Designing efficient dividend recapitalization legislation

(1)

Master Thesis

Universiteit van Amsterdam

Designing efficient dividend recapitalization legislation

Student: V.R. Wilhelm

E-mail: vincent.r.wilhelm@gmail.com Student number: 10774459

Mastertrack: Law & Finance

Supervisors: Dhr. dr. J.E. Ligterink & Dhr. prof. mr. dr. M.G.C.M. Peeters Date: 22 July 2020

(2)

Abstract

This thesis examines dividend recapitalization legislation for Private Equity (PE) firms. Dividend recapitalizations by PE firms are criticized as an aggressive financial engineering tool that does not add value, but increases insolvency risk resulting in externalities. Financial theory and academic research on dividend recapitalizations create a more nuanced picture. Dividend recapitalizations can be effective tools in creating value for portfolio companies through tax benefits and managerial incentive benefits.

Academic research shows that PE firms are skilled at managing highly leveraged portfolio companies and, on average, insolvency risk does not increase following a dividend

recapitalization. For these reasons, legislation should not be overly strict in deterring

dividend recapitalizations. However, dividend recapitalizations can result in insolvency and cause redistributions of value among stakeholders creating externalities. Legislation should be able to deter these inefficient dividend recapitalizations as much as possible. This thesis examines what elements are necessary to design efficient dividend recapitalization legislation that deters undesired dividend recapitalizations leading to externalities without being overly strict on value-increasing dividend recapitalizations. By comparing legislation regarding dividend recapitalizations in the United States, United Kingdom and the Netherlands and performing case studies of dividend recapitalizations in each of these jurisdictions, lessons and insights will be derived on what the necessary elements are to design efficient dividend recapitalization legislation.

From the examined case studies it follows that directors’ liability should be assessed through a distribution test which focuses on the continuity of the portfolio company and where the specific circumstances of the transaction dictate whether the dividend recapitalization was unlawful. Directors’ liability should be extended to the backing PE firm and fund when it plays a role in setting the policy of the portfolio company or when it knowingly received an unlawful distribution. This knowledge should be presumed when the PE firm is the majority shareholder of the portfolio company. The “asset stripping” rule of the European AIFMD cannot be considered part of efficient dividend recapitalization legislation as it would deter value-increasing dividend recapitalizations and is not effective at deterring externalities. Transaction avoidance laws should focus on the specific circumstances of the dividend recapitalization to determine whether and what kind of role it played in the portfolio

(3)

company’s insolvency. There should not be a strict time limit on the ability of the trustee to annul such a transaction and a presumption should be present that the dividend

recapitalization caused the insolvency if it took place in the year prior to insolvency. Key words: dividend recapitalization, private equity, directors’ liability, asset stripping

(4)

Assets under management in global private markets reached an all-time high of $6.5 trillion in 2019 of which $3.9 trillion was managed by Private Equity (PE) firms.1_{Since 2000, the} global PE net asset value has grown more than eightfold, which is three times higher than the growth of the public market capitalization, as investors continue to shift capital from public markets in the search for higher returns.2_{As PE firms are playing a larger role in the}

international corporate world3_{, it is important to understand the implications of tools used by} PE firms. One of those tools, the dividend recapitalization, has been used more frequently in 2019 to take advantage of the higher supply in debt markets due to lower interest rates.4 A recapitalization is a transaction that changes the capital structure of a company.5_{In a} leveraged recapitalization a company takes on an amount of debt and uses the proceeds to repurchase shares or pay dividends to its shareholders.6_{A leveraged recapitalization where} capital is distributed to the company’s shareholders through dividends is known as a dividend recapitalization.

Dividend recapitalizations used by PE firms are a controversial financial tool.7_{Having a} portfolio company issue large amounts of debt to be able to pay dividends to shareholders 1_{Alejandro Beltran de Miguel and others, ‘A new decade for private markets: McKinsey Global Private}

Markets Review 2020’[2020] 16

<https://www.mckinsey.com/~/media/mckinsey/industries/private%20equity%20and%20principal%20investors /our%20insights/mckinseys%20private%20markets%20annual%20review/mckinsey-global-private-markets-review-2020-v4.ash> accessed 2 April 2020

2_{Ibid 5 and 17}

3_{Jason Kelly, ‘Everything Is Private Equity Now’ (Bloomberg, 8 October 2018)}

<https://www.bloomberg.com/news/features/2019-10-03/how-private-equity-works-and-took-over-everything> accessed 16 April 2020

4_{John Gilligan and Mike Wright, Private Equity Demystified (ICAEW Corporate Finance Faculty, 3}rd_edn, 2014) 87; Unknown, ‘Dividend recapitalizations are back on the rise’ (Private Equity International, 10 July 2019) <https://www.privateequityinternational.com/dividend-recapitalisations-back-rise/> accessed on 18 April 2020; Robert Smith, ‘Why Wall Street is cheering the return of the ‘divi recap’ (Financial times, 2 May 2019) <https://www.ft.com/content/443572f6-6c16-11e9-80c7-60ee53e6681d> accessed on 18 April 2020

5_{Jonathan Berk and Peter DeMarzo, Corporate Finance (4th edn, Pearson 2016) 560} 6_Ibid

7_{Abhinav Ramarayan, ‘Divisive ‘dividend recap’ deals return in red hot debt market’, (Reuters, 22 January} 2020) < https://www.reuters.com/article/us-europe-debt-dividendrecap/divisive-dividend-recap-deals-return-in-red-hot-debt-market-idUSKBN1ZL27A> accessed on 18 April 2020; Adam Lewis, ‘PE firms keep deploying dividend recaps despite the risks’ (PitchBook, 15 August 2019) < https://pitchbook.com/news/articles/pe-firms-keep-deploying-dividend-recaps-despite-the-risks> accessed on 18 April 2020 ; Kenneth Hackel, ‘How Dividends Can Destroy Value’ (Forbes, 13 December 2013)

<https://www.forbes.com/sites/kenhackel/2010/12/13/how-dividends-can-destroy-value/#61f4baa64a04> Accessed on 18 April 2020; David Tol, ‘In Defense of ‘Greedy, Parasitic, Transactions’ (PE Hub, 15 March

(6)

increases insolvency risk and could be a way for PE firms to redistribute value from other stakeholders of the company. However, there are some indicators that dividend

recapitalizations can help increase the total value of a portfolio company.

As dividend recapitalizations are a controversial tool with potentially both positive and negative consequences, it has to be examined whether and how legislation should be adapted to police these transactions. In this thesis, the following research question will be answered:

What are necessary elements for efficient dividend recapitalization legislation?

To answer this question, it is important to understand the consequences and potential threats a dividend recapitalization has on a portfolio company and the extent to which legislation is necessary and desirable. This thesis adds on the international academic literature on the redistributive effects of PE investments on the stakeholders of a company8_{and the increased} use of debt by PE firms9_{as a tool for value creation}10_{by examining what role legislation} should play in these transactions.

