Proper management of capital is becoming a more important issue for shareholder-oriented banks and thrifts, and special cash dividends have become a valuable tool offering immediate relief in the face of stockholder activism and market pressure for capital efficiency.

In deciding whether to pay a special cash dividend, a company should consider the fundamental tax and accounting issues as well as the less obvious issues of state law limits on corporate activity, securities law disclosure requirements, regulatory limitations, and the effect on existing or proposed stock-based benefit plans.

As a general matter, a special cash dividend is taxable to the stockholders because it is just a larger dividend than is normally paid. However, a recent private letter ruling issued by the Internal Revenue Service to a thrift holding company in Ohio got significant publicity because it permitted the company to pay a special dividend that, for the most part, was tax-free to its stockholders.

While a special dividend need not be tax-free in order to serve its primary purpose, that aspect could enhance stockholder good will and ease its approval by the board of directors.

A part of the Ohio thrift's special dividend was ruled tax-free because it exceeded the holding company's earnings and profits. The term "earnings and profits" is a tax concept that is roughly equivalent to retained earnings. By paying out more than it had earned, the holding company effectively returned a portion of invested capital to the stockholders. For federal income tax purposes, a return of capital is not taxed to the recipient.

A key issue in determining a company's earnings and profits is whether the company or its subsidiary has ever filed a consolidated tax return. When companies file consolidated tax returns, earnings and profits of all subsidiary companies are generally reflected as part of the earnings and profits of the parent.

Because a company may pay a dividend only to the extent permitted by the state law under which it was formed, it is crucial that a company ensure its actions are not outside the scope of its authority.

Assuming a special dividend is allowable under state law and is also allowable under a company's own charter and bylaws, the board of directors should carefully document its decision in the minutes of board meetings and in appropriate resolutions.

This process will not only reflect due consideration but also supply credible evidence that the board considered the best interests of stockholders in such a significant disposition of corporate assets.

As the directors and managers of every public company know, the web of securities laws and rules is so pervasive and the penalties for violations so severe that even such a seemingly harmless matter as a special dividend should be carefully handled.

An initial issue to be addressed is one of disclosure. Stockholders act on information in the marketplace and therefore are not pleased by sudden corporate actions that contradict prior information.

The company's securities counsel should review its recent securities filings to find whether any information previously disseminated in the marketplace by the company would suggest it would never pay a special dividend. This would include not only any recent prospectus but also 10K and 10-Q reports and other types of public disclosures, such as press releases or newspaper accounts of statements by corporate officials.

New disclosures may need to advise stockholders of the possibility of a special dividend.

A company should also consider whether it expects to acquire or be acquired during the two years after payment of a special dividend. Such payment could prevent the company from using the pooling of interests method of accounting in an acquisition.

Finally, it's necessary to consider a special dividend's often large impact on stock-based benefit plans. Adjustments to ensure these plans are not harmed take careful planning and may come at a steep price.

For instance, option holders will be adversely affected by a special dividend unless they get a concurrent reduction in the exercise price of their options. While most stock option plans adjust the number of shares subject to option upon significant corporate changes such as stock splits, they usually lack any provision to adjust the exercise price merely because a dividend has been paid.

If the exercise price is not adjusted, the options' value will fall because the stock price will usually drop.

Ideally, a stock option plan submitted to shareholders for approval should include a provision allowing for an adjustment in the exercise price of stock options upon payment of a special dividend. If the plan has already been approved, then revising it to include such a provision could also require stockholder approval to maintain the plan's exemption from the short-swing profits rules under securities law and to ensure its continued tax qualification.

This stockholder approval requirement would be dropped under proposed securities rules being considered for adoption. Unfortunately, the Office of Thrift Supervision and Federal Deposit Insurance Corp. are not letting converting thrifts include exercise price adjustments in their option plans.

Regardless of when such a provision is added to a plan, companies should also ensure that the amount of any change does not exceed accounting guidelines. Otherwise, a company would be required to recognize additional compensation expense upon adjustment of the exercise price.

Adjustment of the option exercise price could also prevent use of the pooling method for two years afterward.

In order to maintain the value of outstanding options without reducing the exercise price, a company could establish a bonus plan tied to dividend payments.

Under such a plan, option holders would get a bonus equal to the amount of dividends they would have received had they exercised their options. These bonuses could be paid to the account of the option holder and, to avoid immediate taxation, not be released until the exercise or vesting of the options.

The major drawback to such plans is their adverse effect on a company's income statement because a compensation plan based on dividends would reduce net income. Furthermore, given the heightened concern expressed by federal regulators concerning benefits to insiders, it is uncertain whether banking or thrift regulators would approve such an arrangement.

Mr. Wagner is a vice president at Trident Financial Corp., Raleigh, N.C. Mr. Borja is a lawyer in Washington at Reinhart Boerner, Van Duren Norris & Rieselbach. The first part of this essay was published July 8.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.