Creditors may have more claim to the salaries paid out to directors as a company becomes insolvent, writes Ailbhe O’Neill

In last month’s column, we looked at some of the pitfalls that company directors need to avoid in the coming months when dealing with their assets.

The focus was on the temptation to move assets out of a company in times of economic stress. This month, we turn to the issue of salaries paid out of the company. There are two key principles to bear in mind here.

The first is that it is the job of a liquidator to swell the assets of the company in a winding up. This can include the retrieval of unauthorised salary payments to directors.

Second, the law takes the view that, as a company becomes insolvent, the creditors of the company have a more legitimate claim on the assets of the company than the shareholders. With these principles in mind, we can look in more detail at the issues that can arise regarding salaries paid out the company in times of economic downturn.

There are relatively few provisions of the Companies Acts dealing with directors’ salaries. The Companies Act 1963 provides that fees and salaries paid to directors may not be paid free of income tax and that the company’s set of annual accounts must include or be accompanied by a statement showing the aggregate of directors’ emoluments. Nothing is said in the statutes regarding the amount a director may be paid by the company.

Where, then, does the authority for directors’ salaries come from? This can become a pressing issue when a company is being wound up. The liquidator in such circumstances has the power and indeed the duty to swell the assets of the company.

This can extend to an inquiry into the validity of payments out of company funds, including payments to directors. It is important to be clear, therefore, that any payments to directors are or have been validly made.

In some companies, the authority for salary payments may be contained in the articles of association of the company. This will often leave it to the board to set the amounts.

Alternatively, it may be that the setting and ratification of salaries is left to the general meeting i.e. the shareholders. Where the latter is the case, it is important to ensure that records of such meetings have been kept and that the meetings themselves complied with the requirements of the Companies Acts so as to validly make the decision regarding salaries.

In cases where the setting and ratification of salary is left, under the articles of association, to the shareholders, and salaries have not validly been set/ratified, the position is that there is no strict obligation on the company to pay the directors unless there is some agreement to the contrary.

Any payments made in the past can be characterised as ex gratia payments. The good news is that it should be possible to ratify the payments as valid salary payments by calling a general meeting. Where a company is approaching insolvency, however, this may not save the payments so this is something to take care of sooner rather than later.

Where there is no contract between the company and the directors, and no mechanism in the articles of association dealing with salaries, directors may nonetheless be entitled to some payment on what the courts refer to as a quantum meruit basis.

This has been applied by the courts so as to entitle directors to a reasonable rate for services performed. Critically, however, this entitlement will not arise where the articles of association provide a procedure for setting salaries and this has not been done so. Prevention is definitely the safest form of cure.

Salaries for inactive directors

It is not uncommon in small private companies for one or more family members to be listed as company directors in circumstances where it is not envisaged that they will play an active role in the running of the company. They may be a spouse, sibling or child of another director.

The payment of salaries to such passive directors out of company funds is likely to come under scrutiny when the company is wound up. The courts in England have looked behind the labelling of such payments and found them to be, in reality, gifts out of company funds which can be recovered by the company in the interests of the creditors.

As with the situations discussed above, these payments are liable to be recalled at any time. The appointment of a liquidator to an insolvent company just makes it more likely in practice that this will be identified as having been wrongly paid.

Directors need to be aware of the importance of ensuring that any payments made to them and any perks provided to them by the company have been provided validly.

This is, of course, something that should be borne in mind throughout the lifetime of the company. This issue is of particular practical importance, however, as more companies are approaching insolvency and liquidators are looming on the horizon. n

Ailbhe O’Neill is a barrister-at-law

This article appears in the December 2008 edition of Irish Construction Industry Magazine