The thesis continues as follows. In section 2, the use of dividend recapitalization by PE firms is described, followed by the criticisms and the theoretical justification of the dividend recapitalization tool. Section 2 will conclude with the definition of efficient dividend

2012) <https://www.pehub.com/in-defense-of-greedy-parasitic-transactions/> accessed on 18 April 2020; Robert Smith, ‘Why Wall Street is cheering the return of the ‘divi recap’ (Financial times, 2 May 2019) <https://www.ft.com/content/443572f6-6c16-11e9-80c7-60ee53e6681d> accessed on 18 April 2020

8_{See: Jarrad Harford and Adam C. Kolasinski, 'Do Private Equity Returns Result From Wealth Transfers And} Short-Termism? Evidence From A Comprehensive Sample Of Large Buyouts' [2012] SSRN Electronic Journal < https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1785927> accessed 16 May 2020; Jeroen E. Ligterink, Jens K. Martin and Arnoud W.A. Boot, ‘Private Equity in the Netherlands: Value Creation, Redistribution and Excesses’ [2017] Faculty of Economics and Business

<https://pure.uva.nl/ws/files/19952764/PE_UvA_private_equity_FINAL_Nov15_2017_for_distribution_Eng.pd f> accessed on 15 May 2020

9_{Alejandro Beltran de Miguel and others, ‘A new decade for private markets: McKinsey Global Private} Markets Review 2020’[2020] 22

<https://www.mckinsey.com/~/media/mckinsey/industries/private%20equity%20and%20principal%20investors /our%20insights/mckinseys%20private%20markets%20annual%20review/mckinsey-global-private-markets-review-2020-v4.ash> accessed 2 April 2020

10_{See: Steven N. Kaplan and Per Johan Strömberg, 'Leveraged Buyouts And Private Equity' [2008] SSRN} Electronic Journal 13 < https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1194962> accessed 22 May 2020; Rongbing Huang, Jay R. Ritter and Donghang Zhang, 'Private Equity Firms’ Reputational Concerns And The Costs Of Debt Financing' [2013] SSRN Electronic Journal <

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2205720> accessed 1 May 2020; Jonathan B. Cohn, Lillian F. Mills and Erin M. Towery, 'The Evolution Of Capital Structure And Operating Performance After Leveraged Buyouts: Evidence From U.S. Corporate Tax Returns' (2014) 111 Journal of Financial Economics; Eileen Appelbaum and Rosemary L Batt, Private Equity At Work (Russell Sage Foundation 2014) 266 and further

(7)

recapitalization legislation and what it must intend to achieve. Section 3 shows a comparative legal review of legislation regarding dividend recapitalizations in large PE markets in the western world, namely the United States, the United Kingdom and the Netherlands. In section 4, the workings of the legislations in practice will be examined through several case studies in the respective jurisdictions. From these case studies, lessons and insights will be derived on how the international financial and legal literature relates to these particular case studies of dividend recapitalizations and what other considerations are involved for private equity firms when considering a dividend recapitalization. These lessons and insights will lead to the formulation of the necessary elements for efficient dividend recapitalization legislation in section 6. Thereafter, a conclusion and possible considerations for further studies will follow.

(8)

2. The uses, criticism and justifications of dividend recapitalizations

This section explains why dividend recapitalizations are an interesting tool for PE firms. Thereafter, the criticism of this tool will be discussed followed by the theoretical justification for the use of dividend recapitalizations. The section ends with a definition of efficient dividend recapitalization legislation.

2.1. Uses of dividend recapitalizations for Private Equity Firms

To understand why the dividend recapitalization tool is useful for PE firms, it is important to develop a basic understanding of the workings of a PE firm.

According to Ligterink, Martin and Boot, “Private equity is risk-bearing capital invested by private equity funds in what are ultimately non-listed companies.”11_{The objective of a PE} fund is to buy equity stakes in companies, actively managing those companies and

subsequently realizing the value created by selling the equity stake.12_{The companies a PE} fund invests in are known as the portfolio companies. The PE fund is managed by a PE firm. Depending on the size and maturity of the companies a PE firm typically invests in, a PE firm can be classified as a venture capital firm, a growth capital firm or a buyout firm.13_{The PE} firm creates the PE fund. A PE fund has a pre-determined, finite term of usually around ten years.14_{The PE fund is injected with some capital from the PE firm itself, as general partner} (GP). However, the majority of the capital is provided by outside investors, such as pension funds, wealthy individuals or other institutional investors, known as the limited partners (LPs). The long-term and irrecoverably committed capital of the PE fund, often combined with substantial amounts of debt obtained from outside banks or financiers15_{, allows the PE}

11_{Jeroen E. Ligterink, Jens K. Martin and Arnoud W.A. Boot, ‘Private Equity in the Netherlands: Value}

Creation, Redistribution and Excesses’ [2017] Faculty of Economics and Business 1

12_{John Gilligan and Mike Wright, Private Equity Demystified (3rd edn, ICAEW Corporate Finance Faculty} 2014) 14

13_{John Gilligan and Mike Wright, Private Equity Demystified (3rd edn, ICAEW Corporate Finance Faculty} 2014) 14-15

14_{Stefan Povaly, Private Equity Exits (1st edn, Springer 2007) 37}

(9)

fund to make substantial investments in portfolio of companies for a four to six year investment horizon.16

It is the PE fund’s intention to achieve a return on its investments by increasing capital growth and shareholder value.17_{According to Ligterink, Martin and Boot, “the private equity} fund obtains a return for its investors by improving a portfolio company’s operational

efficiency, revising its strategic focus, improving the portfolio company’s governance structure, enhancing the portfolio company’s capital structure through financial engineering, selecting undervalued companies for their investment and timing the market correctly.”18 After the PE fund tries to extract additional value from these sources during a portfolio company’s holding period, the PE fund will achieve a return on its investment which can be distributed to its limited and general partners.

The PE fund will want to monetize the increase in value and transfer part of it to its limited partners through an exit.19_{In a traditional exit the equity stake of the portfolio company will} be sold through a trade sale, a secondary buyout or an initial public offering (IPO).20_{In a} trade sale, the portfolio company is sold to a strategic acquirer, usually a competitor or

conglomerate trying to increase market share or extract synergies. A secondary buyout occurs when a PE fund sells the portfolio company to another, possibly larger, PE fund. It is also possible that the buying PE fund is better suited to extract more value from the company or that the selling PE fund has to sell due to the expiration of the fund’s term and transfers the investment to another PE fund. In an IPO the PE fund lists the portfolio company on the public stock market and can sells its shares in the portfolio company through this stock market.

However, it is also possible for the PE fund to earn a return on its investment before exiting the portfolio company. The PE fund can charge monitoring, transaction and arrangement fees

17_{Ibid 14}

18_{Jeroen E. Ligterink, Jens K. Martin and Arnoud W.A. Boot, ‘Private Equity in the Netherlands: Value} Creation, Redistribution and Excesses’ [2017] Faculty of Economics and Business 3-4

19_{Harold Kent Baker, Greg Filbeck and Halil Kiymaz, Private Equity: Opportunities And Risks (Oxford} University Press 2015) 216

(10)

to portfolio companies to compensate for their costs in undertaking investments and

monitoring or advising the specific portfolio companies.21_{The PE fund can also profit from} the portfolio companies before the exit by receiving (significant) interest payments on shareholder loans provided to the portfolio companies.22_{Furthermore, the PE fund can} receive a distributions from its portfolio companies through ordinary or preferred dividends.23 If a portfolio company does not have cash available for a dividend, the PE fund wants to distribute more cash than is currently available in the portfolio company or wants to maintain the portfolio company’s current cash position while still receiving a dividend, the PE fund can perform a dividend recapitalization. By issuing new debt, the portfolio company obtains cash which it can distribute to shareholders through a special dividend payment.24_This allows the PE fund to regain (a part of or even more than) the invested capital before the exit of the portfolio company and remain in control of the company. This monetization reduces the PE fund’s equity exposure25_{, it accelerates cash returning from the investment and} increases the Internal Rate of Return (IRR) of the fund. Although some academics consider this the worst performance metric used in an investment context26_{, IRR is the standard metric} to evaluate PE returns and is often used to calculate the compensation of the PE firm.27

Finally, a dividend recapitalization allows the firm to make better use of its tax shield and can create a more efficient governance structure, as will be discussed further in section 2.3.

