Dividend Options for REITs Amidst Economic and Market Turmoil
A company is generally required to distribute to its stockholders at least 90% of its taxable income each year in order to qualify as a real estate investment trust (“REIT”) under the Internal Revenue Code. REITs generally satisfy this requirement through quarterly or monthly cash distributions of all or substantially all of their taxable income.
Recent economic and market turmoil resulting from COVID-19 has strained the ability of many REITs to maintain sufficient liquidity to meet their obligations to creditors. As a result, a number of REITs are considering their options with respect to paying dividends on their common and preferred securities in the near future. This alert provides an overview of these options under Maryland and Delaware law.
State Law Considerations
The general rule in Maryland is that a dividend may not be revoked after declaration because the declaration of the dividend creates a debtor-creditor relationship between a corporation and its stockholders. However, there may be extraordinary circumstances in which a board may revoke or modify a previously declared dividend.
The board of directors of a Maryland corporation generally may authorize a dividend only if, after payment:
- the corporation will be able to pay its debts as they become due in the ordinary course of business; and
- the corporation’s assets will be greater than its liabilities, plus, unless the charter permits 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 stockholders whose preferential rights on dissolution are superior to those receiving the distribution (these tests are collectively referred to as the “Solvency Tests”).
If the payment date for a dividend of a Maryland corporation is within 120 days after the board approves the dividend, the date on which the board approved the dividend will be used for purposes of evaluating whether the Solvency Tests have been satisfied.
We believe that the boards of a number of Maryland-incorporated REITs recently approved payments of dividends at a time at which these companies satisfied both of the Solvency Tests. However, due to intervening market events, we also believe that the subsequent payment of these dividends could cause some of these REITs to fail to satisfy, or be in jeopardy of failing to satisfy, one or both of the Solvency Tests. While there is not conclusive case law on point, we believe that the board may have new grounds to overcome the general rule described above and revoke or modify the dividend, depending on its circumstances.
As in Maryland, the declaration of a dividend by a Delaware corporation generally creates a debtor-creditor relationship between the corporation and its stockholders that cannot be revoked or modified. Again, however, there are exceptions to this general rule, particularly where payment of a previously declared dividend would jeopardize the ability of the company to continue its business.
Under Delaware law, a Delaware corporation generally may pay a dividend only if the corporation has sufficient “surplus” (as defined in the Delaware General Corporation Law (the “DGCL”)) or net profits available for payment of the dividend. In addition, if the board believes payment of the dividend would render the corporation insolvent, the board is prohibited from paying the dividend until such time as lawful funds become available.
Companies seeking to preserve cash have the following options with respect to previously declared dividends:
- Delay the record and payment dates.
- Retain the current record date and delay the payment date.
- Convert to an elective stock/cash dividend with up to 80% paid in stock (available only for common dividends).
- Revoke the dividends.
- Pay the preferred stock dividends and delay, revoke or convert common dividends.
Delay Record and Payment Dates
This option can help the company buy some time to make a definitive decision on paying dividends. Converting to a stock/cash dividend or revoking the dividend (each of which is discussed below) are still available options prior to the new record date.
As noted above, for a Maryland corporation, as long as the dividend payment date is still within 120 days after the board approval date, the board approval date will be used for purposes of evaluating whether the Solvency Tests have been satisfied. If the payment date is pushed beyond 120 days, the Solvency Tests will be evaluated as of the date of payment, rather than the date of authorization. In addition, under Maryland law, the record date must be within 90 days of the payment date. There is no minimum period between record and payment dates under Maryland law.
With respect to Delaware corporations, the DGCL does not prohibit changing a record date or payment date that has not occurred. Accordingly, subject to any requirements under the corporation’s charter, a board could change the record date and payment date for a previously declared dividend to a future date, so long as the payment date occurs within 60 days after the new record date.
Retain Current Record Date; Delay Payment Date
This option can help companies save cash by delaying the payment of dividends, while preserving the original record date for the dividend.
Under Maryland law, a company electing this option could only delay the payment of the dividend to a date up to 90 days after the record date. For a Delaware corporation, however, the payment of the dividend could only be delayed to a date up to 60 days after the record date.
Companies electing this option should be aware that revoking, further delaying or converting to a stock/cash dividend would become more complicated and difficult to defend if done after the date that the shares begin to trade “ex-dividend” (which means that the expected payment of the dividend has been factored into the trading price of the shares).
Convert to Stock/Cash Dividend with up to 80% Stock
In 2017, the Internal Revenue Service issued a revenue procedure permitting “publicly offered” REITs to make elective stock dividends (i.e., dividends paid in a mixture of stock and cash), with at least 20% of the total distribution being paid in cash, to satisfy their REIT distribution requirements. As a result, a company could convert a previously declared cash dividend to an elective stock/cash dividend in order to save cash.
Companies electing to pay stock/cash dividends must comply with the following requirements:
- Each stockholder must have the ability to elect to receive part or all of its distribution in either cash or stock.
- At least 20% of the aggregate declared distribution must consist of cash (the “Cash Limitation Percentage”).
- If the Cash Limitation Percentage is not exceeded, each stockholder must receive cash in accordance with its election.
