From The CorporateCounsel.Net:
The question of the legality of a dividend or repurchase under Delaware law is one that often arises in leveraged recaps and other transactions involving large distributions to shareholders. The answer usually depends on whether the company has sufficient “surplus” within the meaning of Section 154 of the DGCL. The Delaware Supreme Court has held that what matters in the surplus calculation is the present value of the company’s assets & liabilities, not what’s reflected on the balance sheet. Since that’s the case, valuations are often used to determine the amount of available surplus.
While that’s a pretty common practice, there’s not a lot of Delaware case law on how the board’s valuation decisions will be assessed. That’s kind of disconcerting, particularly since directors face the prospect of personal liability for unlawful dividends or stock repurchases. Fortunately, the Chancery Court’s recent decision in In re The Chemours Company Derivative Litigation, (Del. Ch.; 11/21), provides some guidance to boards engaging in this process. Here’s an excerpt from this Faegre Drinker memo on the decision:
In this case, the board approved both dividends and stock repurchases at a time when the company also faced legacy contingent environmental liabilities that conceivably could render Chemours insolvent.
The court deferred to the board’s determination that there was sufficient surplus to permit these transactions, even though the board looked beyond GAAP-metrics to evaluate its contingent liabilities. The court held that it “will defer to the Board’s surplus calculation ‘so long as [the directors] evaluate assets and liabilities in good faith, on the basis of acceptable data, by methods that they reasonably believe reflect present values, and arrive at a determination of the surplus that is not so far off the mark as to constitute actual or constructive fraud.” This standard is consistent with the court’s prior guidance that the DGCL “does not require any particular method of calculating surplus, but simply prescribes factors,” total assets and total liabilities, “that any such calculation must include.”
As for reliance on experts, the court held that, under the DGCL, utilization of and good faith reliance on experts “fully protects” directors from personal liability arising from their surplus calculation. In reaching this conclusion, the court rejected the argument that the directors were required to second-guess the GAAP-based reserves calculated by the experts — an analysis that permitted the board to significantly reduce the size of these liabilities on Chemours’ balance sheet.
This should not be a surprising result. As I explain in my book Corporate Law:
Consider a relatively simple balance sheet:
Assets
Liabilities and Shareholder equity
Land
$ 9,000
Total liabilities:
$38,000
Other
$24,000
Capital:
$15,000
Total
$33,000
Surplus
($20,000)
Total shareholder equity
($ 5,000)
This corporation could not pay a dividend under either the MBCA or Delaware approach. Under the MBCA, total liabilities already exceed total assets, so a distribution could not be made. Under Delaware law, the corporation has no surplus and, assuming it could not pay a nimble dividend, thus could not pay a dividend.
Notice, however, that the corporation owns real property being carried on the balance sheet at $9,000. Because assets generally are carried on the books at their historical cost, and land tends to appreciate in value, it is a fair supposition that the land may be worth much more than $9,000. Suppose the fair market value of the land in fact is $30,000. If we “write up” the value of the land to $30,000, the corporation will have total assets of $54,000, and now may pay a dividend. Under the MBCA, total assets exceed total liabilities by $16,000, which is available for distribution. Under Delaware law, net assets are now $16,000, which results in a surplus of $1,000, which is available for payment of a dividend.
Generally accepted accounting principles (GAAP) require that most assets be carried on the books at historical cost less depreciation. Accordingly, you may not write up assets to reflect an increase in their fair market value, but must write them down to reflect depreciation. In contrast, state corporate law generally does not require adherence to GAAP in determining whether a dividend lawfully may be paid. Indeed, MBCA § 6.40(d) expressly authorizes a corporation to use “a fair valuation or other method that is reasonable under the circumstances” in determining the amount of total assets and total liabilities. Accordingly, while the corporation may rely on financial statements prepared in accordance with GAAP, there is no requirement that it do so. The drafters’ comments on § 6.40, moreover, go on to state that the statute authorizes departures from historical cost accounting in determining the funds available for distribution. The comments further indicate that a corporation generally may not selectively revalue assets, however. If it is going to revalue some assets, all must be reappraised and adjusted to their fair market value. Delaware and New York reach the same result through case law.[1]
The principal wrinkle in the Chemours case is that, instead of suing directors for departing from GAAP, the plaintiffs here are suing the directors for "relying on GAAP-based accounting reserves to calculate surplus, which the Plaintiffs argue exclude contingent environmental liabilities."
[1] See, e.g., Morris v. Standard Gas & Electric, 63 A.2d 577, 582 (Del.Ch.1949) (the board of directors has a “duty to evaluate the assets on the basis of acceptable data and by standards which they are entitled to believe reasonably reflect present values”); Randall v. Bailey, 23 N.Y.S.2d 173, 183 (N.Y.Sup.1940)(rejecting contention that “cost and not value must be used in determining whether or not there exists a surplus out of which dividends can be paid”); see also Klang v. Smith’s Food & Drug Centers, Inc., 702 A.2d 150 (Del.1997) (authorizing revaluation of assets for purposes of determining whether a repurchase of shares complied with DGCL § 160).
