A Brave New World Under California's Relaxed Standards for Corporate Distributions

Background

Sections 500-509 of the California Corporations Code (the “Code”) govern if and when a California corporation or quasi-corporation can make a distribution to its shareholders (for purposes of this article, references to “distributions” include dividends of cash or property and repurchases and redemptions of shares). The existing provisions of Section 500 of the Code provide that a California corporation or quasi-corporation may make a distribution only if either a “retained earnings” or a two-pronged “balance sheet and liquidity” test is satisfied.

These restrictions are aimed at protecting creditors and senior equity holders of the corporation from transactions that might improperly bleed the corporation of necessary capital to operate its business and meet its current liabilities or undermine the preferences of senior equity holders. Unfortunately, a financially healthy corporation, whose assets have a fair market value that greatly exceed the corporation’s liabilities, may be unable to satisfy either of the Section 500 standards based on its historical operating losses and failure of either standard to account for appreciated property. Accordingly, many emerging growth companies, which typically have significant historical loses and/or appreciated assets, are often disproportionately affected and are hard-pressed to meet these challenging standards, which, in turn, may adversely impact the ability of such companies to raise funds from venture capital firms seeking income-producing investments. In addition, the “balance sheet and liquidity” test is difficult to apply in practice and, if a distribution is made in violation of such standards, a director of a corporation may become subject to personal and criminal liability for such miscalculation.

Amendments to Sections 500-509 of the Code

As a result of the enactment of California Assembly Bill 571, effective January 1, 2012, various provisions of Sections 500-509 of the Code will be amended or repealed (collectively, the “Amendments”). Of note, the Amendments do not affect the "liquidity" test set forth in Section 501 of the Code, which must be separately satisfied before a distribution may be lawfully made. The following summarizes the text and impact of the Amendments.

Revised Section 500 Tests

The Amendments will replace the existing rigid and convoluted “balance sheet” test with a more accommodating and simplified balance sheet test, which provides that a corporation is permitted to make a distribution if, immediately after giving effect to the distribution, the value of the corporation’s assets equals or exceeds the sum of (i) its total liabilities plus (ii) the liquidation preference of any shares (including accrued and unpaid dividends) which have a preference upon dissolution over the rights of shareholders receiving such distribution (which the Amendments refer to as the “preferential rights amount”). In its articles of incorporation, a corporation may also exclude the preferential dividends arrears amount and the preferential rights amount from either Section 500 test with respect to any class or series of its preferred stock.

The Amendments will also modify the existing “retained earnings” test to provide that the amount of retained earnings must equal or exceed the sum of (a) the amount of the proposed distribution and (b) the amount of cumulative dividends in arrears on a class or series of preferred stock that are senior in dividend preference to the class or series to which the applicable distribution is being made (which the Amendments refer to as the “preferential dividends arrears amount”). Under existing law, neither the preferred dividends arrears amount nor an equivalent concept is included in the calculation of the retained earnings test.

New Board Discretion on Valuation Determination

Existing Section 500 of the Code also requires that the board of directors, in determining whether either the retained earnings test or the balance sheet and liquidity test is satisfied, be bound by the historical carrying costs of the corporation’s assets and liabilities as set forth on its balance sheet prepared in accordance with GAAP. In an effort to provide additional flexibility, the Amendments now permit the board of directors to base its good faith determination on whether the retained earnings test or the new balance sheet is met on the basis of (i) the corporation’s financial statements prepared on the basis of accounting practices and principles that are reasonable under the circumstances, (ii) a fair valuation, or (iii) any other method that is reasonable under the circumstances.

Timing of Determination

Under AB 571, the date on which the board of directors must determine whether either of the foregoing standards are met is the date on which the distribution is authorized (provided that the distribution is made 120 days after the date of authorization). This is in contrast to the existing law which requires the determination to be made as of the date that the distribution is made.

Other Changes

The following is a list of additional changes to existing California law as result of the enactment of AB 571:

• If a corporation issues debt to its shareholders in connection with the repurchase of their shares, each payment of principal or interest under such debt obligation will be treated as a distribution and must satisfy the requirements set forth in Sections 500 through 509 of the Code.
• If a corporation makes a distribution, it is no longer required to notify its shareholders if the distribution is not being made from retained earnings and the accounting treatment of such distribution.
• A four-year statute of limitations (commencing on the date of the distribution) on any cause of action involving the obligation of a shareholder to return an improper distribution.
• Preferred shareholders are no longer able to bring suit against shareholders who improperly receive distributions unless the amount of their preferred dividend amount in arrears or their preferential rights upon dissolution is greater than zero.
• The Amendments also clarify that a corporation that has shares which are redeemable at its option may redeem their shares in accordance with its articles of incorporation or as provided in Section 509 of the Code.

Summary

With the enactment of AB 571, California has adopted a new, more modern approach to determining how and when shareholder distributions can be made and aligns the shareholder distribution standards in California more closely with those applicable to California limited liability companies and limited partnerships and those standards followed in most other states. As a result of the revisions to the existing rigid Section 500 tests, more healthy California corporations and quasi-corporations will be able to make distributions (and, hopefully, as a consequence, will be to attract new venture capital sources who are focused on alternative income returns) and will no longer be subject to competitive disadvantage to corporations organized in other states which have not adopted similarly rigid shareholder distribution standards.