constructive dividends

Constructive Dividends 

Allegations that directors or controlling shareholders are manipulating dividends to “oppress” minority shareholders typically arise when the majority shareholders not only withhold dividends but also use some alternative method to distribute the corporation’s profits exclusively to themselves—frequently, by inflating their own salaries.  The “[r]efusal to pay dividends [and] paying majority shareholders outside the dividend process,”  the Texas Supreme Court noted in Ritche v. Rupe, “may be redressed through a derivative action, or through a direct action brought by the corporation, for breach of fiduciary duty.”  While that may be true in most instances, the same conduct also constitutes a corporate breach of trust in failing to deal with shareholders impartially and appropriating the minority’s share of what are actually coonstructive dividends being paid the the majority. The differences between addressing this oppressive conduct derivatively as withholding dividends plus excessive compensation versus directly as a breach of trust in the disproportionate payment of constructive dividends are real and significant.

What Constitutes a Constructive Dividend?

“A distribution by a corporation to its shareholders may constitute a dividend in law even though not formally designated as a dividend by the board of directors.” In Moroney v. Moroney, a guardian controlled a corporation with 500 shares, one of which he owned personally, and the other 499 he held in trust for the wards of the estate. The guardian caused the corporation to pay himself a large sum of money, and the wards of the estate later sued him for their 499/500 share. The defense was that the money was not a distribution but a misappropriation, and only the corporation could bring the suit. The Texas Commission of Appeals held:

Now, it is not essential to the right to receive a dividend that there should have been a formal declaration of a dividend, but where the corporation sets apart a fund for distribution to its stockholders to such extent as to become segregated from the property of the corporation, such property henceforth becomes, equitably, the stockholders’ property. There has been in legal effect a declaration of a dividend, and of course if such fund is actually delivered to the stockholders, there has been a payment, and the fund is legally that of the stockholder. In other words, where there has been such a segregation of the corporate funds, and such a dedication to the stockholders, the assets thus segregated cease to belong to the corporation, but do belong to the stockholders individually.

The court held that the payments were “in effect” dividends even though “there was never at any time a formal declaration of dividends”—it being “presumed that [the corporation] intended to do a lawful thing, and that the sums paid represented a legal liability of the corporation.” “The evidence indicates the corporation was a prosperous concern, and by common consent it pursued this method of distributing its proceeds to the rightful owners of such profits. The transaction evidences an intention to distribute the proceeds of the business to the rightful owners.” Furthermore, it made “no difference whether the corporation, Moroney Hardware Company, does or does not have a cause of action against [the guardian]. The estate recovers in this case upon the merits of its own claim.” As the Texas Supreme Court has held: “[W]hether or not a corporate distribution is a dividend or something else, such as a loan, gift, compensation for services, repayment of a loan, interest on a loan, or payment for property purchased, presents a question of fact to be determined in each case.”

Constructive Dividends or Misappropriation of Funds

Assume that a corporation is paying no dividends, that the 40% minority shareholder draws no salary, and that all corporate profits are consumed in payment of a large salary to the 60% majority shareholder—so that, in reality, part of the payment to the majority is compensation for services and part is a distribution of profits, a constructive dividend. Under the approach described in Ritchie, the plaintiff is required to address two very different questions. First, was the majority shareholder excessively compensated? This requires an inquiry into whether there was wrongdoing by the directors in setting the majority shareholder’s salary and will focus on whether the majority shareholder is being paid above-market. Because of the wide range of executive salaries, the plaintiff’s burden is very difficult. Second, the plaintiff must prove that dividends should be declared. This requires proof that the decision not to pay dividends was based on a purpose other than benefiting the corporation—again a difficult thing to prove in the face of plausible corporate purposes always available to be claimed by the directors and a judicial policy of extreme deference on dividend decisions. If the plaintiff is successful on both questions, the constructive dividend is cancelled—the defendant puts the money back into the corporation, and the plaintiff receives his portion of the constructive dividends. If the amount of the constructive dividends were $120,000, then the plaintiff would recover his 40%, or $48,000.

Equitable Remedy for Constructive Dividends

If the plaintiff were to approach the problem not as a breach of fiduciary duties to the corporation, but as a breach trust by the corporation, the analysis is very different. When dividends are declared, the corporation becomes indebted to each stockholder individually for the amounts of his respective shares. Dividends cannot be rescinded. As the Texas Supreme Court held in Yeaman v. Galveston City Co., the corporation has a fiduciary duty to hold and preserve the minority shareholder's share of the dividends and to pay them on demand. The factual question would not involve an issue of wrongdoing or of business judgment but merely one of value. Recognizing that it is perfectly appropriate to distribute profits in a closely-held corporation by means of salary and bonuses, the jury would only need to determine how much of the payment to the majority shareholder was for services and how much was distribution of profit? Because the directors must make compensation decisions in compliance with the formal fiduciary duties that they, as officers or directors, owe to the corporation, and thus to the shareholders collectively, and because “equity regarding as done that which ought to be done,” the jury would have to assume that the compensation for services would be valued at the lowest amount that comparable services could be procured on the market, and the rest is profit distribution--i.e., constructive dividends. If the amount of the constructive dividends actually paid to the majority shareholder was $120,000, then the corporation would have a fiduciary duty to pay the minority shareholder $80,000, because the total dividend constructively declared would have been $200,000—60% to the majority ($120,000) and 40% to the minority ($80,000). The corporation would be deemed to be holding the minority shareholder's portion in trust. This would clearly represent an instance where the legal remedy of a derivative action ($40,000) is not adequate when compared with the equitable remedy for breach of trust ($80,000).

