When directors fail to keep a proper eye on the state of a company’s finances, there are risks involved, including difficult judgments when a company is in economic difficulty but not yet in the position where it needs to be wound up.

Global Corporate Limited v Hale [2017]

In Global Corporate Limited v Hale [2017], the Court scrutinised a financial arrangement which is, or certainly was, common for many SMEs, where directors who are also shareholders are paid a relatively modest amount by way of employment income (set at a level sufficient to discharge national insurance contributions), and extract the remainder of their money from the company by way of dividend.

There is nothing generally ‘wrong’ with such arrangements from a legal perspective. However, it is important that a remuneration structure which involves reliance on dividends is properly considered and documented on a regular basis. Dividends can only be paid in accordance with the arrangements set out in a company’s constitution and in compliance with the Companies Act – the main requirement being that there must be distributable profits available to fund any dividend.

Consequences of paying dividends incorrectly

In our experience the extent to which this is addressed correctly varies dramatically from company to company; this is not just minor legal compliance. If a dividend is declared in contravention of the Act, it will be unlawful. This problem may not always manifest itself immediately, but if it hasn’t already done so it is likely to crystallise if, for example, the company is sold, or wound up. The consequences can be fairly severe and directors/shareholders may be obliged to repay the relevant amounts.

These issues around dividends come into even sharper focus if a company is struggling financially, despite its accounts showing that it has distributable reserves available to fund the payment of dividends. There is no offence under English law of simply trading whilst insolvent. However, it is incumbent on directors to monitor the financial condition of the company and if a point is reached at which there is no reasonable prospect of avoiding an insolvent liquidation, immediate steps should be taken to wind the company up or put it into administration.

Furthermore, even if a company is lawfully continuing to trade whilst insolvent, the normal overriding duty to act in the interests of shareholders is replaced by a duty to act in the interests of creditors.

Paying dividends in financial difficulty

On this basis, a practice of paying out dividends when the company is clearly in financial difficulty, particularly if paid out in the immediate run up to liquidation is potentially susceptible to challenge and could create personal liabilities for the directors concerned. 

In Global Corporate Limited v Hale [2017], the Court considered dividend payments which had been made by a company in the period between June 2014 and October 2015, when the company had gone into voluntary liquidation in November 2015. The company’s normal practice was to make payments which were labelled as dividends throughout the financial year, but to have a reconciliation at year end to check that distributable profits were available to justify this. If no distributable profits were available, the payments were re-characterised accordingly. Whilst this is certainly not best practice, it was intended to comply with the substance of the legislation, and indeed in some previous years this had led to dividends being treated as payments of employment income.  

However, no distributable profits were available to justify the dividends in dispute in this case, and because of the timing of the liquidation, the normal year end reconciliation had not been carried out.

Conclusion

Various arguments were raised as to whether the dividends were lawful, and in particular whether dividend payments which were made when the company must have been contemplating liquidation could amount to a transaction at an undervalue or an unlawful preference under insolvency legislation.

On the facts of this case, the Court was willing to find that these arguments had not been made out. The Court was willing to accept the defendant’s argument that the relevant monies should in fact be treated as payments for services rendered, and that this was the intention of the parties at the time, rather than dividends. 

However, this decision was very much based on the particular circumstances of the case. It is telling that the claimant had thought the claim sufficiently worthwhile to pursue the relevant directors all the way to the High Court. This decision should not hide the general need to be cautious in this type of situation.