Dividends

Overview to Dividends and Distributions

Once an investor has chosen to invest money in a company, there are only a fixed number of ways that he can recreate his initial liquidity and get his money back out. In a public company, he could sell his shares or wait for the company to go bankrupt or dissolve to get his money back. However, the shareholder may not want to sell his shares, as he may like the company and its prospects, and he certainly does not want to see the company go bankrupt, as that would dash any hopes of his shares appreciating in value. 

The problem, from the investor’s standpoint, is how to get money out of the company while still owning shares in the company. The answer is to receive some sort of distribution from the company during the course of the company’s lifetime. That term, “distribution,” and its cousin, “dividend”, are terms that we have used several times before in this class. However, we are now going to take a look at what they mean and how they operate in a business context.

To start with, keep in mind that the terms “distribution” and “dividend” differ. There are a variety of ways that companies pay money out to their shareholders; all of these are called “distributions.” “Dividends” are merely a subclass of “distributions” consisting of the payments of money to shareholders. Note, however, that there are a variety of other distributions that can be made, which include the following:

• Distributions of property
• Share repurchase plans
• Pay-in-kind (PIK) securities

EXAMPLE: Steve has been a major investor in Old Co. for some time. Old’s management has consistently refused to pay any money out to investors – either in the form of a dividend or other distribution – indicating that they are saving the funds “for a rainy day.” Steve, who would like to maintain his investment in Old, has argued with several Board members that they should make some form of distribution, especially because the huge cash reserve held by the company makes the company a ripe and attractive target for a takeover, and weakens investor confidence by raising the suspicion that the management is simply hoarding money to pay themselves bigger bonuses and insure their positions.

Why Dividends?

So, why do shareholders want dividends? This may sound like something of an unusual question. After all, don’t investors put their money into the company in order to get a return on their investment? Why shouldn’t the company pay some of that money back over the course of its life?

While the answers to all of these questions may seem obvious, the question of why exactly companies pay dividends is something that has ruffled the feathers of business and legal academics for many years. On the one hand, are the motives of investors who want to see cash from their investment as soon as possible, and often would prefer to have that cash themselves, rather than leaving it in the hands of management who may squander it. However, on the opposite side of the coin is the issue of dividend taxation, which we touched on previously. When a company pays a dividend, that dividend is taxed. The problem is that the company has already paid a tax on the same money when it initially earned the funds. As such, providing a dividend to shareholders subjects it to the “double-taxation” problem that we discussed earlier.

Ultimately, it is not quite clear why companies pay dividends or why shareholders really want them, given the tax considerations. In the end, it is probably a balance of issues that suggests that shareholders are willing to pay a higher tax bill in order to ensure that they get something from their investment and companies are willing to pay the dividends because it is a sign of good faith; i.e., that they are not squandering the money. In addition, the market likes to see dividends, as they are a sign of the company’s profitability and financial success. Thus, declaring dividends, while perhaps decreasing the company’s value in the short run (by paying out company assets), may actually help keep the stock price high in the long run.

EXAMPLE: Charlie is on the Board of Big Co. Big Co. has consistently earned profits for the last five years, but has never paid shareholders a dividend. Charlie is approached one day by a group of major shareholders who ask him to create a board initiative to pay a dividend. The shareholder group argues that having so much cash on hand makes the company a ready target for a takeover attempt and that they are worried that the board will invest in foolish projects, simply to continue expanding its power. Charlie responds to the criticism by saying the board has been keeping cash on hand because it expects to complete a major acquisition some time in the near future, and furthermore, it would hate to see shareholders faced with a large tax bill if it simply distributes cash in a high-tax year such as the current one.

How Dividends Happen

The first rule of dividends is that their creation is solely within the jurisdiction and discretion of the board. See 8 Del. C. § 170. While shareholders and market watchers may be clamoring for a dividend, absent some sort of fraud, virtually no court in this country will force a company to pay a dividend against the board’s wishes. The reason is that, as with the business judgment rule, the courts view the board as having the best perspective on how the company is doing from a financial and business perspective. Thus, if the board chooses to withhold funds, thereby refraining from issuing a dividend, the board is suggesting that it needs the money either for continued operations of the company or because it sees something on the horizon that it feels it will need cash on hand to pursue. Given this situation, courts do not like to second-guess the board on how to operate the corporation. As such, the board has wide latitude to pay out dividends and can do so for any valid business reason. See Sinclair Oil Corp. v. Levien, 280 A.2d 717 (Del. Sup. Ct. 1971).

The mechanics of dividends are straightforward. Once the board has decided to issue a dividend, the Board “declares” the dividend, indicating the amount of the dividend, which classes of stock will be entitled to receive the dividend, and when/how it will be paid. The date on which the board declares the dividend is known as the “declaration date” (sometimes known as the “record date”). Subsequently, the market will reprice the shares to indicate that there is a dividend to be paid. All of those who own shares as of the date when the dividend is actually paid are entitled to their pro-rata share of the dividend for each share that they own.

