I. Why are dividend recaps controversial?
A dividend recap occurs when a company issues bonds or borrows from a bank to pay a special dividend to its equity investors. In the case of a private equity-backed company, a sponsoring firm may exert control over a portfolio company’s decision to undertake a dividend recap. Because the private equity firm almost always stands to receive a dividend (and perhaps the majority of it), its involvement can give the appearance of self-dealing. Dividend recaps may also appear to lack an exchange of reasonably equivalent value between companies and their investors because they leave the company with more debt without a benefit to operations. Although dividend recaps are not illegal, they can expose the participants to legal risks under federal and state law.
II. Benefits and Drawbacks
The benefits for the equity investor are clear. The dividend recap provides the investor with a return on investment, in addition to any distribution of profits, without having to sell an ownership stake.
The benefits for the company, however, are less clear. Arguably, the dividend recap could maintain a positive relationship between the company and investors, mainly to induce the investors to finance growth or provide funds during hard times.
However, as with any debt-incurring strategy, a dividend recap can reduce a company’s cash flow by increasing interest and principal repayment expenses. That can impede its growth, leave it vulnerable to economic downturns, and lead it into insolvency and perhaps even into bankruptcy. See, e.g., In re Appleseed’s Intermediate Holdings, LLC, 470 B.R. 289, 295 (D. Del. 2012) (alleging that a dividend recap left debtors vulnerable to the unexpected challenges of a recession and resulted in their insolvency and eventual bankruptcy); In re Atherotech, Inc., 582 B.R. 251, 256 (Bankr. N.D. Ala. 2017) (alleging that a dividend recap resulted in company’s insolvency and bankruptcy).
III. Investor-Side Legal Risks
Where a dividend recap leaves a company insolvent or with unreasonably little capital, and without having received any value in exchange, unsecured creditors commonly rely on fraudulent transfer statutes to “avoid” the dividend payments to those who benefited. Such suits allow creditors to recover the dividend payments from the investors rather than having to first exhaust their remedies against the company or its directors.
Every state has a form of fraudulent transfer law, with a majority of states adopting either the Uniform Fraudulent Transfer Act or the Uniform Voidable Transfer Act. In most states, the statute of limitations is, or can exceed, four years. Further, if a company becomes subject of a bankruptcy proceeding, federal bankruptcy law permits the bankruptcy estate to pursue fraudulent transfer claims for transfers made within two years of the bankruptcy filing, see 11 U.S.C. § 548, or under applicable law, see 11 U.S.C. §544 (incorporating state fraudulent transfer laws as an alternative means of recovery).
Fraudulent transfer claims take several forms. One form is an “actual fraudulent transfer.” There, a debtor makes a transfer with the intent to hinder, delay, or defraud creditors. A second form is a “constructive fraudulent transfer.” There, the debtor’s intent is irrelevant. What matters is that the debtor was rendered insolvent (or lacking reasonable capital to sustain operations or unable to pay debts as they came due) and did not receive reasonably equivalent value. Equity dividends almost never constitute reasonably equivalent value. A third form is an “insider preference.”[1] There, a transfer to an “insider” (which typically includes controlling shareholders or shareholders holding significant equity investments in a debtor, as well as in its affiliates) for antecedent debt, at a time when the company was insolvent and the insider had reasonable cause to believe the debtor was insolvent.[2]
For example, in In re Appleseed’s Intermediate Holdings, LLC, the bankruptcy trustee sued under state and federal law to avoid and recover dividends paid to private equity parties who orchestrated a dividend recap. 470 B.R. 289, 294 (D. Del. 2012). The lawsuit included fraudulent transfer claims under theories of actual and constructive fraud. Id. at 299–300. The court found that the complaint had sufficiently alleged a claim for actual fraud based on allegations that: (1) the dividends were issued to insiders because the debtors were controlled by the private equity parties; (2) the transfer of the debt-funded dividends occurred at the same time the company incurred substantial new debts; (3) the debtors (the company and its affiliates) received no value in exchange; and, (4) the debtors were or became insolvent when it paid the dividends. Id. at 300.
Courts have viewed dividend recapitalizations as lacking fair consideration and susceptible to fraud. See e.g., Boyer v. Crown Stock Distribution, Inc., 587 F.3d 787, 794 (7th Cir. 2009) (holding a transfer fraudulent where a company made dividend payments without receiving in exchange “reasonably equivalent value”); Reynolds v. Behrman Cap. IV LP, 2022 WL 163693, at *6 (N.D. Ala. Jan. 18, 2022); In re Color Tile, Inc., 2000 WL 152129, at *5 (D. Del. Feb. 9, 2000) (same).
