4- 1

4-1

Chapter 4

Captial Structure

Types of Financial Instruments 4-2• Warrants (Options)• Common Stock• Preferred Stock

– Blank Preferred– Cumulative Preferred– Participating Preferred– Convertible Preferred

• Short-Term Debt– Asset –based financing (receivables, inventory) (including structured

financing)– Lines of credit for temporary working capital– Commercial Paper

• Long-Term Debt– Bonds– Debentures– Capital Leases– Structured Finance

Eliasen v. ITEL Corporation 4-3

• Class B Debentures suing to obtain residual value from sale of the Railroad

Order of Creditor Priorities From 4-4

1896 Bankruptcy Reorganization

• First mortgagees received common stock

• New investors received Class A debentures

• Second mortgagees and old shareholders received Class B debentures.

The Class B Debenture Certificate 4-5

• [This[ … certifies that this is one of a series of seven thousand of its Class B Debentures, in the sum of ONE THOUSAND DOLLARS each, aggregating in all the sum of Seven Million Dollars, which sum of One Thousand Dollars will be payable to the bearer hereof as follows: viz., only in the event of a sale or reorganization of the Railroad and property of said Company, and then only out of any net proceeds of such sale or reorganization which may remain after payment of any liens and charges upon such railroad or property, and after payment of Six Hundred Thousand Dollars to the holders of a series of Debentures known as Class A, issued or to be issued, by said Company, and the sum of Two Million Five Hundred Thousand Dollars to and among the stockholders of said Company. Any such net proceeds remaining after such payments shall be distributed pro rata to and among the holders of this series of Class B Debentures.

Questions on Eliason v. Itel 4-6

• 1. What priorities does Plaintiff argue for?• 2. Does Plaintiff’s argument give any meaning to the face

value of the Class B debentures?• 3. What priorities does Itel argue for?• 4. What does the plain language provide?• 5. Does Itel’s position give any meaning to the language

that stockholders shall be paid $2.5 million?• 6. Why does the court look at ancient history and describe

the bankruptcy priorities in 1896?• 7. Who stood last in line in the bankruptcy? Is this

important to the court? Should it be?• 8. Who had voting rights? Why is this relevant to

determining priorities on payment?• 9. If the B debentures only receive “dividends” after the A

debentures and stock, what does this suggest?

Question 1 on Eliason v. Itel 4-7

1.What priorities does Plaintiff argue for?

• $600,000 to Class A;

• $2,500,000 to shareholders;

• (“and then only out of any net proceeds . . . which may remain after payment [of the previous sums]”), $7 million to Class B.

• Residue (in excess of $7 million) to Class B holders (“Any such net proceeds remaining after such payments shall be distributed pro rata to and among the holders of this series of Class B Debentures”)


2. Does Plaintiff’s argument give any meaning to the face value of the Class B debentures?


2. Does Plaintiff’s argument give any meaning to the face value of the Class B debentures?

• Just the amount of the initial payment.

• It doesn’t really mean much but neither does par value of Common in a liquidation.


3.What priorities does Itel argue for?


3. What priorities does Itel argue for?

• $600,000 to Class A holders (who invested new money in the reorganization).

• $2,500,000 to Shareholders (who were creditors in the bankruptcy)

• $7,000,000 to Class B holders, per the first sentence of the debentures.

• Balance to Shareholders.


4.What does the plain language provide?

The Class B Debenture Certificate 4-13

• [This[ … certifies that this is one of a series of seven thousand of its Class B Debentures, in the sum of ONE THOUSAND DOLLARS each, aggregating in all the sum of Seven Million Dollars, which sum of One Thousand Dollars will be payable to the bearer hereof as follows: viz., only in the event of a sale or reorganization of the Railroad and property of said Company, and then only out of any net proceeds of such sale or reorganization which may remain after payment of any liens and charges upon such railroad or property, and after payment of Six Hundred Thousand Dollars to the holders of a series of Debentures known as Class A, issued or to be issued, by said Company, and the sum of Two Million Five Hundred Thousand Dollars to and among the stockholders of said Company. Any such net proceeds remaining after such payments shall be distributed pro rata to and among the holders of this series of Class B Debentures.


4. What does the plain language provide?

Posner tries to reconcile the sentences. Yet language is ambiguous.


5.Does Itel’s position give any meaning to the language that stockholders shall be paid $2.5 million?


5.Does Itel’s position give any meaning to the language that stockholders shall be paid $2.5 million?

