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Dividend and Liquidation Litigation

Overview Of An Illegal Dividend

Illegal dividends can arise in a number of ways. Dividend backdating, for example, might appear attractive but the potential consequences of attempting to re-write history on the other hand might not.

An illegal dividend can arise due to:

  • insufficient reserves
  • failure to declare the dividend
  • taking money without engaging in the procedures
  • not referring to relevant accounts
  • being insolvent

What Is A Dividend?

In order to consider what is an illegal dividend, it is first necessary to consider what is a dividend. A dividend is a shareholder’s right or entitlement to a sum of money from a company. It is not merely the payment of that sum of money from the limited company.

Although it is common to refer to the payment of a dividend with the dividend itself, it is not the case that the payment of a dividend is the dividend.

The Companies Act 2006 enables subject to certain conditions for shareholders to receive dividends. In a nutshell, a dividend can only be paid from profits. This is to protect the company’s creditors so that a company’s wealth or money is not extracted by the shareholders at their expense.

Declaring A Dividend

If a Director wishes to pay a dividend to the limited company’s shareholders, he or she has to DECLARE the dividend otherwise it is not created.

In order to declare a dividend, the Board of Directors will need to pass a board resolution to formalise the declaration. The resolution should ensure that it refers to the accounts that are relied upon to justify the dividend. These are referred to as the RELEVANT ACCOUNTS accounts.

Why Are Dividends Declared?

Dividends are declared because the company’s shareholders that own the company will want to receive a return on their investment in the company. Such return can typically take two forms:

  1. Receipt of regular dividends.
  2. Sale of the shareholding.

Consequences Of Failing To Declare The Dividend – An Illegal Dividend!

If payment is made to a company’s shareholders intending it to be a dividend without having been properly declared then the transaction is not a dividend. The consequence of such a failure is that the transaction may well have to be reversed and repaid to the company as Mr Belcher found out in the matter of BM Electrical Solutions Ltd & Anor v Belcher [2020] EWHC 2749 (Ch) which has featured in our post Ouch! Director Dividends, Director Loans and Director Liability.

What Are The Conditions For A Dividend?

Dividends Can Only Be Made Out Of Profits

In order to consider what is a dividend and therefore what is an illegal dividend you need to break down all the special features of dividends. Dividends can ONLY be declared out of profits. You can see from the extract of Section 830 of the Companies Act 2006 the restriction imposed.

What Are The Profits Available For A Dividend?

The profits available for a dividend are the accumulated realised profits.

Profits are not simply cash in the limited company bank account.

Profits are also not the ‘net’ profit figure shown on the last Profit and Loss Account of the company.

The Illegal Dividend Dilemma And Backdating

The Dividend Dilemma. Beware of backdating dividends because what is cheap now can be expensive later.

The backdated dividend might not be uncommon and I might be forgiven for thinking that it might even be widespread but it is a problem often misunderstood.

Tax Efficiency

Dividends for owner-managed businesses are often an attempt to enable directors to extract money in a tax-efficient way. At least the theory of remunerating directors via dividends rather than salary is based upon that general proposition.

However, it is one thing to organise one’s company’s affairs to remunerate oneself via payment of a dividend; it is quite something else to backdate a dividend. A backdated dividend is unlawful and would need to be repaid.

Beware Backdating Can Cause Illegal Dividend

So what do I mean by a backdated dividend? Well, the scenario is one where a Director in an owner-managed business draws money every month from their company, rather like a salary. The money is taken by the Director from the company bank account and placed into their personal bank account. The purpose of the transaction when it is taken is simply typically to enable the Director to discharge his or her monthly personal liabilities. At the time the money is transferred from the company in question, no real thought necessarily might be given as to the construction to place on the transaction. It might simply be removed from the company to be sorted out later on. Therein lies the problem.

Director Fiduciary Duty

The Director owes their company fiduciary duties and to use reasonable care, skill and diligence by virtue of Section 174 of the Companies Act 2006. It is axiomatic that such duties involve keeping adequate accounting records by virtue of Section 386 of the Companies Act 2006 so that they can, inter alia, show the purpose and nature of the transactions that they cause and or permit the company to enter into. This is all the more important because these are transactions that Directors (who are fiduciaries) themselves may have the personal benefit of.

