England and Wales High Court (Chancery Division) Decisions

IN THE HIGH COURT OF JUSTICE
CHANCERY DIVISION

		Royal Courts of Justice Strand, London, WC2A 2LL
		16 September 2005

1. It's A Wrap (UK) Ltd ("the company") was incorporated on 29 August 2000. It was placed into insolvent Liquidation by a meeting of members and creditors on 20 January 2004.
2. It had conducted business as a retailer of cards, gifts and candles. It was commercially unlucky in the effects of changes in the competitive environment in both its first two shops, and never recovered.
3. During the period of its business it was run by the Defendants, Mr and Mrs Gula. They were the only shareholders and the only directors. They had set it up following the end of Mr Gula's previous employment. They had invested substantially in it, making unsecured loans of £80,000 to the company.
4. The business was Mr and Mrs Gula's livelihood. Accordingly they wanted to draw remuneration from it. As they saw it, they drew money from it. The payments in successive years were £14,000 each and £14,000 each, therefore each received £28,000.
5. The company's accounts show that in the year ended 31 December 2001 it made a loss on ordinary activities before taxation of £17,641. The accounts show that it paid dividends for that year of £28,000. In the year ended 31 December 2002 it made a loss on ordinary activities before taxation of £36,189. The accounts show that it again paid dividends of £28,000. In neither year were there profits available for distribution.

6. Part VIII of the Companies Act 1985 begins with section 263(1):

"A company shall not make a distribution except out of profits available for the purpose."

6. On the assumption that the payments made were correctly classified in the accounts as dividends, this section was contravened by the payments totalling £28,000 to each Defendant referred to in paragraph 4 above.

8. Section 277 of that Act provides, so far as is relevant to this case:

"(1) Where a distribution, or part of one, made by a company to one of its members is made in contravention of this Part and, at the time of the distribution, he knows or has reasonable grounds for believing that it is so made, he is liable to repay it (or that part of it, as the case may be) to the company or (in the case of a distribution made otherwise than in cash) to pay the company a sum equal to the value of the distribution (or part) at that time."

"(2) The above is without prejudice to any obligation imposed apart from this section on a member of a company to repay a distribution unlawfully made to him; ... "

7. In these proceedings the company asserts the contravention of section 263(1) and claims repayment under section 277(1) of that Act.
8. Before the proceedings were started. Mr Gula wrote to Mr Clark (the liquidator) on 2 August 2004. He explained that the reason that the payments appeared in the accounts as dividends was that paying them in that way was seen as a tax efficient way of drawing a salary. The relevant part of his letter reads:

" ... the directors dividends shown on accounts to which you refer for December 200 I and December 2002 were not paid as dividends. These amounts were taken as salary over the course of the year. The fact that they are shown as dividends is an accounting method as advised and set up by our then accountant Russell Lebe, as a tax efficient way of drawing a salary. We were also advised that this was the normal practice for small businesses and was not contravening any laws." [Italics mine.]

He continued:

"Surely when these accounts were audited and filed, any errors or misunderstandings would have been raised by the revenue or companies house."

9. When the decision was first taken to pay dividends, and when the same decision was taken as to the later payments, it was not appreciated that payment of a dividend was prohibited. I heard Mr Gula and it was clear to me that, firstly, what he had set out in the sentence italicised by me in the quotation above was true; secondly, that the classification of the payments as dividends was a deliberate decision for the specific purpose of gaining what was understood to be a proper tax advantage; thirdly that the directors were aware that the company had made only losses; and fourthly that they were unaware that paying dividends in the circumstances involved contravention of the Act. In my opinion the directors would not have done anything to contravene the Act had they been aware that to act in such way would involve contravention of the Act. However, I consider that the dividends were correctly classified as such. There was a conscious decision. The fact that it may have turned out disadvantageously does not mean that the decision was not effective.
10. The question arises, What is the meaning of section 2777 When one is concerned with whether a distribution is "so made", that is, made in contravention of Part VIII of the Act, is there a liability to repay on the part of the member if the member receiving it knows at the time, or has reasonable grounds for believing, the factual situation to be that which has the consequence that the distribution is in contravention of the Act, even if he is unaware that that is the legal consequence of the factual situation, or is there a liability to repay only if the member receiving it knows at the time, or has reasonable grounds for believing, that what is happening amounts to a contravention of the Act?
11. Apart from Bairstow v. Queens Moat Houses Plc [2001] EWCA Civ 712 [2001] 2 H.C.L.C. 53, referred to below, no authority was cited to me, and I have found none in additional research that I have done, in which this question was raised for actual decision.
12. Mr Stephen Tudway, who appears for the claimant and drew to my attention material which could be relied upon by the unrepresented Defendants as well as that on which he relied, drew attention to the principle that ignorance or mistaken understanding of legislation is not an excuse for failure to comply with it, citing pp.28-32 of Bennion, Statutory Interpretation.
13. I do not find the words of section 277(1) provide me with a clear answer. Despite the strength of the principle referred to, which had its initial attraction, my reaction was that the words "is so made" amount to "is made in contravention of this Part" and so do require that the member knows or has reasonable grounds to believe not just the facts which give rise to the contravention but the legal result of contravention. Mr Tudway's authorities and my own addition to them have not changed that view.
14. Section 277(1) is the successor of section 44(1) of the Companies Act 1980. That provision was enacted to give effect to Article 16 of the Second Council Directive of 13 December 1976 (77/91/EEC). The recitals to that included:

"Whereas in order to ensure minimum equivalent protection for both shareholders and creditors of public limited liability companies, the coordination of national provisions relating to their formation and to the maintenance, increase or reduction of their capital is particularly important; ...