• Yes it shows that the Common get contractual priority as to $2.5 M before B Debentures. Default priority would go to the B debentures.


6.Why does the court look at ancient history and describe the bankruptcy priorities in 1896?


6. Why does the court look at ancient history and describe the bankruptcy priorities in 1896?

Parole Evidence Rule. Even though the final esntence standing alone is clear; the paragraph as a whole is ambiguous.


7. Who stood last in line in the bankruptcy? Is this important to the court? Should it be?



Posner argues the 2d mortgagees and shareholders got B Debentures which were meant to be the lowest value in the bankruptcy. It explained why the reading that B get $7.0 M and no more makes sense.



“The presumption in 1896 as now was (is) that the residual, unprovided-for value of a corporation belongs to the shareholders rather than to the holders of debentures or other bonds.” - page 205



The problem is that when the language was written the assumption was that the railroad would never be worth more than the $10.1 M provided distribution (there would be no residue upside). This shows the danger of drafting to present assumptions only.


8. Who had voting rights? Why is this relevant to determining priorities on payment?



Voting Rights should go to the holder of residual value so they will have an incentive to maximize value above the liquidation preferences. Having voting rights and a fixed return encourages play it safe.



Here holder of residual value was B until the full $$10.1 million achieved then the shareholders.

“The only way to give the shareholders a robust incentive to maximize the railroad’s value is to give them an equity kicker above the Class B entitlement, and so the debenture contract can be presumed to have done this.” - page 207.


9. If the B debentures only receive “dividends” after the A debentures and stock, what does this suggest?


9. If the B debentures only receive “dividends” after the A debentures and stock, what does this suggest?

P argues it suggests the B are equity holders and Common are preferred.

Posner says it suggests the Common really represents a combined preferred return of $2.5M and residual value after the payment of the B debeuntures (equity)

Firm One – All Equity - $100,000 invested earning 4-28

$12,000

Firm Two – 50% Debt, 50% equity (times two)

• Firm One: Operating income $12,000

• Firm Two: Operating income $24,000• less interest @ 8% - 8,000• Net Income $16,000

• Equity of Firm One: $12,000 = $100,000• .12• Equity of Firm Two: $16,000 = $133,333• .12

Effects of Leverage on Profits 4-29

• FIRM ONE• A B C• Assumed Operating• earnings $2,000 $12,000 $22,000• Earnings to • shareholders $2,000 $12,000 $22,000

• FIRM TWO• Assumed operating• earnings $2,000 $12,000 $22,000• Interest (4,000) (4,000) (4,000)• Earnings to • shareholders ($2,000) $8,000 $18,000

Return to shareholders, 4-30 assuming equal probabilities

• Rate of return on equity

• Firm One: ($100,000 equity)– $2,000 2%– $12,000 12%

• $22,000 22%– Expected returns: $12,000 12%

• Firm Two: ($50,000 equity)• ($2,000) - 4%

– $8,000 16%• $18,000 36%

– Expected returns: $8,000 16%

Pricing Default Risk – Valuing Firm Two 4-31

• (1) $16,000 = $133,333• .12

• (2) $16,000 = $114,285• .14

• (3) $16,000 = $100,000• .16

Home Made Leverage 4-32

• Choice One - An unleveraged investment.

• You get expected 12% rate of return ($12,000 on $100,000)

• Choice Two - A leveraged investment.

• You invest $50,000 equity in each of two firms.

• You borrow $100,000 at 8% to buy the balance of the equity in both firms.

• Results: $24,000 total income• - 8,000 interest• $16,000 net income

• You get expected 16% rate of return on your $100,000.

Firm Leverage 4-33

• Firm One is an all equity firm with $100,000 invested

• Firm One would have an expected return to shareholders of $12,000.

• Net income $12,000

• Firm Two has $100,000 equity and $100,000 borrowings

• Firm two would have an expected return to shareholders of $16,000.

