Dividend Restriction Covenant - Detailed Explanation

A Dividend Restriction Covenant is a Negative Covenant - also called a Restricted Payments Covenant or Dividend Lock-up.

Definition: It is a clause in a loan agreement, bond indenture or shareholders agreement that prevents or limits the company from distributing profits to shareholders if doing so would breach financial covenants or reduce ability to meet debt obligations.

Purpose is creditor protection: ensure that borrower prioritizes repayment of loan principal and interest and retains enough earnings for growth and debt repayment.

1. Why Lenders Impose It?

1. Agency Problem: Shareholders want cash out, lenders want cash retained in company.
2. Capital Erosion: Unchecked dividend reduces net worth, increases leverage.
3. Insolvency Zone: When company is near distress, dividends become fraudulent transfer.
4. Cash Flow Control: Lender ensures DSCR, Debt/EBITDA maintained.

2. Types / Drafting Variants

A. Absolute Prohibition:
"No dividend shall be declared or paid so long as Event of Default continues."

B. Conditional / Ratio-Based - Most Common in India:
Found in Term Loans from SBI, ICICI, L&T Finance:

Borrower shall not declare dividend if:
a) DSCR < 1.25x
b) Debt-Equity > 2:1
c) Any default in repayment of dues
d) Without prior written consent of Lender
e) Dividend > 50% of PAT of that year

C. Basket / Builder Basket (High-Yield Bonds - US):
Dividend allowed only out of "Builder Basket" - 50% of cumulative Consolidated Net Income + equity issuance proceeds + returns on investments. If CNI negative, basket doesn't grow.

D. Statutory Restriction Under Companies Act, 2013:
This is a mandatory covenant under law:

• Section 123(1): Dividend can be declared only out of current profits after depreciation, past undistributed profits, or both. Board recommendation mandatory.
• Section 123(6): A company which fails to comply with Section 73 & 74 (Deposits from public) shall not, so long as such failure continues, declare any dividend on its equity shares. This is absolute statutory dividend restriction.
• Section 123(5): Dividend only in cash, not in kind - exception bonus shares.
• Section 123(4): Dividend amount including interim must be deposited in separate scheduled bank account within 5 days of declaration.

Violation leads to Sec 127 penalty - simple interest 18% p.a. + imprisonment.

3. Sample Clause - Law Insider

Dividend Restriction. Company shall not, directly or indirectly, declare or pay any dividend or make any distribution on account of Equity Interests, unless (i) no Default or Event of Default has occurred and is continuing, (ii) after giving pro forma effect, Company is in compliance with Financial Covenants, and (iii) Restricted Payments do not exceed 25% of Net Income for such fiscal year.

4. Breach - Consequences

1. Event of Default: Loan becomes immediately repayable, acceleration.
2. Cross Default: Triggers default in other loans.
3. Dividend declared void: If violates Sec 123(6), ultra vires.
4. Personal Liability: Directors liable for breach of fiduciary duty to creditors in zone of insolvency.
5. Injunction by Bondholders: Can seek court order restraining payment.

5. Case Laws

A. Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch.) - The Leading US Case

Facts: MGM-Pathe, controlled by Giancarlo Parretti (98.5%), near bankruptcy, unable to repay Credit Lyonnais loan. Parretti wanted risky projects and dividend-like extraction.

Holding: Chancellor Allen observed that when firm is in "zone of insolvency", directors owe duty not only to shareholders but to community of interest that sustained the corporation, including creditors. Board must exercise judgment in an informed, good faith effort to maximize corporation's long-term wealth creating capacity.

Principle: Dividend restriction covenants become fiduciary in zone of insolvency. Even if shareholders want dividend, directors must respect creditors.

This changed US law - before, duties only to shareholders.

B. Shintom Co., Ltd. v. Audiovox Corp., Delaware
Plaintiff argued Delaware law Sec 151(c) mandates preferred stock must receive dividend rights, otherwise void. Chancellor Chandler rejected - preferred dividend is contractual, not mandatory. If charter has dividend restriction, no right to dividend.

Principle: Dividend rights are creatures of contract. Covenant can validly restrict.

C. Indian Cases on Statutory Restriction - Section 123(6):

1. Anand Limited Case - MCA Interpretation: Board proposed 20% dividend while failing to repay deposits under Sec 73/74. ROC held declaration prohibited under Sec 123(6) - statutory dividend restriction applies even if company has huge profits.
2. Bombay High Court - Gifting Shares Case: Company gifted shares of subsidiary to shareholders as "dividend in kind" under scheme of arrangement. Court held violates Sec 123(5) - dividend only in cash. Scheme void as violates dividend restriction.
3. Delay in deposit of dividend - ROC Adjudication Orders 2023: Company declared final dividend but deposited amount after 5 days limit u/s 123(4) - delay of 7 days from 05.10.2023 to 11.10.2023. ROC imposed penalty for violation of dividend payment procedure.

D. US High Yield Covenant Cases:

Marriott Corp Spin-off Litigation (1992): Marriott announced spin-off that transferred profitable assets, leaving bondholders with debt-heavy entity. No dividend restriction covenant breach, but court examined if dividend of subsidiary shares was fraudulent conveyance. Led to inclusion of tight restricted payment covenants in all bonds after 1990s.

Wilmington Trust v. Bank of America (Delaware): Court enforced restricted payment covenant - borrower could not upstream dividend to parent to pay parent's debt when leverage covenant breached.

6. How to Negotiate / Protect

For Borrower:
Ask for carve-outs: tax distributions, permitted dividends up to X% of PAT, dividends if DSCR post-dividend > 1.2x, existing shareholders agreements.

For Lender:
Add:

• Prior consent requirement
• No dividend if any default, not just payment default
• Subordination clause
• Certificate from CFO that post-dividend covenants compliant
• Reporting: quarterly compliance certificate

If you are drafting for an Indian term loan, the standard SBI language is: "The Borrower shall not declare or pay dividend for any year out of profits relating to that year or previous years without obtaining prior written approval of the Bank, if there is default in payment of dues or DSCR falls below..."