High Court clarifies extent of directors’ and shareholder’s liability in relation to unlawful distribution

The High Court has held that the liability of directors and shareholders of a company in respect of a distribution exceeding the company’s distributable profits, as properly calculated, was limited to the amount of the excess: SSF Realisations Limited (In Liquidation) v Loch Fyne Oysters Limited [2020] EWHC 3521 (Ch).

Previous authorities had suggested doubt as to whether the liability of directors in relation to unlawful distributions extends to the entire amount of the distribution, or is limited to the excess over the amount which could lawfully have been paid. Having reviewed the authorities, Zacaroli J found that, in a case where only part of the distribution exceeded the company’s distributable profits (had they been properly calculated), the directors were liable only in respect of that part, and not the entire amount of the distribution. The position may be different, however, where the argument is not that only part of the distribution was out of capital, but that a lawful distribution could have been paid if the company had acted differently.

Taken together with a decision of the same judge in Burnden Holdings (UK) Ltd v Fielding [2019] EWHC 1566 (Ch) (noted here), which held that directors could be liable only where they were at fault, the present decision will give comfort to directors, shareholders and their professional advisers who may become the target of unlawful distribution claims, particularly after a company has become insolvent and it is suggested that the accounts which were used to justify previous distributions were improperly or incorrectly prepared. However, those taking comfort from the decision should note that, as a High Court decision, it is not binding as a matter of precedent and that appellate courts have historically expressed conflicting views in this area.

Background

Statutory framework

Under the Companies Act 2006 (the “Act”), a company may only make a distribution out of profits available for the purpose, being its accumulated, realised profits so far as not previously utilised by distribution or capitalisation less its accumulated, realised losses so far as not previously written off by a reduction or reorganisation of capital. The profits available for distribution are known as “distributable profits”.

A company’s distributable profits are calculated by reference to the figures stated in its relevant accounts. Sections 836 and 837 of the Act make provision for identifying the relevant accounts, which are often the company’s last annual accounts. For accounts to be relied upon, they must be properly prepared in accordance with the Act. For example, the accounts must give a true and fair view under s.393 and will generally be required to be prepared in accordance with applicable accounting frameworks under s.395.

Under s.847 of the Act, a shareholder is liable to repay a distribution, or part of one, if at the time of the distribution they knew or had reasonable grounds for believing that it was made in breach of these provisions (without prejudice to any obligations to repay imposed by the common law).

Under s.1157(1), a director or other officer of a company may be relieved of liability for a breach of duty, if it appears to the court that they acted honestly and reasonably and that, having regard to all the circumstances of the case, they ought fairly to be excused.

Factual background

Having entered liquidation, SSF Realisations Ltd (“SSF”) brought a claim against its sole shareholder, Loch Fyne Oysters Ltd (“LFO”), and five of SSF’s directors (one of whom was also a director of LFO) in relation to the lawfulness of two charges recorded in SSF’s accounts in November 2011:

• an interim dividend to LFO in the amount of £500,000; and
• a management charge in the amount of £330,000 (subsequently reduced to approximately £245,000) in favour of LFO, which the liquidators asserted was a disguised distribution.

SSF’s management accounts for November 2011 showed that, as a result of these payments, it was insolvent with net liabilities of approximately £140,000.

SSF sought to recover the dividend and the management charge. It contended that the management charge amounted to a disguised distribution and since the relevant accounts, prepared in October 2011, showed distributable profits of only approximately £605,000, the total distribution of £745,000 exceeded the distributable profits. Further, SSF argued that the October accounts had not complied with the relevant accounting framework so were not properly prepared and could not be relied upon in any event.

If the distribution was unlawful, SSF’s position was that the directors were liable for breach of duty in respect of the entire amount of the distribution, and that LFO was liable to return the distribution because it knew or had reasonable grounds for believing that the payment was unlawful.

Decision

The High Court (Zacaroli J) held that two of SSF’s directors were liable to compensate the company in the amount of approximately £317,000. LFO was liable to pay the same sum under s.847 of the Act. Of SSF’s other three directors, two were not pursued at trial and one, though found to have been in breach, was excused of liability under s.1157 of the Act. The judge’s reasons are summarised below.

Did the management charge payment amount to a distribution?

It was common ground between the parties that, until November 2011, LFO had never imposed a management charge on SSF. The management charge assumed in November 2011 had been intended, in conjunction with the dividend, to eliminate intragroup debt owed by LFO to SSF.

