How To Avoid An Unlawful Dividend

How To Avoid An Unlawful Dividend?

In this case, the shareholder and two of the Directors of the company in liquidation, SSF Realisations Limited (“the Company”) were held liable for unlawful dividends but a third director was not, thereby being excused.

One good way to find out how to avoid an unlawful dividend is to know what an unlawful dividend happens to be.

What Is An Unlawful Dividend?

A dividend is unlawful if it does not comply with the following:

  • A company may only make a distribution out of profits available for the purpose
  • There must be sufficient distributable reserves
  • A dividend can only be drawn with reference to relevant accounts, being the last annual accounts or if that would amount to an unlawful dividend, then reference can be to interim accounts
  • For the company’s last annual accounts (being those last circulated to members) to be relied on, they must have been properly prepared in accordance with the Companies Act 2006
  • For interim accounts to be relied on, they must be accounts that enable a reasonable judgment to be made on the position as to distributable reserves

The matter considered claims brought by liquidators against directors and shareholders.

The company that paid the dividends in question, paid them to its shareholder Loch Fyne Oysters Limited (“LFO”). That position sprouted because of financial issues. However, before a purchaser of LFO would proceed to purchase LFO, it required the Company to be sold to a third party and nothing be owed from LFO to the Company.

The Company was due an intercompany debt from LFO and this was to be cleared by way of a dividend and a management charge.

To avoid liability for an unlawful dividend a director or shareholder will have to consider how a liability might arise.

Shareholder Liability For An Unlawful Dividend

The Court considered in detail how a shareholder could be liable legally for an unlawful dividend:

Section 847 of the 2006 Act applies where a distribution, or part of one, made by a company to one of its members is made in contravention of Part 23. If at the time of the distribution the member “knows or has reasonable grounds for believing that it is so made”, he is liable (a) to repay it (or that part of it, as the case may be) to the company, or (b) in the case of a distribution made otherwise than in cash, to pay the company a sum equal to the value of the distribution (or part) at that time: s.847(2). This is without prejudice to any obligation imposed apart from s.847 on a member of a company to repay a distribution unlawfully made to him.
In It’s a Wrap (UK) Ltd v Gula (above), the Court of Appeal held that it is enough, in order to establish that a shareholder knew or had reasonable grounds for believing that the distribution was made in contravention of the Companies Act 1985 that it had the relevant knowledge of facts which, if they existed, led to the conclusion that the distribution contravened the statute. It was not necessary that the shareholder had knowledge of the legal rules and the consequences of those rules when applied to the facts.
It was unnecessary for the Court of Appeal in that case to determine the precise meaning of “had reasonable grounds for believing”, but Arden LJ and Chadwick LJ went on to give (obiter) consideration to that question. The statutory provision was enacted in order to give effect to Article 16 of the second EC directive on company law (77/91/EEC). Article 16 provides as follows:
“Any distribution made contrary to Article 15 must be returned by 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.”
Arden LJ, at [24] considered that the concluding words of Article 16 (and thus the words “has reasonable grounds for believing” in the UK statute) “must be directed to a situation where the shareholders ought reasonably to have been aware of the factual situation that the distribution contravened the Act.” Chadwick LJ, on the other hand, at [52], considered that it was by no means self-evident that the words “has reasonable grounds for believing” were to be equated with constructive knowledge, “if by that expression is meant knowledge which a person would have but for his negligence”. He cited Swain v Natui ram Puri [1996] PIQR P442 (a case concerned with liability under the Occupiers Liability Act 1984) for the proposition that the phrase “has reasonable grounds to believe” was not equivalent to “ought to have known”. While it would not permit an occupier to turn a blind eye, it was not sufficient (in the words of Evans LJ at P488) to prove that the occupier ought to have known particular facts. The occupier must be proved “either to have actual knowledge of the relevant fact or to have known facts which gave reasonable grounds for the relevant fact.” Chadwick LJ’s provisional view, therefore, was that:
“The knowledge which the legislature has sought to describe in s.277(1) of the 1985 Act is, I think, knowledge which the member has and knowledge which the member “must be taken to have” or, perhaps, “may reasonably be taken to have”.”
The statutory remedy is without prejudice to any relief available at common law: s.847(3) of the 2006 Act. At common law, a distribution of a company’s assets to a shareholder, except in accordance with specific statutory provisions, is unlawful and ultra vires the company: Progress Property Co Ltd v Moore [2011] 1 WLR 1, per Lord Walker JSC at [15].
In Precision Dippings Ltd v Precision Dippings Marketing Ltd [1986] Ch 447, Dillon LJ, at p.457H to 458A held that because the shareholder, who received a dividend pursuant to an ultra vires act on the part of the company, “had notice of the facts and was a volunteer in the sense that it did not give valuable consideration for the money”, it was a constructive trustee for the company, citing Rolled Steel Products (Holdings) Ltd v British Steel Corporation [1986] Ch 246, 298 (per Slade LJ) and 303 (per Browne-Wilkinson LJ), who held that those who received money from a company as a consequence of its directors’ breach of duty were liable where they had notice of the breach.
The parties were in agreement that the liability of LFO under s.847 as recipient of the Distribution is limited to that part of the Distribution which LFO knew or had reasonable grounds for believing was made in contravention of Part 23. No argument was advanced that the measure of relief at common law would be different.

