Appendix B. Dividends
B.1 Payment of Dividends from Surplus
A 1922 opinion from the Board of Governors' Legal Counsel.
To: Federal Reserve Board
From: Mr. Walter S. Logan, General Counsel
Subject: Payment of dividends of Federal Reserve Banks out of surplus
Date: April 11, 1922
You have requested my opinion upon the question of whether a Federal reserve bank, which has accumulated a surplus fund out of earnings of past years, has authority to use a part of this fund to pay to its stockholding member banks the dividend for a subsequent year during which the current earnings of the federal reserve banks are insufficient to pay such dividend.
I am of the opinion that the question should be answered in the affirmative.
The material portions of Section 7 of the Federal Reserve Act read as follows:
"After all necessary expenses of a Federal reserve bank have been paid or provided for, the stockholders shall be entitled to receive an annual dividend of six per centum on the paid-in capital stock, which dividend shall be cumulative. After the aforesaid dividend claims have been fully met, the net earnings shall be paid to the United States as a franchise tax except that the whole of such net earnings, including those for the year ending December thirty-first, nineteen hundred and eighteen, shall be paid into a surplus fund until it shall amount to one hundred per centum or the subscribed capital stock of such bank, and that thereafter ten per centum of such net earnings shall be paid into the surplus.
"…Should a Federal reserve bank be dissolved or go into liquidation, any surplus remaining, after the payment of all debts, dividend requirements as hereinbefore provided, as the par value of the stock, shall be paid to and become the property of the United States and shall be similarly applied."
This section provides that the earnings of the Federal reserve banks shall be used for the following purposes in the order named:
- For the payment of or provision for expenses.
- For the payment to stockholders (who are member banks exclusively) of cumulative dividends at the rate of six percent per annum on paid-in capital.
- For creating and adding to a surplus fund until such fund equals 100 percent of subscribed capital.
- The balance to be paid 90 percent to the United States as a franchise tax and 10 percent into surplus.
The question for determination is what are the rights of a Federal reserve bank with respect to the payment of dividends when the bank has already accumulated a surplus out of its past earnings but has failed during some subsequent year to earn a sufficient amount to pay the full dividends for that year.
No payment can be made into the surplus fund unless the earnings for the current year are sufficient to pay in full the dividends for that year and any dividends for past years that may remain unpaid. Thus Congress has directed that the payment of current and past dividends shall take precedence over the accumulation of a surplus fund. In the absence of any indication to the contrary, it would be natural to assume from this that Congress intended also that the payment of current and past dividends should take precedence over the maintenance of a surplus fund already accumulated.
It is to be noted that the provision in the second paragraph of Section 7, regarding the disposition of the surplus fund in the event of the dissolution or liquidation of a Federal reserve bank, makes it clear that the surplus fund of a Federal reserve bank will be available ultimately to pay the cumulative dividends in full.
It is clear also that the payment of dividends out of surplus can result in no loss of revenue to the United States, for no franchise tax can become due until the six percent cumulative dividends have been paid in full. If the surplus should not be used to pay dividends for a year in which the current earnings are insufficient for this purpose, the back dividends would have to be paid out of future earnings before the United States becomes entitled to any franchise tax. In fact, the failure to pay dividends out of surplus in excess of 100 percent of subscribed capital would result in loss of revenue to the United States; because if dividends for any year should remain unpaid, they would have to be paid in full out of the earnings of future years before any franchise tax becomes payable, whereas, if dividends should be paid out of the surplus and the surplus were not thereby reduced below 100 percent of subscribed capital, future payments into the surplus fund would amount to only 10 percent of future earnings over and above current dividend requirements, the other 90 percent being paid to the United States.
It may be argued that, without regard to the questions of the franchise tax, Congress intended that each Federal reserve bank should accumulate a surplus fund for the purpose of protecting such bank against possible future losses and that the fund should be available for no other purpose. It is to be noted in this connection, however, that under the present terms of Section 7 there is no limit to the size of the surplus fund that must be accumulated. All of the earnings, over and above dividend requirements are required to be paid into the surplus fund until such fund equals 100 percent of the subscribed capital (which is equivalent to 200 percent of paid-in capital since under the law only one-half of the subscribed capital is required to be paid in and the balance now remains subject to call), and after a surplus fund equal to 100 percent of subscribed capital has been accumulated, ten percent of all future net earnings over and above dividend requirements must be paid in to the surplus fund. It is hardly reasonable to assume that Congress intended to prevent a Federal reserve bank from paying its current dividends while its surplus fund is far in excess of the amount of its subscribed capital.
