Capital Maintenance and Distributions — SQE1 FLK1 Business Law and Practice

Your client's board has just won three building contracts. Forecasts show trading profits of about £500,000 in the coming year. Advance payments have left healthy cash in the bank. The board resolves to pay an immediate dividend of £50,000. The accountant advises against it. The directors reply that the profits are as good as earned and no creditor can be prejudiced. Can they pay it? No.

Not a penny. The company has accumulated realised losses of £100,000 and made no profit this year. Cash is not the test. Forecasts are not the test. This is Capital Maintenance and Distributions. The whole topic turns on one idea. A company's capital belongs to its creditors, and only its profits can be handed to its members. Keep that board in mind.

Here is the route. First the principle itself, and why creditors care. Then distributable profits, which is the heart of it. Then dividends, and who declares which kind. Then what happens when a distribution is unlawful, and who has to pay it back. Then the two routes for reducing capital. Then a company buying its own shares. And last, financial assistance.

Start with the idea. A company's capital is the money the members put in, and it has to stay in the company as a cushion for creditors. Why? Because the members have limited liability. They are only liable for what is unpaid on their shares. The creditors have nothing to look to but the company's assets. If the members could take the capital back out at will, that protection would be worthless.

So here is the key principle, and everything else hangs off it. A company may only make distributions to its members out of profits available for the purpose. It cannot distribute its capital, except through specific regulated procedures.

What counts as profits available? Section 830 of the Companies Act 2006 gives the formula, and it is worth memorising. Accumulated, realised profits, less accumulated, realised losses. Four words doing the work. Accumulated, so profits brought forward from earlier years count. Realised, so the gain must have been converted into cash or other assets. And you subtract the losses on the same basis.

Try one. A company's properties have been revalued upwards by £500,000, credited to a revaluation reserve. It has trading profits for the year of £200,000, all in cash, and retained earnings brought forward of £100,000. None of the properties has been sold. The board wants to pay £400,000. How much is actually available? £300,000. The revaluation surplus is unrealised appreciation on assets the company still owns, and it cannot be distributed.

And directors cannot turn an unrealised surplus into a realised profit by resolving that it is one. Only a disposal does that. Cash in the bank does not do it either.

One extra rule for public companies. Section 831 adds a net-assets test. A public company may only distribute if, and to the extent that, its net assets are not less than the aggregate of its called-up share capital and its undistributable reserves. Private companies do not face that second hurdle.

Dividends next. A final dividend is declared by the shareholders in general meeting, on the recommendation of the directors. The directors propose a figure. The members approve it. An interim dividend is different. The directors declare it themselves under their delegated authority, and no shareholder approval is needed at all. Both must come out of distributable profits.

Two other labels worth knowing. A special dividend is a one-off payment, often out of exceptional profits. A preference dividend is a fixed rate paid to preference shareholders before the ordinary shareholders get anything at all.

Now what happens when it goes wrong, which is where our builders were heading. A hotel group once paid dividends when its accounts showed insufficient distributable profits, some directors relying on projected future profits. The Court of Appeal held the dividends unlawful. Whether profits are available is tested by the accumulated realised figures at the time of the distribution. Future profits cannot be taken into account. That is Bairstow v Queens Moat Houses plc, from 2001.

Two separate liabilities follow, and candidates mix them up. The first is the member's. Under section 847, a member who at the time of the distribution knew, or had reasonable grounds for believing, that it was unlawful is liable to repay it. What has to be known is the facts, not their legal effect. A recipient who took the money in good faith, with no knowledge and no grounds for belief, keeps it.

The second is the directors', and it is not section 847. Directors who cause a company to pay a dividend out of capital misapply its property and must restore it. That is a common law and equitable liability. It turns on what they knew or ought to have known, not on dishonesty. The court may relieve them under section 1157.

Reducing capital. Sometimes a company genuinely wants to return surplus capital, or to cancel capital that has simply been lost. It can, but only through a regulated route, and there are two. Both need a special resolution, which means 75%. The difference is what backs it up. A private company can use a solvency statement. Any company can go to court, and a public company must.

The solvency statement route is section 641, and the detail is examinable. Every director must make the statement. It must be made not more than 15 days before the resolution is passed. Each director states that there is no ground on which the company could then be found unable to pay its debts. And that it will be able to pay its debts as they fall due during the year immediately following the date of the statement.

Two traps live in that sentence. The year runs from the date of the statement, not from the date of the reduction. And in forming the opinion, the directors must take into account all the company's liabilities, including contingent and prospective ones. Making the statement without reasonable grounds is a criminal offence. No auditor's report is required for this route.

The court route is section 645, and it is open to any company. The court hears creditor objections and may sanction the reduction with or without conditions. That is stronger protection for creditors, which is why a public company has no choice about it.

A company buying its own shares. First question: which resolution? An off-market purchase, which is the normal case where a private company buys out a named shareholder, needs a special resolution approving the specific contract. That is section 694. A copy of the contract must be available to the members for the 15 days ending with the meeting. And the member being bought out may not vote the shares being sold.

A market purchase, where the shares are traded on a market, needs only an ordinary resolution. Section 701. But that resolution has to specify the maximum number of shares, a maximum and a minimum price, and the date the authority expires. Five years is the ceiling. An open-ended authority is no authority.

