BILL ANALYSIS Ó
SENATE BANKING & FINANCIAL INSTITUTIONS COMMITTEE
Senator Juan Vargas, Chair
AB 571 (Hagman) Hearing Date: June 29,
2011
As Amended: April 25, 2011
Fiscal: No
Urgency: No
SUMMARY Would update sections of the Corporations Code
governing the issuance of dividends and redemption of shares by
California corporations.
DESCRIPTION
1. Would prohibit a California corporation or any of its
subsidiaries from making any distribution to the
corporation's shareholders, unless the board of directors of
that corporation determines either of the following in good
faith:
a. The amount of 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; or
b. The value of the corporation's assets immediately
after the distribution would equal or exceed the sum of
its total liabilities plus the preferential rights
amount.
2. Would define the preferential dividends arrears amount as
the amount, if any, 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, as specified.
3. Would define the 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, including accrued but unpaid dividends, of other
shareholders upon dissolution that are superior to the
rights of the shareholders receiving the distribution, as
AB 571 (Hagman), Page 2
specified.
4. Would allow a board of directors to issue a distribution
based on financial statements prepared on the basis of
accounting practices and principles that are reasonable
under the circumstances, a fair valuation, or any other
method that is reasonable under the circumstances.
5. Would clarify that the effect of a distribution is measured
as of the date the distribution is authorized, if the
payment occurs within 120 days after the date of
authorization.
6. Would delete the existing law requirement that each
dividend, other than one chargeable to retained earnings, be
identified in a notice to shareholders as being made from a
source other than retained earnings.
7. Would add a four year statute of limitations to any a cause
of action involving the obligation of a shareholder to
return a distribution.
EXISTING LAW
8. Prohibits a California corporation or any of its
subsidiaries from making any distribution to the
corporation's shareholders, except as follows:
a. The distribution may be made if the amount of the
retained earnings of the corporation immediately prior to
the distribution equals or exceeds the proposed
distribution (Corporations Code Section 500(a)).
b. The distribution may be made if, immediately
following the distribution, the sum of the assets of the
corporation would be at least equal to 125% of its
liabilities, and:
i. Either the current assets of the
corporation would be at least equal to its current
liabilities, or,
ii. If the average of the earnings of the
corporation before taxes on income and before
interest expense for the two preceding fiscal years
was less than the average of the interest expense
AB 571 (Hagman), Page 3
for those fiscal years, the current assets of the
corporation would be least equal to 125% of its
current liabilities, as specified (Corporations Code
Section 500(b)).
9. Provides that the amount of any distribution payable in
property must be determined on the basis of the value at
which the property is carried on the corporation's financial
statements in accordance with generally accepted accounting
principles (Corporations Code Section 500(c)).
10. Prohibits a California corporation or its subsidiaries from
making any distribution to the corporation's shareholders,
if the corporation or the subsidiary making the distribution
is, or as a result of the distribution would be, unable to
meet its liabilities as they mature, as specified
(Corporations Code Section 501; SB 571 would retain this
provision).
11. Provides that each dividend, other than one chargeable to
retained earnings, must be identified in a notice to
shareholders as being made from a source other than retained
earnings (Corporations Code Section 507).
AB 571 (Hagman), Page 4
COMMENTS
1. Background and Discussion: This bill is sponsored by the
Corporations Committee of the Business Law Section of the
California State Bar, to simplify the formula used by
corporations to determine whether and in what amounts they
may issue dividends and make other distributions to
shareholders.
According to the bill's sponsor, AB 571 will accomplish five
things: 1) simplify and clarify the formula pursuant to
which California corporations may make distributions to
shareholders; 2) remove unnecessarily rigid restrictions on
the ability of financial healthy California corporations to
make distributions to shareholders; 3) eliminate material
differences between the standards relating to dividends and
distributions by California corporations and the standards
relating to dividends and distributions by California
limited liability companies (LLCs) and limited partnerships
(LPs); 4) enable shareholders of S-Corporations to receive
dividends and/or distributions to satisfy their tax
obligations, just as partners or members of LLCs and LPs are
able to do; and 5) align the approach used by California to
restrict the issuance of dividends and distributions with
the approach used by other states, and, in doing so, remove
an existing competitive disadvantage experienced by
California corporations.