Under Section 7 as originally enacted, the argument that the surplus fund of a Federal reserve bank was intended solely as a protection to the bank against possible future losses could have been made with greater force. Prior to the amendment of March 3, 1919, the provisions of Section 7, which correspond to those already quoted form the present Section, read as follows:
"After all necessary expenses of a Federal reserve bank have been paid or provided for, the stockholders shall be entitled to receive an annual dividend of six per centum on the paid-in capital stock, which dividend shall be cumulative. After the aforesaid dividend claims have been fully met, all the net earnings shall be paid to the United States as a franchise tax, except that one half of such net earnings shall be paid into a surplus fund until it shall amount to forty per centum of the paid-in capital stock of such bank.
"…Should a Federal reserve bank be dissolved or go into liquidation, any surplus remaining, after the payment of all debts, dividend requirements as hereinbefore provided, and the par value of the stock, shall be paid to and become the property of the United States and shall be similarly applied."
Thus, the maximum surplus fund which could have been accumulated under the original section was 40 percent of the paid-in capital and it might well have been argued that the purpose of Congress in making provision for this limited surplus was solely to protect the bank against future losses. Even under the original section, however, the question was open to serious doubt, for a Federal reserve bank was required to apply its earnings to the same purposes and in the same order as under Section 7 as amended, and the payment of cumulative dividends therefore took precedence over the accumulation of a surplus fund. Furthermore the payment of dividends out of surplus fund would not have reduced the revenues of the United States. So the same arguments, except that which is based on the unlimited size of the surplus fund, could have been advanced in support of the right of a Federal reserve bank, under the terms of the original Section 7, to pay dividends out of surplus. In my judgment Congress in amending Section 7 so as to require the accumulation of a surplus fund of unlimited size must be considered to have recognized that under both the original section and the section as amended the surplus fund could be used for the payment of the cumulative dividends. Otherwise, it is only reasonable to assume that Congress would have required or permitted some part of the earnings, which must now go into the unlimited surplus, to be paid into a fund of "undivided profits" out of which the dividends could be paid currently in a year of small earnings.
This leads to the observation that under the terms of Section 7 a Federal reserve bank is not permitted to accumulate a fund of "undivided profits". It is the usual custom of commercial banks to show among their liabilities an item of "undivided profits", in addition to their liabilities on account of capital and surplus. From this fund of "undivided profits", dividends are customarily paid and from it also transfers are made from time to time to increase the surplus fund. No banks, so far as I am aware, are prohibited from paying dividends out of this fund of "undivided profits" even though such dividends are in excess of the earnings for the current year. Consequently, by accumulating a fund of "undivided profits" from year to year a bank may make provision for the continuance, during years when earnings are small, of dividend payments without reducing its surplus fund. A Federal reserve bank cannot make provision for the continuance of dividends in this particular manner, because the law absolutely requires Federal reserve banks to dispose of earnings, over and above the amount paid as dividends, either by payment into the surplus fund or by payment of the franchise tax to the United States.
The continuity of dividends is fully as desirable in the case of Federal reserve banks as it is in the case of commercial banks, and Congress, having precluded the Federal reserve banks from making provision for such continuity by setting up "undivided profits", may reasonably be assumed, in my opinion, to have contemplated that the surplus funds, which are required to be accumulated without limit as to size, would be available for the purpose of paying dividends as well as for the purpose of protecting the banks again possible future losses.
From the statement heretofore made that the dividends of commercial banks are customarily paid out of undivided profits, it is not to be inferred that the payment of dividends out of the surplus of commercial banks is prohibited. As I shall now attempt to show, the general rule is that banks may pay dividends out of surplus unless the terms of their charters, or the statutes to which they are subject, prohibit them from so doing.
In deciding the specific question now under consideration no great weight can be attached to the general rules of law as to the powers of corporations generally, or banks in particular, with respect to the payment of dividends; for Federal reserve banks are sui generis, and they are governed by the mandatory provisions of Section 7 of the Federal Reserve Act which take away from the directors all discretionary power as to the disposition of any part of current earnings. Nevertheless, I am of the opinion that a consideration of these general rules of law will serve in some slight measure to confirm the conclusion that a Federal reserve bank may use its surplus fund for the payment of dividends for a year in which its current earnings are insufficient for that purpose.
