DEFINITION of 'Illegal Dividend'

An illegal dividend is a dividend declared by a corporation that is in violation of its charter and/or of state laws. Should an illegal dividend be declared, the company's board of directors can be sued by shareholders and creditors, and in many cases must give back the dividend; the company may also face prosecution.

BREAKING DOWN 'Illegal Dividend'

A dividend is an amount of money paid (usually on a regular basis) to shareholders based on a company’s profits. A dividend can only be issued from company profits, and it can be issued in the form of money or company shares. It is essentially a division of a company’s taxed earnings. Corporations are not required by law to issue dividends, and states have different rules regarding dividends.

Directors of a company are in charge of voting and distributing dividends, and are therefore mostly accountable for making sure the numbers are in line. Oftentimes it is simply poor administrative operations that cause an illegal dividend. In a case of director or operational oversight, a dividend can be accidentally overpaid because it was declared, for example, based on the company’s bank balance instead of just its profits. This results in an illegal dividend being paid to shareholders. Illegal dividends may significantly weaken the financial position of the company and expose its creditors to a greater degree of risk.

If shareholders were aware that a company’s profits would not cover a dividend, they could be liable. However, if shareholders were unaware of the company’s financial status, the directors would be held liable. In some cases the directors would have to repay their own dividends as well as dividends paid to shareholders. 

Example

A company has a net income $40 million, but recently raised $30 million of new capital from a loan. The company declares a $0.10 dividend and pays it out of the $30 million loan. That is an illegal dividend because it is paid out of a capital account. The same would happen if the company paid a dividend on the combined $70 million.

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