Legal Definitions - dividend-credit rule

The dividend-credit rule, also known as the cast-iron-pipe doctrine, is a legal principle that governs how companies must handle funds related to unpaid dividends on preferred stock. Essentially, if a company has a reserve fund that has accumulated because it previously failed to pay dividends to its preferred stockholders, this specific fund must be used to pay those outstanding and any subsequent preferred stock dividends. This payment must occur before any dividends can be distributed to common stockholders. The rule prioritizes preferred stockholders, ensuring they receive their due compensation for missed payments before common stockholders can receive any share of the company's profits.

To understand this, it's helpful to know:

• Dividends: A portion of a company's profits distributed to its shareholders.
• Preferred Stock: A type of stock that typically pays a fixed dividend and has priority over common stock in receiving dividends and assets in the event of liquidation. If preferred dividends are missed, they often accumulate (are "cumulative").
• Common Stock: A type of stock that represents ownership in a company and a claim (after preferred stockholders) on a portion of profits and assets. Common stock dividends are variable and are only paid after all preferred stock obligations are met.

Here are a few examples illustrating the dividend-credit rule:

• Example 1: Manufacturing Company's Recovery

  Imagine "Industrial Innovations Inc.," a manufacturing company, had a challenging year in 2022 and, despite having preferred stock outstanding, could not afford to pay the $1 million in preferred stock dividends due that year. This $1 million in unpaid dividends effectively becomes a liability that must be addressed. In 2023, the company experiences a strong rebound and generates $3 million in profit. According to the dividend-credit rule, the first $1 million of that $3 million profit must be allocated to pay the preferred dividends that were missed in 2022. Only after those accumulated preferred dividends are fully paid can the remaining $2 million be considered for current preferred dividends for 2023, and then, finally, for any dividend payments to common stockholders.

• Example 2: Tech Startup's Delayed Profitability

  "Quantum Leap Solutions," a promising tech startup, issued preferred stock to its initial investors to raise capital. For its first three years of operation, the company was not yet profitable and therefore accumulated $500,000 in unpaid preferred dividends. In its fourth year, the company finally achieves profitability, earning $1 million. The dividend-credit rule dictates that the first $500,000 of that $1 million profit must be used to cover the previously unpaid preferred dividends from the initial three years. Only once this accumulated debt to preferred stockholders is settled can the remaining $500,000 be considered for current preferred dividends and, if any funds remain, for common stock dividends.

• Example 3: Retail Chain's Strategic Expansion

  "Global Retail Group," a large and typically profitable retail chain, decided to temporarily withhold preferred stock dividends for two years, totaling $2 million, to fund a major international expansion project. This strategic decision created an accumulated reserve of unpaid preferred dividends. After the expansion is successfully completed and the company decides to resume dividend payments, the dividend-credit rule comes into play. Before any dividends can be distributed to common stockholders, the $2 million in accumulated unpaid preferred dividends must be paid out from the company's current or accumulated earnings. This ensures that preferred stockholders are fully compensated for the period their dividends were deferred to support the company's growth initiative.