The coronavirus (COVID-19) pandemic has forced companies to reassess their financial projections amid the rapidly shifting landscape of the global economy. In response, there has been a rapid uptick in the number of corporations that have suspended dividend payments to preserve assets and capital. The last few weeks have seen corporations in the auto, aerospace, cruise line, entertainment, hospitality, mining, and restaurant industries, to mention a few, suspend dividends.
As the COVID-19 pandemic continues, corporations should analyze whether it is in their best interests to suspend the payment of dividends or refrain from declaring dividends. This LawFlash highlights a few considerations corporations and their board of directors should keep top of mind as they contemplate the declaration/payment of dividends, including state law considerations under California, Delaware, New York, and Pennsylvania corporate law, and is one of a series focused on COVID-19’s impact on corporate governance, including the duties and actions of boards and committees, and mergers and acquisitions.
For more discussion on corporate governance, mergers and acquisitions, securities and a myriad of other issues companies and individuals face during the crisis, visit our Coronavirus COVID-19 resource page.
State Law Considerations
Generally, the board of directors of a corporation, subject to any additional restrictions in the corporation’s governance documents or to covenants in agreements to which it is a party, has the power to declare and pay dividends. In practice, to pay a dividend the board of directors must first declare a dividend and set record and payment dates. Although dividends may be paid in cash, property, or in shares of the corporation’s capital stock, the considerations below apply primarily to the payment of cash dividends.
- Creditor-Debtor Relationship. Established case law in multiple jurisdictions holds that the declaration of dividends creates a creditor-debtor relationship under which a shareholder may recover the declared amount in a contract action against the corporation. This creditor-debtor relationship may be problematic for corporations that have declared dividends but have seen their financial condition adversely affected by the COVID-19 pandemic prior to the record or payment dates.
- Legal Sources of Dividend. Although states may recognize the existence of a creditor-debtor relationship upon the declaration of a dividend by a board of directors, it is important to note that in many instances state law restricts the legal sources from which dividends may be paid. Generally, as noted below, boards of directors must satisfy certain solvency or balance-sheet tests before declaring or paying dividends.
- Delaware. Under Sections 170 and 173 of the Delaware General Corporation Law (the DGCL), dividends may only be paid out of either the corporation’s “surplus” (as defined in the DGCL) or when there is no such surplus, “out of its net profits for the fiscal year in which the dividend is declared and/or the preceding year” (the so-called “nimble dividend”).
- California. In California, pursuant to Section 500(a) of the California Corporations Code (the CCC), a dividend may be paid only to the extent the board of directors has determined in good faith that (i) the “amount of retained earnings of the corporation immediately prior to the distribution equals or exceeds the sum of (A) the amount of the proposed distribution plus (B) the preferential dividends arrears amount” or (ii) “immediately after the distribution, the value of the corporation’s assets would equal or exceed the sum of its total liabilities plus the preferential rights amount.”
- New York. Section 510(a) of the New York Business Corporation Law (the NYBCL) prohibits the payment of dividends if the corporation is insolvent or would be made insolvent as a result of the paid dividend. Section 510(b) of the NYBCL provides that dividends may be declared and paid “out of surplus, so that the net assets of the corporation remaining after such declaration, payment or distribution shall at least equal the amount of its stated capital”, or in case there is no surplus, “out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year.”
- Pennsylvania. In Pennsylvania, a dividend may not be paid if the corporation would be unable to pay its debts as they come due in the usual course of business. In addition, pursuant to Section 1551(b)(2) of the Pennsylvania Business Corporation Law (the PBCL), dividends may not be paid if “the total assets of the corporation would be less than the sum of its total liabilities plus (unless otherwise provided in the [articles of incorporation]) the amount that would be needed, if the corporation were to be dissolved at the time as of which the distribution is measured, to satisfy the preferential rights upon dissolution of shareholders whose preferential rights are superior to those receiving the distribution.”
- Impairment of Capital. In light of the various statutory language cited above, even though the declaration of a dividend creates a creditor-debtor relationship, to the extent a corporation’s capital has been impaired such that the corporation no longer has a lawful source for the payment of dividends, a court may hold that the dividend cannot be paid. In other words, a court may hold that the creditor-debtor relationship is contingent upon the existence of a lawful source for dividends at the time of payment.
For corporations considering issuing dividends or that have already declared a dividend, the board of directors should consider the following actions if there are concerns about liquidity, whether due to the COVID-19 pandemic or otherwise:
- Conditional Dividends. To avoid creating a creditor-debtor relationship, corporations should be careful not to declare an unconditional dividend. A board of directors should make clear that the declaration and payment of dividends is at its sole discretion and conditioned on, among other things, the board of directors evaluating the corporation’s financial condition, operating results, available cash, anticipated capital needs, and the board of directors not revoking the dividend before the payment date.
- Delaying Payment of Dividends. In the event that an unconditional dividend has been declared, a board of directors may still be able to delay the payment of dividends if the record date has not passed, subject to any requirements under the corporation’s governance documents. In Delaware, a board of directors is not prohibited from changing the record and payment dates, as long as the payment date occurs within 60 days of the record date pursuant to Section 213(c) of the DGCL. Section 604 of the NYBCL and Section 701(a) of the CCC provide for substantially similar requirements. In Pennsylvania, Section 1763(a) of the PBCL provides that the record date may not be more than 90 days before the payment date.
