Anonymised, illustrative composite. The commonest step in a share deal, governed by a provision that is usually paraphrased as a cash-flow test and is not one.
At a glance
An Ontario distribution business incorporated federally was being sold on a share deal at $6,800,000, priced cash-free and debt-free against a locked box effective date. As is standard, the vendor intended to take the surplus cash out before closing rather than leave it for the buyer. The board declared a $1,450,000 dividend six days before the closing date and paid it four days later. See paying a dividend before you sell the shares.
The company was profitable, current with every supplier, and comfortably inside its covenants. The vendor's accountant confirmed there was ample cash. Nobody asked corporate counsel, because on any ordinary reading of the word there was nothing about the company that looked insolvent.
The statutory test for a dividend is not a test of whether the company can pay its bills. It has two limbs and the second one is a balance-sheet comparison that includes a number no operating manager has ever looked at.
A 2018 estate freeze had exchanged the founder's growth shares for redeemable preferreds with a stated capital of $2,290,000. Stated capital records what was paid in for shares. It does not go down when cash goes out, it is unrelated to the market value of the business, and it sits inside the s.42 comparator permanently until a formal reduction is done.
Realizable assets $8,900,000. Liabilities $5,400,000. Stated capital of all classes $2,300,000 — $2,290,000 of freeze preferreds plus $10,000 of common. The comparator is therefore $5,400,000 + $2,300,000 = $7,700,000.
Pay $1,450,000 and realizable assets fall to $7,450,000. That is $250,000 below the comparator, so limb (b) fails. Limb (a) passes on any view: after the dividend the company still had $610,000 of cash, a clean receivables ledger and no facility maturing inside a year.
The largest lawful dividend on those figures is $1,200,000, which lands exactly on the line. Taking $1,100,000 leaves realizable assets at $7,800,000 against a $7,700,000 comparator — a $100,000 margin, which is what a board wants when the inputs are estimates of realizable value rather than book value.
CBCA s.42, under the marginal note Dividends, provides in full: “A corporation shall not declare or pay a dividend if there are reasonable grounds for believing that (a) the corporation is, or would after the payment be, unable to pay its liabilities as they become due; or (b) the realizable value of the corporation's assets would thereby be less than the aggregate of its liabilities and stated capital of all classes.”
Two corrections to the way this section is usually described.
First, it is not a declaration test. The words are “shall not declare or pay”, and each verb is its own prohibition. A board that satisfies itself at the declaration and does nothing further has done half the job: if a judgment, an assessment or a customer failure lands in the four days between declaration and payment, the payment is caught even though the declaration was not. On a pre-closing sweep, where the declaration and the payment straddle the diligence bring-down, that gap is not theoretical.
Second, the balance-sheet limb is a stated capital test, not a net-worth test. Compare s.190(26)(b), which stops at “the aggregate of its liabilities” and would have permitted a far larger distribution on these same figures. The Act uses three different balance-sheet formulations in three different places and this is the strictest of the ones that apply to money leaving the company for its shareholders. Reading one across to another is the error class this library has already been repaired for once.
The unit is the corporation's own balance sheet. Not the group's, not the vendor's, and not the price. A locked-box mechanism allocates the economic benefit of pre-closing cash between the parties by contract; it has no effect at all on whether the corporation may lawfully declare or pay the dividend that moves it. That is why this file is not the same as cash swept out of the company the week before closing, which turns on a no-leakage covenant and an escrow — a contractual claim between buyer and seller. Here the question is whether the company was permitted to make the payment at all, and the answer would be the same if there were no purchase agreement in existence.
Buyer's counsel raised it on the bring-down call. The declared dividend was rescinded by directors' resolution before payment and re-declared at $1,100,000. The remaining $350,000 stayed in the company and the price was increased dollar-for-dollar, so the economics between the parties were unchanged and only the route the money took was different.
The buyer also required a directors' certificate at closing addressing both limbs of s.42 by reference to the actual figures, rather than the customary recital that all dividends were properly declared. That certificate is the document that tells a buyer whether it is inheriting a company whose directors have a restoration liability.
Directors who authorise it anyway carry it personally. Section 118(2) makes directors who vote for or consent to a resolution authorising “a payment of a dividend contrary to section 42” jointly and severally, or solidarily, “liable to restore to the corporation any amounts so distributed or paid and not otherwise recovered by the corporation”. Section 118(4) and (5) then let a director who has paid apply to the court to compel the recipient shareholder to hand it back. Section 118(7) allows two years from the date of the authorising resolution to commence the action — which on a sale means the exposure outlives the transaction, and lands on directors who by then are former directors of a company somebody else owns. See director liability the share buyer inherits.
The obvious workaround is to do the sweep as a repayment of shareholder loans. Repaying a genuine debt is not a dividend and s.42 has nothing to say about it — but the analysis moves to a different statute with different clocks. Under Bankruptcy and Insolvency Act s.95(1) a payment by an insolvent person to a creditor is reviewable as a preference over three months where the creditor is at arm's length and twelve months where it is not — and a shareholder repaying himself is not at arm's length. Under s.96(1)(b) a non-arm's-length transfer at undervalue is reviewable over one year without more, and over five years where the debtor was insolvent or intended to defraud, defeat or delay a creditor.
A pre-closing dividend in a company that has ever done an estate freeze, a share-for-share exchange or a section 85 rollover. Any of those can leave a large stated capital figure on the books that no one has thought about since, and stated capital is invisible on the management accounts the deal is being run from. Ask for the stated capital account by class before the sweep is sized, not after the resolution is signed — and check the figure again on the payment date, not just on the declaration date.
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