On September 1, 2011, Governor Brown signed into law AB 571, which significantly amends and streamlines Chapter 5 of the California Corporations Code governing dividends and distributions by corporations. The principal changes effected by AB 571 were to replace the rigid and antiquated balance sheet and liquidity tests contained in the existing statute with a simpler test, similar to that used in most other states, which permits a solvent corporation to make distributions to its shareholders so long as the value of the corporation’s assets would exceed its liabilities (and, if applicable, preferred stock preferences) after giving effect to the distribution. AB 571, which will become effective on January 1, 2102, was sponsored by the Corporations Committee of the Business Law Section of the State Bar of California and introduced in the California State Legislature by Assemblyman Curt Hagman.
Chapter 5 of the Corporations Code governs “distributions” by corporations and covers California corporations as well as, by virtue of Section 2115 of the Corporations Code, certain out of state corporations that have sufficient ties to California. The Corporations Code defines distributions to include dividends and share repurchases. Prior to the adoption of AB 571, Chapter 5 of the California Corporations Code required these corporations to satisfy a solvency test and one of two additional tests (namely, a retained earnings test or a two-pronged balance sheet and liquidity test) in order to make distributions to their shareholders. The general solvency test, which prohibits distributions that would render a corporation insolvent, remains unchanged by AB 571 and will continue to operate as an important protection for creditors against improper distributions. A corporation can satisfy the retained earnings test, which also remains unchanged under AB 571, if it has retained earnings prior to a distribution that equal or exceed the amount of the distribution. Because the retained earnings test necessarily requires a corporation to have retained earnings, a corporation with low or no past earnings history would likely be unable to satisfy the retained earnings test even if the value of its assets exceeds the amount of its liabilities. As a result, such a corporation would need to satisfy both prongs of the balance sheet and liquidity test of the existing statute in order to make distributions to shareholders.
Under the two-pronged balance sheet and liquidity test of the existing statute, a corporation is permitted to make a distribution 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 is less than its average interest expense during the same period). In making the balance sheet and liquidity calculations under the existing statute, certain assets and liabilities are excluded altogether, and, consistent with generally accepted accounting principles, assets are generally required to be valued at their historical carrying value (which is not necessarily reflective of the current fair market value of those assets). Corporations that are unable to satisfy both prongs of this balance sheet and liquidity test and that do not have accumulated retained earnings are prohibited from making distributions to their shareholders under the existing statute, even if the fair market value of their assets exceeds the amount of their liabilities. As a result, the rigid and formulaic two-pronged test contained in the existing statute prohibits many financially healthy corporations from making distributions to their shareholders. Corporations and legal practitioners alike have been frequently frustrated by the complexity and unnecessarily rigid restrictions that are imposed by this two-pronged test.