Lich v. United States Rubber Co.

part, by the cutting down of dividends which

39 F. Supp. 675/ 1941 / Smith, J/CORPO -DIVIDENDS would otherwise have been paid to preferred
stockholders, that fund, so far as it
SUMMARY. After the 3 fiscal years that the company suffered represents moneys so retained, is available
losses, it reconstructed its capital structures and declared for the payment of subsequent dividends
dividends for the preferred stocks for 3 fiscal years after the upon the preferred stock”
restructuring. Lich, holder of non-cumulative preferred shares, o The rule there was to prevent the board to
claims dividends for years that they were not declared because defraud the preferred stockholders by not
the company suffered losses. Lich made this demand in the declaring dividends when they are due.
year that the company declared dividend for both preferred and  US Supreme Court:
common stock. The Court held for the company and stated  The doctrine in Cast Iron Pipes is limited to the
that since the accumulation of reserves were in accordance circumstance of the case (the court said that the
with sound business policy and not shown to be tainted with doctrine in Cast Iron Pipes departs from the general
bad faith, the right to maintain reserve is not open to challenge. rule that the holders of non-cumulative preferred stock
DOCTRINE. Dividends on non-cumulative preferred stock are lose with the close of the fiscal year all rights in the
payable only out of net profits and for the years in which said undistributed net profits of the year
net profits are actually earned.  It applied instead, the Day case where it limited the
application of the doctrine in Cast Iron Pipes
The right to dividends is conditional upon: (1) accrual of net o Test of applicability: WON there were, in
profits, and (2) retention in the business. the years in which dividends were not
declared, net profits available for the lawful
If the annual net earnings of a corp. are justifiably applied to declaration and payment of dividends, but
legitimate corp. purposes, such as payment of debts. If they withheld from the non-cumulative preferred
are applied against prior losses and thereby completely stockholder and retained in the business.
absorbed, there are no net profits from which dividends may be o What are "net profits" within the meaning of
lawfully paid.. the statute? The statute is devoid of any
definitive answer. The term, however, is one
FACTS. of common usage and the ordinary
 United States Rubber Co. was organized under the laws of acceptation must be adopted. The term
the State of New Jersey, incorporated in 1892. connotes the clear pecuniary gain remaining
after deducting from the gross earnings of
 Lich is a holder of 300 shares of non-cumulative preferred
the business the expenses incurred in its
stock during the years in question of US Rubber.
conduct, the losses sustained in its
 In fiscal years 1935, 1936, 1937: annual net earnings of
prosecution, and the capital invested. Where
$2,231,377.69, $10,172,484.46, $8,607,902.92 but it
capital is impaired, annual net earnings, if
suffered deficits of $25,870,402.67, $17,204,158.52,
insufficient to offset the impairment, do not
$10,471,626.89 respectively.
constitute net profits.
 The deficit representing accrued losses of prior years o Rule Laid Down in Day Case:
existed in 1934 and was carried over into the succeeding
years, impairing the capital.
Cumulative Preferred Stock Non-Cumulative Preferred
 No dividends were declared for the 3 years for both
Stock
common and preferred shares. Despite the deficit, the
Have priority in payment for Priority in payment is limited
company maintained adequate reserves.
all years past and present, to the unpaid dividends for
 1938: as per statute, reconstructed its capital structure. It
until paid, whether the net those years when such net
issued $10 par value common stock. This resulted in a
earnings for any particular earnings were sufficient to
capital surplus which was applied to the deficit. past or present year were or pay such dividends
 1938, 1939, 1940:te company gained net profits and it were not sufficient to pay the
declared dividends declared for PS but none for CS. stipulated cumulative
 March 5, 1941: declared dividend for both common and dividends
preferred stock. This contemplates payment only for the o Reason for this rule: to prevent the payment
current year. This declaration did not affect the reserves, of a dividend on the common stock in
keeping it intact. violation of the priority rights of the preferred
 Lich alleges that preference as to dividends extends not stockholders.
only to current year but to prior years of 1935-37 Lich was o In the absence of fraud, therefore, two
arguing that dividends may not be paid on common stock
things are essential to accomplish this,
until dividends are paid on the preferred ones for the years namely: First, affirmative action of some
the company did not declare dividends (1935-37)
kind by the board of directors establishing
ISSUES & RATIO. the fact of earnings for the previous years,
1. WON the preferred shareholders are entitled to
now available for the payment of the withheld
dividends during 1935-37? NO or `passed' dividends for those years upon
the preferred stock; and, second, affirmative
 No dividend is earned in any year unless the action of the board of directors declaring a
operations for that year produce a fund. Lich used the dividend upon the common stock in violation
ruling in Bassett v. United States Cast Iron Pipe & of the priority rights thus established of the
Foundry Co: preferred stockholders.
o “the right to earned dividends is not o (the court noted that this distinction
extinguished upon the mere passing of the preserves the difference between cumulative
fiscal year. “On the other hand, when the and non-cumulative preferred shares)
reserve fund is accumulated, in whole or in
  The Law itself sets limits in declaring dividends: "The
directors of a corporation shall not pay dividends
except from its surplus * * * or from the net profits
arising from the business of the corporation, nor shall
they divide, withdraw, or in any way pay to the
stockholders or any of them, any part of the capital
stock of the corporation or reduce its capital stock
except as authorized by law." (N.J.S.A. 14:8-19)
 The corporation is charged with the duty of
maintaining the integrity of the capital, on the faith of
which credit was extended, as a "trust fund" for the
security of the creditors as well as for the benefit of
the corporation.
 In this Case:
From 1935-37, there were no net profits to which the
inchoate right to dividends, could have attached. No
dividends out of net profits are earned until there is a
balance of assets over liabilities, arising from the
business of the corporation.
 Dividends on non-cumulative preferred stock are
payable only out of net profits and for the years in
which said net profits are actually earned.
 The right to dividends is conditional upon: (1) accrual
of net profits, and (2) retention in the business.
 The corporation maintained in the years in question
adequate reserves for insurance, pensions, and
contingencies. It does not appear, however, that the
sum retained in this account was disproportionate or
that it represented profits withheld from the non-
cumulative preferred stockholders, as was the fact in
the Cast Iron Pipe cases. It appears in the immediate
case that the reserves are, and have been,
maintained in accordance with the sound business
policy. The directors are charged with the
management of the corporate business, and, in the
absence of fraud or bad faith, their authority must be
regarded as absolute. Questions of management and
policy must be left to their honest judgment and
discretion. The right to maintain reserve is not open to
challenge.

DECISION.
Judgment in favor of the defendant and against the plaintiff is
entered.