Can a Company Withdraw Dividends Declared Before Insolvency?

The declaration of dividends is a common practice for companies to distribute profits to their shareholders. However, when a company is facing insolvency proceedings under the Insolvency and Bankruptcy Code (IBC), the withdrawal or reversal of dividends declared before insolvency can become a complex issue. The IBC and its regulations focus on ensuring that the interests of creditors are prioritized, and any actions taken before the insolvency filing that might prejudice creditors can be scrutinized.

Regulation of Dividend Withdrawal During Insolvency:

Dividends Declared Before Insolvency:

If a company has declared dividends before entering insolvency proceedings, these dividends are typically paid out to shareholders based on the company’s financial situation.

However, if the company subsequently enters insolvency, the insolvency professional may investigate whether the dividend payments were made when the company was already insolvent or in financial distress, and whether the dividends were paid in good faith.

Reversal of Dividends Under the IBC:

Under the IBC, if the dividends were declared fraudulently or as part of a strategy to prefer shareholders over creditors, the insolvency professional (IP) can apply for a reversal of such payments.

This is often categorized as a fraudulent transfer or a preference under Section 43 of the IBC, which allows for the reversal of payments made within a specified period before the insolvency application (typically one year for related parties and two years for other creditors).

Fraudulent Preference and Undue Payments:

If dividends are declared at a time when the company is insolvent or about to enter insolvency, and it can be proven that these payments were made to favor shareholders over creditors, the dividend payment can be deemed a fraudulent preference.

The IBC allows the insolvency professional to reverse any payments that are found to be preferential or made with the intent to defraud creditors.

Financial Health and Debt Repayment:

A key consideration in whether dividends can be reversed is the financial health of the company at the time the dividends were declared. If the company was not in a position to meet its financial obligations (e.g., repaying creditors) and declared dividends anyway, this can be challenged during the insolvency proceedings.

The insolvency professional is tasked with assessing whether the declaration of dividends compromised the ability to pay off debts and whether it was done with the intent of avoiding creditors.

Impact on Shareholder Rights:

While shareholders generally have the right to receive dividends, the IBC prioritizes the rights of creditors in the event of insolvency. If dividends have been paid in a manner that harms the interests of creditors, the IBC allows for measures to reverse such actions.

However, it is important to note that dividends that were lawfully declared and paid under appropriate circumstances may not be automatically reversed unless they fall under the scope of fraudulent preference or were made with the intent to deceive creditors.

Legal Actions and Insolvency Resolution:

If a resolution plan is being formulated, the insolvency professional will consider the treatment of all past transactions, including dividend payments. The professional has the power to reverse payments made inappropriately during the period of suspicion before insolvency.

Creditors may also challenge the dividend payments in insolvency court if they feel that the payments were made unfairly or without due consideration of the company’s financial obligations.

Example:

Let’s assume XYZ Ltd., a publicly listed company, declared dividends to its shareholders just two months before filing for insolvency. The company was already facing financial difficulties at the time of the dividend declaration, and its liabilities were increasing.

Fraudulent Preference:

The insolvency professional (IP) reviewing the company’s financials during the CIRP discovers that the dividend payments were made when the company had insufficient resources to pay its creditors, and the payments were made to shareholders instead of settling debts.

Reversal of Payments:

The IP might seek to reverse the dividend payments under the fraudulent preference provisions of the IBC. This would require demonstrating that the payments to shareholders were preferential and hindered the ability of the company to pay its creditors.

Legal Proceedings:

If necessary, the insolvency court could order the reversal of the dividends, directing the funds to be redirected to meet the claims of creditors.

Conclusion:

The Insolvency and Bankruptcy Code (IBC) regulates actions such as the withdrawal or reversal of dividends declared before insolvency to prevent fraudulent preferences that could harm creditors. If dividends were paid during a period of financial distress or insolvency and can be shown to have favored shareholders over creditors, they may be subject to reversal. The insolvency professional plays a key role in investigating such transactions and ensuring that the interests of creditors are safeguarded during the insolvency resolution process.