The Dangers of Distribution

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The Dangers of Distribution

10 Dec 2018

As shareholders and/or directors of successful businesses, many of our clients are regularly dealing with distributions, but we find that they are not always aware of the complicated laws surrounding how distributions can be lawfully made. These laws are designed to protect creditors.

What is the danger?

If distributions are unlawful, they can be clawed back by the company. For example, if shareholders receive a dividend from a company, and it is considered to be unlawful, then the shareholders are liable to repay it.

If a director authorises the payment of an unlawful distribution, they will be in breach of their fiduciary duties to the company, such as their duty to exercise reasonable care, skill and diligence. They may be personally liable to repay the distribution to the company (even if they’re not the shareholder who received it!).

What is a distribution?

Unsurprisingly, the definition of a distribution is rather wide in the Companies Act 2006 and covers all manner of things that companies may do frequently; essentially, all returns of value made to shareholders are captured by the definition.

The most obvious example of a distribution is a dividend to shareholders.  Other examples are gifts of cash or assets from a company to a shareholder, or a transfer of property/non-cash assets from the company to a shareholder at an under value (i.e. not at market value).

However, a company waiving a shareholder loan or a parent/sister company assuming a liability that is owed to a third party (without receiving consideration of the same value) are both scenarios that are also captured.

Shareholders/directors need to be extremely careful when deciding to distribute cash or assets or, for example, writing an intra-group loan off as this is usually a distribution.

How to avoid danger – questions to ask

The main two questions a company should ask itself are:

1. Are there sufficient distributable reserves? In other words, are there accumulated, realised profits in the company available to make the distribution?

2. Are these distributable reserves showing in the individual company accounts (whether annual accounts, management accounts or specially prepared accounts)?

In addition, before making a distribution, the directors of the company must also look forward, beyond the date to which the relevant accounts are prepared, in respect of events after the balance sheet and future solvency.

Dangerous distributions

If the answer to either of the above questions is “no” then any distribution made by a company will be considered unlawful.

There are obvious cases of fraud or deliberate false accounting, but breaches of a technical nature also render a distribution unlawful. For example, if a company does not prepare management accounts (and interim accounts are not prepared on this occasion) and the last annual accounts show insufficient distributable reserves, but the management or interim accounts would have shown sufficient profit (had they been prepared), this is still an unlawful distribution.

On the bright side, if a company makes a distribution in excess of its distributable profits, the distribution is only unlawful to the extent of the deficiency – not its entirety – and the repayment of the distribution is only required to the extent of the deficiency.

Staying out of the danger zone

Directors should exercise extreme caution when considering making a distribution.

It is essential that legal advice is sought when there is any doubt about the lawfulness of a potential distribution.

Public Companies

Please note that the above information is based on the rules for a private company limited by shares and a public company is subject to far more onerous criteria.

Please contact Kuits for expert advice in respect of distributions or call us on 0161 838 7806.

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