Illegal Dividend ?

A bit more detail

Alastair

I think what happened here was that the group bought a business for £30m which had nil net assets (but presumably terrific potential). The thinking was that there was a good 'fit' between the group's existing businesses and this new one, and the group's skills in its existing businesses could be applied to improve the results of the new business. This purchase created goodwill of £30m in the consolidated Balance Sheet.

A few years later the group decided it had made a mistake. The new business was different in key respects from the group's original businesses and the group's existing business skills were not relevant to the business that it had purchased. So it sold the business it had purchased, but could only get £5m for it. The original businesses were however retained by the group.

The loss on sale plunged the group into negative equity. However it continued to trade and some subsidiaries were profitable.

All cash at bank appears to have been pooled in a bank account in the name of the holding company. In fact this account was substantially overdrawn. The overdraft was secured by charges on all the assets of the group (with appropriate guarantees fron individual subsidiaries to the group's bankers).

Some subsidiaries generated large positive seasonal cashflows.

I am assuming that the original £30m purchase was made not by the holding company but by a subsidiary. That would mean the loss on sale would sit in a subsidiary Balance Sheet and the impact on the holding company's own Balance Sheet would be limited to the write off of its investment in the subsidiary.

That would explain the holding company continuing to have distributable reserves in its own individual Balance Sheet. For another 2 or 3 years it continued to pay dividends (it was a quoted PLC) despite the negative equity in the consolidated Balance Sheet.

However the group suffered further trading difficulties in the continuing businesses.

When the bank intimated that it would be unable to continue its support and the group had no way of coping with an anticipated seasonal outflow of funds, administrators were appointed. They sold off profitable subsidiaries and the bank fully recovered its lending (or at least recovered the bulk of it).

Unsecured creditors suffered heavily.

My question is, should the holding company have continued declaring and paying dividends after the sale of the business at a huge loss when the consolidated Balance Sheet showed negative equity?

David

Not illegal if sufficient P&L reserves.

If the cash was there then it could've been drawn and reinvested back into the company via the DLA so the position is the same.

Can I ask a follow-up?

I recently came across a case involving a quoted PLC in which the consolidated Balance Sheet showed substantial negative equity (largely due to the sale of a subsidiary which had been purchased a few years earlier at a much higher price) but the holding company Balance Sheet showed positive equity.

Dividends were declared and paid notwithstanding inter-company loans and cross guarantees of bank borrowings within the group.

It all ended in tears with administrators called in and there is likely to be only a small payout to unsecured creditors.

Presumably the payment of dividends in this case was legal. Any thoughts from the esteemed AccountingWEB community?

David

hi David
you raise an interesting question! As has been pointed out, dividends are declared and paid by a company from distributable reserves. If there are insufficient distributable reserves when the dividend is declared then it is "illegal". In the group situation the rules are the same - it is the component companies who deal with the dividends, and their distributable reserves are relevant to the dividends they declare.

In the circumstances you describe (with limited information) it sounds like the fraud word might be relevant - presumably the banks might be looking to open up the veil of incorporation and attack the shareholders? And they will be presumably questioning the recoverability of inter company loans, and hence whether the accounts on which the dividends were based were true and fair, or indeed if the directors and/or auditors should have been aware - which of course then opens up another avenue for action.

...commercial or legal.....!!
David
"should the directors have paid a divi".

Commercially?
Well, the directors were (assuming good faith) naive / stupid / greedy. But they would no doubt argue they were none of these things ; that they thought (with wonderful projections and clear calculated reasons)everything would be alright long term despite the bad acquisition leaving a short term £25m loss ; that to keep the group share price going, payment of dividends was justified/essential etc etc.

Legally?
That question would have to be posed on a lawyers forum !!
I have a (non-lawyer and non-expert) feeling that the divi would indeed be legal in UK.
If lawyers gave a multitude of answers, and if the sums were big enough, and if the directors (not shareholders) had big enough assets to go after, no doubt this would be tested in court.
(on Alaistair's comment, I very much doubt the shareholders could be pusued - they would not be assumed to realise the divis were illegal? If they had no such reason, then they are in the clear).

I would be astonished if the directors had not taken legal advice before they declared/paid the dividends (although stranger things have happened). In which case, the lawyers who advised them would be either pretty sure of their ground, or reviewing their PI policy!!

..hi jacked!! I think not.
Dear oh dear.
The question wasn't hijacked at all.
It was admirably , fully and succinctly answered immediately in the very first posting by Samuel.
Therefore David's self-confessed "follow on" question was not remotely a hi-jacking.

What is an illegal dividend
There is case law (I think I came accross it on this site in the last 12 months, but I don't have the energy to look for it - sorry)

But it involved a company which had awarded dividends even thought there was not enough profits to pay them. I think the company went to court and tried to get a ruling to say they were illegal. They failled.

Any dividend award is not illegal (the HMRC may try and say they are, but thats a tax not company issue). The directors may have by awarding the dividends to make the company insolvant and thats a different matter.

In this case the company is not insolvant - so what is the problem? Sounds like a sensible way to deal with it.

whoaao there...
...let's not get carried away. It is most definitely NOT the case that "any dividend award is not illegal". Far from it. There are various reasons why a dividend award could be illegal.

There was a recent case in 2006 where the court upheld a petition that a dividend was illegal. Unfortunately I don't have case details to hand. It involved a husband and wife company, hubbie merrily "declared" divis to them both, but court overturned them. It is true that the case involved a subsequent insolvency, but it was a salutory reminder that even when the company is solvent (which it was initially) there is a need to get this dividend declaration thing right. Hubbie and wife lost the money they thought they had safely in their bank accounts!!

(Again, to ensure there is no confusion, David's original question case is fine. The first post from Samuel answered it totally).

It's A Wrap
No I'm not meaning that this answer wraps it up but could the case you refer to be It's A Wrap (UK) Ltd v Ghula & another which gave the basics thats officeholders should be sure that they are aware of the requisite steps to perform in voting dividends. It is not a cavalier function to be performed without careful thought and considerations.... However in thsi case if there were sufficient distributable reserves available to cover all dividends being voted then it is more than likely that the dividends would be above board and legal. The directors would however need to satisfy themselves as to this by either considering the company's distributable reserves by interim accounts if need be and also by checking the liquidity of the company.

hope this helps
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oh no - not again!
Two interest comments that raise an interesting point. Ignoring the issue of distributable reserves the question that is raised is can a dividend be illegal if proper process is not followed. From the evidence presented that is a maybe, but it is not clear.

However there are other threads on this site that indicate that if due process is not followed then HMRC might choose to attack the dividend on the grounds that because proper process has not been followed then it is not a dividend. Illegallity is not relevant - there is no dividend - and you probably end up with an overdrawn directors loan account, and consequent penalties.

Of course this is clearly off topic!

Director's Loan contravenes Companies Act
Yes Alistair but if its not a dividend what is it? Who says it's a Loan?

It would depend on the facts. For example, if the records of the company were contemporaneously updated to show that what was being paid was a dividend why shouldn't this be taken as evidence that dividends were voted and paid. HMRC might choose to say whatever they like so it's all the more important that clients and directors voting dividends are fully appraised by their professional advisers whenever they are performing statutory duties -paperwork or none.

No doubt this wee thread will raise another question or two in the interesting is it or isn't it a dividend.