It is commonplace that directors will be paid relatively modest salaries and will receive the majority of their income through dividends.
Whilst this is a legitimate practice and has numerous tax benefits, if the company later becomes insolvent, these payments are at risk of being challenged as “unlawful dividends” pursuant to section 847 of the Companies Act 2016.
Case law developments
On 27 November 2018, the Court of Appeal provided much needed clarification of the rules regulating the payment of dividends to directors in Global Corporate Ltd v Hale  EWCA Civ 2618.
Mr Hale was a director and shareholder of Powerstation UK Limited (the Company) and received an extremely modest salary of £456 in PAYE each month. Mr Hale also received monthly payments of £1,383, described as ‘dividends’, between 24 June 2014 and 26 October 2015, which totalled £23,511.
At the time the dividends were paid the company was balance sheet insolvent and, as such, there were insufficient distributable reserves to justify the payment of any dividends. Accordingly, proceedings were issued against Mr Hale to recover the full £23,511.
The Judge in the first instance held, amongst other things, that any misfeasance claim against the director could be successfully defended by his quantum meruit claim for remuneration. In other words, the director could look to set off the “salary he claims he would otherwise have had” as against the unlawful dividend claim.
This decision was entirely inconsistent with Guinness PLC v Saunders  2 AC 663 in which it was held that the law would not imply a contract for remuneration when the same could only be put into place under the articles of association by an appropriate resolution of the board.
The decision in Hale was later reversed by the Court of Appeal which held that Mr Hale had no valid quantum meruit defence based on services he had provided to the Company. It was held that there was no service contract entitling Mr Hale to additional remuneration and, affirming the decision in Guinness, that no such contract would be implied by the law.
Implications for Directors
Payment of a low salary which is supplemented by dividends presents a significant risk to directors in an insolvency situation. Directors, particularly in times of financial difficulty, are likely to work long hours, which could ultimately go unpaid in the event that they are required to repay any dividends received. Directors need to be able to demonstrate that there were sufficient distributable reserves in the company to justify the payments at the time that they were made.
Directors therefore need to take a risk-based approach when deciding how they wish to be remunerated. Either they increase their salaries and pay the additional associated taxes, or they receive dividends in the knowledge that if the company becomes insolvent, the dividends will be unlawful and will need to be repaid. If a company has insufficient distributable reserves, then it may well be prudent for a director to put in place a contract of employment and /or increase their salary entitlement.
Implications for Insolvency Practitioners
The judgment in Hale provides much needed clarity and makes it clear that, where dividends have been paid and a company is insolvent, a quantum meruit defence in response to an unlawful dividends claim is unlikely to be valid.
It is important to note that in any event, a quantum meruit claim for remuneration would be an unliquidated claim, which would need to be proven in the liquidation. Therefore, even in circumstances where the director wishes to defend the payment of dividends, they would still be liable to repay the dividends to the company and would then need to pursue any claim separately.
If you have questions about any of the issues raised in this blog, please contact a member of our Business Restructuring and Insolvency Team.
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