• Operating income $24,000• less interest - 8,000• Net Income $16,000

The Relation Between Risk and Return 4-34

• Rate of• Return Expected Return on Equity

• 16%

• Expected Return on Assets• 12%

• 8% Expected Return on Debt

Low Debt Ratio High Debt Ratio

The One-Owner Corporation 4-35

• Firm One Firm Two• Gross income $12,000 $12,000• Firm interest expense 0 - 4,000• Net firm profits $12,000 $8,000• Less interest paid by • shareholder - $4,000 0

• Net available to shareholder $8,000 $8,000

The Impact of Taxes 4-36

• All Equity Firm: Corporate Shareholder Level

• Level Payments Taxes@40% Net• Net Operating Income $12,000 • Less Corp. Taxes @ 35% (4,200)• Corp. Income after taxes $7,800• Dividend to Shareholders ($7,800) $7,800 ($3,120) $4,680

• 50% Leveraged Firm:• Net Operating Income $12,000• Less interest expense: (4,000) $4,000 (1,600) $2,400• Net Corporate Income $8,000• Less Corp. Taxes @35% (2,800)• Corp. Income after taxes $5,200• Dividend to Shareholders ($5,200) $5,200 (2.080) $3,120• Totals $9,200 $3,680 $5,520

• 100% Leveraged Firm:• Net Operating Income $12,000• Less Interest (12,000) $12,000 ($4,800) $7,200

Quick Check Question 4.1 4-37

• Rate of Tax on dividends falls to 15% what does this do to the return to investors?

Quick Check Question 4.1 4-38

• Firm One – All Equity with $100,000 invested & expected return of $12,000• Corporate Shareholder Level

Level Payments Taxes @15% Net to s/h Net corp. income $12,000 Less taxes @ 35% (4,200) Net corp. income $7,800

• Dividend to s/h $7,800 ($1,150) $6,630

• Firm Two – 50% equity w/ $100,000 invested & expected return of $12,000• Corporate Investor Level

Level Payments Taxes Taxes Net to s/h

@40% @15% Operating income $12,000 Less interest (4,000) $4,000 ($1,600) $2,400 Net income $8,000 Less 35% taxes (2,800) Net corp. income $5,200 Dividend to s/h $5,200 ($780) $4,420 Totals: $9,200 $6,820

The Impact of Expected Bankruptcy Costs 4-39

• Rate of• Return Expected Return on Equity

• 16%

• Expected Return on Assets• 12% • Impact of bankruptcy• costs

• 8% Expected Return on Debt

• Low Debt Ratio High Debt Ratio

Weighted Average Cost of Capital 4-40

(1) WACC = (Value of debt x int. rate) + (Value of Equity x capitalization rate) Value of Firm Value of Firm

(2) After tax cost of debt = (interest rate) (1- corp. tax rate)

(3) WACC = (Value of debt x int. – tax rate) + (Value of Equity x cap. rate) Value of Firm Value of Firm

Agency Costs 4-41

• With 100% owner manager there are no agency costs. Mager bears all cost of fringe benefits as the owner.

• The more outside equity the greater the agency costs as the owner only bears a pro rata portion of the costs of fringe benefits as manager. Overcome with monitoring and/or equity incentives.

• Debt can act as a discipline on agency costs – Covenant restrictions and performance measures. Yet these have their own costs to administer.

• At some point Debt increases agency costs by reducing risk and increasing reward. E.g. 1% owner manager has little risk but all the reward. More outside debt reduces Debt Agency costs.

• Companies change mix to try to achieve most efficient structure.

Agency Cost Model of Optimal Capital Structure 4-42

• Agency Costs

• Total Agency Costs

• Agency Cost Agency Cost

• of Debt of Outside Equity

•

• Optimal Structure % Outside Equity

What are LBOs? 4-43

• A Sponsor organizes the acquisition of a business or part of a business from a sole owner (can be public company owner).

• Combination of acquisition debt (gives discipline), LBO sponsor equity (reduces the excessive risk taking cost and monitors the managers) and management incentive equity (reduce manager shirking).

• Likely candidates in the 1980s were stable cash flow businesses (tax payers) in mature industries with high agency costs (conglomorates)

Simple LBO Model? 4-44

• Target enterprise value of $120M with $20M EBITDA (6x valuation) and $13M net income ($7M in taxes)

• $90 M Debt at 10%, $30M Equity• Sponsor provides 90% of the equity and

managers 10% (often cheaper for the managers)

• After deal there will be $20M EBITDA and $7.15 net income ($9M interest and $3.85 taxes

Simple LBO Model? 4-45

• Sponsor assumes it can increase EBITDA by $5M by cutting agency costs of management.

• It uses $3.5M EBITDA a year to pay down debt.• In five years the Company will sell for $150M

(6xEBITDA) divided among: • Debt (no premium) $72.5• Sponsor (no preferred) $70.0• Management $ 7.5• Sponsor made $70 on an investment of $27 or

2.6x return

New England Tel. Co. 4-46

• Regulated Utility Companies have their rates set by Commissions.

