This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
It would be inadvisable to close this chapter without calling attention to some well-established legal principles which should always be kept in view. Perhaps the most important of these principles is that dividends shall be paid only out of surplus and never out of capital. The Corporation Act of New Jersey provides that directors who take part in such action, or who do not enter a protest within a reasonable period, shall be personally liable during a period of six years following the payment of such dividends. The best-known case which has established and emphasized this principle is that of the American Malting Company. During the first year of the existence of this company the directors declared cash dividends, apparently on the strength of "anticipated" profits which were included in the income account. After the facts became known, suits were brought by stockholders both in New York and New Jersey, and in both states the suits were decided in favor of the stockholders. After litigation lasting almost five years, the matter was settled by the payment on the part of individual directors of $500,000, $340,000 of which went into the treasury of the company and $160,000 to the plaintiffs for the expenses of their suits.
Another important legal principle is that dividends once declared become an indebtedness of the corporation to the stockholders and cannot afterward be rescinded by the directors. It is even held in most jurisdictions that dividends once declared no longer belong to the corporation but have become the property of the stockholders as individuals.
There are numerous special requirements and limitations contained in the constitutions of the various states. As an example, attention may be called to a law in the State of Massachusetts forbidding the issuance of stock and scrip dividends by public utility companies, which reads as follows:
No company shall declare any stock or scrip dividend or divide the proceeds of any sale of stock or scrip among its stockholders; nor shall any company create any additional new stock or issue certificates thereof to any person unless the par value of the share so issued is first paid in cash into its treasury.