Business Owners – Beware Unlawful Dividend Payments

It is standard for directors/shareholders of SMEs (and there is usually some crossover between the two) to be paid a relatively low salary through PAYE and receive the bulk of their remuneration via dividends. This blog explores how such dividends are declared and the risk which unlawful dividends pose to company directors and shareholders, particularly during the current crisis.

The coronavirus pandemic has resulted in UK businesses having to make difficult decisions about how their companies are run, with the repercussions of these decisions often having the biggest impact on small and medium-sized enterprises (SMEs). Whilst we have seen the relaxation of some of the rules to help struggling SMEs (including the temporary pausing of company strike-offs), others remain very much in place. In particular, company directors should be reminded that their statutory duties have not been relaxed.

How does a company declare a dividend?

To lawfully pay a dividend to its shareholders, a company must have profits available to it (referred to as distributable profits or distributable reserves). The process for declaring and paying dividends is usually set out in a company’s articles of association, which typically provide that dividends are declared by shareholders following a recommendation from the board of directors.

Once a dividend has been approved by shareholders, it becomes a debt due and payable to them. For many companies, final dividends are declared at its Annual General Meeting and you can find out more about Covid-19’s impact on AGMs by clicking here.

What is an unlawful dividend?

A dividend which contravenes either common law (such as a distribution out of capital) or Part 23 of the Companies Act 2006 (such as a dividend declared in excess of a company’s distributable profits) is unlawful. Common examples include:

• a subsidiary of a company undertaking a capital reduction using the solvency statement procedure, preparing interim accounts that show a positive reserve, and distributing a dividend to its parent company, only to discover that the capital reduction procedure was followed incorrectly and the reduction is therefore invalid; or
• a company not preparing interim accounts and the last annual accounts show insufficient distributable reserves (even though sufficient reserves would have been shown had the accounts been prepared).

Although the risk of declaring an unlawful dividend is ever-present, the current uncertainty brought about by the Covid-19 pandemic means that directors, shareholders and those that advise companies will need to be extra vigilant when considering whether or not a dividend should be declared.

Why is there currently an increased risk?

The impact that coronavirus is having on many SMEs’ ability to continue as going concerns, could mean that some dividends are unlawful. In particular, those associated with a company will need to:

• pay attention to capital maintenance and ensure that sufficient reserves are available when the dividend is made, not just proposed. When the dividends are declared, the directors must review trading since the company’s year-end and the effect which this will have on distributable reserves.
• consider whether the company is still a going concern and if possible, obtain financial forecasts which support that view.

On 26 March 2020, the Financial Reporting Council (FRC) published guidance for companies preparing financial statements in the current economic environment. As part of its recommendations, the FRC noted that the assessment of whether a dividend is or remains appropriate should include “consideration of current and likely operational and capital needs, contingency planning and the directors’ legal duties”. The directors’ duties are set out in the Companies Act 2006 and particular attention should be given section 172 (the duty to promote the success of the company).

What are the consequences of paying an unlawful dividend?

A shareholder who knows or has reasonable grounds to believe that a dividend (or part of it) contravenes the statutory rules will be liable to repay it (or the portion of it that is unlawful). A director who authorises the payment of an unlawful dividend may be in breach of their statutory or common law duties and may be personally liable to repay the company (even if s/he is not a shareholder). The Companies Act 2006 does not, however, impose criminal penalties on directors for making an unlawful dividend.

If a company has paid an unlawful dividend, it will need to consider how to rectify that position. The shareholders may be able to release the directors from liability and, depending on the circumstances, they may also be able to approve some of the following rectifying actions:

• 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;
• ratifying accounting entries in respect of the unlawful dividend, so that the profits are appropriated in each set of relevant accounts.

Comment

If a company’s distributable profits have been considerably reduced as a result of coronavirus, directors need to be particularly careful when authorising any dividend payments. If they are in any doubt, it is advisable to switch to salary only payments through PAYE rather than risk having to repay the entire dividend to a liquidator at a later date.

If you have any queries about this topic, please contact any member of the Business Protection Team.

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