Dividend recaps are all the rage. 2012 saw a record volume of recap transactions (over $60 billion, according to data provider S&P Capital IQ LCD), and 2013 is shaping up to be another big year in the U.S. and abroad. A recent report from Thomson Reuters noted that the dividend recap volume in 2Q 2013 ($18.4 billion completed and $5.4 billion currently in the market as of the June 17 report) may exceed the previous market high of $19.3 billion seen in the last quarter of 2012. This frenzy of activity isn’t surprising, as dividend recaps have turned out to be a powerful tool for private equity firms focused on returning capital.
As with all power tools, however, there are certain precautions that anyone involved in a recap transaction will want to take to help reduce the inherent risks.
Dividend Recaps Are Prevalent for Good Reasons . . .
Many attributed the record number of recaps in 2012 to looming changes in the U.S. tax code that caused private equity firms to want to realize profits before the end of the tax year. But even as 2012 recedes into memory, there is a near-continuous flow of such deals in the U.S., and the activity has been spreading worldwide. In Europe, despite a traditional reluctance toward dividend recaps, the market in 2013 has already witnessed several major transactions, including loan-funded dividends for Pets-at-Home and Mivisa. And PE fund Investcorp recently announced that it would scrap sale plans for its portfolio company, Armacell, in favor of a dividend recap. Even Asia, where this financing mechanism had been almost unheard of, has recently seen a handful of dividend recap transactions, led by the recent offerings of Nord Anglia Education that were used, in part, to channel funds to sponsor Baring Private Equity Asia.
There are good reasons for these developments. With prevailing interest rates at near-historic lows, dividend recaps offer an attractive opportunity for funds to obtain a return of – or even a profit on – invested capital, without giving up the potential for future equity upside. Thus, this tool allows a fund to accelerate returns to a point early in the business cycle, at a point when a full exit might not be attractive because business growth or improvements have not yet been fully realized.
The recently robust credit market has allowed borrowers to access more money at lower interest rates and with lighter covenants than is typical in tighter credit environments. This means that many portfolio companies have been able to increase their leverage and pay a dividend even as, in some cases, they have improved their covenant position and kept their debt service costs constant. Companies have also been able to insulate against unexpected cash flow hiccups by taking advantage of re-emergent PIK toggle features in dividend recap financing (in which interest may, at the borrower’s option, be paid in the form of additional debt instead of in cash).
. . . But There Are Still Associated Risks
While a dividend recap can provide clear benefits for shareholders and financial sponsors, there are still risks for the company, its shareholders, and its officers and directors. If the debt-funded dividends are too large relative to the company’s earnings and available capital, the company will be vulnerable after the transaction to downturns, as it may be left without the ability to adequately fund day-to-day working capital needs. The company also risks devoting so much of its working capital to debt service that future growth opportunities are impaired.
Ultimately, if the company is unable to comply with its covenants, meet its interest obligations or repay its debt at maturity, it may find itself in a workout or bankruptcy scenario. In that case, creditors who are not being paid in full may, with the benefit of 20/20 hindsight, blame the dividend recap for having caused the problem and may sue directors, officers and shareholders in an attempt to recoup some of their lost investment.
This creates distinct risks for the various constituents:
- Directors and officers are at risk if disgruntled creditors argue they breached their fiduciary duty by over-levering the company – thereby rendering it insolvent – in order to pay an unlawful dividend to shareholders. These claims can raise the specter of personal liability for directors and officers: even if they ultimately are unsuccessful, they are an unpleasant and expensive distraction. While D&O insurance will generally cover such claims, private equity firms and individual directors are well-advised to ensure that they can overcome exclusions in the policies (including for willful misconduct or improper personal benefit from the transaction).
- PE funds and other shareholders are at risk if creditors attempt to claw back the dividend payment on the theory that it was “constructive fraud” that left the business insolvent. With a lookback period that can extend to ten years or more, clawback actions can be filed against both shareholders that received a dividend and any follow-on recipients, raising the possibility that PE funds, their LPs, and individual shareholders such as management teams may be pursued for return of a dividend years after it was originally paid.
Applicable Legal Standards . . . Why It All Boils Down to “Solvency”
Challenges to Officer and Director Decision-Making
To successfully sue directors and officers over a dividend recap, creditors must generally show as a threshold matter that the company was insolvent at the time of, or was rendered insolvent by, the dividend recap. Under the laws of most states, this is a factual predicate for alleging that a dividend was illegal or improper. For example, Delaware law requires that corporations pay dividends to their shareholders only from capital “surplus”: in essence, the fair value of assets less liabilities, less stated capital (this last item is often a de minimis amount).
Insolvency or near-insolvency at the time of the transaction is also a requirement for creditor claims that directors and officers breached fiduciary duties. Courts in most U.S. states hold that directors and officers have no duties to creditors, unless and until the corporation is insolvent or, in some states, near-insolvent. Similar solvency-based constructs apply in many jurisdictions outside the United States.
To defend against these types of claims after the fact, it is therefore crucial that directors and officers be able to demonstrate solvency at the time of the transaction.
