Void Corporate Dividends

What is a corporate dividend?

This is a dividend paid by a company to its shareholders. This is done by companies from time to time as a way of distributing the company's profits. This paper does not deal with dividends paid by external administrators to creditors - they are dealt with in another Fact Sheet. The dividends explained in this Fact Sheet are paid to shareholders before the liquidation.

Who declares and pays the dividend?

The directors declare a dividend, calculate the amount to be paid and decide when it is to be paid. This process is governed by the Constitution or Articles of the company and the Corporations Act, all of which give the necessary powers and guidelines on the process and on shareholder's entitlements.

Section 254U of the Corporations Acts sets out this original power.

(1) The directors may determine that a dividend is payable and fix:
(a) the amount; and
(b) the time for payment; and
(c) the method of payment.
The methods of payment may include the payment of cash, the issue of shares, the grant of options and the transfer of assets.

Can directors get into trouble paying a dividend?

Yes, in two circumstances the directors may become personally liable to compensate the company for the amount of the dividend.

It is an offence under section 254T to pay a dividend except out of profits. The claim arises when dividends are paid and the company has not earned sufficient profits to support the dividend.

The second is where dividends are paid while the company is insolvent. This could result in an insolvent trading claim being made against the directors. This claim will only be possible if the company is wound up after the payment of the dividend.

SECTION 254T

Dividends out of profits

Section 254T of the Corporations Act states that dividends to shareholders must be paid out of the profits of the company. There is a duty for directors to maintain the share capital base of the company, or not reduce it to the prejudice of creditors. A company should not pay a dividend to shareholders if it has not earned the profits to do so. Distributions that are not from profits are seen as a disguised return of paid up capital and require a different procedure.

Section 254T simply states:

"A dividend may only be paid out of profits of the company."

When considering this question, the New Zealand Courts have stated that:

"The payment of a dividend out of paid up capital will occur if the payment has the effect of reducing the company's net assets below the amount of its paid up capital" [Hilton International Ltd v Hilton & Anor (1989)]

What are profits?

Some rules apply to the calculation of profits. The Courts have summarized the position as follows:

(a) Profits can be trading or revenue profits. The Courts do not set any strict rules as to what is trading profit and generally leave that question to accountants and businesspeople. The Court may sometimes rule that some items must be included in, or excluded from, the calculation.
(b) Profits can be capital profits accrued from the increase in value of capital assets. These capital profits may be from a revaluation of capital assets or from the realization of capital assets.

(c) Dividends can be paid from one year's revenue profits without needing to make back past revenue losses - but only if the company remains solvent, or section 588G will apply.

(d) The company must have earned profits in order to declare and pay a dividend, but it does not need to have collected them. Case law has provided that a company can pay a dividend from borrowed monies, if the profits have been actually earned. The principle is designed to set the upper limit on the source of the dividend to profits earned, not on the capacity to pay the dividend. But, the company must be solvent at the time.

What happens if this section is breached?

A breach of the section can lead to an action against the directors for compensation in the amount of the dividend. That is, directors may be personally liable to the company for the amount of a dividend, whether or not they received any part of that dividend personally. Compensation is sought to bring the company back into the position that it held before paying the dividend.

Does the company need to be insolvent?

No. There is no requirement for the company to be insolvent or in liquidation. It is usual that the action will be taken because the payment of the dividend made the company insolvent, and then it is likely to be taken by the liquidator, but this is not necessary.

INSOLVENT TRADING

What is insolvent trading?

Insolvent trading is allowing the company to incur a debt when the company is insolvent. Insolvent trading is governed initially by section 588G of the Corporations Act that places directors under a duty to prevent a company from incurring a debt when the company is insolvent. That section states that the payment or the declaration of a dividend is incurring a debt:

when the dividend is paid or, if the company has a constitution that provides for the declaration of dividends, when the dividend is declared

If a dividend is paid (a debt is incurred) whilst the company is insolvent, the directors may be liable for insolvent trading.

The incurring of a debt by paying a dividend is also set out in section 254V.

(1) A company does not incur a debt merely by fixing the amount or time for payment of a dividend. The debt arises only when the time fixed for payment arrives and the decision to pay the dividend may be revoked at any time before then.
(2) However, if the company has a constitution and it provides for the declaration of dividends, the company incurs a debt when the dividend is declared.

Insolvent trading is explained in more detail in another Fact Sheet.

Does the company need to be insolvent at the time?

Yes. The company must be insolvent at the time of, or become insolvent because of, the payment of the dividend. Without insolvency at the relevant time, there is no insolvent trading claim. The legislation defines solvency and insolvency in the following terms:

Section 95A - Solvency and Insolvency
(1) A person is solvent if, and only if, the person is able to pay all the person's debts, as and when they become due and payable.
(2) A person who is not solvent is insolvent.

The calculation of solvency is detailed in another Fact Sheet

What can a liquidator do?

A liquidator can seek compensation from a director in an amount equal to the amount of the dividend. This claim can be made whether the directors were shareholders or not, or received any benefit from the dividend or not.

This section does not allow the liquidator to commence proceedings against the shareholders that received the dividend.

Who else can take an insolvent trading action?

If a liquidator does not take an action, the creditors of the company may commence one. There are certain conditions that must be met before this may occur. These are set out in the insolvent trading fact sheet.

SUMMARY

The New Zealand Courts in Hilton International Ltd v Hilton & Anor set out 9 points that state the general position. These points can be summarized as follows:

1. Dividends including capital dividends can only be paid out of profits and not from a reduction of paid up capital.

2. The payment of a dividend out of paid up capital will occur if the payment has the effect of reducing the company's net assets below the amount of its paid up capital.

3. Whether there are profits and how much should be paid out as divided is a matter of commercial judgment, but made with the following in mind.

4. No dividend may be paid, whether out of capital or income profits, if the company is in a state of trading insolvency.

5. No dividend may be paid, whether out of capital or income profits, if the company is in a state of balance sheet insolvency, or will enter that state as a result of the payment.

6. No dividend may be paid, whether out of capital or income profits, if the company is in a state of doubtful trading or balance sheet solvency, unless the directors can demonstrate a good faith belief on reasonable grounds that the payment would not jeopardize the company's ability to pay creditors.

7. No dividend should be paid, even if the company is solvent, if the directors ought to have appreciated that the payment was likely to jeopardize the company's balance sheet or trading solvency.

8. The directors of the company owe a duty to the creditors of the company.

9. Directors who act in breach of these principles are liable to compensate the company for its loss arising as a result of the breach.

Disclaimer
The enclosed information is of necessity a brief overview and it is not intended that readers should rely wholly on the information contained herein. No warranty express or implied is given in respect of the information provided and accordingly no responsibility is taken by Worrells or any member of the firm for any loss resulting from any error or omission contained within this fact sheet.

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Last Updated: 7.3.2008