Dividends under Maryland Law in the Shadow of Coronavirus
In light of the coronavirus outbreak and its attendant and likely growing financial impact on the economy and individual companies, many clients have been seeking advice on the proper procedures and standards for the payment and revocation of dividends and other distributions under Maryland law.
Under the Maryland General Corporation Law ("MGCL"), a "distribution" includes a dividend and also a share purchase, redemption (either by put or call), other acquisition of shares and an issuance of evidence of indebtedness of the corporation.
The first step in paying a dividend is that it must be "authorized" by the board of directors (or a duly authorized committee of the board). After authorization, a dividend is typically "declared," i.e., announced by the corporation via a press release or other means reasonably likely to provide stockholders with notice of the dividend. After declaration, the amount of the dividend becomes a liability of the corporation.
The MGCL imposes two primary restrictions on the power of a Maryland corporation to pay dividends and make other distributions to its stockholders. A Maryland corporation may not make any type of distribution if, "after giving effect to the distribution":
- the corporation would not be able to pay its debts as they become due in the usual course of business (the equity insolvency test); or
- the corporation's total assets would be less than the sum of the corporation's total liabilities plus, unless its charter permits otherwise, the amount that would be needed, if the corporation were to be dissolved at the time of the distribution, to satisfy the preferential rights upon dissolution of stockholders whose preferential rights on dissolution are superior to those receiving the distribution (the balance sheet insolvency test).1
In addition, the MGCL permits a corporation that fails to satisfy the balance sheet insolvency test to make a distribution from (a) its net earnings for the fiscal year in which the distribution is made, (b) its net earnings for the preceding fiscal year or (c) the sum of its net earnings for the preceding eight fiscal quarters.2
In determining whether the corporation will meet the equity insolvency test, the board may make a reasonable judgment about whether the corporation is a "going concern" and may consider the corporation's current and anticipated operations, sources and needs for cash, including any anticipated debt and equity financing, and any unasserted contingent liabilities or potential recoveries.
In determining whether the corporation will meet the balance sheet insolvency test, the MGCL permits the board to "base [its] determination" on a "fair valuation or other method that is reasonable in the circumstances." Real estate held on the company's balance sheet at cost, for example, may have increased significantly in fair value. However, in fair-valuing its assets, a company should not "cherry-pick" among them, selecting only the ones that have increased in value. Likewise, if a company fair-values its assets, it should fair-value its liabilities, which may be a benefit to its net worth as long-term liabilities may often be dischargeable at less than face. Independent opinions are important in fair valuation of both assets and liabilities. (Fair valuation is also available for the equity insolvency test but is principally useful for the balance sheet insolvency test.)
To aid directors in determining whether a dividend or other distribution would satisfy the equity and balance sheet tests, especially during challenging financial times, we have prepared and recommend to clients the use of a certificate of the chief financial officer stating that, after the distribution, the corporation will comply with each of the two tests.
Determining that a distribution is not prohibited under either the equity insolvency test or the balance sheet insolvency test should not be the only consideration of the board in deciding whether to authorize a distribution. The board should also weigh other factors commonly considered by boards in authorizing distributions, including the financial condition of the corporation, its credit obligations, debt covenants, its short- and long-term capital needs and resources, its current and projected earnings, cash flow, prior distribution history, investor expectations, the market price of its stock and any regulatory requirements related to dividends or other distributions.
In the absence of a specific provision otherwise, the board is generally free to revoke a previously authorized dividend before it is declared. While the general rule is that a dividend may not be revoked after declaration, there may be extraordinary circumstances (e.g., severe turmoil in the capital markets or destruction of a major corporate asset) in which a corporation may be able to convert a cash dividend to a stock dividend,3 defer the payment of a dividend to a later date, suspend it indefinitely or revoke it altogether, especially if there is reason to believe that the payment of the dividend could result in insolvency or the inability of the corporation to continue its business. Of course, in light of the absence of clear precedents, a board of directors should carefully consider all relevant facts and circumstances, including equitable considerations, and consult with counsel prior to revoking an already declared dividend.
Finally, a director who votes for a dividend or other distribution in violation of the equity or balance sheet insolvency tests, and in violation of the statutory standard of conduct for directors, is personally liable to the corporation for the amount of the distribution that exceeds what could have been made without violating the statute or the charter. The director may be entitled to contribution from (a) every other director who "could [also] be held liable . . . for the unlawful distribution" and (b) each stockholder who accepted the distribution knowing it was unlawful or violated a charter provision. The exculpation provisions in many corporations' charters will also relieve directors from any liability for money damages except for liability resulting from (i) the director's actual receipt of an improper benefit or profit in money, property or services or (ii) a final judgment based upon a finding of active and deliberate dishonesty by the director that was material to the cause of action adjudicated.
* * * *
As always, our colleagues and we are available to discuss these or other matters of Maryland law.
- While the Maryland REIT Law does not prescribe any standards for the making of a distribution by a Maryland real estate investment trust to its shareholders, we generally advise that a board of trustees of a Maryland REIT should satisfy itself prior to authorizing a distribution that the Maryland REIT will be able to satisfy the equity insolvency and balance sheet insolvency tests after giving effect to the distribution.
- This provision was added to the MGCL during the financial crisis of 2008-09, a time when many profitable companies found that because of the stock market decline, their liabilities for unfunded pension payments may otherwise have caused them to fail to satisfy the balance sheet insolvency test.
- In 2017, the Internal Revenue Service issued a revenue procedure permitting "publicly offered" REITs to make elective stock dividends (i.e., dividends paid in a mixture of stock and cash), with at least 20 percent of the total distribution being paid in cash, to satisfy their REIT distribution requirements.