The company law regime’s rules
governing the extraction of money from companies are founded on the capital
maintenance doctrine, which states that capital (ie money which shareholders
have contributed to the company in exchange for its shares) must not normally
be returned to the shareholders. The
regime does not impose a blanket ban on returning capital to shareholders: not only can a company engage in a formal
reduction of capital, but private companies can in certain circumstances carry
out share buybacks out of capital or redeem shares out of capital. The Companies Act 2006 does, however, provide
that dividends may only be paid out of profits, and both the Act and the courts
take any breach of this requirement very seriously.
It might be thought that the
obvious step to take in the event that a company has paid out a dividend
otherwise than out of profits is to pursue those to whom the money has been
paid, namely the shareholders, and the law does, indeed, provide mechanisms for
recovering unlawful dividends from shareholders. In some cases, however, it may be
impracticable or even impossible to recover the dividend from the shareholders,
and so the regime also provides for the directors who were involved in its
payment to refund the full amount paid out.
Shareholders are liable to repay
an unlawful dividend under section 847 of the Act. The effect of that section is that any
shareholder who knows or has reasonable grounds for believing that a dividend
is paid in contravention of the Act is liable to repay it. This may seem to imply that the obligation to
repay a dividend can only ever arise in respect of a shareholder who is aware
of the provisions of the Act, and therefore knows that a dividend may only be
paid out of distributable profits. The
courts have, however, adopted an interpretation of section 847 which is rather
more generous, at least from a company’s point of view: according to the Court of Appeal in It’s a Wrap (UK) Ltd (in liquidation) v Gula
 EWCA Civ 544, the obligation will be triggered in any case in which the
shareholder is aware of the underlying facts which constitute the
contravention. In other words, a
shareholder who knows that his company has no profits will be liable to repay any
dividend which he receives, even if he does not realise that the Act prohibits
the payment of a dividend in such circumstances.
Shareholders also have a residual
liability to repay an unlawful dividend at common law in certain circumstances
(Precision Dippings Ltd v Precision
Dippings Marketing Ltd  Ch 447).
If the shareholders do not
possess the knowledge required to trigger their obligation to repay an unlawful
dividend or if the company has a large shareholder base, such that the costs of
securing repayment from individual shareholders are prohibitive, the company
may wish to pursue the directors instead.
The Act does not deal with the
question of directors’ liability, but the courts have long taken a very dim
view of directors who distribute the company’s assets otherwise than in
accordance with the law. The most famous
case in this area is Re Exchange Banking
Co, Flitcroft’s Case (1882) 21 ChD 519.
The facts, in outline, were that shareholders had declared dividends on
the basis of accounts which recorded as assets various debts which the
directors knew were bad, and which therefore showed that the company had
profits when in fact it did not. When
the company went into liquidation, the liquidator sought an order that the directors
should refund the entire amount of the dividends. The Court of Appeal held that the directors
were liable not only to pay back the dividends which they had received, but
also to refund the company in respect of the dividends which they had paid to
the other shareholders. As Cotton LJ put
it: “directors are in the position of
trustees, and are liable not only for what they put into their own pockets, but
for what they in breach of trust pay to others”.
As to whether a director’s
liability is triggered only if he is culpable in some way, whilst there is no
doubt that a director is liable if he participates in the payment of a dividend
in circumstances in which he knew or ought to have known that it was unlawful,
it is less clear whether a director who is wholly “innocent” is liable. In Holland
v Commissioners for Her Majesty’s Revenue and Customs  UKSC 51,
however, Lord Hope took the view, obiter, that a director’s liability in
respect of an unlawful dividend is strict.
He also pointed out, though, that an “innocent” director could seek to
persuade a court to excuse him under its general power pursuant to section 1157
to grant relief in respect of a director’s liability for a breach of duty or a
breach of trust.
No doubt there may be instances
in which a conscientious and diligent director is tricked by unscrupulous
fellow board members into agreeing to pay a dividend which, it transpires, is
unlawful, and in such cases the director in question may escape liability under
section 1157. Such are the high standards
to which directors are held, though, and such is the importance which the law
attaches to the need to protect creditors’ interests, that in most cases a
director is likely to find it difficult to persuade a court that he took all
reasonable steps to satisfy himself that a dividend which proved to be unlawful
was, in fact, lawful.
Directors are obliged
by virtue of their duty under section 174 to carry out their functions with
care, skill and diligence. Given the
risk that the payment of an unlawful dividend carries in terms of their
exposure to personal liability, they will want to take particular care to
ensure that any dividend paid by the company complies with the law.