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mate evidence, such as the correctness of inventory values of property and the manner in which the capital stock was subscribed and paid, is competent as bearing on the question of the solvency of the corporation at the time it declared a dividend, and of impairment of its capital thereby.40a

b. Debts or interest owing by corporation; sinking fund.

In determining the net earnings of a corporation out of which dividends. may properly be declared, the amount of loans, advances, or charges falling due, which should have been paid, and which would have been paid, at the time the expense was incurred, had the corporation then possessed the necessary funds for the purpose, should be deducted.1 Thus, the rule has been laid down in an English case,42 regarding the method of ascertaining the profits of a railway company for dividend purposes, that all of the debts of the company are first payable other than those which may be called funded debts; that, for instance, if the company had raised the money by mortgage for the purpose of completing its line, this does not constitute such a debt as should be paid out of profits before they are divided; but that, on the other hand, debts which have been incurred and which are due was insolvent, it appeared that the company, a manufacturing concern, had purchased certain articles and placed an inventory value thereon which included the good will of the seller, and two years later the court, in valuing the assets, found that the articles were not worth half the sum at which they were inventoried, but stated that it was unable to determine what the good will was worth, as no evidence was offered on that subject, it was held that the findings should be treated on appeal for the purpose of determining whether the company was solvent at the time the dividend was declared, as a finding of overvaluation in the inventory of at least one half of the amount there stated. Davenport v. Lines (1899) 72 Conn. 118, 44 Atl. 17.

And the finding by the court that a certain sum expended by the corporation for advertising purposes at a World's Fair "represented no tangi

from the directors of the company, for instance, for rails, for completing stations, or the like, which ought to have been and would have been paid at the time had the company possessed the necessary funds for the purpose, are deductions from the profits, and until they are paid the profits are not ascertained.

And in a Maine case,43 the court said that in a general sense net earnings of a railway company are the gross receipts less the expenses of operating the road to earn such receipts; that, however, several kinds of charges must first come out of net earnings before dividends are declared; that the creditor comes in for consideration before the stockholder; and that, since the property of a corporation is a trust fund obligated for the payment of its debts, not only must the interest on any permanent or bonded debts be reckoned out of net earnings, but, if there is a floating debt which it is not wise and prudent to place in the form of a funded debt or to postpone for later payment, that should also be paid; so, if the financial condition of the company is such as to render it expedient to begin or continue the scheme of a sinking fund for the extinguishment of the company's indebtedness at some future time, an

ble assets" was held to be equivalent to a finding that it had no value, and should not have been included among the assets, for the purpose of determining whether the company was solvent, or whether the dividend constituted an impairment of capital. Ibid.

40a Davenport v. Lines (Conn.) su

pra.

41 Mobile & O. R. Co. v. Tennessee (1894) 153 U. S. 486, 38 L. ed. 793, 14 Sup. Ct. Rep. 968 (recognizing rule); Corry v. Londonderry & E. R. Co. (1860) 29 Beav. 263, 54 Eng. Reprint, 628.

It is said (dictum) in Cochrane v. Interstate Packing Co. (1918) 139 Minn. 452, 167 N. W. 111, that the term "net profits" denotes what remains after defraying every expense, including loans falling due as well as interest on such loans.

42 Corry v. Londonderry, supra. 43 Belfast & M. L. R. Co. v. Belfast (1885) 77 Me. 445, 1 Atl. 362.

annual contribution out of the net earnings for that purpose would be reasonable.

The law does not require that a corporation shall be entirely out of debt, even as to floating debts, before it declares a dividend; but a reasonable provision for eventual payment of its

44 Since debts often represent investments in machinery or other property, the fact that the debts may be greater than the net earnings does not prove that the corporation has made no net profits out of which a dividend may properly be declared. O'Shields V. Union Iron Foundry (1913) 93 S. C. 393, 76 S. E. 1098.

In Belfast & M. L. R. Co. v. Belfast (Me.) supra, the court said, that it did not necessarily follow that debts should be first wholly paid before a declaration of dividends, merely because they are of a floating character; that it might be that it would be reasonable and proper to convert such liabilities into a funded debt; that all depends upon the financial resources and abilities of the corporation and the prospects of the same.

And in Hazeltine v. Belfast & M. L. R. Co. (1887) 79 Me. 411, 1 Am. St. Rep. 330, 10 Atl. 328, the court observed that, while the definitions of net profits in the case of railroad corporations, which are generally more heavily in debt than other kinds of business corporations, call for the payment of company's debts, they do not necessarily require payment of any portion of the principal; and that, while the authorities make a distinction between the payment of the floating debt and the payment of the permanent or bonded debts, it is not indispensable that the company should be free from the pressure of floating debts before it may lawfully pay dividends even to holders of nonpreferred stock. The case was one involving the right of preferred stockholders to dividends.

