Adapting to the new shareholder-centric reality.

• Author: Rock, Edward B.
• Position: IV. Grappling with Residual Shareholder-Creditor Agency Costs A. A Failed LBO 2. Delaware Corporate Law Doctrines through Conclusion, with footnotes, p. 1947-1988

2. Delaware Corporate Law Doctrines

With most of the fallout from failed LBOs playing out in the

bankruptcy courts and targeting LBO lenders, it is not surprising that corporate law doctrines and remedies have remained at the margins. (177) To the extent that corporate law will adapt to the reappearance of the shareholder-creditor agency cost problem, these doctrines will form the starting point--the "doctrinal resources" for addressing this new-old problem.

Restrictions on distributions to shareholders, whether through share repurchases or dividends, have a long and complicated history. (178) Before turning to the restrictions and liabilities under Delaware law, it is important to understand how these types of rules work. There are two kinds of legal tools for restricting distributions: limits on the sources of distributions and limits on the effects of distributions. Generally, three factors enter into the determination: the corporation's cash flow, its earnings, and its net assets. (179)

The traditional limitation on the source of distributions is that they must be out of "surplus," a term of art. (180) There are two ideas behind this restriction. First, distributions should not be made to shareholders when the firm already owes more money to creditors and preferred shareholders than its assets are worth. Second, at least a portion of the equity capital is committed for the life of the firm and provides a cushion to protect creditors and others dealing with the firm. This cushion must thus be protected from distributions to shareholders. Although this class of restrictions is often referred to as a "balance sheet solvency test," it is quite different from true accounting-based tests, and the "balance sheet" need not be prepared according to GAAP. (181)

How the "balance sheet insolvency" test is implemented has changed over time and varies from jurisdiction to jurisdiction. In contrast to the Model Business Code, Delaware takes a very traditional approach to restricting distributions. Under Delaware law, dividends and share repurchases can be funded out of "surplus," which is defined as the amount of "net assets" in excess of "capital." (182) "Net assets" is defined as the amount by which total assets exceed total liabilities. (183) "Stated capital" cannot be less than the "par value" of all shares with "par value," but may be more, at the board's discretion. (184) If shares are issued without par value, as is permitted under Delaware law, the board will determine at the time of issue what portion will be considered "capital." (185)

A board may thus repurchase shares or pay dividends so long as total assets are greater than total liabilities plus capital. (186) When the market values of the assets and/or liabilities differ from the book value, the board may revalue the assets and liabilities (upward or downward) on the basis of such information as it considers reliable, with no specific method mandated by the courts. (187)

The second type of limitation on distributions to shareholders looks not at the source of distributions but at their effect on creditors. These are known as "equity insolvency tests" and focus on the corporation's cash flow. Here, the idea is to prohibit distributions when the corporation is unable to pay its debts as they come due, or would be rendered unable by the distribution. (188) Thus, for example, the Model Business Code provides, "No distribution may be made if, after giving it effect: (1) the corporation would not be able to pay its debts as they become due in the usual course of business...." (189) Although Delaware's statutes do not contain "equity insolvency" limitations, the case law does, as I discuss below.

Before turning to the application of Delaware doctrine, recall exactly what an LBO is. An LBO is an acquisition of a target company, through any of a variety of different structures, in which a significant portion of the purchase price is borrowed, with the loan ultimately secured by the assets of the target company. (190) Although there are a host of alternative structures available, the reverse triangular merger has become the standard approach for LBOs in the United States. To illustrate briefly, Buyer establishes an acquisition shell, NewCo, and, if a toehold position is desired, NewCo acquires it. After reaching terms with Target, NewCo merges with Target, with Target as the surviving corporation, and with Target's shareholders receiving cash for their shares. Simultaneously at closing, funds are borrowed from Lender to pay Target's shareholders, secured by Target's assets. (191) In order to complete the transaction, Target's board must recommend it and Target's shareholders must approve it.