EXAMPLE: TechE Inc. has had a stellar year. Sales of their new portable DVD-VCR-CD-MP3-Record-Tape deck have been sky high. As such, the Board decides to declare a dividend. After reviewing the company’s financial statements and making certain that they have adequate cash on hand for the next several years, they declare a dividend of $.02 per share of common stock and $.05 per share of preferred stock, to be paid on November 15th.

It is important to note that once the dividend has been “declared” the dividend is now considered a debt of the corporation and it must be paid in the same way that the corporation would need to pay its suppliers. Prior to declaration, shareholders have no right to sue for the dividend, but upon declaration, they become creditors of the corporation and may sue if the company subsequently fails to pay the dividend. See Bryan v. Aikin, 86 A. 674 (Del. Sup. Ct. 1913).

Limitations and Liability

While distributions are usually within the directors’ discretion, distributions are not permitted if:

• the corporation would not be able to pay its debts as they become due in the usual course of business, or the corporation’s total assets would be less than the sum of its total liabilities plus the amount that would be needed to satisfy preferential rights on dissolution, should the corporation be dissolved at time of distribution. See RMBCA §6.40(c).
  

Note that a director who votes for or assents to a distribution that violates these rules is personally liable to the corporation for the amount of the distribution that exceeds what could have been properly distributed.

Share Repurchase Plans

In addition to paying an outright cash dividend, a company might otherwise choose to make a distribution by buying back shares that it had previously issued. This is known as a “share repurchase plan.” Through a share repurchase plan, the company makes a filing with the SEC (if it is publicly traded) or otherwise informs its shareholders that it intends to repurchase shares that it previously sold to investors. The shareholders are then invited to “tender” – i.e., offer up for resale to the company – a certain percentage of their shares equal to their pro-rata ownership in the company. The company then purchases the shares from each tendering shareholder and pays the shareholder cash for the shares. The company then will make the decision either to retire the stock outright (thus increasing the percentage of ownership inherent in the other outstanding shares), or hold it as “treasury stock” (see terms) for later re-issuance. 

Share repurchases are efficient means of returning value to shareholders. First, on the sale of shares to the company, the shareholder is receiving a distribution of cash in return for the shares. Perhaps more importantly is the fact that if all shareholders can sell shares to the corporation, each individual shareholder who sold shares back to the corporation has not seen her ownership in the company decrease. That is to say, that while the shareholder has received cash, she has also sold shares back into the company thereby decreasing the number of shares issued and outstanding. As a result, and given any price differential in the value of the shares to the value of the repurchase, the value of the shares still outstanding will have risen in response to the purchase. Thus, the company can also effect a secondary goal of raising the price of the shares if it feels that the shares as they existed in the market prior to repurchase were undervalued. 

EXAMPLE: The members of ToolPool Inc.’s board have decided that they would like to make a distribution to shareholders. However, they do not want to pay a cash dividend as they feel that the company’s shares are already undervalued in the market and that paying cash to shareholders would further depress that value. As such, they decide to institute a repurchase plan whereby each shareholder will be allowed to tender one share of stock for every 100 shares that she owns, and those shares will be purchased by the company. After canceling the shares that they repurchase, management believes that the market will revalue the company’s shares to indicate that the company is willing to move cash back into the hands of shareholders. This will hopefully elevate the stock price.

Smaller corporations (companies that are not public) often draft provisions in the corporation’s bylaws or incorporation papers that specifically allow the corporation to “repurchase” shares from the shareholders. In this manner, a small company can assure that its management continues to be concentrated in the founders or original managers of the company. Agreements of this nature will usually be specifically enforced by courts (a court will issue injunctions forcing shareholders to allow such a repurchase if that was called for in the corporation’s governing documents). See Concord Auto Auction, Inc. v. Rustin, 627 F. Supp. 1526 (D. Mass. 1986).

Distributions of Property

Another method that a company may choose in order to provide a payment to shareholders is through the distribution of property. In the small company context, a distribution of property may be just that: e.g., a piece of land or equipment may be given over to a shareholder as a payment. Such a distribution only works in a small company, as it is obvious that dividing up a piece of land or a machine between the millions of shareholders of a public company would be near impossible.

That is not to say, however, that large and even public companies do not effect distributions of property. In the large company context though, distributions of property typically come in the distribution of shares representing ownership in a part of the larger company’s operations. This means of creating a distribution was seen often during the internet “bubble” days as well-known firms distributed shares in businesses that were not part of their core operating lines, but had resulted from the investor clamor and demand to buy stock in “dot com” companies. Consider the following as an example:

EXAMPLE: Computer Crew, Inc., a corporation engaged in the manufacture and sale of a variety of computers and computer-related products, has been doing exceptional business producing and selling watches with miniature TVs built in to their screens. Because of the fact that the market has been clamoring for the issuance of high-tech stocks, Computer Crew decides to separately incorporate the watch line and distribute shares of the new company to shareholders who can then in turn, sell them on the market.