COVID-19 and the dividends dilemma

As the COVID-19 virus continues to dominate our lives, we are coming across more and more headlines like these: “Coronavirus: Big banks stop shareholder dividends until the end of 2020” (news.sky.com), “JPMorgan warns it could suspend dividend in ‘extreme’ scenario (ft.com)”.

These entities and their decisions on whether to distribute a dividend or otherwise, have come under the spotlight because of their systemic relevance to a country or industry and hence their continued financial health is not only important to a select group of stakeholders but to society at large. On the other hand, although smaller privately-owned companies are unlikely to pose systemic risk, they too, albeit on a smaller scale, face a dilemma whether to return profits to the shareholders by way of dividends during such uncertain times.

What is all the more worrisome is that in smaller set-ups directorship roles are often filled by the shareholders and beneficial owners themselves and naturally conflicts of interest may arise. In these instances, directors may feel that their decisions are immune from scrutiny since they would think that they ultimately only report “to themselves”.

The dilemma which should be faced by directors today is whether, in the circumstances, a return on profits to the members of the company may be justified and what their obligations at law are in this regard. To answer this question one needs to consider the regulation of dividends under Maltese law as well as the objective and subjective nature of a proposal for the payment of a dividend.

Under Maltese law, a dividend is classified widely as a “distribution of assets.” It is a term that is left purposely wide in the Companies Act (Chapter 386 of the Laws of Malta) (the “Companies Act”). In fact the definition covers “every description of distribution of a company’s assets to its members, whether in cash or otherwise”.

As one may reasonably surmise, the rationale is to ensure that stakeholders (and particularly creditors) are adequately protected from the risk of a company dispersing its assets to its shareholders to their detriment unless such assets are comprised of profits which are available for this purpose. This protection, along with other protective measures provided for in the Companies Act includes; rules in relation to the reduction of share capital and premium, redemption of shares as well as share buy backs. Together these rules are often referred to as capital maintenance rules.

A second rule is that a company may only distribute assets by way of a dividend to its shareholders when the company has sufficient distributable reserves and hence the company must have “profits available for this purpose.” In short, the term “distributable reserves” refers to a company’s net accumulated profits having deducted the net accumulated losses. Generally, profits of a company are calculated by making reference to the company’s most recent accounting statements which may be the final annual audited accounts or else interim management accounts.

The test to determine whether distributable profits are available is an objective test and one which is backward-looking. It looks back at the performance of the company until the date of the preparation of the accounts and it is objective because there are either accumulated profits or there aren’t.

Unfortunately this objective test alone is not sufficient to justify the proposal of a payment of dividends. By virtue of their office, directors tasked with making this decision have further obligations to fulfill and are therefore required to deliberate further.

Whilst the objective / historical test is certainly the starting point when proposing a dividend, directors must also be forward-looking and apply their minds to the present scenario in which the company operates and will operate and determine whether by doing so they are acting in the best interests of the company as a whole (and its creditors where the company is at risk of becoming insolvent) and not solely in the interests of the members. In so doing, the directors would need to act in accordance with the fiduciary duties which emanate from both the Companies Act as well as the Civil Code. Furthermore, they would also need to consider whether the company’s going concern is at risk should such a distribution of assets be made.

In line with this, whilst the relevant accounts may show that the company has profits available for distribution, if a future event has a negative effect on the going concern of the company – that is that the company will continue in operation and that it is not intended or required to liquidate the company or cease trading, a distribution made may still be questioned.

In practice therefore, in addition to reviewing the accounts, directors should also consider extraneous factors that may have a bearing on their decision-making process. These are subjective, forward-looking tests and therefore ones that require close attention. COVID-19 and its economic impact is clearly one such extraneous factor.

Whilst on face value one could conceivably argue that a proposal for a declaration of dividend considered solely on the basis of the financial statements of the company would be in line with the specific provisions relating to distributions, the directors would still nonetheless run the risk of breaching their fiduciary duties of skill and care should they not apply their minds to the new realities within which they now operate.

At this point in time, the only “known” is that COVID-19 has given rise to several unknowns and directors would be well-advised to exercise caution. Directors are expected to consider not only the company’s current financial position but also how and whether this may be impacted by these new realities. It may also be useful for directors to seek advice from independent third-party professionals to help them in their assessment. Other options could include deferring the declaration (or at least payment) of dividend to a future date when the future seems clearer and more stable and ensuring that the Company has adequate reserves saved for a rainy day. In all cases, it is crucial that any such decisions are carefully documented and recorded in accordance with the law.

Directors are therefore well advised to ensure that they are adequately informed of their obligations at law and to properly understand their fiduciary duties which aim to paint a relationship of trust between the director, the company, the shareholders and other stakeholders. Prevention is better than cure and any irresponsible decisions taken by a director today may lead to liability in the future.