Texas courts have frequently been willing and able to find a variety of financial benefits that majority shareholders confer on themselves to be constructive dividends. In Ramo, Inc. v. English, the corporation distributed substantial sums of money to the controlling shareholder, which were recorded on the books as advances. Only the first advance was documented with a board resolution; none of the advances were evidenced by a promissory note; and apparently the advances were without interest. The jury found that the controlling shareholder had no intention to repay the money. A lender contended that these distributions were not loans, but were actually de facto dividends in violation of a covenant in the security agreement. The Texas Supreme Court held that whether the distributions were loans or constructive dividends was a question for the jury, but that the evidence would have supported a finding that the distributions were really dividends if a jury question had been submitted. 

In Rivas v. Cantu, the plaintiff sued the controlling shareholder for breach of contract and fraud for having failed to transfer 50% of the shares in a corporation as promised prior to incorporation. The plaintiff claimed as special damages 50% of the amount of “constructive dividends” that the controlling shareholder had received. The court of appeals approved this measure of damages. The court noted that “a constructive dividend occurs when an expenditure is made by a corporation for the personal benefit of a stockholder, or corporate-owned facilities are used by a stockholder for his personal benefit” and that “the crucial concept is that the corporation conferred an economic benefit on the stockholder without expectation of repayment.” The court held that constructive dividends could be established by evidence of excessive compensation paid by the corporation to family members of the controlling stockholders; however, a constructive dividend does not occur automatically when a stockholder’s family member works for the corporation, but only when that relative is overcompensated. There must be evidence that compensation was paid for work that was not done, or work that was not needed by the corporation, or that the compensation for the services performed was unreasonably high. 

In Davis v. Sheerin, the jury found that “appellants received informal dividends by making profit sharing contributions for their benefit and to the exclusion of appellee.” The trial court awarded $20,893 to the plaintiff individually on a defacto dividends claim, separate and apart from his shareholder oppression and derivative claims. In Redmon v. Griffith, the plaintiff’s pleading that defendants made improper loans to themselves, paid personal expenses from corporate funds, and paid excessive dividends to themselves was held to properly state a pattern of oppressive conduct. In Boehringer v. Konkel, the majority shareholder withheld dividends for two years, claiming that the corporation did not have the funds to pay dividends in those years. However, the plaintiff also increased his salary to $20,000 per month during this time. The court concluded that the majority “withheld payment of a dividend and used his two-fold pay increase as a means of denying [the minority shareholder] his proportionate participation in the company’s earnings . . . .” The court stated that the sizeable salary increase for the majority shareholder resulted in a “de facto dividend” to the exclusion of the minority shareholder. In In re White, the court held payments of bonuses to the majority shareholders that tracked the profits of the company constituted “$4,900,000 in disguised dividends.”

Illegal Constructive Dividends

The equitable remedy for constructive dividends described here may result in constructive dividend declarations that subject the majority shareholder to additional liability to the corporation. The premise of the plaintiff’s claim is that funds taken from the company by the majority shareholder were constructive dividends—meaning that a court of equity would presume that was “done that which ought to be done,” and the corporation had declared a dividend in the amount reflected by what was paid to the majority. If the majority owns 60% of the stock and takes $600,000 in constructive dividends, then the actual amount of the constructive dividend declaration would be $1 million, and the corporation would owe the minority shareholder his 40% or $400,000 of the constructive dividend. What if the corporation doesn’t have $400,000? Directors are prohibited by statute from declaring dividends that would render the corporation insolvent or exceed the distribution limit. The distribution limit for dividends is the amount of the surplus of the corporation, meaning the amount by which the net assets of the company exceed the stated capital of the company. If the majority shareholder has been doing a thorough job of cleaning out the excess profits of a corporation through constructive dividends distributions to himself, then the amount of the grossed-up
 total constructive dividends declaration would frequently exceed the corporation’s surplus, in which case directors who vote for or assent to such a constructive dividend will be jointly and severally liable to the corporation for the amount by which the distribution exceeds the limit. The practical result is that the majority shareholder would be personally responsible for funding the plaintiff’s dividend if the corporation were unable to do so. However, the liability for an illegal dividend is solely to the corporation, therefore, this claim would be required to be asserted by the minority shareholder as a derivative claim.