The Companies Act 2006 requires shareholder approval for loans exceeding £10,000, including a director’s loan account (DLA). Upon entering an insolvency process, directors face claims from insolvency practitioners to repay their overdrawn DLA in circumstances where they are often unaware the DLA is illegal.
In this article we identify some of the pitfalls of operating a director's loan account and risks faced by directors when a company is insolvent and placed into administration or liquidation. We also provide recommendations for accountants and directors to mitigate some of the risk.
It's common practice for accountants and directors to agree that directors should be remunerated by way of dividends. Payments made to directors pending declaration of a dividend will be recorded as a loan against their director’s loan account.
Section 197 of the Companies Act 2006 states that a company may not make a loan to a director unless the transaction has been approved by a resolution of the members of the company. There is an exception set out in section 207 of the Companies Act 2006 whereby approval is not required for ‘minor transactions’, where the level of the loan does not exceed £10,000.
Accordingly, in circumstances where a director of a company receives the benefit of a loan which exceeds £10,000, that loan must be ratified by the shareholders of the company. The loan is otherwise unlawful. Section 213 of the Companies Act 2006 sets out the consequences of an unlawful loan; it must be repaid. This liability may fall on all directors.
We often see in owner-managed companies that two or more family members are appointed as shareholders. The affairs of the company may be treated informally and no resolution is passed to allow a loan to exceed £10,000, even if the shareholders would have consented.
When a company is insolvent and placed into administration or liquidation, we commonly see DLAs well in excess of £10,000, with many being for very substantial sums.
It's the duty of an insolvency practitioner to realise the assets of the insolvent company, and that includes recovering the overdrawn DLA.
Directors are therefore often faced with proceeding to recover large balances on overdrawn DLAs in circumstances where they do not understand why they are liable to repay what they consider to be their remuneration and do not understand the illegality of the DLA.
On receipt of such claims, directors will often seek to set off expenditure they have personally incurred on behalf of the company against their overdrawn DLA, but critically find themselves unable to do so due to the illegality of the loan.
No set off is available to a director and a company in liquidation in circumstances where the director has acted in breach of duty, or secured the benefit of an unlawful loan, as displayed in the Manson v Smith case and rule 14.25 of the Insolvency Rules 2016.
We would therefore recommend on creating any such arrangement whereby a director may be remunerated by way of future dividends recorded against their DLA, at the inception of this arrangement, shareholders should pass a resolution to approve the company making a loan to the director in excess of £10,000 and retain a copy of that resolution.
Latterly, on declaring a dividend to allow the DLA to be repaid, proper dividend vouchers should be issued alongside minutes which record the calculation of the available distributable profits to declare the dividend.
This exercise must comply with the Companies Act 2006 and requires an assessment of the company’s reserves, as identified in the company’s last filed accounts at Companies House or where the reserves are insufficient in the last filed accounts, would require management accounts to be reviewed and analysed to identify the distributable reserves.
For further information, please contact Melissa George, Nikki Brastock or Olivia Reader in our restructuring and insolvency team.
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