As the US Treasury Department continues to lend to or make senior equity investments in corporate America, especially its financial institutions, people debate whether those taxpayer investments should be accompanied by limits on investees’ right to pay cash dividends to common stockholders.
This is a fundamental issue in corporate finance, requiring mediation of a tension between senior investors, who want security of repayment, and common (junior) stockholders, who want periodic returns on their investment.
The balance and how to resolve it is reflected in state corporation law regulating dividends. In general, those laws provide a minimum level of protection to senior lenders and equity holders, restricting distributions to common stockholders to minimize bankruptcy risk, and assuring that a corporation has flexibility to make such distributions.
A review of state corporation law approaches may be useful to assess what policies Treasury should consider when investing taxpayer funds in senior loans or equity in corporate America. The review suggests that: (1) Treasury may go too far if it prohibits cash dividends altogether; and (2) tools it is developing to assess investee’s positions, called stress tests, routinely used under some state statutes to determine the legality of distributions to common stockholders, should be applied to determine, on a case by case basis, to what extent, if any, government investment of taxpayer funds should be conditioned on investees’ restricting dividends on common stock.