Corporate Securities and Capital Structure

8/14/2019 Corporate Securities and Capital Structure

1/33

Corporate Securities and Capital Structure -- How you finance a corporation?

2 principal types of financing structures for corporation

Debt: Borrow money

Equity: Sell shares = legally ownership interests

Determines how the cash flow of business of corporation generates are divided among providers

of capital

Size of the pot = corps business

Capital structure = division of the pot

Idea: can create a capital structure that essentially generates any kind of division of the pot that

you want a lot of flexibility

Dividing pot of unknown size

Two principal dimensions:

Order: who gets $$ first and who gets $$ later

Priority in payments; seniority in payment

Magnitude: how much do you get at each level of order

Five ways of dividing unknown amounts of $$ among three investors ABC

Divide equally: each gets 1/3

Only one dimension of order

30M shares of common stock each investor gets 10M of each

For common stock: What matters is the proportion that you own;

having more common stock is no good if everyone else owns

that much the share of your stock out of all the stock that is

out there is what is important

Term of art = issued and outstanding shares that are out there

the fraction of shares you own out of all shares that are issuedand outstanding

A first $ 1M; B 2/3 of the rest, C 1/3 of the rest

Different relations of Order

A 1 M shares of preferred stock

Or debt securities

Principal amount of 1M dollars the amount of

debt that you own

Would never say 10,000 bonds bonds dont

come in units of equal value; can come in units

of diff size versus Stock comes in shares(fixed units)

Shares: Preferred stock has certain liquidation

preference:

What you want to give A is preferred stock of an

aggregate liquidation preference of $1M

10,000 shares of preferred stock

B and C 20 M / 10M out of 30 M common stock


2/33

A 2/3 of the first 1M; B 1/3 of the first 1M; C gets the rest

Different relations of order

A first 1M; B second 1M; C rest

Different relations of order

A first 1M; B second 1M; C third 1M Problems?

Option 5: doesnt specify what happens to the rest if there is more than

3M doesnt specify who gets money in all circumstances

Residual Owner: person who gets the rest (econ term)

To have well-designed capital structure, always need to specify residual

owner

In corp = residual owner is owner of common stock = common

stockholders

follows that you always need to have common stockholders in

corporation = ppl who owns the rest should always get common shares

How do we generate order and magnitude in capital structure?

By giving investors different types of securities

Generate different degrees of magnitude within one order by giving investors different

amounts of securities of the same type

Equity:

Common Stock

Preferred Stock: gets paid ahead of common stock

Debt:

Gets paid ahead of equity

Different forms of debt: borrow from bank; issue securities that are debt securities (notes,

debentures, bonds etc)

Securities: book entries (pieces of paper) that reflect certain type of claim

Order of priority: Bonds (debt securities) preferred stock residual owners

= three types of securities; can generate three levels of payment at different levels of priority (can

have more than three)

Order of seniority is usually related to the degree of control:

The lower you are in seniority, the more control rights you have (generally)

b/c the residual owners have the most risk: once the company has 2 M, A and Bno longer care about the company C has most incentive to ensure that

company is doing well

Division of cash flows:

How do we divide cash flow on yearly basis

How do we divide at the end (when company is liquidated)

need to specify priority in respect to both of these


3/33

Bonds: ultimate amount you get at the end principal; until then you get interest

(percentage of the amount that is being owed)

Preferred stock:

What you get at the end: liquidation preference

Number you get annually/periodically: dividends

Expressed as a $$ figure, not typically as a percentage

Four other aspects of stock:

Voting rights: election of directors, changes to certificate of incorporation etc

Somebody must have them

Who has them whoever the certificate of incorporation says they have them;

can design in whatever way you want

Typically common share holders have a lot of voting rights; and preferred share

holders have little voting rights in publicly held companies; for venture startups,

preferred stockholders tend to have more voting rights

Par Value: each shareholder either has a par value or doesnt have a par value

For almost all purposes, par value has no significance whatsoever

If you want to play it safe, give share very low (1/100 cent) positive par value

Its irrelevant

Conversion and Redemption: applies to stock and bonds

Ability to change your security for a different security

Typically, the ability to convert bonds or preferred stock into common stock; but

u can do whatever

Stocks/bonds can be convertible or nonconvertible

Conversion right: refers to right of the holder to convert security into common

stock

Redemption:

Ability to change your security for cash

Person who decides: company company has right to go to holder and

say that you no longer own your security in return for certain amount of

cash

These rights are contained in:

Certificate of incorporation (rarely)

Certificate of designation (typically): similar to cert of incorp except for

Cert of incorp will say that the company has power to issue up to

certain number of preferred stock; the rights, preferences holders

of preferred stock shall be specified in cert of designation, at the

time the preferred stock is actually issued by the directors directors have authority to determine whatever these rights are

= Blank Check Preferred Stock: authorization in the

Charter to issue preferred stock where terms of the PS

are left for directors to determine at the time of issuance

before they are issued, directors can determine

preferred stock

Two purposes:


4/33

If company wants to issue preferred

stock to raise capital; enables BoD

flexibility to do this generally SH

rights advocates dont have big problem

with that b/c preferred stock raised forcapital raising purpose are very much

like bonds

Most companies traded dont have

preferred stock b/c preferred stock is

WEIRD; are used as an element of anti-

takeover device; dont really need

preferred stock

For debt securities diff contract

Corporate bonds not usually held by individuals

Tues: most of the class dealing with p 16 + the Marriott case

Sept. 9, 2008 Reading Notes

p. 16 Questions

$3.07 Cumulative Convertible Preferred Stock of Integrated Resources, Inc.

3 M shares of Common Stock

1 M shares of Preferred Stock all held by Tamara

Certificate of Designation

Dividends: Fixed dividend = $3.07 per annum

Payable on March 1, June 1, Sept 1, and Dec 1; starting March 1, 1981

Dividends will only be paid when, as, and IF declared by the BoD not an absolute

right to fixed dividend

Out of funds legally available for the dividends

Unpaid dividends will be cumulative anything unpaid will accrue to the next date.

Redemption: Company can redeem (=buy back) the whole or any part of the then outstanding

shares of the Preferred Stock..

Conditions:

Only possible from 1 yr after the date of the issuance of the preferred stock

Must give notice

If redeemed during 12 month period beginning Nov 26: Prices listed lower price every year (since holder has been stocking up on its

dividends, i.e. profiting from the stock, makes sense that company would pay

holder less to redeem with every additional year of dividends

Must pay accrued and unpaid dividends existing as of the date of redemption as

well.


5/33

Liquidation: In case of liquidation/dissolution/winding up of company Preferred holders get

priority in payment: before any distribution or payment is made on any common stock + subject

to rights of holders of senior securities (debt securities??)

