1 M.C. Jensen & W.H. Meckling, Agency Costs and the Theory of the Firm, 3 J. FIN. ECON. 305, 310 (1976).

2 Id. at 311.

3 FRANK H. EASTERBROOK & DANIEL R. FISCHEL, THE ECONOMIC STRUCTURE OF CORPORATE LAW 34 (1991). Some empirical studies have also suggested that shareholders are indifferent to both the choice of the state of incorporation and to changes in the relevant state's corporate law doctrines. See, e.g., Elliott J. Weiss & Lawrence J. White, Of Econometrics and Indeterminacy: A Study of Investors' Reactions to "Changes" in Corporate Law, 75 CAL. L. REV. 551 (1987).

4 See, e.g., Frank H. Easterbrook & Daniel R. Fischel, The Corporate Contract, 89 COLUM. L. REV. 1416 (1989). This analysis somewhat overstates the arguments of the "corporation as nexus of contract" proponents. Proponents of this theory concede that some provisions of corporate law are mandatory. Id. at 1417-18. While proponents of the nexus theory concede that certain types of market failures may justify some mandatory provisions, id. at 1436, they generally oppose mandatory terms in corporate law because such terms "halt the process of natural selection and evaluation" that corporate participants use to produce the optimal arrangement for their particular corporation. Id. at 1442.

5 Melvin Aron Eisenberg, The Structure of Corporation Law, 89 COLUM. L. REV. 1461, 1486 (1989) ("The characterization of corporation law as a standard-form contract whose terms each firm is generally free to vary is belied by the great number of mandatory rules of corporation law."); Ronald J. Gilson, Corporate Governance and Economic Efficiency: When Do Institutions Matter?, 74 WASH. U. L. Q. 327, 329 (1996) ("[O]ne need not entirely disregard corporate governance in order to question the relative magnitude of its importance.").

6 Something has economic significance or consequences if it affects the decision-making behavior of business, government, unions, investors, creditors or other stakeholders in the business entity. Stephen A. Zeff, The Rise of "Economic Consequences," J. ACCT., Dec. 1978, at 56.

As previously noted, Professor Eisenberg is a harsh critic of the nexus of contract theory, yet he has also written that "the traditional [legal capital] statutory provisions concerning distributions bear virtually no relation to economic reality." Melvin Aron Eisenberg, The Modernization of Corporate Law: An Essay for Bill Cary, 37 U. MIAMI L. REV. 187, 200 (1983). Professor Bebchuk, for example, argues that regulation of corporate dividend policy is an important issue, but that "the limits on dividends established by state law are generally so weak and ineffectual as to have virtually no practical significance." Id. Lucian Arye Bebchuk, Federalism and the Corporation: The Desirable Limits on State Competition in Corporate Law, 105 HARV. L. REV. 1437, 1490 (1992). See also Philip McGough, Statutory Limits on a Corporation's Right to Make Distributions to Shareholders: The Law of Distribution in the 1984 Revised Model Business Corporation Act, 21 AKRON L. REV. 27 (1987) "Not only do [legal capital restrictions on dividends] not work, but an argument can be made that the provisions were irrelevant." There are also scholars who suggest that all dividends lack economic consequences. See, e.g., Daniel R. Fischel, The Law and Economics of Dividend Policy, 67 VA. L. REV. 699, 701 (1981) "[T]he overwhelming weight of theoretical authority and recent empirical evidence does not support the proposition that dividend policy affects share prices apart from earnings." Id.; WILLIAM A. KLEIN & JOHN C. COFFEE, JR., BUSINESS ORGANIZATION AND FINANCE: LEGAL AND ECONOMIC PRINCIPLES 377 (5th ed. 1993) "[T]he total value of a firm is determined by its investment decisions and not by its dividend policy"; but see C. Wayne Shepherd & David F. Scott, Jr., Corporate Dividend Policy: Some Legal and Financial Aspects, 13 AM. BUS. L.J. 199 (1975) (comparing a particular firm's dividend policy with the industry standard yields important information about the company in question).

7 This is largely seen as a welcome example of the principle that policymakers should take these economic consequences into consideration when deciding such questions. Since stock distributions involve both legal and accounting issues, it should be noted that this principle applies with equal force to policymakers in the accounting profession. "There is a growing recognition that the setting of financial accounting standards which govern what business corporations must report (i.e., disclosure issues) and how they must describe their economic operations (i.e., measurement issues) needs to be viewed more broadly than simply from a technical accounting perspective? . The expanded view of standard setting comes from an increasing recognition that the legislation of accounting standards involves a potential redistribution of wealth, i.e., it imposes restrictions or costs on some while conferring benefits to others." Alfred Rappaport, Economic Impact of Accounting Standards-Implications for the FASB, J. ACCT., May 1977, at 89.

"It is a fair generalization that historically accounting standards have been based in a greater measure on technical accounting considerations than on the potential economic and social ramifications they might be expected to have." Arthur Wyatt, The Economic Impact of Financial Accounting Standards, J. ACCT., Oct. 1977, at 92.

8 Both types of stock distributions result in an increase in the number of outstanding shares of a particular corporation's common stock without changing the pro rata holdings of any shareholder. Most accountants would suggest, however, that both types of stock distributions are basically cosmetic maneuvers having little to do with income determination and balance sheet valuation. ELDEN S. HENDRIKSEN, ACCOUNTING THEORY 477 (4th ed. 1982).

9 Id.

10 Similarly, economists would argue that a stock distribution is

irrelevant by appealing to the efficient market hypothesis. "The primary role of the capital market is allocation of ownership of the economy's capital stock. In general terms, the ideal is a market in which prices provide accurate signals for resource allocation; that is, a market in which firms can make production-investment decisions, and investors can choose among the securities that represent ownership of firm's activities under the assumption that security prices at any time 'fully reflect' all available information. A market in which prices always "fully reflect" available information is called 'efficient.'" Eugene F. Fama, Efficient Capital Markets: A Review of Theory and Empirical Work, 25 J. FIN. 383 (1970).

11 A stock split by itself does not convey new information to market participants. Id. at 405. Legal scholars have criticized stock distributions and the concept of legal capital for similar reasons. See, e.g., LEWIS D. SOLOMON, ET AL., CORPORATIONS: LAW AND POLICY 261 (3d ed. 1994) (Stock dividends "produce no meaningful change in the financial status of the corporation or its shareholders"); Robert C. Art, Corporate Shares and Distributions in a System Beyond Par: Financial Provisions of Oregon's New Corporation Act, 24 WILLIAMETTE L. REV. 203, 221 (1988) (Stock distributions have "virtually no economic significance.").

12 Contrary to the conventional wisdom of accountants, economists and lawyers, empirical evidence suggests that shareholders associate stock distributions, i.e., stock dividends and stock splits, with fundamentally more important information, such as increased cash dividends. Eugene F. Fama, Lawrence Fisher, Michael C. Jensen & Richard Roll, The Adjustment of Stock Prices to New Information, 10 INT'L ECON. REV. 1, 16 (1969).

13 Id. at 9.

14 The use of legal capital to restrict dividends can be traced back to the seventeenth century. McGough, supra note 6, at 30. See also ALFRED F. CONARD, CORPORATIONS IN PERSPECTIVE 308 (1976) ("An idea almost as old as the business corporation is the notion that corporation should maintain a pool of assets which is not only equal to its debts, but contains a 'cushion' of some measure beyond its debts.").

15 Wood v. Dummer, 30 F.Cas. 435 (no. 17,944) (C.C.D. Me. 1824). According to Manning and Hanks, "the entire range" of legal capital doctrines can be traced to Justice Story's decision in Wood v. Dummer. BAYLESS MANNING & JAMES J. HANKS, JR., LEGAL CAPITAL 30-31 (3d ed. 1990); accord, MORTON J. HORWITZ, THE TRANSFORMATION OF AMERICAN LAW 1870-1960: THE CRISIS OF LEGAL ORTHODOXY 93 (1992). Justice Story, however, rested his landmark holding that the corporation held the money paid for stock as a trust fund for the benefit of the corporation's creditors not only "general principles" and "common sense," 30 F.Cas. at 436, but also on two earlier Massachusetts cases, Vose v. Grant, 15 Mass. 505 and Spear v. Grant, 16 Mass. 9.

