Give it back – unlawful distributions

Both common law and statute impose strict requirements around distributions by UK incorporated companies to their shareholders. These relate in particular to the prohibition on companies making distributions except out of profits that are available for the purpose – so– called distributable reserves – and the need to evidence these reserves. Full compliance with all aspects of the detailed rules is important, as even a minor technical error will render a distribution unlawful. Where a company pays an unlawful dividend, there are significant consequences. In particular:

• the payment of an unlawful dividend is likely to be considered a breach of each director’s statutory and fiduciary duties, as well as a breach of the Companies Act 2006 (2006 Act);
• each director is liable to repay to the company a dividend paid in contravention of the 2006 Act if they knew, or ought to have known, that the payments were unlawful;
• each shareholder is obliged to repay the unlawful dividend if they knew, or had reasonable cause to believe, that the distribution was not made in accordance with the 2006 Act; and
• even if they didn't know that the distribution was not made in accordance with the 2006 Act, at common law each shareholder holds the money received on trust for the company.

Any company that has made an unlawful distribution will therefore need a remediation strategy. Shareholders cannot ratify the failure to comply with the statutory capital maintenance rules, but steps can be taken to remedy the position. Depending on the circumstances, in the event of an inadvertent or technical breach of the requirements of the 2006 Act, this may involve:

• drawing up interim accounts and filing them;
• taking capital maintenance action to create the correct level of profits in the company making the distribution (eg carrying out a reduction of capital or paying dividends up the group chain); and
• appropriating profits recorded in different accounting periods.

The company is also likely to enter into deeds of release with:

• the recipient shareholders, to release them from any liability to repay amounts received; and
• the directors, to waive any right to pursue any of the directors regarding the decision to make the distribution.

These steps will require shareholder approval. The deeds of release with the company’s directors and any substantial shareholders will also be related party transactions for the purposes of the UK Listing Rules or AIM Rules, as applicable, and so will need to comply with the requirements of the relevant rules.