Payment:

cash of $25 per share on each outstanding share of the Preferred Stock + accruedand unpaid dividends

Out of assets of Company available for distribution to SHs

Preferred holders NOT entitled to any further payment (= one time payoff; not ongoing)

Priority:

No dividends (cash nor property) can be paid on Common Stock if dividends on the

Preferred Stock have not yet been paid

Note: not just current dividends, but all past quarterly dividends and full

dividends for the then current quarterly period must be paid for dividend on any

junior security to get paid.

Exception: This provision on priority of payment does not apply to dividends

payable in the Common Stock or any other security of the Company junior to thePreferred Stock.

= For cash or property dividends on the Preferred Stock (in this case, the

3.07 fixed dividend), preferred stockholders get priority over common

stockholders; however, for any dividends payable in common stock

When would preferred stockholders be entitled to dividends payable in

common stock? Does it depend solely on the Certificate of Designation?

Would it be when there is a diverse range of dividends that preferred

holders can hold; e.g. preferred holder has right to both fixed dividend +

certain number of common stock?

Conversion rights Preferred stock can be converted into fully paid and non-assessable shares of common

stock at any time b/f termination at the option of the respective holders

Conversion rate applied: Conversion rate in effect at the time of the conversion

Initial conversion rate: 1:1 ratio

each share of Preferred Stock one share of Common Stock

Adjusted conversion rates:

If Company: Q: Why would any of the below negatively impact Preferred

holders?

Uses shares of capital stock of the Company to pay dividend on its

Common Stock (pay common stockholders with more stock)

Why would this dilute value of common stock? Maybe b/c it

would require company to issue more stock, therefore bringing

down price of stock???

Subdivides its outstanding Common Stock

Combines outstanding Common Stock into a smaller number of shares

By reclassification of its Common Stock, issues any shares of the capital

stock of the Company


6/33

THEN:

Conversion rate in effect on record date for stock dividend or the

effective date of any such other event WILL BE INCREASED:

(or decreased in the case of a reverse stock split)

Holder of preferred stock entitled to receive the number ofshares of Common Stock (or other capital stock) that he would

own or have the right to own after the happening of any of the

above events, HAD such share of preferred stock been converted

immediately before the close of business on such record date or

effective date.

Q: Why before the close of business on such record date or

effective date???? Shouldnt it be before close of business on the

day BEFORE????

= Trying to protect the holder of preferred stock from dilution of

value of common stock, i.e. value of its conversion right

If Company issues rights or warrants to Common Stock holders allowing them topurchase Common Stock at price per share less than the current market price per

share of the Common Stock:

THEN: PS CS ratio determined by

Original # of shares of Common Stock (into which Preferred

Stock was convertible) * (# of CS shares outstanding on the date

of issuance of such rights and warrants + # additional CS shares

offered for subscription or purchase) / (# of CS shares

outstanding on the date of issuance of such rights and warrants +

# of shares which the aggregate offering price of the total

number of shares so offered would purchase at such current

market price (????)

Voting Rights: Preferred SHs no right to vote, except as provided in DGCL and

Unpaid dividends on preferred stock add up to at least six fully quarterly dividends

Preferred SHs have right to vote two additional members of the BoDs (must vote as

one class, but can vote with any other series of preferred stock that are entitled to vote)

Two BoD members elected in addition to the directors elected by all other SHs

Conditions:

Preferred SHs and holders of any other series of preferred stock entitled to vote

must hold a meeting within 60 days of the non-payment of the sixth dividend.

Voting power terminates when all accrued dividends and current quarterly

dividends on all outstanding shares of the Preferred Stock have been paid ordeclared and provided for.

Repealing/Changing the Certificate of Designation or Certificate of Incorporation of the

Company in a way that would

increase or decrease the total number of authorized shares of preferred stock;

increase or decrease the par value of the sharesof the Preferred Stock

alter of change the powers, preferences, or rights of the Preferred Stock


7/33

So as to adversely affect the powers, preferences, or rights of the Preferred

Stockholders.

NEED:

Consent or affirmative vote of holders of at least 2/3 of the THEN

OUTSTANDING Preferred Stock. Expressed in writing or at a meeting held for that purpose

Voting as one class with any other series of the Companys preferred stock

entitled to vote

BUT: IF the Preferred Stock would be affected in a different manner than

any other outstanding series of preferred stock

Company cant take action w/o 2/3 majority consent/affirmative vote

of the total number of shares of the Preferred Stock then outstanding =

Need 2/3 of specifically affected Preferred Stock group to give

affirmative vote out of the overall 2/3 affirmative vote required above.

Each Preferred Stock one vote

Questions: Whats the difference between paid and declared and provided for? (7(c))


8/33

0909 Class Notes Page 16, Answers

1. Not entitled

a. BoD gets to choose whether to pay dividends

b. Quarterly cumulative dividends

c. Any dividends that are skipped are supposed to be made up = if you want to resume

paying dividends to the Common Stock, you have to make up all skipped dividends on

the Preferred Stock so technically, you dont HAVE to pay dividends on PS but paying

these dividends is a condition for paying dividends on the Common Stock

d. If Company doesnt pay dividends on Preferred Stock Cant pay dividends on

Common Stock either

2. T will receive $3.07/4 * 1Meach quarter= 767500

3. Company gets to decide whether to redeem or not

a. Price per share for redemption on Aug 1, 1982 = $28 (redemption price)

i. Starts in the 12 month period indicated in 1981

ii.any time or from time to time to make sure that it includes multiple occasions

(legalese; paranoid lawyering)

b. Accrued and unpaid dividends: March 1 = 76.75; June 1 = 76.75

c. Accrued = reflects economic reality.

i. Betwn June 1 and Aug 1, you earned some dividends = accrued dividends = 2

months of earned dividends means you should get 2/3 of the quarterly

installments of dividends (???)

ii.Problem: even if you eventually get dividends, you get less in terms of present

value getting same amt later means getting less prb with preferred stock

iii.~ Earn your dividend each day and then it gets paid every quarter

4. Liquidation next week. No accrued and unpaid dividends.

a. How much T gets depends on the net asset value = companys assets after all the

companys creditors have been paid off (only PS holders and CS holders left)

b. T holds onto the Preferred Stock: Total: $25 * 1M = 25M

c. If T converts to CS: 3M issued and outstanding + 1M newly issued and outstanding (1:1

conversion rate) = 4M T = of total CS issued and outstanding

Net Assets Hold on to PS Convert to CS10M 10M 2.5M25M 25M 6.25M50M 25M 12.5M100M 25M 25M150M 25M 37.5M200M 25M 50M

i. Net Assets must rise to 100M to become profitable for T to convert to CS

ii.For CS = what matters is the proportion

5. Stock split: proportion each CSH has remains the same


9/33

a. No more assets or liabilities

b. First take: stock splits dont change anything

c. But complicates situation: For each share of CS 2 CS = 6 M outstanding

d. If T gets 1M upon conversion = would only get 1/7 of the total < of the total

e. Section 6(C)(i):i. Time lag between when event happens and when ppl participate but this

doesnt matter

ii.The # of shares you would have owned after the stock split had you converted

prior to the stock split

iii.If you had converted before the split (1:1), then after the split, you would own 2

shares of CS per share of CS

iv.2M shares of CS = of total

v. What if we have successive stock splits

1. 2:1 stock split 6M CS outstanding

a. 2 (CS):1 (PS) conversion rate

2. 3:1 stock split

18M CS outstandinga. 6:1 conversion rate

3. Why do we adjust the 2:1 rate not the 3:1 the conversion rate in

effect on the record date for any stock dividend

4. Each adjustment you make forms the baseline for the subsequent

adjustment (?)

