What it is:
How it works/Example:
For example, let's say Company XYZ has $20,000,000 of retained earnings. It recently raised $20,000,000 of new capital from a bank loan.
The company decides to declare a $0.05 per share dividend. It pays the dividend out of the $20,000,000 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, and in many cases the company making the illegal dividend must rescind the dividend (i.e., get it back). Both parties become concerned very quickly that the company's managers are using cash in nonapproved ways. For lenders, this could mean the companies are jeopardizing their ability to make loan payments or using funds for purposes other than what was agreed to in the loan agreement.