A calculation had been prepared in order to seek to justify the management charge. This calculation included line items relating to SSF’s use of LFO employees and shared costs of transportation and accommodation. Though a management charge of £855,000 was said to be justified, LFO limited the charge to £330,000 as this was all that was needed to eliminate the intragroup debt.

SSF argued that the management charge reflected a pre-conceived figure – the intragroup debt – from which SSF and LFO had worked backwards to determine what amount was required to ”square up” the debt. LFO countered that the purpose of the charge in the context of the intragroup debt was not relevant and that all of the costs included in the calculation were actually incurred by LFO and fairly recharged to SSF.

The judge referred to the principle, set out in well-known authorities such as Aveling Barford Ltd v Perion Ltd [1989] BCLC 626, that characterisation of a payment as a distribution is one of substance not form. At the time of the November 2011 board meeting, SSF had been under no obligation to reimburse LFO for any of the services in question. There had not been any prior agreement about reimbursement, whether express or implied. LFO could expect to benefit from SSF’s success through the increased value in its shares in the subsidiary and/or dividends. As such, a parent company might choose to support a subsidiary financially by providing services or goods without imposing any obligation on the subsidiary to pay for them.

The judge therefore held that the management charge was properly characterised as a distribution within the meaning of s.829 of the Act. Its lawfulness therefore fell to be assessed by reference to the Act.

Was the total distribution lawful?

Taking the dividend and the management charge together, SSF had distributed £745,000 to LFO. As at October 2011, the company’s accounts recorded distributable profits of only £605,000. The distribution exceeded distributable profits and was therefore unlawful based on those accounts.

However, the judge was satisfied that the October 2011 accounts had not been properly prepared. Had they been properly prepared in accordance with the relevant accounting framework, distributable profits as at October 2011 would have been £428,000. As a consequence, the amount of the distribution which had been paid out of capital (not out of distributable profits) was £317,000, representing the difference between £745,000 and £428,000.

LFO’s liability as shareholder

As noted above, s.847 of the Act provides that if, at the time of a distribution, a shareholder “knows or has reasonable grounds for believing” that the distribution is unlawful, the shareholder is liable to repay the distribution to the company. A shareholder will know or have reasonable grounds for believing that a distribution was made in contravention of the Act if the shareholder had relevant knowledge of facts which, if they existed, would lead to the conclusion that the distribution was unlawful. The shareholder need not actually appreciate the legal consequence that the distribution is unlawful.

It was common ground between the parties that LFO’s liability was limited to that part of the distribution which LFO knew or had reasonable grounds for believing was unlawful.

The judge found that Mr Sutherland, a director of both SSF and LFO, had knowledge of the facts leading to the conclusion that the distribution was unlawful. Mr Sutherland was aware of an error in the last audited accounts of the company that had been carried forward into the October 2011 management accounts and which caused distributable profits to be overstated. Mr Sutherland’s awareness could be attributed to LFO. LFO was therefore liable for £317,000, representing the difference between the distribution amount and the true amount of the distributable profits.

Liability of directors

In relation to the liability of the directors for approving the unlawful distribution, it was common ground that directors are to be treated “as if they were trustees of the company’s funds… if they knew the facts which constituted an unlawful dividend, then they would be liable as if for breach of trust irrespective of whether they knew that the dividend was unlawful”.

Three of the five directors of SSF were liable on the application of this test. Two of them did not participate in the proceedings and no finding was made as to their liability.

The parties disagreed as to the extent of a director’s liability in respect of a dividend which was partially made out of distributable profits and partially out of capital.

SSF relied on dicta of Lord Hope in the Supreme Court decision in Re Paycheck Services 3 Ltd [2010] 1 WLR 2793 to the effect that, where a distribution has been paid unlawfully, a director’s obligation is to account to the company for the full amount of the distribution. The director’s liability was seen as restitutionary, not compensatory, and so was not limited to the amount of any loss (though it was open to the court to limit the amount the director should pay to what the only creditor in the company’s liquidation had lost).

The directors submitted that the directors were only liable for the distribution to the extent that it was unlawful, relying on Re Marini [2003] EWHC 334 (Ch). The judge agreed. He distinguished between: (a) a situation such as the present, where a company pays a distribution which, on the basis of what it in fact did, was only out of capital as to part of the payment; and (b) circumstances where the distribution might have been lawful had the company acted differently.

In the current case, the three directors’ liability was limited to the difference between the distribution amount and the true distributable profits, being £317,000.

One of those three directors was excused from liability under s.1157 of the Act on the grounds that he had no financial or accounting expertise and had been reliant on other directors with the relevant expertise. He had played a limited role and had acted honestly and reasonably.