5. Convertible PS more likely to be traded than nonconvertible PS some

PS traded on market, some not

6. Assume that Integrated net value prior to whatever happens is $200M.

a. Better off converting T will receive 1M CS shares worth 50M upon conversion

b. CSHs would divide up the remaining 150M

c. Each CS T receives will equal 50M /1M = $50/share (Market Value Estimate)d. Part b: Warrant = right to purchase stock at certain price ~ type of option

i. How do warrants differ from other types of options: The share that you buy is

issued by the Company newly issued share (only Company can give you

this right; investor can give you right to option); for regular option, option to

buy already issued and outstanding common share

ii.Attractive option because you pay 5 dollars where market price of common

stock is 50$; but value of the warrant isnt 45 b/c the value of it comes partly

out of your own pocket

iii.If everybody exercises warrant (=purchases additional shares for cheap

under warrant): 6M CS outstanding

iv.Net Asset Value of the Company increases: 200M + 15M (3M*5 [newlypurchased CS under warrant = more equity for company]) = 215M

v. Value of the warrant: Difference between exercise price and ____

vi.Point: what happens to the stock price?

1. Goes down

2. If no changes are made in conversion right, then T pissed off. If she

can convert now, get 1M shares, 1/7 of the Company would be

worth 215M/7 (30M+); before, would get 50M upon conversion


10/33

3. 50M 30M

4. See book for details:

a. Protection offered under cert. of design: 6(C)(iii)

b. Formula: # of CS converted with old conversion rate * (# of

CS outstanding when warrant issued + # of additional CSissued with warrant)/ (# of CS outstanding when warrant

issued + # of CS you could buy under the CURRENT market

price for CS for the total purchase price of the newly issued

CS under the warrant)

i. = 1M*(3M + 3M) / (3M + [3M*$5]/50) =

1M*(3M+3M)/3M+300,000)

If warrant had given right to purchase 1/10 share per share additional number of shares issued

would be 3M/10 = to get additional number of shares purchased whatever number of new

shares per old share you can buy, times it to the number of old shares

ii.= 1.818181 = 1.82M

iii.1M PS 1.82M CS (1:1.82 ratio)iv.Total number of CS outstanding upon conversion:

6M + 1.82M = 7.82M

v. Ts proportion = 1.82M/7.82M

vi.= 1/4.314 (~one quarter T would have had prior to

warrant)

vii.215M * .314 = 49.8M about 50 M, like before

viii.* note* Net assets of company remain at 215M b/c

converting PS to CS doesnt provide additional

funds to the company; with warrant, CSHs

BOUGHT additional shares for cheap = providing

additional funds to company = increased net assets How contracts designed to protect some of the economic rights of holders of preferred stock

holders

e. A lot of what lawyers do: how to get this w/o making too many loopholes

HB Korenvaes Investments, L.P. v. Marriott Corporation (Del. Ch. 1993) p.19: Class Notes in Red

1. Facts:

Interesting: illustrates how certain type of transaction is done a spinoff

Spinoff = when corp takes a chunk of its assets and either distributes it to its SHs or

sells it off as a newly publicly traded company

In this case spinoff to its shareholders

Big Marriott: wants to reorganize its business

One entity: Host = owns real estate

International = services, operates hotels

Owners: shareholders of Big M

How can you get there?

1. Create new company

2. Transfer hotel-operating assets to new company


11/33

3. Pay dividend to SHs consisting of stock of new company

= Simple way to do the same thing (divide into two businesses): spin

off the real estate part

Or offer stock in IPO

Dividend policies: Host: wont pay any dividends

Intl: the same dividends as Big Marriott used to pay

Holder of Big Mar, from cash flow perspective: will get the same amount of

dividends

Host has no profits:

Operating profits (earnings before payments are made to providers of

capital) of Host are lower

Net income after interest expense lower b/c Host has a lot more

debt

Big M paid dividends to the CS holders, so must have paid dividends

to Preferred stock holders PSH: no dividends paid after the spinoff

so PSH unhappy if you dont convert

Read up to page 40

i. Marriott wants to reorganize by transferring its cash-generating services business

to a subsidiary called Marriott International, which will be spun-off and paid as a

special dividend to all common shareholders of Marriott.

1. Would fall within the case of paying dividends in form of capital stock in

the sample Cert of Desigs anti-dilution clause

ii.Marriott will change name to Host Marriott, which will keep the debt-laden real

estate business which would be incurring a negative net income and hence not

paying dividends.iii.Prior to the spin-off, Marriott was paying a cash dividend to shareholders. After

the spin-off, Host Marriott wasnt going to pay any dividends at all while

International was going to pay the common shareholders the same dividends that

Big Marriott was paying prior to the spin-off.

iv.Thus, the spin-off will have no effect on common shareholders dividends.

However, preferred shareholders will only be left with Host Marriott which will

be debt laden and incurring a loss and so will not be paying any dividend.

v. Thus, preferred holders can either stay with Host as preferred holders and get no

dividends or convert to common before the split (and thus get International spin-

off shares and dividends).

vi.Plaintiffs want injunction to stop special dividend. The argue that the reason

Host is doing what its doing is because after distribution of the dividend the

preferred holders will be in a position to convert and control a majority of Hosts

common stock as per the Certificate of Designation which adjusts the preferred

stock conversion rate. The Marriott family wants to maintain control so Marriott

is going to stop paying dividends after transaction to coerce preferred holders

into converting.


