BILL ANALYSIS Ó
AB 571
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Date of Hearing: May 2, 2011
ASSEMBLY COMMITTEE ON BANKING AND FINANCE
Mike Eng, Chair
AB 571 (Hagman) - As Amended: April 25, 2011
SUBJECT : Corporations: distributions.
SUMMARY : Seeks to amend and delete portions of the General
Corporation Law concerning dividends and reacquisitions of
shares. Specifically, this bill :
1)Provides that a corporation cannot distribute to its
shareholders unless the board of directors has determined in
good faith the following:
a) The amount retained earnings of the corporation
immediately prior to the distribution equals or exceeds
the sum of the amount of the proposed distribution plus
the preferential dividends arrears amount.
b) Immediately after the distribution the value of the
corporation's assets would equal or exceed the sum of its
total liabilities plus the preferential rights amount.
2)Defines "preferential dividends arrears amount" as an amount
of cumulative dividends in arrears on all shares having a
preference with respect to payment of dividends over the class
or series to which the applicable distribution is being made,
provided that a distribution can be made without regard to
preferential dividends arrears amount, then the amount shall
be zero.
3)Defines "preferential rights amount" as the amount that would
be needed if the corporation were to be dissolved at the time
of the distribution to satisfy the preferential rights.
4)Allows the board of directors to determine that distributions
are not prohibited on the following:
a) Financial statements prepared on the basis of
accounting practices and principles
b) A fair valuation
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c) Any other method that is reasonable under the
circumstances
5)Deletes the requirement that corporations provide notice to
shareholders with respect to a dividend other than one
chargeable to retained earnings, stating that dividend is
being made from a source other than retained earnings.
EXISTING LAW establishes the Corporations Code to provide the
fundamental terms and provisions for the governance of
corporations. Section 500-511 relates to dividends and
requisition of shares.
FISCAL EFFECT : None.
COMMENTS :
According to the sponsor, the Business Law Section, Corporations
Committee, of the State Bar of California, this measure is
necessary to replace the unnecessarily complicated and rigid
balance sheet and liquidity tests in the existing statute with
tests that permit a corporation to distribute cash or property
to shareholders (whether as a dividend or repurchase or
redemption of shares) if, after giving effect to the
distribution, the value of the corporation's assets equals or
exceeds the sum of its liabilities and the liquidation
preference of any preferred stock, and provides the corporation
with greater flexibility in how to value assets and liabilities.
AB 571 would allow a corporation's board of directors may base a
determination that the value of its assets exceeds the amount of
its liabilities on financial statements prepared on the basis of
accounting practices and principles that are reasonable in the
circumstances, a fair valuation, or any other method that is
reasonable under the circumstances. The Proposed Statute would
not change the ability of a corporation's board of directors to
declare a dividend out of retained earnings as provided under
the Existing Statute. All distributions will continue to be
subject to the same solvency test that is applied under the
existing statute.
According to the Author, this measure will simplify and clarify
the formula pursuant to which corporations may make
distributions to shareholders; remove unnecessarily rigid
restrictions contained in the existing balance sheet and
liquidity tests on the ability of financially, healthy
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corporations to make distributions to shareholders; eliminate
material substantive differences in the standards relating to
dividends and distributions applicable to California
corporations, on the one hand, and California limited liability
companies and limited partnerships, on the other hand; enable
shareholders of S-corporations to receive dividends or
distributions to satisfy their tax obligations related to their
ownership interests to the same extent that partners or members
of a limited partnership or limited liability company can
receive such distributions; and, make the approach used by
California to restrict distributions more consistent with the
approach used in other states so that California will not be
competitively disadvantaged in attracting new businesses.
BACKGROUND: In 1977, California significantly modified corporate
law restrictions on corporations paying distributions to their
shareholders by redeeming shares. Prior to 1977, the law
permitted corporations to pay dividends only from the
corporation's "earned surplus," which was an antiquated legal
accounting concept based on the idea that shares had a "par
value" representing the stated amount of capital contributed to
the corporation. The law treated such stated capital as a trust
fund for creditors and provided that dividends to shareholders
could only be paid out of a corporation's "earned surplus"
capital (i.e., the amount of its actual capital in excess of its
stated and paid-in capital). Before distributing corporate
assets to shareholders (whether as a dividend or payment to
redeem shares), a corporation had to calculate its earned
surplus using concepts of par value, stated capital, earned
surplus, paid-in surplus, reduction surplus, and treasury
shares. Several exceptions allowed corporations to make
distributions out of "net profits" for a six to twelve month
period (so called "nimble dividends"), paid-in surplus (the
amount paid by investors for shares in excess of stated capital)
and surplus resulting from a corporation reducing its stated
capital.
The new law adopted in 1977, embodied in Chapter 5 of the
General Corporation Law (the "Existing Statute"), substantially
abandoned all of these legal accounting concepts in favor of
rules that focus on modern financial accounting concepts of
retained earnings, balance sheet and liquidity tests, and
solvency. The change in law was precipitated by perceptions
that the prior approach and restrictions did not provide
adequate protection to creditors.
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Under the existing statute, a corporation can make a
distribution of cash or property to shareholders only if either
the corporation has retained earnings prior to such distribution
equal or exceeding the amount of the distribution or the
corporation can satisfy both a balance sheet test and a
liquidity test (based on current assets and current liabilities)
after giving effect to such distribution, and the distribution
will not render the corporation insolvent. The two-prong balance
sheet and liquidity tests referenced permit a distribution to be
made only if, after giving effect to the distribution, the
corporation's total assets equal or exceed 125% of its total
liabilities and the corporation's current assets equal or exceed
its current liabilities (or 125% of current liabilities if the
corporation's average earnings before interest and taxes for the
two preceding fiscal years were less than its average interest
expense during the same period). In making the balance sheet and
liquidity calculations, certain assets and liabilities are
excluded altogether, and consistent with generally accepted
accounting principles, assets are generally valued at their
historical carrying value (not their current fair market value).
Companies that cannot satisfy both the above-referenced balance
sheet test and liquidity test and that do not have accumulated
retained earnings cannot make distributions to their
shareholders under the existing statute, even if the fair market
value of their assets exceeds the amount of their liabilities.
The retained earnings test in the existing statute replaced the
"nimble dividends" concept under the pre-1977 statute, and the
State Bar Committee is not aware of any problems or concerns
with respect to its implementation in practice. In addition, the
solvency test contained in the existing statute (which must be
satisfied in addition to the retained earnings or balance sheet
and liquidity tests) is fairly well understood by corporations
and their advisors and is consistent with restrictions on
distributions imposed on limited liability companies and limited
partnerships under California law and the approach used for
corporations in most other states. The balance sheet and
liquidity tests, however, are overly rigid and do not provide
sufficient flexibility to corporations desiring to make
distributions under varying circumstances, are inconsistent with
the restrictions on distributions applicable to limited
liability companies and limited three
partnerships under California law, and are out of step with
dividend restrictions imposed on corporations in most other
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states in the United States.
REGISTERED SUPPORT / OPPOSITION :
Support
The State Bar of California - Sponsor
Opposition
None on file.
Analysis Prepared by : Kathleen O'Malley / B. & F. / (916)
319-3081