This bill's sponsor asserts that existing California law imposes
unnecessary restrictions on the issuance of dividends and
other distributions by financially healthy corporations,
particularly those which have both historical book losses
and appreciated property. Because these corporations have
no retained earnings, they are unable to rely on
Corporations Code Section 500(a) to make distributions to
their shareholders. These corporations might have assets
with values far in excess of liabilities, but cannot rely on
Section 500(b), because the carrying value of those assets
on their books is not reflective of their fair market value.
A discrepancy between the carrying value of an asset on a
corporation's books and its fair market value can occur for
a number of reasons. Under generally accepted accounting
principles, long term and intangible assets are generally
carried on a corporation's financial statements at their
AB 571 (Hagman), Page 5
historical acquisition cost (subject to impairment charges,
which may be taken from time to time) and are generally not
trued up to reflect unrealized appreciation. In addition,
certain assets, such as valuable long term contracts, may
not be reflected on a corporation's balance sheet at all.
Generally accepted accounting principles also require
depreciation of certain long term assets (including
definite-lived intangibles), even though the amounts
depreciated may not be reflective of the actual reduction in
value of the underlying asset. For all of these reasons,
existing law can produce the unbalanced result that a
corporation receives no benefit from the unrealized
appreciation of its assets, but suffers the detriment of
artificial depreciation on the value of some types of
assets.
Section 500(b) can also operate to prohibit distributions to
shareholders in situations where the value of a
corporation's assets under generally accepted accounting
principles exceeds the amount of its liabilities, because
existing law requires a corporation to satisfy both a
general assets/liabilities balance sheet test (Section
500(b)(1) and a liquidity test (Section 500(b)(2)). Thus, a
corporation with assets valued at 500% of the value of its
liabilities would be prohibited from declaring a dividend
if, at the time of the proposed dividend, its current assets
did not exceed or were not at least 125% of its current
liabilities.
In further support of its rationale in proposing the changes
contain in AB 571, the sponsor observes that California's
laws governing distribution of dividends by LLCs and LPs
focus on the actual fair market value of the distributing
entity's assets and invoke a rule of reasonableness for
purposes of determining whether the value of the entity's
assets would exceed the amount of its liabilities after the
distribution is made. This bill's sponsor is unaware of any
complaints by creditors rights groups that the interests of
creditors and preferred equity holders are not protected by
the rules that apply to LLCs and LPs. Thus, the sponsor
does not see any reason why corporations should be subject
to restrictions that are different from, less flexible than,
and more stringent than the restrictions applicable to LLCs
and LPs.
2. Summary of Arguments in Support: The Corporations Committee
AB 571 (Hagman), Page 6
of the Business Law Section of the California State Bar is
sponsoring the bill for the reasons stated above.
The Civil Justice Association of California echoes the arguments
of the Corporations Committee and adds that AB 571 provides
a four-year statute of limitations for lawsuits over
improper share or dividend distributions. Current law does
not contain a specific time limit to file suit. The time
limit imposed by this bill would be the same as it currently
is for claims about improper dividend distributions in the
LLC Act and the LP Act. Ensuring there is a definitive
limit on these lawsuits gives both plaintiffs and defendants
appropriate guidance on the scope of legal liability and
would reduce unwarranted litigation. Measures like these
will help encourage companies to incorporate in California
and help our state's economy rebound.
3. Summary of Arguments in Opposition: None received.
LIST OF REGISTERED SUPPORT/OPPOSITION
Support
Corporations Committee of the Business Law Section of the
California State Bar (sponsor)
Civil Justice Association of California
Opposition
None received
Consultant: Eileen Newhall (916) 651-4102