Kelli Purcell

Law & Valuation
Professor Palmiter
Spring, 1999

Text of Paper

Shareholders receive benefits from their corporations in many different forms, such as dividends, stock repurchases, and liquidations.  Stockholders may also receive compensation or interest income from the corporation which are not related to stock ownership. These transactions are often analyzed to determine whether they are appropriate.


1.  How does the Model Business Corporations Act address distributions to shareholders?
2.  Can creditors of a pre-merger corporation use distribution statutes such as that in the MBCA to sue the board of directors after a cash-out merger when the post-merger files for bankruptcy?
1.  Under MBCA § 6.40, distributions are acceptable so long as they meet either the equity insolvency test or the balance sheet test.
2.  The Circuit Courts are split, with the Fourth Circuit holding that cash-out mergers are not distributions and with the Eleventh Circuit finding that they are.
The Model Business Corporations Act addresses distributions to shareholders in Section 6.40.  This act gives a corporation much flexibility with regard to distributions to shareholders.  According to the MBCA, the board of directors is only limited by the corporation’s articles of incorporation and the capital requirements set forth in the act. Distributions are not allowed if the corporation would not be able to pay its debts or if the assets would be less than its liabilities plus the amount needed to satisfy shareholders in the event the corporation is dissolved.  Additional limitations are imposed by state fraudulent conveyance laws and state and federal bankruptcy codes.
The MBCA states two tests for determining whether the corporation has sufficient capital to authorize a distribution, the equity insolvency test and the balance sheet test.  The first test deals with cash flows and is measured by the ability of the corporation as a going concern to pay its debts.  The second test is concerned with the liquidation value, which requires a valuation of the net worth of the corporation.  Any distribution that exceeds the net worth fails the test.  However, since the calculation of net worth is subject to subjective ideas of what constitutes assets and liabilities, the MBCA provides some additional guidelines stating that the accounting method must be reasonable in the circumstances.  The Generally Accepted Accounting Principles are stated to be reliable for determining assets and liabilities. Instead of using financial statements, a fair valuation could also be used to determine the appropriateness of a distribution. The method must be reasonable based on the circumstances of the case and must take into consideration the value of all material assets and material obligations. If the board of directors authorizes a distribution that violates the MBCA tests, then there is personal liability to the extent of the excess distribution, if it is found that the board members violated their general corporate duties. A defense is if the distribution is found to be reasonable and the director in good faith relied on information provided by lawyers, accountants and valuation experts.
Corporate distribution statutes have also been used by creditors of a corporation to challenge the appropriateness of cash-out mergers. Usually, a corporation will redeem shareholders for a predetermined price before the merger. The new corporation may later file for bankruptcy, causing the creditors to try to get the payments to the shareholders set aside as improper distributions, with varying results. In C-T of Virginia, Inc. v. Barrett, the Fourth Circuit held that a cash out merger was not a distribution under Virginia corporate law, which had a statute similar to MBCA § 6.40. Here, a corporation made distributions of $20 per cancelled share when they underwent a leveraged buy-out.  The post-merger corporation filed for bankruptcy, leading the creditors to sue the pre-merger directors for breach of fiduciary duties and violation of Virginia law on distributions. The court found that the distribution statute was aimed at actions by a corporation to unjustly enrich its shareholders, and since a new corporation paid the shareholders, this was not the case in a cash-out merger. The Eleventh Circuit disagreed in Munford, Inc. v. Valuation Research Corporation.  In this case, when the post-merger company went bankrupt, the creditors sued under the theory that the Georgia distribution statute prevented the cash-out transaction. The Georgia statute uses the equity insolvency test.  The court believed that the distribution statute was applicable to a merger to a corporation with few assets of its own, where distribution to the former shareholders led to insolvency, regardless of the fact that the new corporation assured the directors future solvency of the corporation.
It must be taken into consideration that the valuation of a corporation for the purposes of a leveraged buy-out will be different than what is acceptable under distribution statutes.  Valuations for a cash-out merger are to determine a fair price for the shares of stock.  This valuation would probably not meet the requirements of MBCA § 6.40(d).