IV. Debtor/Dividend Issuer-Side Risks
Liability can be imposed against those who issued the debt and dividends, including the company’s directors. State law typically requires a company to maintain sufficient assets to support its decision to pay dividends. See, e.g., Del. Code Ann. tit. 8, §174(a); N.Y. Bus. Corp. Law § 719(a)(1); Cal. Corp. Code § 316(a)(1). In Delaware, directors can be liable for having approved a dividend when the company was insolvent or that rendered it insolvent. EBS Litig. LLC v. Barclays Glob. Invs., N.A., 304 F.3d 302, 305 (3d Cir. 2002). In these cases, directors will be liable for the amount of the dividend, with only a limited possibility that they may be able to recover the dividends from investors. See, e.g., Del. Code Ann. tit. 8, § 174(c); N.Y. Bus. Corp. Law § 719(d); Cal. Corp. Code § 316(f).
Directors may also be subject to claims that they breached their fiduciary duties and violated securities laws. See, e.g., EBS, 304 F.3d at 307; Chrysler Cap. Corp. v. Century Power Corp., 778 F. Supp. 1260, 1265 (S.D.N.Y. 1991) (bringing claims for violations of securities laws based on allegations that defendants fraudulently transferred funds from a subsidiary to its parent as a dividend); see also 15 U.S.C. § 78j(b) & 17 CFR 240.10b-5 (prohibiting fraudulent conduct in connection with the purchase or sale of securities, which can include a company’s issuance of bonds). None of these claims would necessarily create duplicative liability.
V. Pre-Dividend Steps / Defenses
Before approving a dividend recap, a company should consider the following:
- A company should obtain a solvency opinion from an independent advisor who can opine that the company maintains sufficient assets to demonstrate its ability to pay its outstanding debts and that the fair value of its assets exceeds its liabilities.
- The company should provide the independent advisor with accurate and complete financial information, including projections. See, e.g., Appleseed, 470 B.R. at 294 (alleging that defendants’ third party solvency opinion contained projections with “unreasonably comparisons and relied upon faulty factual assumptions provided by the [defendants]”); Reynolds, 2022 WL 163693, at *2 (finding solvency opinion “inaccurate and unreliable” where defendant “concealed the existence of significant contingent liabilities”).
- A company should also have a firm assessment of its liabilities, including any contingent liabilities,[3] to make sure it can support the additional debt.
- To avoid claims that a majority shareholder unduly influenced the decision, a company should delegate decisions related to a dividend recap to either an independent board or an independent special committee. A court is less likely to conclude fraud where the directors initiating the transaction laced a direct interest. See, e.g., Appleseed, 470 B.R. at 299 (noting that, whether the dividend distribution was made to an insider, is a persuasive factor in determining whether the transfer was fraudulent).
- Directors should be given sufficient time and information to act on “good faith, on an informed basis, honestly believing that their action is in the best interests of the company.” In re Tower Air, Inc., 416 F.3d 229, 238 (3d Cir. 2005). That will enable them to take advantage of the business judgment rule. ; see also, e.g., Del. Code Ann. tit. 8, § 141(e) (directors “shall … be fully protected in relying in good faith upon … information, opinions, reports or statements presented to the corporation by … any … person as to matters the member reasonably believes are within such … person’s professional or expert competence and who has been selected with reasonable care by or on behalf of the corporation.”). But that requires that the directors are independent. They cannot appear on both sides of the transaction and cannot derive any personal financial benefit (as opposed to a benefit that goes to the company or all its shareholders). In re Musicland Holding Corp., 398 B.R. 761, 788 (Bankr. S.D.N.Y. 2008).[4]
VI. Conclusion
As with any debt-incurring strategy, dividend recapitalizations can create legal hazards. When considering a dividend recap, a company needs to carefully evaluate its financial condition and take measures to protect against potential legal claims seeking to undo the transaction.
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Endnotes:
[1] Although every state has a form of actual fraudulent transfer and constructive fraudulent transfer, not every state has an insider preference claim.
[2] Although dividends paid in a dividend recap are not payments on account of antecedent debt, to the extent that a dividend recap also funds payments made to a management company affiliated with a controlling shareholder (which does arise in dividend recaps in sponsor circ*mstances), such payments could be viewed as an insider preference.
[3] Any company with significant contingent liabilities such as mass torts exposure or environmental liabilities should estimate such liabilities before proceeding with a dividend recap. Cf. In re Tronox Inc., 503 B.R. 239, 309 (Bankr. S.D.N.Y. 2013) (noting that solvency analysis under fraudulent transfer law requires determining all “unmatured, contingent, and unliquidated” liabilities, and analyzing company’s environmental and tort liabilities).
[4] The business judgment rule will not insulate transferees of a dividend recap from liability for a fraudulent transfer. Good faith and unconflicted determinations by a company’s fiduciaries as to the reasonableness of financial projections, however, can be powerful evidence that a company was solvent or had reasonable capital to sustain operations.