2.2. Criticism of dividend recapitalizations

PE firms are often criticized in the international press.28_{Because the PE fund has to realize a} profitable exit on a portfolio company within approximately four to six years, the investment

22_{Jeroen E. Ligterink, Jens K. Martin and Arnoud W.A. Boot, ‘Private Equity in the Netherlands: Value} Creation, Redistribution and Excesses’ [2017] Faculty of Economics and Business 12

24_{Jonathan Berk and Peter DeMarzo, Corporate Finance (4th edn, Pearson 2016) 560} 25_{Stefan Povaly, Private Equity Exits (1st edn, Springer 2007) 125}

26_{Ludovic Phalippou, 'The Hazards Of Using IRR To Measure Performance: The Case Of Private Equity'} [2008] SSRN Electronic Journal 15 < https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1111796> accessed 20 May 2020

27_{Ibid 3}

(11)

strategy of PE firms is often criticized for being focused on the short-term.29_{Although this} critique is been disproven in academic literature30_{, as will be discussed further in section 2.3,} the supposed short-term focus of PE firms resulted in them being described as follows by a German politician in 200431_:

“[PE firms act as] irresponsible locust swarms, who measure success in quarterly intervals,

suck off substance and let companies die once they have eaten them away.”

The locust-analogy is still used to describe the PE industry.32_{The practice of leveraging} portfolio companies with the purpose of immediately paying out a dividend to the PE fund itself does not help the reputation of the PE industry.33

The practice of leveraging portfolio companies by PE firms is a heavily debated topic and has sparked (discussions on) legislative proposals in the Netherlands34_{and the United States}35_in recent years, following an earlier investigation into the industry by the United Kingdom’s House of Commons Treasury Committee.36_{The dividend recapitalization tool is targeted as} one of the problems regarding PE firms37_{, with former Fortune writer Dan Primack}

29_{John Gilligan and Mike Wright, Private Equity Demystified (3rd edn, ICAEW Corporate Finance Faculty}

2014) 17; Per Johan Strömberg, Edith S. Hotchkiss and David C. Smith, 'Private Equity And The Resolution Of Financial Distress' [2014] SSRN Electronic Journal 5

<https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1787446> accessed 20 May 2020

30_{Jarrad Harford and Adam C. Kolasinski, 'Do Private Equity Returns Result From Wealth Transfers And} Short-Termism? Evidence From A Comprehensive Sample Of Large Buyouts' [2012] SSRN Electronic Journal 30

< https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1785927> accessed 16 May 2020 31_{Marcus Walker, ‘German Party Calls Investors ‘Locusts’(Wall Street Journal, 2 May 2005)} <https://www.wsj.com/articles/SB111498371843621593> accessed on April 15 2020 32_{Robert Landgraf, ‘Return of the Locusts’ (Handelsblatt, 4 December 2017)}

<https://www.handelsblatt.com/today/opinion/private-equity-return-of-the-locusts/23568802.html> accessed on 19 April 2020; Jason Kelly, ‘Private Equity’ (The Washington Post, 1 October 2019)

< https://www.washingtonpost.com/business/private-equity/2019/10/01/c602ccc8-e440-11e9-b0a6-3d03721b85ef_story.html> accessed on 20 April 2020

33_{Kenneth Hackel, ‘How Dividends Can Destroy Value’ (Forbes, 13 December 2013)}

<https://www.forbes.com/sites/kenhackel/2010/12/13/how-dividends-can-destroy-value/#61f4baa64a04> accessed on 18 April 2020

34_{Henk Nijboer and Ed Groot ‘Parlementaire monitor: 34 267 Initiatiefnota van de leden Nijboer en Groot over} private equity: einde aan de excessen’[2015] 12

<https://www.tweedekamer.nl/debat_en_vergadering/commissievergaderingen/details?id=2016A00137> accessed 20 May 2020

35_{Stop Wall Street Looting Act 2019}

36_{House of Commons Treasury Committee ‘Private Equity – Tenth Report of Session 2006-07’ [2007]} <https://publications.parliament.uk/pa/cm200607/cmselect/cmtreasy/567/567.pdf> accessed 20 May 2020

37_{Per Johan Strömberg, Edith S. Hotchkiss and David C. Smith, 'Private Equity And The Resolution Of}

Financial Distress' [2014] SSRN Electronic Journal 5

(12)

describing dividend recapitalizations as Private Equity’s worst enemy.38_{It is argued that the} increased interest payments from (among others) the dividend recapitalization and the following payout leaves the portfolio company with reduced cash flow. The reduced cash flow prevents the portfolio company from undertaking future opportunities for growth39_and diminishes the portfolio company’s chances of survival in an economic downturn.40_The financial flexibility of the portfolio company is reduced by the dividend recapitalization, increasing insolvency risk and leading to possible externalities.41_{Allegedly, PE firms} redistribute value at the expense of employees, creditors, suppliers, tax authorities and society.42_{The debt used in PE transactions causes these stakeholders and society to bear an} increased insolvency risk, without being compensated for this increased insolvency risk in some cases.43_{When it is not possible for stakeholders to adjust their prices or interest rates to} the increased insolvency risk resulting from the increased leverage set by the shareholder of a portfolio company, i.e. the PE fund, it can be said that the redistribution at the expense of these non-adjusting stakeholders are externalities of the PE investment.44_{The PE fund does} not internalize the full cost of the increased insolvency risk of the portfolio company, but is able to redistribute this risk to the non-adjusting stakeholders.

