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Mind the trap: dividends during the Covid-19 crisis

July 28, 2020 | By Patrick T. McCloskey

As the Covid-19 pandemic has wreaked havoc on the economy, few businesses in the New York metropolitan area have gone unscathed. Some were forced to temporarily close, while others were required to substantially curtail operations, causing unprecedented disruptions in revenue and a scramble to cut expenses.

Months later, as government stimulus programs and employee layoffs/furloughs play themselves out, small businesses that managed to survive are reopening or otherwise attempting to normalize operations. As that trend evolves, dividends or distributions to equity holders are likely to be explored. However, before going down that path, directors and managers should be mindful of the applicable legal requirements, the contravention of which could result in a personal liability trap.

Under Section 510(a) of the New York Business Corporation Law (BCL), dividends are permitted except while the corporation is insolvent or would be rendered insolvent by the dividend.1 Under the BCL, insolvent means “the inability to pay debts as they become due in the usual course of the debtor’s business.”2

As a result of Covid-19, overdue trade payables, unpaid rent and other undischarged liabilities may pile up, necessitating a careful examination of the solvency standard by corporate directors, preferably with the assistance of qualified advisors (more on that below).

In addition to the solvency analysis, BCL § 510(b) contains the technical requirements for dividends by New York corporations, generally limiting their payment from surplus or, in the absence of surplus and provided there is no decline in capital below the stated capital of all classes of stock with a liquidation preference, from net profits during the current or preceding fiscal year.3 There is a special exception that applies to corporations “engaged in the exploitation of natural resources or other wasting assets, including patents, or formed primarily for the liquidation of certain assets.”4

Calculating compliance with the BCL § 510(b) requirements is a mechanical exercise that includes variables such as the par value of the corporation’s stock and the amount of its net assets.5 As a result, in most cases this computation will require the assistance of someone who is familiar with accounting, as well as the corporation’s finances and capital structure.

Failure of a corporate board to comply with the requirements of BCL § 510 can result in personal liability for any director who votes in favor of the applicable dividend,6 and this potential personal liability cannot be eliminated or limited by the exculpation clause that is typically included in a corporation’s certificate of incorporation.7 Knowing and intentional approval of an unlawful dividend can result in criminal liability for a director.8

The good news is that directors can protect themselves from personal liability9 by complying with BCL § 717(a), the statutory standard for a director’s duties.10 BCL § 717(a) expressly provides that, in performing their duties, directors are entitled to rely on information, opinions, reports or statements (including financial statements or other financial data) prepared or presented by officers, employees, counsel, public accountants or other persons whom the director believes to be competent in the area.11 Accordingly, directors can avert the personal liability trap by enlisting competent officers, employees, lawyers and/or accountants who render an opinion or report on the dividend criteria after analyzing the relevant financial information.

For New York limited liability companies (LLCs), Section 508(a) of the New York Limited Liability Company Law (LLCL) prohibits distributions to the extent that, at the time of the distribution, after giving effect to the distribution, the LLC’s liabilities exceed the fair market value of its assets.12 For purposes of this calculation, liabilities to members on account of their membership interest and liabilities for which creditor recourse is limited to specified property are excluded—with the fair market of such specified property limited to the amount it exceeds the applicable limited recourse liability.13 Unless otherwise agreed, a member who receives a distribution in violation of LLCL § 508(a) has potential personal liability for three (3) years, but only if such member had knowledge of the violation at the time of the distribution.14

Similar to the above referenced BCL provisions, an LLC cannot exculpate managers for violations of LLCL § 508(a) through the LLC’s constituent documents.15 However, in discharging their LLCL statutory duties,16 LLC managers, like corporate directors, can protect themselves by relying on information, reports or statements (including financial statements and other financial data) presented by agents, employees, counsel, public accountants and other persons with professional or expert competence.17

Importantly, there is no exception to the above referenced statutes for small businesses. This means that closely held corporations and LLCs, subchapter S corporations and family-owned businesses—including any of the foregoing wholly-owned by a solopreneur—are all covered, to the extent organized in New York.

Although creditor rights are beyond the scope of this post, the failure to adhere to the above referenced statutory provisions could result in personal liability for a director, shareholder, manager or member under applicable bankruptcy and insolvency laws.18 Again, to reduce this risk, directors and managers should consult with legal counsel and financial advisors when considering a dividend or distribution, especially in light of the economic challenges caused by Covid-19.