Each investor in a business venture is motivated by a highly individualized set of preferences.  Some investors are principal participants in the business and want control of decision-making.  Others invest purely for long or short-term profits, either through dividend or other payments or appreciation in price. Within this group there are investors that prefer small but steady returns while others demand large or quick payments.  Some may even expect little or no income from the investment.  Various business forms and ownership structures are available today to businesses to enable them to satisfy many diverse goals of investors.  Business can choose to raise capital by enabling investors to participate in equity holdings or may use debt or both.  There are a myriad of business forms available today that help structure those choices.  The choice of entity may be driven by a number of factors, including the business’ preference for equity participation.  One reason many businesses choose to incorporate is to take advantage of the ability to raise capital through sale of stock.  Whether the business envisions selling stock to a small number of interested investors or a large public offering, state corporate law rules will determine the relationship between the investors and the managers of the business.
Payments made to shareholders are governed by corporate law, but are also subject to scrutiny by state and federal bankruptcy laws.  Since most companies also use debt to finance business ventures there may be tension between the expectations of shareholders for returns on their investment and creditors financing transactions of the business, particularly in a troubled business.  In recent years corporate mergers have highlighted this tension.  This paper will briefly outline the general approach to legal capital requirements in most state corporate codes and discuss the courts’ application of these laws to corporate mergers.

Payments to shareholders

Shareholders may receive payments from the corporation on their shares in many forms and in many contexts.  Dividends, stock repurchases and liquidations are common types of shareholder payments.  While many stockholders also receive compensation or interest income from the corporation, these payments are not payments related to stock ownership.  Excessive compensation to shareholder-employees and large interest payments to shareholder-creditors are often analyzed for appropriateness by the same standards as the payments with respect to share ownership.

A.  Limitations on Distributions to Shareholders

The Model Business Corporations Act (Revised) addresses distributions to shareholders in section 6.40.The MBCA gives corporation’s board of directors a great degree of latitude in controlling distributions to shareholders.  According to the MBCA, the Board is limited only by the corporations’ articles of incorporation and the capital requirements outlined in the MBCA.[1]  In particular, section 6.40(c) provides:
“(c)  No distribution may be made if, after giving it effect:
(1)  the corporation would not be able to pay its debts as they become due in the usual course of business; or

(2)  the corporation's total assets would be less than the sum of its total liabilities plus (unless the articles of incorporation permit otherwise) the amount that would be needed, if the corporation were to be dissolved at the time of the distribution, to satisfy the preferential rights upon dissolution of shareholders whose preferential rights are superior to those receiving the distribution.”

The official comments to section 6.40 recognize, however, that additional limitation on distributions to shareholders can be imposed by state fraudulent conveyance laws and state and federal bankruptcy codes.[2]

MBCA section 6.40(c) outlines two alternative tests for determining whether the corporation has sufficient capital to authorize a distribution.  Section 6.40(c)(1) is an equity insolvency test and Section 6.40(c)(2) is a balance sheet test.  Equity insolvency is concerned with cash flows and is measured by the ability of the corporation as a going concern to pay its debts.  The general formulation of equity insolvency is: “no distribution can be lawfully made if it will put the corporation in a position where it cannot meet its obligations as they mature.”[3]  On the other hand, the balance sheet test is concerned with the liquidation value of the enterprise.[4]  The test first requires a valuation of the net worth of the corporation by subtracting assets from liabilities.[5]  For the purposes of MBCA sec. 6.40(c)(2), preferential rights to distributions by another class of shareholders are considered liabilities.  All distributions must conform to the adjusted net worth calculation. Any distribution that exceeds the net worth of the business violates the balance sheet test.  Since amounts of assets and liabilities are susceptible to differences of judgement, the MBCA provides additional guidance.  Under MBCA sec. 6.40(d), the board of directors can rely on either “financial statements prepared on the basis of accounting practices and principles that are reasonable in the circumstances or on a fair valuation or other method that is reasonable in the circumstances.”  The official comment indicates that statements prepared under Generally Accepted Accounting Principles are reliable unless the board is aware of newly discovered information not reflected in those statements.[6]  Other accounting practices are not specifically blessed by the comments, but there is certainly recognition that in particular circumstances other reasonable methods of accounting may be acceptable.
An alternative to using the financial statements to determine the appropriateness of a distribution is a “fair valuation.” Neither the statute nor the official comments indicate that any particular valuation method would be inappropriate in all circumstances.  In any case it is clear that the method must be “reasonable” in the case at hand.  The only specific direction in the official comment warns that a corporation “should consider the value of all its material assets, whether or not reflected in the financial statements” as well as “material obligations.”[7]  Revaluation of material assets and obligations to the “extent appropriate and possible” is directed by the comment.
MBCA 6.40(d) also provides a board may rely on an assessment under any “other method that is reasonable under the circumstances.”  The comment indicates that “this phrase is intended to comprehend within section 6.40(c)(2) the wide variety of possibilities that might not be considered to fall under a ‘fair valuation’ or ‘current value’ method” but might within the board’s judgement be reasonable given the particular circumstances.[8]
If the board of directors authorizes a distribution in violation of MBCA sec. 6.40, personal liability to the extent of the excess distribution is imposed, subject to a finding that the board members violated their general corporate duties outlined in MBCA sec. 8.30.[9]  Particularly important in the context of distributions to shareholders is MBCA sec. 8.30(b) allowing the board member to rely on statements and financial data prepared or presented by experts.  The MBCA contemplates an assessment of the reasonableness of the distribution and so long as the director, in good faith, believes it prudent can rely on the information provided by lawyers, accountants and presumably valuation experts.