The creditor protection issue in an LBO is clear: debt is substituted for equity. Target's shareholders are bought out, potentially leaving Target's pre-LBO creditors high and dry, with none of the proceeds of the loans (secured by Target's assets) invested in Target projects. LBOs thus raise the specter of "asset dilution"--the siphoning off of assets to the shareholders, leaving creditors worse off.

a. Theory I: The Delaware Limitations on Share Repurchases

Given what LBOs do, it is reasonable to view them as share repurchases. As noted above, Delaware adopts a "balance sheet insolvency" limitation on share repurchases. Delaware General Corporation Law (DGCL) section 160(a) provides (in relevant part):

Every corporation may purchase, redeem, receive, take or otherwise acquire, own and hold, sell, lend, exchange, transfer or otherwise dispose of, pledge, use and otherwise deal in and with its own shares; provided, however, that no corporation shall: 1) Purchase or redeem its own shares of capital stock for cash or other property when the capital of the corporation is impaired or when such purchase or redemption would cause any impairment of the capital of the corporation.... (192) In addition, there is a longstanding common law "equity insolvency" test that prohibits a corporation from repurchasing its shares when the corporation is or would be rendered unable to pay its debts as they come due. (193)

DGCL section 174(a) imposes liability on directors for improper share repurchases, liability that cannot be exculpated under DGCL section 102(b)(7). (194) Because Delaware law contains both "balance sheet" and "equitable" insolvency limitations on share repurchases, if a hypothetical LBO that rendered the firm insolvent is viewed as a share repurchase, it would quite clearly violate DGCL section 160. (195)

Section 172, however, provides directors with a defense when they rely

in good faith upon the records of the corporation and upon such information, opinions, reports or statements presented to the corporation by any of its officers or employees, or committees of the board of directors, or by any other person as to matters the director reasonably believes are within such other person's professional or expert competence and who has been selected with reasonable care by or on behalf of the corporation, as to the value and amount of the assets, liabilities and/or net profits of the corporation or any other facts pertinent to the existence and amount of surplus or other funds from which dividends might properly be declared and paid, or with which the corporation's stock might properly be purchased or redeemed. (196) As with other parallel provisions, such as section 141(e), (197) such reliance must be reasonable. (198) Directors' liability would thus depend on the reasonableness of their reliance on the information they had before them about the solvency of the post-LBO company. From a counseling perspective, this provides a clear incentive to make sure that the board has a strong basis for concluding that the post-LBO company would be solvent before approving a transaction that could or would be viewed as a share repurchase. In practice, this could be achieved by requiring a credible solvency opinion from Target's investment banker prior to approving the LBO, as is done in the United Kingdom.

b. Theory II: Dividends and Reductions-in-Capital

Share repurchases are just one of the ways in which managers may "shovel all the assets in the corporate treasury out to the shareholders when the corporation has insufficient assets to pay its creditors or when the shareholder distribution renders the corporation unable to pay its creditors." (199) It can also be done by dividend or reduction of capital. Because the effects on creditors are the same, the restrictions are largely the same. (200)

i. The Analysis Under DGCL Section 174

Under sections 170 and 173, dividends may only be paid out of surplus or net profits. (201) As noted above, "surplus" is defined by subtracting "stated capital" and liabilities from assets. "Net profits" is a rather obscure concept, and dividends out of net profits are subject to limitations. (202) The idea is clear enough: even when the firm has had years of losses and no surplus, it may be necessary to promise dividends to attract new capital. The "net profits" provision makes it possible to pay dividends in those circumstances. But how, exactly, to interpret this provision is quite problematic. (203)

In the hypothetical LBO described earlier, the amounts distributed to shareholders are sufficiently large--and destructive of the firm's solvency--that if the distribution is viewed as a dividend, it would likely be held to exceed even the most flexible interpretation of sections 170 and 173. Moreover, as with share repurchases, so too here there seems to be a principle that a firm cannot pay a dividend if it "diminishes the ability of the company to pay its debts, or lessens the security of its creditors." (204)

The rest of the analysis follows the previous discussion. Under section 174, directors are personally liable for willful or negligent violation of section 173. (205) Under section 102(b)(7), this violation is understood to be a breach of...