What are the consequences of an unlawful distribution and payment of profit? #7

In the previous parts of our series, we looked at the conditions that must be met before a company may distribute its profit and pay it out. But what happens if the company breaches these rules? The consequences can be surprisingly harsh and affect everyone involved: the company, its shareholders and the members of its statutory body.

The rules on profit distribution protect not only the shareholders but, above all, the company’s creditors. Creditors are to be satisfied before the shareholders divide what is left. This is why the law attaches stricter consequences to a breach of these rules than is usual for ordinary defects in corporate resolutions.

A general meeting resolution with no legal effect

Many people assume that a defective resolution of the general meeting remains binding until a court sets it aside on a shareholder’s motion. When it comes to profit distribution, this is only partly true.

If a resolution of the general meeting breaches the rules protecting creditors – typically because it is based on financial statements that are too old, or because it conflicts with the balance-sheet test or the equity test – it has no legal effect at all. It is treated as if it had never been adopted. There is no need to challenge it in court, no one has to invoke its defects, and no time limits run.

The logic behind this strict consequence is simple. Creditors themselves cannot challenge a resolution of the general meeting, and the shareholders, who could, usually have no interest in doing so.

Other defects that do not concern the protection of creditors – for example an improperly convened general meeting or a distribution of profit among the shareholders in proportions contrary to the company’s articles of association – are dealt with in the classic way. Such resolutions can be challenged in court; if no one does so in time, they remain valid.

The statutory body must not pay out the profit even if no one has challenged the resolution

The payment of profit that has already been distributed is decided by the statutory body – and this is where the law places its second safeguard.

The statutory body must refrain from paying out a profit share that was distributed contrary to the law – regardless of whether anyone has challenged the general meeting’s resolution in court. A managing director or a board member therefore cannot hide behind the fact that the resolution “formally stands”. They must assess for themselves whether the distribution holds up.

One clarification is needed, though. The statutory body may – and must – assess on its own whether a resolution has no legal effect, i.e. whether it conflicts with the rules protecting creditors. Such a resolution is treated as if it had never been adopted, and payment under it is out of the question. The situation is different where a resolution suffers “only” from a defect making it voidable. The invalidity of such a resolution can be declared only by a court; until that happens, the resolution is treated as valid and the statutory body cannot reach a conclusion on its invalidity by itself. Even so, it should suspend the payment if proceedings for a declaration of invalidity are already pending and appear highly likely to succeed. Otherwise, it risks paying out a profit share whose legal basis will retroactively fall away.

Added to this is the insolvency test we discussed earlier in the series: even a duly distributed profit must not be paid out if the payment would render the company insolvent. This test is performed as at the moment of the payment, not as at the moment of the general meeting’s decision. The distribution decision itself therefore remains valid – the shareholder’s claim simply does not become due for as long as the obstacle lasts. This does not mean, however, that an impending insolvency may be ignored when the general meeting decides on the distribution of profit. If it is already clear at that time that the payment would render the company insolvent, a statutory body acting with due managerial care should not even propose such a distribution to the general meeting – and the general meeting should not resolve on it.

The insolvency test also has one lesser-known epilogue. If, because of the test, the profit share is not paid out by the end of the accounting period, the right to the profit share lapses. The company returns the unpaid share to the equity item from which it was distributed and, where that is no longer possible, transfers it to retained earnings. The shareholders can reach it again only through a possible new distribution in the following years.

Must an unlawfully paid-out profit be returned?

If the payment has nevertheless been made, the question of restitution arises. The basic rule is that whatever was paid without a legal basis must be returned to the company as unjust enrichment.

The good-faith protection of the recipient is narrower today than is often assumed. Until the end of 2020, the general rule was that a profit share received in good faith did not have to be returned. The amendment to the Business Corporations Act, however, retained this rule only for shareholders of joint-stock companies: in a joint-stock company, a paid-out share is not returned unless the recipient knew, or should have known, that the statutory conditions were breached at the time of the payment. In case of doubt, the recipient’s good faith is presumed.

In a limited liability company and in a cooperative, no comparable rule has existed since 2021, and the recipient will usually not escape the obligation to return an unlawful payment. In practice, however, the difference is not as significant as it might seem: a member who voted on the distribution and knows the company’s situation would hardly be able to invoke good faith anyway. By contrast, a small shareholder with no realistic possibility of verifying that all the tests were met will typically be in good faith – and it is precisely for such shareholders that the protection was retained.