It is a fundamental principle of the law of corporations, that unless otherwise provided by statute, charter or other limitation, the question of whether a corporation which has surplus profits on hand shall declare a dividend, and what part of such profits shall be distributed by means of such dividend, is a question for the determination of the directors in the exercise of their discretion, and the courts will not interfere with action taken by the directors in the exercise of such discretion unless they act fraudulently or in bad faith.
Gibbons v. Mahon,136 U.S., 549 ;
N.Y. Ry. Co. v. Nickals,119 U.S., 296 .
See also 14 Corpus Juris, p. 808-810 and cases there cited.
It is also held generally that dividends may lawfully be declared out of any surplus of corporate assets over corporate debts and capital stock, that is to say, anything remaining after provision for the corporation's capital stock and liabilities is properly available for distribution to stockholders, although as seen above its actual disposition rests with the directors:
Bowers v. Post, 209 Fed. 660,
Hyams v. Old Dominion Copper Co. 82 N.J. Eq. 507
Equitable Life Assurance Co. v. Union Pacific Ry Co.,
212 N.Y. 360;
14 Corpus Juris, 803, and cases there cited.
Furthermore, it is immaterial what may be the amount of such surplus of corporate assets; whatever the surplus may amount to, it is available for dividend purposes. Hyams v. Old Dominion Copper Co. supra.
It has been held specifically that dividends may be paid from surplus accumulated out of the profits of previous years, although there have been no actual profits for the year in which the dividends are paid.
Beers v. Bridgeport Spring Co., 42 Conn. 17
Murray v. Beattie Mfg Co. 7, N.J. Eq. 322, 648
Williams v. Western Union Co., 93 N.Y. 182
Brouty v. Michigan etc. Ry Co., 4 T. & C. 230 (N.Y.)
The authorities cited above clearly confirm the right, which as heretofore stated is customarily exercised by banks, to pay dividends out of its funds of "undivided profits", without regard to the amount of the earnings for the years in which the dividends are paid. The authorities are not controlling upon the right of banks to pay dividends out of their "surplus" funds, because the surplus fund of a bank is peculiar to this special type of corporation. Corporations other than banks and banking institutions are not as a general rule required to set aside any part of the their earnings into special "surplus" funds distinct from "undivided profits", nor is it their practice to do so, and the surplus of a corporation other than a bank consists of the entire excess of assets over liabilities and capital stock. On the other hand it is universally true, so far as I am aware, that banks in this country are required by their charter or the statutes under which they operate to set aside a certain proportion of their current earnings into a fund designated surplus, until such fund amounts to a certain percentage of the bank's capital, and in speaking of the surplus of a bank this specific fund is referred to, not including any undivided profits that may represent further excess of assets over liabilities and capital stock.
For this reason banks stand upon a somewhat different basis as regards surplus than do other corporations, but the general rule is nevertheless applicable to banks as well as to other corporations that unless controlled by statue, charter or otherwise, questions relating to the payment of dividends out of the excess of assets over liabilities and capital stock are left to the discretion of the directors. See in re Heaton, 89 Vt. 550, holding that in the absence of any prohibition by charter or otherwise a bank may declare a stock dividend payment out of surplus. See also Morse on Banks and Banking, 5th Ed. Sec. 66.
Unless, therefore, some prohibition is expressed in or implied from the charter of a bank or the statues to which it is subject, the bank may pay dividends out of surplus at the discretion of the directors. Applying this rule to the case now under consideration, I am of the opinion that there is nothing in Section 7 or any other part of the Federal Reserve Act which can reasonably be construed as a prohibition against the payment of dividends out of the surplus of a Federal reserve bank, but on the contrary that, for the reasons stated in the early part of this opinion, in order to give a reasonable and consistent purpose to the express provisions of the law, it is necessary to conclude that the law authorizes the payment of dividends out of surplus.
In considering the question of the right of a Federal reserve bank to pay dividends out of surplus, it is natural to look at the provisions of the National Bank Act, and to determine, if possible, what is the right of a national bank in this respect. The relevant provisions of the National Bank Act are contained in Sections 5199 and 5204 of the Revised Statutes of the United States. These sections provide as follows:
"Sec. 5199. The directors of any association may semiannually, declare a dividend of so much of the net profits of the association as they shall judge expedient; but each association shall before the declaration of a dividend, carry onetenth part of its net profits of the preceding half year to its surplus fund until the same shall amount to twenty per centum of its capital stock."