16 30 F.Cas. 435, 436 (no. 17,944) (C.C.D. Me. 1824).

17 Id. at 436. (holding that creditors have the first claims upon it; and the stockholders have no rights, until all other creditors are satisfied); MANNING & HANKS, supra note 15, at 32; ALFRED F. CONARD, supra note 14, at 309 ("Nineteenth and early twentieth century decisions started from the premise that whatever values had been originally paid in for the shares should be maintained.").

18 McGough, supra note 6, at 29 ("Historically, the primary purpose of the law has been to protect creditors."). Id.

19 Id.

20 William H. Ralston, Note, The 1980 Amendments to the Financial Provisions of the Model Business Corporation Act: A Positive Alternative to the New York Statutory Reform. 47 ALB. L. REV. 1019 n.6 (1983).

21 "Watered stock," not purchase prices in excess of par value or illegal dividends, was the main concern of courts dealing with legal capital doctrines. "This question ? represented one of the two or three most important issues in corporate law during the late nineteenth century and generated hundreds of cases and thousands of pages of legal writing." HORWITZ, supra note 15, at 93 (1992). See also LAWRENCE M. FRIEDMAN, A HISTORY OF AMERICAN LAW 514-16 (2d ed. 1985).

22 MANNING & HANKS, JR., supra note 15, at 22-26.

23 See, e.g., Coit v. North Carolina Gold Amalgamating Co., 14 F. 12, 14 (C.C.E.D. Pa. 1882) ("[I]n the case of stock dividends fairly made, in consideration of profits earned, and of accumulations of the property, ? a court of chancery would have no power to revive a claim against the stockholders because they had not advanced actual cash for the shares.").

24 MANNING & HANKS, JR., supra note 15, at 28-29.

25 See MORTON J. HORWITZ, SANTA CLARA REVISITED: THE DEVELOPMENT OF CORPORATE LAW, IN CORPORATIONS AND SOCIETY 13 (W.J. Samuels and A.S. Miller eds., 1987) (linking the history of the trust fund theory to changing notions of the role of shareholders in corporations). In 1891, the United States Supreme Court praised the trust fund theory as a "wholesome doctrine," but the Court also felt that the theory only applied to insolvent corporations. Handley v. Stutz, 139 U.S. 417, 430 (1891). A year later, the Supreme Court of Minnesota called the doctrine "misleading"in Hospes v. Northwestern Mfg. & Car Co., 50 N.W. 1117, 1119 (Minn. 1892). The Hospes court stated that the "capital of a corporation is its property." Id. Corporate property, said the court in Hospes, "is not held in trust, in any proper sense of the term." Id. In direct contradiction of the Handly decision, the court in Hospes held that a creditor could not hold a shareholder liable for the unpaid par value of stock absent a showing of actual fraud.

26 MANNING & HANKS, JR., supra note 15, at 29-30; HORWITZ, supra note 15, at 97.

27 The conventional wisdom of the times was torn between a desire for flexibility and an attachment to Victorian conceptions of par value can be seen from a contemporary treatise on corporate law. WILLIAM ALLEN WOOD, MODERN BUSINESS CORPORATIONS (2d ed. 1917). At one point, Wood stresses that a corporation should "make the market value of [its] stocks ? correspond as nearly a may be with their par value." Id. at 35. The "general and best," Wood says, requires shareholders who received "bonus or partly paid stock" from the corporation to "be held liable to the full amount of the par value" if the corporation becomes insolvent. Id. at 112. Later, however, Wood concedes that "par value may be confusing and that after a corporation is organized, it is practically meaningless." Id. at 297. Noting that Pennsylvania, Maryland, and Delaware had quickly copied New York's provision for no par stock, id. at 298-99, Wood reported that "investors, bankers and managers ? are pleased with the law and its results" and that this "tendency seems to be a simplification in the right direction." Id. at 309.

28 See, e.g., Comment, The Statutory Responsibility for Payment of Dividends Out of Capital, 35 YALE L.J. 870 (1926) (calling for clarification of directors' duties, rather than a fundamental overhaul of legal capital doctrines).

29 Although the last iteration of the MBCA came out in 1969, the basic legal capital framework was set out in the 1950 version of the Model Act. McGough, supra note 6, at 33-34.

30 MODEL BUS. CORP. ACT ANN. § 2, ¶2 (2d ed. 1971) ("These terms, or similar ones serving the same function, are used in all corporate statutes in the United States today, although they are not always defined.").

31 MODEL BUS. CORP. ACT ANN. 2d § 45(c) to (e) ¶ 2 (1971).

32 CAL. CORP. CODE §§ 166, 500; Richard O. Kummert, State Statutory Restrictions on Financial Distributions by Corporations to Shareholders Part II, 59 WASH. L. REV. 185, 187 (1984) ("[I]t is now apparent that the era began with the adoption by the California legislature in 1975 of that state's unique series of restrictions on dividends and share repurchases by corporations.").

33 MANNING & HANKS, JR., supra note 15, at 39 (Legal capital "is initially the product of par value-itself an arbitrary dollar amount printed on the stock certificate and recited in the certificate of incorporation-multiplied by the number of shares 'outstanding.'").

34 The amendments were proposed in 1979, Committee on Corporate Laws, Changes in the Model Business Corporation Act-Amendments to Financial Provisions, reprinted in 34 BUS. LAW. 1867 (1979), and adopted in December 1979. Committee on Corporate Laws, Changes in the Model Business Corporation Act-Amendments to Financial Provisions, 35 BUS. LAW. 1365 (1980). Because notice of the adoption was not published until the following April, id., many commentators have erroneously indicated that the amendments were adopted in 1980.

35 Committee on Corporate Law, supra note 34, at 1867 ("The amendments ? reflect a complete modernization of all provisions of the Model Act concerning financial matters, including ? the elimination of the outmoded concepts of stated capital and par value"); Elliott Goldstein & Robert W. Hamilton, The Revised Model Business Corporation Act, 38 BUS. LAW. 1019, 1021 (1983) The amendments "eliminated the traditional concepts of par value, stated capital, and treasury shares and substituted a simpler, less confusing, and potentially less misleading treatment.") Id. see also, Art, supra note 11, at 204 ("The financial provisions of [the RMBCA] proceed from a radical premise: that 'par value' of stock-the core concept of legal capital requirements throughout the country for generations-served no worthwhile purpose and should be abandoned.").

36 Kummert, supra note 32, at 196.

37 Yoav Ben-Dror, An Empirical Study of Distribution Rules Under California Corporations Code §500: Are Creditors Adequately Protected?, 16 U.C. DAVIS L. REV. 375, 378 (1983).