As to whether directors of a mining corporation may be held liable for declaring dividends before discharge in full of debts which the company has incurred by acquiring property encumbered with a debt, or by making permanent improvements for the working of the mine, see Excelsior Water & Min. Co. v. Pierce (Cal.) under note 218, infra.

45 All the net earnings of an indebt

debts is a proper deduction from earnings.45

Of course, accrued interest on debts owing by the corporation is deductible from the earnings before the net profits are ascertained from which dividends may be paid.46

The directors, acting in good faith, ed corporation should not always be devoted to dividends; the company has a right to base its calculations in this regard upon a final payment of its debts at some time; steps, however, in that direction should not be untimely or oppressive to other interests, and should be such as not unreasonably to interfere with the expectation or interests of stockholders. Hazeltine v. Belfast & M. L. R. Co. (Me.) supra.

Not only interest on a sum borrowed by a railway company on the credit of the state under legislative authority, in order to relieve stockholders of hasty and heavy calls on their stock for the construction of a new line of railroad, should be deducted from the profits before a division thereof is made among the stockholders, but an additional sum should be set apart from year to year as a sinking fund for the ultimate payment of the principal. Gratz v. Redd (1843) 4 B. Mon. (Ky.) 178, where a division of the profits was not authorized by the charter until "all the necessary current and probable contingent expenses" were paid. The decision is approved and followed in Lexington & O. R. Co. v. Bridges (1847) 7 B. Mon. (Ky.) 556, 46 Am. Dec. 528.

46 Union P. R. Co. v. United States (1879) 99 U. S. 402, 25 L. ed. 274; Mobile & O. R. Co. v. Tennessee (1894) 153 U. S. 486, 38 L. ed. 793, 14 Sup. Ct. Rep. 968; St. John v. Erie R. Co. (1872) 10 Blatchf. 271, Fed. Cas. No. 12,226, affirmed in (1875) 22 Wall. (U. S.) 136, 22 L. ed. 743; Excelsior Water & Min. Co. v. Pierce (1891) 90 Cal. 131, 27 Pac. 44; Hubbard v. Weare (1890) 79 Iowa, 678, 44 N. W. 915; Gratz v. Redd (1843) 4 B. Mon. (Ky.) 178, approved and followed in (1847) 7 B. Mon. 556, 46 Am. Dec. 528; Belfast & M. L. R. Co. v. Belfast (1885) 77 Me. 445, 1 Atl. 362; Hazeltine v. Belfast & M. L. R. Co. (1887) 79 Me. 411, 1 Am. St. Rep. 330, 10 Atl. 328; Bankers Trust Co. v. R. E. Dietz Co. (1913) 157 App. Div.

28

AMERICAN LAW REPORTS, ANNOTATED.

have a large measure of discretion in
determining whether net profits shall
be divided among the stockholders as
dividends or devoted, through the op-
eration of a sinking fund, to the grad-
ual retirement of its debts.47

c. Taxes; insurance; rent.
Taxes are to be deducted in deter-
mining net profits for dividend pur-
poses.48 And the assets account of a
corporation for dividend purposes can-
not be increased even by the amount
of prepaid taxes, since these are not
available for a refund, and are paid
for past expenses of the government
as well as future.49 But prepaid in-
surance should be listed as an asset,
in making up the balance sheet of a
corporation for dividend purposes, it
being proper to increase the assets

594, 142 N. Y. Supp. 847 (sustaining right to issue scrip dividends bearing interest.)

Annually accruing interest on the bonded debt of a railroad company is a proper charge against the net earnings, to be paid before dividends can be declared therefrom. Mobile & O. R. Co. v. Tennessee (1894) 153 U. S. 486, 38 L. ed. 793, 14 Sup. Ct. Rep. 968; Union P. R. Co. v. United States (1879) 99 U. S. 402, 25 L. ed. 274 (recognizing rule).

was

It was held in Gratz v. Redd (1843) 4 B. Mon. (Ky.) 178, that interest on a sum borrowed by a railroad company on the credit of the state, pursuant to legislative authority, in order to relieve stockholders from hasty and heavy calls on their stock for construction of a new railroad, chargeable against profits before a division of earnings in the form of dividends was paid, and should not be charged to capital construction account, where a division of the profits was not authorized by the charter until all "necessary current and probable contingent expenses" had been dedúcted.