Even in a joint-stock company, however, the protection has its limits. It covers only shareholders – it does not extend to members of corporate bodies receiving profit-based bonuses (tantiemes) or to other persons granted a profit share by the articles of association; they must always return the payment. A stricter yardstick also applies to shareholders who are at the same time members of the board of directors or the supervisory board, or who have above-standard insight into the company’s affairs owing to their position. Nor can good faith be invoked by the recipient of an unlawfully paid advance on a profit share – advances must always be returned.

Liability of the members of the statutory body

For managing directors and board members, an unlawful payment of profit is one of the riskiest scenarios of holding office.

The law establishes a presumption that members of the statutory body who consented to an unlawful payment did not act with due managerial care. The company thus does not have to prove anything – on the contrary, it is the member of the body who must prove that they met the standard of care.

The consequences are familiar: the duty to compensate the company for the harm caused, statutory liability for the company’s debts towards creditors who cannot obtain satisfaction, and, in extreme cases where the unlawful payment contributed to the company’s insolvency, also disqualification from office, the duty to surrender any benefit obtained in connection with the office, or the duty to contribute the missing assets to the insolvency estate. The good-faith protection enjoyed by the recipients of profit shares does not extend to the members of the statutory body.

A member’s liability is always measured against the standard of due managerial care, based on the information available at the time of the payment. Whoever carefully verified beforehand that all the conditions were met – from the age of the financial statements and the effects of the general meeting’s resolution, through the balance-sheet tests, to the insolvency test – is not liable for the harm, even if it later turns out that the payment breached the rules. Conversely, whoever underestimates the verification of the conditions or skips it altogether is simply relying on luck: as long as nothing happens, they bear no consequences, but once a problem emerges, they will hardly rebut the presumption that they failed to act with due managerial care.

The relationship between the company’s two claims is also worth noting. The claim for damages against the members of the statutory body stands alongside the claim for restitution against the recipients. The company may choose whom to pursue, or sue both – in total, however, it may recover no more than the amount it lost.

Beware of hidden profit distributions

The trickiest situations arise where the company does not “use” the profit-distribution rules at all and channels its assets to a shareholder in another way. Typically through a gift, an interest-free loan, a sale below market price, or remuneration that clearly does not correspond to the consideration received.

Such transactions are assessed as a breach or circumvention of the profit-distribution rules. Today, the law expressly prohibits gratuitous performances to shareholders and persons close to them, with the exception of customary occasional gifts, donations in a reasonable amount for a public benefit purpose, performances satisfying a moral obligation or considerations of decency, and advantages provided in accordance with the law.

Legal scholarship is not entirely united on the precise consequences of a breach of this prohibition. Some authors conclude that such a transaction is absolutely null and void, which the court takes into account even without an objection – because the profit-distribution rules protect creditors and thus public order. According to others, the transaction remains valid, but the recipient must surrender to the company whatever they gained at its expense. The practical outcome is the same in both cases: the performance must be returned to the company, and the members of the statutory body who allowed it are liable for the resulting harm.

It is further argued that nullity need not always affect the entire contract. In the case of an interest-free loan to a shareholder, only the arrangement on its interest-free nature may be invalid – the loan remains valid but bears interest at the usual rate. And where the company had sufficient resources and could have provided the shareholder with the same amount through a proper distribution of profit, one can argue that the creditors were neither harmed nor endangered and that the harshest sanction is not warranted. We would not, however, recommend relying on this.

Caution is also required with non-equivalent performances provided to third parties; the risk is elevated in particular where they occur at the instigation and in the interest of a shareholder. The remuneration of members of corporate bodies may also be assessed as a hidden distribution of profit – a “silent tantieme”. However, there is no silent tantieme where the remuneration corresponds to the usual level of income of persons in the same position as well as to the company’s financial results, and was duly approved.

Summary

A breach of the rules on the distribution and payment of profit has consequences on several levels. A general meeting resolution adopted contrary to the rules protecting creditors has no legal effect at all – without any motion and without any time limits. The statutory body must not pay out an unlawfully distributed profit even if no one has challenged the resolution, and it must perform the insolvency test as at the moment of the payment.

If the insolvency test blocks the payment and the share cannot be paid out by the end of the accounting period, the right to it lapses. An unlawfully paid-out share must be returned; today, good faith protects only the shareholders of joint-stock companies. Members of the statutory body who consented to the payment are caught by the presumption of a breach of due managerial care, with all the ensuing consequences, including statutory liability for the company’s debts. Hidden transfers of assets to shareholders outside the proper distribution procedure must be returned to the company.

The practical recommendation is therefore unequivocal: before every payment, re-verify that all the conditions discussed in the previous parts of this series are met. And if a company wishes to provide its shareholders with any advantage, it is safer to do so through a proper distribution of profit than through any other route.