Payment of an advance against anticipated dividends is attractive for shareholders but carries a major risk, particularly for the company. At the end of the financial year it may turn out that there is no basis for paying a dividend. Then can the company require the shareholders to return the advance?
Shareholders in a Polish limited-liability company (sp. z o.o.) have a right to participate in the profit stated in the company’s annual financial report if the shareholders’ meeting adopts a resolution earmarking the profit for distribution of a dividend. In specific instances, the management board may pay the shareholders an advance against the anticipated dividend. The conditions for paying an advance dividend in a limited-liability company are set forth in Art. 194 and 195 §1 of the Commercial Companies Code. While the conditions for paying an advance are quite clear, the rules for repayment of the advance can generate problems in practice.
Grounds for payment of advance dividend
Under Commercial Companies Code Art. 194, the company’s articles of association may empower the management board to pay an advance against anticipated dividends if the company has sufficient funds to pay the advance. Additional conditions for payment of an advance dividend are set forth in Art. 195 §1 of the code.
Under these provisions, an advance dividend may be paid if:
- The articles of associations empower the management board to make such payment
- A dividend is anticipated for the given financial year
- The company has sufficient funds to make the payment
- The company’s financial report for the prior financial year was approved under Art. 231 §2(2) of the code
- The approved financial report for the prior year indicated a profit
- The company has generated a profit since the end of the prior financial year, and
- The advance will be no greater than half of the profit generated since the end of the prior financial year, plus undistributed profit from preceding financial years placed in supplemental capital (or funds) created from the profit which can be earmarked by the management board for payment of a dividend, less uncovered losses and own shares.
The management board may pay an advance dividend if all of these conditions are met. But the management is then only permitted, not required, to pay an advance dividend.
Lack of dividend and refund of advance
It may happen that despite payment of an advance dividend, a dividend is not declared or is declared in an amount less than the total advance dividend paid to the shareholders. This could happen if the approved financial report shows a loss, or a profit lower than forecast. And for various reasons the shareholders may resolve to retain all of the profit in the company or to distribute the profit in an amount less than the total advances paid out to shareholders. Then the question arises whether the shareholders (former or current) are required to pay back the advances they have received. To answer that question, it should first be determined whether the advance dividend was paid out in compliance with the law and the company’s articles of association.
If the payments were made by the management board in violation of law (particularly Commercial Companies Code Art. 194 and 195 §1) or the articles of association, then the shareholders who have received an advance dividend are liable to repay it, jointly and severally with the members of the management board responsible for the payment. This is provided for in Art. 198 §1 of the code. If a full refund of the payment cannot be obtained from the recipients, all of the shareholders are liable to make up the shortfall in the company’s assets necessary to fully cover the share capital, in proportion to their shares; any amounts that cannot be obtained from specific shareholders shall be covered by the remaining shareholders in proportion to their shares (Art. 198 §2). Such claims shall become time-barred three years after the date of payment of the advance dividend, except for claims against shareholders receiving advance dividends who knew of the unlawfulness of the payment (Art. 198 §4).
This provision should not interpreted expansively. It is thus impermissible to equate the situation referred to in Art. 198 with a case in which an advance dividend was paid out in compliance with law (particularly Commercial Companies Code Art. 194 and 195 §1) and the articles of association, but profit was not distributed at the end of the financial year. This is because it may happen that despite fulfilment of all the conditions set forth in Art. 194 and 195 §1, a dividend is not paid for the reasons mentioned above. The code does not expressly address the legal consequences of such factual situations. This raises the question whether, and on what basis, the company may demand that the shareholders refund the advances paid out to them in this situation.
The legal literature indicates two different views on this issue. Under the first position, the shareholders cannot be required to disgorge the advance dividend, but the amounts received shall be applied against profit earned in future financial years until the advances have been exhausted, or by requiring the shareholders to pay surcharges on their shares. Under the second view, shareholders may be required to pay back the advance dividends they have received on the basis of provisions on unjust enrichment, under the assumption that they received a payment that was not due (Civil Code Art. 410 §2 in connection with Commercial Companies Code Art. 2).
