At a time when nearly everyone is under financial pressure, company directors must take great care when paying dividends to shareholders. In SME’s this is even more acute when the directors are often the shareholders too.
How are dividends normally calculated?
In simple terms, by reference to the last annual accounts. If they show sufficient distributable profits to meet the Companies Act 2006’s statutory test to pay a dividend then one can be declared.
If more recent accounts have been prepared that show more distributable profits then they can be distributed too,
How much can be paid will depend on the level of distributable reserves. A £100,000 retained profit means dividends of up to £100,000 could be declared. If a further £30,000 of profit is shown in more recent accounts then dividends since your last year end could be £130,000.
If it’s that simple, why should a director be concerned?
As with most things, it is not that simple.
A company needs to maintain it’s capital base. To do that, company directors needs to understand what the financial position is from the balance sheet of the last annual accounts up to the date of the proposed dividend.
This is because the company may have incurred losses since the year end, which will have eroded its distributable profits. An erosion in distributable profits means there is less or, in the worst case scenario, nothing to now distribute.
In addition to this, company directors should consider what is around the corner. If, by declaring a dividend, there is nothing left in the company to allow it to pay its debts as they fall due, the company may close. If that happens this is likely to be through a formal insolvency process.
Once a formal insolvency process commences the insolvency officeholder will examine the conduct of the director(s). Where those holding office as a director have not taken appropriate action to promote the success of the company then personal liability may arise. Promoting the success of the company can include refraining from declaring a dividend if it’s declaration leaves the company insolvent.
So, what should a director consider?
A director must consider the Companies Act 2006 and Insolvency Act 1986 and plethora of case law created by court decisions.
Firstly, make sure you have up to date figures.
Secondly, make sure those figures are reasonable and don’t include items that are years out of date. The reasonableness needs to be on the basis of what is known at this point in time. Impairment of investments, provisions against doubtful debts, the inclusion of deferred tax, or write downs of stock are common areas to consider. On the subject of stock, it is common for the records of any SME to contain a stock value several years out of date. This is because it is common to rely upon ‘the accountant’ to update it at the end of the year. With the extension of the deadline to file accounts, the stock value could easily be nearly 2 years or more out of date.
Thirdly, consider what is around the corner. Are there any onerous contracts that are going to cause a problem if you are about to reduce your number of stores. Perhaps you know the next lockdown means you cannot offer anything other than takeaways. What if you buy goods from overseas and you know 4 week ago they entered a national lockdown – you are clearly about to have supply issues. Consider how will what you can reasonably foresee affect the company’s cashflow needs?
Fourthly, consider whether the carrying values of assets are actually true values. When a company ceases to be a going concern its asset values plummet. If declaring a dividend leaves the company very close to being insolvent or at ‘break even’ then the asset values stated in the accounts may well be questionable. If they were adjusted to reflect their true value, much of the dividend just declared would be illegal.
What is an illegal dividend?
An illegal dividend is a dividend declared out of capital rather than distributable reserves (which is more often than not just the profit and loss reserve).
This article is not designed to discuss the finer detail of what distributable reserves are, but the ICAEW have some useful information here – Document Guidance on Realised & Distributable Profits under the Companies Act 2006 – . Paragraphs 2.2. to 2.10 are the relevant ones.
What are the consequences of paying an illegal dividend?
Well, I am sure you are hoping none is the answer to the question, but the answer is only none in one circumstance.
If a dividend is illegal, but a company remains live AND returns to profitability then it is unlikely anyone will take an issue with it. That doesn’t mean that the ‘illegality’ is cancelled out, it just means nobody will challenge it.
However, if the company falls into some form of insolvency then an insolvency officeholder will take exception to this.
When a company becomes insolvent, the interests of creditors becomes paramount. Therefore, an insolvency officeholder is mandated to see whether anything ‘illegal’ has taken place when looking backwards after their appointment. If it has, then the officeholder is again mandated to challenge it and challenge it in predominantly two ways. One, against the recipient of the illegal dividend, and two against the person who declared it.
This may mean a director is made liable to repay the dividend, which can be an expensive and unexpected consequence for not getting it right.
Can I reverse or cancel a dividend once it is declared?
Once a dividend is declared a strange thing happens in that it can become a debt due to the shareholder. Whether it does or not depends on whether it is an interim or final dividend.
A final dividend becomes a debt once it is declared and approved by shareholders. As a result of this, a shareholder can sue the company for payment of the debt. This means that once a final dividend is declared it cannot be cancelled, nor can it be reversed.
An interim dividend does not however become an enforceable debt and, subject to what the articles may say (if they are standard articles the articles are silent), then the dividend can be cancelled.
But, I relied upon the advice of my accountant, surely that’s ok?
Even the best accountant, who watches your company very closely, cannot be responsible for understanding the precise financial position of your company. It is not their position to know what factors may be around the corner or decide upon their impact.
They may be responsible for making sure accurate figures are available to you, but don’t forget those figures will be based upon whatever you provided. Your accountant cannot know what, if anything, is missing or needs to be considered unless you tell them everything.
Therefore, unfortunately, responsibility starts and finishes with the company director.
We know this is a terrible burden placed on every director, which is why we are here to help in times of financial turbulence. Just like a medical problem, don’t leave it too late to seek advice. You may still receive difficult news by seeking an early consultation, but it will be better than the news you receive when things are worse in 6 months time.
If you would like any further information, advice or support, then do not hesitate to contact me at phil@lucasross.co.uk