38 The specific state statutes referenced in this chart are: ALA. CODE § 10-2A-67 (1991) (repealed 1994); ALASKA STAT. § 10.06.358 (Michie 1991); ARIZ. REV. STAT. ANN. § 10-045 (West 1991) (repealed 1994); ARK. CODE ANN. § 4-27-6402 (Michie 1991); CAL. CORP. CODE §§ 166, 500 (West 1991) (CAL. CORP. CODE § 500 amended 1994); COLO. REV. STAT. § 7-5-110 (1991) (repealed 1993); CONN. GEN. STAT. ANN. § 33-356 (West 1991) (repealed 1994); DEL. CODE ANN. tit. 8, § 170, 173 (1991) (DEL. CODE ANN. tit. 8, § 170, amended 1993); D.C. CODE ANN. § 29-340 (1991); FLA. STAT. ANN. § 607.06401 (West 1991); GA. CODE ANN. § 14-2-640 (Michie 1991); HAW. REV. STAT. § 415-45 (1991); IDAHO CODE § 30-1-45 (1991); ILL. COMP. STAT. ANN. ch. 32, § 9.10 (West 1991); IND. CODE ANN. §§ 23-1-28-1-23-1-28-6 (Michie 1991); IOWA CODE ANN. § 490.640 (West 1991); KAN. STAT. ANN. §§ 17-6420, 17-6423 (1991) (KAN. STAT. ANN. § 17-6423 amended 1992); KY. REV. STAT. ANN. § 271B.6-400 (Michie 1991); LA. REV. STAT. ANN. § 12:634 (West 1991); ME. REV. STAT. ANN. tit. 13-A, § 514 - 515 (West 1991); MD. CODE ANN., Corps. & Assn'ns §§ 2-301, 2-309-2-3118 (1991)(MD. CODE ANN., Corps. & Assn'ns §§ 2-310 and 2-311 amended 1992); MASS. GEN. LAWS ANN. ch. 156B, §§ 9, 54, 61 (West 1991); MICH. COMP. LAWS ANN. § 450.1345 (West 1991) (amended 1993); MINN. STAT. ANN. § 302A.551 (West 1991) (amended 1991 and 1993); MISS. CODE ANN. § 79-4-6.40 (1991); MO. ANN. STAT. § 351.220 (West 1991); MONT. CODE ANN. § 35-1-711 (1991) (repealed 1991); NEB. REV. STAT. § 21-2043 (1991) (repealed 1995); NEV. REV. STAT. § 78.290 (1991) (repealed 1991); N.H. REV. STAT. ANN. § 293-A:45 (1991) (repealed 1992); N.J. STAT. ANN. §§ 14A:7-14.1, 7-15, 7-15.1 (West 1991) (N.J. STAT. ANN. § 14A:7-15.1 amended 1995); N.M. STAT. ANN. § 53-11-44 (Michie 1991); N.Y. BUS. CORP. LAW § 510 (McKinney 1991); N.C. GEN. STAT. § 55-6-40 (1991) (amended 1991); N.D. CENT. CODE § 10-19.1-92 (1991) (amended 1995); OHIO REV. CODE ANN. § 1701.33 (Anderson 1991) (amended 1993); OKLA. STAT. ANN. tit. 18, § 1049 (West 1991); OR. REV. STAT. § 60.181 (1991); PA. STAT. ANN. tit. 15, § 1551 (West 1991); P.R. LAWS ANN. tit. 14, § 1517 (1991); R.I. GEN. LAWS § 7-1.1-40 (1991) (amended 1992); S.C. CODE ANN. § 33-6-400 (Law Co-op. 1991); S.D. CODIFIED LAWS §§ 47-3-70 - 47-3-76 (Michie 1991); TENN. CODE ANN. § 48-16-401 (1991) (amended 1994); TEX. BUS. CORP. ACT ANN. art. 2.38 (West 1991); UTAH CODE ANN. § 16-10-41 (1991)(repealed 1992); VT. STAT. ANN. tit. 11, § 1889 (1991) (repealed 1993); VA. CODE ANN. § 13.1-653 (Michie 1991); WASH. REV. CODE ANN. § 23B.06.400 (West 1991); W. VA. CODE § 31-1-99 (1991); WIS. STAT. ANN. § 180.0640 (West 1991) (amended 1995); WYO. STAT. ANN. § 17-16-640 (Michie 1991).

Since August of 1991 the following states have adopted the RMBCA approach: Alabama, ALA. CODE § 10-2B-6.40 (1996); Arizona, ARIZ. REV. STAT. ANN. § 10-640 (West 1996); Connecticut, CONN. GEN. STAT. ANN. § 33-687 (West 1994); Nebraska, NEB. REV. STAT. § 21-2050 (1996); Nevada, NEV. REV. STAT. § 78.288 (1995); New Hampshire, N.H. REV. STAT. ANN. § 293-A:6.40 (1995); Utah, UTAH CODE ANN. § 16-10a-640 (1996); Vermont, VT. STAT. ANN. tit. 11A, § 6.40 (1996). Montana revised its business corporation statute effective 1992 and recodified its dividend restrictions. MONT. CODE ANN. § 35-1-712 (1995).

39 Ben-Dror, supra note 37, at 381 (The "dual insolvency test prohibits distributions [to shareholders] that cause either 'equitable insolvency,' an inability to pay debts as they become due, or '[balance sheet] insolvency,' wherein total liabilities exceed total assets.").

40 In addition to the two major restrictions discussed in this section, the corporation may not pay a dividend when it would violate a restriction contained in the articles of incorporation. MODEL BUS. CORP. ACT § 45 (1969) ("The corporation may pay dividends in cash, property, or its own shares, except when the declaration or payment thereof would be contrary to any restriction contained in the articles of incorporation."). The MBCA also contains provisions designed to protect the proportionate interest s of shareholders. See, e.g., MODEL BUS. CORP. ACT § 45(e) (1969).

41 MODEL BUS. CORP. ACT ANN. 2d § 45 (1971) (Official Comment, at 890-91).

42 "'Insolvent' means the inability of a corporation to pay its debts as they become due." MODEL BUS. CORP. ACT § 2(n) (1969).

43 MODEL BUS. CORP. ACT § 45 (1969) ("The corporation may pay dividends in cash, property, or its own shares, except when the corporation is insolvent or when the or payment thereof would render corporation insolvent or when the declaration or payment thereof would be contrary to any restriction contained in the articles of incorporation.").

44 MANNING & HANKS, JR., supra note 15, at 64.

45 "Surplus means the excess of net assets over the corporation's stated capital." MODEL BUS. CORP. ACT § 2(k) (1969). Net assets means the amount by which the corporation's total assets exceed its total debts. MODEL BUS. CORP. ACT § 2(i) (1969). Total debts include all cumulative dividends accrued on all preferred or special classes of shares entitled to preferential dividends. MODEL BUS. CORP. ACT § 46(c) & (d) (1969). Stated capital means the par value of all shares issued plus all or some portion of the consideration received on shares issued without par value. Also included are such amounts having been transferred to stated capital, whether upon the issue of shares as a share dividend or otherwise, minus all reductions from such sum as having been effected in a manner permitted by law. MODEL BUS. CORP. ACT § 2(j) (1969). See also MODEL BUS. CORP. ACT § 21 (1969) (the determination of and additions to stated capital) and MODEL BUS. CORP. ACT §§ 67-69 (1969) (steps that in each case will reduce stated capital).

46 MODEL BUS. CORP. ACT § 2(l) (1969) ("'Earned surplus' means the portion of the surplus of corporation equal to the balance of its net profits, income, gains and losses from the date of incorporation."). The accounting literature refers to this same account as retained earnings. See, e.g., STANLEY SIEGEL & DAVID A. SIEGEL, ACCOUNTING AND FINANCIAL DISCLOSURE: A GUIDE TO BASIC CONCEPTS 98 (1983) ("The accumulated income of the corporation ? is separately identified in the account as Retained Earnings.").

47 MODEL BUS. CORP. ACT § 2(m) (1969) ("'Capital surplus' means the entire surplus of a corporation other than its earned surplus."). The accounting literature often refers to capital surplus as "capital in excess of par value" or "additional paid in capital." See, e.g., SIEGEL & SIEGEL, supra note 46, at 98.

48 MODEL BUS. CORP. ACT ANN. 2d § 2 (1971) (Official Comment, at 35).

49 Earned surplus becomes "reserved" by a board of director's resolution to that effect. Such action requires that a corporation designate a portion of earned surplus for a particular purpose thus making it unavailable for dividends. Boards of directors may appropriate earned surplus for discretionary purposes such as plant expansion or in anticipation of future losses. MODEL BUS. CORP. ACT § 70 (1969) ("A corporation may, by resolution of its board of directors, create a reserve or reserves out of its earned surplus for any proper purpose or purposes, and may abolish any such reserve in the same manner. Earned surplus of the corporation to the extent so reserved shall not be available for the payment of dividends or other distributions by the corporation except as expressly permitted by this Act.").