Clawback/Fraudulent Conveyance Challenges
Creditors may also attempt to unwind a dividend recap transaction – thereby clawing back the dividend – by alleging it was a fraudulent conveyance under the United States Bankruptcy Code, applicable state laws (i.e., the Uniform Fraudulent Conveyance Act) or equivalent provisions under non-U.S. law.
Under U.S. law, to claw back a payment, the creditor must show that (a) the company was insolvent at the time of, or rendered insolvent by, the transaction, and (b) the transfer in question was made for less than reasonably equivalent value. Because shareholders receiving a dividend get cash without making an equivalent transfer to the company (satisfying the second element), the only real U.S.-law defense to a clawback challenge is to prove that the company was solvent at the time of the dividend. While standards outside the U.S. may be more forgiving, it is fair to say under most jurisdictions that the ability to prove solvency at the time of transfer is a key element of defending a dividend.
What Is the Best Way to Demonstrate Solvency?
In evaluating solvency, courts generally consider:
- Whether the fair value of a company’s assets exceeded its liabilities (including stated liabilities and identified contingent liabilities);
- Whether the company should be able to satisfy its debt obligations – related to existing debt as well as to any new debt incurred as a result of the transaction – as those debts mature; and
- Whether the company should have a reasonable level of surplus capital following a leveraged transaction to provide downside protection in the case of deteriorating business conditions.
An unfortunate reality in defending litigation claims related to dividend recaps is that lawsuits occur only after something has gone unexpectedly wrong. If all goes as planned and the portfolio company performs as projected, it will repay or refinance its funded debt and honor other creditor claims in the ordinary course, and the dividend recap will never be challenged. It is only if there is a problem – e.g., the company’s asset value declines to below book value; EBITDA fails to grow as anticipated; the macroeconomic situation deteriorates; or unexpected litigation or other claims arise – that the portfolio company will enter a bankruptcy or workout, which in turn may spur unsatisfied creditors to pursue litigation.
As a matter of law, courts generally should evaluate both director decision-making and questions related to fraudulent conveyance from the perspective of what was known or anticipated at the time of the transaction. Practically speaking, however, it can be difficult for a court to ignore the very fact of the portfolio company’s failure in evaluating whether it was solvent at the time of a dividend recap. Hindsight bias is not limited to Monday mornings. For example, if projections were not met, that may influence a judge’s view as to whether they were reasonable in the first instance, or whether they were properly stress-tested. Similarly, if asset values at the time of challenge are below book value, the judge may question whether the fair value was overstated at the time of the transaction. For this reason, when planning a dividend recap, the parties should be sure to construct a careful factual record, designed to withstand later litigation scrutiny, demonstrating that the transaction was appropriate at the time it was entered into.
Best Practices for Director, Officer and Shareholder Protection
While there are no silver bullets in this context, there are a few simple steps that directors, officers and shareholders can take to mitigate the risk of a court second-guessing a dividend recap transaction.
Make a Clear, Contemporaneous Record of the Decision-Making Process
If a dividend recap is challenged in hindsight following a restructuring, it will be invaluable for defensive purposes to have a clear record that the directors and officers engaged in a careful, deliberative process before approving the transaction. Board minutes should reflect that directors considered the company’s solvency both before and after the transaction, articulated a clear business purpose for the action, and determined, based on contemporaneously available information including well-vetted projections, that there should be a reasonable level of surplus capital following the dividend recap to provide downside protection in event of a downturn. Directors and officers will be best protected if the record shows they consulted outside professionals, carefully reviewed the available information, asked questions, and had plenty of time to consider the issues (for example, by receiving board materials well in advance and by holding more than one meeting to discuss the transaction).
Get a Solvency Opinion
Although a solvency opinion cannot in and of itself ensure against future financial distress (or provide a complete litigation shield if such distress ensues), it can support – with the imprimatur of a well respected outside expert – the officers’ and directors’ decision to enter into the transaction. A contemporaneous solvency opinion is a foundation for the directors’ belief that the dividend was paid from the company’s balance sheet surplus, thus deflecting illegal-dividend claims. A solvency opinion also provides important contemporaneous evidence that the company was solvent at the time of the transaction, thus helping to defeat clawback claims and fiduciary duty claims for the reasons described above.
Cover Every Borrower/Guarantor Subsidiary
In most dividend recap transactions, multiple corporate entities will be involved, whether as borrowers or as guarantors of the new debt obligations or as entities through which the dividend will pass. Litigation claims may arise with respect to not only the primary corporate holding company, but also any other participating affiliates. Thus, for every participating entity, care should be taken to document the relevant facts and board deliberations as to each entity’s solvency, its business purpose in participating in or facilitating the transaction, and the benefit that it will receive for any value (including liens and guarantees) it is transferring as part of the deal.
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While there is no perfect protection against litigation risk if a portfolio company fails after a dividend recap transaction, following best practices at the time of the transaction can significantly improve litigation outcomes. As the current open credit cycle (hopefully) continues, private equity firms will no doubt continue to view divided recaps as attractive partial-exit opportunities, but would be well-advised to use them with care.