12/33

vii.Issue: whether the planned transaction is consistent with the conversion

price adjustment contained in the Certificate of Designation.

viii.Court: While the suspension of dividends may influence PSH to convert,

there was no coercion and no violation of any implied right to good faith

that every commercial contractor is entitled to.

a. First, plaintiffs wrongly construed Big Ms actions as coercion.Court says coercion was not involved and that this is essentiallya contract action, as the case involves the construction of therights and duties set forth in the charter.

i. Court has held that actions principally designed tocoerce SH in the exercise of a choice given to them bycharter, bylaws or statute, but those cases were basedon existence of fiduciary duty of directors with respect totransaction under review

ii. This is not a fiduciary duty case though, but one ofconstruction of rights and duties set forth in thecertificate of designation

iii.The PSHs protections against suspension of

dividends lie in the charter, and are several:1. Cumulative dividends2. Liquidation preference3. Redemption price adjusted to reflect accrued

unpaid dividends4. If prolonged suspension of dividends get right to

elect 2 directors5. Conversion right6. Restriction on the proportion of net worth that

may be distributeda. This restriction is inherent in the formula

used to revise the conversion ratio:formula doesnt work if you give somuch away that new net worth is less

than PSs share of net worth before thedividend

iv.These provisions are a recognition of1. The risk that dividends might not be paid.2. The correlative right of directors to discontinue

dividendsb. Second, the discontinuation of dividends can be seen as a

prudent, good faith, business-driven decision.c. Thus, though the suspension of dividends may exert a powerful

influence, there has been no violation of the duty of good faiththat commercial contractors are entitled to expect

2. Court: More important claim is based on Charter Section 5(e)(iv) whenthe assets of the firm are depleted through a special distribution to SHs,

the preferred will be protected by the triggering of a conversion priceadjustment formula.a. The # of shares into which the preferred can convert will be

proportionately increased in order to maintain the value of thepreferreds conversion feature.

b. In a narrow range of extreme cases, the provision will not work topreserve the pre-dividend value of the preferreds conversionright. (see examples on p. 24-25)

c. If this case fell within that narrow range, Marriot could beprevented from declaring dividends of a proportion that would


13/33

deprive the PSH of the protection this section was intended toafford, which would violate the rights of the PSH created by thecertificate of designations conversion feature. But this is not oneof those cases.

d. Rule: If, when declared, the dividend will leave the

corporation with sufficient assets to preserve theconversion value that the PSH possesses at that time, itsatisfies the limitation that such a protective provisionimplies

ix.HOLDING: Court held that while the suspension of dividends may influence

Preferred to convert, there was no violation of any implied right to good faith that

every commercial contractor is entitled to.

1. Plaintiffs wrongly construed this case as a breach of fiduciary duty. This

is essentially a contract action, as the case involves the construction and

interpretation of rights and duties set forth in the certificate of

designation. Marriott has a right to suspend dividend payments as a

business judgment. The court says the certificate of designation says

nothing on the matter although it has in the past helped preferredshareholders when a company issued a gratuitous threat to delist the

preferred stock.

2. However, in this case, the court says the preferred shareholders are

protected by provisions in the certificate

a. (i.e., cumulative dividends, liquidation preference, right to elect

2 directors after prolonged suspension of dividends, Redemption

price adjusted to reflect accrued unpaid dividends, Restriction on

the proportion of net worth that may be distributed

b. (This restriction is inherent in the formula used to revise the

conversion ratio: formula doesnt work if you give so much

away that new net worth is less than PSs share of net worthbefore the dividend).

c. These provisions are there because the shareholders recognize

the risk of being a preferred shareholder. The court recognizes

that the shareholders foresaw the problem and contracted for

protections. Thisis all the preferred shareholders are getting

since this is all they contracted for.

d. The preferred shareholders should have negotiated for the

contract to include a prohibition on in-kind dividends.

3. The court also found that a provision in the certificate 5(e)(iv) that

reduced the conversion price protected the value of the preferred

conversion whenever Marriott distributed assets to its common

shareholders.

0911 Corps


14/33

Cap on how high PS will go once it becomes redeemable

Redemption = forced repurchase of the shares; repurchase can also be on the market

Contd from Marriott Case:

Spin off as a transaction Financial status of the company post-spin off

Preferred Shareholders:

Claim: Big M trying to force PS to convert to CS of Big Marriott b/c if they stay as PSHs

of Marriott Host then become SHs of BM and MIntl

If they dont convert before spinoff, and convert after spinoff, PSHs will get control over

Host will only get shares of Host if they convert after spinoff to compensate for the

fact that Host is a much smaller company, PSHs will get much larger number of CSs if

they convert post-spin off

B/F spinoff conversion: shares of Big M then Big M does spinoff all CSHs

of Big get shares of Host (Big turns into Host)

Big M trying to force Plaintiffs to convert before spinoff = coercion

Not such a strong case though

Convert after spinoff get more shares of the company you used to be

shareholder of more shares of Big/Host (same legal entity) to adjust for the

fact that company paid big dividend when spinning off that PSHs were unable to

get

Analysis:

Pls right in terms of the economic argument underlying their case

big difference to the PSHs in terms of what they get between converting before spinoff

and after spinoff

1. Big is current on its dividends can pay dividends to CSHs

2. Big: going to pay BIG dividend to the CSHs (i.e. paid the PSHs), then after that will

stop paying dividends to CSHs and PSHs at all

Clear that this screws the PSHs; if the PSHs couldnt convert, then the value of their

stock would decline HUGELY

Pls argue that this is a breach of fiduciary duties

Precedent cited by Pls as parallel:

Company made tender offer to buy preferred stock

After tender offer, going to delist the stock (=will no longer be publicly traded

stock) loses liquidity much more difficult to sell depresses value of the

stock = Crt characterizes this as gratuitous

= no reason to delist the stock if company had said, maybe the market will

force us to delist the stock would be OK; but intentional threat to delist the stock

constituted coercion

= breach of fiduciary duties

Pls: in this case, spinoff makes keeping Bigs shares less attractive, and forces

PSHs to convert


15/33

Courts 2 reasons for rejecting Pls case:

1. Cert of incorp giving significant protections to Pls

Redemption price goes up

Can elect 2 directors

Cumulative dividends

Liquidation preference

Some limit conversion

Do these protections protect the PSHs from what company is doing now?

Isnt it true that the PSs will substantially decline in value?

Even with the protections, PSHs are pretty screwed. But why is

it OK to say that even if you get screwed, thats all you get

Could have written in contractual protections

Why is this different from the delisting case?

Could have written in contractual protections too no?

Why is the court holding ppl in THIS case to the K? (not the delistingcase)

Posit that this was a good biz decision; any other way to do this

(create 2 companies) could have spun off Host

Then Big would have had to stop paying CSHs or would have

had to pay PSHs

NOT a necessary consequence of the spinoff that the PSHs get

screwed; just a consequence of how the company decided to do

the spinoff.

Difference here:

Notion of company stopping to pay dividends has clearly been

anticipated the specific protections embodied in the certificate

court: since you anticipated and put this in, thats all you get

Why approp to hold PSHs to these enumerated protections?

You invested KNOWING all of this

Did the investors really know this?

Even if you didnt know it, not harmed b/c the market

was aware and the price of the market reflected this (per

efficient market hypothesis)

Figuring out HOW to distinguish between cases:

Court will sometimes help you and other times will not help you

Court will sometimes do things that go beyond what the K says;if ambiguity will rule in your favor; other times will not.

