REIT Dividends in the Wake of the Coronavirus

A REIT must distribute 90 percent of its taxable income as computed prior to the distribution (with certain modifications such as the exclusion of net capital gain) to maintain its REIT status under the Internal Revenue Code. 

Dividends are the most common way REITs satisfy this requirement, as “distributions” under Maryland law include dividends. But in the wake of the recent economic downturn and resulting liquidity concerns, REITs must take care to not run afoul of dividend requirements under state corporate law when declaring, paying and potentially revoking dividends.

Maryland REIT Law does not prescribe any standards for making a distribution to its shareholders. However, we generally advise that Maryland REITs nevertheless confirm compliance with the dividend requirements of the Maryland General Corporation Law (MGCL): In order to declare and pay a dividend as a Maryland corporation, the corporation must ensure that it does not violate either of the following financial solvency tests. Under the MGCL, dividends are not permitted, if, after payment:

• The corporation would not be able to pay its indebtedness as it becomes due in the usual course of business, or
• Except as noted below, the corporation’s total assets would be less than the sum of its total liabilities plus, unless the charter permits otherwise, the amount 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.

Notwithstanding the second financial solvency test above, the MGCL allows a Maryland corporation that otherwise fails this test to nevertheless make a distribution from its net earnings for either the fiscal year in which the distribution is made or the preceding fiscal year, or from the sum of its net earnings for the preceding eight fiscal years. There is no exception for the first financial solvency test; even if a corporation takes advantage of the net earnings carve-out, it must still be able to pay its debts as they become due.

Boards of directors have discretion when determining whether a distribution passes muster under either financial solvency test. The board may base such a determination on reasonably prepared financial statements, or on a fair valuation or other method that is reasonable under the circumstances. In addition, the deferential business judgment rule applies to a decision to distribute dividends, allowing boards to avoid court scrutiny absent gross negligence or bad faith.  Despite this latitude, and against the backdrop of COVID-19 and ubiquitous financial uncertainty, Maryland REITs and their directors must exercise caution before deciding to declare and pay dividends (particularly as personal liability may arise for directors who vote for distributions in violation of the financial solvency tests, governing documents, standards of conduct, or other applicable restrictions).

As with any major financial decision, directors should carefully consider the REIT’s overall financial condition, short- and long-term liquidity concerns, and market sentiment, in addition to the legal requirements, before declaring a dividend. After considering both the financial solvency tests and these practical considerations, many Maryland REITs may find that they cannot or should not declare a dividend. Alternatively, the rapid and unexpected economic downturn as a result of the global pandemic may find boards confronting dividends declared in good faith before the pandemic that no would longer pass either financial solvency test if paid today.

The financial solvency tests are measured as of the date the board approved the dividend, as long as payment is made within 120 days of the authorization. Thus, even REITs that are facing a rapidly deteriorating balance sheet can nevertheless pay out the previously declared dividend, if it would pass legal muster on the date it was authorized. But REITs experiencing liquidity challenges may be seeking to avoid payment, even if it would not technically give rise to legal concerns under the MGCL. Boards can consider the following options:

Run the 120-Day Clock. As noted above, corporations have 120 days to pay the dividend without triggering an evaluation of the financial solvency tests as of the payment date (rather than the authorization date). REITs looking to buy some time and preserve cash can delay payment of the dividend until the end of this 120-day period. However, boards should keep in mind that payment must be made within 90 days of the record date under Maryland law.

Elective Stock Dividend. Pursuant to a revenue procedure issued by the Internal Revenue Service (IRS) in 2017, “publicly offered” REITs (i.e., those that are required to file annual and periodic reports with the SEC under the Securities Exchange Act of 1934) can use elective stock dividends to satisfy their REIT distribution requirements, as long as certain conditions are met. A pure stock dividend is generally not treated as a taxable income distribution for purposes of satisfying the 90 percent distribution requirement. However, this revenue procedure established a safe harbor allowing “publicly offered” REITs to treat stock dividends as qualifying distributions, so long as (among other requirements):

• Stockholders have the right to elect to receive the dividend in either stock, cash, or a combination of the two; and
• The amount of cash available to be distributed in the aggregate to all stockholders electing cash must be at least 10 percent of the aggregate declared distribution. Certain proration rules apply in the event that the aggregate of all stockholders’ elected cash amounts exceeds the 10 percent threshold. REITs should note that although the 2017 revenue procedure prescribed a 20 percent cash distribution requirement, the IRS, in Rev. Proc. 2020-19, relaxed the annual income distribution requirement for “publicly offered” REITs by temporarily reducing the cash distribution requirement to 10 percent for distributions declared between and including April 1, 2020, and December 31, 2020.

REITs could minimize liquidity concerns by relying on this safe harbor to convert previously declared cash dividends on their common stock into an elective stock dividend. Because this safe harbor only applies to publicly offered REITs, non-publicly offered REITs would be well-advised to seek private letter rulings from the IRS before considering this alternative. Additionally, boards should take care to comply with applicable corporate law requirements and their own governing documents (including ensuring sufficient authorized but unissued shares). The revenue procedure also raises several interpretive questions, so REITs should consult with legal and tax advisors to analyze the facts of each proposed distribution.

Revoke the Dividend. A debtor-creditor relationship is established between a Maryland corporation and its stockholders as soon as a dividend is declared, which makes revocation both rare and risky. Corporations typically seek to revoke a previously declared dividend in the face of material intervening events—such as a global pandemic—that could give rise to insolvency issues or create (or exacerbate) significant liquidity concerns. Given the risks and lack of established precedent, REITs considering revocation in the wake of the recent economic downturn should consult with counsel and must carefully weigh the likelihood of stockholder litigation against the financial consequences of payment and the board’s fiduciary duties.

The financial impact of COVID-19 has highlighted the challenges of walking the line between required REIT distributions and the financial solvency tests under Maryland law. REITs considering their options in the face of liquidity constraints should consult with legal and tax advisors prior to delaying, converting or revoking a previously declared dividend.

Pillsbury’s experienced, multidisciplinary COVID-19 Task Force is closely monitoring the global threat of COVID-19 and providing real-time advice across industry sectors, drawing on the firm’s capabilities in crisis management, employment law, insurance recovery, real estate, supply chain management, cybersecurity, corporate and contracts law and other areas to provide critical guidance to clients in an urgent and quickly evolving situation. For more thought leadership on this rapidly developing topic, please visit our COVID-19 (Coronavirus) Resource Center.