B.  Distributions in the Context of Mergers

Creditors of a pre-merger corporation to challenge the appropriateness of so-called cash-out mergers have used corporate distribution statutes.  The typical case involves a corporation that merges into an acquirer in a leveraged buy out and redeems shareholders of the old corporation for a predetermined price.  When the new corporation later files for bankruptcy, the creditors of the pre-merger corporation look to set aside the cash payments to shareholders as improper distributions.[10]  Some creditors have successfully applied distribution statutes similar to MBCA sec. 6.40 to these mergers.  Others, on very similar facts, have not been successful.
In C-T of Virginia, Inc. v. Barrett, 958 F.2d 606 (1992), the Fourth Circuit determined a cash out merger is not a distribution under Virginia corporate law.  C-T of Virginia, Inc. was an over-the-counter traded shoe manufacturer, wholesaler and seller.  Based on the recommendations of Prudenital-Bache Securities, C-T’s board decided to pursue a leveraged buy-out of C-T in April 1985.  In November 1985 HH Holdings made an unsolicited offer to buy C-T for $19 per share in cash.  An agreement to sell at $20 per share was signed in December 1985 and a plan of merger was formalized in January 1986. [11]   C-T shareholders approved the merger at the recommendation of the board on April 17, 1986. C-T was merged into a wholly owned subsidiary of HH April 30, 1986.  The $30 million required to purchase the pre-merger shares of C-T was deposited with an exchange agent who then paid $20 per cancelled share to the C-T shareholders as certificates were presented.[12]  As part of the plan of merger, C-T directors resigned their offices and were no longer associated with the business. The post-merger corporation filed for Chapter 11 bankruptcy in October 1987.[13]  The unsecured creditors of C-T sued the pre-merger directors and officers of C-T in October 1989, alleging a breach of fiduciary duties and that they had violated the Virginia law on distributions.  The Virginia provisions are based on MBCA sec. 6.40(c).
The C-T of Virginia court analyzed the definition of “distribution” and concluded that a cash-out merger did not meet the statute.  Key to the court was the requirement that a distribution be made “by a corporation” to its shareholders.  Here, the payments were made by a new corporation and its financiers through another bank to the former C-T shareholders. The court analyzed the purpose of the distribution statute and concluded:  “the distribution statute is aimed by its terms at actions taken by a corporation to enrich unjustly its own shareholders at the expense of creditors and to the detriment of the continuing viability of the company.”[14] The C-T court considered it important that the pre-merger directors were not involved in the post-merger business and therefore would not be able to control the use of assets.  The court favored the pursuit of a claim under fraudulent conveyance law[15] or in bankruptcy[16] in this context. Unequivocally, the court admonished “state distribution statutes simply do not authorize courts to rearrange the losses that inevitably result from risks taken in the hope of gains.”[17]
No matter how unequivocal the Fourth Circuit’s refusal to consider a leveraged buy-out and cash-out merger a distribution, the Eleventh Circuit disagrees.  In Munford, Inc. v. Valuation Research Corporation, 97 F.3d 456 (1996) the Eleventh Circuit rejected the C-T of Virginia court’s distinction between a merger and a distribution.  In Munford, the pre-merger corporation was a publicly traded holding company of retail chains.  The Munford, Inc. management engaged Sherason Lehman Brothers to value the company and recommend the most appropriate way to maximize shareholder value in the event of a sale.[18]  Shearson’s recommendation did not favor a leveraged buy-out in the first instance, but the failure of interested buyers led to the consideration of leveraged buy-out offers. After the first leveraged buy-out offer was withdrawn, the Munford board accepted an offer by the Panfida Group for a leveraged buy-out at $17.00 per share.[19]  The plan of merger was approved by the shareholders in October 1988. Like the C-T of Virginia transaction, the pre-merger directors and managers were to resign and the shareholders would be paid through a third party for their cancelled shares.  The Munford directors were given severance payments in exchange for their services through the merger transaction.[20]  The Munford directors obtained promises from Panfida that additional capital would be invested in Munford, it would remain solvent and would remain able to pay debts as due.[21]  When the post-merger corporation filed for bankruptcy in January 1990, the creditors of Munford, Inc. sued on among other theories, the theory that the Georgia stock distribution and repurchase statute prohibited the transaction.[22]  The Georgia statute in question enables a corporate board to distribute assets in cash or property to shareholders out of “capital surplus” of the corporation.  Distributions are prohibited when the corporation is insolvent or when the distribution would create insolvency.[23]  While these provisions are not identical to MBCA sec. 6.40(c), the statute embodies the equity insolvency test retained in MBCA sec. 6.40(c)(1).  The Munford directors argued that the lack of control by them following the merger made the distribution statute inapplicable.  Instead, the Munford court opined that the applicability of the distribution statute to a “paper merger” to a shell corporation with few of its own assets was appropriate.  “To hold that Georgia’s distribution and repurchase statutes did not apply to LBO mergers such as this, while nothing in these statutes precludes such a result, would frustrate the restrictions imposed on such directors who authorize a corporation to distribute its assets of to repurchase shares from stockholders when such transaction would render the corporation insolvent.”[24] The court expressly refused to follow the Fourth Circuit’s reasoning in C-T of Virginia.  The Eleventh Circuit utilized the rationale behind the limitations on distributions to invigorate a suit against directors by creditors of the former corporation. Notwithstanding the assurances the Munford board obtained from Panfida regarding the future solvency of the corporation, the board was considered to be liable for under the Georgia distribution statute.
While neither C-T of Virginia or Munford, Inc. directly addressed the reasonableness of the valuation of the corporation in determining the viability of the LBO transaction it is implicit in these decisions.  The valuation of the corporation for the purposes of engaging in a leveraged buy-out is clearly different than what would be acceptable under the distribution statutes in question.  Valuations were performed to determine a negotiated fair price for the shares. It is doubtful, however, that this valuation while apparently reflecting “fair value” would necessarily meet the requirements of MBCA sec. 6.40(d).  The requirement that the valuation be “reasonable under the circumstances” is important in assessing whether it can be upheld.  While the Fourth Circuit in C-T of Virginia refused to apply the distribution statute in that case it was because of the lack of control of the pre-merger directors and the potential conflict with their duties to obtain the highest merger price possible.  The difference in valuation methods and determination of a “correct” valuation was not addressed.