• Supreme Court has held that Utilities are entitled to a reasonable return on capital for shareholders. If rates are too low to do that, there is a taking.

• Rate setting involves finding invested capital amount, finding a weighted average cost of capital and then setting rates at a level to produce income to meet that return.


Capital Structure:

long-term debt $135 million

AT&T advances 120

$255 million (62% of capital)

Common Stock $155

• Current cost of debt was 3.61%.

• Commission found cost of debt could be reduced to 3.45% with new debt financing.

• Composite rate of return allowed by Commission was 4.7% or 4.8%.


• Court found that Commission was not bound to debt equity ratio desired by the Company but could use 45% debt level.

• Commission only allowed 6% on equity.

• No witness, even the Commission’s, thought the cost of equity was less than 8%.

• Court rejects Commission’s reasoning that 6% was adequate for “normal” times.


• Takings Clause means company is entitled to earn actual cost of capital dedicated to public service.

• Held: The minimum return permitted on equity should be 8.5%.

At 45% debt, this results in the following weighted cost of capital:

Debt: 3.45% x .45 = 1.55%Equity: 8.5% x .55 = 4.68%Composite Return: 6.23%

Questions – New England Tel. Co. 4-50

1.Why do you suppose the Department uses the cost of debt and equity separately to determine the cost of capital?


1. Why do you suppose the Department uses the cost of debt and equity separately to determine the cost of capital?

It is determined from different sources:

• Cost of debt is readily determinable from current interest rates demanded by investors on the company’s debt.

• current cost of equity should be determinable from the yield required by investors on its stock.


2.In determining the cost of debt, does the Department use the current yield demanded by investors on its debt or the face amount of the interest obligation? Why?


2. In determining the cost of debt, does the Department use the current yield demanded by investors on its debt or the face amount of the interest obligation? Why?

• Neither. It uses the rate it thinks the Company can get by refinancing.

• Apparently the face amount of its interest obligation, which is 3.61%, is expected to be reduced to 3.45% with low cost new debt issues. - page 230

• Apparently new debt could be issued at lower rates, lowering the total cost of debt.


3.What rate of return is used to calculate a cost of equity capital, some historic figure or current costs of equity?


3. What rate of return is used to calculate a cost of equity capital, some historic figure or current costs of equity?

• “The amount which the company would have to pay in order to ‘hire’ its equity capital under current conditions.” - page 235

• Court rejects the use of a “normal” rate of 6%, in favor of the current cost. - page 233


4.What method did the Department and the witnesses appear to use in determining the cost of equity capital?


4. What method did the Department and the witnesses appear to use in determining the cost of equity capital?

• The opinion does not say what method was used.


5.The court said “the return to the equity owner should be commensurate with returns on investments in other enterprises having comparable risks.” How would you suggest identifying stocks of such companies?


5. The court said “the return to the equity owner should be commensurate with returns on investments in other enterprises having comparable risks.” How would you suggest identifying stocks of such companies?

• Use the beta of its stock, and find the cost of capital for companies with similar betas.

• Or use an unlevered beta for the company, by referring to the beta for its stock.


Hypothetical ExampleUnlevered Beta = Leveraged Beta of the company

1 + (1-tax rate for company) Percent debt / percent equity

Assume a levered beta of 1.00 for this utility.Unlevered beta = 1.00 1 + (1 - .35) (62/38)Unlevered beta = 1.00

1.65 (1.63)Unlevered beta = 1.00 = 0.37

2.69Assume risk-free rate of 5% and equity premium of 5% (market rate = 10%)

Cost of capital = Risk free rate 5.00%Equity premium x beta = 5% x .37 1.85%

• Cost of capital = 6.85%

Subordination 4-61

• Taking a claim and moving it down the priority list.

• Can be agreed by parties (subordination agreement) and will generally be recognized by the court (bankruptcy)

• Can be done by the Court for cause on grounds of equity. Recharacterise debt as equity.

Fett Roofing 4-62

• Fett ran the business as sole proprietor until incorporation in 1965.

• Fett contributed $4,914.85 capital for 25 shares, and was the sole shareholder.

• Fett was in total control of the business.

• Fett advanced funds to the corporation as the need arose over the years.

• He advanced money in 1974, 1975 & 1976 on demand notes.

