Insolvency ‘Tipping Point’ – When are directors liable for misfeasance and unlawful dividends?
This is often a question for faced by office-holders of insolvent companies when investigating a company’s affairs, and more of a concern for former directors and shareholders when potentially facing a claim for the return of unlawful dividends or misfeasance.
The Companies Act 2006 (the ‘CA 06’) sets out (1) what profits are available for distribution by dividend and (2) the justification required. The two main criteria that must be met are that the Company must have had sufficient distributable reserves available and the dividend must be paid with reference to the relevant Company accounts. Failure to meet either one of these criteria may mean that the dividend is found to be illegal.
Whilst spotting an unlawful dividend with reference to the CA 06 can be relatively straightforward, it is a much more tricky task to establish when a former director may be liable for misfeasance under section 212 of the Insolvency Act 1989 (the ‘IA 1989’), as a result of the directors misapplying and / or retaining company money (for example, by declaring a dividend) at a time when the Company was insolvent.
It is well established that the duty to consider the creditors’ interests as paramount arises in circumstances where a company is insolvent. But what about when the Company is on the verge of insolvency, or when there is a risk of insolvency? When is the tipping point for the term ‘insolvency’ to apply to such circumstances…
In determining the stage at which the directors’ duties are triggered, in relation to the onset of insolvency and for the purpose of a claim for misfeasance, the essence of the test is when the directors ought in their conduct of the Company’s business to be anticipating the insolvency of the Company. In BTI 2014 LLC v Sequana SA  EWHC 1686 (ch), the duty was said to arise unless the risk of insolvency can be described as remote.
Sequana provided four possible answers to when the said duty arises:
- first, when the company is actually insolvent;
- second, when the company is on the verge of insolvency or nearing or approaching insolvency;
- third, when the company is or is likely to become insolvent; or
- fourth, where there is a real, as opposed to remote, risk of insolvency.
Further, it was held that ‘when a company, whether technically insolvent or not, is in financial difficulties to the extent that its creditors are at risk, the duties which directors owe to the company are extended so as to encompass the interest of the company’s creditors as a whole, as well as those of shareholders.’
When considering this ‘risk of insolvency’, it is not a defence for the former directors of the Company to allege they were not aware of the risk. The duty is triggered if the directors know or ought to have known that there was a real risk of, or that the company is or is likely to become insolvent and this is a subjective test. In Regentcrest v Cohen  2 BCLC 80], it was held that the question is whether the director honestly believed that his act or omission was in the interests of the company.
Even where the company is not insolvent at the time of a dividend being declared (again, there is just a ‘risk of insolvency’), ‘a distribution which renders a company insolvent will constitute an unlawful return of capital. Further, if the directors know or should have known that following a distribution the company would be insolvent or dubious solvency, they are under a duty to have regard to the interests of creditors and a failure to do so will constitute a breach of duty.’ (David Richards LJ in Burnden Holdings (UK) ltd v Fielding  EWCA Civ 557 ). It therefore seems that the risk does not only have to be a ‘risk of insolvency’ at the time of the distribution, but equally applies where the directors ought to have known that the company would be insolvent (or dubious solvency) following the dividend.
The courts have even taken this one step further, to deal with dividends declared where directors are looking to reclassify them as salary (seemingly with a view to avoid a claim for misfeasance where the company would be ‘insolvent or dubious solvency’). It is now not possible for the former directors to attempt to ‘re-categorise’ a dividend as remuneration for the services rendered in order to avoid liability in misfeasance. In Global Corporate Ltd v Hale EWCA Civ 2018, the Court of Appeal made it clear that ‘provisional’ dividends do not exist. Rather, if a payment is declared as a dividend, it remains a dividend unless and until it is, in some way, reversed.
Whilst this all seems to broaden the scope of what we had previously considered as ‘insolvency’ for the purpose of misfeasance claims, particularly in the context of dividends declared, the subjectivity (real risk, on the verge, real as opposed to remote, dubious insolvency…? ) has perhaps made a potential claim more difficult to spot. This will also no doubt be a concern to directors, seeking advice as to when the duty arises. There is clearly scope to argue what these terms mean in the context of ‘insolvency’, and it seems likely that further case law will follow providing further clarification.