Proceed with caution

Thinking about doing a dividend recap on a portfolio company? With the debt markets loosening up and US tax cuts on dividends expiring at the end of the year, the timing looks good. But two recent lawsuits are evidence GPs need to proceed cautiously before taking dividends.

Caxton-Iseman Capital and Sentinel Capital Partners are being sued by the bankruptcy trustees of one of their portfolio companies, Buffet Holdings, for taking out “illegal dividends”. And Carlyle/Riverstone is being sued by the creditors of bankrupt energy trading company SemGroup for allegedly taking out improper dividends as well.  

Suppose you have a perfectly healthy portfolio company and you’re ready to take out a dividend. How can you protect yourself from liability should the company be brought down later by unforeseen and uncontrollable factors?

Under state corporate law in the US, a GP needs to demonstrate that the portfolio company has sufficient “surplus” – a concept similar to net worth – to take out a dividend. For private equity-owned portfolio companies that typically have a significant amount of debt on their balance sheets, the book value of their assets is often not enough to allow the payment of a dividend. At that point, the company can bring in an outside auditor to revalue its assets at fair value. If fair value is greater than book value, then fair value can be used to calculate surplus.

It’s important the auditors be diligent in their valuation, because under Delaware law a company’s directors can be held personally liable for issuing a dividend that is later found to have been improper.

Once the company clears this hurdle, the next step is to obtain a solvency opinion. Again, the company must bring in a third party to evaluate whether the company’s assets will be greater than its liabilities, and whether the company will be able to meet its debt payments, after the dividend is issued.

Every step of the solvency opinion must be methodical and carefully considered. One 2009 Florida bankruptcy case involving a holding company called TOUSA illustrates some of the pitfalls. A solvency opinion given by a third party advisor was deemed invalid because 1) TOUSA agreed to pay the advisor more if the advisor found the company to be solvent, 2) the advisor analysed the solvency of TOUSA on a consolidated basis rather than analysing the solvency of each subsidiary company and 3) the advisor issued an opinion just five days after its retention was finalised.

If the portfolio company goes bankrupt within a certain period of time after the dividend was issued – between six months and two years depending on the state – the dividend is attackable as a fraudulent conveyance. If that happens, the court will closely scrutinise the determination of the revaluation surplus and the solvency opinion, in which case the board had better have a careful record of every step of the decision process. Practically, there is no such thing as an airtight solvency opinion, so a GP needs to be as scrupulous as possible.

In the case of a portfolio company that goes bankrupt, the GP starts out with two strikes against it. It’s hard to argue that a company that is bankrupt today was truly solvent six months ago. In many cases, the GP had better be able to point to some very significant macroeconomic or industry-wide problems to explain what went wrong.