Thursday, September 25, 2014

Dividends and Share Repurchases When Companies Are Approaching Insolvency

Here's an interesting subject for distressed investors to think about: the legal boundaries regarding dividends and share repurchases when a company is approaching insolvency.

One good paper is "Wrongful Corporate Cash Distributions Under Delaware and Georgia Law" [pdf]. Some highlights:

A Summary of the Key Formula
Title 8, sections 160 and 170 of the Delaware code allow a corporation to purchase its own stock or issue dividends, provided that such transactions do not result in an impairment of the corporation’s capital. If the amount calculated is less than the amount distributed, then the transaction is unlawful, and directors who willfully or negligently conducted the unlawful redemption are jointly and severally liable. Del. Code, tit. 8, §§ 160, 174.[...]

Section 174 of the General Corporation Law makes directors personally liable for their willful or negligent conduct in connect ion with the repurchase of stock or the payment of an unlawful dividend. The director s are liable to the corporation, and in the event of dissolution or insolvency, to its creditors, at any time within six years from the date of the unlawful stock repurchase or the payment of the unlawful dividend, for the full amount of the payment. However, Sections 141(e) and 172 of the General Corporation Law provide protection to directors who in good faith rely on the books of the corporation or on reports of officers or outside experts selected with reasonable care in determining whether there are sufficient funds legally available for a stock repurchase or payment of a dividend. [...]

The purpose of the limitations on the sources of funds for effecting valid stock repurchases contained in Section 160 and permissible dividends contained in Section 170 are to protect creditors (and in some cases stockholders as well) from fraud. Therefore, it appears that the reference to 'value' in Morris must be read as a reference to fair market value of assets and liabilities because it is only fair market value that represents a potential fund from which creditors' claims may be satisfied.
This article points out some other potential causes of action if directors or management improperly deprive creditors of value through dividends or share repurchases: breach of fiduciary duty, fraudulent conveyance, and state law provisions such as Section 14-2-640 of the Georgia Business Corporations Code.

Another good article is "American Corporate Law: Directors' Fiduciary Duties and Liability during Solvency, Insolvency and Bankruptcy in Public Corporations" [pdf]:
"A check-list for [corporate directors to avoid] personal liability to creditors for their actions when the corporation is or may be in the zone of insolvency includes: [...] Consider retaining financial advisors to evaluate whether contemplated transactions are fair to the creditors of the corporation; [...] Assure that decisions are defensible on the basis of good faith judgment - generally, it is prudent to avoid dividends or stock redemption while in the zone of insolvency; Be prepared to demonstrate, based on reports and outside advisors, reflected in the records of the board's deliberations, that any awards of executive compensation were reasonable and necessary..."
Last article worth mentioning is "Protecting Directors and Officers of Corporations That Are Insolvent or in the Zone or Vicinity of Insolvency: Important Considerations, Practical Solutions" [pdf]:
"[C]ourts may judge in hindsight whether the corporation was insolvent at the time that the corporate decision in question was made, 'notwithstanding contrary presentations made in the company's audited financial statements or made to its board of directors.' Accordingly, it is prudent for directors and officers to adopt a conservative approach in their evaluation of the corporation's solvency and to assume that the corporation is insolvent or within the zone of insolvency if there is any reasonable question about the corporation’s solvency."
These rules for directors to follow result in two important signals of corporate insolvency: ceasing dividends and hiring financial advisors. Debtwire is a subscription service that costs a fortune but delivers valuable scoops about what companies have hired restructuring advisors or counsel; investors then know to unload those companies shares.

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