Directors, shareholders, their counterparts in other business entities, and their attorneys routinely ignore the statutory conditions and restrictions on distributions to shareholders and other equity holders. The subject was discussed at the most basic level in a prior blog post here. A recent Washington appellate decision demonstrates how costly disregard for those restrictions can be.
As noted in the prior blog post, state law often limits the amounts a corporation or other business entity can distribute to its shareholders as dividends or as payments in partial or complete redemption of a shareholder’s equity interest. In Oregon for instance, ORS 60.181 authorizes such distributions only if the directors first determine that, after giving effect to the redemption:
- the corporation will be able to pay its debts as they come due in the usual course of business; and,
- the corporation’s total assets will at least equal the sum of its total liabilities plus, unless the articles of incorporation permit otherwise, the amount that would be needed if the corporation were to be dissolved at the time of the distribution, to satisfy the preferential rights upon dissolution of shareholders whose preferential rights are superior to those receiving the distribution.
Other statutes impose similar restrictions on distributions to owners of equity in other business entities: e.g., ORS 63.229 restricts distributions to members of limited liability companies in Oregon.
As a practical matter small businesses and their professionals often disregard these restrictions when making distributions to owners. Their directors never consciously consider the specific statutory restrictions which might limit a specific distribution nor do they document such consideration with corporate minutes to prove that they actually considered the statutory preconditions to such distributions.
A director who authorizes and a shareholder or equity owner who accepts a distribution made in disregard of these statutory preconditions and limits may incur personal liability to the corporation for the difference between the amount distributed and the amount by which a specific distribution exceeds what would have been the amount permissible at the time.
As a practical matter, if the corporation subsequently becomes insolvent, the liability will be asserted by the corporation’s creditors or by a trustee in bankruptcy. Of course, any contract of redemption or distribution which violates statutory limitations and conditions may be unenforceable against the corporation or entity. That is, the corporation may legally avoid payment to its shareholder. This was the result in Taylor v. Bell, 185 Wn. App. 270 (2014).
In Taylor the Idaho courts had already held that a redemption agreement with the company’s founder to pay $7.5 million and other value over 10 years to buy his equity was unenforceable. There was no record that the company’s directors had made the statutory determinations required before entering into such an agreement or that the corporation’s financial condition at the time could support such an agreement under the applicable Idaho statute when the parties reached agreement on the terms of the redemption of the founding shareholder’s equity.
The shareholder, Taylor, then made a claim against his Washington attorney for malpractice. Taylor said that his attorney hadn’t told him about the corporation’s disregard of the statutory preconditions to such distributions nor had his attorney told him about the consequent risk that the redemption agreement would be declared unenforceable under Idaho law. On these facts the Washington Court of Appeals held that Taylor stated a valid claim against his attorney.
In short, disregarding the restrictions on distributions to shareholders and other equity owners can cause a lot of pain both to the participants and to their attorneys. It is, moreover, pain that could have been easily avoided simply by reading and complying with the applicable statutes. That is, after all, what attorneys are paid to do.