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  • J.B. Heaton

The Social Costs of Dividends and Share Repurchases

Updated: Mar 21

Below is a reprint of an article published in Law360, based on published research available for free download here.

Sanders And Schumer (Mostly) Right On Share Repurchases

By J.B. Heaton (February 8, 2019, 4:18 PM EST)

As Law360 reported this week, Senate Minority Leader Chuck Schumer, D-N.Y., and Sen. Bernie Sanders, I-Vt., plan to propose legislation limiting share repurchases and dividends. One need not agree with all parts of the Sanders-Schumer plan to acknowledge that there is something compelling in the argument that corporations pay out too much money to shareholders.

In a new article, The Social Costs of Dividends and Share Repurchases,[1] forthcoming in the Journal of Business, Entrepreneurship and the Law — edited and published at Pepperdine University School of Law — I propose restricting dividends and share repurchases to corporations with low debt that are adequately insured against harm to involuntary creditors and which meet high thresholds for wages and benefits. Such a rule would still allow corporations to operate without doing those things — they could have high debt levels, be under insured and pay minimum wages with minimal benefits. But if they did, they could not pay shareholders until they first met all their other obligations.

My view — and my support of the premise behind the Sanders-Schumer proposal — is that society has for too long ignored the severe social costs of permissive laws allowing dividends and share repurchases. When we think back to our law school days, shareholders were supposed to be “residual claimants” in the sense that they would be paid in full only after the corporation pays its creditors. The influential Delaware Court of Chancery, often heavily influenced by corporate legal scholarship, has taken the “residual claimant” view to heart as well, stating, for example, that “[i]n a solvent corporation, the residual claimants are the stockholders”[2] and setting out its most fundamental rule of corporate law in such terms:

Directors of a Delaware corporation owe fiduciary duties to the corporation and its stockholders which require that they strive prudently and in good faith to maximize the value of the corporation for the benefit of its residual claimants.[3]

The reality on the ground, however, is far different. Shareholders routinely get paid before creditors. In particular, corporations give away significant assets to their shareholders in the form of dividends and share repurchases — financial economists recognize that dividends and share repurchases are substitute methods for paying out cash to shareholders — long before they have satisfied creditors, both voluntary contract creditors and involuntary tort creditors. Existing law is so permissive in allowing indebted corporations to distribute cash to shareholders that shareholders are hardly the “last-paid” capital providers of corporate-law folklore but “first-in, first-out, and then some” capital providers who receive their capital back and much more while the corporation has outstanding liabilities, often very large in amount.

Two kinds of law are supposed to protect corporate creditors from excessive dividends and share repurchases, but both are too weak. First is corporate law that forbids dividends and share repurchases when a corporation is insolvent, but — under Delaware law — creditors have no direct remedy against recipients of dividends and share repurchases and even the corporation itself has remedy only against those recipients who had insufficient notice of their illegality. Second is voidable transfer law that allows creditors to recover dividends and amounts paid for shares when the corporation is insolvent, unable to pay its debts as they come due, or inadequately capitalized, but creditors cannot easily enforce such laws outside bankruptcy because the creditor typically must enforce voidable transfer law on behalf of all creditors and has no clear means of being paid for its efforts since funds are returned to the debtor. Both sets of laws use insolvency or near-insolvency — inadequate capitalization — to trigger creditor protections. But by the time a corporation is insolvent or near insolvency and the law no longer allows dividends and share repurchases, it usually is too late. The corporation has paid out sometimes massive value that might otherwise have gone to satisfy creditor claims.

The permissive allowance of dividends and share repurchases by corporations has severe negative social consequences. I mention two here. First, the existing legal regime requires a bankruptcy system that can process frequent large and complex corporate failures. For example, PG&E Corporation filed for bankruptcy protection on Jan. 29, 2019, because of potential liabilities it faced in connection with California wildfires. At the time of the filing, PG&E had nearly $20 billion of debt outstanding but had paid out $7.25 billion in dividends from 2009 through 2018. When General Motors Corporation filed for bankruptcy protection in 2009, it did so after paying out more than $15 billion to shareholders from 1998 through 2008. At least some of these bankruptcies would likely have been unnecessary with less permissive rules allowing dividends and share repurchases.

Second, current permissive rules unfairly shift costs of insolvency to involuntary and unsophisticated creditors in violation of the implicit social bargain of limited liability, i.e., we give shareholders limited liability in return for the agreement to stand last in line for payment. Again, PG&E Corporation provides a good example. The company filed for bankruptcy because of potential liability for a wildfire that began near Paradise, California on Nov. 8, 2018. The fire consumed 153,336 acres, led to 86 fatalities and destroyed 13,972 residences, 528 commercial structures and 4,293 other buildings. There is considerable evidence — according to the company’s Form 8K disclosures — that the utility’s equipment caused the fire. If the corporation is unable to pay in full for the damages the fire caused, it will leave bankruptcy with unpaid and very innocent victim-creditors, having paid billions of dollars in dividends in prior years that were then not available to pay such claims.

It is not too much to ask corporations to pay their creditors — voluntary and involuntary — before paying shareholders. If that is the effect of the Sanders-Schumer legislation, society at large will surely benefit.

[1] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3330269.

[2] Quadrant Structured Prods. Co. v. Vertin , 102 A.3d 155, 172 (Del. Ch. 2014).

[3] In re Trados Inc. S'holder Litig. , 73 A.3d 17, 20 (Del. Ch. 2013).