Section 54 of the Companies Act 1997 is what gives the solvency test its teeth.
Section 54(1) — recovery from shareholders
A distribution made to a shareholder at a time when the company did not, immediately after the distribution, satisfy the solvency test may be recovered by the company from the shareholder unless —
(a) the shareholder received the distribution in good faith and without knowledge of the company’s failure to satisfy the solvency test; and
(b) the shareholder has altered the shareholder’s position in reliance on the validity of the distribution; and
(c) it would be unfair to require repayment in full or at all.
The defence is cumulative. A shareholder must show good faith and no knowledge, and that they altered their position in reliance, and that repayment would be unfair. Failing any one limb means the distribution is recoverable in full.
That makes the defence very hard for a controlling shareholder who is also a director — the usual position in an owner-managed company. Such a person will rarely establish absence of knowledge of the company’s financial state.
Spending the money is not automatically enough. What is required is a change of position in reliance on the validity of the distribution — a commitment made, an asset bought, a debt incurred that would not otherwise have been. Ordinary living expenses may qualify in a modest case; a shareholder who simply banked the dividend has altered nothing.
Section 54(2) — personal liability of directors
(a) the procedure in section 50 or section 63 has not been followed; or
(b) reasonable grounds for believing the company would satisfy the solvency test did not exist at the time the relevant resolution was passed,
a director who (c) failed to take reasonable steps to ensure the procedure was followed, or (d) voted for the resolution, as the case may be, is personally liable to the company to repay so much of the distribution as is not able to be recovered from shareholders.
| Subsection | Trigger | Which director is liable |
|---|---|---|
| 54(2) | The section 50 or section 63 procedure not followed, or no reasonable grounds existed when the resolution was passed | One who failed to take reasonable steps to ensure the procedure was followed, or who voted for the resolution |
| 54(3) | The distribution is deemed unauthorised under section 50(3) — the board ceased to be satisfied between authorisation and payment | One who ceased to be satisfied and failed to take reasonable steps to prevent the distribution being made |
| 54(4) | A discount deemed unauthorised under section 53(5) | One who failed to take reasonable steps to prevent it |
In each case the director repays so much of the distribution as is not able to be recovered from shareholders. So the company must pursue the shareholders first; the directors carry what is left. In a company whose shareholders have spent the money or successfully raise the section 54(1) defence, that shortfall can be the whole distribution.
Section 54(5) — the relieving power
Where, in an action against a director or shareholder under this section, the Court is satisfied that the company could, by making a distribution of a lesser amount, have satisfied the solvency test, the Court may —
(a) permit the shareholder to retain; or
(b) relieve the director from liability in respect of,
an amount equal to the value of any distribution that could properly have been made.
This is a sensible proportionality rule. If the company could lawfully have paid K200,000 and paid K300,000, the exposure is directed at the excess rather than the whole. The onus is on the party seeking relief to establish what could properly have been paid, which means evidence about the company’s position at the relevant time.
How a director defends a section 54 claim
- Produce the section 50(2) certificate — and the grounds it was required to state. A certificate that recites the conclusion without the reasoning is worth little.
- Produce the working papers — the compliant financial statements relied on under section 4(2)(a)(i), the cash flow forecast, the schedule of contingent liabilities, and the valuations relied on under section 4(2)(b).
- Show the review before payment — minutes recording that the board reconsidered solvency before the distribution was actually made, answering section 50(3) and 54(3).
- Rely on section 116 where the board relied on information, reports or advice from officers, professional advisers or experts, within the limits that section sets.
- If you dissented, show it. Section 54(2)(d) fastens on the director who voted for the resolution; a recorded dissent matters.
- Invoke section 54(5) to confine liability to the excess over what could properly have been distributed.
- Consider section 140 — but note the limits it places on indemnity and insurance, and that an indemnity outside them is ineffective.
Section 54 in the wider picture
A distribution that should not have been made is rarely the only problem. The same facts commonly engage:
- Section 348 — liability where there is a failure to prevent insolvent trading;
- Section 348A — liability where proper accounting records were not kept;
- Sections 340 and 340A — voidable transactions and voidable charges in a subsequent liquidation;
- Section 346 — recovery from a related entity;
- Sections 112 and 115 — breach of the duties of good faith and best interests and of care and diligence; and
- Section 143 — a derivative action where the company itself will not sue.
Section 54 gives the right of recovery to the company. In practice the claim is usually brought by a liquidator after the company has failed — which is precisely when the shareholders have spent the money and the directors are left carrying the shortfall.
Sources
- Companies Act 1997 — ss 4, 50, 53–55, 63, 112, 115, 116, 140, 143, 340, 340A, 346, 348, 348A
Before relying on anything here, read the current text of the Companies Act 1997 and check for later amendments. If a decision matters to you, get advice — start with the Office of the Public Solicitor, or find a firm in the law firms directory.