The provisions summarized above apply to corporations and LLCs domiciled in New York State. For entities formed in another jurisdiction, the corporate and LLC statutes of the applicable jurisdiction should be examined to confirm compliance. As an example, dividends by Delaware corporations are governed by Section 170 of the Delaware General Corporation Law and distributions by Delaware LLCs are governed by Section 18-607 of the Delaware Limited Liability Company Act.

This post is for general informational purposes only and does not constitute legal advice. No one should rely on the information in this blog post without seeking appropriate legal, accounting, tax or other appropriate advice from an attorney, accountant or other professional properly licensed in the applicable jurisdiction(s).

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1See BCL § 510(a) (“A corporation may declare and pay dividends or make other distributions in cash or its bonds or its property, including the shares or bonds of other corporations, on its outstanding shares, except when currently the corporation is insolvent or would thereby be made insolvent, or when the declaration, payment or distribution would be contrary to any restrictions contained in the certificate of incorporation.”)

2See BCL § 102(a)(8) (“‘Insolvent’ means being unable to pay debts as they become due in the usual course of a debtor’s business.”)

3See BCL § 510(b) (“Dividends may be declared or paid and other distributions may be made either (1) 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 (2) in case there shall be no such surplus, out of its net profits for the fiscal year in which the dividend is declared and/or the previous fiscal year. If the capital of the corporation shall have been diminished by depreciation in the value of its business or by losses or otherwise to an amount less than the aggregate amount of the stated capital represented by the issued and outstanding shares of all classes having a preference upon the distribution of assets, the directors of such corporation shall not declare and pay out of such net profits any dividends upon any shares until the deficiency in the amount of the stated capital represented by the issued and outstanding shares of all classes having a preference upon the distribution of assets shall have been repaired. ”)

4Id. (“A corporation engaged in the exploitation of natural resources or other wasting assets, including patents, or formed primarily for the liquidation of specific assets, may declare and pay dividends or make other distributions in excess of its surplus, computed after taking due account of depletion or amortization, to the extent that the cost of wasting or specific assets has been recovered by depletion reserves, amortization or sale, if the net assets remaining after such dividends or distributions are sufficient to cover the liquidation preferences of shares having such preferences in involuntary liquidation.”)

5See BCL § 102(a)(13) (“‘Surplus’ means the excess of net assets over stated capital.”) See also BCL § 102(a)(9) (“‘Net assets’ means the amount by which the total assets exceed the total liabilities. Stated capital and surplus are not liabilities”); BCL § 102(a)(12) (“‘Stated capital’ means the sum of (A) the par value of all shares with par value that have been issued, (B) the amount of the consideration received for all shares without par value that have been issued, except such part of the consideration received therefor as may have been allocated to surplus in a manner permitted by law, and (C) such amounts not included in (A) and (B) as have been transferred to stated capital, whether upon distribution of shares or otherwise, minus all reductions from such sums as have been effected in a manner permitted by law.”

6See  BCL§ 719(a)(1) (“Directors of a corporation who vote for or concur in any of the following corporate actions shall be jointly and severally liable to the corporation for the benefit of its creditors or shareholders, to the extent of any injury suffered by such persons, respectively, as a result of such action:. . . (1) [t]he declaration of any dividend or other distribution to the extent it is contrary to the provisions of paragraphs (a) and (b) of Section510 (Dividends or other distributions in cash or property).” (Italics added).

7See BCL § 402(b)(1) (“The certificate of incorporation may set forth a provision eliminating or limiting the personal liability of directors to the corporation or its shareholders for damages of any breach of fiduciary duty in such capacity, provided that no such provision shall eliminate or limit: (1) the liability of any director if a judgment or other final adjudication adverse to him establishes that his acts or omissions were in bad faith or involved intentional misconduct or a knowing violation of law or that he personally gained in fact a financial profit or other advantage to which he was not legally entitled or that his acts violated section 719 . . .”) (Italics added).

8See  New York Penal Law § 190.35 Misconduct by corporate official. “A person is guilty of misconduct by a corporate official when: 1. Being a director of a stock corporation, he knowingly concurs in any vote or act of the directors of such corporation, or any of them, by which it is intended: (a) to make a dividend except in the manner provided by law; . . . Misconduct by corporate official is a class B misdemeanor.”

9See BCL § 719(e) (“A director shall not be liable under this section if, in the circumstances, he performed his duty to the corporation under paragraph (a) of Section 717”).

