Directors’ remuneration: Lawfulness and reasonableness if the company fails

Directors don’t usually expect their pay or dividends to be questioned years later, particularly in micro and small owner-managed companies. But if a company becomes insolvent, those decisions are often reviewed in detail. We look at how directors’ remuneration is assessed after insolvency, the challenges that can arise, and what directors and advisers should consider at the time decisions are taken.

When a company goes into insolvency, when and how directors have taken money out of the company is often closely examined, with a particular focus on whether those decisions were consistent with their legal responsibilities as directors.

This is typically assessed by reference to two separate questions. The first is whether the remuneration was lawful. The second is whether it was reasonable in the circumstances. These are distinct tests. A payment may be lawful but still unreasonable, or unlawful regardless of the amount. Failing either test can expose directors to recovery action and breach of duty claims.

Common ways directors extract value

Directors may  receive money from a company through salary or fees paid under PAYE, drawings through a director’s loan account, dividends where the director is also a shareholder, or a combination of these. 

Each carry different legal requirements and risks. These can become especially important if the business’s financial position worsens and decisions are reviewed in an insolvency context.

Directors’ loan accounts and later scrutiny

It’s common for directors to draw funds monthly through a director’s loan account, with the expectation that a dividend will be declared at the end of the financial year to clear the balance. Difficulties arise where the company doesn’t have sufficient distributable reserves to support that dividend.

In those circumstances, the overdrawn balance doesn’t disappear. It remains a debt owed by the director to the company and may be demanded by a liquidator or administrator. 

There’s also a specific statutory issue to consider. Subject to limited exceptions, loans to directors of more than £10,000 require shareholder approval under section 197 of the Companies Act 2006 (the Companies Act). Where approval hasn’t been obtained, the loan is voidable and the director may be required to repay it immediately.

This issue can extend beyond the borrowing director. Other directors may face claims if they allowed an unauthorised loan to be made or to continue, particularly if they were aware of it and didn’t take steps to address it. These situations are often examined closely in insolvency cases, especially where directors have differing financial means which might allow an insolvency practitioner a better prospect of recovering funds from one director than another.

Dividends and the limits of technical compliance

For a dividend to be lawful, the Companies Act requires the company to have sufficient distributable reserves, and the company’s Articles of Association and approval processes to be followed. If these requirements aren’t met, a dividend may be unlawful and repayable. 

Even where the technical requirements appear to have been met, risks remain. Dividends paid when the company is insolvent may still expose directors to liability. 

A company may, for example,  be balance sheet solvent and have distributable reserves, but still be unable to pay its debts as they fall due. In that situation, paying dividends to directors or shareholders while creditors remain unpaid may lead to breach of duty claims.

Reasonableness and objective commercial judgement

Establishing that remuneration is lawful doesn’t end the analysis. Directors’ pay must also be reasonable. 

The courts have made clear that there’s no single correct figure for reasonable remuneration. The question is whether, applying objective commercial criteria, the level of remuneration falls within a reasonable range for someone carrying out that role with that level of responsibility.

Directors’ duties and good governance

Questions of remuneration and dividends sits within directors’ wider statutory duties. Directors must act in good faith, promote the success of the company, exercise reasonable care, skill and diligence, and, where insolvency is a real risk, have regard to the interests of creditors.

Where remuneration or dividends appear to prioritise directors’ personal benefit over the company’s financial position, or over the interests of creditors, those decisions are more likely to be challenged after insolvency. Good governance is not just about technical compliance. It’s about being able to explain, justify and evidence decisions if they’re later reviewed.

What may follow if the company becomes insolvent

Where concerns are identified after insolvency, a range of actions may be considered. These can include claims to repay overdrawn director’s loan balances, recovery of unlawful dividends, and breach of duty claims against directors. Claims may also be brought against other directors who allowed unlawful arrangements to continue. 

These factors are likely to be  considered in a report on director conduct to the Insolvency Service. This could ultimately lead to a director being disqualified from acting as a director. or being involved in company management for between two and 15 years.

Matters to consider at the time decisions are taken

The issues outlined above underline the importance of thinking carefully about remuneration and dividends at the time they’re paid, rather than assuming they won’t ever be scrutinised. 

Directors should be able to demonstrate that remuneration is lawful, that directors’ loans are properly approved where required, and that dividends are supported by appropriate accounts and distributable reserves. They should also be able to explain why the level of remuneration is appropriate, taking into account the role performed, the responsibilities assumed, market context and the company’s financial position, and how decisions promote the success of the company.

Directors often rely on advice from their accountants and other professional advisers on tax-efficient remuneration strategies. However, advisers also play an important role in helping directors understand the legal framework, encouraging appropriate challenge where necessary, and making sure that key decisions are properly considered and recorded. This can potentially reduce the risk of future professional indemnity claims where appropriate advice hasn’t been given.

A preventative approach

Many disputes in insolvency don’t arise because directors acted dishonestly, but from arrangements that seemed routine at the time and can’t later be justified when the company fails. 

Taking a preventative, governance-focused approach to remuneration and dividends - grounded in directors’ duties and supported by appropriate records, helps protect both the company and those who run it.