47 See cases supra this subdivision; and generally, as to discretion of directors, see VI. infra.

48 Burk v. Ottawa Gas & E. Co. (1912) 87 Kan. 6, 123 Pac. 857, Ann. Cas. 1913D, 772; People ex rel. Jamaica Water Supply Co. v. Tax Comrs. (1908) 128 App. Div. 13, 112 N. Y. Supp. 392, modified on other grounds in (1909) 196 N. Y. 39, 89 N. E. 581,

[55 A.L.R. account by the amount of the unearned premiums.50

It has been held that an amusement company which is a lessee is not obliged, before it can lawfully pay dividends, to set aside against the future sufficient money or assets over and above its capital to pay all of its future running expenses, such as liability for future instalments of rent and future accruing taxes; and that the lessor has no right to complain that dividends were declared and paid without setting aside such a fund.51 d. Depreciation; maintenance; repairs.

It has been held that, in determining net profits from which a dividend may properly be declared, directors must make proper provision for depreciation, 52 alreargument denied in (1909) 197 N. Y. 33, 90 N. E. 112.

49 Cox v. Leahy (1924) 209 App. Div. 313, 204 N. Y. Supp. 741. 50 Ibid.

51 Majestic Co. v. Orpheum Circuit (1927; C. C. A. 8th) 21 F. (2d) 720.

52 Lever V. Land Securities Co. (1891) 8 Times L. R. (Eng.) 94; Davison v. Gillies (1879) L. R. 16 Ch. Div. (Eng.) 347, note. See also Glasier v. Rolls (1889) L. R. 42 Ch. Div. (Eng.) 453, C. A. (opinion of Kekewich), an action for deceit for representing that the net profits were a certain per cent. See also cases in note 56, infra.

It is the duty of a board of directors in declaring dividends to set aside sufficient funds for depreciation and for contingencies which may be reasonably expected to arise. Hastings v. International Paper Co. (1919) 187 App. Div. 404, 175 N. Y. Supp. 815.

That a charge should be
against earnings for depreciation of
made
plant, before profits available for divi-
dends can be ascertained, at least in
the case of a mining company whose
plant is located at a remote mine and
can be of little or no value after the
mine is exhausted, is supported by
Wittenberg v. Federal Min. & Smelt-
ing Co. (1926) Del. Ch.
48, which is affirmed in the reported
133 Atl.
case (FEDERAL MIN. & SMELTING CO.
v. WITTENBERG, ante, 1).

Where a company's assets consisted
principally of leasehold
preciation, the court in Lever v. Land
which was subject to risk through de-
property

though they have a reasonable discretion in the matter. 53

But while ordinarily directors of a corporation are not only justified in setting aside from the profits a sum for depreciation, before declaring a dividend, but are in duty bound to do so, this course may be precluded by the articles of the company constituting the contract among its sharehold

Securities' Co. (1891) 8 Times L. R. (Eng.) 94, while taking the position that directors should make due allowance for such depreciation in computing the net profits out of which only dividends could be declared, held that this risk did not come under the head of "claims and contingent liabilities," to meet which the articles required the directors to maintain a reserve fund; that the latter referred to such matters as outstanding debts and possible adverse verdicts against the company in pending actions.

Findings of fact as to the amount to be paid as a dividend-under a statute making compulsory dividend to the amount of the surplus accumulated over and above the capital stock, and the amount of a working capital fixed by the stockholders-should not be based upon the statement of the financial condition of the corporation, without taking into account as a liability of the corporation the amount reserved by that statement for depreciation on machinery, buildings, etc. Cannon v. Wiscassett Mills Co. (1928) N. C., 141 S. E. 344.

53 Where rolling stock of a railway company has become worn out, or there is need of repairs to stations or other property, it has been held that directors cannot be compelled by a shareholder to replace or repair all of the same before declaring dividends out of revenue, no rights of the public being violated. Kehoe v. Waterford & L. R. Co. (1888) Ir. L. R. 21 Eq. 221. As to discretion of directors generally, see VI. infra.

54 Thus, in Paterson v. Paterson [1917] S. C. (Scot.) 13-H. L., it was held that a provision that directors might, before recommending any dividend, set aside out of the profits of the company such sums as they thought proper as a reserve, was inconsistent with a provision of the articles of the company that, after allowing for all charges, including the payment of directors' salaries, the profits

ers.54 And if the amount set apart for depreciation is larger than is reasonably necessary, it seems that the excess may still be available for dividend purposes.55

Likewise, in ascertaining the net profits out of which dividends may be declared, provision should be made for expenditures for maintenance, upkeep, and repairs.56

of the company should be applied in a prescribed manner, and that the latter precluded the creation of a reserve, the former provision being among those incorporated in the articles only so far as not excluded or modified thereby.