Important point made here: Court says PSHs addressed,

generally, the issue of company stopping to pay dividends

If case categorized as case what happens if company stops

paying dividends => read the K and it gives you the protections


16/33

Recategorization: This is a case about a company paying big

dividend in devious way to create BIG spinoff intentionally put

itself in this position PSHs did NOT predict this

Lets say, in the past, no company has spun off such a

huge profit-making part of its operations, so PSHs didntanticipate this (unprecedented spinoff)

Court Arg 2: Prudent business decision

Company still put itself in position where it had to make this prudent

business decision (to not pay dividends if company does the spinoff)

Anticipated that company wouldnt pay dividends in normal business

decision, but not that company would deliberately put itself in this

position to not pay dividends such a HUGE business decision.

Say you are the judge and want to compensate the PSHs: To the extent to

which the PSs lose value from the fact that the company goes from one

that pays dividends to does not pay dividends, PS market price declines

and PSHs hurt. So analysis would be same even without convertibility

If judge has sympathy for Pls, question is whats the proper structure of

the remedy?

Ideally, want parties to provide for it; judge doesnt want to

figure out cumbersome and to some level arbitrary to impose

remedy here unless you say EVERY time company does spinoff,

PSHs get compensation way too broad of a provision

Then if you were to distinguish between big and small spinoff,

would be hard to draw the line

judges dont like drawing arbitrary lines

Not an attractive argument Right to convert:

As a result of spinoff, what happens to your right to convert?

New Conversion Price = Old conversion Price * CMP FMV / CMP

Appendix: This formula works in that it gives you effective protection: but if

distribution goes up to certain point, then formula no longer works when there

isnt enough assets left in the company

What does court conclude from this?

If the distribution were so large, that it was beyond this limit, then you

would be violating

Then court would have prohibited the spinoff.

Section 5: does it say anywhere that dividends above a certain amount

are prohibited? NO

Why is it that the court in this part of the opinion, willing to read

prohibition into the certificate? but earlier in opinion, said you should

have contracted for it, not in certificate, dont get it

In this part of the opinion:


17/33

Student: K tells us what to do, but if Conversion Rate becomes

negative, then cant do it so need to get as closely as we can

Court calculates current market price

CMP: if dividends you are about to get is 5, then CMP could not

possible be less than that (if it is less, would make the conversionrate negative)

When court says the formula doesnt work court doesnt

mean formula becomes negative means that you cant get the

right amount of CS through that formula (b/c CMP would

always be slightly higher than the amount of dividends by nature

of market)

Gives non-implementable negative conversion rate

Court: formula doesnt work in that you dont get stock

with a sufficient value; but IN FACT, it will still be

implementable

CAN execute the formula just that result thatwe get wont give you effective protection

HERE:

The line Court is drawing is NOT an arbitrary line

Section 5(e) gives a stopping point; line is derived from

the certificate

So the court can say: not making it up, based on

the certificate

Parties came up with solution in the K; solution works

98% of the time then court will help parties a little:

parties tried to have formula making the conversion rate

before stock split always equal that after the stock split

(???)

BUT, in the case of dividends, there is NO limit

asking court to totally making it up

HUGE loophole court not willing to fill up; small

loophole, more willing to fill up

Balance Sheet of NYT

Balance sheet: snapshot at one point in time of the companys financial condition

Two columns one year beforehand, year end (compare the two)

Three segments Assets: what co owns

Liabilities: what co owes

SHs equity: whats left over

NYT Balance Sheet Equity:

Preferred Stock: 200,000 authorized, 0 outstanding

Common Stock Class A: 300M; 150 M issued

Common Stock Class B: 840,000; 840,000 issued


18/33

Authorized shares: max number that company can issue comes from certificate of

incorporation comes from the SHs/SHs can modify this provision

authorized but not issued

authorized and issued shares: Company has sold or given the shares to the

shareholders Can company own its own stock? when Company buys shares back

that it issued (repurchases) these are called = treasury stocks

Treasury stocks: Common Stock held in treasury column

In parenthesis: parenthesis indicates negative number not a positive

contribution to the equity number that REDUCES equity, since

company has used money to buy back the stocks

Treasury shares: number of shares that company has issued and since bought

back

From perspective of corp law = same as shares that are authorized but

NOT issued company can choose to sell or not sell in future but if

company chooses not to sell them, nothing happens, they have no

function

Company can convert it to shares that are authorized but no issued (b/c

they are the same thing anyways) and accountants will make book

entries of this (retire treasury stocks) but no economic/functional

significance; only treated differently from accounting perspective

Issued and outstanding: number of issued shares number of treasury shares

These are the relevant ones.

09 12 2008 Friday

Balance sheet of NYT

Listing of the stocks => # on the right = stated capital

Class A Common

Class B Common

840,000 shares issued Right hand of the balance sheet: $84,000 = stated

capital

Stated capital = # of issued shares * par value per share

stated capital cannot be less than # of issued shares times par value per

share

Stated capital not so important

Par value = 10 cents

When NYT issued stock, got more than 10 cents per share

So if NYT sells stock for $10/share

10 cents go to par value stated capital, Remainder 9.90 cents goes to

additional capital or capital surplus Add up stated capital and additional paid-

in capital = can find out how much NYT recd for issuing stocks it has issued


19/33

If you were to sell stock at less than par value, would be a problem; picking low

par value, then you are fine.

Retained earnings

Profits made not paid out as dividends Retained earnings (reinvestment)

Equity twofold Equity from issuing shares: stated capital + additional capital (arbitrary division betwn

the two)

Retained earnings: profits not paid out

Two types of common stock

Class A

Many more shares

Class B

Right to convert into Class A

Elects 70% of the directors on its own

Who owns Class B stock?

The people who founded the NYT wanted to maintain family control

over the mngt of the company (while owning only small fraction of

equity)

Diff classes of common stock with diff voting power: relatively rare arrangement

in the U.S.

Class A and B: Monetarily the two are the same (same dividends, liquidation the same)

Voting power is different

Class B has more voting power

Retiring shares: total equity does not change

When you retire shares: no longer treasury shares treasury shares entered as negative

number number goes up Some other number has to go down stated value will go down by par value * number

of shares issued retired

take it out of paid-in capital

Remember: balance sheet is only a snapshot; all numbers are [up to 2004] all prior years

combined

E.g. retained earnings: not during 2004, but up to 2004

Treasury shares: issued but not outstanding

Issued and outstanding: Issued treasury shares = issued and outstanding shares

Common stock held in treasury at cost dollar figure = $$ NYT has spent to repurchase treasury

shares (up to that point in time)


20/33

DEBT

Debt has maturity (date at which it must be paid); interest rate; can be redeemable or convertible;

Debt can also have other features that are restrictions oraffirmative reqs on the way thecompany conducts its business

E.g. restrictions on amt of dividends that company can pay

Limitations on amt of other debt that company can incur

General ability to have these restrictions will come up a lot in discussion of creditor

rights

Priority structure of debt:

All debt has priority over equity

Within same company:

Debt gets paid first

Then pay equity (preferred first, then common)

Priority within debt

If company doesnt have enough money to pay off all of its debt, how are assets

allocated among its creditors?