"Sec. 5204. No association, of any member thereof, shall during the year it shall continue its banking operations, withdraw, or permit to be withdrawn, either in the form of dividends or otherwise, any portion of its capital. If losses have at any time been sustained by any such association, equal to or exceeding its undivided profits then on hand, no dividend shall be made; and no dividend shall ever be made by any association, while it continues its banking operations, to an amount greater than its net profits then on hand, deducting therefrom its losses and bad debts."
There do not appear to have been any court cases construing these sections with reference to the right of national banks to pay dividends out of surplus, but the office of the Comptroller of the Currency has always construed them as prohibiting the payment of dividends from any surplus not in excess of 20 percent of capital, but as permitting the transfer of any surplus above 20 percent of capital to undivided profits and the payment of dividends out of the fund thus transferred. Thus, in spite of the express prohibition of Sections 5204 that "no dividend shall ever be made by any association, while it continues its banking operations, to an amount greater than its net profits then on hand, deducting therefrom its losses and bad debts", the surplus fund of a national bank in excess of 20 percent of capital may be used for the purpose of paying dividends, provided only, that the bookkeeping operation is first preformed of making a transfer from surplus to undivided profits; and if it were not for this express prohibition it would seem that dividends could be paid directly out of surplus. There is no express prohibition against the payment of dividends by Federal reserve banks from any sources, and in so far as the Comptroller's construction of Sections 5199 and 5204 of the Revised Statues has any bearing upon the question now under consideration, it tends to confirm the right of a Federal reserve bank to pay dividends out of surplus.
National banks are not expressly prohibited from transferring surplus to undivided profits even when by so doing surplus is reduced to less than 20 percent of capital, or from declaring dividends out of the funds thus transferred; and it may be argued that the office of the Comptroller of the Currency in implying such prohibitions from the express provisions of the sections 5199 and 5204 of the Revised Statues has recognized that a surplus fund, which is required by statute to be accumulated, is for the exclusive purpose of paying possible losses and should not be used for the payment of dividends, and that this principle should be applied in construing Section 7 of the Federal Reserve Act. In my opinion, however, this argument is not sound, because national banks and Federal reserve banks stand upon very different ground as to the payment of dividends and accumulation of surplus.
With respect to national banks, (1) there is no limit as to the size of the dividends that may be paid out of the earnings not carried to surplus, (2) at least 10 percent of all earnings, no matter how small, must be paid into surplus until a surplus equal to 20 percent of capital has been accumulated, and (3) after a surplus of 20 percent of capital has been accumulated no further payments into surplus are required. On the other hand, with respect to Federal reserve banks, (1) dividends are absolutely limited to six percent per annum, (2) no payments can be made into surplus until stockholders have been paid the full amount of the current cumulative six percent dividends, and (3) no matter how large a surplus may have been accumulated out of past earnings it is still mandatory upon the bank to continue making additions to such fund out of future earnings in excess of dividend requirements.
In order to give any effect to the provisions of Section 5199 of the Revised Statutes it is necessary to construe them as prohibiting a national bank from paying dividends out of its surplus fund not in excess of 20 percent of capital, because otherwise the bank could, as fast as it put funds into surplus, pay them out again as dividends, and thus never accumulate any surplus at all, no matter how large its earnings may be. There can be no doubt, therefore, that the office of the Comptroller of the Currency is correct in construing Sections 5199 and 5204 of the Revised Statues as prohibiting a national bank, either directly or indirectly, from paying dividends out of its 20 percent surplus fund, the accumulation of which, on the one hand, need be commenced as soon as the bank makes any earnings at all, and, on the other hand, must not be continued after the fund amounts to 20 percent of capital. It does not follow, however, that a similar prohibition is to be implied with respect to the surplus of a Federal reserve bank, the accumulation of which, on the one hand, cannot begin until all current and past cumulative six percent dividends have been paid, and on the other hand, must continue without limit as to the ultimate size out of earnings in excess of dividend requirements.
The conclusion might be reached that a Federal reserve bank may pay dividends out of a surplus in excess of 100 percent of subscribed capital, but may not pay dividends out of surplus not in excess of this amount. I am of the opinion, however, that this conclusion is not warranted under the terms of Section 7 of the Federal Reserve Act. There is no minimum surplus for a Federal reserve bank, as there is for a national bank. It is just as mandatory upon a Federal reserve bank, after it has accumulated a surplus of 100 percent of subscribed capital, to pay into surplus 10 percent of earnings over and above dividend requirements, as it is to pay into surplus 100 percent of such earnings prior to such accumulation. All of a Federal reserve bank's surplus is required surplus, and while it might have been reasonable for Congress to make such a distinction between surplus above and below 100 percent of subscribed capital, I believe that no such distinction was made or would be justified under the terms of the existing law.
