PARTNERSHIPS,CORPORATIONS
AND THE VARIANTS
PROF. BRUCE MCCANN
LECTURE 12DIVIDENDS AND DUTY OF CARE
PP. 479-528
Business Organizations2009-2010 Lectures
PIERCING THE CORPORATE VEIL
Lec. 12, pp 479-528 Corporations Prof. McCann
The issue is not whether the corporate entity should be disregarded for all purposes, nor whether its very purpose was to defraud the plaintiff. Rather, the issue is whether in the particular case and for purposes of that case "justice and equity can best be accomplished and fraud and unfairness defeated by a disregard of the distinct entity of the corporate form." (Kohn v. Kohn (1950) 95 C.A.2d 708)
Sea-Land Rule
Lec. 12, pp 479-528 Corporations Prof. McCann
Corporate entity will be disregarded and veil of limited liability pierced if: There is a unity of interest and ownership such that the
separateness of the personalities of the entity and the individual (or other entity) no longer exists Unity of interest determined by analysis of
Lack of corporate formalities Commingling of corporate and non-corporate assets Undercapitalization Treating corporate assets as if belonged to owner(s)
Circumstances must be such that adherence to the fiction of separateness would
SANCTION A FRAUD PROMOTE INJUSTICE
Sea-Land Rule – “Promote Injustice?”
Lec. 12, pp 479-528 Corporations Prof. McCann
Means more than that a creditor will go unpaid.
There must be a wrong beyond creditor’s inability to collect, e.g., Unjust enrichment to person or entity who looted
corporation Scheme to move assets to one entity and liabilities to
another Must be sufficient to “merit the evocation” of the
court’s equitable powers.
Declaring Dividends
Lec. 12, pp 479-528 Corporations Prof. McCann
Highlights the tension between creditors and shareholders CREDITORS do not want money taken out of the
corporation until they have been paid SHAREHOLDERS like dividends because
(a) represents a return on investment that is no longer subject to market forces;
(b) declaring a dividend signals optimism about the future and often drives the share price higher.
Basic Policy Objective: Protect the Creditor
Lec. 12, pp 479-528 Corporations Prof. McCann
Limit so that dividends can only be paid from “surplus” after sufficient capital held in reserve to pay debts.
Solely Within Authority of Directors
Lec. 12, pp 479-528 Corporations Prof. McCann
Holders of common shares have no vested right to a dividend Some preferred shares carry right to a dividend and
enforcement power (such as right to name directors) if required dividend is not paid to preferred shareholders
Courts will not interfere with directors’ decision to declare or withhold dividend absent showing of fraud, bad faith or abuse of discretion by directors
BUT once a dividend is declared, shareholders may enforce in court
TYPES OF SURPLUS
Lec. 12, pp 479-528 Corporations Prof. McCann
Capital surplus Excess portion of price received by corporation for its stock
after subtracting the par value Plus any amount directors deem necessary (sometimes
required by creditors) Earned surplus
Earning of the company from operations after subtracting liabilities and net of capital accounts
Reduction surplus The amount directors vote to take out of Stated Capital (e.g.,
by reducing par or because augmented from capital surplus and now unwinding
Revaluation surplus The amount of previously unrealized appreciation directors
choose to recognize (and which moves into earned surplus)
Approaches Vary By Jurisdiction:
Lec. 12, pp 479-528 Corporations Prof. McCann
1. Can only be paid from Earned Surplus2. Can only be paid if balance sheet shows there is
money left over after liabilities and stated capital are subtracted from assets (the “Balance Sheet” test).
3. Can only be paid if there are “current profits” (regardless of whether there is any earned surplus) (the “nimble dividends” test);
4. Can only be paid of assets exceed liabilities (doesn’t consider stated capital or other equity); and
5. Can pay so long as won’t leave company “insolvent”
Delaware
Lec. 12, pp 479-528 Corporations Prof. McCann
Sec. 170: Can pay dividends from surplus (over stated
capital) or, if there is no surplus, can pay from current net profits and last year’s net profits.
RATIONALE: If company has not been profitable such that there is no surplus, probably cannot borrow. If law forbid the payment of dividends until there is a surplus, much more difficult to attract investors seeking a return on their investment.
Model Act
Lec. 12, pp 479-528 Corporations Prof. McCann
Does not distinguish between dividends and redemptions or other distributions, calls all of them “Distributions”
Requires all distributions meet two tests: 1. The “equity solvency” test – after the distribution will
the corporation still be able to pay its debts as they come due?
2. The “balance sheet” test – after the distribution, are the remaining assets greater in value than its liabilities plus the amounts the corporation would have to pay to shareholders under existing agreements if the corporation were dissolved at the time of the distribution
Stock Dividends
Lec. 12, pp 479-528 Corporations Prof. McCann
Issue additional shares in lieu of cash.Reasons:
Don’t want to spend the cash but want to appease shareholders
Want to increase voting rights of pro-board shareholders in case of takeover bid
Need to issue more shares to make an offering work and must issue stock dividends to keep voting rights intact
Drives down stock price somewhat (because more shares over which ratios operate, such as “earnings per share”)
Are Creditors Really Protected By These Rules?
