As Gheewalla and MetLife show, creditors must mostly rely on explicit contractual provisions for protection. This note explains the little protection that is offered by statutory rules and equitable principles. How might these have helped bondholders in MetLife v. RJR Nabisco (or a tobacco tort claimant of RJR)? Should they have?
Minimum Legal Capital
In the old days, founding shareholders needed to provide some statutorily determined minimum amount of capital to a corporation. In some jurisdictions, that is still the case. In particular, Art. 6(1) of the Recast (2nd EU Company Law) Directive 2012/30/EU requires a minimum capital of €25,000 for European public limited liability companies. The Directive also prescribes elaborate provisions “for maintaining the capital, which constitutes the creditors' security, in particular by prohibiting any reduction thereof by distribution to shareholders where the latter are not entitled to it and by imposing limits on the company's right to acquire its own shares.”
Such minimum legal capital rules are fundamentally flawed. They consume much of corporate lawyers’ time and attention without affording creditors genuine protection. The basic problem is that the minimum is not calibrated to the proposed business of the corporation. For example, €25,000 is laughable for a large corporation like JPMorgan or Alcoa, but possibly prohibitive for a small grocery store. And even if the initial minimum capital were adequate, it would very quickly become outdated as the business of the corporation grows, shrinks, or changes. Nor do shareholders need to replenish capital once it is depleted – after all, that is the nature of limited liability. Even a small start-up corporation, however, might spend €25,000 on wages in the first month of its existence, leaving nothing of the minimum capital. As a result, minimum legal capital provides no guarantee whatsoever to a creditor that the corporation is adequately capitalized (whatever that means).
To be sure, capital regulation need not be as blunt as the European directive. Certain industries, notably banking, are subject to more finely calibrated capital requirements. In particular, these requirements tend to use ratios (e.g., debt to equity) rather than absolute amounts. Moreover, they are adapted to the risks of that particular industry, and perhaps even to the specific risks of individual companies — for example, bank capital requirements depend on the assets held by each bank. Last not least, they apply not only at the creation of the company but throughout its life. Similarly, debt contracts often contain finely calibrated covenants regarding financial ratios, permissible investments, and the like. General minimum capital rules, however, lack such finesse.
In recognition of these flaws, U.S. jurisdictions have fully abandoned minimum legal capital requirements.
Under the DGCL, the only remaining role for legal capital is in determining the permissible amount of distributions to shareholders, i.e., dividends and share repurchases. The enforcement of the limits is quite strict: Directors are jointly and severally liable for negligent violations (DGCL 174). However, the limits are rarely binding outside of insolvency because legal capital can be, and usually is, reduced to a minimal amount.
DGCL 173 and 170 provide that dividends can be paid out of “surplus” (or, if there is no surplus, out of net profits for the last two years). DGCL 154 defines surplus as net assets minus capital, and net assets as total assets minus total liabilities (i.e., equity). In other words, Delaware corporations can declare dividends up to the value of their equity minus capital.
So, what is “capital”? It is what the board resolves it to be, provided it is at least aggregate “par value” (DGCL 154, 1st sentence). Par value is another number determined by the charter or, if authorized by the charter, the board (DGCL 151(a)). Par value’s only other role is that the corporation cannot issue shares for consideration less than par value (DGCL 153(a)). In practice, Delaware corporations tend to issue stock with no par value or very low par value (e.g., 0.00001 cent per share), and set capital near zero. The bottom line is that the DGCL permits corporations to pay out almost their entire equity as dividends.
DGCL 160(a)(1) contains an equivalent restriction on share repurchases — practically none short of insolvency. Again, the limit is capital: repurchases may not impair capital. The only difference here is that the repurchase of par value shares reduces the aggregate par value of outstanding shares. This allows for a reduction in stated capital, if aggregate par value was previously a binding constraint (cf. DGCL 244(a)(2)).
By the way, it makes sense that the limits on dividends and repurchases are the same. Dividends and repurchases are largely equivalent as means for payouts to shareholders. Consider a corporation with equity worth $100 and 10 shares outstanding (such that the value of each share is $10). Imagine that the corporation wants to distribute $10 to shareholders. One option is to pay a $1 dividend on each share. Another option is to buy back one share for $10. The amount of cash returned to shareholders collectively will be the same. In the dividend option, 10 shares will remain outstanding, with a value of $9 per share. In the repurchase option, 9 shares will remain outstanding, with a value of $10 per share. The aggregate value of shares outstanding, or “market capitalization,” will be the same under either option: $90. The choice between the two methods is mostly relevant for tax purposes. In particular, many shareholders would prefer not to receive dividends (taxed at personal income tax rates) and instead sell some of their shares to the corporation or a third party buyer (taxed at the lower capital gains tax rate).
Of more practical relevance are restrictions on so-called fraudulent transfers (a/k/a fraudulent conveyances). The animating purpose behind fraudulent transfer rules is that creditors should be able to claim back an asset from a transferee who obtained the asset from the debtor without paying adequate consideration. A paradigmatic case is the heavily indebted wife who transfers her assets to her husband to shield them from her creditors. But the rules are considerably more general. Their main advantage over the aforementioned corporate distribution constraints is that they also catch transactions in which the recipients paid some, but insufficient, consideration.