Director Liability For An Unlawful Dividend

The Court considered in detail how a director could be liable legally for an unlawful dividend:

The parties were also in agreement that the relevant legal principles as to the liability of a director for causing the company to pay an unlawful dividend were as recently summarised in Burnden Holdings (UK) Ltd v Fielding [2019] EWHC 1566 (Ch) at [139] and [157]:
“First, directors, although not trustees, were to be treated as if they were trustees in relation to the company’s funds. Second, if they knew the facts which constituted an unlawful dividend, then they would be liable as if for breach of trust irrespective of whether they knew that the dividend was unlawful. Third, however, if they were unaware of the facts which rendered the dividend unlawful then provided they had taken reasonable care to secure the preparation of accounts so as to establish the availability of sufficient profits to render the dividend lawful, they would not be personally liable if it turned out that there were in fact insufficient profits for that purpose. Fourth, they were entitled to rely in this respect upon the opinion of others, in particular auditors, as to the accuracy of statements appearing in the company’s accounts.”
The parties disagreed, however, as to the extent of a director’s liability in respect of a dividend which was partially made out of profits and partially out of capital.
The claimant relied on Re Paycheck Services 3 Ltd [2010] 1 WLR 2793 for the proposition that a director is liable for the whole of the dividend, not merely the difference between the unlawful distribution and the distribution which could lawfully have been paid. At [49], Lord Hope said:
“Where dividends have been paid unlawfully, the directors’ obligation is to account to the company for the full amount of those dividends: see Bairstow v Queens Moat Houses Plc [2001] EWCA Civ 712, [2002] BCC 91, [54], per Robert Walker L.J.”
He went on, however, to conclude that it was open to the court to limit the amount the director should pay to what the only creditor in the liquidation of the company had lost (relying upon a discretion which he considered arose under s.212 of the Insolvency Act 1986).
In Bairstow, it was contended that directors were liable to the extent that their actions caused the company loss, in accordance with the decision of the House of Lords in Target Holdings Ltd v Redferns [1996] 1 AC 421 and, on that test, it was apparent that there was no actionable loss occasioned by the unlawful dividends since they could have been declared and paid by the company in a lawful manner, if the company’s subsidiary had first paid up its distributable profits to the company (see [52]). Robert Walker LJ rejected that argument (at [53] to [54]), noting that the case was very different from Target Holdings: the directors in Bairstow had deliberately and (at least in relation to one of the relevant years of account) dishonestly paid unlawful dividends.
In Paycheck in the Court of Appeal ([2010] Bus LR 259), a similar argument based on Target Holdings was advanced. Rimer LJ rejected it, at [96], concluding that the basic remedy was one of restitution because directors, if not trustees in the strict sense, owe a duty as a trustee not to misapply the company’s assets, and referring among other things to the judgment of Robert Walker LJ in Bairstow (above). In the Supreme Court, Lord Walker (at [124] to [125]) and Lord Clarke (at [146]) agreed on this issue with Rimer LJ.
The first, second and fifth defendants in this case advance a different argument to that run in Bairstow and Paycheck. Mr Hinks submitted, not that the directors’ liability was limited to loss caused to the Company, but that they were liable (subject to any defence based on s.1157 of the 2006 Act) for the Distribution to the extent that it was unlawful, that is to the extent that the October management accounts (once adjusted by a reduction of the distributable profits to reflect the creditor cut-off and accruals issues) did not reveal sufficient distributable reserves.
In my judgment, the defendants’ approach is to be preferred both as a matter of principle and on authority. So far as authority is concerned, that was the conclusion reached by HHJ Richard Seymour in Re Marini Ltd [2003] EWHC 334 (Ch), at [48] to [50]. As a matter of principle, there is a difference between (1) seeking to justify an unlawful dividend on the basis that the company could have done something different which would have enabled it to make a distribution in the relevant amount and (2) a dividend which, on the basis of what the company in fact did (and the accounts which it in fact had in front of it) was only out of capital as to part of the payment.
Accordingly, the liability of the directors to compensate the Company in respect of the Distribution is limited in amount by reference to that part of the Distribution which was made out of capital and thus in contravention of Part 23.
It was common ground that the directors also owed the statutory duties set out in s.171, 172 and 174 of the 2006 Act: (1) to act in accordance with the company’s constitution and not to make dispositions which are ultra vires the company; (2) to exercise powers only for the purposes for which they were conferred; (3) to act in ways which they considered, in good faith, would be most likely to promote to the success of the company, including the duty to act in the interests of creditors where the company is, or is likely to become, insolvent; and (4) to exercise reasonable care, skill and diligence.

