Distribution of dividends and the precautionary rule
Can a dividend distribution be made by a wholly owned subsidiary that has been reporting losses for years, despite financial support from its parent company? In the Case T 5171-23, the Swedish Supreme Court examined the application of the precautionary rule (sw. försiktighetsregeln) in the Swedish Companies Act, which restricts value transfers if they jeopardise the company’s financial stability. Despite the subsidiary’s negative results, the Court ruled that the dividend distribution was justifiable, highlighting key aspects of the precautionary rule and noting that the board’s statement (required when a value transfer is to be made in the form of a dividend), while lacking detailed reasoning, was still sufficient given that the shareholder base had the authority to determine the required level of information.
Case T 5171-23 concerns a transfer of value from a limited liability company, where the Swedish Supreme Court was tasked with examining whether a dividend distribution in a wholly owned subsidiary was permissible under the precautionary rule (Sw. försiktighetsregeln) in Chapter 17, Section 3, Paragraph 2 of the Swedish Companies Act. In this case, the question was whether or not a dividend distribution by a wholly owned subsidiary was justifiable when the subsidiary had incurred losses for several consecutive years and had been financially supported by its parent company during those years through group contributions (Sw. koncernbidrag).
A Swedish limited liability company (the “Subsidiary“), which was a wholly owned subsidiary of a sole shareholder (the “Sole Shareholder“) had reported negative operating results for the three most recent fiscal years. In its annual report for 2017, the board of directors proposed that SEK 8.4 million of the Subsidiary’s retained earnings be distributed as dividends. In the statement from the board of directors, the board contemplated whether the distribution could be made taking into account the precautionary rule and concluded that, considering the nature, scope, and risks of the company’s operations and the requirements these impose on the scope of the company’s equity, as well as the company’s need for consolidation, liquidity, and overall financial position the proposed dividend was compatible with the precautionary rule. The Sole Shareholder also resolved to approve and execute the proposed dividend. In May 2020, the Subsidiary was declared bankrupt. The trustee initiated legal proceedings for the repayment of the dividend.
In its decision, the Supreme Court focused on the key provisions of the Swedish Companies Act concerning value transfers, including Chapter 17, Section 3, which stipulates that a value transfer may not take place if, after the transfer, the company’s restricted equity is not fully covered. Further, under the so-called precautionary rule which is set out under the second paragraph of this section, a value transfer may still be prohibited even if full coverage for restricted equity exists. In this second context, the value transfer must also appear “justifiable”. The amount that the shareholders are actually entitled to dispose of may be lower (but never higher) than the amount that results from the application of the amount restriction. In previous case law, the precautionary rule has been described as a type of general clause, that’s application should be carried out with restraint. When applying the prudence rule, attention must be paid to the need for equity given the nature, scope, and risks of the company’s operations.
According to Chapter 18, Section 4 of the Swedish Companies Act the board of directors is required to submit a statement if a value transfer is proposed in the form of a dividend. This statement must accompany the dividend proposal and include a justification for the proposal under the precautionary rule. In this case, the board submitted a statement pursuant to that provision, but without detailed reasoning in support of the dividend proposal. Regarding the scope of the board’s statement, the Supreme Court stated that a unanimous shareholder base may determine the extent of the information required that the board needs to provide in connection with a dividend proposal.
The Supreme Court ultimately concluded that it had not been demonstrated that the dividend of SEK 8.4 million violated the precautionary rule in Chapter 17, Section 3, Paragraph 2 of the Swedish Companies Act and thus the Sole Shareholder is not obligated to repay any portion of the distributed dividend. The Supreme Court justified its position by, among other things, noting that the Subsidiary had legitimate grounds to expect increased revenue in future years, and therefore the prudence rule was not violated and the value transfer was not impermissible.
After analysing the reasoning, it becomes clear that the Supreme Court’s focus, and perhaps one of the reasons why they decided to review the case, was to further clarify the prudence rule, as its application can be somewhat complex. The Supreme Court also noted through its decision that a unanimous group of shareholders is determinative as to the scope of the information that the board of directors needs to provide in connection with a dividend proposal.
