illegal dividend

How can a dividend be illegal? Can you cite an example?

Corporate law does not allow dividend payments that jeopardize the entity's ability to make its creditors whole. Illegal dividends often entail treasury stock transactions, whereby stock is repurchased by the issuing company, reducing the entity's legal capital and potentially exposing creditors to greater risk

For example, assume that a firm had the following balance sheet: $100 of assets = $60 of liabilities + $40 of shareholders' equity. Its equity consisted of $15 of common stock and $25 of retained earnings. Further assume that the firm bought back most of its stock in a secondary market for $20. This transaction would reduce assets and shareholders' equity by $20, resulting in a revised balance sheet of $80 = $60 + $20. (The $20 of equity consists of $15 common stock + $25 retained earnings - $20 treasury stock). An illegal dividend would occur if the firm then paid a dividend equal to its $25 retained earnings. Such a transaction would reduce assets (cash) and shareholders' equity (in the form of retained earnings) by $25. The dividend, in other words, would bankrupt the firm. It would have only $55 of assets remaining to meet $60 of liabilities. The illegal dividend would result in a negative $5 of equity ($15 of issued common stock + 0 retained earnings - $20 of treasury stock). The illegal dividend yields an untenable balance sheet: $55 of assets = $60 of liabilities - $5 of equity.

Peter M. Bergevin, PhD, Professor of Accounting, School of Business, University of Redlands, Redlands, CA