Director Liability and the Business Judgment Rule
Boards of directors should be mindful of the potential for personal liability that comes with declaring and paying dividends, particularly under circumstances where there is potential for a corporation’s assets to deplete rapidly, such as during the COVID-19 pandemic.
- Delaware. Under Section 174 of the DGCL, directors under whose administration an unlawful dividend was paid may be held jointly and severally liable to the corporation, and to its creditors in the event of dissolution or insolvency, for the full amount of the dividend unlawfully paid, with interest from the time the liability accrued. The statute of limitations for claims under Section 174 is six years. It is important to note, however, that the declaration of the dividends is generally governed by the business judgment rule. Section 172 of the DGCL makes clear that a member of the board of directors “shall be fully protected in relying in good faith upon the records of the corporation.” In addition, as to the surplus or net profits of the corporation, Section 172 of the DGCL provides that directors generally may rely upon “information, opinions, reports or statements presented to the corporation by any of its officers or employees, or committees of the board of directors, or by any other person as to matters the director reasonably believes are within such other person’s professional or expert competence.”
- California. In California, Section 316 of the CCC provides that directors of a corporation who approve an unlawful distribution are jointly and severally liable to the corporation for the amount of such distribution. Pursuant to Section 506(b) of the CCC, the statute of limitations for claims in connection with unlawful distributions is four years. However, a director will not be liable to the extent such director performed his or her duties in good faith, in a manner such director believes to be in the best interests of the corporation and its shareholders, and with such care (including reasonable inquiry) as an ordinary prudent person in a like position would use under similar circumstances. In addition, under Section 309(b) of the CCC, in performing his or her duties, a director may rely on information prepared by the following parties: one or more officers or employees of the corporation who the director believes to be reliable and competent; counsel, independent accountants, or other persons as to matters which the director believes to be within such person’s professional or expert competence; and a board committee (upon which the director does not serve) as to matters within such committee’s designated authority, which the director believes to merit confidence.
- New York. Similar to California and Delaware law, under Section 719(a)(1) of the NYBCL, directors may be held jointly and severally liable for the improper payment of dividends. However, directors will not be held liable to the extent they perform their duties “in good faith and with that degree of care which an ordinarily prudent person in a like position would use under similar circumstances.” Pursuant to Section 717(a) of the NYBCL, a director may also rely on information provided by the following: an officer or employee of the corporation; counsel, public accountants, or other persons the director deems to have relevant professional or expert competence; and a board committee (upon which the director does not serve), which committee the director believes to merit confidence.
- Pennsylvania. Under Section 1553(a) of the PBCL, in the event of an unlawful payment of dividends, a director may be held jointly and severally liable for the “amount of the dividend that is paid or the value of the other distribution in excess of the amount of the dividend or other distribution that could have been made without violation of the provisions” of the PBCL or the restrictions in the bylaws. With respect to standards of care and justifiable reliance by directors, Section 1712(a) of the PBCL includes substantially similar provisions as those that appear in the corporate statutes of California and New York.
CARES Act Considerations
In light of the recent passing of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), which provides economic relief to various organizations facing financial challenges due to the COVID-19 pandemic, boards of directors considering the payment of dividends should analyze whether they will be taking advantage of any of the many economic relief programs offered through the CARES Act. However, applying for loans or other forms of relief may come with a whole host of eligibility requirements, restrictions, and covenants. Some of these restrictions apply to the payment of dividends. As such, corporations and their boards of directors should carefully consider any restrictive covenants in the CARES Act prior to availing themselves of its benefits. For a more detailed discussion of some of the restrictions imposed on organizations participating in economic relief programs under the CARES Act, read our recent LawFlash, Cares Act and Federal Reserve Offer Economic Assistance to Stabilize US Economy.
As the COVID-19 pandemic continues and corporations face greater financial challenges, boards of directors should be mindful of the various statutory schemes that govern the declaration of dividends, their payment and suspension, and the liability that may attach for unlawful distributions. In addition to state law considerations, boards of directors of public companies should keep in mind the implications of federal securities laws and national securities exchange rules governing the declaration and payment of dividends, for example, ex-dividend dates, exchange notifications, and public disclosures. Finally, boards of directors should also consult with legal counsel as to the various forms of relief available to companies under the CARES Act and any requirements that may attach to benefits they receive.
Coronavirus COVID-19 Task Force
For our clients, we have formed a multidisciplinary Coronavirus COVID-19 Task Force to help guide you through the broad scope of legal issues brought on by this public health challenge. We also have launched a resource page to help keep you on top of developments as they unfold. If you would like to receive a daily digest of all new updates to the page, please subscribe now to receive our COVID-19 alerts.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
Timothy J. Corbett
Thomas P. Giblin, Jr.
Howard A. Kenny
Kimberly M. Reisler
Justin W. Chairman
James W. McKenzie
Joanne R. Soslow
David C. Schwartz
Joo Khin Ng*
David A. Sirignano
*A solicitor of Morgan Lewis Stamford LLC, a Singapore law corporation affiliated with Morgan, Lewis & Bockius LLP