This paper consists of five sections, including this introduction. The background section of this article consists of several parts. First, we provide an historical overview of the legal capital doctrines restricting dividends. Second, we briefly summarize and illustrate six basic types of state statutory restrictions on dividends and other distributions to shareholders. Third, we examine the criticisms of legal capital that has led many states to abandon the use of concepts like stated capital and surplus to restrict financial distributions to shareholders. Fourth, a discussion of the generally accepted accounting principles ("GAAP") and mechanics of legal capital and stock distributions is provided for the benefit of readers not already familiar with this topic. Fifth, we examine prior research that suggests the market value of a firm increases when it announces a stock distribution, i.e., the announcement of a stock split or dividend increases the common stock price. This research suggests that shareholder reaction to stock distribution announcements stems from the information that the stock distribution decision conveys about the firm’s future earnings potential and other fundamentally important information.

In the data and method section, we test the hypothesis that if stock distribution announcements increase share prices, then the choice between stock split and stock dividend accounting treatment may also have an effect on share prices. We correct for specific flaws found in the research design of other empirical studies and present the results in the fourth section of this article. Our tests of the empirical evidence support the hypothesis that investors react more positively to the announcement of a large stock dividend than a stock split. In addition, market response is more pronounced when managers are constrained by the combination of legal capital doctrines restricting cash distributions to shareholders and the method used to account for large stock distributions.

In the final section of this article, we conclude, based on the results of our empirical tests, that statutory dividend restrictions based on legal capital enhance management’s ability to use stock distributions to communicate with shareholders. This suggests that the critics of legal capital may have been too harsh and that state legislatures may be acting too hastily in replacing legal capital doctrines with other types of statutory restrictions on dividends.