Lec. 12, pp 479-528 Corporations Prof. McCann
All decisions still made by the shareholders.The “real” assets of the corporation, the ones
that could readily generate money to pay creditors, aren’t weighted any differently than assets like patents So balance sheet test is almost meaningless to
creditor
By gaming “par” values or using “nimble dividends” test, the creditors are put well behind the shareholders
How Creditors Protect Themselves
Lec. 12, pp 479-528 Corporations Prof. McCann
COVENANTS
“(a) Use of Proceeds. Proceeds received from the Payee pursuant to this Note will be used by the Borrower for working capital and general company purposes.
(b) Affirmative Covenants. Until the conversion or repayment (or prepayment) of this Note in accordance with the terms and conditions set forth herein, each Borrower shall perform all covenants in this Section 4(b).
Typical Terms
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(c) Negative Covenants. Until the conversion, repayment (or prepayment) of this Note in accordance with the terms and conditions set forth herein, the Borrower will not, without the prior written consent of the Payee, undertake to do any of the following: (i) create, issue, sell or transfer any debt securities of the Borrower or enter into or incur other indebtedness other than indebtedness which, together with this Note, does not exceed $200,000 in principal amount (for purposes hereof, “Indebtedness” shall mean any indebtedness of the Borrower for borrowed money from banks, other financial institutions, (except indebtedness consisting of drawing down on existing lines of credit) and any Person (defined as natural persons, corporations, limited liability companies, limited partnerships, general partnerships, limited liability partnerships, joint ventures, trusts, land trusts, business trusts, or other organizations, irrespective of whether they are legal entities));
Negative Covenants Continued
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(ii) (A) redeem, repurchase or otherwise acquire for consideration any outstanding equity securities of the Borrower (or securities convertible or exercisable into or exchangeable for equity securities of such entity) or permit any Borrower to take such action; or (B) declare or pay any cash or property dividend or distribution of any kind on any class of stock or membership interest (except with respect to ordinary course inter-company transfers and accounts of the Borrower); (iii) make any material change in its ownership or organization or the manner in which its business is conducted outside of the ordinary course of its business; (iv) transfer, sell, lease, or in any other manner convey any equitable, beneficial or legal interest in any assets of the Borrower except inventory sold in the normal course of business, or allow to exist on its assets any mortgage interest, pledge or security interest , title retention device, or other encumbrance, junior or senior to Payee, other than as set forth herein.
STOCK BUY-BACKS (REDEMPTIONS)
Lec. 12, pp 479-528 Corporations Prof. McCann
Clearly a Distribution of Money to the Shareholder Cash goes to shareholder Stock goes to company Shareholder ends up with fewer shares but there are
now fewer shares altogether, so net effect on percentage of ownership is unaffected
What does company have? Nothing of value. The stock it has purchased cannot be shown as an asset because to do so would allow any stock it issued and kept to be an “asset.”
KLANG V SMITH FOOD & DRUG
Lec. 12, pp 479-528 Corps Prof. McCann
Because the policy behind the rule that payments must come from surplus is to prevent a board from draining capital to the detriment of creditors, and if surplus is determined by asset valuation, valuation at time of determination is appropriate and it is irrelevant whether or not the balance sheet uses current valuations. Therefore, balance sheet amounts are not determinative.
Board’s determination will be accepted absent showing of bad faith or fraud
Why Buy-Backs?
Lec. 12, pp 479-528 Corporations Prof. McCann
Often want to empty large cash holdings which attract take-over interest.
Repurchase tends to drive stock price up because Now are fewer shares outstanding, giving those
outstanding shares more value Evidences economic health, increasing confidence
If directors issued large dividend checks instead, shareholders would pay taxes at higher rates than if got a “return on capital” which is a capital gains item
Directors’ Duty of Care
Lec. 12, pp 479-528 Corporations Prof. McCann
Francis v United Jersey Bank: Director is fiduciary of the corporation and its
shareholders And in the context of the business of the
corporation, may be a fiduciary to its creditors Where there is constructive or actual trust
Director must “discharge duties in good faith and with that degree of diligence, care and skill which ordinarily prudent men would exercise under similar circumstances in like positions”
Francis v United Jersey Bank
Lec. 12, pp 479-528 Corporations Prof. McCann
Where director breaches duty, personally liable if negligence was a proximate cause of a loss to the creditor or shareholder or corporation
Plaintiff has burden of showing loss would have been avoided if defendant had performed her duties
Analysis includes determination of “reasonable steps” director should have taken
BUT causation will be inferred where reasonable to conclude particular result from a failure to act and that result has occurred.
Caremark
Lec. 12, pp 479-528 Corporations Prof. McCann
Director liability can be grounded on several theories: Liability following poor decision by board
because decision was negligent and ill advised Liability based on failure to act where due
diligence would prevent the loss
BUT, “absent cause for suspicion there is no duty…to install and operate a system of corporate espionage to ferret out wrongdoing that they have no reason to suspect exists.”
Caremark cont’d
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There must be a system in place adequate to assure the board that appropriate information will come to its attention in a timely manner
Failure to insist upon and maintain such a system may render a director liable
Caremark cont’d
Lec. 12, pp 479-528 Corporations Prof. McCann
Plaintiffs must show:Director knew orShould have known were violations of lawTook no steps to prevent or remedyFailure proximately caused the loss
Rule
Lec. 12, pp 479-528 Corporations Prof. McCann
Model Act and ALI, and most statutes, allow directors to rely on others if that reliance is reasonable because the adviser “merits confidence”