- If the Cash Limitation Percentage is exceeded, each stockholder electing to receive cash may receive a pro rata amount of cash, but in no event may any stockholder electing to receive cash receive less in cash than the Cash Limitation Percentage.
- The calculation of the number of shares to be received by a stockholder must be determined by a formula set forth in the revenue procedure that uses market prices designed to equate in value the number of shares to be received with the amount of cash that could be received instead.
During the 2008 financial crisis, the IRS issued temporary guidance that allowed REITs to make elective cash/stock dividends in a ratio of 90% to 10% (as opposed to a ratio of 80% to 20%) . NAREIT has asked the IRS to allow this increased stock percentage again for 2020 and 2021, but the IRS has not yet acted.
A company considering payment of an elective stock/cash dividend should ensure that it has enough authorized but unissued shares of common stock available to be issued to pay the stock portion of the dividend. Most Maryland incorporated REITs have a provision in their charters permitting the board of directors, without stockholder approval, to amend the charter to increase or decrease the aggregate number of authorized shares of stock or the number of authorized shares of any class of stock. However, Delaware does not permit corporations to include a similar provision in their charters. Accordingly, if a Delaware corporation does not have enough authorized but unissued shares of common stock available to be issued to pay the stock portion of the dividend, the corporation will need stockholder approval to amend its charter to increase its authorized stock.
Revoking a previously declared dividend is likely the riskiest option for a company seeking to preserve cash. As alluded to above, the declaration of a dividend generally creates a debtor-creditor relationship between a company and its stockholders under both Maryland and Delaware law. Accordingly, revoking a previously declared dividend could subject a company to a claim from a stockholder seeking to compel the company to declare the dividend.
In assessing this risk, boards of both Maryland and Delaware corporations should take into account in satisfying their fiduciary duties the following factors related to the current market environment:
- There have likely been significant intervening events between when the board declared the dividend and today. These intervening events may have led to liquidity constraints that would be exacerbated by paying the previously announced dividend.
- Payment of a previously announced dividend could result in the inability of the company to continue its business. If the company is unable to continue its business, the company’s stockholders will miss out on all future dividends, not just the previously declared dividend. Consequently, payment of a previously announced dividend could be viewed as putting the short-term interests of certain stockholders ahead of the long-term interests of the corporation as a whole.
- If there is stockholder litigation, it may take some time to resolve. This could buy the company some time to consider additional options.
Pay Preferred Stock Dividends and Delay, Revoke or Convert Common Dividends
To the extent that the company has preferred stock outstanding, the company should consider the terms of the preferred stock in connection with any decisions that it makes with respect to its dividend policy. In many cases, the terms of any outstanding preferred stock may provide that, if dividends on the preferred stock are not paid or set apart for all past dividend periods, the company may not pay common dividends, or repurchase any shares of common or preferred stock, unless it is a purchase or exchange offer made on the same terms for all of the preferred stock. In addition, holders of preferred stock often have the ability to elect, voting together with the holders of any other series and classes of preferred stock having similar voting rights, two additional directors to a company’s board of directors in the event that six or more quarterly dividends (whether or not consecutive) payable on the preferred stock are in arrears. These punitive provisions may lead companies with outstanding preferred stock to prioritize keeping their preferred dividends current, while common dividends could be revoked, delayed or converted, in each case as discussed above.
Another reason to consider prioritizing keeping preferred dividends current is General Instruction I.A.4(a) to Securities and Exchange Commission (“SEC”) Form S-3. Pursuant to that instruction, a registrant that fails to pay any dividend on preferred stock in 2020 would be unable to use Form S-3 until it files its Annual Report on Form 10-K for 2020.
Any change to a previously declared dividend will need to be publicly announced immediately after the board authorizes the change. Companies announcing changes to previously declared dividends should work with their advisors to ensure that the messaging is accurate and balanced.
Irrespective of what path a company chooses to take, REITs will still need to comply with the REIT distribution requirement described above. In the fourth quarter of 2020, these companies should assess their estimated taxable income for 2020 and consider whether they need to authorize the payment of a “catch up” dividend. This “catch up” dividend could be paid in cash or via an elective stock/cash dividend, as described above. The “catch up” payment could be made as late as the end of January 2021, provided that the dividend is both declared and has a record date on or before December 31, 2020, which is commonly referred to as the “January Dividend Procedure.”
Finally, REITs have the ability to “spill back” 2021 dividends which are (a) declared before their tax return filing due date (including extensions) for 2020 and (b) paid not later than their first regular dividend payment date after the declaration. REITs considering this option should be aware that the “spill back” procedure could potentially (a) lead to a distribution shortfall in 2021 and (b) subject the REIT to a 4% excise tax to the extent that at least (i) 85% of the REIT’s ordinary income, (ii) 95% of the REIT’s capital gain income, and (iii) any undistributed taxable income from prior periods is not distributed in calendar year 2020 (with dividends paid pursuant to the January Dividend Procedure being treated as paid during calendar year 2020).
Please visit our Coronavirus: Preparation & Response series for additional resources we hope will be helpful.
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.