The impact of debt covenants on the ability to declare dividends and redeem shares

Author: todd-strang posted in: Corporate Commercial

Directors of corporations routinely declare dividends which are paid to the shareholders who hold the class of shares that the dividend was declared on. In many privately held corporations the shareholders, directors and officers are the same individuals.

When directors receive advice to declare dividends there is often little thought given to legal factors that might impair the directors’ ability to declare dividends or the consequences that might follow if dividends are improperly declared. Similarly, when a corporation determines it advisable to redeem or repurchase its shares from a shareholder consideration is not always given to legal factors that might create risk with such a transaction.

One area that often is overlooked when declaring dividends or redeeming shares is the corporation’s obligations under its debt covenants. Debt covenants are restrictions that benefit the borrowing corporation by reducing the cost of borrowing. Without the restrictions the corporation’s lenders would be less likely to lend to the corporation or would seek higher interest and or additional collateral.

Debt covenants fall into two categories – positive and negative covenants. Positive debt covenants state what the borrower must do such as maintain certain levels or working capital, follow generally accepted accounting procedures, and provide audited financial statements to the lender. Negative covenants state what a borrower cannot do. In some circumstances these covenants will include not paying dividends or allowing dividends to be declared only when certain financial thresholds are met. Other negative covenants might prohibit the issuance of more debt, the entering into certain types of agreements and may even prohibit reorganization and restructuring type transactions without lender approval.

Violation of debt covenants can lead to serious consequences including but not limited to interest rate increases, penalties, requirements to increase the amount of collateral, demand for immediate loan repayment, and termination of the debt facilities. In some circumstances these consequences could lead to the failure of the corporation to continue as a going concern and could trigger cross corporate and individual debt obligations because of the unintended default.

It is important to review a corporation’s debt obligations before declaring dividends or redeeming shares.  Existing debt contracts and supporting documentation should be reviewed with the corporation’s legal advisors to determine if the proposed transactions will have unintended consequences.