An unlawful payment of dividends, often termed an "illegal dividend," occurs when a company distributes money to its shareholders without having sufficient distributable profit to cover the sum paid. This means the dividend is not paid out of accumulated realized profits, but effectively out of the company's capital, which is generally prohibited by company law. Directors bear significant responsibility for ensuring that dividends are only paid lawfully.
Understanding Unlawful Dividend Payments
A dividend is a distribution of profits by a corporation to its shareholders. For a dividend to be lawful, it must be paid out of distributable reserves. These reserves typically consist of accumulated realized profits (less realized losses) that have not been previously distributed or capitalized.
What Constitutes Distributable Profit?
Distributable profit is not simply the cash a company has in its bank account. It is a legal and accounting concept determined by specific rules, primarily under company law. In many jurisdictions, such as the UK under the Companies Act, distributable profits are generally defined as accumulated realized profits, so far as not previously distributed or capitalized, less accumulated realized losses, so far as not previously written off in a reduction or reorganization of capital duly made.
- Realized Profits: These are profits that have actually been earned and can be determined with reasonable certainty. Unrealized gains (e.g., an increase in the value of an asset that hasn't been sold) generally cannot be distributed.
- Accumulated: The calculation considers the company's entire profit and loss account history, not just the profits of the current financial year.
Directors have a duty to ensure they understand the company's financial position thoroughly before declaring and paying dividends.
Key Characteristics of an Unlawful Dividend
An unlawful dividend is typically characterized by:
- Insufficient Distributable Reserves: The most common reason, where the company's accumulated realized profits are not enough to cover the dividend payment.
- Payment from Capital: Effectively, the dividend depletes the company's capital base, which is crucial for creditor protection and the company's long-term stability.
- Non-Compliance with Articles of Association: A company's Articles of Association may impose additional restrictions on dividend payments that must also be adhered to.
- Lack of Proper Procedure: Even if profits exist, dividends must be properly declared by resolution (e.g., board resolution for interim dividends or shareholder resolution for final dividends) and recorded.
Consequences and Risks
The implications of an unlawful dividend can be severe for all involved parties.
For the Company
- Financial Instability: The company's financial health can be severely damaged, potentially leading to insolvency if capital is unduly depleted.
- Reputational Damage: Unlawful payments can signal poor governance and financial mismanagement, harming the company's reputation with lenders, suppliers, and potential investors.
For Directors
Directors face the most significant personal risks due to their fiduciary duties.
- Personal Liability: Directors who approve unlawful dividends may be personally liable to repay the amount to the company, especially if they knew or ought to have known the payment was unlawful.
- Breach of Fiduciary Duty: Paying an unlawful dividend can constitute a breach of a director's duties to act in the best interests of the company and to exercise reasonable care, skill, and diligence.
- Disqualification: In serious cases, directors could face disqualification from acting as a director for a specified period.
For Shareholders
- Obligation to Repay: Shareholders who receive an unlawful dividend may be required to repay it to the company, particularly if they knew or had reasonable grounds to believe the dividend was unlawful.
- Reduced Share Value: The company's financial distress resulting from unlawful dividends can significantly reduce the value of their shareholding.
Preventing Unlawful Dividend Payments
Preventing unlawful dividends requires diligent financial management and adherence to legal requirements. Directors must exercise great care when issuing dividends.
Best Practices for Directors
- Thorough Financial Due Diligence: Always ensure an accurate and up-to-date assessment of the company's financial position, specifically its distributable reserves, before declaring any dividend. This often involves reviewing the latest management accounts and audited financial statements.
- Accurate Accounting Records: Maintain meticulous and accurate accounting records that clearly show the company's profit and loss history and the current balance of its distributable reserves.
- Proper Documentation: Ensure all dividend declarations are properly documented with board resolutions and signed dividend vouchers for each shareholder.
- Professional Advice: Regularly consult with qualified accountants and legal professionals to confirm the legality of proposed dividend payments, especially in complex situations or if there are any doubts about distributable profits. This helps ensure compliance with company law and avoids potential pitfalls.
Regular Financial Health Checks
- Monitor Profit & Loss and Balance Sheet: Continuously monitor the company's financial performance and position to anticipate any shortfalls in distributable profits.
- Understand Distributable Reserves: Directors should have a clear understanding of how distributable reserves are calculated and what can legally be paid out as dividends.
By adhering to these principles, companies can ensure that dividend payments are lawful, protecting both the company's financial stability and the personal liability of its directors.
