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Directors cannot avoid unlawful distribution claims by re-categorising payments as remuneration

Directors cannot avoid unlawful distribution claims by asserting that dividends should be retroactively re-categorised as remuneration for services they have provided to the company, the Court of Appeal has confirmed in Global Corporate v Hale [2018] EWCA Civ 2618

The court confirmed that the legality of a payment to directors must be tested at the time when it is made.  Any "subsequent realisation that the distributions should not have been made" will not cure an unlawful distribution.

This will be welcome news for insolvency practitioners (IPs) currently investigating and pursuing claims against directors.  It sets aside an unhelpful first instance decision and confirms that a distribution described as a dividend but not paid out of distributable reserves will be unlawful.

First instance decision

Powerstation UK Limited (the company) had two directors, who were also its sole shareholders and only full time employees.  When the company began to experience financial difficulties, the directors restructured their remuneration.  They reduced their monthly salaries to £456 each, and received an additional £1,383 each per month by way of dividend.  At the end of the financial year the company's accountant would check whether or not there were sufficient distributable reserves out of which a dividend could be declared.  If there were not, the £1,383 payment would be re-characterised for accounting purposes and attract a PAYE charge. The directors completed dividend tax forms throughout the year. 

The company went into liquidation, and the liquidators assigned the claim against one of the directors to a third party.  The third party brought a claim to recover the sums paid to the director during the period when the company had no distributable reserves. 

HHJ Matthews held that:

  • There were no distributable profits out of which dividends could lawfully be paid at the relevant times.
  • On the evidence before the court the payments were not dividends.  The director did not think that he was making a definitive decision about the nature of the payments (despite completing tax forms suggesting the contrary).  Treatment as a dividend was decided only in principle each month, with the formal decision left to be made at year end. 
  • If no dividend was declared, but the payments were made, then, whatever the nature of the payments made to the director, they were not dividends, and the director could not be liable to repay them as unlawful distributions.
  • The director was entitled to a reasonable sum in remuneration for the services that he provided to the company in order to prevent the company being unjustly enriched at his expense.  Accordingly, in causing the company to make the payments the director was causing it to satisfy its liability for services provided.  This was not misfeasance justifying a claim under section 212 Insolvency Act 1986.  Neither was it a transaction at an undervalue, because the company had received services in return for the payments.

Subsequent High Court decisions

The first instance decision in Global Corporate v Hale was questioned in two subsequent High Court judgments.  Both declined to apply the unjust enrichment approach.  They noted that HHJ Matthews had not had the opportunity to consider the decision of the House of Lords in Guinness plc v Saunders [1990] 2 A C 663 because this case had not been cited in argument before him. 

In 1990 the House of Lords heard an appeal of a former director of Guinness plc against a judgment for £5.2 million.  The director had been paid that sum by a committee of the board for services he had provided.  The director claimed that the committee had the power to make the payment under the company's articles of association or, in the alternative, that he was entitled to a reasonable sum for his services in order to prevent the company's unjust enrichment at his expense.

The court held that the equitable principle that a director cannot make an unauthorised profit from his position trumped the unjust enrichment argument.  As neither the contract for services nor the payment to the director had been entered into in accordance with the company's articles of association, the director was not entitled to the sums he had been paid. 

Court of Appeal decision

The applicant appealed the Judge's dismissal of the claim to recover the sums paid to the directors as unlawful dividends.  There was no appeal against the dismissal of the measfeasance, transaction at undervalue and preference claims. 

Lord Justice Patten delivered the leading judgment.  He held that:

  • The Judge's ultimate finding at first instance was based on a new line of cross-examination introduced by the Judge himself for which there was no evidential basis before the court.
  • "At the point of payment the monies were…gratuitous distributions from the company's assets which had the effect of increasing the deficit on its balance sheet…it is immaterial that a subsequent realisation that the distributions should not have been made would prompt their being treated as remuneration. That cannot cure the illegality of the original payment."
  • The Judge at first instance had erred in concentrating on the directors' state of mind when authorising the payments, and should instead have focussed on whether or not the payments were lawful distributions of the company's assets.

Patten LJ referred briefly to the decision in Guinness plc v Saunders, and noted a further difficulty with any attempt by a director to rely on a unjust enrichment claim as a defence and set off against a misfeasance claim.  Once a company is in liquidation, any such claim would be an unliquidated claim for compensation which would need to be proved in the liquidation. 

Lady Justice Asplin and Lord Justice Coulson agreed with Patten LJ's conclusions and reiterated his criticism of the Judge's approach to cross-examination at first instance.

Implications for IPs

IPs will welcome the Court of Appeal's decision.  The judgment confirms that a dividend not paid out of distributable reserves is unlawful.  The legality of any such payment should be tested as at the date it was made.

Equitable principles prohibit directors (as trustees) from making an unauthorised profit.  These principles take priority over any entitlement a director may have to receive payment for services provided to the company.  Directors don't have a free pass to re-categorise dividend payments as remuneration after the event simply in order to avoid an unlawful distribution claim by the company, even when following advice from external advisers.  There will be a collective sigh of relief from insolvency professionals that this controversial High Court decision has been set aside.

Contributor: Tessa Durham

This publication is intended for general guidance and represents our understanding of the relevant law and practice as at December 2018. Specific advice should be sought for specific cases. For more information see our terms & conditions.

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