Stakeholders that could see their position diminish following a dividend recapitalization are a portfolio company’s employees, creditors, suppliers, tax authorities and society as a whole.45 As discussed, the dividend recapitalization causes interest payments of the portfolio company

38_{Linette Lopez, ‘DAN PRIMACK: Here's The Private Equity Industry's Worst Enemy’ (Business Insider, 28} May 2012) < https://www.businessinsider.com/dan-primack-heres-the-private-equity-industrys-worst-enemy-2012-3?international=true&r=US&IR=T> accessed 20 May 2020

39_{Stop Wall Street Looting Act 2019 4}

40_{Henk Nijboer and Ed Groot ‘Parlementaire monitor: 34 267 Initiatiefnota van de leden Nijboer en Groot over} private equity: einde aan de excessen’[2015] 12

<https://www.tweedekamer.nl/debat_en_vergadering/commissievergaderingen/details?id=2016A00137> accessed 20 May 2020

41_{Kenneth Hackel, ‘How Dividends Can Destroy Value’ (Forbes, 13 December 2013)}

<https://www.forbes.com/sites/kenhackel/2010/12/13/how-dividends-can-destroy-value/#61f4baa64a04> accessed on 18 April 2020

43_{Ibid 1}

44_{Rolef J.de Weijs, 'Secured Credit And Partial Priority: Corporate Finance As A Creation Or An} Externalisation Practice?' (2018) 7 European Property Law Journal 69-70

<https://pure.uva.nl/ws/files/19952764/PE_UvA_private_equity_FINAL_Nov15_2017_for_distribution_Eng.pd f> accessed on 15 May 2020; Eileen Appelbaum and Rosemary L Batt, Private Equity At Work (Russell Sage Foundation 2014) 266

(13)

to increase, thereby reducing its cash flow. This reduced cash flow may force the portfolio company to violate longstanding implicit agreements with employees regarding employment terms, duration and pension, it creates increased negotiating power for the portfolio company to renegotiate agreements or defer payments to non-adjusting suppliers and the increased tax shield results in lower tax returns for government authorities.46_{It must be noted that some of} these result could also be viewed as achieving greater efficiency by the PE firm, as will be discussed in section 2.3. When the potential insolvency materializes due to the increased insolvency risk, employee layoffs increase, suppliers lose part of their business, unsecured creditors lose a large part of their claim and tax authorities receive lower tax returns while the government also has to mitigate some of the wealth lost due to the company’s insolvency. Wealth is lost because firm-specific investments made by employees47_{and suppliers}48_{are not} being recovered and claims of non-adjusting creditors and tax authorities are not being repaid. These externalities are a result from the dividend recapitalization.

By extracting a part of (and sometimes even more than) the original equity investment through the dividend recapitalization, the PE firm reduces its own equity exposure in the portfolio company.49_{The dividend recapitalization can be seen as a redistribution where the} PE firms captures the “upside” of a portfolio company prematurely at the detriment of the non-adjusting stakeholders in the company.50_{This is a redistribution of value in the form of a} redistribution of insolvency risk. PE firms pride themselves with being able to obtain superior returns for their limited partners.51_{However, when this return is achieved by shifting the risk} of their investments to other stakeholders of the portfolio companies, the risk-bearing nature of the PE fund’s capital is reduced and the PE firm can be said to expropriate non-adjusting stakeholders.

46_{Eileen Appelbaum and Rosemary L Batt, Private Equity At Work (Russell Sage Foundation 2014), 266} 47_{Margaret M. Blair and Lynn A. Stout, 'A Team Production Theory Of Corporate Law' (1999) 85 Virginia Law} Review 248-249

48_{Ernan Haruvy and others, 'Relationship-Specific Investment And Hold-Up Problems In Supply Chains:} Theory And Experiments' (2018) 12 Business Research 46

49_{Stefan Povaly, Private Equity Exits (1st edn, Springer 2007) 114}

50_{Elizabeth Warren, ‘End Wall Street’s Stranglehold On Our Economy’ (Medium, 18 July 2018)}

<https://medium.com/@teamwarren/end-wall-streets-stranglehold-on-our-economy-70cf038bac76> accessed 1 May 2020

(14)

From this point of view, it is possible to think that PE firms redistribute wealth through dividend recapitalizations without taking possible externalities into consideration. However, as will be discussed in the next section, the increased leverage can also be beneficial and add value to a portfolio company.

2.3. Justifications of dividend recapitalizations

According to Milton Friedman, the objective of a company is to maximize profit or market value. As the management of a company is an agent of the owners of the company, the shareholders, management has a direct responsibility to conduct the business in accordance with the shareholders’ desires. The desire of shareholders will most likely be to maximize the value of their shares while adhering to ethical and legal rules of society.52_{The company,} according to Friedman, should not be concerned with social responsibilities, as the shareholders will have other means of achieving their social desires.

As previously discussed, financial engineering is one of the main techniques through which a PE firm tries to generate a return for its investors.53_{The PE firm has specific expertise and} experience to develop a superior capital structure for the portfolio company, i.e. the

optimization of leverage.54_{Although leveraging portfolio companies is sometimes considered} to only improve the returns of the PE fund, increased leverage can add value to a portfolio company. Modigliani and Miller proposed an answer to the question of how to set the ideal capital structure.

The first Modigliani-Miller proposition states that, in perfect capital markets, the market value of any firm is independent of its capital structure.55_{In perfect capital markets, a}

52_{Milton Friedman, ‘The Social Responsibility of Business Is to Increase Its Profits’ The New York Times}

Magazine (New York, 13 September 2017) and Anant K. Sundaram and Andrew C. Inkpen, 'The Corporate

Objective Revisited' (2004) 15 Organization Science 351-352

53_{Steven N. Kaplan and Per Johan Strömberg, 'Leveraged Buyouts And Private Equity' [2008] SSRN Electronic} Journal 13 < https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1194962> accessed 22 May 2020; Dawn Lim, ‘Lim’s Take: More Private Equity Firms Turn to Financial Engineering to Unlock Cash’ (WSJ Pro Private Equity, 9 August 2018) < https://www.wsj.com/articles/lims-take-more-private-equity-firms-turn-to-financial-engineering-to-unlock-cash-1533814200> accessed 12 May 2020

55_{Franco Modigliani and Merton Miller, ‘The Cost of Capital, Corporation Finance and the Theory of} Investment’(1958) 48(3) American Economic Review 268

(15)

dividend recapitalization does not change the overall value of the company. The dividend payment will simply reduce the value of existing shares, while debt is added to the balance sheet. The second Modigliani-Miller proposition states that the required return on levered equity increases when the portfolio company’s debt-to-equity ratio increases.56_Although returns increase with leverage, no actual value is created as the risk of the underlying cash flows to shareholders has increased and with that the required rate of return to compensate for this higher risk. However, when we relax the perfect capital markets assumption of the

Modigliani-Miller propositions, the increased leverage can actually create value for the shareholders.

Tax benefits

Leverage can increase the present value of a portfolio company through its ability to reduce tax payments. If interest payments are (partially) tax deductible, as is the case in most

jurisdictions, interest payments on debt reduce a company’s earnings before taxes (EBT) and therefore lowers the taxable profit of the company. The reduction in payable taxes is known as the interest tax shield.57_{The interest tax shield increases the cash flows of a company and} increases the present value of a levered company compared to the unlevered company.58_This increased present value can be distributed to the shareholder through a leveraged

recapitalization or can be realized at the moment that the PE fund liquidates the investment through an exit.59

Agency benefits of debt

The second way in which leverage can increase value for shareholders is the disciplining effect of debt on the management of a company, known as agency benefits. PE firms try to improve the portfolio company’s governance structure by aligning their incentives with that of management through renumeration and by playing a more active role within the board of directors of a portfolio company.60_{Another way for a PE firm to discipline a portfolio} company’s management is by reducing its cash flow.61_{According to the control hypothesis,} cash flows in excess of what is needed to make positive net present value (NPV) investments

56_{Ibid 271}

57_{Jonathan Berk and Peter DeMarzo, Corporate Finance (4th edn, Pearson 2016) 553} 58_{Ibid 554}

59_{Ibid 562}

60_{Steven N. Kaplan and Per Johan Strömberg, 'Leveraged Buyouts And Private Equity' [2008] SSRN Electronic} Journal, 13 < https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1194962> accessed 22 May 2020

(16)

allows managers to engage in wasteful spending and reduces the value of the company.62 Leverage can be used to counter this wasteful spending and motivates managers to run the firm as efficiently as possible.

