Definition
An illegal dividend is a dividend declared by a corporation’s board of directors in violation of its charter or state laws. Most states stipulate that dividends be paid out of current income or retained earnings. They prohibit dividend payments that:
- Come out of capital surplus,
- Would make the corporation insolvent,
- Are prohibited by a bond indenture.
Legal Ramifications
The declaration and distribution of illegal dividends can have severe consequences for a corporation and its stakeholders. These can include penalties, fines, potential lawsuits, and personal liability for the directors.
Types of Illegal Dividends
Paid from Capital Surplus
Dividends are typically expected to be distributed from profits or retained earnings. When a company pays dividends from its capital surplus, it is effectively reducing its net worth, compromising financial stability, and violating legal requirements.
Insolvency-Inducing Dividends
Some jurisdictions prohibit the declaration of dividends if the payout would render the company insolvent. Insolvency means that the company’s liabilities exceed its assets, which can lead to bankruptcy.
Restricted by Bond Indentures
Bond indentures are agreements between a bond issuer and bondholders outlining the terms of the bond. These often include covenants that prevent the payment of dividends if certain financial thresholds are not met. Violating these covenants can constitute an illegal dividend.
Historical Context
The regulation of dividend payments has evolved significantly over time. Initially, there was greater leeway for companies regarding dividend declarations. However, increased corporate scandals and bankruptcies led to stricter state laws and financial regulations to protect creditors and minority shareholders.
Applicability
Corporate Governance
Boards of directors must ensure that dividend declarations comply with all applicable regulations. The board should have access to the company’s financial statements and legal advice to make informed decisions.
Financial Reporting
Accountants and auditors play a critical role in ensuring that the financial figures used to justify dividend payments are accurate and compliant with legal standards. Financial restatements can sometimes reveal previously declared illegal dividends.
Comparisons and Related Terms
Legal Dividends
Legal dividends are those properly declared and paid out of profits or retained earnings. These dividends do not violate any statutes or bond indenture covenants.
Retained Earnings
Retained earnings refer to the portion of net income not paid out as dividends but retained for reinvestment in the business or to pay off debt. State laws often require dividends to be paid out of retained earnings.
Insolvency
Insolvency is the state of being unable to pay debts owed as they come due. Declaration of a dividend that renders a company insolvent can be highly detrimental and illegal.
Fraudulent Conveyance
An illegal dividend can sometimes be regarded as a form of fraudulent conveyance, where assets are transferred to avoid creditors, violating bankruptcy or insolvency laws.
FAQs
Can directors be held personally liable for illegal dividends?
How can companies prevent illegal dividend declarations?
What are the consequences of receiving an illegal dividend?
How is insolvency determined for purposes of dividend legality?
References
- Black, K. H. (Year). Corporate Law. Publisher.
- Smith, J. L. (Year). Financial Management and Policy. Publisher.
- “Dividends.” Investopedia, LLC. URL.
- “Corporate Governance and Dividend Policy.” Journal of Finance, Volume, pages. URL.
Summary
Illegal dividends represent a serious breach of financial and corporate regulations, enforced to protect the interests of creditors, shareholders, and the financial stability of the corporation. Understanding the legal landscape governing dividend declarations helps ensure that companies remain compliant and financially healthy.
