Two former executive directors of defunct technology retailer Dick Smith were recently held personally liable for nearly $12 million – the full amount of a dividend paid to shareholders in late 2015.
The backdrop
In January 2016, the Dick Smith retail business went into voluntary administration and later, liquidation. In the aftermath, the company’s receivers sued six non-executive directors (against whom the claims fell away on appeal) and two executive directors - Mr Potts (the company secretary and CFO) and Mr Abboud (the Managing Director and CEO).
The receivers claimed that the directors had breached their duty of care and diligence to Dick Smith by voting in favour of board resolutions to pay an interim dividend of $16.555M and a final dividend of $11.826M at board meetings held in February 2015 and August 2015 respectively without considering whether such payments breached statutory rules.
Unpacking the statutory dividend payment test
A company must not pay a dividend unless, among other things, the payment ‘does not materially prejudice the company’s ability to pay its creditors’.
The Court considered the meaning of this restriction and concluded that:
- the concept of ‘material prejudice’ encompasses a company’s ability to pay the claims of its creditors as and when they fall due;
- the thing that must be materially prejudiced is a company’s ability to pay its creditors, as opposed to the interests of the creditors themselves;
- the concept of ‘ability’ is a matter of objective capacity to pay creditors, not a subject question of choice (e.g. to pay late); and
- a company’s ability to pay creditors is determined with reference to all of its resources, whether assets or income.
In short, a company cannot pay a dividend if it will materially affect its ability to pay creditors on time.
However, the broad approach taken by the Court concerning what constitutes ‘ability’ means that directors and company officers still have the flexibility to ‘pull levers’ to generate cash for a dividend payment. For instance, by quickly selling stock at a discount (in the case of a retailer like Dick Smith). Naturally the other statutory requirements must be met, not to mention the overhang of the common law profits test.
The relevance to directors’ duties
Courts have accepted that a director may contravene their duties by failing to take reasonable care to ensure that their company does not breach legal rules. This includes the rules regarding dividend payments.
In this case, the cash flow forecasts provided at each board meeting suggested that despite its financial difficulties, Dick Smith could pay both the interim and final dividends. At trial, the non-executive directors were entitled to rely on this and accordingly avoided liability.
However, due to Dick Smith’s accounting and supplier repayment practices, this information did not represent the company’s peak debt and true financial position. Mr Potts was aware of this due to his access to more up-to-date cash flow forecasts as CFO. The Court considered it something that Mr Abboud should also have been aware of, or at least inquired into, due to his awareness of the company’s ongoing issues with paying creditors on time.
Neither director was found to have breached their duty by approving the interim dividend. This was because Dick Smith was still sufficiently under its facility limit that it theoretically could borrow to afford the dividend without delaying creditor payments, even if it ultimately did choose to delay payments.
However, by the time of the final dividend, the information available to Mr Potts and Mr Abboud suggested that Dick Smith would significantly exceed its facility limit up to and on the date of the payment. Inevitably, paying the dividend would cause delays in its payments to creditors and, by failing to raise this issue at the meeting, both directors were found to have breached their duties. They were held liable to Dick Smith for damages equal to the full amount of the payment.
Takeaways for directors
This decision highlights that if directors fail to properly consider whether a dividend payment is lawful, it can amount to a breach of duty and ultimately liability for the full amount of the dividend.
Accordingly, when considering dividend payments, directors should:
- ensure that true and complete key financial information (in particular, an up-to-date cash flow forecast) is included in the board papers;
- raise any other information they are aware of that creates doubts about the company’s financial position as represented in the board papers; and
- actively consider, in light of all the information, whether the company can pay the dividend without materially affecting its solvency or ability to repay creditors on time.
This is particularly pertinent for executive directors/officers; courts will expect them to possess certain knowledge of, or make inquiries into, the company’s financial position based on the duties allocated to them by the board charter or assumed by them in practice.
