Law clarified on unlawful distributions of dividends

The Court of Appeal decision in It’s a Wrap (UK) Limited v Gula has resolved a difficult issue with regard to the right of a company to require shareholders to repay unlawful distributions. Recovery of unlawful dividends becomes an issue perhaps most frequently when the company has become insolvent or otherwise runs into financial difficulties; the most high profile example in recent years involved Queens Moat Houses plc (where remedies were sought on common law grounds against the directors).

In the “It’s a Wrap” case, the company had made trading losses and there were no retained realised profits. Apparently acting on advice from accountants, the directors (who were the only shareholders) deliberately, in order to gain a tax advantage, classified certain amounts taken by them as salary during the year as dividends.

Section 277(1) of the Companies Act 1985 provides that, if a distribution is made by a company in contravention of the restrictions in the Act, and the shareholder knows or has reasonable grounds for believing that it is so made, he is liable to repay it. The case turns on the meaning of “he knows or has reasonable grounds for believing that it is so made”. Does he have to have knowledge of the facts constituting the contravention or must he also know that those facts involve a contravention of the Act?

The judge at first instance thought that the shareholder had to know that the facts involved a contravention. This has now been reversed by the Court of Appeal. Their reason is based largely on the need to interpret section 277 in conformity with article 16 of the Second EC Directive on Company Law, which it is designed to implement. The Court of Appeal held that, on its true interpretation, article 16 of the Second Directive means that a shareholder is liable to return a distribution if he knows or could not have been unaware that it was paid in circumstances which amount to a contravention of the restrictions on distribution in the Second Directive, whether or not he knew of those restrictions. This means that, under section 277, the shareholder will be liable if he knew or ought reasonably to have known of the facts which meant that the distribution contravened the requirements of the Act. It does not help him to claim that he did not know of the restrictions in the Act.

The first instance decision was generally thought to be incorrect, especially as it seemed to open the way for a shareholder to say that, although he knew the facts, he did not know that there was a contravention of the Act – even if, as in the case, he was a director. The Court of Appeal has now remedied this. It remains unclear, incidentally, why the company chose a remedy under section 277 rather than to pursue the defendants as directors. There is ample authority that directors who authorise an unlawful payment are jointly and severally liable to account to the company for the whole amount of the unlawful distribution, as in the Queens Moat Houses case.