Financial Distress Cost of debt

One of the previously discussed criticisms of increases in leverage is that it increases the probability of insolvency or financial distress risks of the portfolio company. The higher debt increases the possibility of the portfolio company not being able to meet its debt

commitments and reduces the value of the company in an amount equal to the present value of the expected financial distress costs of the company.63

Agency costs of debt

Increasing leverage can also create agency costs. These costs arise when there is a conflict of interest between stakeholders.64_{When a portfolio company faces financial distress, the PE} firm can benefit at the expense of creditors by increasing the risk of the portfolio company’s operations (risk shifting), by refusing to invest more fund capital or cash of the portfolio company in the portfolio company’s positive NPV projects as the upside would be received by the creditors (debt overhang) and by withdrawing as much cash as possible from the firm through, for example, a super dividend (cashing out).65_{However, because creditors are aware} of these possible actions by the shareholders of a company, the creditors will adjust the terms of their loan accordingly if possible.66_{This reduces the present value of a portfolio company} to the shareholders.67

When setting the optimal level of leverage, the tax and agency benefits have to be weighed against the financial distress and agency costs to maximize the value of the corporation.68 This is known as the trade-off theory.69

62_{Michael C. Jensen, ‘Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers’ (1986) 79} American Economic Review 323-324

63_{Stewart C. Myers, 'The Capital Structure Puzzle' (1984) 39 The Journal of Finance 581} 64_{Jonathan Berk and Peter DeMarzo, Corporate Finance (4th edn, Pearson 2016) 597} 65_{Ibid 597-599}

66_{Ibid 600}

67_{Stewart C. Myers, 'The Capital Structure Puzzle' (1984) 39 The Journal of Finance 580} 68_{Stewart C. Myers, 'The Capital Structure Puzzle' (1984) 39 The Journal of Finance 577} 69_Ibid

(17)

Leverage management by PE firms

Managing high amounts of debt is a core skill of PE firms.70_{Although portfolio companies} managed by PE firms are more likely to default (4.9% for PE portfolio companies, 3.6% for non PE backed companies), when controlled for leverage, there is no difference between default estimates.71_{In studies focusing on the U.K.}72_{individually and Europe}73_{as a whole,} there is no notable difference between the insolvency risks of portfolio companies and companies without PE backing. Furthermore, evidence shows that for companies with higher levels of leverage, PE portfolio companies are less likely to default than non-PE backed firms.74_{The probability of default of PE portfolio companies does not increase on average} following a dividend recapitalization. Under some circumstances, PE portfolio companies having engaged in a dividend recapitalization even have a lower probability of default compared to non PE backed companies, suggesting that recapitalizations are undertaken in better performing portfolio companies.75_{Huang, Ritter and Zuang examine whether they can} find evidence for a wealth expropriation hypothesis, where PE firms are able to expropriate bondholders due to their incentives and power as a shareholder.76_{As PE firms use leverage in} multiple portfolio companies, it is likely that PE firms transact with a group of creditors repeatedly. When it is clear that the PE firm is redistributing wealth from groups of creditors, these creditors will adjust their prices to account for this fact. These reputational concerns of PE firms prevent them from expropriating creditors of portfolio companies77_{, thereby}

reducing the agency cost of debt. Finally, Harford and Kolanski find evidence to disprove the short-term hypothesis that states that PE firms increase short-term profits at the cost of

70_{Ludovic Phalippou and Peter Morris, 'Thirty Years After Jensen’S Prediction – Is Private Equity A Superior} Form Of Ownership?' [2019] SSRN Electronic Journal 17

<https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3495465> Accessed 13 May 2020

71_{Per Johan Strömberg, Edith S. Hotchkiss and David C. Smith, 'Private Equity And The Resolution Of} Financial Distress' [2014] SSRN Electronic Journal 14

<https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1787446> accessed 20 May 2020

72_{Mike Wright and others, 'Financial Restructuring And Recovery In Private Equity Buyouts: The UK} Evidence' [2014] 16 Venture Capital 122

73_{Tereza Tykvová and Mariela Borell, 'Do Private Equity Owners Increase Risk Of Financial Distress And}

Bankruptcy?' (2012) 18 Journal of Corporate Finance 145

74_{Per Johan Strömberg, Edith S. Hotchkiss and David C. Smith, 'Private Equity And The Resolution Of} Financial Distress' [2014] SSRN Electronic Journal 16

<https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1787446> accessed 20 May 2020 75_Ibid

76_{Rongbing Huang, Jay R. Ritter and Donghang Zhang, 'Private Equity Firms’ Reputational Concerns And The} Costs Of Debt Financing' [2013] SSRN Electronic Journal 1 <

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2205720> accessed 1 May 2020 77_{Ibid 16}

(18)

creating long term value by forgoing valuable long-term investments.78_{It must be noted that} Harford and Kolanski do not consider stakeholders without financial claims, such as workers, suppliers or customers.79_{Combining these findings with the PE firms’ ability to achieve} higher or equal returns compared to the public equity benchmark80_{and creating economic} value on average81_{, it could be argued that the use of leverage and dividend recapitalizations} by PE firms might not be such a problem as portrayed in the press and it can therefore be questioned whether new legislation regarding PE firms would be necessary.

The evidence above shows that PE firms can have added value and could have advantages as an ownership structure.82_{However, shareholder value maximization as a desirable objective} of the company has been questioned. Friedman’s assumption that money making activities can be completely separated from unethical activities and can be offset by a shareholder through engaging in socially desirable activities is doubted.83_{Furthermore, legal rules have} not always proven to be completely efficient at directly deterring externalities by

companies.84_{Other objectives of the company have been offered. The stakeholder theory} states that the objective of a company is to serve the interest of all stakeholders in the firm.85 As non-adjusting employees, consumers, creditors, suppliers, tax authorities and society are vulnerable to expropriation, due to the incompleteness of contracts, they should be taken into consideration when taking business decisions.86_{Other possible objectives of the firm include}

78_{Jarrad Harford and Adam C. Kolasinski, 'Do Private Equity Returns Result From Wealth Transfers And} Short-Termism? Evidence From A Comprehensive Sample Of Large Buyouts' [2012] SSRN Electronic Journal 4

< https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1785927> accessed 16 May 2020 79_{Ibid 1}

80_{Ludovic Phalippou and Peter Morris, 'Thirty Years After Jensen’S Prediction – Is Private Equity A Superior} Form Of Ownership?' [2019] SSRN Electronic Journal 23

<https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3495465> Accessed 13 May 2020

81_{Steven N. Kaplan and Per Johan Strömberg, 'Leveraged Buyouts And Private Equity' [2008] SSRN Electronic} Journal 13 < https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1194962> accessed 22 May 2020

83_{Oliver Hart and Luigi Zingales, 'Companies Should Maximize Shareholder Welfare Not Market Value' (2017)} 2 Journal of Law, Finance, and Accounting 249

84_Ibid

85_{Wesley Cragg, 'Business Ethics And Stakeholder Theory' (2002) 12 Business Ethics Quarterly 115}

86_{Oliver Hart and Luigi Zingales, 'Companies Should Maximize Shareholder Welfare Not Market Value' (2017)} 2 Journal of Law, Finance, and Accounting 251

(19)

the shareholder welfare theory87_{and the enlightened value maximization theory.} 88_{From a} stakeholders approach, the use of dividend recapitalizations might be less desirable than under Friedman’s model. As previously discussed, the increase in leverage will reduce wasteful spending and PE firms are skilled at handling the leverage in such a way as to not jeopardize the portfolio companies or their reputation among adjusting creditors with whom it is likely they will have repeated interactions. However, the reduction in cash flow might have negative effects on other non-adjusting stakeholders resulting in externalities.

