Covid-19: what it means for company dividends

When the pandemic is over or even before then, many companies will be seeking to raise extra finance and will be trying to induce investors to invest in their company. Alternatively owners of companies may be wanting to raise extra finance by drawing down additional dividends from their company.

For most practical purposes the main form of return on investment comprises dividends and only incidentally (at the end of the life of the company) from capital gains through retentions of profit. In turn many companies will be looking at the resources (principally profits) they generate in order to be able to pay dividends. Traditionally the starting point was sometimes known as distributable profit, as by definition, losses could hardly give rise to a distribution. The problem with looking at it this way was that accounting profits were subjective whereas dividends had (in the main) to be paid in cash, something never to be underestimated but frequently is. This is why public companies are often reluctant to reduce dividend payments as it is usually interpreted as a sign of a future decline in distributable profits (and its corollary dividends).

The distribution of profits has been recognised in Guernsey Company Law in section 304 (1) which states that a company may pay a dividend if the board of directors is satisfied on reasonable grounds that the company will, immediately, after the payment satisfy the solvency test and conjunctively although increasingly less importantly it satisfies any other requirement in its memorandum and articles.

This requirement to be satisfied on reasonable grounds is a continuing one as section 304(3) provides that if economic circumstances change between when it was authorised and when it is paid then the dividend, not surprisingly will not be authorised and will be ultra vires. In these circumstances any dividend paid would be repayable and in addition it would expose the directors to a breach of duty action. For this purpose ‘reasonable’ will be fact based and depend on the circumstances.

To underpin the dividend the board of directors must approve a certificate stating that in their opinion the company will, immediately after payment of the dividend satisfy the solvency test and state the grounds for that opinion, section 304(6). The final element is the definition of ‘solvency test’ which is in section 527. This requires a company to be able to pay its debts as they become due, which is a form of profit and loss test and a balance sheet one that, not surprisingly, the value of the company’s assets is greater that its liabilities.

Some help is given as regards the latter as in subsection (2) it is provided that again, not surprisingly, regard must be had to the accounts of the company and perhaps more subjectively that the directors know or ought to know all the other circumstances which affect or might affect the value of the company’s assets and the value of the company’s liabilities but this is softened by the qualification that they may rely on valuation of assets or estimates of liabilities that are reasonable in the circumstances. The final point in this section is that in the case of a supervised company there are particular hurdles to satisfy which are a function of the regulatory law involved eg. The Protection of Investors 1987.

What does this mean in practice?

It means this – the more complicated the production process, the more difficult the distribution decision is likely to be as the more uncompleted transactions there are likely to be. Conversely the simpler the production process, the simpler the distribution decision is likely to be, although it does not necessarily follow. Prior to the introduction of formal accounts it was much easier as typically a merchant would finance a voyage of discovery whereby the captain would be financed by the merchant and the spoils from the voyage including the boat would be shared by the merchant and the captain. The problem is the accounting period which is a snapshot of the financial position at a point in time, dictated by tax and financial considerations.

The key driver is obviously the profit figure but this is a function of working capital items such as debtors, creditors and stock and (in appropriate cases) work in progress. This in turn requires decisions about bad debts and slow or even obsolete stock (which may be particularly relevant in retailing and market gardening). The problems are even greater in terms of the construction and manufacturing industries where often a large degree of subjectivity is involved not only in valuing the work in progress but allocating the overheads. A perennial problem for many businesses is the valuation to be attributed to litigation which can have sensitive commercial issues if the accounts will become available to your opponent as it will be on discovery. Effectively the decisions made in relation to the profit and loss account will determine where the balance sheet test is satisfied, i.e. that the value of the assets is greater than the liabilities.

However, suppose both the balance sheet and profit and loss account are satisfied, is that sufficient? The answer is no because there is the solvency test which requires that the company is able to pay their debts as they fall due, a combination of profit and cash flow test. This implies that for most businesses a credible cash flows prediction is made for the next 12 months. This time period is, it is submitted, dictated by the length of the accounting period. Often it is wise to do a sensitivity analysis in terms of assuming cash flows are greater or less than the estimated amount by 10/20% to get some idea of the variance of the cash flows.

As a corollary this would highlight the vulnerability if cash flows are less than expected and the implications if they are under-estimated. Such evidence would be very helpful should the dividend be challenged at a later date. The difficulty of this exercise and its importance is entirely a function of the cash flow cycle of the business, which is a factual matter. It is a relatively easy matter in a financial services business where billing is once a year although this might be more complicated where it is spread throughout the year, as compared to a (non-financial) business which is very seasonal or cyclical.

It follows that the dividend decision is a complicated matter not to be under estimated particularly where the company is vulnerable to insolvency. Before this stage is reached specialist advisers should be called in and extensive documentation recorded, especially in view of the proposed new insolvency legislation.

This article provides a broad indicator of the issues to consider.