Dividend Distributions: Rights, Restrictions, And Liabilities

• Author: James D. Cox/Thomas Lee Hazen
• Profession: Professor of Law at Duke University/Professor of Law at the University of North Carolina, Chapel Hill
• Pages: 462-484

20.13 The Innovations of the California Statute

and the Model Business Corporation Act

20.14 Stock Dividends and Stock Splits

20.15 Capitalization of Surplus for Stock

Dividends and Stock Splits

PART C. LIA BILITIES OF DIRECTORS

AND SHA REHOLDERS

20.16 Directors’ Liability for Unlawful Dividends

20.17 Shareholders’ Liability to Return Illegal Dividends

PART A. RIGHTS TO DIVIDENDS

§ 20.1 Declaration and Payment of Dividends

A dividend is properly declared by formal resolution of the board of

directors specif ying the amount, t he time of payment, and the “record

date,” and fixing the date for ascertaining the shareholders of record.

Most dividends are distributed to shareholders in the form of cash. Dis-

tributions may also be made in property or in the corporation’s own

shares. Regardless of the method of declaration or payment, the dis-

tribution of dividends among shareholders of the same class must be

without discrim ination and pro rata unless it is otherwise ag reed by all.1

§ 20.2 Directors’ Refusal to Declare Dividends

A corporation may have a surplus or accumulated profits legally avail-

able for dividends, but the right of the shareholders to the maki ng of

any distribution is dependent on the exercise of the d irectors’ good faith

discretion with regard to financial advisability at the time.2 An abuse of

this discret ion may call for equitable relief.

There are two dangers of abuse of the direc tors’ discretion in declar-

ing or withholding dividends. One is a policy of wastefulness or prodi-

gality— improvident distributions that are injurious to present or fut ure

creditors and investors reduce working capital a nd weaken the corpo-

ration as a going concern. The converse abuse is undue accumulation

beyond the reasonable needs of the business—the arbitrary ref usal to

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pay shareholders a fair return on their investment when it clearly would

be possible and wise to divide accumu lated profits. Investors purchasi ng

shares in a business often expect to obtain a return in the form of more

or less regular div idends according to the corporation’s ability to pay.

The management’s desire for expansion and more compensation instead

of dividends in some cases may defeat the shareholders’ just expecta-

tions.3 The law has been concerned pri marily with restraining dividend

distributions that are dangerous to the rights of corporate creditors.

The major source of funds for business expan sion is the accumulated

but undistributed profits of the busi ness. The board of directors’ decision

to expand the business open s a host of questions as to how the expansion

should be financed—by issuance of equity, by debt, or from undistrib-

uted earnings. Even though a school of financial theory counsels that

the firm’s value is not impacted by whichever of these choices occurs,

this “irrelevancy principle” can be seen as placing more emphasis on

intangible considerations that are best com mended to the board of direc-

tors unless an abuse of discret ion is otherwise demonstrated. Thus, the

courts hesitate to substitute their judgment on complicated questions of

business policy for that of the elected managers of the business and have

limited the scope of judicial rev iew that they are wil ling to undertake.

It is accordingly a well-settled doct rine that whether or not divi-

dends shall be paid, and the amount of the distribution at any time, is

primarily to be determined in the good faith discretion of the direc-

tors.4 Courts exam ine directors’ decisions regard ing dividends through

the lens of the business judgment ru le. In fact the rhetoric of the cases

suggests a slightly more deferential standard, stating the court w ill not

intrude upon the decision to not declare dividends absent “fraud or

gross abuse of discretion.”5 In sum, dividend declarations are like other

matters within the discretion of the board of directors for which direc-

tor judgments are presumptively val id. The mere fact that a corporation

reports a substantial surplus or large profits out of which a dividend

might lawfully be declared is not of itself sufficient ground to compel

the directors to make a d ividend.6 Directors are given a great deal of

discretion to use corporate resource s to expand the business, to increase

executive compensation by bonuses and profit-sharing contracts, and

to establish various reserves if they consider it to be in the interests of

the corporation to do so. Thus, many reasonable bases have successf ully

been advanced to justif y the directors’ decision not to declare dividends:

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