2.4. Implications of dividend recapitalizations for legislation

The analysis above shows a mixed view regarding the use of dividend recapitalizations by PE firms. From a conventional economic perspective of maximizing value, dividend

recapitalizations certainly have their uses and can increase managerial motivation, tax benefits and returns for investors. However, it is difficult to differentiate whether this increase in value for the shareholders is at the detriment of other non-adjusting stakeholders of the portfolio company or whether actual value has been created. From a stakeholder perspective, dividend recapitalizations may be detrimental to overall social welfare. More research is needed on the effects that PE investing has on non-adjusting stakeholders of a portfolio company to better understand the severity of the externalities created by PE firms. It is also important to investigate whether legislation could be improved to be more efficient at regulating dividend recapitalizations. The legal system should balance a PE firm’s

capabilities of incentive alignment and leverage management and the wealth lost from undesirable dividend recapitalizations resulting in externalities.

2.5. Defining efficient dividend recapitalization legislation

It follows from the previous section that dividend recapitalizations by PE firms can have both positive and negative consequences for the PE portfolio companies. The fact that the average default probability does not increase after a dividend recapitalization, combined with the theoretical potential for value creation, indicates that the majority of dividend

87_{Ibid 247}

88_{Michael C. Jensen, 'Value Maximization, Stakeholder Theory, And The Corporate Objective Function'}

[2000] SSRN Electronic Journal <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=220671> accessed 26 May 2020.

(20)

recapitalizations can increase the value of the portfolio company. However, it remains possible that due to such a transaction, value is redistributed among stakeholders of the portfolio company, possibly resulting in insolvency and creating externalities. It is therefore important to devise legislation which allows dividend recapitalizations to the extent that they improve the performance of PE portfolio companies, while curbing the possibility of the transaction leading to externalities. Dividend recapitalization legislation can be considered efficient when it is successful at deterring externalities and the loss of welfare that follows, while allowing other dividend recapitalizations to take place, as they can be a useful tool in the creation of value.

To see whether current legislation can be considered efficient, in the next two sections, a comparative review of legislations regarding dividend recapitalizations in the United States, the United Kingdom and the Netherlands follows and it is examined how these legislations function in practice through several case studies in each jurisdiction. Thereafter, it will be assessed what elements are necessary in efficient dividend recapitalization legislation following the lessons and insights derived from the different case studies.

(21)

3. Comparative review of dividend recapitalizations legislation among major private equity markets

Studies show that the legal origin of laws in a country has an effect on investor protection.89 Civil law countries tend to be regulated more heavily than common law countries having adverse impacts on markets, such as greater corruption, larger unofficial economies and higher unemployment. It is argued that common law countries seek to support private market outcomes, while civil law countries tend to replace such outcomes with state desired

allocations.90_{It is therefore interesting to see how the use of dividend recapitalizations is} regulated under Dutch law, having civil law origins, and United States and United Kingdom, having common law origins. Seretakis finds that, due to the introduction of legislation by the European Union, a restrictive legal regime has developed in Europe and the United Kingdom compared to the United States.91_{A brief explanation of the dividend recapitalizations}

legislation in the United States, United Kingdom and the Netherlands follows, after which the different legal systems will be compared and evaluated.

3.1. United States

In the United States, PE firms and their appointed directors have to comply with both federal and state law. Most PE firms are formed as limited partnerships under the Delaware

jurisdiction. Delaware is the preferred choice of jurisdiction for both the PE firm and its portfolio companies as it has a well-developed statutory regime and case law.92

State Law

The Delaware General Corporation Law (DGCL) provides a statutory authority for dividend payments, stock repurchases and redemptions in its legislation.93_{Section 170(a) of the DGCL}

89_{Rafael La Porta, Florencio Lopez-De-Silanes and Andrei Shleifer, “Law and Finance After a Decade of} Research” in G.M. Constantinides, M. Harris and R. M. Stulz (eds), Handbook of the Economics of Finance (Elsevier 2013) 426

90_{Ibid 427}

91_{Alexandros Seretakis ‘A Comparative Examination of Private Equity in the United States and Europe:} Accounting for the Past and Predicting the Future of European Private Equity’ (2013) 18 Fordham J. Corp. & Fin. L. 613

92_{Larry Jordan Rowe and Justin T Kliger, ‘Private equity in United States: market and regulatory overview’} [2018] Thomson Reuters Practical Law 6 <

https://uk.practicallaw.thomsonreuters.com/1-500-5474?transitionType=Default&contextData=(sc.Default)&firstPage=true&bhcp=1> accessed 20 May 2020 93_{Section 173 Delaware General Corporation Law}

(22)

states that the directors of a company may declare and pay dividends upon the shares of its capital stock (i) out of its surplus, defined as the net assets of the company94_{, and (ii) in case} there is no surplus, out of its net profits for the current and/or preceding fiscal year, also known as a “nimble” dividend95_{. However, if the capital of the corporation is lower than the} amount of capital represented having a preference upon the distributions of assets, directors shall not declare and payout net profits until the deficiency has been repaired.

The board of directors is responsible for determining the existence of net assets and may for its determination either (i) rely on the books and financial statements of the corporation if reliance is in good faith or (ii) decide that the aforementioned information does not accurately reflect the value of the corporation and re-value, using acceptable data and standards of which the board believes that reasonably reflect the present value of the assets and liabilities.96_{This gives a board of directors more flexibility to find a surplus. When the} requirements of a lawfully declared dividend are willfully or negligently violated, the directors who declared such a dividend are jointly and severally liable for the full amount of the unlawfully paid dividend at any time within six years after the unlawful dividend

payment.97_{However, the directors are protected from this liability when, in their}

determination of the availability of sufficient funds for a dividend payment, they relied in good faith on the books of the corporation or on reports of officers or outside solvency experts selected with reasonable care.98

Federal law

Another way in which directors can be held liable for a dividend recapitalization is through fraudulent conveyance.99_{When a company completes a dividend recapitalization and}

subsequently becomes insolvent, fails to pay its debts or files for bankruptcy, the creditors of the portfolio company can, through the trustee, file a claim for constructive fraudulent conveyance.100_{When the transaction took place within two years before the filing of the} petition for bankruptcy, less than a reasonably equivalent value was exchanged for such