• Loans were used to finance (permanent) equipment & material necessary to operate the business.

Fett Roofing 4-63

• When the business was insolvent, the company pledged its assets to secure the loans with back-dated deeds of trust.

• The Bankruptcy Judge found the business was undercapitalized from the beginning.

• In bankruptcy, it had $413,000 in secured debt, and less than $5,000 in capital stock; an 80: 1 ratio.

• Bankruptcy Judge found deeds were give to hinder, delay & defraud creditors. (The District Judge doesn’t rule on this because of subordination.)

Fett Roofing - The Law 4-64

• Insiders can make secured loans to the company, but the burden is on the insider to show good faith & inherent fairness to corporation and “those interested therein.”

• Shareholder loans to a company will be subordinated when paid-in capital is “purely nominal, the capital necessary for the scope and magnitude of the operation of the company being furnished by the stockholder as a loan.” - page 246, quoting Pepper v. Litton

• This “cast serious doubt on the advances by a person in plaintiff’s special situation being considered debt rather than equity.” - page 247

Fett Roofing - The Law 4-65

• Three Legal Tests

• Fraudulent Transfer

• Thin Capitalization

• Piercing Alter Ego

Fett Roofing Questions – 1 4-66

1. When the court says an insider such as a director, officer or majority shareholder owes a duty of fairness when lending on a secured basis to the corporation “and those interested therein,” who else is interested?



• Other Shareholders (minority)



• Other Shareholders (minority)• Creditors (affects their return of investment and they are the

effective owners in bankruptcy)


2.If the sole shareholder makes an initial secured loan to the corporation at the time of incorporation, and if the loan is disclosed to subsequent creditors doing business with the corporation, what complaint of unfairness might they have?


2. Not all creditors are informed (or able to adjust) about the insider situation even if disclosed.

• Tort Creditors• Trade Creditors• Small Creditors


3.The court states that shareholder loans to a company will be subordinated when paid-in capital is “purely nominal, the capital necessary for the scope and magnitude of the operation of the company being furnished by the stockholder as a loan.” Does this formula provide any guidance for clients? Isn’t all capital, both equity and debt, “necessary” for the scope and magnitude of the operation?


3. This is not a useful formula. It could mean all necessary capital is to be in the form of equity.

• What about a revolving working capital line like a bank would provide

– Clean down would be requried– But Clean down in this context looks more

like alter ego.– This is where lawyer judgement is

necessary


4.The court notes that the secured debt: equity ratio at the time of bankruptcy was 80:1. Is this the right time to test the ratio to determine

whether the shareholder’s loans were in fact a capital contribution rather than bona fide loan


4. Ex Post Facto Testing seems unfair as testing at the worst possible time.

In a creeping investment like this perhaps it should be broken down and tested as each new loan is made.

Consider ratios outside banks would accept as reasonable

Foreign laws often have fixed ratios for insiders and all debt (3:1)


5.The court notes that the proceeds of the loans were used to finance the acquisition of equipment and material necessary to the functioning of the business. Why should the use of proceeds be relevant to the characterization of the loans?


5. May need to distinguish equipment from materials (inventory)

• Equipment as permanent asset may imply capital is used

• Inventory implies seasonal financing often done with debt


6.Many parent - subsidiary corporations have centralized cash management programs, designed to make efficient use of the cash of the several corporations owned by a parent. In these cases, when one corporation has cash and another needs cash, a transfer is made by the parent from the cash-rich subsidiary to the cash-poor subsidiary. Book entries are made for both subsidiaries, and typically interest is charged to the receiving corporation at the rate the parent has obtained on any bank loans it may have. What precautions would you advise the parent to observe in order to avoid subordination of loans should one subsidiary sink into bankruptcy?


6. Precautions:• Documentation should be regular and careful.• Loans that start as advances might be converted into

notes if they remain unpaid for a significant period.• If the debtor corporation wishes to pledge assets to

secure loans, it should do so at the time of a loan, or of a “refinancing,” rather than later when it may be in trouble.

• Whenever pledges are entered into, the parent should determine that the subsidiary isn’t insolvent, so there are no charges of fraudulent conveyance later.

• If the loan situation keeps getting worse, you might conclude there isn’t enough permanent capital.

• Even if the business is growing, continuing loan financing might be dangerous; more permanent capital may be needed.