While MBCA and like corporate law statutes provide guidance about how to value a corporation in the context of the appropriateness of distributions, this valuation can only be used so far.  In the context of avoiding obligations to creditors, it has a long history and has worked to deter fraud.  However, the application of this provision to leveraged buy-outs is a development that will challenge the use of the distribution valuation.  The valuation called for in distribution statutes is not equivalent to sale price, although directors may argue the same elements are used to determine both values.  Directors should proceed with caution, as case law proves that there is significant difference of opinion as to the applicability of distribution law to leveraged buy- outs.

[1]  Model Business Corporations Act sec. 6.40(a).
[2]  Model Business Corporations Act sec. 6.40, official comment 3.
[3]  Manning, Bayless, & Hanks, Jr., James, Legal Capital, 3rd ed. (1990) at 64.
[4]  The term “balance sheet test” is used in official comment 4 to MBCA sec. 6.40.  Commentators also use the more descriptive term “adjusted net worth test” to refer to the test under MBCA sec. 6.40(c)(2).  See. Manning & Hanks, infra note 4, at page 182.
[5]  Manning & Hanks, infra note 4, at page 182.
[6]  Model Business Corporations Act, sec. 6.40, official comment 4(a).
[7]  Model Business Corporations Act, sec. 6.40, official comment 4(b).
[8] Id.
[9]  Model Business Corporations Act sec. 8.33.
[10]  These suits often also allege claims under state fraudulent conveyance law and apply virtually the same equity insolvency tests.
[11] C-T of Virginia, Inc. v. Barrett, 958 F.2d 606, 608 (1992).
[12] Id.
[13] Id.
[14] Id. at  611.
[15] Id. at 613.
[16] Id. at 611.
[17] Id. at 614.
[18]  See Munford, Inc. v. Valuation Research Corporation, 98 F.3d 604 (11th Cir. 1996).  This is a companion case involving other claims in the lawsuit and sets out a detailed chronology of the transaction.
[19] Id. at 607.
[20] Id.  The 11th Circuit concluded that these “payments” to directors were not fraudulent conveyances since Georgia law considers it valid consideration to for directors to secure assurances for the purchase of shares. Id. at 612.
[21] Id. at 607.
[22] Munford, Inc. v. Valuation Research Corporation, 97 F.3d 456 (1996).  Claim III, which related to the distribution issue was contained in this opinion.
[23] Id. at 458.  See also Official Code of Georgia Annotated sec. 14-2-91.
[24] Id. at 460.