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During the coronavirus pandemic, due to the uncertainty of future trading and potential deterioration of financial position from the last annual accounts, entities looking to pay dividends or make other distributions will need to be especially aware of their legal obligations and fiduciary duties, including considering additional factors than they may previously have needed to.  

What does the legislation say?

In making distributions there are two key requirements for companies and their directors to consider:

Capital maintenance rules

The Companies Act 2006 requires that a dividend may only be paid out of distributable profits and the common law ‘capital maintenance rule’ means that a company cannot lawfully make a distribution out of capital. For a public company an additional test is applied which is that its net assets must not be less than its capital reserves.

The justification for a distribution should be by reference to the relevant accounts of the company. The relevant accounts of the company are usually the last annual accounts unless these do not justify the distribution in which case initial or interim accounts may be required.

The directors must consider both at the time of proposing a distribution, and at the time it is made, whether the company, subsequent to the balance sheet date to which the relevant accounts were prepared, has incurred losses that have eroded its profits available for distribution.

Directors fiduciary and other duties

Directors are subject to fiduciary and other duties, in addition to the capital maintenance rules, including the obligation to safeguard the company’s assets and take reasonable steps to ensure the company can settle its debts as they fall due.

It’s worth emphasising that the law operates at the individual company level and not the group, and therefore the assessments referred to must be carried out at individual company level. Note, however, that there can be some legal arrangements that may spread adverse consequences directly from company to company – eg, cross-guarantees of bank debt amongst group members could make all such companies in the group subject to the same liquidity issues.

Practical impact and interpretation for preparers

Capital maintenance rules

The effect of the capital maintenance rules is to require a company to update its consideration of the financial position from the date of the last annual accounts, to the date of the proposed dividend. It is important that companies do not assume that distributable profits that existed at the most recent balance sheet date still exist, as distributable profits could have been subsequently lost through the financial effects of coronavirus, for example through impairment of assets, provisions against doubtful debts, restructuring provisions etc. 

If distributable profits have been eroded, and a distribution is made, the distribution would be unlawful as it would now be made out of capital and legal advice should be sought to consider the implications. 

It’s important to note that the capital maintenance rules apply equally to payments in respect of shares classified as liabilities, as they do to shares classified in equity. The ability to pay dividends on preference shares is therefore still determined by reference to distributable profit even if those dividends are reported as an interest expense.

Directors fiduciary and other duties

The capital maintenance rules require the directors to consider the financial position of the company at the date of distribution, however, they are also required to look forward from this date before recommending or paying a dividend. The directors should consider whether the company will, following payment of the proposed dividend, be solvent and be able to continue to pay its debts as they fall due. 

This decision needs to be taken in light of the uncertainty presented by coronavirus and the ensuing financial pressures on the company. With some companies operating at reduced levels due to reduction in customer demand or supply-chain disruption, the requirements for cash preservation are likely to be the company’s top priority.

In the context of fair value accounting, volatility is an aspect where directors will need to consider their duties. The fair value of financial instruments may be volatile even though such fair value is properly determined in accordance with accounting standards. Directors should consider, as a result of their duties, whether it is prudent to distribute profits arising from changes in the fair values of financial instruments considered to be volatile, even though they may otherwise be realised profits.

Finally, the directors should consider not only the rules of any government support which may preclude dividends being paid, but also the spirit of the support provided and their own requirements to act in the best interests of the company. The reputational impact should be weighed up when deciding (and communicating that decision) whether it is in the best interests of the company to pay cash out to shareholders when in receipt of government support and potentially needing to make staff redundant.

Our advice 

• Ensure management information is updated to the date of the proposed dividend, and date of payment, to confirm that sufficient distributable profits are available to support the distribution. 
• Consider any additional adjustments that might be required as a result of coronavirus to management information that are not part of the regular monthly reporting cycle e.g. impairment of assets, additional provisions etc.
• Prepare projections that consider how the company will pay its debts due in the months after the proposed dividend to ensure that sufficient cash is available.
• Review regular payments of dividends on preference shares classified as a liability that may be treated as an interest expense or equity dividends to ensure these are not being made out of capital and therefore be unlawful.
• Where dividends have been proposed but not paid, directors should consider whether payment should now be made given changes in the company’s financial position. If a company has declared a dividend which has not been paid and the directors now wish to cancel it, they should seek legal advice based on the specific facts and circumstances.
• The directors should retain a record of how they have reviewed and challenged the information presented to them for the purpose of considering the proposed distribution to demonstrate how they have satisfied their fiduciary duties.
• Under s837 of the Companies Act 2006, where the audit report has been qualified, the directors will require a statement from the auditor as to whether the matters giving rise to the qualification are material in determining the legality of a proposed distribution.
• In group situations, consider what cross-guarantees are in place that may have an impact on the liquidity and distributable profits of the entity making a distribution.
• It is important that proposed distributions are considered on a legal entity basis rather than by reference to the financial position of a consolidated group.
• Review the terms of any government support to ensure distributions are permitted, as well as considering the reputational impact of paying dividends when other cuts are potentially required.

For more information please contact Paul Merris and Lee Marshall.