A "distribution" is a transaction in which a corporation pays money to its shareholders. There are two basic types of distributions:
The board of directors has the sole power to authorize a distribution.
From a shareholder's perspective, the two types of distribution are very different. Dividends are essentially a freebie—the shareholder gets cash, and they don't have to give anything in return. (Note that "stock dividends," also known as splits, are not distributions since the corporation is not paying anything.) Stock repurchases, to a shareholder, are the same as selling stock on the open market—they get paid in exchange for giving up their interest in the company.
Distributions take on a simpler face when you look at them from the perspective of a creditor, or a holder of preferred stock. If a corporation pays a dividend or buys back outstanding shares, the transaction reduces the total assets of the corporation, and therefore makes it less likely that the creditor or preferred shareholder will get their money back in the future. People in such positions will therefore be wary of distributions.
Since directors are usually elected by holders of common stock, there is a real danger of distributions that screw over creditors and preferred shareholders. So there are specific rules to tell corporations when they can make distributions.
The "traditional" rules
"Traditional" rules apply under corporate laws that recognize par value—a legal "floor" on the value of stock. The most important contemporary examples are the Delaware General Corporation Law, which governs many big American companies, and the New York Business Corporation Law.
Under par value regimes, distributions can only be made from the "surplus" of the corporation. The exact definition of "surplus" varies from place to place, but Delaware and New York both define it as the assets that exceed the legal capital of the corporation—the aggregate par value of its shares. This means that in such states, creditors can only rely upon recovering a fraction of the corporation's assets: the rest are free to be distributed to shareholders at any time.
A few other states impose a further restriction: that distributions have to come from earned surplus, the money that comes from corporate profits. This means that companies cannot pay dividends that would bring their assets below the amount of paid-in capital, the total amount that has been directly paid in by shareholders since the company's incorporation.
The problem with the traditional rules is that par value is "squishy." It's usually kept low to begin with. Even if it isn't, a corporation can usually reduce the par value of its stock by amending its articles of incorporation. So traditional rules don't generally do a whole lot to stop companies from giving all of their assets to shareholders, leaving creditors high and dry in the process.
The "contemporary" rules
Under the Model Business Corporation Act, which has inspired the corporate laws of at least 35 U.S. states, stock does not have par value unless the corporation decides to include a value in its articles of incorporation. Since par value gets in the way, companies like to avoid it if they can. This means that a new standard is needed.
The Official Comments to the MBCA, drafted by the American Bar Association, suggest that a corporation must meet two tests before it makes a distribution. These are:
- Equity insolvency test - After the distribution, the corporation must be able to pay its debts as they become due in the usual course of its business.
- Balance sheet test - After the distribution, the corporation's total assets must be greater than or equal to its liabilities plus the amount needed to buy out all of the holders of preferred stock.
Some states have adopted these tests verbatim. Others have gone further: in California, for instance, the balance sheet test requires the corporation to have assets greater than 125% of its liabilities after the distribution.
Compliance with these rules falls upon the directors themselves. If they break the rules, they can be individually liable to the company's creditors. The Official Comments indicate that the decision to make a distribution should be treated as any other business decision, and therefore should be subject to the business judgment rule. This means that as long as the directors make the decision in good faith, on an informed basis, and absent a conflict of interest, they will usually be safe.
- Bauman et al., Corporations: Law and Policy (5th ed., West 2003)