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Have Directors Improperly Refused to Declare a Dividend?

September 1, 2014

Payment of dividends rests within the sound discretion and business judgment of the board of directors. Shareholders have no “right” to dividends even if adequate funds are available. For example, the board of Apple Inc. did not declare its first dividend until March of 2012 even though the computer giant had previously held cash and other financial assets valued at up to $100 billion. In this, as in all such instances, the directors alone have the power to determine if, when and how much of a dividend will be paid.

Board’s Duties Regarding Dividends: The power to declare dividends is unique to the board and must be exercised by the board as a whole. A dividend declaration typically requires the board to adopt a resolution authorizing the dividend payment (although written consent from every member of the board to pay a dividend may take the place of a resolution). Once the board of directors has lawfully declared a dividend for each shareholder entitled to receive it, the board may not revoke it or withhold dividend distribution without the consent of each such shareholder.

Good Faith as Limitation on Board’s Discretion: The board’s discretion on whether, when and how much to pay dividends must be exercised in good faith. If the directors act “fraudulently” or “in bad faith,” they may be held personally liable to shareholders injured by their actions.

For example, directors who vote excessive “salaries” to themselves or controlling shareholders, while refusing to declare dividends, may be personally liable to other shareholders. Shareholders who bring suit in such instances can ask the court to find that all or some part of the salaries were “disguised dividends,” and that the other shareholders were entitled to share in them. However, because of the business judgment rule, courts are generally very reluctant to second-guess the decisions of directors regarding the payment of dividends. There are simply too many business factors involved. A strong showing of “bad faith” or “fraud” is required.

Fiduciary Obligation Owed by Controlling Shareholders: Controlling shareholders owe a fiduciary duty to minority shareholders not to exercise their control of the corporation so as to enrich themselves at the expense of the minority. Arguably, therefore, even if minority shareholders have no “right” to dividends, they may have a cause of action against a controlling shareholder who causes the corporation to adopt a dividend policy designed to serve his or her own personal interests, at the expense of the minority.

One example of such an action is if minority shareholders refuse to sell their shares at a deflated price to a controlling shareholder, who then attempts to “freeze them out” by causing the board of directors to stop paying dividends, although ample funds are available. The specific objective of such an action is to deflate the value of the minority’s shares and pressure them into selling out to the controlling shareholder, which is a breach of the board’s fiduciary duty to all shareholders.

Board Obligations in Declaring a Dividend: In order to determine the shareholders entitled to receive payment of the dividend, the board of directors may fix a “record date.” In so doing, the board announces that a dividend payment will be made on the specified payment date to all shareholders listed on the company’s books as owners as of the close of business on the record date (which typically is a stated period of time prior to the payment date). If the board fails to specify the record date, the California Corporations Code automatically fixes the date for such determination.

Setting the payment date rests within the sound discretion of the board of directors. Normally, it is set within 30-60 days following the “record date,” to allow a reasonable period for administrative preparation to make dividend distributions.

There is no statutory time limit on how long, after declaration, the dividend may be made payable. Thus, the dividend payment date could be put off for months, or even years. If the board declared a dividend but failed to fix any date for its payment, the dividend would probably be deemed payable within a “reasonable” period of time following declaration. However, failure to pay a declared dividend to all shareholders of record, while certain shareholders receive financial considerations in lieu of dividend payment, is a violation of the board’s fiduciary duty and could be a cause for shareholder litigation.

Board Obligations in Funding a Dividend: If a dividend is paid from sources other than a company’s retained earnings, the corporation must notify the shareholders receiving the dividend from what source it was paid. Such notice must be given either at the time of payment, or within three months after the close of the fiscal year in which the dividend was paid. This enables the shareholder who received the dividend to determine whether the dividend is taxable income (paid out of retained earnings), or tax-free as a return of capital (paid out of capital). Dividends paid should be reported to shareholders for tax purposes on Form 1099-DIV, which reports dividends, qualified dividends and capital gains distributions.

A final caution is that, although dividends are not required to be paid from retained earnings, this is the most prudent financial course. While the board’s decision to pay a dividend from any source other than retained earnings likely cannot be questioned due to the business judgment rule, it may alert the shareholder to question the value of his or her shareholdings, given that the dividend declaration policies of the board of directors may be ill-advised.

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This Alert is made available for educational purposes and to provide general information on current legal topics, not to provide specific legal advice. The publication of this Alert does not create any attorney client relationship, and this Alert should not be used as a substitute for competent legal advice from a licensed professional attorney.