50 Creditors may also impose restrictions on cash dividend payments in loan agreements and indentures as a precondition to lending money. MODEL BUS. CORP. ACT ANN. 2d § 45 (1971) (Official Comment, at 890).

Treasury shares also restrict earned surplus. Treasury shares are issued shares of a corporation that have been subsequently acquired by and belong to the corporation, and have not been canceled or otherwise restored to the status of authorized but unissued shares. MODEL BUS. CORP. ACT § 2(h) (1969); see also MODEL BUS. CORP. ACT ANN. 2d § 2(g) (1971). In order to restrict a corporation from influencing its net income by trading in its own stock, a corporation cannot recognize a gain or loss when reacquiring its own shares. The amount of earned surplus is "restricted" by the cost of the treasury stock holdings so that payment of cash dividends will not reduce contributed capital (stated capital and paid-in capital). Consequently, treasury stock is a reduction of stockholders' equity even though its acquisition does not formally reduce legal capital - i.e., the amount of stockholders' equity that cannot be distributed to shareholders.

51 MODEL BUS. CORP. ACT § 45(a) (1969) ("Dividends may be declared and paid in cash or property only out of the unreserved and unrestricted earned surplus of the corporation."). An alternative section 45(a) provides that "[d]ividends may be declared and paid in cash or property only out of earned surplus or the corporation, or out of the unreserved and unrestricted net earnings of the current fiscal year and the next preceding fiscal year taken as a single period." MODEL BUS. CORP. ACT § 45(a) (1969) (alternative). These are "nimble dividends." The MBCA also allows a corporation to reduce capital surplus instead of earned surplus for a cash or property dividend under certain circumstances. MODEL BUS. CORP. ACT § 46 (1969).

52 MODEL BUS. CORP. ACT § 45(d) (1969) ("Dividends may be declared and paid in [the corporation's] own authorized but unissued shares out of any unreserved and unrestricted surplus of the corporation.").

53 MODEL BUS. CORP. ACT § 45(d)(1) (1969).

54 Id. at § 45(d)(2) (1969).

55 HARRY G. HENN & JOHN R. ALEXANDER, LAWS OF CORPORATIONS 921 (3d ed. 1983) ("No share dividend itself can affect a corporation's insolvency in either [the] equity or bankruptcy sense.").

56 Id. "At a minimum, there must be sufficient surplus, earned or unearned, to cover a sufficient transfer to stated capital to represent the new issued shares resulting from the share dividend." Id. Although Henn and Alexander subsequently state that a stock dividend cannot "affect a corporation's insolvency in [a] bankruptcy sense," id., they must mean bankruptcy insolvency in the strict sense of liabilities exceeding assets.

57 Of course, the corporation's board of directors could remedy this situation by amending the articles of incorporation to reduce par value and create surplus.

58 MODEL BUS. CORP. ACT § 45 (1969) ("A split-up or division of the issued shares of any class into a greater number of shares of the same class without increasing the stated capital of the corporation shall not be construed to be a share dividend.").

59 MODEL BUS. CORP. ACT ANN. 2d § 45 (1971) (Official Comment, at 925).

60 Id. at § 45 (1971) (Official Comment, at 889-90).

61 Avner Kalay, Stockholder-Bondholder Conflict and Dividend Constraints, 10 J. FIN. ECON. 211 (1982). Clifford W. Smith & Jerold B. Warner, On Financial Contracting: An Analysis of Bond Covenants, 7 J. FIN. ECON. 117 (1979). MODEL BUS. CORP. ACT ANN. 2d § 45 (1971) (Official Comment, at 891).

62 MODEL BUS. CORP. ACT. § 45(a) (1969) ("[Alternative] (a) Dividends may be declared and paid in cash or property only out of the unreserved and unrestricted earned surplus of the corporation, or out of the unreserved and unrestricted net earnings of the current fiscal year and the next preceding fiscal year taken as a single period, except as otherwise provided in this section.").

63 MANNING & HANKS, JR., supra note 15, at 82-84; HENN & ALEXANDER, supra note 55, at 892; Kummert, supra note 32, at 194.

64 MANNING & HANKS, JR., supra note 15, at 83.

65 MODEL BUS. CORP. ACT § 45 (1969).

66 Bondholders, who perceive that their rights are subject to greater jeopardy under this alternative, may, of course, respond by imposing more restrictive covenants. Kummert, supra note 32, at 196. When debt covenants restrict a larger amount of retained earnings, accounting for stock distributions as stock dividends increases the probability that a firm will default or be forced to cut future cash dividends. Mark S. Grinblatt, Ronald W. Masulis & Sheridan Titman, The Valuation Effects of Stock Splits and Stock Dividends, 13 J. FIN. ECON. 461, 463 (1984).

67 MANNING & HANKS, JR., supra note 15, at 82-84.

68 Delaware does not distinguish between earned and capital surplus. DEL. GEN. CORP. LAW § 154. The statute provides that a corporation may pay dividends "either (1) out of its surplus ? or (2) in case there shall be no such surplus, out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year." DEL. GEN. CORP. LAW § 170(a). Manning and Hanks find the wording of this statute is ambiguous. Some accounting questions include, for example, a definition of "profits". Do profits imply earnings? What are "net" profits? A related question concerns time. Does the reference to fiscal year mean a full year so that corporations may not, at six months into the year, pay dividends out of the net profits of the first six months? In addition, what does "and/or" mean? In short, what is distributable given the ambiguous wording of the statute? MANNING & HANKS, JR., supra note 15, at 84.

69 See N.Y. BUS. CORP. LAW § 510(b) ("Dividends ? may be made out of surplus only, so that the net assets of the corporation remaining after such ? distribution shall at least equal the amount of its stated capital."). Id. New York also prohibits cash and property dividends when the corporation is insolvent or would be rendered insolvent by payment of the dividend. N.Y. BUS. CORP. LAW § 510(a). Unlike the MBCA, the New York statute does not apply this equity insolvency test to stock dividends. N.Y. BUS. CORP. LAW § 511.

70 Kummert, supra note 32, at 211-17.

71 Id. at 202.

72 Some states, such as Delaware, combine the balance sheet surplus test with the nimble dividends test. See DEL. GEN. CORP. LAW §§ 154 & 170.

73 Kummert, supra note 32, at 220.

74 Committee on Corporate Law, supra note 34, at 1867; MANNING & HANKS, JR., supra note 15, at 176-209.

75 Committee on Corporate Law, supra note 34, at 1867; MANNING & HANKS, supra note 15, at 179 (The RMBCA "eliminated almost every reference to par, and eradicated all references to stated capital, treasury shares, surpluses, and all their fearsome progeny."). Id.

76 REV. MODEL BUS. CORP. ACT § 1.40(6) (1987) ("'Distribution' means a direct or indirect transfer of money or other property (except its own shares) or incurrence of indebtedness by a corporation to or for the benefit of its shareholders in respect of any of its shares. A distribution may be in the form of a declaration or payment of a dividend; a purchase, redemption, or other acquisition of shares; a distribution of indebtedness; or otherwise"); see Committee on Corporate Law, supra note 34, 34 BUS. LAW. at 1867.

77 REV. MODEL BUS. CORP. ACT § 6.40(c)(1) (1987) ("No distribution may be made if, after giving it effect ? the corporation would not be able to pay its debts as they become due in the usual course of business); Committee on Corporate Law, supra note 34, 34 BUS. LAW. at 1868.

78 Committee on Corporate Law, supra note 34, at 1868; MANNING & HANKS, JR., supra note 15, at 182-86.

79 REV. MODEL BUS. CORP. ACT § 6.40(c)(2) (1987) ("No distribution may be made if, after giving it effect? the corporation's total assets would be less than the sum of its total liabilities plus (unless the articles of incorporation permit otherwise) the amount that would be needed, if the corporation were to be dissolved at the time of the distribution, to satisfy the preferential rights upon dissolution of shareholders whose preferential rights are superior to those receiving the distribution"); Committee on Corporate Law, supra note 34, at 1872; see also, Kummert, supra note 32, at 244.

