When can an insolvency practitioner pursue directors for declaring unlawful dividends?
Does an insolvency practitioner need to demonstrate that the directors knew, or ought to have known, that the dividend was paid unlawfully, or is it a strict liability issue?
Can director/shareholders rely on professionally prepared accounts to avoid liability?
Dividends paid prior to a company entering into an insolvency process are often subject to scrutiny by the insolvency office-holder. The issue is a common one for owner-managed businesses where for tax purposes, directors often elect to draw a nominal salary to satisfy the national insurance threshold, whilst taking the majority of their earnings via interim dividends.
However, if the business enters into an insolvency process and the insolvency practitioner can demonstrate that the company did not have sufficient retained profits at the time the dividends were paid, then the recipients of those dividends are liable to repay the sums received in full.
This can therefore be both a significant liability for directors/shareholders, and a significant realisation for the insolvency estate.
There have been a series of recent cases examining the circumstances in which a dividend can be challenged on the basis that it has been unlawfully paid. See our previous blogs on those cases Careful consideration can pay dividends and When is a decision to declare an interim dividend a decision?
The latest case is Burnden Holdings (UK) Ltd (in liquidation) v Fielding  EWHC 1566 (Ch), in which the High Court had to consider a number of key principles regarding the payment of dividends and the circumstances in which the directors can be pursued for dividends paid prior to an insolvency.
The judgment provides some comfort to directors who rely on professional advisers in determining whether to declare a dividend payment. Provided they take reasonable steps to establish that there are sufficient reserves out of which to declare a dividend (and relying on third-party professional advisors can help with that), directors may not be personally liable if such dividends turn out to be unlawful in hindsight.
In October 2007, the Burnden group of companies demerged one of its subsidiaries from the group’s holding company. The holding company was financed principally by its director-shareholders. The de-merger was structured so that the holding company distributed the shares in the subsidiary to the shareholders by way of a dividend in specie, following which a number of the shares would be sold to a third party buyer. Half of the sale proceeds were then loaned to the holding company, to assist the group’s cash-flow.
In October 2008, the holding company entered into administration, and subsequently entered compulsory liquidation in December 2009. The liquidators challenged the dividend on a number of different bases. One of the primary issues of interest in the case was did the liquidators need to demonstrate that the directors knew or ought to have known that there were insufficient reserves to justify the dividend, or is it a strict liability issue?
Fault based or strict liability?
The judge held that he liquidators needed to demonstrate that the directors were aware, or ought to have been aware of the facts that would have given rise to the dividend being unlawful (such as a material liability being omitted from the accounts), even if the directors did not actually appreciate that those facts would mean that the dividend was unlawful. This was not therefore a strict liability offence and required an element of fault.
The decision is in contrast to a provisional (non-binding) view stated by Lord Hope in the Supreme Court case of Re Paycheck Services 3 Limited  UKSC 51.
Relying on third party advisors?
As a matter of fact, the judge found that there were sufficient reserves to enable the dividend to be declared but ruled that even if there were insufficient reserves, the directors would not have been culpable in declaring the dividend, because it was reasonable for them to rely on their finance colleagues and external professionals to ensure that the accounts justifying the dividend were properly prepared.
The facts of this case are complex, and the case ultimately came down to the fact that the judge found that the holding company did have the required reserves to enable the dividend to be lawfully declared.
However, the judge’s comments regarding whether or not the liability of the directors is strict or fault-based are worth noting.
It appears that a Court will have sympathy with directors who reasonably rely upon their advisors to advise them whether or not a dividend can be lawfully paid, even if it transpires that the accounts that were used to justify the dividends contained errors (providing that the directors were not aware of those errors).
It is also a reminder that transactions which would otherwise be justifiable if the company were solvent, may be challenged if the company subsequently enters into an insolvency process. That is a risk, and also one which comes at a cost.
Even though the directors successfully resisted the claim, no doubt, the directors will have incurred significant legal costs in resisting the claims, and a proportion of those costs will inevitably be irrecoverable.