Corporate Law Update

• The court finds that dividends paid to only one class of shareholder should, in the absence of a dividend policy, have been paid to all shareholders
• The CMA publishes its final report on competition in the statutory audit market

Absence of dividend policy meant dividends had to be paid to all shareholders

The High Court has held that a company whose constitution required it to pay dividends under a defined dividend policy was required to pay dividends proportionally to shareholders until that policy was in place.

What happened?

Routledge v Skerritt concerned a company providing financial services. The company was founded by a husband and wife, who were initially the company’s sole shareholders.

Early in the company’s life, an independent financial adviser began to work for the business on a commission basis. In due course, he acquired a 5% stake in the company from the founders on the understanding that his stake would not dilute the founders’ earnings from the business.

To achieve this, the company passed a resolution re-designating the founders’ shares as “A” shares and the financial adviser’s shares as “B” shares. The company’s articles were amended to give the “A” shares a right to receive dividends “before all other ordinary shareholders” and the “B” shares the right to dividends “only to the extent that there are profits available for distribution after the declaration of dividends to … the ordinary 'A' shareholders”.

Importantly, the articles stated that both the “A” shares and “B” shares would receive dividends “in accordance with the policy in relation to dividends as made … by the Company's Board of Directors”. This was underscored by a shareholders’ agreement between the three shareholders, which required dividends to be paid “in accordance with the policy on dividends as set out by the Board”.

However, the company never put a formal dividend policy in place as contemplated by its articles.

In the years that ensued, the company paid millions of pounds’ worth of dividends on the “A” shares, but no dividends on the B shares. The financial adviser complained that he should have been receiving dividends on his “B” shares, and that the company’s behaviour was unfairly prejudicial to him.

What did the court say?

The court agreed. The judge said that the “A” shares did not have an unqualified right to be paid dividends before the “B” shares. There had been no prior understanding that the “B” shares would not receive dividends. The articles made it clear that the “A” shares would enjoy priority to dividends only if there was a dividend policy in place. Until that time, there was no basis for treating the “B” shares any differently from the “A” shares.

In addition, the judge found that the company’s directors had breached their duties as directors by failing to adopt a dividend policy, paying dividends outside of an agreed policy, and not acting fairly between the company’s different shareholders.

What does this mean for me?

This is a good example of how important it is to ensure that dividend rights in articles are drafted properly and reflect the shareholders’ understanding. In this case, failing to adopt the policy envisaged by the articles meant that the “default” position applied: the shareholders shared in dividends equally.

When putting bespoke dividend rights in place, shareholders and their advisers should ask themselves the following:

• Will dividends be determined by a formal dividend policy? If so, who will set that policy? Will it need approval from the shareholders? Does that policy need to be in writing? Will the board be able to amend the policy itself, or will it need shareholder approval?
• If a dividend policy is required, has a policy been put in place? Has it been communicated to the company’s shareholders? If the directors have failed to put a policy in place, they could find themselves in breach of duty.
• When declaring dividends, have the directors taken the dividend policy into account? In this case, failing to pay dividends in accordance with a policy amounted to a breach of duty.
• Do the articles state what will happen if no dividend policy is in place? Unless they say otherwise, dividends may be payable to all participating shareholders in proportion to their respective holdings.

CMA publishes final report on competition in statutory audit market

The Competition and Markets Authority (CMA) has published its final report on choice and competition in the statutory audit market. The report follows the CMA’s provisional findings, which it published in December 2018.

The report comes after the Financial Reporting Council recently published a call for views on behalf of the independent Brydon Review into audit quality and effectiveness.

In short, the CMA has made the following recommendations:

• Separating audit and non-audit services. Audit firms should introduce an “operational split” between their audit and non-audit (e.g. consultancy) arms. In particular, the CMA recommends that a firm’s audit arm have separate management and prepare separate financial statements, and that profit-sharing between audit and non-audit arms end.
• Mandatory “joint audits”. FTSE 350 audits should be conducted jointly by at least two firms, one of which should be outside the “Big Four”, or by a sole non-Big Four firm. This would not apply to the “largest and most complex companies” (which would instead be subject to “peer reviews” commissioned by the new Audit, Reporting and Governance Authority (the ARGA)).
• Regulating audit committees. Audit committees should be held more vigorously to account. The CMA recommends setting “minimum standards” for appointing and overseeing auditors. It says the ARGA should be able to require information from and place observers on audit committees, and publicly reprimand committees if it is unsatisfied with their selection and oversight of auditors.
• Five-year reviews. The ARGA should review the effect of the new measures after five years, and then periodically. It should keep in mind whether further measures may be required, including deepening the “operational split” and possibly moving to independent appointment of auditors.

The Government will now consider the CMA’s recommendations alongside the outcome of the Brydon Review.