Who Takes the Spoils? – Dividends and Losses in the Life of a Company

Who Takes the Spoils? – Dividends and Losses in the Life of a Company

May is the month when annual reports are approved in the life of business entities. If a company has multiple owners, the question naturally arises: who gets how much of the profit, and who bears how much of the loss if things go wrong?

According to the definition in the Civil Code, a business entity represents a community of interests among its members, in which the members jointly expect profits, jointly bear the risk, and are obligated to cooperate with one another. This has serious practical consequences: the company’s profits are distributed to the members in proportion to their capital contributions, and they must also bear losses in the same proportion. It is possible to deviate from this, however, but there is an absolute limit: no member may be completely excluded from the profits, and no one may be completely exempt from bearing the losses.

Does working more mean getting more? – Freedom in Dividend Distribution

The law assumes that everyone receives a share of the profits in the same proportion as their contribution to the share capital. However, this is only the default rule, not a mandatory requirement. Members are free to agree on different proportions in the company’s articles of association. For example, they may stipulate that one member receives a larger share of the dividends than their paid-in capital, while another receives a smaller share. Furthermore, according to the position established in judicial practice, the articles of association may even authorize the shareholders’ meeting to determine different ratios from year to year. There is only one limitation: no one may be completely excluded from the profits. If someone is a member of the company, they are entitled to a share of the profits.

Why would anyone want to deviate from the default ratio? There could be many reasons. For example, one member contributes less capital but runs the company, receiving a larger dividend in return. Or the opposite: an investor puts in more money but waives part of the dividend because, in return, they are in charge.

The Limits of Freedom

The freedom to distribute dividends among members does not mean that any amount of money can be taken out of the company. The law strictly protects creditors: dividends may only be paid from freely available profits, and the payment must not jeopardize the company’s solvency. However, this rule does not concern how members distribute profits among themselves, but rather the total amount they may draw down.

Courts have confirmed in several cases: the ratio of dividend distribution among members can be freely determined, as this is not a matter of creditor protection. The only inviolable limit is the prohibition of the so-called “societas leonina”, so that one may be completely excluded from profits or exempted from losses.

From a fable over two thousand years old to modern corporate law

The term refers to Aesop’s fable in which the lion, the donkey, and the fox joined forces to hunt, but when it came time to divide the spoils, the lion ultimately kept the entire haul for himself. The moral of the fable was already incorporated into Roman law. Ulpianus, the renowned Roman jurist, noted that a partnership formed by an agreement in which one member bears only the losses but is completely excluded from the profits does not, in fact, qualify as a partnership, since it lacks two essential elements of a partnership: shared risk-taking and good faith.

Modern Hungarian corporate law preserves this fundamental principle of Roman law, as Section 3:88(2) of the Civil Code states, with regard to all forms of companies, that “any provision in the articles of incorporation that completely excludes a member from sharing in profits or bearing losses is null and void.”

Is 1% enough? – Where is the line between “a little” and “nothing”?

The big question, however, is what it means to “completely” exclude someone. If a member is entitled to something – say, 1% of the profits, even though they contributed a much larger share of capital – that is not yet “complete” exclusion (according to the letter of the law). According to emerging case law and legal commentaries, however, it is not enough to look at the letter of the law; one must also examine its spirit. The essence of a company is a community of interests: members associate because they want to achieve profits together and share the risk.

The Civil Code generally prohibits the abuse of rights – and this applies in corporate law as well. If the majority members formally comply with the rules but their actual goal is to exclude the minority member from the profits, this may constitute an abuse of rights.

The biggest open question, however, is where the line is drawn between “less dividends” and “practically nothing.” The courts will have to answer this, but the trend is clear: formal tricks will work less and less.

The best defense: a well-drafted contract

The best defense is prevention: it is advisable to specify in the articles of association at the time of the company’s incorporation exactly who is entitled to what amount of dividends, and what happens if the majority wishes to change this. If a dispute arises later, the member may first object at the members’ meeting where the decision detrimental to them is made; if this is unsuccessful, they may also challenge the decision through legal channels. The most important lesson, however, is that lengthy litigation can be prevented with a well-drafted contractual provision.