The first of these views assumes that payment of the advance dividend is not conditioned on ultimate achievement of a profit, not to mention adoption of a resolution calling for distribution of the profit. The conditions for payment of an advance dividend are set forth in Commercial Companies Code Art. 194 and 195 §1, and when they are fulfilled the advance cannot be regarded as an undue payment for purposes of Civil Code Art. 410 §2. The main condition for payment of an advance dividend is the reasonable assumption that a profit will be earned and then distributed to the shareholders in the form of a dividend. This is a contingent state—future and uncertain. But if prior to the payment all of the conditions set forth in Commercial Companies Code Art. 194–195 are met, then despite failure to earn the anticipated profit or refusal to distribute the profit to the shareholders, the company cannot demand repayment of the advance under Civil Code Art. 410 §2. This does not mean that the company cannot settle accounts with the enriched shareholders, as the advance can be set off against dividends paid to the shareholders in future years. But this position has serious drawbacks. A shareholder who has received an advance dividend may sell the shares. Then recouping the advance paid to the shareholder may be particularly problematic and sometimes impossible. The new shareholder could effectively dispute attempts to set off the advance against future dividends payable to the new shareholder.
The second view calls for application in this instance of the regulations governing unjust enrichment. Since the company is paying an advance against an anticipated dividend, if the profit is ultimately not distributed this makes the advance an undue payment within the meaning of Civil Code Art. 410 §2.
Under this section, payment is not due when, among other reasons, the basis for the payment has lapsed or the intended purpose of the payment has not been achieved. One such instance may arise when at the end of the financial year it turns out that there are no grounds for declaring a dividend. But it should be pointed out that the regulations on unjust enrichment sometimes permit avoidance of the obligation to return an undue payment. Under Civil Code Art. 409, the obligation to disgorge the benefit or return the value lapses if the recipient of the benefit has consumed it or lost it in such a manner that it is not enriched, unless when consuming or disposing of the benefit the recipient should have expected that it would have to be returned. But relying on the final reservation in this provision, it can be stated that a shareholder receiving an advance dividend should expect to be required to refund it, as the final amount of the profit or how it is earmarked will not be known until the annual shareholders’ meeting is held. Nonetheless, this is not obvious, due to the lack of an unequivocal regulation in this respect.
This issue is significant because as a result of payment of the advance dividend, the company’s equity is depleted and thus the assets of the company are reduced. If at the close of the financial year the company achieves a profit which is then earmarked for distribution among the shareholders, the amount of the advances reduces the payments to be made to shareholders, and in this situation this does not infringe the interests of the company itself or its creditors. However, in a case where at the end of the financial year the company generates a loss, or the profit is less than the total advance dividends paid out, there is an unjustified depletion of the company’s assets, which can impact its solvency.
For this reason, it would be desirable to enact an unequivocal regulation on this fundamental issue concerning payment of advance dividends, i.e. the obligation to repay them if at the end of the financial year the company has not earned a profit or the profit is lower than the total advance dividends paid out. After all, the institution of advance dividends is mainly intended to allow the shareholders to receive earlier payment of some of the anticipated profit when there are grounds for doing so. But the regulation should not enable the shareholders to receive payments from the company that could ultimately prove not to be due, where there are unclear grounds for demanding refund of the payments and for determining whether or not the shareholders should have expected to be required to refund the payments.
Refund of advance when the shares have been sold
The question can also be raised of who should be required to refund the advance dividend if the shares are transferred during the time between payment of the advance and occurrence of the grounds for repaying it. Can such refund be pursued against the seller of the shares who received the undue payment, or against the buyer (assuming that the claim is connected with the shares)? Applying regulations on unjust enrichment to payment of the advance dividend, it should be assumed that repayment of the advance should be sought from the person who obtained a financial benefit at the cost of the company (Civil Code Art. 405), and thus from the shareholder who received the advance, even if at the time when the obligation to repay the advance arises that person is no longer a shareholder of the company. However, these issues should be addressed expressly in the Commercial Companies Code to avoid doubts of this nature that may arise when pursuing repayment of advance dividends.
Limiting the legal risk
As indicated above, awarding advances against anticipated dividends based on unclear provisions of the code entails a significant risk for the company, the shareholders and the management board members. To avoid these doubts, the consequences of payment of advance dividends, particularly the rules for settling accounts if there is no profit or the amount of profit designated for distribution as a dividend is less than the advance dividend paid out, should be spelled out in the articles of association or a shareholder agreement. Regulating this issue is also in the interests of the acquirer of shares, particularly if the transaction is carried out in the period between payment of an advance dividend and the final distribution of profit. As a precaution, the acquirer of the shares should be sure to secure its interests in this respect in the share sale agreement.
Kinga Ziemnicka, legal adviser, Marta Rybacka, M&A and Corporate Law practice, Wardyński & Partners