Dividends are a common way for limited companies to return profits to their shareholders. However, it is crucial for companies, and their directors, to understand the legal requirements surrounding dividends and doing them correctly to avoid serious legal consequences, possible reputation damage, and, for public companies, possible market issues. What constitutes an unlawful dividend, what are the consequences of making one, and what are the possible remedies available in such circumstances?
Distributions and dividends
A distribution by a company is a return of economic value to its shareholders and a way for companies to share their financial success and provide shareholders with a return on their investment. The Companies Act 2006 defines a distribution as "every description of distribution of a company's assets to its members (shareholders), whether in cash or otherwise".
The most common form of distribution by a company is a dividend, which is a distribution of a portion of a company's profits to its shareholders. A dividend is usually paid out in cash but can be satisfied by the transfer of other assets held by the company, which is known as a dividend in specie or dividend in kind. Final dividends are approved by the shareholders following a recommendation by the company's board of directors, whereas interim dividends are declared by the directors alone.
While this Insight will focus on dividends many of the issues discussed will equally apply to other types of distributions.
When making a dividend, a company must comply with provisions set out in Part 23 of the Companies Act 2006 which specify how a dividend can lawfully be made so as to not offend the principle of capital maintenance, and also common law capital maintenance rules (that is, retaining sufficient assets within the company to meet ongoing creditor obligations).
The process for making a dividend must be considered on a case by case basis with the company's articles of association potentially setting out additional requirements and details of how a dividend can be made. This may be more complex where a company has multiple classes of share capital or varying rights attaching to its shares. Also, any process for making a dividend will be slightly different and more involved in respect of public companies, as additional rules apply.
Understanding unlawful dividends
An unlawful dividend is a distribution of profits that does not comply with the legal requirements set out in the Companies Act 2006 or the common law. Failing to comply with the articles will not make a dividend unlawful, and it may be capable of being ratified, but there are other problems that will arise that are outside the scope of this Insight.
Common scenarios where dividends may be considered unlawful include:
- Insufficient distributable profits: dividends can only be paid out of the company's distributable profits, meaning its accumulated realised profits less its accumulated realised reserves. If a company pays dividends without having sufficient profits available, it will be deemed unlawful. It can be difficult for companies to establish whether particular amounts within profit and loss account are realised, or not, and this may require substantive accounting analysis.
- Failure to comply with formalities: the Companies Act 2006 sets out specific requirements regarding the process and documentation for declaring and paying dividends. Failure to comply with these formalities can render the dividend unlawful. This includes justifying a dividend with reference to consolidated accounts, accounts that do not give a true and fair view of the company's financial position, interim accounts not being prepared and the last annual accounts showed insufficient distributable reserves (even though sufficient reserves would have been shown had interim accounts been prepared), or a historical set of annual accounts in circumstances where there has been a failure to prepare annual accounts for the relevant financial year.
Impact of an unlawful dividend
Although the Companies Act 2006 does not contain any specific offences in respect of making a dividend that is deemed to be unlawful, the consequences of such a dividend can still be widespread, potentially affecting the shareholders, directors and the company itself:
- Shareholders who know, or had reasonable grounds to know, that the dividend was unlawful will be liable to repay the dividend received or a cash equivalent sum in the case of a dividend in specie (to the extent that it was unlawful); there may be a greater risk of being required to repay in the case of insolvency of a company.
- Directors of a company making an unlawful dividend may be in breach of their own fiduciary duties in authorising or permitting the company to make an unlawful dividend and can be personally liable to repay the amount of the unlawful dividend themselves.
- The unlawful dividend will always remain unlawful; it cannot be rectified so that it is lawful.
- The company's accounts may contain errors and will need fixing and this may mean that other transactions carried on the basis of their contents are tainted too.
- A company can itself be impacted by appearing balance sheet insolvent in respect of the unlawful dividend being included within its accounts. This could mean the company may have difficulties in obtaining credit from lenders or suppliers, and it may be in breach of existing arrangements which could have further implications for the business.
- Where a dividend relating to a prior year's accounts is deemed unlawful, there may be requirements for amendment and restatement of those accounts and there may be potential liability on the directors in respect of a misstatement of accounts.
Remedying an unlawful dividend
In some corporate circumstances, the shareholders of a company are able to ratify the company's actions authorised by the directors to remedy an apparent breach of duty. However, such an action is not available in respect of an unlawful dividend since this is an ultra vires act.
Further, as the legality of the dividend is considered at the time it is made and the relevant formalities are required to be complied with at that point in time, it is not possible to retrospectively legalise an unlawful dividend. An unlawful dividend cannot be resolved by characterising it as some other type of payment either.
It is possible to remedy or otherwise mitigate some of the negative consequences that may arise following an unlawful dividend, provided the company is not insolvent. While the available options will depend on the specific facts leading to the unlawful dividend, and legal, tax and accounting advice should be sought in respect of the specific circumstances, potential options include:
Addressing the original issue: the company should seek to remedy the fact or issue that resulted in the purported dividend being unlawful. For example, where a dividend is unlawful due to a failure by a public limited company to file interim accounts, the company should ensure that those accounts are appropriately filed.
Appropriating the distributable profits to the payment of the dividend: the shareholders can authorise, by way of a special resolution, to ratify the accounting entries in respect of the unlawful dividend by appropriating the distributable profits of the company to the payment of the unlawful dividend, provided that the accounts now do show sufficient profits. This should take effect so that the distributable profits are appropriated with reference to the same record date as the original accounting entry of the unlawful dividend.
Release of shareholders: the company may enter into a deed of release pursuant to which it agrees to waive and release any and all claims which it has or may have against any of its shareholders in connection with their receipt of the improper dividend and under which it agrees to release them from any and all liability that they have or may have to the company in respect of it.
Payment of dividend: the release in favour of the shareholders itself is a distribution by the company in an amount equal to the original (unlawful) dividend and so the company would need to comply with all requirements (such as having sufficient distributable reserves at the time of the release).
Release of directors: the company may also enter into a separate deed of release with the directors under which it agrees to waive and release any and all claims which the company has or may have against its directors and former directors in connection with the making of the improper distribution.
Correction of accounts: accountants may advise that the accounts need corrections.
Osborne Clarke comment
An unlawful dividend can create a myriad of issues for a company and can be costly to resolve. It is always preferable to follow the requisite legal procedures when making a dividend, or any other kind of distribution, and having taken legal, tax and accounting advice, where appropriate.
For material dividends or public companies, involving auditors early in the process or asking them to review the company's interim accounts can prevent a number of issues.
Where an unlawful dividend has or is believed to have occurred, the directors should seek appropriate advice to understand the relevant facts in their circumstances. There are always steps that can be taken to mitigate the consequences, but it is important that appropriate advice is gained in the first instance.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.