The balance sheet test may be based upon financial statements prepared on the basis of (1) accepted accounting practices or (2) a fair valuation or other method that is reasonable in the circumstances. REV. MODEL BUS. CORP. ACT § 6.40(d) (1987) ("The board of directors may base a determination that a distribution is not prohibited under subsection (c) either on financial statements prepared on the basis of accounting practices and principles that are reasonable in the circumstances or on a fair valuation or other method that is reasonable in the circumstances"); Committee on Corporate Law, supra note 34, 34 BUS. LAW. at 1872.

80 Committee on Corporate Law, supra note 34, 34 BUS. LAW. at 1868-69; MANNING & HANKS, JR., supra note 15, at 183-84 (A corporation may "fix a par [value] for its shares ? [b]ut for purposes of assessing the legality of a distribution to shareholders, all those things matter not.").

81 Kummert, supra note 32, at 249-50.

82 MASS. GEN. LAWS ANN. ch. 156B, §§ 45, 61.

83 MINN. STAT. ANN. § 302A.551 Subdivision 1.

84 N.D. CENT. CODE § 10-19.1-92.1.

85 One commentator has suggested that while Massachusetts statutory law does not place any express limits on a corporation's ability to pay dividends, the state's common law uses a test essentially equivalent to the RMBCA. James E. Tucker, Director and Shareholder Liability for Massachusetts Corporations' Distributions to Shareholders: A Suggestion for Change in Standards of Director Liability, 28 NEW ENG. L. REV. 1025 (1994).

86 Kummert, supra note 32, at 257.

87 The Minnesota Act, for example, follows the basic structure of the Revised Model Business Corporation Act in that par value, stated capital, paid-in surplus, and earned surplus are no longer required. Kummert, supra note 32, at 256.

88 See MINN. STAT. ANN. § 302A.551; N.D. Cent. Code § 10-19.1-92(5).

89 Kummert, supra note 32, at 261.

90 CAL. CORP. CODE §§ 166, 500 (1996).

91 Kummert, supra note 32, at 242, 284-87.

92 CAL. CORP. CODE § 166 (1996) ("'Distribution to its shareholders' means the transfer of cash or property by a corporation to its shareholders without consideration, whether by way of dividend or otherwise, except a dividend in shares of the corporation, or the purchase or redemption of its shares for cash or property, including the transfer, purchase, or redemption by a subsidiary of the corporation.").

93 CAL. CORP. CODE § 500 (1996) (Legislative Committee Comment) ("These provisions are based on the current financial condition of the corporation and permit a corporation to make a distribution to its shareholders out of retained earnings.").

94 CAL.CORP. CODE § 501 (1996) ("Neither a corporation nor any of its subsidiaries shall make any distribution to the corporation's shareholders (Section 166) if the corporation or the subsidiary making the distribution is, or as a result thereof would be, likely to be unable to meet its liabilities (except those whose payment is otherwise adequately provided for) as they mature"); see also, CAL. CORP. CODE § 500 (1996) (Legislative Committee Comment ("any distribution is subject to a solvency test")).

95 CAL.CORP. CODE § 500 (a) (1996) ("The distribution may be made if the amount of the retained earnings of the corporation immediately prior thereto equals or exceeds the amount of the proposed distribution.").

96 CAL. CORP. CODE § 500 (b)(1) (1996) ("The distribution may be made if immediately after giving effect thereto [t]he sum of the assets of the corporation (exclusive of goodwill, capitalized research and development expenses and deferred charges) would be at least equal to 1 1/4 times its liabilities (not including deferred taxes, deferred income and other deferred credits)").

97 CAL. CORP. CODE § 500 (b)(2) (1996) ("The distribution may be made if immediately after giving effect thereto [t]he current assets of the corporation would be at least equal to its current liabilities.").

98 CAL. CORP. CODE § 500 (b)(2) (1996) ("[I]f the average of the earnings of the corporation before taxes on income and before interest expense for the two preceding fiscal years was less than the average of the interest expense of the corporation for those fiscal years, [current assets must be] at least equal to 1 1/4 times its current liabilities.").

99 Kummert, supra note 32, at 234-35.

100 ALASKA STAT. § 10.06.358, et seq. (1996).

101 MODEL BUS. CORP. ACT § 45(a) (1969).

102 Id. at § 45(e).

103 See id. at § 2(h). Treasury shares' means shares of a corporation which have been issued, have been subsequently acquired by and belong to the corporation, and have not, either by reason of the acquisition or thereafter, been canceled or restored to the status of authorized but unissued shares. Treasury shares shall be deemed to be issued shares, but not outstanding shares.

104 See id. at § 6.

105 LOREN A. NIKOLAI & JOHN D. BAZLEY, INTERMEDIATE ACCOUNTING 792 (4th ed. 1988).

106 See, e.g., N.Y. BUS. CORP. LAW § 510(b).

107 REV. MODEL BUS. CORP. ACT § 6.40 (1984).

108 See, e.g., Ralston, supra note 20, at 1021 ("The need to adopt a modern approach to the regulation of dividends and other distributions is long overdue."); Art, supra note 11, at 225 ("The time for statutory reform of the legal capital system was long overdue, and the proper course was repeal, not repair.").

109 "The issue of whether any change is required in the state's corporate financial provisions should receive a resounding affirmative answer from the legislature in any state currently basing such provisions on legal capital. ? Legislatures deciding to alter their corporate financial provisions must then face the more difficult question of which of the alternative systems not based on legal capital should be chosen." Kummert, supra note 32, at 282.

110 CONARD, supra note 14, at 311; see also Uriel Procaccia, Crafting a Corporate Code from Scratch, 17 CARDOZO L. REV. 629, 633 (1996) ("[P]ar values have no connection to any real yardsticks of corporate worth.").

111 "It has long been recognized ? that the pervasive structure in which 'par value' and 'stated capital' are basic to the state corporation statutes does not today serve the original purpose of protecting creditors and senior security holders from payments to junior security holders." Committee on Corporate Law, supra note 34, at 1867. See also Art, supra note 11, at 205 ("The original goals of the traditional legal capital system ? were laudable: the protection of investors and creditors."); Ben-Dror, supra note 37, at 378 ("the primary goal of distributions law" is the "protection of creditors"); Ralston, supra note 20, at 1025 ("The intention behind the traditional statutory scheme ? is to provide a cushion for the protection of creditors.").

Some scholars have suggested that legal capital serves additional purposes such as the "protection of the stockholders themselves, the stockholders as consumers." McGough, supra note 6, at 33. This purpose arises when the corporation is required to inform shareholders (or to receive their approval) of dividends that result in a reduction of legal capital. Apparently, this keeps the corporation from liquidating without notice to shareholders. Additionally, legal capital was supposed to protect investors by assuring "equitable contribution by each purchaser of shares of the same stock." Art, supra note 11, at 206. The advent of low par and no par stock eliminated the validity this latter purpose of legal capital. Id. at 210.

112 MANNING & HANKS, JR., supra note 15, at 28; CONARD, supra note 14, at 311 (Legal capital "can be readily reduced without the consent of, or notice to, the people likely to be most interested ?. Creditors who may be adversely affected are not consulted, nor are they even told.").

