J.B. Heaton

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A long-held view in the academy is that shareholders are "residual claimants” in the sense that shareholders are paid in full only after the corporation pays its creditors. The reality on the ground is far different. Corporations give assets away to their shareholders long before they have satisfied creditors, both voluntary contract creditors and involuntary tort creditors. In particular, existing U.S. corporate and voidable transfer laws allow corporations to pay dividends and make share repurchases up to the point where the corporation is insolvent or nearly so. Voluntary creditors can limit dividends and share repurchases by contract, but involuntary creditors like tort claimants cannot, and unsophisticated voluntary creditors rarely do so. I use a simple Black-Scholes model of a debtor firm to illustrate the incentive that shareholders have to take dividends and share repurchases before debts are repaid. I then present data on the huge payouts of asset value by indebted U.S. publicly-traded corporations from 2010 to 2018. While good for shareholders, the permissiveness of corporate payout rules brings with it substantial social costs. Dividends and repurchases (1) dramatically increase the riskiness of corporate debt, diverting large resources into credit monitoring and speculation, (2) require a larger bankruptcy system to process large and complex corporate failures, (3) make firms more fragile and less resilient to financial crises, (4) unfairly shift costs to involuntary and unsophisticated creditors in violation of the implicit social bargain of limited liability, and (5) distort the supply of securities toward riskier debt that is publicly subsidized through tax deductibility of interest expense, simultaneously reducing the availability of safe assets that are in high demand. It would be socially beneficial to restrict dividends and share repurchases to corporations that have low debt and adequate insurance against harm to involuntary creditors, and that meet higher thresholds for wages and benefits. Such a rule would still allow corporations to operate without doing those things; they could still have high debt, be underinsured, and pay minimum wages with minimal benefits. But if they did so, they could not pay out assets to shareholders until they first met all their other obligations.

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