10See BCL § 717(a) (“A director shall perform his duties as a director, including his duties as a member of any committee of the board upon which he may serve, in good faith and with that degree of care which an ordinarily prudent person in a like position would use under similar circumstances.” )

11Id. ("In performing his duties, a director shall be entitled to rely on information, opinions, reports or statements including financial statements and other financial data, in each case prepared or presented by:
(1) one or more officers or employees of the corporation or of any other corporation of which at least fifty percentum of the outstanding shares of stock entitling the holders thereof to vote for the election of directors is owned directly or indirectly by the corporation, whom the director believes to be reliable and competent in the matters presented, [or]
(2) counsel, public accountants or other persons as to matters which the director believes to be within such person’s professional or expert competence . . .”)

12See LLCL § 508(a).

13Id. (“A limited liability company shall not make a distribution to a member to the extent that, at the time of the distribution, after giving effect to the distribution, all liabilities of the limited liability company, other than liabilities to members on account of their membership interests and liabilities for which recourse of creditors is limited to specified property of the limited liability company, exceed the fair market value of the assets of the limited liability company, except that the fair market value of propertyt hat is subject to a liability for which the recourse of creditors is limitedshall be included in the assets of the limited liability company only to the extent that the fair value of such property exceeds such liability.”) (Italics added).

14See LLCL § 508(b) (“A member who receives a distribution in violation of subdivision (a) of this section, and who knew at the time of the distribution that the distribution violated subdivision (a) of this section shall be liable to the limited liability company for the amount of the distribution. A member who receives a distribution in violation of subdivision (a) of this section, and who did not know at the time of the distribution that the distribution violated subdivision (a) of this section, shall not be liable for the amount of the distribution. Subject to subdivision (c) of this section, this subdivision shall not affect any obligation or liability of a member under the operating agreement or other applicable law for the amount of a distribution.”) See also  LLCL § 508(c) (“Unless otherwise agreed, a member who receives a wrongful distribution from a limited liability company shall have no liability under this article or other applicable law for the amount of a distribution after the expiration of three years from the date of the distribution.”)

15See LLCL § 417(a)(1) (“The operating agreement may set forth a provision eliminating or limiting the personal liability of managers to the limited liability company orits members for damages for any breach of duty in such capacity, provided that no such provision shall eliminate or limit: (1) the liability of any manager if a judgment or other final adjudication adverse to him or her establishes that his or her acts or omissions were in bad faith or involved intentional misconduct or a knowing violation of law or involved intentional misconduct or a knowing violation of law or that he or she personally gained in fact a financial profit or other advantage to which he or she was not legally entitled or that with respect to a distribution the subject of subdivision (a) of section five hundred eight of this chapter his or her acts were not performed in accordance with sectionfour hundred nine of this article . . .”) (Italics added).

16See, LLCL § 409(a) (“A manager shall perform his or duties as a manager, including his or her duties as a member of any class of managers, in good faith and with that degree of care that an ordinarily prudent person in a like position would use under similar circumstances”).

17See, LLCL § 409(b) (“In performing his or her duties, a manager shall be entitled to rely on information, opinions, reports or statements, including financial statements and other financial data, in each case prepared or presented by . . . (1) one or more agents or employees of the limited liability company; [or] (2) agents, employees, counsel, public accountants or other persons as to matters that the manager believes to be within such person’s professional or expert competence . . .”)

18See, e.g., New Gold Equities Corp. v. Valoc Enters., Inc., 2018 Slip Op 33259(U) (Sup Ct. NY County 2018) (sole director and estate of sole shareholder found liable under New York Debtor and Creditor Law (DCL) and potentially liable (defendants’ motion to dismiss denied) under BCL §§ 719 and 720 for BCL § 510 violation(s), in each case as a result of salaries, dividends and distributions paid while the corporation was insolvent); see also , Crete Concrete Corp. v. Josephs, 66 Misc.2d 837, 842 (Sup. Ct. Rockland County 1971): modified on other grounds, 39 AD2d 543 (2d Dep’t 1972); leave denied 31 NY2d 644 (1972) (judgment rendered against the president and sole shareholder of six subchapter S corporations under the DCL and under BCL § 719 for a BCL § 510 violation); see also In reDie Fliederamus, 323 B.R. 101 (US Bankruptcy Court SDNY 2005) (even though certain claims of the bankruptcy trustee to recover distributions made to members of a New York LLC while the entity was insolvent were time-barred as a result of the three-year look back in LLCL § 508(c), the defendant members’ motion to dismiss other claims of the bankruptcy trustee (preference action and breach of fiduciary duty) on the grounds members were not “insiders” was denied). Effective as of April 4, 2020, the DCL was amended to enact the Uniform Voidable Transfers Act (UVTA), which replaced the Uniform Fraudulent Transfer Act (UFTA) in New York.