113 CONARD, supra note 14, at 313.

114 Richard O. Kummert, State Statutory Restrictions on Financial Distributions by Corporations to Shareholders Part I, 55 WASH. L. REV. 359, 396 (1980) ("Even in cases where the surplus limitation appears to restrict a corporation's ability to make a distribution, surplus may be created by a change in accounting principles, by the recognition of unrealized appreciation in the value of the corporation's assets, or by a reduction of stated capital."); Committee on Corporate Laws, Changes in the Model Business Corporation Act-Amendments Pertaining to Distributions, 42 BUS. LAW. 259, 261 (1986) ("While most of [pre-1980] statutes contained elaborate provisions [regarding legal capital], the net effect of most statutes was to permit the distribution to shareholders of most or all of the corporation's net assets-its capital along with its earnings-if the shareholders wished this to be done."); Art, supra note 11, at 211-20 (outlining the "numerous methods" used "to drain amounts out of stated capital and ? into the hands of shareholders"); SOLOMON, supra note 11, at 260 ("[C]oncepts of par value provided little protection to creditors because of the ease with which restrictions could be circumvented.").

115 Ben-Dror, supra note 37, at 379 ("[L]egal capital ? tends to be arbitrary and subject to manipulation.").

116 See Ralston, supra note 20, at 1021 ("Capital accounts ? have no direct relationship to any cash or other property which the corporation actually owns.").

117 MANNING & HANKS, JR., supra note 15, at 57 ("[I]n the unusual circumstance in which the shareholder has been left open to risk, the creditor who seeks to take advantage of that delinquency will find his way beset with one procedural pitfall after another, and almost no statutory or judicial chart to guide him.").

118 Id. at 98-114; accord, Art, supra note 11, at 210; Ralston, supra note 20, at 1020, 1025-28.

119 MANNING & HANKS, JR., supra note 15, at 37; accord, Ralston, supra note 20, at 1021 n.13.

120 MANNING & HANKS, JR., supra note 15, at 39 (emphasis in the original); Ben-Dror, supra note 37, at 381 ("[T]he Model Business Corporation Act's dual insolvency test serves merely to ascertain, rather than predict, bankruptcy and is therefore useful only after the fact as a tool for litigation, not planning.").

121 Ralston, supra note 20, at 1027.

122 Committee on Corporate Law, supra note 34, at 1867.

123 Kummert, supra note 32, at 200-09.

124 Legal capital restrictions "cause corporations ? to expend significant amounts for the advice of lawyers, accountants and possibly appraisers ?. Such groups can thus be said to benefit greatly from the existence of such provisions." Kummert, supra note 32, at 210.

125 MANNING & HANKS, JR., supra note 15, at 90.

126 Kummert, supra note 32, at 207-08 ("The directors,? after considering the costs involved in determining the validity of a proposed distribution and its unavoidable risks, may decide not to make a distribution that would have been beneficial to most of the parties connected with the corporation.").

127 Ben-Dror, supra note 37, at 381 ("[T]he [Model Business Corporation Act's] dual insolvency test provides no consistent rule for determining the amount of allowable distributions.").

128 Kummert, supra note 32, at 208.

129 Id. at 209 n.119 ("[O]nly 126 cases have involved the corporation law restrictions since 1946.").

130 See, e.g., Byrne v. Lord, 1996 Del. Ch. LEXIS 65 (Del. Ch. 1996); Hanewald v. Bryan's Inc., 429 N.W.2d 414 (N.D. 1988).

131 MANNING & HANKS, JR., supra note 15, at 45-49 (emphasis in the original).

132 Id. at 50-53. The five theories are: (1) the "trust fund" theory, (2) the "holding out" or fraud theory, (3) the statutory obligation theory, (4) breach of contract, and (5) misrepresentation. Id.

133 Id. at 65.

134 Id. at 66 ("[L]aymen who are neither trained nor experienced in accounting tend to assume that these principles have a certainty, precision and exclusivity which they do not in fact have.").

135 SOLOMON, supra note 11, at 259.

136 MANNING & HANKS, JR., supra note 15, at 66.

137 Also implicit to some degree in most criticisms of legal capital is the assumption that the interests of shareholders and creditors are in conflict, i.e., that shareholders want to eliminate restrictions on dividend payments while creditors want to impose them.

138 If, as will be shown infra, shareholders react positively to dividend restrictions, then maybe the interests of shareholders and creditors are more in harmony than previously thought.

139 The term stock split-up "refers to an issuance by a corporation of its own common shares to its common shareholders without consideration and under conditions indicating that such action is prompted mainly by a desire to increase the number of outstanding shares for the purpose of effecting a reduction in their unit market price." FINANCIAL ACCOUNTING STANDARDS BOARD, ACCOUNTING STANDARDS, ORIGINAL PRONOUNCEMENTS ISSUED THROUGH JUNE 1973, at Chapter 7, Section B(2), (1987) [hereinafter "FASB"]. "Where this is clearly the intent, no transfer from earned surplus to capital surplus or capital stock account is called for, other than to the extent occasioned by legal requirements." Id. at Chapter 7, Section B(15) (1987).

Accounting Research Bulletin (ARB) 43 does not recommend a specific accounting treatment for stock splits. ARB 43, at 49-53. Accounting practice, however, dictates that firms proportionately decrease par or stated value per share while leaving the total dollar amount of the stated capital account unchanged. Bill N. Schwartz & Thomas F. Monahan, Accounting for Stock Dividends & Stock Splits, 31 NAT'L PUB. ACCT. 24, 24-25 (1986).

140 DONALD E. KIESO & JERRY J. WEYGANDT, INTERMEDIATE ACCOUNTING 782-84 (8th ed. 1995).

141 Art, supra note 11, at 223.

142 KIESO & WEYGANDT, supra note 140, at 780-81. Note that the MBCA allowed the transfer to be made from either capital or earned surplus. MODEL BUS. CORP. ACT § 45(d) (1969) ("Dividends may be declared and paid in [the corporation's] own authorized but unissued shares out of any unreserved and unrestricted surplus.").

143 Although the MBCA requires that the minimum amount transferred from surplus be equal to the par or stated value of the shares issued, MODEL BUS. CORP. ACT §§ 45(d)(1) & (2) (1969), GAAP requires that the amount transferred from earned surplus be equal to the fair market value of the stock issued. Both the American Institute of Certified Public Accountants ("AICPA") and the New York Stock Exchange ("NYSE") objected to periodic and regular payments of stock dividends. Hence, in 1941 the AICPA sought to make it more difficult for corporations to maintain such a practice by requiring that fair market value be used to record the issuance of stock dividends where such market value was substantially in excess of book value. "Unless this is done, the amount of earnings which the shareholder may believe to have been distributed to him will be left, except to the extent otherwise dictated by legal requirements, in earned surplus subject to possible further similar stock issuances or cash distributions." American Institute of Accountants, Accounting Research Bulletin No. 11, Corporate Accounting for Ordinary Stock Dividends, 102-03 (1941) [hereinafter "ARB No. 11"]. "The reasoning is ? recipients look on the stock dividends as distributions of corporate earnings equal to the market price of the shares issued. Therefore, if less than the market price were capitalized, an amount of retained earnings thought to have been distributed to the stockholders would be available for additional stock dividends or cash distributions." HENDRIKSEN, supra note 8, at 480.

144 Art, supra note 11, at 222.

145 Id. at 204-05.

146 Because a stock distribution makes no demands on the corporation's present or future assets, a stock distribution cannot by itself render a corporation unable to pay its debts as they come due.

147 Art, supra note 11, at 223.

148 ARB No. 11, at 102-03.

149 A material reduction in the market value of the common stock unit is the underlying purpose of a stock split. Id.

150 FASB, supra note 139, at Section B(10).

151 Id. at Section B(13).

152 Sherman Chottiner & Allan Young, A Test of the AICPA Differentiation Between Stock Dividends and Stock Splits, 9 J. ACCT. RES. 367 (1971).

153 FASB, supra note 139, at Section B(11); see also DONALD E. KIESO & JERRY J. WEYGANDT, INTERMEDIATE ACCOUNTING 690 (3d ed. 1980)

154 FASB, supra note 139, at Section B(11).

155 Instruction (iv), Additional Listing Application -- Stock Dividends, Distributions, or Split-up, American Stock Exchange Company Guide, at 3, (1988).