94_{Section 154 Delaware General Corporation Law}

95_{Richard A. Booth, 'Capital Requirements In United States Corporation Law' [2005] SSRN Electronic Journal} 20 <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=864685> accessed on 9 July 2020

96_{Klang v. Smith's Food and Drug Centers Inc., 702 A.2d 150 (Del. 1997)} 97_{Section 174(a) Delaware General Corporation Law}

98_{Section 141(e) & 172 Delaware General Corporation Law} 99_{Section 548 Bankruptcy Code}

(23)

obligation and the company was (or became so due to the transaction) undercapitalized or unable to pay its debts, the trustee can avoid or unwind the transaction, leaving the directors personally liable and recovering the dividend payment from the PE fund.101

Following the Organisation for Co-operation and Development’s (OECD) 2015 report on Limiting Base Erosion Involving Interest Deductions and Other Financial Payments102_{, the} United States adopted a rule limiting the tax deductibility of interest payments in the Internal Revenue Code (IRC) in 2017. The new rule states that interest expenses allowed for

deduction shall not exceed 30% of its adjustable taxable income, where adjustable taxable income is defined as the taxpayer’s Earnings Before Interest Taxes Depreciation and Amortization (EBITDA).103_{Small businesses averaging less than $25 million in gross} receipts over the three previous taxable years are exempt from this rule.

3.2. European Union

AIMFD

As the United Kingdom and the Netherlands were both member states of the European Union, both jurisdictions are currently subject to the Alternative Investment Fund Managers Directive (AIMFD)104_{. The AIFMD followed the Great Financial Crisis, which was regarded} as a crisis of Anglo-Saxon capitalism.105_{Its objective was to create a harmonized regulatory} and supervisory framework for Alternative Investment Fund Managers (AIFMs). AIFMs include managers of PE funds, hedge funds, commodity funds and real estate funds.106_The AIMFD was heavily opposed by the United Kingdom fearing for their position as a center of hedge and buyout funds operating in Europe.107_{The AIFMD imposes on AIFMs licensing}

101_{Section 548(a)(1)(B) and 550(a) Bankruptcy Code}

102_{Organisation for Economic Co-operation and Development, ‘Limiting Base Erosion Involving Interest} Deductions and Other Financial Payments, Action 4 - 2016 Update’(OECD, 22 December 2016) <

https://www.oecd.org/tax/beps/limiting-base-erosion-involving-interest-deductions-and-other-financial-payments-action-4-2016-update-9789264268333-en.htm> accessed 21 May 2020

103_{Section 163(j) Internal Revenue Code}

104_{Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative} Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010 or AIFMD

105_{Alexandros Seretakis ‘A Comparative Examination of Private Equity in the United States and Europe:} Accounting for the Past and Predicting the Future of European Private Equity’ (2013) 18 Fordham J. Corp. & Fin. L. 655

106_{Art. 4 AIFMD}

107_{Elena Moya, ‘City Lobbying Helps Water Down European Hedge Fund Legislation Plans’ (The Guardian,} 27 July 2009) < https://www.theguardian.com/business/2009/jul/27/hedge-funds-european-directive> accessed 21 May 2020

(24)

and capital requirements108_{, the maintaining of liquidity and risk management systems}109_, renumeration policies discouraging excessive risk-taking110_{and the maintaining of structures} for identifying and managing conflicts of interest.111_{Furthermore, the AIFMD increases the} transparency and disclosure obligations towards investors and supervisory authorities.112_The AIMFD has a more direct effect on the dividend recapitalization tool through article 30. Article 30 AIFMD prevents an AIFM, for the first two years after acquiring control in an EU-incorporated private company, from facilitating a distribution which would lower the net assets of the company below its subscribed capital and reserves shown in the previous annual account or would exceed the amount of profits available for distribution at the end of the last financial year. This article is meant to prevent the AIFM from engaging in “asset

stripping”113_{, the practice of acquiring a portfolio company to sell off its assets to improve} returns for the PE fund.

ATAD

Following the OECD’s recommendations regarding base erosion and profit shifting, the European Union introduced the Anti Tax Avoidance Directive (ATAD).114_{The goal of this} directive is to ensure the good functioning of the internal market by implementing the recommendations of the OECD regarding base erosion and profit shifting, discouraging tax avoidance practices and ensuring fair and effective taxation in the Union in a coherent and coordinated fashion.115_{The ATAD prescribes a similar rule to the new U.S. rule to be} implemented in the Member States. A company’s interest expenses exceeding €3 million are deductible only up to 30% of the company’s EBITDA.116

3.3. United Kingdom

Article 30 of the AIFMD is implemented in section 43 of The Alternative Investment Fund Managers Regulation 2013. Section 44 gives the Financial Conduct Authority (FCA)

108_{Art. 7 and 9 AIFMD} 109_{Art. 15 and 16 AIFMD} 110_{Art. 13 AIFMD} 111_{Art. 14 AIFMD} 112_{Art. 22 AIFMD}

113_{Louise Gullifer and Jennifer Payne, Corporate Finance Law (2nd edn, Hart Publishing 2015) 802} 114_{Council Directive (EU) 2016/1164 of 12 July 2016 laying down rules against tax avoidance practices that} directly affect the functioning of the internal market or ATAD

115_{Recital 2 ATAD} 116_{Art. 4 ATAD}

(25)

regulatory powers in relation to section 43. Further rules regarding dividends are set out in section 830 of the Companies Act 2006. This section states that a company may only make distributions out of profits available for the purpose. Profits available for the purpose are accumulated, realized profits,so far as not previously utilised by distribution or

capitalisation, less its accumulated realized losses, so far as not previously written off in a reduction or reorganisation of capital duly made.117_{The distribution has to be justified by} reference to the relevant accounts of the company, usually the company’s last annual

accounts as provided for under section 339 Companies Act 2006.118_{It is not possible for the} directors of a company to re-value the assets and liabilities, but the Companies Act prescribes a backward looking test.119_{If a distribution is subsequently deemed to be unlawful, the} shareholders receiving such distribution are liable to repay the distribution to the company if such shareholder knows or has reasonable grounds of believing that it is so made.120_A director that authorizes an unlawful dividend has likely acted in breach of their statutory duties121_{and can be liable to repay or restore the funds amounting to the losses they caused} the company as a result of the dividend payment.122

The director can also be held liable if the company subsequently becomes insolvent.123 Similar to U.S. federal law, if a dividend payment to a connected party occurred within two years before the onset of insolvency, the office-holder of a company in liquidation or

administration can request the court to make an order as it thinks fit to restore the position of the company to what it would have been if the company had not entered into the dividend payment.124_{The dividend payment has to be at a time where the company is unable to pay its} debts or becomes unable to pay its debts due to the transaction, but these requirements are presumed to be satisfied in a transaction with a connected party.125_{The court shall not make} such an order if it is satisfied that (i) the company entered into the transaction in good faith

117_{Section 830 Companies Act 2006}

118_{Section 836 and 837 Companies Act 2006}

119_{Louise Gullifer and Jennifer Payne, Corporate Finance Law (2nd edn, Hart Publishing 2015) 164} 120_{Section 847 Companies Act 2006}

121_{Section 171-177 Companies Act 2006}

122_{Precision Dippings Ltd v Precision Dippings Marketing Ltd [1986] 1 Ch 447 and Louise Gullifer and} Jennifer Payne, Corporate Finance Law (2nd edn, Hart Publishing 2015) 165

