The Wall Street Journal has reported an increase in debt-financed dividends this year. This increase relates to concerns over a potential tax increase on dividends at the end of 2012. According to Moody's Investors Service, in the first three quarters of 2012 there were over $16.5 billion in debt-financed dividend payments, with $5.5 billion of those payments occurring in the third quarter of 2012. These figures include payments made by both non-public companies and companies that are controlled by private equity.

These debt-financed dividend deals are known as dividend recaps and their increase has coincided with an increase in the issuance of covenant-lite loans in 2012 (see Legal Update, Covenant-lite Loans Increase Sharply in 2012). Covenant-lite loans are often used by private equity firms to fund dividend recaps.

Stockholders support the payment of dividends now because:

Companies also favor these dividends because they can issue large amounts of debt cheaply while interest rates are low. Financial markets are generally supportive of debt-financed dividends at present because of the strong demand by investors seeking to acquire more debt instruments.

However, dividend recaps expose existing bondholders and other creditors of companies to increased risk as the company is taking on additional debt without any corresponding increase in cash flow or revenue. In some cases, this can be a cause for concern. The increase in the company's leverage may result in a credit rating downgrade, such as the one suffered by Booz Allen & Hamilton Holding Corporation earlier this year in response to a proposed debt-financed special dividend.

For more information on dividend recaps, see Practice Note, Leveraged Dividend Recapitalizations.