156 New York Stock Exchange Revised Company Manual, § 703.02 (1991) provides in relevant part:

Stock Dividends -A distribution of less than 25% of the outstanding shares (as calculated prior to the distribution). Capitalize retained earnings for the fair market value of the additional shares to be issued. Fair market value should closely approximate the current share market price adjusted to give effect to the distribution.

Partial Stock Split-A distribution of 25% or more but less than 100% of the outstanding shares (as calculated prior to the distribution). Requires capitalization of paid-in capital (surplus) for the par or stated value of the shares issued only where there is to be no change in the par or stated value.

Stock Split-A distribution of 100% or more of the outstanding shares (as calculated prior to the distribution). Requires transfer from paid-in capital (surplus) for the par or stated value of the shares issued unless there is to be a change in the par or stated value.

Id.

157 Schwartz & Monahan, supra note 139.

158 Id.; see also, Craig A. Peterson, James A. Millar, & James N. Rimbey, The Economic Consequences of Accounting for Stock Splits and Large Stock Dividends, 71 ACCT. REV. 241 (1996); Linda J. Zucca & David P. Kirch, A Gap in GAAP: Accounting for Mid-Range Stock Distributions, 10 ACCT. HORIZONS 100 (1996).

159 HENDRIKSEN, supra note 8, at 477.

160 See, e.g., James C. Dolley, Characteristics and Procedures of Common-Stock Split-Ups, 12 HARV. BUS. REV. 316 (1933); C. Austin Barker, Effective Stock Splits, HARV. BUS. REV., JAN.-FEB. 1956, at 101; C. Austin Barker, Stock Splits in a Bull Market, HARV. BUS. REV., MAY-JUNE 1957, at 72; C. Austin Barker, Evaluation of Stock Dividends, HARV. BUS. REV., JULY. 1958, at 99; Fama et al., supra note 12; Sasson Bar-Yosef & Lawrence. D. Brown, A Reexamination of Stock Splits Using Moving Betas, 32 J. FIN. 1069 (1977).

161 Studies offering a signaling or information content explanation for investor reaction to stock distribution announcement include: Grinblatt et al., supra note 66; Paul Asquith, Paul Healy, & Krishna Palepu, Earnings and Stock Splits, 64 ACCT. REV. 387 (1989); Michael J. Brennan & Thomas E. Copeland, Stock Splits, Stock Prices, and Transaction Costs, 22 J. FIN. ECON. 83 (1988); Maureen McNichols & Ajay Dravid, Stock Dividends, Stock Splits, and Signaling, 45 J. FIN. 857 (1990); Michael J. Brennan & Patricia J. Hughes, Stock Prices and the Supply of Information, 46 J. FIN. 1665 (1991).

Although Professor Fischel is skeptical about the value of dividends under any circumstances, he seems to concede that changes in dividend policy may be used by management to convey information about the firm's future prospects to shareholders. Fischel, supra note 6, at 708-09.

162 Hayne E. Leland & David H. Pyle, Informational Asymmetries, Financial Structure, and Financial Intermediation, 32 J. FIN. 371 (1977); Stephen A. Ross, The Determination of Financial Structure: The Incentive Signaling Approach, 8 BELL J. ECON. 23 (1977); Sudipto Bhattacharya, Imperfect Information, Dividend Policy and 'The Bird in the Hand' Fallacy, 10 BELL J. ECON. 259 (1979).

163 Asquith ET AL., supra note 161, at 196.

164 Grinblatt ET AL., supra note 66; McNichols & Dravid, supra note 161, at 871 Managers incorporate private information about future earnings in setting the split factor in a stock split. Id.

165 Grinblatt ET AL., supra note 66, at 461-62.

166 Id. at 463-64 ("If the firm faces legal restrictions, stock exchange rules or has bond covenants written in terms of retained earnings, the additional shares can further restrict the firm's ability to pay cash dividends. Firms that anticipate increased earnings will not find it costly to reduce retained earnings. However, firms that expect poor earnings in the future will expect the restrictions to be binding, making it costly to mimic the signals of higher-valued firms.").

167 See, e.g., Bebchuk, supra note 6, at 1490 (1992) (suggesting that states have gutted statutory restrictions on the payment to benefit shareholders at the expense of creditors); Joy Begley, Debt Covenants and Accounting Choice, 12 J. ACCT. & ECON. 125 (1990); Kummert, supra note 32, at 189 ("Shareholders in a publicly held corporation ? appear to value stability in [cash] dividend payments by the corporation."); McGough, supra note 6, at 31 ("[I]f states are competing to attract corporations, one tactic is to liberalize ? the basic restrictions on distributions.").

168 Kummert, supra note 32; Kalay, supra note 61; Smith & Warner, supra note 61; Ralston, supra note 20, at 1025-26 (Debt "covenants limit[ing] the payment of dividends [impose] standards much stricter than those found in corporate dividend statutes.").

169 The economic signaling literature posits that management might choose an accounting treatment moving the firm closer to its constraints, i.e., policies that put the firm at greater risk of defaulting on its debt covenants, because the choice will be interpreted as a signal by shareholders. Richard D. Morris, Signaling, Agency Theory and Accounting Policy Choice, 18 ACCT. & BUS. RES. 47 (1987). Only high quality firms choose counter-intuitive accounting policies to communicate or signal their bright prospects to shareholders; lower quality firms would choose accounting methods dictated by conventional wisdom because they could not afford to risk their ability to pay cash dividends in the future. Id. at 53.

170 Grinblatt ET AL., supra note 66, at 463-65.

171 Michael Spence, Job Market Signaling, 87 Q. J. ECON. 355, 358 (1973); Anjan V. Thakor, Strategic Issues in Financial Contracting: An Overview, 18 FIN. MGMT. 39, 40-41 (1989).

172 Grinblatt ET AL., supra note 66, at 466-68; McNichols & Dravid, supra note 161, at 864-67.

173 Peterson ET AL., supra note 158, at 242 (fewer than 17 percent of the 285 firms in the sample actually accounted for those distributions as stock splits, despite the language employed in their announcements to the press). Schwartz and Monahan find similar evidence. They examine the annual reports for 103 Fortune 500 companies that had stock distributions greater than 25 percent for the 1984 calendar year. Their findings show that only 14 companies adjusted the par value without making a journal entry. Schwartz & Monahan, supra note 139; see also Zucca & Kirch, supra note 158.

174 Peterson ET AL., supra note 158, at 242.

175 Id. Banker, Das and Datar also present empirical evidence that previously disclosed accounting information, including the relative reduction in unrestricted surplus, is useful in explaining cross-sectional variation in investor response to stock dividend announcements. Rajiv D. Banker, Somnath Das, & Srikant M. Datar, Complementarity of Prior Accounting Information: The Case of Stock Dividend Announcements, 68 ACCT. REV. 28 (1993). However, the focus of their study is small (< 25%) stock dividends.

176 Peterson ET AL., supra note 158.

177 The data, method and results draw heavily on Peterson's research as reported in Peterson ET AL., supra note 158, and Craig A. Peterson, Financial Signaling with Stock Splits and Stock Dividends 28 (1992) (unpublished Ph.D. Dissertation, University of Arkansas) (on file with authors).

178 The CRSP data files are the property of The University of Chicago. The files provide a comprehensive security price data base for financial researchers at subscribing institutions.

179 Event studies provide a direct test of market efficiency. The magnitude of abnormal performance at the time the event actually occurs is a measure of the impact of that type of event on the wealth of the firm's stockholders. So long as the abnormal performance could not be predicted with certainty by any investor, the market response to the new information implicit in the event announcement remains consistent with market efficiency. Stephen J. Brown & Jerold B. Warner, Measuring Security Price Performance, 8 J. FIN. ECON. 205, 205-06 (1980).

180 Brown and Warner's simulation analysis with monthly common stock return data shows that commonly used event-study methods will detect abnormal market performance if the empiricist can establish the time at which a specific event occurs. Brown & Warner, supra note 179.

