Definition
An illegal dividend is a type of dividend declared by a corporation’s board of directors that violates the company’s charter or state laws. Most state laws stipulate that dividends must be paid out of current income or retained earnings, and prohibit payments from capital surplus. Additionally, any dividend distribution that would render the corporation insolvent or is prohibited by terms within a bond indenture is considered illegal.
Examples of Illegal Dividends
- Dividends from Capital Surplus: A corporation has had a poor financial year and does not have sufficient current income or retained earnings but decides to pay dividends from capital surplus. This would be illegal as it violates state laws that require dividends to be paid from earnings.
- Insolvency Risk: A company decides to pay a dividend that would leave it with insufficient capital to cover its debts, thereby making it insolvent. Such a dividend is illegal.
- Bond Indenture Prohibition: A corporation with outstanding bond covenants that prohibit dividend payments beyond a certain amount decides to exceed this limit. Declaring dividends in this situation would violate the bond indenture, making it illegal.
Frequently Asked Questions (FAQs)
What makes a dividend “illegal”?
A dividend becomes illegal if it is declared in violation of corporate charters or state laws, which typically require that dividends be sourced from current earnings or retained profits and not from capital surplus or in ways that render the company insolvent.
What are the consequences of declaring an illegal dividend?
Consequences for declaring an illegal dividend can include personal liability for directors, legal action from creditors, and financial penalties against the corporation.
How can a company prevent the declaration of illegal dividends?
Companies can avoid declaring illegal dividends by ensuring compliance with state laws, corporate bylaws, and bond indentures, often by consulting with legal and financial advisors before declaring any dividends.
Can shareholders recover dividends paid illegally?
Shareholders who receive illegal dividends might be required to repay the amount if the company’s creditors seek recovery, especially if the company becomes insolvent.
Are illegal dividends a common occurrence?
While not common, they do occur, often as a result of oversight or financial mismanagement. Companies generally strive to comply with legal requirements to avoid the repercussions of illegal dividend declarations.
- Dividend: A payment made by a corporation to its shareholders, usually in the form of cash or additional stock, representing a portion of the company’s earnings.
- Capital Surplus: The portion of a company’s equity that is not derived from net earnings; often resulting from stock issued above par value.
- Retained Earnings: The accumulated portion of net income that is retained by a corporation rather than distributed to its shareholders as dividends.
- Bond Indenture: A legal document outlining the terms and conditions of a bond issue, including covenants that may restrict certain actions of the issuer, such as dividend payments.
Online Resources
Suggested Books for Further Studies
- “Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen
- “Corporate Finance” by Jonathan Berk and Peter DeMarzo
- “Advanced Accounting” by Paul M. Fischer, William J. Tayler, and Rita H. Cheng
Fundamentals of Illegal Dividends: Corporate Law Basics Quiz
### What must most states stipulate about dividends?
- [ ] They must be paid monthly.
- [ ] They can be paid from any source of funds.
- [x] They must be paid out of current income or retained earnings.
- [ ] They must be paid in the form of stock only.
> **Explanation:** Most states require that dividends be paid out of current income or retained earnings to ensure the financial stability of the corporation.
### Paying dividends from which source is typically prohibited by state laws?
- [ ] Current income
- [ ] Retained earnings
- [x] Capital surplus
- [ ] Cash surplus
> **Explanation:** Dividends paid from capital surplus are generally prohibited by state laws as they can jeopardize the financial standing of a corporation.
### What might render a declared dividend illegal?
- [x] Causing insolvency of the corporation
- [ ] Increasing stock prices
- [ ] Attracting new investors
- [ ] Fulfilling shareholder expectations
> **Explanation:** Declaring a dividend that would make the corporation insolvent makes it illegal because it compromises the company’s ability to meet its financial obligations.
### Who may face personal liability for declaring an illegal dividend?
- [ ] Shareholders
- [ ] Employees
- [x] Board of Directors
- [ ] Customers
> **Explanation:** The board of directors may be personally liable if they declare dividends in violation of company charters or state laws.
### What kind of prohibition might a bond indenture include regarding dividends?
- [ ] Prohibiting stock splits
- [ ] Detailed reports daily
- [x] Limits on the amount of dividends payable
- [ ] Prohibiting new hires
> **Explanation:** A bond indenture may include covenants that limit the amount of dividends a corporation can pay to protect bondholders' interests.
### Can shareholders be required to return illegal dividends?
- [x] Yes, if creditors demand recovery in case of insolvency
- [ ] No, once received they are the shareholders' property
- [ ] Yes, only if they are preferred shareholders
- [ ] No, only directors are liable
> **Explanation:** Shareholders may need to return dividends if creditors demand recovery, especially if those payments were illegal and the corporation becomes insolvent.
### Why do states regulate the source of dividend payments?
- [x] To ensure corporations remain financially healthy
- [ ] To control the stock market
- [ ] To prioritize state taxes
- [ ] To support shareholder wealth
> **Explanation:** Regulations ensure that companies remain financially healthy and solvent, preventing reckless distribution of dividends that could harm the company's longevity.
### What are retained earnings?
- [ ] Funds set aside for dividends
- [ ] Profits given to employees as bonuses
- [x] Accumulated earnings not distributed as dividends
- [ ] Capital allocated for future projects
> **Explanation:** Retained earnings are accumulated portions of net income that a corporation keeps rather than distributing to its shareholders.
### What might illegal dividends endanger apart from the company's financial health?
- [ ] Local municipal bonds
- [ ] Company's marketing strategies
- [ ] Employee job security
- [x] Corporate board's legal standing
> **Explanation:** The declaration of illegal dividends can put the corporate board in a position of personal and legal liability and harm the overall governance of the company.
### How can a corporation ensure compliance with dividend payments?
- [ ] Ignoring state laws
- [x] Consulting legal and financial advisors
- [ ] Paying dividends sparingly
- [ ] Only paying dividends in cash
> **Explanation:** To ensure compliance, corporations should consult legal and financial advisors to align with all state laws, corporate bylaws, and bond indenture agreements.
Thank you for exploring the comprehensive details regarding illegal dividends and engaging with our quiz to bolster your understanding of corporate law fundamentals. Happy learning!