General Rule:all debt has equal priority, unless there is specific reason/category

that changes this

If there isnt enough money to pay off all creditors within same class,

they are paid off pro rata

Each creditor gets paid the same fraction of the claim (proportion

of the debt owed to her): divide assets by the debt pay off

each creditor this fraction of what they are owed

3 exceptions to general rule of equal priority

Federal bankruptcy law: certain types of claim have priority over others

E.g. taxes owed to the fed govt get paid off before you get paid

off

Wont talk more about this: limited exceptions all listed in the

Bankruptcy Code

Equitable subordination will discuss later

Secured debt and subordination

Secureddebt and subordination: Priority structures created

contractually or quasi contractually By creditors or company

If company wants to create priority structure within diff

classes of debt two mechanisms: sec debt and subord

These two are diff but functionally parallel

Secured debt: involves the company through some procedures

prescribed by law designating specific assets (something

company owns) as collateral (only assets can be collateral)


21/33

These assets (collateral) used first to pay off the secured

debt

Sec debt has priority over other debt (= unsecured debt)

if there is collateral

Effect: Collateral is used first to pay off securedcreditors. 2 possibilities:

1. If paid off secured creditors and collateral

left over: then collateral goes into general pool

of other assets of the company and used to pay

off unsecured creditors

2. No collateral left over but still secured

creditors claims left over: deficiency claims (=

remaining claims) of secured creditors get paid

as if they were unsecured creditors

P. 31 problem set

Subordination: doesnt involve any assets ( no collateral)

Involves dealbetween two types of creditors

Subordinated creditors Subordinated say to the senior: if the company

doesnt have enough money to pay you in full,

then any money that we get (we would be

entitled to get but for this deal) we will take

and give it to you up to the point that it is

necessary for you to get paid in full.

Possibilities:

Subord pays s senior gets paid in full remaining gets to subordinated

Senior doesnt get paid in full even

when subord hands all over thats all

seniors get; and subords get nothing

Senior creditors Third group of creditors: not part of the deal/not

beneficiaries of the deal

Just get whatever they would get if the deal

didnt exist

Getpro rata distribution

How do youfigure outhow much each creditor gets?

First: what creditors get that are not part of the

subordination agreement: ignore subord agrt and treat

all creditors equal figure out the pro rata share = how

much the others get


22/33

Whatever else is left after paying the third group pro

rata: goes to the seniors; then anything left goes to

subordinated

Motivation for creditor agreeing to be subordinated: you get higher

interest rate; seniors get lower interest rate Monday: read up to pg 48


23/33

HB Korenvaes Investments, L.P. v. Marriott Corporation (Del. Ch. 1993) p.19:

2. Facts: Interesting: illustrates how certain type of transaction is done a spinoff

Spinoff = when corp takes a chunk of its assets and either distributes it to its SHs or

sells it off as a newly publicly traded company

In this case spinoff to its shareholders

Big Marriott: wants to reorganize its business

One entity: Host = owns real estate

International = services, operates hotels

Owners: shareholders of Big M

How can you get there?

1. Create new company 2. Transfer hotel-operating assets to new company

3. Pay dividend to SHs consisting of stock of new company

= Simple way to do the same thing (divide into two businesses): spin

off the real estate part

Or offer stock in IPO

Dividend policies:

Host: wont pay any dividends

Intl: the same dividends as Big Marriott used to pay

Holder of Big Mar, from cash flow perspective: will get the same amount of

dividends

Host has no profits:

Operating profits (earnings before payments are made to providers of

capital) of Host are lower

Net income after interest expense lower b/c Host has a lot more

debt

Big M paid dividends to the CS holders, so must have paid dividends

to Preferred stock holders

PSH: no dividends paid after the spinoff

so PSH unhappy if you dont convert

Read up to page 40

i. Marriott wants to reorganize by transferring its cash-generating services businessto a subsidiary called Marriott International, which will be spun-off and paid as a

special dividend to all common shareholders of Marriott.

1. Would fall within the case of paying dividends in form of capital stock in

the sample Cert of Desigs anti-dilution clause

ii.Marriott will change name to Host Marriott, which will keep the debt-laden real

estate business which would be incurring a negative net income and hence not

paying dividends.


24/33

iii.Prior to the spin-off, Marriott was paying a cash dividend to shareholders. After

the spin-off, Host Marriott wasnt going to pay any dividends at all while

International was going to pay the common shareholders the same dividends that

Big Marriott was paying prior to the spin-off.

iv.Thus, the spin-off will have no effect on common shareholders dividends.However, preferred shareholders will only be left with Host Marriott which will

be debt laden and incurring a loss and so will not be paying any dividend.

v. Thus, preferred holders can either stay with Host as preferred holders and get no

dividends or convert to common before the split (and thus get International spin-

off shares and dividends).

vi.Plaintiffs want injunction to stop special dividend. The argue that the reason

Host is doing what its doing is because after distribution of the dividend the

preferred holders will be in a position to convert and control a majority of Hosts

common stock as per the Certificate of Designation which adjusts the preferred

stock conversion rate. The Marriott family wants to maintain control so Marriott

is going to stop paying dividends after transaction to coerce preferred holdersinto converting.

vii.Issue: whether the planned transaction is consistent with the conversion

price adjustment contained in the Certificate of Designation.

viii.Court: While the suspension of dividends may influence PSH to convert,

there was no coercion and no violation of any implied right to good faith

that every commercial contractor is entitled to.

a. First, plaintiffs wrongly construed Big Ms actions as coercion.Court says coercion was not involved and that this is essentiallya contract action, as the case involves the construction of therights and duties set forth in the charter.

i. Court has held that actions principally designed to

coerce SH in the exercise of a choice given to them bycharter, bylaws or statute, but those cases were basedon existence of fiduciary duty of directors with respect totransaction under review

ii. This is not a fiduciary duty case though, but one ofconstruction of rights and duties set forth in thecertificate of designation

iii.The PSHs protections against suspension ofdividends lie in the charter, and are several:

1. Cumulative dividends2. Liquidation preference3. Redemption price adjusted to reflect accrued

unpaid dividends4. If prolonged suspension of dividends get right to

elect 2 directors5. Conversion right6. Restriction on the proportion of net worth that

may be distributeda. This restriction is inherent in the formula

used to revise the conversion ratio:formula doesnt work if you give somuch away that new net worth is lessthan PSs share of net worth before thedividend


25/33

iv.These provisions are a recognition of1. The risk that dividends might not be paid.2. The correlative right of directors to discontinue

dividendsb. Second, the discontinuation of dividends can be seen as a

prudent, good faith, business-driven decision.c. Thus, though the suspension of dividends may exert a powerfulinfluence, there has been no violation of the duty of good faiththat commercial contractors are entitled to expect

2. Court: More important claim is based on Charter Section 5(e)(iv) whenthe assets of the firm are depleted through a special distribution to SHs,the preferred will be protected by the triggering of a conversion priceadjustment formula.

