Paying Dividends – The Consequences of Paying Illegal Dividends

As the full impact of the Covid-19 Pandemic is becoming clear, we have seen that it has led to drastically increasing numbers of corporate failure and, as part of the process of investigating both Voluntary and Compulsory Liquidations, dividend payments will be scrutinised for legality by Insolvency Practitioners.

Some directors may face a Misfeasance Claim as a result and will be forced to repay dividends.

The adverse impact of Covid-19 on the trading fortunes of a company means that Directors, as business owners, need to tread more carefully than ever as they may be personally liable to repay Dividends when their company goes into liquidation, if the dividend payments have been made unlawfully. Director Disqualification can also be a consequence. As Insolvency Practitioners we find that the law on the payment of dividends is often not widely understood amongst company directors. Nor are the potentially serious consequences of paying illegal dividends, even if the payment was accidental or unintentional.

In this article we look at when a dividend is not legitimate, and whether directors should even consider paying dividends in this pandemic-affected business environment. We also give some advice to directors on what steps they can take to ensure they remain compliant.

What are the rules on the Payment of Dividends?

The rules regarding the payment of dividends are laid down in the Companies Act, 2006 which states:

“a dividend or distribution to shareholders may only be made out of profits available for the purpose.”

In addition, a dividend is also likely to be deemed illegal if:

These rules apply not only to dividends, but to any form of distribution to Shareholders. Put simply, a distribution is any transaction that transfers value to a Shareholder, or any other related party. This includes, but may not be limited to, gifts and other transactions at undervalue.

Typically sums taken out of the company by business owners (for example: school fees, non-business personal expenses, holidays, etc.) are charged to their personal Directors’ Loan Accounts (DLA) during the company’s financial year, which creates an overdrawn position. The company then, to redress that overdrawn position, declares a Dividend to repay the sums due before the company’s Accounts are finalised.

Dividends are different to other earnings because they represent a distribution of post-tax profits to the company’s Shareholders, payable to all Shareholders in proportion to their shareholding. But they can only be paid lawfully if there are profits available.

The key difference, compared to remuneration, is that (in the event of an insolvency scenario) Shareholders and Directors are legally required to repay unlawful Dividends received if they knew or ought to have known that the dividends were paid unlawfully.

What are the profits available?

To determine profit available, the first port of call is usually the last set of annual Accounts. The balance will often show ‘retained’ earnings or ‘accumulated profit and loss’ reserves. It is particularly important to determine which amounts of those reserves qualifies as available to pay Dividends.

By law, only those profits that have been ‘realised’ are available for distribution as a Dividend. Profits from normal trading activity are typically realised profits, as opposed to unrealised profits from, for example, a revaluation of the company’s property, which are not automatically available for distribution until the revaluation is realised.

Further issues may arise if the company is subject to an audit, and additional considerations apply where the auditor’s report is qualified. Under the Companies Act 2006, an auditor’s statement will be required, confirming that the qualification does not affect the proposed Dividend.

A dividend is still illegal even if it has arisen due to a miscalculation of profits, poor record keeping or even “bad advice” from an accountant or other professional advisor. Claiming lack of knowledge or awareness of the rules surrounding dividend payments does not exclude you from being forced to repay an illegal dividend.

Directors should also be mindful of the future financial position of the company; as this must also be a clear consideration when deciding to declare a Dividend. If you cannot evidence that you carefully considered the future financial impact of declaring a Dividend, any defence to a claim against you will be compromised.

What if the financial position has deteriorated since the last Annual Accounts?

Directors must consider the company’s position carefully, as any deterioration since the date of the last Annual Accounts will reduce the reserves from which a Dividend may be paid. Many companies affected by the impact of Covid-19 could well find themselves in this position; certainly given a large proportion of businesses have taken advantage of BounceBack Loans or other forms of repayable financial support. Any subsequent losses could eliminate the potential for legitimate Dividends to be paid. A careful eye needs to be kept on matters.

This is of particular concern where business owners have made regular withdrawals, and debited the amounts to their overdrawn DLAs, with the intention of remedying the overdrawn loan position through the declaration of a Dividend at a point in the future (often their financial year end). If the company falls into insolvency either before the position is regularised, or without sufficient financial reserves from which to properly declare a Dividend, the Director will find themselves liable to a claim from a Liquidator to either repay their overdrawn DLA, or to repay an illegal dividend. Directors must remember that a Liquidator has varying statutory duties, which include the investigation of DLA’s and Dividends. Those duties exist whatever the manner of insolvency; the act of retaining a Liquidator to place your business into Voluntary Liquidation does not mean that matters won’t be thoroughly investigated.

What if the financial position has improved since the last accounts?

In this case, new accounts should be drawn up to determine the profit available for distribution. Subject to the ongoing working capital needs of the business (and again with one eye on the future), Dividends may then be declared and money withdrawn from the business.

Should the company pay dividends, even if it has profits available?

Directors must always consider the potential impact paying Dividends might have on a company’s cashflow. Will the company remain solvent? This means considering the immediate cash flow implications of a Dividend, and the continuing ability of the company to pay its debts as they fall due.

Talk to us if your company is facing Financial Difficulties and you are concerned about Illegal Dividends

We can offer guidance in this area to help ensure directors remain compliant with regulations and are not at risk of personal liability. This is important because what might look like a healthy cash flow and strong existing profits can sometimes lead to a mistaken sense of security; especially in the current financial environment. Directors working under a genuine belief that their company is solvent, may find upon further investigation that a future liability such as Corporation Tax or a BounceBack Loan projects a quite different picture and places the company into an insolvent position. Under these circumstances, what were thought to be lawful dividends become unlawful very quickly.

Lawrence King, Licensed Insolvency Practitioner and Partner at our Thames Valley, Abingdon office points out that:

“Directors will face huge pressure to justify their actions when insolvency is combined with the payment of unlawful dividends. For that reason, it is vital that Licensed Insolvency Practitioners are approached for advice if insolvency and the issue of illegal dividends looms.

We offer guidance in situations such as this, and the sooner we are consulted on such matters the more we can do to help.”

Please contact us or call any of our offices, below, for a FREE initial discussion with our insolvency practitioners on the phone or over a coffee.

Also, K&W Recovery, trading as Antony Batty and Company, Thames Valley: