Overdrawn Directors’ Loan Accounts
In this two part series, solicitor and founding partner James Edward of James Edward & Associates and Barrister Louise Bowmaker of Enterprise Chambers, take a look at the legislation relating to directors’ overdrawn loan accounts.
Seven years since the legalisation of directors’ loans, the ever-flexible directors’ loan account is as popular as ever, particularly for smaller, private companies. Part 1 of this article provides a quick review of the main issues that can arise where an insolvent company is considering challenging an overdrawn account and in part 2 we will be looking at a case study.
Part 1: Companies Act 2006
On 1 October 2007, sections 197-214 of the Companies Act 2006 (“the 2006 Act”) came into force, disposing of the criminal offences and penalties that attached to directors loans under the Companies Act 1985 (“the 1985 Act”) and introduced major reforms.
Whilst the 1985 Act will continue to apply to loans entered into prior to 1 October 2007, under the 2006 Act directors’ loans are no longer illegal but rather require the approval of members or subsequent ratification. The amounts that can be loaned before the statutory regime will apply have been raised; in particular, directors can receive up to £10,000 without having to seek members’ approval. Loans provided to enable the director to make payments for the purposes of the company, or to reimburse him if he has already paid, are excepted from the statutory regime up to a total value of £50,000. Other exceptions set out in the 1985 Act, including intra-group transactions and money-lending companies, were retained in the 2006 Act.
Decriminalising directors’ loans and substantially increasing minimum thresholds before the statutory regime will apply has facilitated the practice of having directors’ loan accounts. Such accounts will be subject to the 2006 Act just as one-off substantial loan payments are; members’ approval will be required if the account is to become more than £10,000 overdrawn. In an insolvency situation the relevant Act will be a good starting point for those considering or advising on potential challenges to an overdrawn account.
In the typical scenario of a small, private company with one or two directors, the requirement to obtain members’ approval for loans exceeding £10,000 will almost certainly have been overlooked (or, more likely, never heard of).
The law as to the remedies available remains virtually unchanged by the 2006 Act. Credits to the director in a loan account are voidable at the instance of the company where the Act has been breached, provided the monies can still be repaid, the company hasn’t been otherwise indemnified for its losses and there are no third parties acting in good faith who would be affected by undoing the loan. Whether the loan can be avoided or not, the director will be liable to account to the company for the gain he has made and must indemnify the company for any loss or damage suffered. If the director is not a worthwhile target, any other directors who authorised the loan are also liable; this extends to a liability to indemnify the company for its loss where the director borrower cannot repay (as in the case of Neville -v- Krikorian [2007] 1 BCLC 1, decided under the 1985 Act, see below).
Likely defences include:
(i) Members’ approval was unanimous, and therefore did not need to be by way of formal resolution. This is a common situation, particularly if the members are the sole director and his or her spouse. The question as to whether informal unanimous members’ approval is sufficient to approve directors’ loans (under the so-called Duomatic principle) remains unanswered. Liquidators can argue that a formal resolution must be obtained on the basis that the provisions are designed to protect creditors as well as members.
(ii) Subsequent ratification by members. This is only possible “within a reasonable period” following the loan. If the members only act in response to a claim from a liquidator, the liquidator will have a strong argument that the time has passed for ratification.
(iii) Set off. The typical scenario is that the director-member of a small company takes his pay as and when he likes by way of a loan account. For the year end, this is then accounted for by way of declaration of a dividend or bonus or similar which is credited to the loan account. If a dividend has been declared in the run up to liquidation, this may well be open to challenge. However, if the loan was unauthorised, the liquidator should be able to resist set off in any event; why should the director benefit from a set off based on his own wrongdoing to the detriment of the creditors? (See Re a Company (No 1641 of 2003)[2004] 1 BCLC 210, a 1985 Act case).
Proceedings under section 213 of the 2006 Act will normally be accompanied by claims for misfeasance and a transaction at an undervalue, depending on the circumstances. Even if an overdrawn loan account is shown to have been approved by members, breaches of directors’ duties may well still be made out if the finances of the company were such that an overdrawn account was not a sustainable state of affairs.
This article was written by James Edward, a Solicitor and the founding partner of James Edward & Associates and Louise Bowmaker of Enterprise Chambers Lincoln’s Inn London. If you have any queries relating to directors overdrawn loan accounts or any other matters please contact James Edward on 0207 467 3980 or click here.
disclaimer
The information and any commentary on the law contained in this article is provided free of charge for information purposes only. No responsibility for its accuracy and correctness, or for any consequences of relying on it, is assumed by any member or employee of James Edward & Associates. The information and commentary does not and is not intended to amount to legal advice and is not intended to be relied upon.
You are strongly advised to obtain advice from a Solicitor about your specific case or matter and not rely on the information or comments in this article.