Companies often make distributions to their stockholders as dividends and stock buybacks. For private equity-backed companies, it is not unusual to see leveraged recaps in which the company borrows money and makes distributions to the private equity investors. These distributions raise the question for boards of directors of whether the company can make the distributions under the corporate statute – i.e., can it do so without impairing capital. Directors have personal liability for distributions that exceed what is permitted under the corporate statute and making that determination can be challenging.
Distributions by Delaware Companies
In Delaware, a company generally needs sufficient surplus to make a distribution to stockholders. The term “surplus” means the excess of total assets over total liabilities and the capital account (usually, the aggregate par value of the outstanding stock). If a distribution exceeds surplus, the directors face personal liability, and this liability is not eliminated by the common exculpation provision most corporations adopt to protect directors. Directors are not liable, though, if they rely in good faith on the company’s records, officers and employees, board committees, or experts, in determining that the company had sufficient surplus to support the distribution.
When directors are sued for unlawful distributions, it is usually because the board used current market value of total assets to calculate surplus instead of the amount shown in the company’s financial statements. For example, a board might use the current appraised value of real estate even though that real estate is carried in the financial statements at historic cost less depreciation. The Delaware Supreme Court has made it clear that a board can use market values to calculate surplus as long as it does so in good faith and on a consistent basis. However, there are other situations, such as determining total liabilities, when the board may want to rely on the company’s financial statements prepared in accordance with generally accepted accounting principles (GAAP).
The Chemours Decision
The Delaware Court of Chancery gave important guidance on what boards may do in determining surplus in In re The Chemours Co. Derivative Litigation, 2021 WL 5050285 (Del. Ch. Nov. 1, 2021). Chemours was spun-off by the DuPont Company in 2015. In the spin-off, DuPont transferred environmental liabilities to Chemours, which Chemours subsequently sued DuPont for understating. The dispute was settled by DuPont sharing the environmental liabilities. After the spin-off, Chemours made a series of stock repurchases and dividend distributions based upon the board’s calculating surplus using Chemours’ contingent environmental liabilities as reflected in its GAAP financial statements. The plaintiffs sued the board on behalf of the company, challenging the distributions as exceeding available surplus. They claimed that the board should have used the amount of the contingent environmental liabilities actually expected, rather than relying on the amount reflected on the balance sheet. The plaintiffs pointed out that Chemours’ own lawsuit against DuPont demonstrated that the financial statements understated the environmental liabilities. Under GAAP, contingent liabilities are not accrued and reflected as liabilities on the financial statements unless they are probable and estimable. Therefore, a company may be exposed to contingent liabilities that do not appear on the balance sheet, and may only be disclosed in the financial statement footnotes. Contingent liabilities that are not probable but are reasonably possible are only disclosed in the footnotes as are contingent liabilities that are reasonably possible or probable but not presently estimable.
The Court found that the Chemours directors did not face a substantial likelihood of liability because of the distributions and therefore the plaintiffs were not entitled to sue on behalf of the corporation without first making a demand on the board of directors.
The Court began its analysis by observing that boards of directors have broad authority to calculate surplus and to choose the method of doing so. Courts will defer to the board’s calculation of surplus so long as the directors evaluate assets and liabilities in good faith, on the basis of acceptable data, by methods they reasonably believe reflect present values, and they arrive at a determination of surplus not too far off the mark – i.e., that the values “reasonably reflect present values.” In the Chemours case, the Court ruled that the board was not required to depart from using GAAP liabilities to calculate surplus. Therefore, the Court found that the directors were not “willful or negligent” as required to be subject to liability. The Court also found that the directors were fully protected in relying on the company’s financial statements, consulting with management and financial advisors, and receiving presentations on the environmental liabilities.
With the threat of personal liability and without the protection of exculpation, directors need to carefully consider any distribution to stockholders that could exceed surplus. The decision in Chemours gives directors considerable flexibility, and therefore protection from liability, in calculating surplus to permit such distributions. This allows directors to assess present values, such as current fair market value of assets, and in some cases to use financial statement amounts recorded as liabilities in accordance with GAAP.
These determinations need to be made in good faith, and to demonstrate good faith boards of directors should follow a careful and considered process. That process should be recorded as part of the minutes.
Although reliance on financial statements can protect directors from the stringent liability provisions for improper distributions, when dealing with contingent liabilities directors may consider going beyond the amounts recorded in the financial statements. To comply with their general fiduciary duties, they also should consider the broader information included in footnote disclosure required under accounting standards, even if liability for a breach of those duties may be exculpated.
If you have any questions about these or related topics, your regular Locke Lord contact or any of the authors can discuss these matters with you.