Both state law and federal bankruptcy law contain fraudulent transfer rules. Please read both!
Bankruptcy Code §548
(a)(1) The trustee may avoid any transfer (including any transfer to or for the benefit of an insider under an employment contract) of an interest of the debtor in property, or any obligation (including any obligation to or for the benefit of an insider under an employment contract) incurred by the debtor, that was made or incurred on or within 2 years before the date of the filing of the petition, if the debtor voluntarily or involuntarily —
(A) made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted; or
(i) received less than a reasonably equivalent value in exchange for such transfer or obligation; and
(I) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation;
(II) was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital;
(III) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured; or
(IV) made such transfer to or for the benefit of an insider, or incurred such obligation to or for the benefit of an insider, under an employment contract and not in the ordinary course of business.
. . .
(C) Except to the extent that a transfer or obligation voidable under this section is voidable under section 544, 545, or 547 of this title, a transferee or obligee of such a transfer or obligation that takes for value and in good faith has a lien on or may retain any interest transferred or may enforce any obligation incurred, as the case may be, to the extent that such transferee or obligee gave value to the debtor in exchange for such transfer or obligation.
Uniform Fraudulent Transfer Act
§ 2. Insolvency.
(a) A debtor is insolvent if the sum of the debtor's debts is greater than all of the debtor's assets at a fair valuation.
(b) A debtor who is generally not paying his [or her] debts as they become due is presumed to be insolvent.
(c) . . .
§ 4. Transfers Fraudulent as to Present and Future Creditors.
(a) A transfer made or obligation incurred by a debtor is fraudulent as to a creditor, whether the creditor's claim arose before or after the transfer was made or the obligation was incurred, if the debtor made the transfer or incurred the obligation:
(1) with actual intent to hinder, delay, or defraud any creditor of the debtor; or
(2) without receiving a reasonably equivalent value in exchange for the transfer or obligation, and the debtor:
(i) was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or
(ii) intended to incur, or believed or reasonably should have believed that he [or she] would incur, debts beyond his [or her] ability to pay as they became due.
(b) In determining actual intent under subsection (a)(1), consideration may be given, among other factors, to whether: (1) the transfer or obligation was to an insider; . . .
§ 5. Transfers Fraudulent as to Present Creditors.
(a) A transfer made or obligation incurred by a debtor is fraudulent as to a creditor whose claim arose before the transfer was made or the obligation was incurred if the debtor made the transfer or incurred the obligation without receiving a reasonably equivalent value in exchange for the transfer or obligation and the debtor was insolvent at that time or the debtor became insolvent as a result of the transfer or obligation.
(b) A transfer made by a debtor is fraudulent as to a creditor whose claim arose before the transfer was made if the transfer was made to an insider for an antecedent debt, the debtor was insolvent at that time, and the insider had reasonable cause to believe that the debtor was insolvent.
§ 7. Remedies of Creditors.
(a) In an action for relief against a transfer or obligation under this [Act], a creditor, subject to the limitations in Section 8, may obtain: (1) avoidance of the transfer or obligation to the extent necessary to satisfy the creditor's claim; . . .
§ 8. Defenses, Liability, and Protection of Transferee.
(a) A transfer or obligation is not voidable under Section 4(a)(1) against a person who took in good faith and for a reasonably equivalent value or against any subsequent transferee or obligee. . . .
In bankruptcy, courts may subordinate some creditors on equitable grounds. In particular, they may treat loans from shareholders to the corporation as corporate equity, i.e., rank these loans after all other creditor claims. Cf. Bankr. Code §510(c)(1).
Mere undercapitalization is generally not sufficient grounds for equitable subordination. But the exchange of capital (equity) for debt at a critical moment probably would be.
Piercing the Corporate Veil
Most radically, courts can hold shareholders directly liable for corporate debt under a doctrine called “piercing the corporate veil.”
The conditions for this radical step are not well defined, to put it mildly. Generally, courts require at a minimum a “unity of interest and ownership” between shareholders and the corporation. They tend to find such “unity” if there has been (a) a disregard of corporate formalities (meetings, minutes, etc.), (b) a commingling of funds, and/or (c) undercapitalization. That is, mere control of the corporation by the shareholders, even in a single-owner corporation, is not sufficient for veil piercing.
From a practitioner’s point of view, the lesson here is to respect corporate formalities. From a policy point of view, this makes some sense because enforcing any claim against anyone becomes difficult when ownership of assets cannot be established because formalities were not followed and funds were commingled.
Practically speaking, piercing hardly ever occurs in large corporations (perhaps because they follow formalities). Courts mostly (but still rarely) pierce the veil of small, single-owner corporations. And they mostly do so for the benefit of involuntary creditors such as tort creditors who did not choose their debtor. See Peter Oh, Veil-Piercing.
In addition to the general principle of veil piercing, special statutory rules impose direct liability on (controlling) shareholders for particular types of obligations. For example, the Employee Retirement Income Security Act of 1974 (ERISA), as amended, holds controlling shareholders liable for the corporation’s pro rata share of vested but unfunded pension benefits when withdrawing from a multi-employer plan.