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Law for Business

Knowhow - guidance - precedents

02 FEB 2015

Did you know ... that directors may have to refund the full amount of any unlawful dividend?

Did you know ... that directors may have to refund the full amount of any unlawful dividend?
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’ liability

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 [2006] 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 [1986] Ch 447).

Directors’ liability

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 [2010] 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.

Practical implications

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.

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