On September 1, 2011, the Governor of California signed into law California Assembly Bill No. 571 ("AB 571"), which will liberalize and streamline the legal standards for California corporations and quasi-California corporations to make cash and property distributions to shareholders, including dividends and share repurchases and redemptions. AB 571 amends portions of the California Corporations Code (the "Code") limiting corporate distributions that have been in effect since 1977, which many lawyers and clients have found confusing and overly restrictive. The new law will make California's restrictions on shareholder distributions more consistent with analogous restrictions applicable to California limited liability companies and limited partnerships and the corporate laws of most other states.

With AB 571, boards of directors of corporations will be free to consider the fair market value of a corporation's assets, instead of historical carrying cost, and rely on whatever financial information a board deems reasonable under the circumstances, when determining whether the corporation has sufficient assets relative to its liabilities to distribute cash or property to its shareholders. This change alone will make it significantly easier for financially healthy corporations with historical book losses and appreciated assets (as is common with many growth companies) to pay dividends or redeem or repurchase shares.

AB 571, authored by Assemblyman Curt Hagman, will take effect on January 1, 2012.  A full copy of AB 571 can be obtained by clicking here

Background

Under existing provisions of Sections 500-509 of the Code, a corporation may make a distribution of cash or property to its shareholders only if it meets either a "retained earnings" test or a two-prong "balance sheet and liquidity" test.

Under the retained earnings test, a corporation's retained earnings prior to a distribution must equal or exceed the amount of the distribution. Under the balance sheet and liquidity test, a distribution may be made only if, after giving effect to the distribution, (a) the sum of the corporation's assets is at least equal to 125% of its total liabilities, and (b) the current assets of the corporation are at least equal to or exceed its current liabilities (or 125% of its current liabilities, if its average earnings before interest expense and taxes on income for the two preceding fiscal years were less than its average interest expense during the same period). Certain assets and liabilities are excluded from the balance sheet and liquidity calculations, and, consistent with generally accepted accounting principles, assets generally are valued at their historical carrying value rather than their current fair market value. Under either test, the distribution may not render the corporation insolvent.

Under existing law, therefore, companies that do not have accumulated retained earnings and cannot satisfy both prongs of the balance sheet and liquidity test may not make distributions to their shareholders – even if the current fair market value of their assets far exceeds the amount of their liabilities. The existing law has been criticized for imposing a potential unnecessary hardship on otherwise financially healthy corporations which have both historical book losses and appreciated property. This can be a particularly sensitive issue for shareholders of an "S" corporation, which is taxed as a flow-through entity for tax purposes, because its shareholders typically want to receive distributions sufficient to pay their share of the S corporation's income, but the Code's existing restrictions on shareholder distributions may not permit such distributions.

The restrictions on corporate distributions to shareholders in the Code apply to all corporations incorporated in California and many privately held non-California corporations that have sufficient ties to California (based on shareholders, employees and property in California) to be deemed "quasi-California corporations" under the Code. For these quasi-California corporations -- which include many venture-backed growth companies organized in Delaware but headquartered in California -- a corporation must satisfy the distribution requirements of both the state in which it is incorporated and California's more restrictive requirements.

Amendments to Sections 500-509 of the Code

The newly enacted law will allow a corporation to distribute cash or property to shareholders, including via a dividend or repurchase or redemption of shares, if the corporation meets either the existing retained earnings test or a new, simplified "balance sheet" test.

Retained Earnings Test.  AB 571 maintains the existing retained earnings test. Under this test, a corporation may make a distribution from retained earnings to the extent that its retained earnings exceed (a) the amount of the distribution plus (b) the amount, if any, of dividends in arrears on shares with preferential dividend rights (defined by AB 571 as the "preferential dividends arrears amount"). AB 571 further provides that corporations may specify in their articles of incorporation that distributions under the retained earnings test can be made without regard to the preferential dividends arrears amount.

Balance Sheet Test.  AB 571 replaces the existing balance sheet and liquidity test with a more flexible balance sheet test. Under the new test, a corporation may make a distribution if, immediately after the distribution, the value of its assets equals or exceeds the sum of (a) its total liabilities plus (b) the liquidation preference of any shares which have a preference upon dissolution over the rights of shareholders receiving the distribution (defined by AB 571 as the "preferential rights amount"). Indebtedness is not considered a liability if the terms of such indebtedness provide that payment of principal and interest thereon are to be made only if, and to the extent that, a distribution to shareholders could be made under the balance sheet test. As with the retained earnings test, corporations may specify in their articles of incorporation that distributions under the balance sheet test can be made without regard to the preferential rights amount.

Board Determination.  Under the new law, a corporation's board of directors may base its determination that a distribution satisfies either the retained earnings test or the balance sheet test, and that the distribution would not render the corporation unable to meet its liabilities as they mature, on the basis of any of the following: (a) financial statements prepared on the basis of accounting practices and principles that are reasonable under the circumstances, (b) a fair valuation or (c) any other method that is reasonable under the circumstances. This change, along with the elimination of the existing balance sheet and liquidity test, effectively enables a corporation to take into consideration the fair market value of the corporation's assets in determining the value of its assets, rather than restricting this determination to historical carrying value.

Timing for Determination.  AB 571 also clarifies the timing for determining whether the applicable statutory tests are satisfied relative to the date a distribution is made. Under the new law, the determination of whether a distribution satisfies either the retained earnings test or the balance sheet test is to be made as of the date the distribution is authorized, provided the distribution is paid within 120 days after the date of the authorization.

Elimination of Notice Requirement.  AB 571 eliminates a requirement under existing law that a corporation notify its shareholders in writing each time the corporation makes a distribution to shareholders other than from retained earnings and describe the accounting treatment of such distribution.

Indebtedness.  AB 571 provides that if a corporation distributes indebtedness to its shareholders, then the restrictions on shareholder distributions in the Code must be satisfied with respect to each payment of principal and interest measured on the dates such payments are made.

Redemption of Shares.  AB 571 clarifies that a corporation that has shares redeemable at its option may redeem these shares by providing a notice of redemption as provided in its articles of incorporation, or in the manner specified in Section 509 of the Code. 

Conclusion

Commencing January 1, 2012, boards of directors of California and quasi-California corporations will enjoy easier-to-navigate standards for determining when dividends can be paid and shares can be redeemed or repurchased. The new standards more closely resemble those applicable to California limited liability companies and limited partnerships and bring California's restrictions more in line with the restrictions on shareholder distributions found in most other states. The shareholder distribution restrictions under Delaware law still will be different than those under the Code (as Delaware law also departs from the approach followed in most states), but the differences will be much less than under existing law and boards of directors will have more flexibility in what they rely on to determine that applicable standards are satisfied.