Purpose Of Transactions

It is fundamental that when a transaction is undertaken that its purpose is known about at the time. Attempting to reconstruct ‘purpose’ when you do not know what it was at the time it arose, is fraught with problems after the event. If you do not know what it was when the transaction was executed, you are hardly likely to know what it is later on either. That accordingly could lead to the somewhat unattractive scenario at the end of the financial year, if the Director thereafter discovers that they owe the company a substantial sum because their director’s loan account was not sufficiently in credit. If it is now substantially overdrawn, they can find themselves in a spot of bother, particularly if they cannot afford to repay it.

However, what might arise is that rather than paying the monthly drawings back to the company, a Director may consider if indeed it might be possible to declare a dividend to clear the overdrawn director’s loan account and avoid having to repay the money back to the company. This would involve the Director paying tax personally on the dividends and declaring the same in their personal tax return. All well and good, or is it? As ever it depends; on what you do and how you do it.

Procedural Issues: How To Avoid An Illegal Dividend

Dividend Procedure should involve a proper assessment of the financial position of the company to ensure that it has sufficient distributable reserves available to be satisfied that the dividend can be lawfully declared. That is a critical feature of how to avoid an illegal dividend being paid.

Sufficient Distributable Reserves

So how are you going to ascertain if you have sufficient distributable reserves to avoid the ultimate problem presented by the dividend dilemma, which would involve having to repay the dividend? Well, the answer is not to look at the bank account and to check that there is sufficient cash available. That I am afraid is artificial and simply not good enough. The answer is to establish that you have sufficient distributable reserves by virtue of Section 830 of the Companies Act 2006. In other words that the company can genuinely after taking into account its present, future and contingent liabilities, be confident that its financial position enables it to properly afford to declare such a dividend and not prejudice its creditors.

The way to do that is to ensure that the company can justify the dividend by reference to ‘relevant accounts’ by virtue inter alia of Section 836 of the Companies Act 2006. Such accounts being ‘relevant’ to the prospective declaration of the dividend ie. so that the dividend does not turn into the dividend dilemma that this post is all about.

Relevant Accounts For Dividends

Another critical feature of how to avoid an illegal dividend being paid is the ‘relevant accounts’ requirement. The ‘relevant accounts’ need to show a true and fair view; a cardinal principle for a proper set of financial statements in any event. They need to enable reasonable certainty for their deployment when the dividend is declared. Once the dividend has been declared it should be minuted with the ‘relevant accounts’ and at that point it can be processed in the books and recorded as a liability; either for immediate payment or to create a credit to the shareholders accordingly.

Just to be absolutely clear, the procedures that are in need of being deployed where dividends are concerned are not perfunctory. The fact that the company might be an owner-managed business and not a PLC does not mean that such procedures can be avoided.

In Bairstow & Ors v Queens Moat Houses Plc [2001] EWCA Civ 712 it was notably held as follows as to matters of perceived informality:

“… the requirement that any distribution should be made only in accordance with a company’s financial statements, drawn up in the proper format and laid before the company in general meeting, cannot be regarded as merely a procedural technicality“.

Distribution Danger Of Illegal Dividend

There are a number of issues that can arise. One is: which year are you going to declare the dividend in and the other point is, do you have sufficient distributable reserves available by virtue of Section 830 of the Companies Act 2006.

If at the point in time when the accounts are being prepared i.e. after the year end, if you have sufficient distributable reserves which can be determined as mentioned above and further considered by virtue of the calculations set out in Section 831 of the Companies Act 2006, then the dividend declaration should by definition fall into the accounts for the year following the period of the transactions referred to in the scenario set out above. The effect of that could mean that there is no problem with the dividend at all. In this example, the problem that can arise however is if instead of declaring the dividend in the year following the financial year of the transactions, the declaration of the dividend is processed in the year of the transactions themselves i.e. you vary the substance of the early transactions. In such an instance then you are in effect making a declaration of a dividend that could be impugned because of the backdating problem.