Second question: where is the money coming from? Out of distributable profits, the purchase is treated as a distribution and you need enough profits at the time. Out of capital is a different animal. Private companies only, under a dedicated procedure in sections 709 to 723, and it is not a Part 17 reduction of capital. It needs a directors' statement supported by an auditor's report, a special resolution, and a notice in the Gazette.

And it gives creditors a way in. Creditors and dissenting members may apply to the court within five weeks of the resolution. Shares bought out of capital must be cancelled. Shares bought out of profits can be cancelled or held as treasury shares, which companies have been able to do since 2003.

Last area, and it is the one where the law changed. Financial assistance. Section 678 of the Companies Act 2006 is the prohibition. A public company, or its subsidiary, must not give financial assistance, directly or indirectly, for the acquisition of shares in that public company. Section 679 covers the other case, where a public company is the subsidiary of a private company and assists an acquisition of shares in that private holding company.

What counts as assistance? Loans, guarantees, security, or any other financial arrangement. A company lending someone the money to buy its shares. A company charging its factory to secure that person's bank loan. The company's resources are funding the purchase of its own shares. And here is the change: the Companies Act 2006 abolished the prohibition for private companies acquiring their own shares.

Which kills a question candidates still get wrong. There is no whitewash procedure any more. The old route under the Companies Act 1985, a directors' statutory declaration, an auditor's report and a members' resolution, went when the prohibition went. A private company needs no clearance at all.

A public company cannot whitewash either. It has to fall inside a statutory exception. There is the principal-purpose exception, where the assistance is incidental to some larger good-faith purpose. There are unconditional exceptions in section 681: lawful dividends, distributions in a winding up, and reductions, redemptions and buybacks made under the Act.

And there are conditional exceptions in section 682: money-lending in the ordinary course of business, and employees' share schemes. Those two only work if the company's net assets are not reduced, or the assistance is paid out of distributable profits. A manufacturer does not lend money in the ordinary course of business.

So run the check on any proposed payment to members. Are there sufficient accumulated realised profits, measured now? If yes, the distribution is lawful. If no, is the company using one of the regulated procedures, a reduction of capital or a purchase of its own shares out of capital? If neither, the distribution is unlawful, and somebody is going to be asked for the money back.

A word on how SQE1 tests this. You will not be asked to recall a case name or a section number. You get a scenario, five answers, and one instruction: pick the best. This topic is nearly all statute, so learn what the rules do, not where they sit.

If you keep only three pegs. Section 830, accumulated realised profits less accumulated realised losses, which decides almost every distribution question. Bairstow v Queens Moat Houses plc, where forecast profits could not justify a dividend that the realised figures did not support. And section 678, the financial assistance prohibition that binds public companies and no longer binds private ones.

Four traps. One: unanimity does not create distributable profits. If every member agrees in writing to a dividend the Act forbids, it is still unlawful. Members cannot authorise what the statute prohibits.

Two: cash is not the test, and neither is solvency. A company can be flush with cash, paying every debt as it falls due, and still have no distributable profits. The profits test is the test. Liquidity is a different question.

Three: keep the two liabilities apart. Section 847 is the member's liability, and it needs knowledge or reasonable grounds for belief. The directors' liability is not section 847 at all. It is misapplication of the company's property, and it turns on what they knew or ought to have known.

Four: an auditor's report belongs to one procedure only. A private company paying for its own shares out of capital needs one. A capital reduction by solvency statement does not. Get those the wrong way round and you lose the mark.

Quick check. A company paid a dividend of £50,000, divided among its three members. The company had no profits available, so the dividend was unlawful. The liquidator wants the money back. The first member is an accountant who received the management accounts every month and could see there were no distributable profits. The second is an outside investor who saw nothing beyond the annual accounts. The third is the finance director, who knew the position exactly.

From which of the members can the company recover? Three candidates. One: from the accountant and the finance director, but not the outside investor. Two: from all three, because the distribution was unlawful when it was made. Three: from the finance director alone, who both authorised the dividend and received part of it. Pause here if you want a moment.

The answer is one. Section 847 makes a member liable to repay if, at the time of the distribution, the member knows or has reasonable grounds for believing it is unlawful. The accountant had the monthly management accounts, so they had reasonable grounds for believing there were no profits. The finance director knew. The outside investor had neither knowledge nor grounds for belief, and keeps the money.

Why the others fail. Option two forgets that unlawfulness alone does not make a recipient liable. The knowledge condition has to be met as well. Option three lets off the accountant, whose access to the monthly figures gave reasonable grounds for belief, and that is enough.

Five things to take away. One: distributions come out of accumulated realised profits less accumulated realised losses, measured at the time of payment. Cash is not the test, forecasts are not the test, and our builders could not pay a penny. Two: unrealised revaluation surpluses are not distributable, however large, and no board resolution can make them realised.

Three: final dividends are declared by the members, interim dividends by the directors alone. Four: on an unlawful distribution, the member repays under section 847 if they knew or had reasonable grounds to believe, and the directors repay separately for misapplying the company's property. Five: financial assistance is a public company prohibition. Private companies were released from it, and the whitewash procedure went with it. Next time, Company Accounts and Audit.

Practise this topic with exam-style questions at sqe1prep.co.uk. This episode is for education and exam revision only, not legal advice, and we are not affiliated with or endorsed by the SRA or Kaplan.