a. The # of shares into which the preferred can convert will beproportionately increased in order to maintain the value of thepreferreds conversion feature.

b. In a narrow range of extreme cases, the provision will not work topreserve the pre-dividend value of the preferreds conversionright. (see examples on p. 24-25)

c. If this case fell within that narrow range, Marriot could beprevented from declaring dividends of a proportion that woulddeprive the PSH of the protection this section was intended toafford, which would violate the rights of the PSH created by thecertificate of designations conversion feature. But this is not oneof those cases.

d. Rule: If, when declared, the dividend will leave thecorporation with sufficient assets to preserve theconversion value that the PSH possesses at that time, itsatisfies the limitation that such a protective provisionimplies

ix.HOLDING: Court held that while the suspension of dividends may influence

Preferred to convert, there was no violation of any implied right to good faith that

every commercial contractor is entitled to.1. Plaintiffs wrongly construed this case as a breach of fiduciary duty. This

is essentially a contract action, as the case involves the construction and

interpretation of rights and duties set forth in the certificate of

designation. Marriott has a right to suspend dividend payments as a

business judgment. The court says the certificate of designation says

nothing on the matter although it has in the past helped preferred

shareholders when a company issued a gratuitous threat to delist the

preferred stock.

2. However, in this case, the court says the preferred shareholders are

protected by provisions in the certificate

a. (i.e., cumulative dividends, liquidation preference, right to elect2 directors after prolonged suspension of dividends, Redemption

price adjusted to reflect accrued unpaid dividends, Restriction on

the proportion of net worth that may be distributed

b. (This restriction is inherent in the formula used to revise the

conversion ratio: formula doesnt work if you give so much

away that new net worth is less than PSs share of net worth

before the dividend).


26/33

c. These provisions are there because the shareholders recognize

the risk of being a preferred shareholder. The court recognizes

that the shareholders foresaw the problem and contracted for

protections. Thisis all the preferred shareholders are getting

since this is all they contracted for.d. The preferred shareholders should have negotiated for the

contract to include a prohibition on in-kind dividends.

3. The court also found that a provision in the certificate 5(e)(iv) that

reduced the conversion price protected the value of the preferred

conversion whenever Marriott distributed assets to its common

shareholders.

09 12 2008 Friday

Balance sheet of NYT

Listing of the stocks => # on the right = stated capital

Class A Common

Class B Common

840,000 shares issued Right hand of the balance sheet: $84,000 = stated

capital

Stated capital = # of issued shares * par value per share

stated capital cannot be less than # of issued shares times par value per

share

Stated capital not so important

Par value = 10 cents

When NYT issued stock, got more than 10 cents per share

So if NYT sells stock for $10/share

10 cents go to par value stated capital, Remainder 9.90 cents goes to

additional capital or capital surplus Add up stated capital and additional paid-

in capital = can find out how much NYT recd for issuing stocks it has issued

If you were to sell stock at less than par value, would be a problem; picking low

par value, then you are fine.

Retained earnings

Profits made not paid out as dividends Retained earnings (reinvestment)

Equity twofold

Equity from issuing shares: stated capital + additional capital (arbitrary division betwnthe two)

Retained earnings: profits not paid out

Two types of common stock

Class A

Many more shares

Class B

Right to convert into Class A


27/33

Elects 70% of the directors on its own

Who owns Class B stock?

The people who founded the NYT wanted to maintain family control

over the mngt of the company (while owning only small fraction of

equity) Diff classes of common stock with diff voting power: relatively rare arrangement

in the U.S.

Class A and B: Monetarily the two are the same (same dividends, liquidation the same)

Voting power is different

Class B has more voting power

Retiring shares: total equity does not change

When you retire shares: no longer treasury shares treasury shares entered as negative

number number goes up

Some other number has to go down stated value will go down by par value * number

of shares issued retired

take it out of paid-in capital

Remember: balance sheet is only a snapshot; all numbers are [up to 2004] all prior years

combined

E.g. retained earnings: not during 2004, but up to 2004

Treasury shares: issued but not outstanding

Issued and outstanding: Issued treasury shares = issued and outstanding shares

Common stock held in treasury at cost dollar figure = $$ NYT has spent to repurchase treasury

shares (up to that point in time)


28/33

DEBT

Debt has maturity (date at which it must be paid); interest rate; can be redeemable or convertible;

Debt can also have other features that are restrictions oraffirmative reqs on the way thecompany conducts its business

E.g. restrictions on amt of dividends that company can pay

Limitations on amt of other debt that company can incur

General ability to have these restrictions will come up a lot in discussion of creditor

rights

Priority structure of debt:

All debt has priority over equity

Within same company:

Debt gets paid first

Then pay equity (preferred first, then common)

Priority within debt

If company doesnt have enough money to pay off all of its debt, how are assets

allocated among its creditors?

General Rule:all debt has equal priority, unless there is specific reason/category

that changes this

If there isnt enough money to pay off all creditors within same class,

they are paid off pro rata

Each creditor gets paid the same fraction of the claim (proportion

of the debt owed to her): divide assets by the debt pay off

each creditor this fraction of what they are owed

3 exceptions to general rule of equal priority

Federal bankruptcy law: certain types of claim have priority over others

E.g. taxes owed to the fed govt get paid off before you get paid

off

Wont talk more about this: limited exceptions all listed in the

Bankruptcy Code

Equitable subordination will discuss later

Secured debt and subordination

Secureddebt and subordination: Priority structures created

contractually or quasi contractually By creditors or company

If company wants to create priority structure within diff

classes of debt two mechanisms: sec debt and subord

These two are diff but functionally parallel

Secured debt: involves the company through some procedures

prescribed by law designating specific assets (something

company owns) as collateral (only assets can be collateral)


29/33

These assets (collateral) used first to pay off the secured

debt

Sec debt has priority over other debt (= unsecured debt)

if there is collateral

Effect: Collateral is used first to pay off securedcreditors. 2 possibilities:

1. If paid off secured creditors and collateral

left over: then collateral goes into general pool

of other assets of the company and used to pay

off unsecured creditors

2. No collateral left over but still secured

creditors claims left over: deficiency claims (=

remaining claims) of secured creditors get paid

as if they were unsecured creditors

P. 31 problem set

Subordination: doesnt involve any assets ( no collateral)

Involves dealbetween two types of creditors

Subordinated creditors Subordinated say to the senior: if the company

doesnt have enough money to pay you in full,

then any money that we get (we would be

entitled to get but for this deal) we will take

and give it to you up to the point that it is

necessary for you to get paid in full.

Possibilities:

Subord pays s senior gets paid in full remaining gets to subordinated

Senior doesnt get paid in full even

when subord hands all over thats all

seniors get; and subords get nothing

Senior creditors Third group of creditors: not part of the deal/not

beneficiaries of the deal

Just get whatever they would get if the deal

didnt exist

Getpro rata distribution

How do youfigure outhow much each creditor gets?

