Dividends are payments made by a company to its shareholders out of its profits or reserves. These payments are a way for shareholders to receive a return on their investment in the company. Directors are typically responsible for declaring dividends and must do so in accordance with legal and financial standards.
What Makes Dividends Unlawful?
Unlawful dividends, sometimes known as illegal dividends, occur when these payments are made without adhering to specific legal requirements. The legality of a dividend largely depends on whether the company has sufficient distributable profits. Distributable profits are calculated after considering all expenses, liabilities, and provisions for future losses. If a dividend is paid out when a company does not have enough profits to cover it, it becomes unlawful.
The implications of paying unlawful dividends become particularly severe when a company is in liquidation. In such scenarios, the financial stability of the company is already compromised, and the payment of dividends can further aggravate the situation. It’s important to understand that during liquidation, the primary obligation of a company shifts towards settling its debts with creditors. Paying dividends in this context not only violates legal norms but also jeopardizes the interests of creditors.
What Are The Conditions For A Dividend?
In the UK, the declaration of dividends is governed by a set of specific conditions to ensure legality and fiscal responsibility. These conditions include:
Condition 1
Availability of Sufficient Distributable Profits
This is the cornerstone of lawful dividend payments. A company must have adequate profits available after accounting for all expenses, taxes, and necessary reserves. These profits are not just the current year’s earnings but also include any retained earnings from previous years.
The key is that the company can only distribute what is available as ‘realised profits’, not based on projected earnings or unrealized gains.
Condition 2
Adherence to the Company's Articles of Association
The Articles of Association may have specific provisions regarding dividend payments, including the process for declaring dividends, any restrictions, and the rights of different classes of shareholders. It’s crucial that directors are fully aware of and comply with these provisions.
The Articles may also outline the procedure for interim dividends, which are dividends paid before the company’s annual profits are determined.
Condition 3
Approval from the Board of Directors
The decision to declare a dividend typically originates from the board of directors. They must make an informed decision based on accurate and up-to-date financial information. This decision should then be ratified by the shareholders, usually at a general meeting.
For interim dividends, the board may have the authority to declare these without shareholder approval, but this depends on the company’s specific Articles of Association.
Condition 4
Compliance with Legal Requirements
The Companies Act 2006 in the UK sets out certain legal requirements for dividend payments. For instance, the Act stipulates that a company can only make a distribution to its shareholders out of profits available for the purpose, after taking into account its accumulated, realized losses.
Condition 5
Consideration of Future Company Solvency
When declaring dividends, directors must also consider the long-term financial stability of the company. Even if a company has sufficient distributable profits, paying out a large dividend that jeopardizes the company’s ability to continue as a going concern would be against the directors’ fiduciary duties.
Questions & Answers about Unlawful Dividends
Here are some frequently asked questions that will help you understand Unlawful Dividends.
Common Circumstances Where Dividends Might be Paid Illegally
Dividends may be paid illegally in a variety of situations. These include:
Declaring Dividends Without Accurate or Up-to-Date Financial Statements: This often happens when directors do not have a clear and current understanding of the company’s financial health. Declaring dividends based on outdated or inaccurate financial data can lead to unlawful distributions if the company does not have sufficient distributable profits at that time.
Overestimating Profits or Underestimating Losses and Liabilities: This scenario involves a misrepresentation (intentional or unintentional) of the company’s financial status. If dividends are declared based on these inflated profits or downplayed liabilities, they may be unlawful, as the actual financial position does not support such distributions.
Paying Dividends During Financial Distress Without Considering Future Obligations: When a company is facing financial challenges, paying dividends can exacerbate its financial difficulties. If dividends are paid without taking into account the company’s ability to meet its future obligations, including debts and operational expenses, these payments can be deemed unlawful.
What are the Risks on Company Directors for Paying Unlawful Dividends?
Directors who authorize the payment of unlawful dividends face several significant risks:
Personal Liability to Repay the Amount of the Illegal Dividend: Directors can be held personally responsible for the repayment of dividends that were distributed unlawfully. This means that directors might have to pay out of their personal assets to cover the amount of such dividends.
Legal Action for Breach of Fiduciary Duty: Directors have a fiduciary duty to act in the best interests of the company and its stakeholders, including creditors, especially in times of financial uncertainty. Paying out unlawful dividends can be seen as a breach of this duty, leading to legal action against the directors.
Potential Disqualification from Serving as a Director: In severe cases, directors who are found to have knowingly or negligently authorised unlawful dividends can face disqualification from holding any directorship for a period of time. This not only impacts their current position but also affects their future opportunities in directorial roles.
Do Directors Have to Repay Unlawful Dividends?
Yes, directors may be required to repay unlawful dividends. This requirement is based on the principle that directors must act in the best interest of the company and its creditors, especially in situations of insolvency. If dividends are paid out unlawfully, directors could be held personally responsible for reimbursing the company.
Can Dividends be Paid to Non-Shareholders?
Generally, dividends are paid only to shareholders as they are returns on investment in the company’s equity. However, there may be specific arrangements like dividend-equivalent payments under certain employee incentive plans. Such arrangements should be carefully structured to comply with legal and tax regulations.
Authorised by the Insolvency Practitioners Association
Members of the Association of Business Recovery Professionals (R3)
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Member of the Institute of Chartered Accountants in England and Wales
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