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.
Related Terms
- 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
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