First: what creditors get that are not part of the

subordination agreement: ignore subord agrt and treat

all creditors equal figure out the pro rata share = how

much the others get


30/33

Whatever else is left after paying the third group pro

rata: goes to the seniors; then anything left goes to

subordinated

Motivation for creditor agreeing to be subordinated: you get higher

interest rate; seniors get lower interest rate Monday: read up to pg 48

Corps 0916

Financing firm

Discretion as to how much you raise in form of equity and debt

Capital structure: relationship between equity and debt

More debt in capital structure more leveraged is the firm

Leverage = amount of debt in capital structure

What leverage does in terms of finance

Increases riskiness of the equity

Generally increases the expected rate of return on the equity

Generally if certain technical condition is satisfied = if

expected rate of return on assets exceeds interest rate

Distinguish operational side of firm from ways the firm is financed

Hypothesis: operations of the firm and financing of the firm are independent

matters (usually true)

Firm that uses $100,000 in capital

Operational side/Assets side: Will produce operating profits, regardless

of how financed Each year:

16,000; or

12,000; or

8,000

Compare two ways of financing the firm:

All equity: 100,000

Mixed

50,000 debt 10% interest rate

50,000 equity

Expected rate of return on assets Each profit has same likelihood of happening

Expected profits / total capital

Expected rate of return on assets: 12,000 12%

Technical condition satisfied: 12% > 10%

Leverage increases riskiness of equity,

Case 1: All equity

Expected rate of return on equity:


31/33

12%

Possible rate of return

16% - 33% likelihood

8% - 33%

Case 2: Mixed Creditors: $5,000 interest even in worst case scenario

(8,000), still enough money; good deal

Equity holder: Expected profits after interest for equity

holder: 7,000

Expected rate of return: 14%

Downside: 3,000/50,000 = 6%

Upside: 22%

Increases expected rate of return on equity: 12 14%

Increases riskiness of equity: swings

+-4% (with probability of 1/3)// +-8% (with probability

of 1/3)

Plus, minus 8% is riskier than plus minus 4%

Conceptual explanation

Risk is inherent in the operations

Risk that is in the project is defined by the numbers given on operational side

Capital structure: APPORTIONS risk

Lets say, this project involves a 100 units of risk

When we have all equity capital structure: for each 1000 dollar invt 1 unit of

risk

Mixed structure:

Debt: for each 1000 dollar invt 0 risk (always gets 5000 in each case) Equity: for each 1000 dollar invt 2 units

Risk of equity has doubled

Reflected in two facts:

1) Swings have doubled 4 % swing to 8%

1 unit of risk in case 1, got 12% return for 1 unit of risk

= gets extra 2 return

0 unit of risk, gets 10%

For 2 units of risk, should get 4 extra return

2) more risk, more return

Finished with introductory segment

NOW: relationship between corp, shs, and creditors

Prb on p. 36

Policy arguments

To understand what drives what the law is

Company ABC Enterprises

Andrea 75% shares

Tamara 25% shares


32/33

Debt 5M

Liability 2M

50,000 past salary to A

500,000 in past due wages to employees

4 M total assets Should Andrea have to pay Rich from her own money? = DISCUSSION

St: Rich should get paid from company before Andrea Andrea should be subordinated

WHY?

B/C Andrea is CEO of company and profited from negligence of

company; part of her responsibility to prevent negligence

Should A be subordinated to everybody (creditors, other employees etc)

since she profited from all of their work/money etc?

BUT Tamara also profited from the company?

K: The people who really profit from risk are the SHs then doesnt make sense

to hold A liable as CEO and T (SH) not liable Puts Andrea on the hook for salary and SH (since her personal assets are

at stake)

Not an uncommon arrangement many non-publicly held companies

have CEOs = SHs

Proposed rule: If company pays dividends after the verdict, then SHs have to

return the money???

Basis: SHs claim on the money is as good as or worse than Rich and

creditors claim on the money

Richs claim: design defect strict liability regime

Company NOT found to be at fault; Andrea SURELY not at fault

SO no finding of fault as far as company and Andrea concerned

K: so whats the basis for holding Andrea at fault?

K: company can have insurance against product design defects

claim; BUT Rich can also have health insurance

If CEO has personal liability if things go bad, and since the benefit of risks are

reaped by the SHs, then would cause CEOs to be overly cautious

Also an incentives issue: want managers to take on necessary risk

If CEO is personally at fault, then it is taken for granted that she can be sued

personally

Rule against excessive CEO salaries?

To protect creditors and SHs

Different rule necessary for protecting creditors v. SHs?

Limit for SHs: lower limit

How would you formulate such a rule?

Limit for creditors:

Interest: as long as enough assets of company left to

fully pay the creditors


33/33

Should Andrea have to pay the Bank?

Should Bank get paid ahead of the employees?

Should Bank get paid from Andrea?

If rule says: Bank only has rights spelled out in K fair b/c the bank can write it

into K (on dividend payment restrictions) BUT: if the legal rule is unless K says otherwise, A has to pay back

dividends that she recd within 1 year of the filing of bankruptcy

could also say that Andrea should have spelled out her rights into the

K

Problem with Ks K with entity, hard to K with SHs in remote places

But could have rule saying if company pays dividends in violation of K,

then you can go after the recipients of the dividends

What protects creditors who cannot bargain?

E.g. Rich

Possible rule: Creditors who cannot bargain should get priority over the bank? If there is a bank, bank will have incentive to bargain on part of Rich

E.g. buy washing machine breaks down warranty claim notion of

contracting to protect yourself is impossible practically speaking

But this is b/c the claims are minimal warranty claims are really small

These claims are so small, amounts to such small risk are diversifiable

So they wont get claimed big deal. Dont amount to huge claim

Usually, financial claims are the ones that are big

If this were the rule: Bank would ask company to get insurance against tort claims

Very common thing even today

If Andrea had transacted in business in personal capacity then she would liable to Rich from her

personal assets

Then why should she be any less liable in personal capacity just b/c she formed a company?

Its her company she gets the upside, she should suffer the downside

She owns the business why should Rich suffer?

Maybe all the SHs should pay from personal assets

Andrea has more control over whether accident happens or not; if things turn out well

Andrea benefits then why does Rich, who doesnt get profits, only suffers!

Even with incentives issue, still cant answer WHY RICH should bear the grunt

E.g. getting into car: bearing risk that you will get into accident that will exceed your

insurance payment and you will go bankrupt

Argument is that limited liability form: creates too much risk

Company: the lowest cost avoider; but when taking precautions, will think of SHs, not

Rich

If you are taking unnecessarily high risk, then you can protect yourself through insurance

Not a finite resource; if demand goes up, supply of insurance companies will go up too

Continue on Thurs: finish Gleneagles case; may do Costello ~pg 51

Corporate Securities and Capital Structure

Documents

Transcript of Corporate Securities and Capital Structure