Navigating Directors' Loan Accounts and Dividends

At Manolete, we commonly encounter claims relating to directors' loan accounts and unlawful dividends. In this article, we explore what those claims are, how they arise and are dealt with in practice.

Directors’ duties
Directors are subject to various duties which are codified under the Companies Act 2006 (sections 171-172). Pursuant to section 172, directors have a duty to act in good faith and promote the success of the company. Where the company is solvent that means directors must act in the interests of the shareholders in good faith. Where the company is insolvent or verging on insolvency, the duty extends to considering the interests of creditors, whose interests become paramount if insolvent liquidation is inevitable.

Directors are also in the position of fiduciaries. The company’s monies are effectively a trust fund which is administered by the directors. The directors are therefore akin to a trustee of those monies and have certain fiduciary obligations imposed upon them (such as a duty of good faith, to avoid conflicts of interest etc.).

Directors’ loan accounts
Overdrawn directors' loan account claims are the simplest form of claim. They are a claim for a debt owed by the director to the company. There is rarely any formal loan agreement or even written repayment terms and, in those circumstances, the usual starting position is that the loan amount is repayable on demand.

Another point to note with directors' loan accounts which tends to be overlooked is that section 197 of the Companies Act 2006 requires any loan to a director of the company to be approved by a shareholder resolution. If the loan has not been so approved, in accordance with section 213 of the Companies Act 2006, the transaction is voidable by the company (or the liquidator or administrator) so that the director must repay it.

Unlawful dividends
To lawfully declare and pay a dividend, the formalities set out in sections 830 – 847 of the Companies Act 2006 must be followed, as well as any relevant provisions in the Company’s Articles of Association.

First, "relevant accounts" (i.e. accounts complying with the relevant provisions of the Companies Act 2006) must be drawn up. These are usually the company’s last filed annual accounts, but they can be compliant interim accounts. The Companies Act sets out what they need to include to be compliant. Secondly, those accounts must show sufficient distributable reserves.

If relevant accounts have not been prepared, or the company did not have sufficient distributable reserves, or the company’s Articles have not been followed (for example, appropriate board or shareholder resolutions have not been passed) the dividend will be unlawful and the recipient shareholder (whether or not they are a director) may be liable to repay it if they know the relevant formalities have not been complied with.

Even if the relevant provisions of the Companies Act and the company’s Articles were followed, the director may still be personally liable if the company was insolvent at the time of the declaration or payment of the dividend. For example, the company may have been balance sheet solvent such that it had distributable reserves, but had significant overdue liabilities at the time the dividend was declared resulting in cashflow insolvency. In those circumstances, the director may be liable on breach of duty grounds i.e. for paying dividends at the expense of the company’s creditors. The director may also be liable for breach of duty where he or she has failed to consider significant contingent or future liabilities which are ultimately not paid.

In practice
It is common practice, especially in owner-managed companies, for directors to draw sums on an ad hoc basis throughout the year. Often a director will take a minimum salary which may not attract PAYE and supplement his or her income with dividends. Directors regularly refer to those ad hoc payments as "drawings" which will be tidied up at the financial year end.

Problems can arise for the director where this structure is adopted when the company encounters financial difficulty, such that it becomes insolvent (either on a balance sheet or cashflow basis). If the company is then placed into an insolvency process, how are those "drawings" to be treated?

There are only really three ways for a director to lawfully take money out of a company: salary, dividends or loan. Usually, the director tries to claim all of the payments he received were either salary or lawful dividends or should be set-off against monies owed to him/her.

Often, the payments are not salary. They are not subject to PAYE, they’re not declared in the Company’s RTI (real time information) records and there is no employment contract. Sometimes director salaries or employment contracts need to be authorised by the Company’s Articles and they haven’t been.

If claimed as dividends, these will often be unlawful either because there aren’t distributable reserves, no relevant accounts were drawn up or some other formality has not been complied with. Even if the relevant procedures were followed, if the company were cashflow insolvent and not paying its creditors, it would be a breach of duty for the director to authorise and pay dividends.

That leaves loans, which are repayable on demand. Sometimes directors try and characterise the payments as repayment of sums owed by the company to the director. That depends on the director showing those payments were genuine loan repayments and not something else, but even if they do, it can lead to other claims against them such as preferences i.e. the director receiving repayment of the loan in full while other creditors go unpaid.

Adjustments to a director’s loan account ledger are frequently made shortly prior to liquidation, often in the days or weeks before liquidation. Very often this is a (misguided) attempt by the director to extinguish any overdrawn loan balance. However, it is usually far too late to make such adjustments as the likelihood is they will be subject to attack under various provisions of the Insolvency Act 1986.

