That overdrawn director's loan account might come back to haunt you
Insolvency litigation funders: Vultures or providers of a valuable public service?
As a business owner, I’ve sometimes come across founders who are alarmingly cavalier with company money. Some director-owners freely spend company money on personal luxuries, and rely on their accountant to regularise this by declaring a dividend at the end of the accounting year. They are effectively borrowing money from the company during the year, and then clearing the loan by declaring a dividend to cover it. These entrepreneurs don’t see anything wrong with this: the company is making lots of money, they are the majority (or only) shareholder, they view the question of when money is paid vs when a dividend is declared as a purely technical matter which their accountant will sort out.
Even the official government guidance about director's loan accounts makes little comment about this beyond explaining the tax implications if you finish the year owing money to your company.
Borrowing money from your company in this way is common practice, but fraught with personal financial risk. Accordingly to s830 of the Companies Act 2006 a dividend can only be paid out of profits, and therefore should only be paid when you are certain the company has profits available. The most correct way to do this is to wait for the annual accounts to be prepared, consider how much profit is available, and then distribute some or all of the profit to shareholders. In that order. Doing it in some other order might mean you get to sign the lease on that supercar earlier, but you risk being hit with a large personal liability if the music stops and your business goes bust before you have sorted out the dividend position.
But how? If the business goes bust, the company is defunct and the “loan” gets forgotten about, doesn’t it?
Not any more. Before the The Small Business, Enterprise and Employment Act 2015, liquidators dealing with insolvent companies might well have decided not to chase directors too hard on this kind of thing because there would be no money in the company to fund legal action against the director, and the liquidator themselves would have personal costs exposure if the action failed.
The important change in the 2015 Act was to allow liquidators to sell these kinds of claims to litigation funders. The litigation funder pays for the legal action, and covers the risk of losing, in return for a cut of whatever they collect. There is now a growing industry of litigation funders privately pursuing directors for overdrawn directors' loan accounts and related claims.
That £100k overdrawn director's loan account will be promptly sold by the liquidator as a debt which can be chased by a litigation funder. The liquidator will get some small (~£5k) payment up front, plus around 50% of the proceeds of the action. The litigation funder gets the other 50%.
Once the company is in the control of liquidators, you can’t retrospectively declare a dividend to cancel out the director's loan account. It might even be hard to get access to the books in order to challenge exactly what transactions are going through that account.
Consider the case of Manolete v Matta. Dr Matta was in the care home business. Manolete is a litigation funder, specialising in company insolvency claims. Dr Matta's company was doing very well for many years, and he bought himself a yacht and other luxury items with company money. He never much troubled to get the accounting paperwork in order, so these purchases were effectively funded by the company loaning money to him.
He ended up being ordered to pay, personally, nearly £1.5m to Manolete after his company went bust. With legal costs on top of that.
A bit more about costs: unless you settle very promptly, you will end up paying some of the litigation funder’s legal costs on top of whatever you owed your company. These can easily get into the tens of thousands of pounds after just a couple of exchanges of letters, and more like a hundred grand if you end up losing at trial.
Is this fair? Yes, totally. It is part of the bargain which company owners strike with society when they set up a limited company. In return for avoiding personal liability for your company’s debts, you have to follow some rules as a director. You have to file annual accounts for the public to inspect (so people trading with your company can find out about its history) and you have to treat the company as a separate entity with its own money and decision-making processes.
If you’ve borrowed money from the company, and the company goes bust soon afterwards, that money is not yours. It should have stayed in the company to pay the company’s suppliers.
Litigation funders look like vultures to the directors they are pursuing. They will be ruthless. They’ll go after your house if necessary (indeed, they will probably only pursue you if they can see that you do have some assets, like a house, available).
Those same ruthless litigation funders will look like heroes to the creditors on whose behalf they are ultimately working. As a business owner, you don’t want other business owners using their company money to buy supercars when they should be paying your invoice. The basic principle of limited liability is that shareholders are paid last, only once the company’s obligations to their trading partners have been settled. As a business owner, you want there to be a system to keep in check those directors who don’t play by the rules.
The good news if you are on the wrong side of one of these cases: you can nearly always negotiate a settlement. The litigation funder will only go to court if they have a technical point of law they need to test. Otherwise, they will likely negotiate a deal with you which keeps their costs and risk to a minimum.
If you are facing one of these cases, the absolutely first thing you should do is lawyer up. Then, probably the very next thing to do: instruct a commercial mediator to help negotiate a settlement. As a former business owner myself, I will understand the issues in these cases better than many other mediators. I’m as happy trawling through your DLA ledger with the accountant as I am relaying technical legal points between each set of lawyers. Get in touch if you’d like an informal chat to find out if I might be able to help.