"Whereas Community provisions should be adopted for maintaining the capital, which constitutes the creditors' security, in particular by prohibiting any reduction thereof by distribution to shareholders where the latter are not entitled to it and by imposing limits on the company's rights to acquire its own shares; ...

Article 15 dealt with prohibitions on distribution, and Article 16 provided:

"Any distribution made contrary to Article 15 must be returned by shareholders who have received it if the company proves that these shareholders knew of the irregularity of the distribution made to them, or could not in view of the circumstances have been unaware of it."

15. I have found no European judicial decision on the provision. These words do in my opinion focus on the shareholders' knowledge not of the facts amounting to irregularity but of the fact of irregularity, despite the recitals to which I have referred. While section 44(1) of the 1980 Act could have treated members receiving irregular distributions more severely than the Directive required, it did not need, for conformity with the Directive, to go further than making them repay if they knew of the irregularity. Particularly bearing in mind the saving provision of section 277(2), this reference to the origin of section 277(1) supports my reaction that its own wording requires knowledge of the fact of contravention as opposed to the facts amounting to contravention.
16. As Mr Tudway helpfully pointed out, provisions to this effect are by no means unknown. In Thorne v. Silverleaf [1994] 1 B.C.L.C. 637 the Court of Appeal was concerned with s.217 of the Insolvency Act 1986. It included this:

"(1) A person is personally responsible for all the relevant debts of a company if at any time ... (b) as a person who is involved in the management of the company, he acts or is willing to act on instructions given (without the leave of the court) by a person whom he knows at that time to be in contravention in relation to the company of section 216."

At p.645f Peter Gibson L.J. (with whose reasons Ralph Gibson L.J. agreed, as well as adding his own reasons) said of this that:

"In s.217(1)(b) knowledge that it is a crime is required."

17. Direct reference to section 277(1) of the Companies Act 1985 was made in Bairstow v.

Queens Moat Houses Plc [2001] EWCA Civ 712 [2001] 2 BCLC 531. At paragraph 47 (p.547) Robert Walker L.J. (with whom Sir Andrew Morritt V.-C. and Sedley L.J. agreed) said:

"The prospect of the former directors being able to obtain contribution from innocent recipients of unlawful dividends was debated (somewhat inconclusively) in the course of the appeal hearing. The statutory remedy in s.277 of the Act is not in point (since it is available only to the company, and only against a shareholder with actual or constructive knowledge of the unlawfulness of the dividend)."

18. Given that the debate was said to be somewhat inconclusive, and that Robert Walker L.J. said in paragraph 48 that this was bound to be the case because the possible liability of long-term investors was not an issue of the appeals, it could be said (and was argued by Mr Tudway) that what was said about section 277 was obiter. I accept that that is so, but what the Court said is obviously powerful, and in the context that I have referred to already I conclude that section 277(1) can only be invoked where the member knew (or had reasonable grounds to believe) that the payment was being made in contravention of Part VIII of the Act, as distinct from knowing of the facts which amounted to a contravention.
19. The above conclusion is consistent with the wording used, without exploration of the argument, in Gore-Browne on Companies at paragraph 25[14] and Gower's Principles of Modern Company Law (7th edition) at p.286, both referring to the test as being one of whether the member knew or ought to have known that the payment was "unlawful".
20. On that basis, the claim as set out in the Particulars of Claim fails. However, Mr Tudway drew attention also to Precision Dippings Ltd v. Precision Dippings Marketing Ltd [1986] 1 Ch. 447 as a case in which s.44(1) of the Companies Act 1980 had been in issue but in which the point of construction had not been decided. In it the claimant had paid a dividend to Precision Dippings Marketing Ltd, which was its parent company. The claimant's case was that the payment was in contravention of sections 39 and 43 of the Companies Act 1980, as there were no available profits at the time, and so were ultra vires the claimant. It sued the parent company and the two directors (Mr Wynne-Jones and Mr King), and sought summary judgment. The directors said, and for the purposes of the appeal it was accepted, that at the time of payment of the dividend they were not aware of the relevant requirements of the Companies Act 1980. They also said, and again it was accepted for the purposes of the appeal, that they were advised by the company's auditors that the sum paid by way of dividend could be paid by way of dividend so long as the dividend was paid by way of available profits. At the time of the appeal the position was that the claimant accepted that the directors should have unconditional leave to defend the claim; the appeal was only against that part of the Judge's order by which Precision Dippings Marketing Ltd had been given unconditional leave to defend.
21. Repayment was sought under section 44( I) of the 1980 Act, the wording of which was in materially identical terms to that which now appears in section 277 of the 1985 Act. It was not necessary for the Court of Appeal to consider the position of the directors under section 44(1). Dillon L.J. (with whom Sir Edward Eveleigh agreed) did, however, say this at p.457G:

"There can be no doubt that because Mr Wynne-Jones and Mr King were the only shareholders in and directors of Marketing and were also the only directors of the company, Marketing must be taken to have known all the facts. But it did not in fact know the terms of sections 39 and 43."

What the Court did not do was consider the effect, so far as the directors themselves were concerned, of it being the case that at the time of the payment of the dividend they were not aware of the relevant requirements of the Companies Act 1980. What it did was to conclude that Precision Dippings Marketing Ltd had no answer to a claim for repayment (and that no relief should be afforded). This conclusion was reached because the payment was ultra vires the claimant; Precision Dippings Marketing Ltd had notice of the facts (through the common directors) and was a volunteer. It was held liable as constructive trustee.

22. Mr Tudway appears from his helpful file submitted after oral argument to rely on this decision. As at present advised it appears to me that a claim on this basis could lie, but it is not the claim made in the Particulars of Claim. I am not at this stage prepared to allow an amendment without at the very least consideration of the consequences that might attach to an amendment. Subject to any argument that may arise from this paragraph, there should be judgment for the Defendants.