181 Clarence C. Y. Kwan, Efficient Market Tests of the Informational Content of Dividend Announcements: Critique and Extension, 16 J. FIN. & QUANTITATIVE ANALYSIS 193, 196 (1981).

182 MODEL BUS. CORP. ACT § 1 (1969).

183 Zeff, supra note 6, at 58. "In all filings of foreign private issuers ? financial statements may be prepared according to a comprehensive body of accounting principles other than those generally accepted in the United States if a reconciliation to United States generally accepted accounting principles ? is also filed as part of the financial statements." Form, Order, and Terminology, 17 C.F.R. § 210.4-01 (2) (1990). "The term 'foreign private issuer' means any foreign issuer other than a foreign government ?." Definitions of Terms, 17 C.F.R. § 230.405 (1990).

184 The Q-Data file is a compilation of SEC statements available from Q-Data Corporation, St. Petersburg, Florida.

185 The Standard & Poor's COMPUSTAT data files are a compilation of company and security price information produced by Standard & Poor's Compustat Services, Inc.

186 Use of the "research" version of the current COMPUSTAT file reduces ex-post selection bias. The bias arises because the current COMPUSTAT data base contains only those companies which are currently viable entities. Companies that have merged, filed for bankruptcy, or for some other reason ceased to exist are excluded from the Industrial file. Rolf W. Banz & William J. Breen, Sample-Dependent Results Using Accounting and Market Data: Some Evidence, 41 J. FIN. 779 (1986).

187 Some events confounded by multiple announcements.

188 Grinblatt ET AL., supra note 66, at 467 & 475.

189 Fama ET AL., supra note 12, at 12-17; J. Randall Woolridge, Stock Dividends as Signals, 6 J. FIN. RES. 1, 2 (1983).

190 Moody's Industrial Manual is the source for the company's state of incorporation.

191 Georgia, Indiana, and New Jersey amended their existing state corporation business code or adopted new code based on the Revised Model Business Corporation Act in 1988, 1986, and 1988, respectively. Texas added Art. 2.38-1, which restricts payment of share dividends if the surplus of the corporation is less than the amount required to be transferred to stated capital at the time the share dividend is paid, in 1987.

192 For firms incorporated in nimble dividend states, the legality of financial distributions may be based on current earnings. However, the amount that can be legally distributed is questionable. MANNING & HANKS, supra note 15. Since nimble dividend states primarily specify corporate distributions in terms of unrestricted and unreserved earned surplus (as in MBCA states) or unrestricted and unreserved surplus (as in balance sheet surplus states), and secondarily specify financial distributions according to the nimble dividend statutes, this study models these jurisdictions according to the first test.

Two groups of states have corporate distribution statutes that are not illustrated by Exhibit 2. The restrictive ratio test statutes of Alaska and California require information from a firm's balance sheet and income statement to test the legality of a cash distribution. Alaska and California corporations are modeled in this study as if they are incorporated in MBCA states because their primary test to determine the legality of a financial distribution is based on retained earnings. Current cash flows determine a corporation's ability to pay cash dividends for firms incorporated in the equitable insolvency jurisdictions. Massachusetts, Minnesota and North Dakota corporations are modeled as if they are incorporated in RMBCA states. Both Minnesota and North Dakota have based their financial distribution statutes on the RMBCA, and even though Massachusetts corporate statutes predate development of the RMBCA, its equitable insolvency limitation suggests modeling firms incorporated in this legal jurisdiction as if they adhere to the RMBCA statutes.

193 Actual accounting treatment is derived from inspection of the Changes in Shareholder's Equity section of the corporation's 10K or annual report from the Q-Data file.

194 Bold L-shaped area defines stock distributions for which the accounting treatment reduces distributable equity.

195 Includes the states of Arkansas, California, Connecticut, Georgia (pre-1988), Indiana (pre-1986), North Carolina, Oklahoma, Pennsylvania, Texas (pre-1987), Tennessee, Utah, Washington, Wisconsin and Wyoming.

196 Includes the states of Delaware, Florida, Iowa, Louisianna, Maryland, Michigan, New Jersey (pre-1988), New York, Nevada, Ohio and Texas (post-1987).

197 Includes the states of Georgia (post-1988), Illinois, Indiana (post-1986), Massachusetts and New Jersey (post-1988).

198 Grinblatt ET AL., supra note 66, at 463-64.

199 We also test the null hypothesis of no association between the accounting treatment for the stock distribution and the firm's legally distributable equity. Using a 3 x 3 classification table, we compare the accounting treatment with the firm's legally distributable equity. The chi-square test (which assumes independence) rejects the null hypothesis (?2 = 14.51, 4 d.f., prob. = 0.006), thus indicating a heterogeneous population. In other words, there is statistical evidence of association between the accounting treatment and legally distributable equity. It should be noted, however, that chi-square tests may not be valid when expected cell counts are less than five. Balance sheet surplus states (row 2) and RMBCA states (row 3) allow firms incorporated in their jurisdictions to distribute a greater proportion of equity capital as cash dividends. When rows 2 and 3 are combined, the chi-square test statistic (?2 = 13.94) is significant at the 0.001 level.

200 Brown & Warner, supra note 179, at 208.

201 Tests of model specification show that the assumption of constant error variance is not appropriate. The variance of the residuals varies positively with the DIV variable, i.e., the ratio of the sum of the stock dividends and cash dividends paid to distributable equity. Hence, weighted least squares is used to obtain the generalized parameter estimates. See, ROBERT S. PINDYCK & DANIEL L. RUBINFELD, ECONOMETRIC MODELS & ECONOMIC FORECASTS 129-32 (3rd ed. 1991).

202 Joanne C. Duke & Herbert G. Hunt, An Empirical Examination of Debt Covenant Restrictions and Accounting-Related Debt Proxies, 12 J. ACCT. & ECON. 45 (1990).

203 Lane A. Daley & Robert L. Vigeland, The Effects of Debt Covenants and Political Costs on the Choice of Accounting Methods: The Case of Accounting for R&D Costs, 5 J. ACCT. & ECON. 195 (1983); Robert M. Bowen, Eric W. Noreen, & John M. Lacey, Determinants of the Corporate Decision to Capitalize Interest, 3 J. ACCT. & ECON. 151 (1981).

204 Grinblatt ET AL., supra note 66, at 467 & 475.

205 Rowland K. Atiase, Predisclosure Information, Firm Capitalization, and Security Price Behavior Around Earnings Announcements, 23 J. ACCT. RES. 21 (1985).

206 Grinblatt ET AL., supra note 66, at 479-80.

207 McNichols & Dravid, supra note 161.

208 Grinblatt ET AL., supra note 66, at 463-64.

209 Appendix 1 shows the univariate test results for the sample and subsamples of large stock distributions.

210 Grinblatt ET AL., supra note 66, at 472 & 475.

211 Some legal scholars, anticipating the possibility that stock distributions may be used as signaling device, have criticized the practice on grounds that it is the information that shareholders react to, not the dividend or split. Art, supra note 11, at 221-22. But this argument misses the point. Legal capital is relevant because it allows management to communicate important information to investors through the choice of accounting treatment for stock distributions. Elimination of legal capital could very well eliminate the communication of the information.

Other scholars are skeptical that stock distributions actually communicate information. KLEIN & COFFEE, supra note 6, at 276-77. Although Klein and Coffee admit that there "appears to be a small, difficult-to-explain increase in the total value of the shares of firms following stock splits," id., at 276, they find it "difficult to see what additional information is conveyed by the issuance of new shares of stock" since they believe "periodic reports to shareholders" are the only means to communicate "the success or failure of the firm." Id. at 277. What Klein and Coffee miss, however, is that the periodic reports are simply a history of the corporation's past success or failure. As noted supra note 6, at 276-77, the choice of accounting treatment for stock distributions may enable managment to signal its expectations of the firm's future success or failure because the choice of accounting treatment affects the company's ability to pay cash dividends in the future.