Directors Remuneration - Is it Lawful, Is it Reasonable?

Insolvency Practitioners have long investigated whether director’s remuneration is lawful, but there is another issue to consider in addition, this being whether the director’s remuneration is reasonable. 

Drawing on Manolete Partners’ extensive experience supporting Insolvency Practitioners with direct misconduct and recovery actions, this article by Rachel McCahill, Associate Director at Manolete Partners Plc discusses these two issues and highlights some practical issues to consider.

Is it Lawful?

Directors may receive company monies in their personal capacity in one of the following ways:

• Remuneration through PAYE under a contract of employment
• Director’s loan
• Dividends if they are a shareholder
• Or a combination of the above

Director’s Loan

It is common practice to see directors paid by way of director’s loan account each month, with a dividend being declared at the end of the financial year, to set off against the indebtedness of the director under his loan account. The difficulty arises with this practice when the Company does not have sufficient distributable reserves at the end of the financial year to set off against the director’s loan account.  In this event, the element of the director’s loan account that has not been credited constitutes a debt due to the Company from the director which is capable of being demanded.

Subject to certain limited exceptions, Section 197 Companies Act 2006 expressly requires any loan to a director of the company of over £10,000 to be approved by a shareholder resolution. If the loan has not been so approved, then in accordance with Section 213 of the Companies Act 2006 the transaction is voidable by the company (and in this context the liquidator or administrator will render it void) so that the director has an obligation to immediately repay it. Importantly, this may also provide other means of attack to an officeholder such as:

• Advancing a loan that is unauthorised may constitute a breach of duty by the directors.
• Breach of duty claims against other directors who haven’t received the money, for allowing an unauthorised loan to subsist or failing to take steps to prevent it.
• Under Section 213 Companies Act 2006 a director may be liable for a loan to a co-director not authorised under section 197 Companies Act

These can be useful where the director who actually borrowed the monies is now impecunious, but the other directors are not.

Unlawful Dividends:

To be lawfully declared and paid, the relevant process at Sections 830 – 847 Companies Act 2006 must be followed, as well as any provisions in the Company’s Articles of Association.  This means that:

• “Relevant Accounts” must be drawn up - so accounts complying with the relevant provisions of the Companies Act - these are usually the Company’s annual filed accounts, but can be interim accounts, and the Companies Act sets out what they need to include in order to be compliant.
• Those accounts must also show sufficient distributable reserves.

If there are not:

• Relevant Accounts; and/or
• Sufficient distributable reserves; and/or
• The Company’s articles have not been followed (e.g. board or shareholder resolutions have not been passed)

Then the dividend will be unlawful and may be repayable if the recipient has knowledge that any of the above circumstances exist. “Knowledge” is knowledge of the facts, not the law – so, if the shareholder (who is often also a director) knows that no relevant accounts were prepared then he/she will be liable to repay the dividend.

Even if the relevant provisions of the Companies Act and the Company’s Articles are followed, but the Company was insolvent at the time of the declaration or payment of the dividend, the director may still be liable in breach of duty.   For example, the Company is balance sheet solvent and had sufficient distributable reserves but also had significant overdue liabilities at the time the dividend was declared resulting in cashflow insolvency. In this scenario effectively a director/shareholder is paying dividends to him/herself from the Company whilst other creditors (usually HMRC or other third-party creditors) are not being paid.

Is it Reasonable?

Once the legality of the director’s remuneration has been established, consideration should turn to whether the director’s remuneration is reasonable in all of the circumstances. 

The relevance of this can be seen in the case of CF Booth Limited [2017] WHC 547 (Ch).

The shareholders received substantial dividends until 1985. In 1986, the company suffered a loss, and no dividends were declared. Following 1986, the company returned to profitability, and, in 1987 the chairman announced his intention never to pay a dividend again (“the no-dividend policy”).

Until 2005, the directors were paid £275,000 pa. This increased to £400,000 pa in 2015 and to £820,000 pa in 2016 resulting in an average annual salary in 2015 of £1,579,000. The Company remained profitable. In addition, the directors (and wives) had the use of a fleet of luxury motor cars and a yacht. 

The minority shareholders argued unfair prejudice due to the lack of dividend income and the negative impact on their shares resulting from the unfair remuneration and the no-dividend policy.

The Court referred to the test as set out in Irvine v Irvine [2007] which was “whether, applying “objective commercial criteria” the remuneration which [the respondent] took was within the bracket that executives carrying the responsibility and discharging the sort of duties that [the respondent] was, would expect to receive.”

It was accepted by the judge that there is no single correct figure for reasonable remuneration, it falls within a bracket.  Here, the remuneration far exceeded the amount that a reasonable director could have thought fair for the work undertaken.   Reliance was placed on evidence provided by the petitioners and “Directors’ Remuneration in smaller companies” a paper published by Deloitte LLP.

The Court held that even if there are profits for distribution, the directors may decide not to declare a dividend and such a decision is only challengeable if the decision is in breach of the directors’ duties.  Here, it was held that the decision not to declare a dividend where the directors were receiving excessive remuneration, was difficult to reconcile, as if excessive monies were paid to directors, there should be monies available to pay a dividend, and that such decisions taken each year were a breach of the duty to promote the success of the Company for the benefit of its members as a whole (Section 172 Companies Act 2006).  That decision, combined with the excessive remuneration, was a policy which promoted the success of the Company for the directors’ own benefit.

Conclusion:

If remuneration is unlawful or unreasonable, this will usually give rise to breach of duty claims against the directors.  These are precisely the types of actions where early assessment and, where appropriate, assignment for value can maximise returns to creditors.

Questions that an IP should consider asking are:

Is the remuneration lawful?

• Was a director’s loan properly approved;
• Were there sufficient distributable reserves to declare a dividend?

Is the remuneration reasonable?

• Is the salary paid fair and reasonable salary for the role or excessive? Has any market research been carried out? Has it been set by reference to fair market value, experience, roles and responsibilities, or by what the director wants or needs to take out of the business to fund their lifestyle?
• Is any salary increase justifiable? Have extra duties/responsibilities been adopted?

If the answer is no to either of those questions, then further consideration should be given to the position. 

Rachel McCahill - Associate Director (Midlands)

rmccahill@manolete-partners.com | 07388 140538