Management Charges: How To Avoid An Unlawful Dividend

In this case the judge found that the Management Charge was in effect a dividend also.

The signs that the Management Charge was not accepted by the Court as a normal contractual relationship between the Company and LFO was because there was deemed to be no obligation:

In my judgment, it follows from the fact that the Company was at the time of the board meeting under no obligation of any kind to reimburse LFO for any of the matters identified in the Breakdown, that the true characterisation of the assumption of the Management Charge is as a voluntary distribution to the shareholder, LFO.
This accords with commercial realities. It is generally in the interests of a parent company that its subsidiary’s business is successful. The parent can expect to benefit from its subsidiary’s success through the increased value in its shares in the subsidiary. A parent company might therefore choose to support a subsidiary financially by contributing capital as opposed to debt, or by providing benefits in kind such as the supply of services or goods without imposing an obligation on the subsidiary to pay for them.
In the absence of any agreement, whether express or implied, for reimbursement, the legal relationship under which LFO provided any support to the Company must have been that of shareholder/company not creditor/debtor. LFO’s entitlement to benefit from having provided those goods and services is via the rights conferred on it as shareholder (e.g. via dividends or an increase in the value of its shares).
By subsequently determining to assume a liability to pay for those goods and services (otherwise than via declaring a dividend) the Company was necessarily agreeing to make that payment for no consideration recognised in law. That was, in substance, a voluntary distribution of its assets to its shareholder.

Excusing A Director From Liability For An Unlawful Dividend

In this case Mr Lucas was a Director who was excused from liability because:

  • he had no financial or accounting expertise at all
  • other directors were the main decision makers on the board
  • he had very limited involvement in the dividends that caused issues in the case
  • he had no involvement in them after the board meeting that considered them
  • although he was deemed conceivably in breach of duty as a director the Court considered them sufficient to relieve him of liability

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How To Avoid An Unlawful dividend is not legal advice and not be relied upon. It is a post presented for information purposes only.