As heretofore indicated my conclusion is that a Federal reserve bank, which has accumulated a surplus fund, has legal authority, under the provisions of Section 7 of the Federal Reserve Act, to pay out of such fund to its stockholding member banks dividends for a year in which the current earnings of the Federal reserve bank are insufficient for this purpose.
Respectfully,
General Counsel
OFFICE OF THE ATTORNEY GENERAL
WASHINGTON, D.C.
April 27, 1922.
The Honorable,
The Secretary of the Treasury.
Sir:
I am in receipt of your letter of the 11th instant relative to the right of a Federal Reserve Bank which has already accumulated a surplus fund to use such fund to pay its regular dividends at the rate of 6 (cents) per annum on paid-in capital stock when its current earnings are insufficient for that purpose. You transmit a copy of an opinion rendered by the General Counsel of the Federal Reserve Board and request to be advised whether the conclusion reached by the General Counsel is concurred in by this Department.
The Federal Reserve Banks are creatures of statute and the rights of such banks must be determined by the statutes creating and governing them. The statutory provisions pertinent to the inquiry are found in section 7 of the Federal Reserve act of December 23, 1913, c. 6, 38 Stat. 258, as amended by section 1 of the Act of March 3, 1919, c. 101, 40 Stat. 1314, which reads in part:
"After all necessary expenses of a Federal reserve bank have been paid or provided for, the stockholders shall be entitled to receive an annual dividend of six per centum on he paid-in capital stock, which dividend shall be cumulative. After the aforesaid dividend claims have been fully met, the net earnings shall be paid to the United States as a franchise tax, except that the whole of such net earnings, including those for the year ending December thirty-first, nineteen hundred and eighteen, shall be paid into a surplus fund until it shall amount to one hundred per centum of the subscribed capital stock of such bank, and that thereafter ten per centum of such net earnings shall be paid into the surplus.
"...Should a Federal reserve bank be dissolved or go into liquidation, any surplus remaining, after the payment of all debts, dividend requirements as hereinbefore provided, and the par value of the stock, shall be paid to and became the property of the United States and shall be similarly applied."
In constructing this statute the purpose is to ascertain the legislative intent. From the language used in the above quoted section, it seems reasonably clear the Congress intended that the dividend of 6 cents per annum on the paid-in capital stock should be considered a charge on the gross earnings of the bank, the same as necessary expenses and the dividend requirements shall any amount be considered "net earnings" to be carried, to the surplus fund.
It is also evident that the Congress, in providing that the net earnings after payment of expenses and dividends, shall be carried, to the surplus fund until such surplus fund "shall amount to one hundred per centum of the subscribed capital stock," intended to provide an adequate surplus fund for the protection of the bank and its stockholders, in order that fixed charges might be paid therefrom, should losses or other exigencies diminish the earnings in any year. In doing this the Congress put into the statute a provision dictated by good business management and followed the practice generally obtaining in well managed banking and other corporations.
While the statute makes no guaranty of the payment of dividends at the rate of 6 on the paid-in capital stock, yet the surplus fund built up from the net earnings, after payment of necessary expenses and dividend requirements in prosperous years, stands as a virtual guaranty to stockholders against failure of dividends in lean years, thereby enhancing confidence in the bank's financial stability.
That the surplus fund is liable for unearned dividends is further shown by the last-quoted paragraph of section 7, which provides that upon liquidation of the bank the surplus fund, after payment of all debts and dividend requirements and the par value of the took, shall be paid to and become the property of the United States. This provision indicates that the dividend requirements are not only a charge upon the gross earnings, but that where the gross earnings are not sufficient to meet the necessary expenses, debts and dividend requirements, such expenses, debts, and dividend requirements become a charge upon the surplus fund and must be paid out of that fund before any amount can be paid to and become the property of the United States.
I, therefore, concur in the conclusion reached by the General Counsel of the Federal Reserve Board, that -
"A Federal reserve bank, which has accumulated a surplus fund, has legal authority, under the provisions of Section 7 of the Federal Reserve Act, to pay out of such fund, to its stockholding member banks dividends for a year in which the current earnings of the Federal reserve bank are insufficient for this purpose."
Respectfully,
(Sgd) H.M. Daugherty
Attorney General