a liquidator? It depends of course!
Breach of Duty
Will I have to repay my director dividend? Well the payment of a dividend is subject to the protection that the company should be solvent and take account of contingent and prospective liabilities, otherwise a Director may risk being in breach of their duty.
In Sequana at paragraphs 328 and 329 it was acknowledged the prospective liabilities could not be ignored:
“This issue is linked with the previous question. The Claimants submit that the directors must take account of the contingent and prospective liabilities by assuming that they will have to be paid in full. They must consider the possible quantum of the liability when it is ultimately payable. The Defendants submit that this taking into account refers only to the need to ensure that proper provision is made in accordance with the accounting rules for potential liabilities. If a prospective liability is not sufficiently certain to merit a provision in the accounts, then there is no need for the directors to consider it.“
“Again, I do not accept that either of these constructions is right. I consider that the test to be applied is the same as was adopted by Sir Andrew Morritt C when he was considering the construction of the same wording in section 123(2) of the Insolvency Act 1986 in BNY Corporate Trustee Services Ltd and others v Neuberger Berman Europe Ltd (on behalf of Sealink Funding Ltd) and others  EWHC 2005 (Ch). Andrew Morritt C said:
“… a prospective liability cannot simply be added at its face value to the present liabilities of the company; on the other hand it cannot be ignored.“” [added emphasis]
If such liabilities cannot be ignored for misfeasance, then why can they be ignored for the original declaration of the dividend? Surely the two issues should be aligned. Should they not?
It is this which Section 836 of the Companies Act 2006 appears conceivably to gloss over where contingent liabilities are concerned.
Why does this even matter? It matters because the accounts are also potentially a key source of evidence when considering solvency. If they do not refer to a material contingent liability, it might make it easier for a questionable distribution to be validated.
Even if the prospective and contingent liabilities are not ignored, are there sufficient controls to safeguard creditors? If the dividend depletes the company to the point of solvency without perhaps tipping it into insolvency, it could still place the company in peril ie. the absence of a proper buffer is perhaps also where a material risk lies.
Question: What sort of buffer is needed to protect creditors?
Disclaimer: The comments in this post “Will I have to repay my director dividend” are not legal advice and ought not be relied upon as such. No liability is accepted by the author for any reliance placed upon the same. You should seek independent legal advice to consider the discrete facts of your scenario.