Why would this be done? Well it could be considered for reasons of tax efficiency but if done incorrectly and through backdating, the conceivably improper nature of such a process will likely outflank any tax savings.

Insolvency and Creditors

If the reserves are insufficient, then the dividend will be unlawful and likely have to be repaid. It really is as simple as that. This position is further highlighted by virtue of Section 172(3) of the Companies Act 2006 which refers to the duty to act in certain instances in the interests of the company’s creditors.

Where a company is insolvent for instance, there will typically be insufficient distributable reserves for a Director to lawfully declare a dividend.

Remember what a dividend is, it is a distribution (reduction) of the company’s available profits to its shareholders. The effect of a dividend declaration inevitably is that the company’s creditors will have less reserves available to discharge debts due to them if the company runs into financial trouble. That ultimately is what gives rise to the dividend dilemma.

In Precision Dippings Ltd v Precision Dippings Marketing Ltd [1986] Ch 447 it was said:

“The term “distribution” includes a dividend such as the dividend in the present case, and the effect of [s.39(1)] is clearly, in my judgment, to make it ultra vires for a company to pay a dividend except out of profits available for the purpose, just as it has long been held to be ultra vires for a company to pay a dividend out of capital: see In re Exchange Banking Co (Flitcroft’s Case) (1882) 21 Ch D 519.”

Creditors Interest

The precise rules on dividends, whilst arguably not necessarily all that complicated, do start from the premise that creditors should be protected from shareholders taking excessive dividends to their detriment. That is why the rules on dividends require certain procedures to be vigorously followed largely without exception. It is not permissible to draw money from a company as a director and then after the event determine that the same was a dividend payment when it never was in the first place. You must declare the dividend first and then follow all the correct procedures when doing so before making the payments. You do not follow such procedures at your peril.

Do Not Backdate: The Risk Of An Illegal Dividend Is Very Real

So do not backdate your dividends. If your company for whatever reason goes into liquidation, such backdated dividends could be clawed back by a liquidator if you did not comply with the dividend regulation procedures, even if you appear to have had sufficient distributable reserves at the time. You do not want such unpleasant and unwelcome surprises to sprout needlessly when the same is avoidable. The dividend dilemma is an entirely avoidable issue if adequate accounting records are kept and proper thought is given to the issue at the time of the transactions being effected.

Repayment Of Illegal Dividends

What happens however if you are the recipient of a dividend and called upon to repay it. You are facing the dividend dilemma.

Well, the issue is whether or not you are a shareholder and or a director of the company in question. If you are only a shareholder, then you might well appear to have a defence by virtue of Section 847 of the Companies Act 2006. That defence has its roots in the position that as a shareholder/member, you did not and could not have reasonable grounds for believing that the distribution was unlawful.

However, if alternatively, you were both a Director and a shareholder at the same time, then the position appears to be rather different. Even if you were not aware of the discrete feature of the laws on distributions and dividends, if you were a director of the company at the relevant time, you are by virtue of that position and the requirement(s), inter alia, to keep yourself appraised of the financial position of the company, taken to have known the facts that are relevant.

It’s A Wrap Case

The position of a shareholder who was not also a director and the person who was both shareholder and director, was neatly articulated in the Court of Appeal’s case It’s A Wrap (UK) Ltd v Gula & Anor [2006] EWCA Civ 544 where the following was promulgated:

I reject the central proposition of Mr Robins that a shareholder must in all circumstances have knowledge of the requirement of the Act that the distribution contravened. I accept the submission of Mrs Jane Giret QC for the appellant that, if that were the law, it is likely to be difficult in practice for a company to show such knowledge is a significant number of cases….”

“There is no suggestion that the respondents did not know the position as shown by the accounts, namely that the company had no profits available for distribution. For the reasons given above, it is not necessary for the company to show that the shareholders knew the provisions of section 263. (Likewise, it is unnecessary to rely on the Latin root of the word “dividend” to reach this conclusion, as Mrs Giret submitted as a subsidiary argument for inputing knowledge to the respondents.) Since Mr and Mrs Gula knew that the company had no profits, they knew that the distributions had been made in contravention of the provisions of the Act for the purpose of section 277(1).”

So just for the last time – do NOT backdate your dividends!

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