123_{Section 212(3) Insolvency Act 1986} 124_{Section 238 and 240 Insolvency Act 1986} 125_{Section 238(2) and 240(2) Insolvency Act 1986}

(26)

and for the purposes of carrying on its business and (ii) at the time the of the transaction there were reasonable grounds to believe that the transaction would benefit the company.126 The U.K. has also incorporated the interest deductibility limitation of the ATAD in the Taxation Act of 2010. The deductibility of interest expenses in excess of £2 million are restricted at 30% of the taxpayer’s aggregate tax-EBITDA.127

3.4. The Netherlands

Article 30 of the AIFMD is implemented in article 4:37v and 4:37z of the Dutch Financial Supervision Act (Wet op financieel toezicht or Wft). The rule on “asset stripping” is enforced and penalized through fines by the AFM, the Dutch financial supervisor (Autoriteit

Financiële Markten).128_{Furthermore, through article 2:216 of the Dutch Civil Code}

(Burgerlijk Wetboek ), directors of the portfolio company have to approve dividend payments to shareholders. The general meeting of shareholders can authorize a dividend payment, as long as the equity residing in the portfolio company, based on the company’s annual

accounts, exceeds the minimal reserves under the law or bylaws of the company.129_However, as most companies are not required to hold minimal reserves, it is possible that all the equity residing in the balance sheet is distributed130_{, i.e. the equity residing in the balance sheet,} distributable reserves and profits up to the point of the distribution.131_{The board of directors} has to approve the decision by the general meeting of shareholders to effect the dividend payment and can only refuse such a dividend payment if it knows or reasonably should know that the dividend payment will impede the portfolio company in paying its outstanding creditors.132_{It bases its decision on a “distribution test” in which the directors evaluate the} liquidity, solvability and profitability of the portfolio company, as well as the company’s ability to pay its foreseeable claims in the near future. Usually the directors have to verify that the portfolio company is able to pay its outstanding creditors for at least a year, however specific circumstances can require a longer period.133_{If , after a distribution, the company is}

126_{Section 238(5) Insolvency Act 1986}

127_{Section 397 Taxation (International and Other Provisions) Act 2010}

128_{Art. 1:79 and 1:80 Wet op het Financieel Toezicht; Kamerstukken II 2011/12 (33 235, 7) 22} 129_{Art. 2:216(1) and 2:362 Burgerlijk Wetboek}

130_{Kamerstukken II 2006/07 (31058, 3) 71}

131_{M.J. Kroeze and H. Beckman, De Rechtspersoon Asser/Maeijer 2-I* 2015/603} 132_{Art. 2:216(2) Burgerlijk Wetboek}

(27)

not able to continue to pay its outstanding creditors, the directors are jointly and severally liable for the deficit which results from the distribution, which is capped at the amount of the distribution increased by legal interest.134_{Also, the receivers of the distribution that know or} should have known that the company would not be able to continue to pay its outstanding creditors are severally liable for the amount received from such distribution.135_Furthermore, active shareholders that participate in setting the company’s policy as if they were a director of the portfolio company, can also be held liable for the distribution.136

It is also possible to annul the decision of the general meeting of shareholders to pay dividends, both inside and outside insolvency. Both the administrator137_{and individual} creditors138_{can annul a transaction when the company (i.e. the directors of the company)} knew or should have known that the transaction put creditors at a disadvantage in their possibilities of redress.139_{If the transaction occurred one year before the company’s} insolvency, it is presumed that the company knew it was putting creditors at a

disadvantage.140_{The annulment of the transaction will also have effect towards the receiver} of the dividend payment.141

In the Netherlands’ the ATAD’s limitation on interest deductibility has also been

implemented. Under the Dutch corporate tax code (Wet op de Vennootschapsbelasting or Wet

Vpb), interest is deductible up to the higher of 30% of EBITDA or €1 million.142 3.5. Comparative review

As stated before, Europe offers stricter rules regarding a company’s legal capital position than the U.S. The U.S. rules provide maximum flexibility to shareholders, while in Europe the threat to creditors from shareholders is considered real and credible.143_{From the}

description above, it follows that the U.S. offers the least strict dividend payment rules and

134_{Ibid 73}

135_{Art. 2:216(3) Burgerlijk Wetboek} 136_{Art. 2:216(4) Burgerlijk Wetboek} 137_{Art. 42 Faillissementswet} 138_{Art. 3:45 Burgerlijk Wetboek}

139_{Art. 3:45 Burgerlijk Wetboek and Art. 42 Faillissementswet} 140_{Art. 45 Faillissementswet}

141_{Art. 45 Faillissementswet}

142_{Art. 15b Wet op de Vennootschapsbelasting}

(28)

the Netherlands offers the most strict rules. The differences between the jurisdictions are as follows.

U.S. law enables directors of a portfolio company to re-value the assets and liabilities of the company and therefore creates the possibility to create a surplus, which subsequently can be distributed to the (PE-) shareholders. By using the market value of comparable assets of other companies, discounted cash flow analysis, applying price earnings ratios and other

methodologies that reflect the value of the assets in a sale from a willing seller to an

independent buyer144_{, the company’s directors are allowed more flexibility in their valuation} practice than when the directors base their valuation on the company’s books and financial statements. Because an independent appraiser will likely opine on the valuation result found by the directors, creating a safe harbor and reducing the liability of the directors, it is possible that this valuation would be higher than it would be in the United Kingdom and the

Netherlands. Here, the calculation for the amount eligible for distribution is based on the annual accounts. Furthermore, the Dutch jurisdictions requires an examination of the continuity of the portfolio company following the distribution by also describing the distribution test. Both the English and the Dutch system make it possible to retrieve an unlawful dividend payment from the directors as well as the backing PE firm, as the

managers of the PE fund are likely acting as if they were directors of the portfolio company. Furthermore, in these jurisdictions PE firms are subject to the “asset stripping” rule for the first two years.145_{However, this rule has been criticized in literature for not being effective at} “asset stripping” as it does not prevent the portfolio company from selling of assets146_{and it} does not completely prevent the PE fund from receiving returns from the portfolio

company.147

Outside insolvency, only the directors who approved the distribution are jointly and severally liable under Delaware law. The Dutch and U.K. jurisdictions offer a wider possibility of

144_{Douglas Warner, Michael Weisser and Joshua Peck, “Leveraged Dividend Recapitalizations” [2019]} Thomson Reuters Practice Law 12

<

https://uk.practicallaw.thomsonreuters.com/0-506-7108?__lrTS=20191204142026982&transitionType=Default&contextData=(sc.Default)&firstPage=true&bhcp =1> Accessed on 21 May 2020

145_{Section 43 The Alternative Investment Fund Managers Regulations 2013}

146_{Barbara Bier ‘No asset-stripping? Wet implementatie AIFM-richtlijn: bijzondere gedragsinstructies in} verband met uitkeringen voor Nederlandse beheerders van alternatieve beleggingsinstellingen’ (2013) 74 Ondernemingsrecht 384

Designing efficient dividend recapitalization legislation

Master Thesis

Universiteit van Amsterdam

Designing efficient dividend recapitalization legislation

Table of Contents