High Court provides a lesson for directors: questions to ask when reducing capital and paying dividends

High Court provides a lesson for directors: questions to ask when reducing capital and paying dividends

A recent High Court case has highlighted the exposure for directors and potential for personal liability when carrying out common intra-group transactions such as reducing share capital and paying dividends.  Directors should always have their duties to the company (and consider solvency implications with regard to creditors – see below) at the forefront of their minds when deciding to take such actions, and there will need to be careful consideration of the company’s solvency.

The facts involved a subsidiary paying two dividends to its parent.  At the time of each payment, a provision had existed in its accounts for meeting the costs of an environmental clean-up operation under indemnity arrangements.   The directors’ decision to pay those dividends was later challenged on the grounds of breach of their fiduciary duties owed to the company.  It was alleged that the accounts relied on made inadequate provision for the environmental liability, and that the directors should have been mindful of the interests of creditors because the company was at risk of insolvency. 

Directors’ duties owed to the company– when do creditors’ interests override those of members?: The case throws a spotlight on directors’ statutory duties, in particular the duty under section 172 of the Act to promote the success of the company for the benefit of its members as a whole.  This is on the basis that the company is solvent.  It is subject to the proviso that, if the company is approaching insolvency, the directors must consider the interests of creditors. 

On a practical level, what questions should the directors ask to assess whether a company is at risk of insolvency?  The Court said the following:

“The essence of the test is that the directors ought in their conduct of the company’s business to be anticipating the insolvency of the company because when that occurs, the creditors have a greater claim to the assets of the company than the shareholders.”

Testing a company’s insolvency involves asking questions like:

  • does the company’s balance sheet show that liabilities exceed assets?
  • are unpaid creditors pressing for payment?
  • is the  company in a downward spiral of accumulating trading losses, with no or insufficient income? 

In such a situation, directors should think very carefully before taking actions such as paying dividends.

In this case, the duty to creditors had not arisen as there was a real possibility that the company would never become insolvent or even close to it.  Mrs Justice Rose commented that:

“It cannot be right that whenever a company has on its balance sheet a provision in respect of a long term liability which might turn out to be larger than the provision made, the creditors’ interests duty applies for the whole period during which there is a risk that there will be insufficient assets to meet that liability.  That would result in directors having to take account of creditors’ rather than shareholders’ interests when running a business over an extended period.  This would be a significant inroad into the normal application of directors’ duties”

“The risk it faced that the best estimate would turn out to be wrong and that the company might not have enough money, when called upon in the future, is a risk that faces many companies that have provisions and contingent liabilities reflected in their accounts. It is not enough in my judgment to create a situation where the directors are required to run the company in the interests of the creditors rather than the shareholders of the company.”

This is a welcome judgment for directors considering potential for personal liability when providing solvency statements or paying dividends. If you have any queries about your duties to creditors, or general corporate or finance advice, please do not hesitate to contact us.

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