55 It has been held that if a limited company retains the item of good will in its balance sheet, and carries profits to a good will depreciation reserve fund, it may distribute such profits, at least to the extent that the amount of the reserve fund exceeds the amount of the actual depreciation, if there is nothing in its constitution to prevent it from doing so; and if, instead of keeping its accounts in this way, it purports to apply profits to the writing off of good will as an asset, it does not so capitalize the profits as to preclude its subsequently restoring them to reserve and dealing with them as profits; but it may restore to the profits account, and distribute as dividends, so much of the depreciation written off good will as has proved to have been in excess of the proper requirements. Stapley v. Read Bros. [1924] 2 Ch. (Eng.) 1.

The court said that no doubt the account as showing the methods adopted were approved from year to year by the shareholders, but it was not satisfied that they thereby intended to bind themselves for all time and in all circumstances to give up their claim to those profits and to treat them as capital only.

56 As to discretion of directors in this regard, see VI. infra.

The net income of a corporation for dividend purposes cannot be determined until all depreciation, maintenance, and upkeep expenditures have been deducted; otherwise the dividend is not paid from the earnings, but by a depreciation of capital account. People ex rel. Jamaica Water Supply Co. v. Tax Comrs. (1908) 128 App. Div. 13, 112 N. Y. Supp. 392 (dictum) modified on other grounds in (1909)

e. Accretions to capital; excess of assets over par value of stock.

It has been held that a realized accretion to the value of capital assets

196 N. Y. 39, 89 N. E. 581, reargument denied in (1909) 197 N. Y. 33, 90 N. E. 112. And this view is quoted with implied approval in People ex rel. Binghamton, Light, Heat & P. Co. v. Stevens (1911) 203 N. Y. 7, 96 N. E. 114.

The question whether or not semiannual dividends declared by directors of a corporation were paid out of surplus or net earnings of the company must be determined by ascertaining the actual value of all the live assets of the company at the termination of the semiannual period during which it was claimed that the supposed surplus or net earnings accrued; and this can only be done by taking into account the cost of repairs, and also a reasonable allowance for depreciation for wear and tear, giving credit for all actual permanent improvements. Whittaker v. Amwell

Nat. Bank (1894) 52 N. J. Eq. 400, 29 Atl. 203.

The cost of operation of the plant of a gas and electric company, including necessary repairs, extensions, and fixed charges, are to be deducted from the entire receipts from the business, in determining net profits for the purpose of declaring a dividend. Burk v. Ottawa Gas & E. Co. (1912) 87 Kan. 6, 123 Pac. 857, Ann. Cas. 1913D, 772. Where for several years no allowance was made by a tramway company for expense of repairs and maintenance, and the road had deteriorated until a sum more than the amount of the proposed dividend would be required to put it in proper state of repair, it was held in Davison v. Gillies (1879) L. R. 16 Ch. Div. (Eng.) 347, note, that an injunction should be granted restraining the payment of a dividend. The articles of the company provided that no dividend should be declared except out of the profits of the company, that the directors should, with the sanction of the company in general meeting, declare annual dividends, payable to the members out of the profits of the company, and that, before recommending any dividends, the directors should set aside out of the profits such sum as they thought proper as a reserve for maintenance, repairs. depreciation,

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and renewals. It was held that the term "profits" in these articles meant net profits, to ascertain which a reasonable sum should be allowed for the items last above indicated.

57 Where a company, having purchased certain property and assets, including promissory notes not apparently considered of any particular value, later received full payment for the notes and interest, it was held in Foster v. New Trinidad Lake Asphalt Co. [1901] 1 Ch. (Eng.) 208, 1 B. R. C. 959, that the company would not be allowed to declare a dividend of all of this stock as a windfall pending the result of the whole account of the company for the year; but the court observed that it should not be understood as determining that this sum, or a portion of it, might not properly be brought into profit and loss account to be taken into consideration in ascertaining the amount available for dividends; and that appreciation in total value of capital assets, if duly realized by sale or getting in of some portion of such assets, may, in a proper case, be treated as available for purposes of dividends.

So, where a bank sold a part of its business for a sum which, after deducting its paid-up capital and incidental expenses, showed a large net balance, it was held that this balance might be treated as profit and carried to the profit and loss account, and distributed accordingly. Lubbock V. British Bank [1892] 2 Ch. (Eng.) 198.

And in Cross v. Imperial Continental Gas Asso. [1923] 2 Ch. (Eng.) 553, it was held that an English company operating in Germany, which during the late World War was compelled to liquidate its holdings in that country, and realized on such liquidation a sum in excess of the book value of the property, might treat the excess as profits available for dividends. It was recognized in earlier decisions that companies registered under the Joint Stock Companies Act might distribute a realized profit on their capital assets, but a distinction was claimed in that the company in question was governed by the Companies Causes Consolidation Act, which specified that companies should not make

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