What Are Illegal Dividends In Insolvency?

When an insolvent company enters into liquidation, the conduct of directors comes under great scrutiny. As part of the formal liquidation process, an insolvency practitioner will be appointed and will investigate the transactions made by directors to assess whether their actions may have caused the business to become insolvent. Dividend payments will be analysed as part of these investigations and, should illegal dividends be uncovered, the repercussions for the directors of a liquidated company can be severe. It is therefore crucial that company directors understand when dividends can and cannot be distributed to ensure that they do not make any illegal dividends, whether deliberately or not.

What Are Dividends?

To understand how situations whereby illegal dividends are uncovered in insolvency, it is first critical to understand the wider rules surrounding dividends and the scenarios in which they can be made.

Dividends are distributions of profits to shareholders of a company and are typically issued when that company is doing well. The Companies Act 2006 sets out the rules regarding dividends in the UK and rules that dividends must be paid from a company’s profits. This ensures that only excess funds are distributed to shareholders and that all liabilities and ongoing operational costs are covered first. By law, dividends must not be paid out if doing so would leave the company unable to meet its debts as they fall due. 

What Are Illegal Dividends?

Illegal dividends or unlawful dividends occur when a company distributes funds to shareholders in breach of the legal requirements set out in the Companies Act 2006. The most common scenario is when dividends are paid while the company lacks sufficient reserves to justify such payments. 

Illegal dividends can be made both deliberately and accidentally. For example, directors may have knowingly paid out dividends while aware that the company is insolvent or on the brink of insolvency and therefore can be deemed to have deliberately prioritised making dividends over paying liabilities as they fall due. Such payments may also be made on the basis of accounting errors if profits have been overstated or liabilities understated. While illegal dividends made in these circumstances will likely be accidental, the consequences can still be severe.

Consequences Of Illegal Dividends

It’s a common misconception that company directors can run away from their actions when their company is placed into liquidation. The reality is that the conduct of directors will be closely examined by an insolvency practitioner when the company enters into liquidation. If they discover that illegal dividends were issued, directors can be held personally liable for the company’s debts. 

Typically, one of two things will happen if illegal dividends are identified during the formal liquidation process:

• Company directors may have a valid defence against any claim of illegal dividends in insolvency. If you can demonstrate that you acted in good faith based on accurate financial information at the time, and took reasonable steps to comply with the law, you may be able to avoid personal liability. 
• Company directors may face legal action if illegal dividends were made as the result of reckless or fraudulent action. For example, if you deliberately pay dividends to extract funds before insolvency, you may be found guilty of wrongful trading. The penalties for this are incredibly severe and can result in heavy fines, personal liability, disqualification from acting as a director in the future and even a custodial sentence in particularly severe cases of misfeasance.

Advice For Company Directors

While it is possible to avoid personal liability in the event of illegal dividends in insolvency, ignorance of the company’s financial position and failure to exercise due diligence is not a valid defence. Directors are expected to take a number of proactive steps to prevent the payment of illegal dividends in insolvency, including keeping up-to-date financial records and avoiding funding dividend payments through borrowed capital.

If your company is insolvent or you are concerned that things may be heading that way, you should seek professional advice as soon as possible. Engaging with a qualified insolvency practitioner can be key in ensuring that your business is acting appropriately and mindful of the risk of making dividend payments in times of financial uncertainty. 

At My Liquidation, our insolvency practitioners have a vast range of experience and can assist your business in its time of need. Get in touch with us today to discuss how you can navigate insolvency effectively.