On December 9, 2002, UAL Corporation, which operated as United Airlines, filed for bankruptcy protection, leading to huge losses by UAL’s creditors. Those creditors included UAL’s pensioners when UAL’s pension plans were terminated and taken over by the Pension Benefit Guaranty Corporation, which guarantees a much lower level of benefits than United had agreed to pay. Yet in the five years before the bankruptcy, UAL paid out more than $1.2 billion to shareholders in dividends and share buybacks. The shareholders kept that money despite the losses to others.
A long-held view in the academy is that shareholders are ‘residual claimants’ in the sense that they are paid in full only after the corporation pays its creditors.
In my recent paper, ‘The Social Costs of Dividends and Share Repurchases’, available here, I demonstrate that the reality is far different. Corporations give away significant assets to their shareholders in the form of dividends and share repurchases long before they have satisfied creditors, both voluntary contract creditors and involuntary tort creditors. Existing law is quite permissive in allowing indebted corporations to distribute this cash to shareholders. As a result, shareholders are hardly ‘last paid’ capital providers of corporate-law folklore but rather ‘first-in, first-out, and then some’ capital providers. They receive their capital back and much more while the corporation has often very large liabilities outstanding.
From the shareholders’ perspective, this behavior is optimal. When payouts to shareholders reduce the value of corporate equity by less than the amount paid, shareholders are better off, since creditors bear some of the costs of the payout but receive nothing in return. Shareholders take the sure dollars today in dividends and share repurchases because it is rational to do so, and they almost never have to settle up with creditors before walking away with the residual.
Two kinds of law purport to protect corporate creditors from excessive dividends and share repurchases, but both are weak. The first forbids dividends and share repurchases when a corporation is insolvent. But creditors have no direct remedy against recipients of dividends and the proceeds of share repurchases, and the corporation can only recover from recipients with insufficient notice of the payments’ illegality. The second is voidable transfer law, which allows creditors to recover dividends and amounts paid for shares when the corporation is insolvent, unable to pay its debts as they come due, or inadequately capitalized. But creditors cannot easily enforce such laws outside bankruptcy, because the creditor typically must enforce voidable transfer law on behalf of all creditors and has no clear means of being paid for its efforts since funds are returned to the debtor. Both types of law use insolvency or near-insolvency (inadequate capitalization) to trigger creditor protections. But by the time a corporation is insolvent or near insolvency and the law no longer allows dividends and share repurchases, it usually is too late. The corporation has paid out sometimes massive amounts that might otherwise have gone to satisfy creditor claims.
The issue of share repurchases recently has captured the attention of United States senators on both sides of the aisle, with Senate Minority Leader Chuck Schumer, D-NY, Senator Bernie Sanders, I-VT., and Senator Marco Rubio, R-FL, each proposing legislation limiting share repurchases and dividends. One need not agree with all parts of the Sanders-Schumer plan to acknowledge that excessive dividends and share repurchases can have severe negative social consequences.
First, they dramatically increase the riskiness of corporate debt, diverting resources into credit monitoring and credit speculation. Voluntary creditors must charge a high price for credit ex ante – subsidized by tax payers through interest expense deductions – to protect them from the ex post effects of the existing legal regime, and many resources are spent on monitoring and trading on the fluctuating risks of default and only partial recovery on corporate debt. Second, the existing legal regime requires a bankruptcy system to process large and complex corporate failures. Third, it leaves firms less resilient to financial crises. Fourth, it unfairly shifts costs to involuntary and unsophisticated creditors in violation of the implicit social bargain of limited liability. Finally, it distorts the supply of securities toward riskier debt that is publicly subsidized through the deductibility of interest, reducing the supply of safer assets.
One possible solution that deserves further study is restricting dividends and share repurchases to corporations that have low debt and adequate insurance against harm to involuntary creditors and pay reasonable wages and benefits. Such a rule would still allow corporations with high debt, little insurance, and low wages and benefits to operate, but they could pay shareholders only after meeting all their other obligations.
J.B. Heaton is the founder of J.B. Heaton Research LLC and J.B. Heaton, P.C.
This contribution was initially published by the CSL Blue Sky blog and is available here.