When authorising directors’ fees or other benefits such as salaries or loans, the Board needs to follow the legal criteria set under the Companies Act 1993 or potentially face personal liability in the event that the company became insolvent. This process is often overlooked by closely held SMEs when shareholders, directors and employees are the same people.
Under section 161 of the Companies Act (Act), the Board may authorise the payment of remuneration or the provision of other benefits by the company to a director if the Board is satisfied that it is “fair” to the company. Under this criteria, the Board may also authorise:
- payments to a director for services;
- compensation for loss of office;
- the making of loans by the company to a director;
- the giving of a guarantee by the company for debts incurred by the director; or
- the entering into a contract to do any of the above.
This power is subject to any restrictions in the company’s constitution.
Directors who vote in favour of approving a payment to a director must sign a certificate stating that, in their opinion, the making of the payment is fair to the company and provide the grounds for that opinion.
If the requirements of section 161 are not complied with, or reasonable grounds did not exist for the director’s opinion that the payment or benefit was fair to the company, then the director who received the payment or benefit may be personally liable to repay the company in the event of a liquidation.
It is important to note (and a requirement that is often overlooked) that after such a payment or benefit is granted by the Board, the particulars must be entered in the company’s interests register. Failure to enter this interest is a breach of section 161.
What is “fair” to the company?
The Act itself does not elaborate on the meaning of the phrase “fair to the company”. However, this was considered in a 2016 Court of Appeal decision, Madsen-Ries v Petera.
In this decision, salary payments had been made to the directors of a road transport company at a time when the company was in financial difficulty, and without compliance with section 161 (that being, the directors had not certified that the payments were fair to the company). The liquidators sought, amongst other claims, to have those salary payments returned to the company on the basis that section 161 had not been complied with and that it was not fair to the company to make these payments without considering the interests of creditors.
The Court of Appeal noted that there was no statutory definition of the concept of fairness, however it did state that when a Board provides a directors’ certificate as required under section 161, the directors did not need to consider the interests of creditors. The Court of Appeal noted the distinction between the directors having to satisfy the solvency test (which protects the interests of creditors against the risk of improper distributions of payment of company funds to its shareholders, at the cost of creditors) as opposed to certifying the fairness of a transaction (where payments are proposed to be made to directors). The fact that section 161 required a consideration of fairness to the company rather than the company satisfying the solvency test was a very clear indication that creditors’ interests did not need to be considered.
In this instance, the Court of Appeal determined that the payments were fair to the company, as the company “gained full value from the work carried out” by the directors. The Court of Appeal also noted that the decision to essentially “purchase” services from one of their number was no different from any other trading decision the company would make.
When directors are authorising a payment or benefit to a director, they should always keep in mind the overarching directors duties under the Act, including the duty to act in good faith and not to trade recklessly.
How we can help
In SMEs, typically shareholders, directors and employees are the same people. Therefore, it can be easy to blur the lines between these roles and not properly document the authorisation of director payments and benefits. However, in the event of a liquidation, the directors could be personally liable for these payments if the legal criteria has not been followed.
If you have any questions as to whether a proposed payment or benefit to a director would be considered fair to the company under section 161 or need assistance in documenting the decision, we suggest reaching out to one of our business law team for expert advice.
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