Dividends and Other Legal Capital Arcana

• Pages: 541-564
• Author: Stephen M. Bainbridge

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Chapter 13

DIVIDENDS AND OTHER LEGAL

CAPITAL ARCANA

§ 13.1 Introduction

A corporation’s balance sheet balances when assets (the left

side) equal the sum of liabilities and shareholder equity (the right

side). Shareholder eq uity thus consists of the corporation’s net

assets—the (hopefully positive) difference between assets and

liabilities. Consequently, we speak of an “equity cushion.” Because

creditors have a prior claim on the corporation’s assets, a fall in the

value of those assets comes out of shareholder equity before it

impairs the corporation’s ability to repay its liabilities.

At common law, the corporation’s shareholder equity thus was

viewed as a “trust fund” held by the corporation for the benefit of its

creditors. This doctrine received its classic expression in the early

19th century decision of Wood v. Dummer.

1

The Hallowell and

Augusta Bank paid out the bulk of its assets in dividends to its

shareholders. As a result, when the Bank later became insolvent,

insufficient assets remained to pay its creditors. Trying the case in

his capacity as a circuit judge, U.S. Supreme Court Justice Story held

that “the capital stock of banks is to be deemed a pledge or trust fund

for the payment of the debts contracted by the bank.” Suppose, for

example, that the Bank issued 2,000 shares of common stock having

a par value of $100. On those facts, its capital equaled $200,000.

Accordingly, the Bank was obliged to maintain net assets of at least

$200,000.

The trust fund doctrine likely was intended to deter

opportunistic conduct by shareholders vis-à-vis creditors. The

corporation’s decision making and financial apparatus is controlled

by the board of directors, elected by and responsible to the

shareholders. In close corporations, the problem is especially

pronounced because the shareholders and the board members likely

will be one and the same. One obvious risk is that shareholders will

divert cash flows to their own pockets in the form of salaries, bonuses,

dividends, and the like. A more subtle problem is that limited

liability creates incentives for shareholders to cause the company to

invest in higher risk projects than the firm’s creditors would like. As

the firm’s residual claimants, shareholders will not be paid until all

creditor claims are satisfied. Shareholders thus will prefer that the

1

30 F.Cas. 435 (C.C.D.Me.1824).

542

DIVIDENDS AND OTHER LEGAL

CAPITAL ARCANA

Ch. 13

corporation select high risk projects that promise high returns.

Because limited liability means that shareholders only put at risk

what funds they have invested in the firm, moreover, they are able

to effectively externalize some of the risk associated with such

projects to creditors. If the high-risk project fails, the creditors may

not be paid, but cannot collect any unpaid debt from the

shareholders.

In the nineteenth century, many states gave teeth to the trust

fund doctrine through minimum capital requirements, which

specified the minimum amount shareholders had to initially invest

in the company. Over time, however, it became obvious that one size

does not fit all and minimum capital requirements have faded from

view. Few states have them today and those that do set the minimum

at nominal amounts.

Instead, legal capital rules tried to implement the trust fund

concept by deterring shareholders from impairing the corporation’s

equity cushion. One prong of this approach regulated the flow of

money into the corporation, while the other regulated the flow of

money out. Requiring that stock be fully paid and nonassessable was

an effort to ensure that the assets of which the corporation’s

shareholder equity purportedly consisted actually existed and, in

fact, had been paid in. Restricting the payment of dividends was an

effort to ensure that the corporation maintained some equity cushion.

Neither effort turned out very well, however, and today the once

proud trust fund doctrine is but a tattered shadow of its fo rmer self.

Instead, modern creditors must rely on self-help. They protect

themselves through private contracting (such as negative pledge

covenants in bo nd indentures or loan agreements), credit

investigations, and charging higher interest rates.

§ 13.2 Money in: Herein of Watered Stock

If the corporation wishes to raise capital by selling equity

securities, it is the board of directors that makes that determination

and also decides the amount and form of consideration to be received

in exchange for the shares to be issued.

2

Accordingly, so long as the

charter authorizes the class of shares in question and there are

sufficient authorized but unissued shares, the board is free to sell

shares for any lawful purpose, provided that the corporation receives

adequate consideration for the shares. That latter proviso leads us to

the questions of par value and watered stock.

At one time, all stock had a “par value,” stated in the articles of

incorporation, which was the price at which the corporation initially

sold shares to the public. A firm could not sell shares for less than

2

DGCL § 153(a).