In summary, where payments to directors are identified there are usually multiple ways to recover those monies, and arguments raised by the directors in respect of those payments can often be defeated by attacking the payment in another way.

Kelly Jordan
Assoiciate Director for the North-East

PROFILE
Stuart Lindley - Q&A
Associate Director - London

Legal journey in the UK
My career in contentious insolvency law began back in 2002. I cut my legal teeth in Yorkshire, before taking my expertise to London in 2008. Prior to my current role, I was a partner in the insolvency department of a prominent national firm's London office. My speciality was representing Insolvency Practitioners in both corporate and personal insolvency issues across the UK. On occasion, I've also provided legal guidance to British companies in financial distress and directors facing legal scrutiny due to their actions.

How long have you been at Manolete?
I'm the freshest face at Manolete, having joined the ranks just last December.

Initial impressions?
Starting work at Manolete has given me a unique opportunity to focus solely on the legal and commercial sides of things, while working in new, dynamic ways with clients with whom I have built up trust over several years.

Career highlights?
The camaraderie within Manolete is remarkable. I'm surrounded by fantastic insolvency litigators in an 18-strong team. Our combined know-how and team approach not only enrich our work but also bring about efficient resolutions, which greatly benefit insolvent estates and their creditors throughout the UK.

And personal life?
Away from the world of insolvency law, I'm a passionate supporter of Leeds United and Wigan Warriors. My downtime is filled with visits to cinemas, music gigs and expanding my extensive collection of retro Adidas trainers—a hobby that's become both time-consuming and wallet-lightening.

FEATURE
Stephen Baister Writes...
On Appeals

Among the many questions you get asked, if people know you are a judge, is how you feel when you get appealed. The answer will depend on the outcome of the appeal and the kind of person you are. Obviously there is pleasure if your judgment is upheld. Just occasionally you will be told that you got it bang on right, but often the appeal judge will get to the same result as you did but by a different route, which can detract from the satisfaction.

I generally took a successful appeal on the chin, accepting it as part of the job, but how you react will very much depend on the detail of what the judge above has actually said and why you decided the case as you did. On some occasions you have to take a risk, knowing that you may be “pushing the envelope”: a judge who is too cautious because he or she is afraid of being appealed is not doing the job properly, in my view.

Sometimes the appeal judge will simply find your reasoning wrong or say you misconstrued something or other. Fair enough, as long as it does not show you to have been an idiot. (Even if that is what he or she actually thinks, it is rare for it to be expressed in such stark terms, but rather more obliquely.)

Sometimes being upheld is not as glorious as you might think. I recall a decision I made on an area of bankruptcy law that had never been considered by a court before. In a case like that you are often starting with pretty much a blank sheet of paper. I was overturned on an appeal to a Chancery judge. But then there was a second appeal to the Court of Appeal which reinstated my decision. It was not, however, that simple. The reality was that, on the first appeal, the legal point in issue was argued on a completely different basis to the one argued before me, and new case law was introduced.

The same happened again at the Court of Appeal stage. So the case at each instance at which it was dealt with was totally different. So not much satisfaction (or, to be fair, dissatisfaction) at the end result.

The case also taught me what I call the “musical chairs” effect: the result of a case may depend, arbitrarily, on the stage at which the music stops. I would have been “wrong” if it had all come to an end after the first appeal; I was “right” after the second appeal. If it had gone further, who knows how it would have ended?

I’m not sure there is a lesson in this, except that appeals can be tricky things and, like first instance decisions, are risky, but in their own peculiar way. And, of course, that the outcome of a case may depend on where the music stops.

CASE STUDY
The Manolete Model in Action

Manolete periodically releases anonymised case studies that highlight the outstanding benefits of our unique model.

This case concerned a company which entered into CVL in 2022. The liquidator had identified legitimate claims that could potentially realise a return to the estate but the defendants didn’t engage.

As soon as Manolete became involved, our involvement quickly changed the dynamic of the legal action, prompting the defendant to engage where they hadn’t previously. Our encouragement to seek mediation prompted a swift resolution. These factors very often lead to a quicker, more efficient conclusion of cases which corresponds to a better return for the estates.

EVENTS
IPA Roadshow - Cardiff - 14 March

Manolete Partners is Principal Sponsor for the forthcoming IPA Roadshow event in Cardiff which will cover the latest developments in insolvency, along with regional perspectives. You will be able to meet colleagues and peers, the speakers and IPA representatives at the drinks reception following the event.

Manolete's Charlotte May (Associate Director for the South West and Wales) will also be speaking at the event on 'Recent Reported Cases'.

Date and time
14 March 2024,
1100-1700

Location
The Marriot Hotel,
Mill Lane,
Cardiff,
CF10 1EZ

Find out more