State Law Guidance for Treasury Investment Program
As the US Treasury Department continues to lend to or make senior equity investments in corporate America, especially its financial institutions, people debate whether those taxpayer investments should be accompanied by limits on investees’ right to pay cash dividends to common stockholders.
This is a fundamental issue in corporate finance, requiring mediation of a tension between senior investors, who want security of repayment, and common (junior) stockholders, who want periodic returns on their investment.
The balance and how to resolve it is reflected in state corporation law regulating dividends. In general, those laws provide a minimum level of protection to senior lenders and equity holders, restricting distributions to common stockholders to minimize bankruptcy risk, and assuring that a corporation has flexibility to make such distributions.
A review of state corporation law approaches may be useful to assess what policies Treasury should consider when investing taxpayer funds in senior loans or equity in corporate America. The review suggests that: (1) Treasury may go too far if it prohibits cash dividends altogether; and (2) tools it is developing to assess investee’s positions, called stress tests, routinely used under some state statutes to determine the legality of distributions to common stockholders, should be applied to determine, on a case by case basis, to what extent, if any, government investment of taxpayer funds should be conditioned on investees’ restricting dividends on common stock.
Surplus. Many state statutes rely upon technical terms of art limiting distributions that would otherwise impair a corporation’s “legal capital.” That technical term usually refers to a nominal sum in the shareholders’ equity portion of a balance sheet that functionally allows distributing assets to common shareholders all the way to nearly the point that total assets just exceed total liabilities (and any commitments to redeem preferred stock).
That means that corporations are permitted to make distributions to common stockholders either from profits generated over time (accumulated retained earnings a/k/a as earned surplus) or from amounts common stockholders earlier invested that exceeded the nominal legal capital amount (called capital surplus).
Earned Surplus. Some older statutes restrict distributions to common stockholders so they are allowed only to the extent of “earned surplus.” That means distributions may not be made in amounts exceeding the total amount of capital invested by common stockholders.
Current Profits (Nimble Dividends). Yet other statutes authorize another basis for distributions to stockholders, even if earned surplus is negative and assets less than liabilities. This is the so-called nimble dividend provision. It permits dividends from current period profits.
The theory of the nimble dividend is a measurement reference, designed exquisitely to mediate the tension between lender and senior equity interests versus common stockholder interests. A company enjoying current profits, even if its capital is impaired, may distribute those profits to common stockholders. The substantive rationale is that returning something to common stockholders may be necessary to avoid having them sell their shares or to induce others to make new common stock investments.
Analytical Solvency. Modern statutes take a more substantive, analytical, approach. These allow distributions if, but only if, after making them, both (1) total assets exceed total liabilities (plus any commitment to preferred stockholders) and (2) the corporation would be able to meet its debts as they come due in the ordinary course of business.
Both tests can be difficult to apply for companies facing financial adversity. The asset and liability test depends on a reliable measure for both. That often requires taking a fresh look at amounts reported using conventional accounting concepts, which may report them at historical cost, for example, and existing market exchange values. The market value of assets may exceed their “book value.”
In difficult economic climates, like today, there may be doubt about the liquidity of certain assets, and hence their value. Then, it may be necessary to reduce the reported amount of assets to reflect current market conditions.
The test of ability to pay debts as they come due can be even more difficult to apply. It requires forecasting reasonably probable sources of net cash flow, identifying sources of cash and uses of cash. Prudential evaluation involves applying stress tests to determine financial capacity amid potential economic adversity.
Treasury’s Stress Tests. Notably, the Obama Administration’s Treasury Department is rolling out its version of such stress tests to aid its investment decisions. After all, for banks in the current environment, it may be difficult both to measure assets and determine ability to pay debts as they come due may be difficult.
As Treasury says, there is today “uncertainty about the real value of distressed assets.” For banks, assets include rights against their borrowers, loans receivable. Given the current crisis, many borrowers are unlikely to repay those loans. For banks, those assets therefore may be worth far less than reported on the balance sheet.
As those assets deteriorate, and liabilities are not reduced, equity evaporates. Capital becomes impaired. The stress test assesses, under various conditions, how much adversity a corporation can handle and remain solvent.
Suggestion. Given that it is important to balance the interests of senior lenders and equity with those of junior, common stockholders, and the way state corporation law default rules balance it, Treasury’s stress test seems like a suitable tool not only for determining how much taxpayer funds Treasury ought to commit to which kinds of institutions. It also would seem useful as a tool to determine to what, if any, taxpayer investments in corporate America should be accomanied by restrictions on common stock dividends.
Hat Tip: Discussion in Corporations Class Thursday February 12, 2009