Another Tool To Recover Excessive Executive Compensation
Updated: Apr 17
Excessive executive compensation has come under fire in recent years. Although generous compensation packages may be justifiable in the case of a healthy company, they are more difficult to defend in a distressed company. Executives who get massive compensation packages and board members who approve them are prime targets for dissatisfied elements, like unpaid creditors, seeking to recoup value. Fraudulent transfer and fiduciary claims are the traditional tools they use to get recovery of excessive managerial compensation. In certain jurisdictions, creditors may also be able to call excessive compensation paid to manager-shareholders as disguised and unlawful dividends. The applicability of this de facto dividend doctrine vary from place to place.
The Delaware General Corporation Law (DGCL) makes a director liable to the corporation, or its creditors if the corporation is insolvent, for the full amount of any illegal dividend, including those paid while the corporation’s capital is less than the capital represented by all outstanding shares having a preference on the distribution of assets. Minority shareholders in an HMO sued corporate directors for siphoning off tens of millions of dollars from the HMO in the form of disguised salaries, bonuses and corporate perquisites, which they said were really de facto dividends. The court denied the claim.
Outside Delaware a number of courts have been willing to recast undue executive compensation as de facto, disguised, or constructive dividends, particularly in closely held corporations. These claims can be brought by creditors or minority shareholders and can be tort or statutory claims. For example, the Colorado Court of Appeals found that a controlling shareholder’s use of company funds from a family-owned liquor store for the payment of excessive salary, personal credit cards, and unauthorized loans qualified as disguised dividends supporting minority shareholders’ civil theft claim.
From an unpaid creditor’s eye, there are advantages to recasting excessive executive compensation as disguised and unlawful dividends. First, a director who is not a transferee may be personally liable for authorizing or acceding to the unlawful dividend. In some jurisdictions, a director’s statutory liability for an unlawful dividend may be based on mere negligence and the business judgment rule is no defense. In some places, a director cannot use a special committee or exculpation language in a corporate charter as a defense.
In most places, creditors may recover dividends paid while a company is insolvent from a manager-shareholder who received it with knowledge of the company’s insolvency. Fraudulent transfer and preference defenses are unavailable because the statutory unlawful dividend claim is like a strict liability claim. Finally, statutory unlawful dividend claims may allow recovery of interest from the date of the distribution.