A Primer on Pursuing Unlawful Dividend Claims Under Delaware Law

The General Corporation Law of Delaware (DGCL) provides a right of action against corporate directors who declare a dividend while the corporation is insolvent. Such conduct may also give rise to claims for fraudulent transfer or breach of fiduciary duty, but unlawful dividend claims have several advantages. When evaluating post-bankruptcy claims, trustees, debtors-in-possession and creditors should consider the propriety of bringing an unlawful dividend claim against the corporation’s directors and the shareholders who received an improper dividend.

The Statute

Section 170 of the DGCL vests the corporation’s board of directors with the exclusive power to declare dividends. However, that power is not without limit. With limited exception, a corporation may only issue a dividend out of its surplus.[1] Likewise, a corporation may not purchase or redeem its own shares if its capital is impaired.[2] “Surplus” is “[t]he excess, if any, at any given time of the net assets of the corporation over the amount . . . determined to be capital.”[3] “Net assets means the amount by which total assets exceed total liabilities.”[4]

Section 174 creates liability for directors who violate these proscriptions. The directors “shall be jointly and severally liable” for the “full amount of the dividend unlawfully paid.”[5] If a director is liable for unlawful dividend, she “shall be entitled to contribution from the other directors who voted for or concurred in the unlawful dividend.”[6] Further, if a director is liable, she is “entitled . . . to be subrogated to the rights of the corporation against stockholders who received the dividend . . . with knowledge of facts indicating that such dividend . . . was unlawful.”[7]

The Advantages of Unlawful-Dividend Claims

If appropriate, a claim for unlawful dividend has two key advantages over fiduciary-breach claims. First, § 174 creates liability for both “willful” and “negligent” violations of the statute. The business-judgment rule does not apply to unlawful-dividend claims, and corporations cannot exculpate their directors from liability for violating § 174. Second, § 174 creates standing for both the company and its creditors to pursue claims against directors. It also implies a right of action against shareholders who knowingly receive an unlawful dividend.

In IT Litigation Trust v. D’Anellio, the court’s order on the defendant’s motion to dismiss illustrates the benefit that unlawful-dividend plaintiffs gain by not having to contend with the business-judgment rule.[8] In D’Anellio, the IT Litigation Trust brought claims for breach of the fiduciary duties of care and unlawful dividends, among other claims, against the former directors of IT Group Inc. prior to its bankruptcy. The defendants filed a motion to dismiss, which the court granted in part and denied in part.

The trustee’s care claims failed. Like many corporations, IT Group’s certificate of incorporation, pursuant to DGCL § 102(b)(7), exculpated the directors from liability for any violation of the duty of care. But the exculpatory provision did not bar the trustee’s unlawful-dividend claim. Section 102(b)(7) prohibits corporations from exculpating directors from liability for unlawful dividend claims, without regard to the directors’ state of mind:

A provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director . . . under § 174 of this title.

In addition to falling outside of § 102(b)(7) and the business-judgment rule, unlawful-dividend claims provide greater flexibility in terms of standing. Section 174 provides a right of action for both the company and its creditors.[9] An unlawful-dividend claim is “derivative rather than direct.”[10] While a creditor cannot “recover its unpaid claim directly from the director,”[11] it has to overcome fewer procedural hurdles — such as obtaining approval to pursue a derivative claim on behalf of the debtor — to bring the claim in the first place. Unlawful-dividend plaintiffs also can pursue claims against both the approving directors and the receiving shareholder, provided the shareholder knew the distribution was unlawful. This means the plaintiff potentially can pursue both the parties enriched by the unlawful dividend (the shareholders) and parties typically covered by D&O insurance (the directors).