Can a board be legally forced to cut dividends?

In June 2017, loyalty program operator Aimia announced it was suspending dividends in the aftermath of Air Canada’s decision to end its Aeroplan relationship. Aimia’s common shares had plunged 63% on news of the loss, and 27% after the dividend cut to close at $1.53 per share a month later.

In suspending dividends, Aimia referenced paragraph 42(b) of the Canada Business Corporations Act (CBCA), which states, “A corporation shall not declare or pay a dividend if there are reasonable grounds for believing that the realizable value of the corporation’s assets would thereby be less than the aggregate of its liabilities and stated capital of all classes.”

In its June press release, Aimia said, “The company currently has the requisite liquidity to pay these dividends, however the statutory capital impairment test legally prohibits us from doing so.”

“Legally prohibits?” In practice, paragraph 42(b) of the CBCA has long been ignored. In fact, we screened the S&P/TSX Composite Index and found that 25% of dividend-paying constituents didn’t heed the requirement (more on that in a moment).

A riddle of reasons

Companies don’t require a reason—legal or otherwise—to cut dividends. They do it to preserve cash, and usually say as much.

In fact, Aimia management (not the board) provided such a take on the matter in its second-quarter conference call. In prepared remarks, the CEO spoke of “actions we’ve already taken to strengthen the balance sheet, and preserve cash, being supplemented by our announcement that we will suspend common dividends for the foreseeable future to give us more financial flexibility in the coming years.”

So, were dividends suspended to preserve cash and provide financial flexibility, as stated by management, or because of a legal restriction, as stated in the June press release?

Aimia didn’t just cut the dividend on common shares; it also eliminated payouts on three series of rate-reset preferred shares. Previously issued at $25, these shares had already declined over the years to less than half their value due to various factors, including persistently low interest rates and the generally poor business outlook. (We issued a sell rating on Aimia common stock three years ago when it was trading over $18.)

Paragraph 42(b) makes no distinction between common and preferred shares. Yet, cutting dividends on the pref shares seemed to be a difference maker for Aimia’s board, and seemingly why they cited 42(b) in their reasoning (in contrast to dozens of other Canadian companies that have suspended common dividends recently without acknowledging the requirement).

Why companies ignore 42(b)

After Aimia’s announcement of its dividend suspension, the company’s balance sheet, as of June 30, 2017, showed assets were just 73% of liabilities plus common and preferred shares. Does this justify the dividend cut? The ratio was the same the quarter before the cut.

In fact, that ratio has been less than 100% for Aimia’s past 29 quarters. And as mentioned already, one-quarter of dividend-paying S&P/TSX companies reported a ratio of less than 100% in their most recent quarters, including BCE, Northland Power, Cineplex and Just Energy.

Why is 42(b) routinely ignored? The issue goes back decades. The CBCA refers to the “realizable” value of assets. When old Canadian GAAP accounting rules used historical cost as the basis for valuing assets on the balance sheet, companies would argue that the book values were outdated and irrelevant as a test of capital impairment.

In the context of the CBCA test, most would define realizable value from a liquidation perspective, whereas accounting measures value from a going concern perspective, the latter of which should be higher. And given that new IFRS accounting rules are supposed to measure assets at fair value, the balance sheet value should far exceed the liquidation value in most cases.

It seems companies routinely ignore the legal test because of unmeaningful accounting, weak oversight, unenforced laws or other reasons.

Mystery as warning for advisors

Aimia’s financial statements before and after the dividend cut show no material difference. And it’s clear that companies, including Aimia, have for many years routinely ignored the CBCA test. So why the about-face, and was Aimia’s board in agreement?

Concurrent with the dividend cut, the company announced the resignation of three directors who had been with the board for various tenures, but all for at least five years. The press release said the resignations were the result of Aimia’s shrinking size, even though all directors had been re-elected concurrent with the news that Air Canada was divorcing Aimia.

The cut to Aimia’s preferred dividends is an ongoing mystery. Based on Aimia’s past actions, as well as the general precedent set by the market, the reasoning seems dubious. Until clarity is brought to the CBCA through either an amendment or an enforcement statement from regulators, advisors will be at risk. That’s because there’s simply no way to predict the risk of a dividend cut to preferred shares given how the law and accounting can be applied or ignored at whim.