Stock Dividends, the Supreme Court, and the Great Crash of 1929

Did a 1920 US Supreme Court case play a role in the 1929 stock market bubble and subsequent Great Crash? This is a question I pose in a new working paper that explores the forgotten role that stock dividends played in fueling the irrational exuberance of the stock market in the 1920s, particularly in the public utility sector. In Eisner v Macomber, the Supreme Court declared it unconstitutional to tax stock dividends as income, thus setting off a decade of huge expansion in the use and abuse of stock dividends, including techniques that amounted to fraudulent overstatements of income, sometimes by orders of magnitude. Public utility holding companies were the most aggressive users of stock dividends—and were also some of the highest fliers, and hardest fallers, in 1929 and after. I argue in the paper that much of this behavior would not have been possible without the Supreme Court’s decision in Macomber.

Stock dividends are the distribution of a corporation’s own stock to its shareholders, typically pro rata, which makes them essentially equivalent to stock splits—shareholders merely receive additional stock, but without any change in their fractional ownership of the corporation, nor with any change in the corporation’s assets. The central difference between a stock dividend and stock split, however, is that stock dividends also require a capitalization of retained earnings into paid-in capital on the corporation’s balance sheet. It’s the shifting of earnings that purports to give the stock distribution a ‘dividend’-like character—earnings are ‘distributed’ out, but only onto a different line on the balance sheet. In this way, stock dividends resemble a cash dividend reinvestment plan, but without the step of actually distributing cash to a shareholder.

My paper goes into detail on why stock dividends are constructed this way, how they came to be, and the long debate over whether they should be considered ‘income’ in some way, whether for accounting purposes or tax purposes. There is a reasonable logic, embodied in some 19th-century tax law (and also trust law and corporate law) that a stock dividend is essentially concrete evidence of corporate income—because of the associated charge against earnings—and thus can be treated as a shareholder’s income to that extent. But as I show, law and practice did not always reflect that logic, and by 1920 there was instead a growing (erroneous) belief that the mere receipt of a stock dividend enriched the shareholder by an amount equal to the stock’s fair market value.

These two theories—stock dividends as evidence of corporate earnings, and stock dividends as income in their own right—differ largely because of the distinction between a stock’s par value and its market value. I’ll leave it to the paper to more fully explain why. But this difference can explain both the abuse of stock dividends and also the error of the Court’s opinion in Macomber.

To illustrate the abuse, my paper provides a detailed case study, based on original archival research, of the energy magnate Samuel Insull and his public utility holding company empire. Insull was a major figure in the early 20th century, and his huge and complex holding company structure encompassed scores of utilities and other companies, which provided something like 10-15% of total electricity in the United States. But he was also a brilliant—and aggressive—financial engineer. I show how he used the differences between stock par value and market value to multiply operating income by at least 150 times, and likely more, by distributing stock dividends upward in the holding company pyramid. That phantom income inflated income statements and balance sheets just as Insull was selling stock in his enterprises to the investing public, bidding the stock prices ever higher.

The Insull empire eventually collapsed after the Great Crash, for this and other reasons. Insull fled the country ahead of a criminal indictment, and after a dramatic chase through Greece and Turkey was ultimately extradited to face trial. But he was acquitted, in part because the accounting rules for stock dividends did not prohibit what he was doing. Indeed, my research uncovered an extended correspondence between Insull and the accountant Arthur Young—of Ernst & Young—in which both first agreed that this use of stock dividends was improper, but then both ultimately determined that it was allowed and went ahead with it anyway.

The confusion about the right way to think about stock dividends was also evident in Macomber. The Court focused almost exclusively on the question of whether a stock dividend could be income in its own right. The Court said no, concluding that there was no real enrichment to the shareholder until the earnings were actually distributed to her. The case thus came to be seen for a time as embodying a constitutional ‘realization’ rule, but it thereby largely ignored earlier tax (and other) law that saw stock dividends instead as evidence of corporate earnings that could be attributed to a shareholder. There is much more to be said about the constitutional errors of Macomber and the damage it posed to the tax system, some of which I and David Gamage wrote about previously. The constitutionality of taxing shareholders on undistributed corporate earnings was upheld by the Supreme Court last year in Moore v. United States, for which Professor Gamage and I submitted an amicus brief.

The irony of Macomber is that it denied that a stock dividend could be income in its own right just as the corporate and investing worlds were leaning into that theory—and that if Macomber had been correctly decided, it might have put a brake on the worst stock dividends abuses. The sort of manufacturing of phantom income that Insull and others engaged in would not have been possible if it generated a tax bill every time. Taxes on real income are unpleasant; taxes on fake income are intolerable. But by removing this friction, the Court allowed Insull and others to let it rip and create income out of thin air—with disastrous consequences.

The author’s complete article can be found here.

John R. Brooks is a Professor of Law at Fordham University School of Law.