Paying directors: the risks of taking a reward

In this uncertain economic climate, company directors should consider if there are any sensible precautions they should be taking when it comes to distributing company funds to themselves, shareholders and their co-directors.

Before a company can lawfully make any distribution, it must ensure that it has sufficient distributable reserves. Directors should consider their common law and equitable duties, and their statutory duties under the Companies Act 2006.

At a time when it is difficult to anticipate future financial requirements, or indeed future profits, company directors will need to give real consideration as to whether or not now is an appropriate time to be making distributions.

Below is a brief outline of the most popular methods directors utilise to distribute company funds, and the potential issues that can arise during times of financial difficulty or insolvency. We refer below to 'director-shareholders' as a director and shareholder of a company (as many small business owners are).

Many company director-shareholders choose to be paid modest salaries, and receive the majority of their income through dividends (a share of the company's profits). While this is a legitimate practice with numerous tax benefits, these payments are at risk of being challenged as "unlawful dividends" if the company later become insolvent, as detailed below. If directors choose to be remunerated by way of salary payments, they must ensure any such payments are authorised in accordance with the company's articles of association or set out in a contract of employment.

Generally a formal contract or members' resolution is required for directors to legitimately take a salary from a company. Failure to take these steps could result in a claim against directors for misfeasance under s212 of the Insolvency Act 1986, or reversal of a transaction at an undervalue pursuant to s238 of that Act.

Directors should take a risk-based approach when deciding how they chose to be remunerated. In the current climate, increasing their salaries and paying the additional associated taxes may provide more stability and perhaps options to utilise government support schemes. Relying on dividends is only possible as long as the company makes a profit and creates an increased fixed cost for the company, which could make it harder for the company to survive.

The most common method of a company distributing funds to its shareholders (and often director-shareholder) is by way of dividend payments. As with all distributions, in order for a company to be able to lawfully pay a dividend, it must have sufficient distributable profits that are justified by reference to relevant accounts. Company directors are under a common law duty to safeguard a company's assets and must also consider the company's future financial requirements before recommending or declaring a dividend.

Directors must generally act in the company's best interests and, when insolvency looms, must act in the best interests of creditors. That, of course, creates an inherent conflict with a director's desire to pay themselves to reflect the hard work put into the company.

A director who authorises the payment of a dividend:

• which is in excess of a company's distributable profits, or
• if at the time of the dividend payment, the company was insolvent and there were no reasonable grounds for believing that the dividend payment would benefit the company

may be in breach of their statutory and common law duties and may be personally liable to repay the company in respect of the 'unlawful' dividends. If the director and shareholder are different people, a liquidator of the company might look to recover the monies from either of them.

Often director-shareholders are paid by this mix of a modest salary topped up with dividends. However, those dividends can only be paid after a profit is declared, so in the meantime directors take an 'interim dividend' or a payment on account on a monthly basis throughout the year.

In reality, those monthly payments are usually loans from the company to the director which are to be repaid to the company on demand, or (in practice) which the company will extinguish when a profit or dividend is declared.

Sometimes a company enters insolvency before that dividend is declared, and the liquidator will then look to recover the outstanding 'loan' from the directors; essentially recovering the directors' remuneration for the past years.

During liquidation, the liquidator's role is to collect all the money that is owed to the company. If the outstanding loan is significant, the liquidator will view an overdrawn director's loan account as an asset they can pursue to increase the repayment for the company's creditors. The liquidator will take action to recover the director's loan, which could put pressure on a director's personal finances. If the director does not have sufficient funds available to repay the loan, their personal assets could also be at risk. Ultimately, legal action could be taken to recover the funds, which could involve petitioning for the director's bankruptcy.

A liquidator will also investigate the circumstances regarding the overdrawn director's loan account. Such investigations could potentially lead to accusations of wrongful trading and misfeasance against the director, which could result in the director being banned from acting as a company director for a period of up to 15 years (in serious cases), in addition to the financial implications detailed above.

Another common theme in liquidation is a substantial expenses claim submitted by directors at a late stage. Obviously all expenses incurred on behalf of the company need to be for a legitimate business purpose, incurred in the best interests of the company, supported by appropriate evidence such as receipts, and should be claimed from the company promptly.

Sometimes directors seek to recover or defend tens of thousands of pounds of expenses, dating back several years. Such claims are often treated with scepticism by a liquidator, and often provide evidence that a director was treating the company's money as his own, failed to keep proper records and that the accounts did not reflect all of the costs incurred by the company. Rather than helping a director, those matters make the position worse; which serves as a timely reminder to stay on top of all expenses claims.

Directors may also look to make use of 'disguised remuneration schemes', which include things like Employee Benefit Trusts (EBT), Employer-Financed Retirement Benefit Schemes (EFRB) and less formal arrangements designed to remove money from a company.

Such schemes often look to exploit legal loopholes to minimise tax liabilities. A string of legal proceedings and changes to legislation since 2012 has sought to crack down on such schemes; which now leaves director-shareholders exposed to a risk of claims when a company enters into liquidation.

Where directors have used such schemes, even with legitimate intentions, they should be particularly wary of the risks they face if the company enters into insolvency.

In the current financial climate, it may be that company directors chose to follow the precautions being taken by the banks, and postpone distributions. In any event directors must give proper consideration as to the company's financial position before making any distributions, or remuneration payments, as the failure to do so could have significant consequences.

As their company approaches insolvency, directors should also be mindful of their historic conduct and any outstanding expenses or loans.

If company directors have any concerns about the legality of any distributions they have or anticipate making, the solvency of their company, or any potential liability that they may incur, they should seek professional insolvency advice.