What it is:
An illegal dividend is a dividend declared in violation of a company's charter or state laws.
How it works (Example):
Let's say Company XYZ has $20 million of retained earnings. It recently raised $20 million of new from a bank .
The company decides to declare a 5-cent-per-share dividend. It pays the dividend out of the $20 million it got from the bank loan. Because many states prohibit companies from paying dividends out of their capital accounts, Company XYZ is paying an illegal dividend. It should've paid the dividend out of retained earnings.
Why it Matters:
Illegal dividends invite shareholder suits and action from lenders, this could the companies are jeopardizing their ability to make payments or using for purposes other than what was agreed to in the loan agreement., and in many cases the company making the illegal dividend must rescind the (i.e., get it back). Both parties become concerned very quickly that the company's managers are using in nonapproved ways. For