7.In L&M Realty Corp. v. Leo, 249 F.2d 668 (4th Cir. 1957), the Court of Appeals called attention to the fact that the stockholders thought loans would be helpful for tax purposes. Is this a sign of an intention to contribute to capital? If so, why?


7. It appears to be evidence that from the beginning the stockholders intended to contribute more capital than they paid for stock, and that they knew this capital would be necessary to conduct the business.


8.Recall the capital structure of New England Telephone & Telegraph Co. v. Department of Public Utilities, supra, where the capital structure was: long-term debt, $135 million, AT&T advances $120 million on demand notes at low interest rates, and common stock $155 million. If New England Telephone’s rates remained too low and AT&T declined to purchase new securities to refinance the demand notes, would this be grounds for subordination of AT&T’s advances to the claims of general creditors?


8.AT&T would be at risk of subordination here. Court noted the desperate need for capital to finance expansion. AT&T provided a timing advantage to getting it quickly. They risk being caught if a take out financing is not found and thus look like capital contributions.


9. Assume your client and two friends wish to incorporate a new business and minimize federal income taxes by financing with as much debt as possible. How would you advise them to structure the capital in order to avoid both subordination to other creditors and disallowance of the interest paid deduction by the Internal Revenue Service, which you can assume is a decision that will parallel that of subordination? Consider the following issues:


a. If total capital required for all eventualities currently foreseeable is $300,000, but it is expected that $150,000 of that amount is required for only part of the year, when inventories must be built up for seasonal sales, how much could they safely put up as loans?


a. $150 looks like seasonal working capital borrowing not permanent capital. To help analysis consider:

• Gathering data on ratios banks would accept of short term debt to captial

• Actually get a loan for a year or two with a bank and then refinance with shareholders (added costs and personal guarantees)

• Get proposals from banks.


b. Should each shareholder make the loans at the time of incorporation, or only as needed?


b. Should each shareholder make the loans at the time of incorporation, or only as needed?

• Issue likely in and of itself not dispositive.• Yet at outset makes it look more like

necessary permanent capital


c. Can you advise the shareholders how the loans should be structured, e.g., maturities, interest rates, pledges to secure them?


c. Find out fair market terms and try to replicate:

• Interest Rate• Clean down• Security package


d. Should each shareholder make a loan in proportion to his or her stock ownership? If not, why not? If not, how do you address their desire to be equal investors in the enterprise?


d. Proportionate lending should nto be dispositive but it is a bad fact.

Consider a lead lender advancing more each year and rotating. This puts one person at greater risk for one year at a time.


9. Real World you may get different results under subordination analysis and tax law.

Check client objective. They may not care about subordination under bankruptcy law (willing to take equity).


10. If all claims sold to investors other than management in an LBO are contractually attached to each other (“stapled”) so that each investor owns a pro rata share of each class of claim, from senior debt to common stock, what effect would this have on the risk of subordination? Should it?


10.As in 9.d this looks like a bad fact. In LBOs “promote” equity usually avoids this

issue.But Fraudulent Transfer issues still exist.


11. If all claimants hold identical stapled packages of securities, and if the LBO is highly leveraged, what will this do to the likelihood that the Internal Revenue Service will disallow some of the interest deductions and treat interest payments as dividends to stockholders?


Get a Tax Lawyers Advice When Structuring!

Factors in Distinguishing loans v. stock 4-97

• (1) intent of the parties;• (2) identity of creditors and shareholders;• (3) extent of participation in management by debt holder;• (4) ability of corporation to obtain funds from outside

sources;• (5) thinness of capital structure in relation to debt;• (6) risk involved;• (7) formal indicia of the arrangement;• (8) relative position of obligees in relation to other creditors;• (9) voting power of holder of instrument;• (10) provision for a fixed rate of interest;• (11) a contingency on the obligation to repay;• (12) source of the interest payments;• (13) presence or absence of a fixed maturity date;• (14) provision for redemption by the corporation;• (15) provision for redemption at option of holder;• (16) timing of advance with reference to organization of the

corporation.

Factors in Distinguishing loans v. stock 4-98

But the ultimate question is whether the investment constitutes risk capital entirely subject to the fortunes of the corporation or a strict debtor-creditor relationship (recognizing that all loans have some risk).

Credit Lyonnais Bank Facts 4-99

• Giancarlo Paretti (with his wife Maria Cecconi) and friend Yoram Globus, controlled Pathe Communications Co. (“PCC”).

• PCC borrowed funds from the Bank for an LBO of MGM-Pathe Communications Co. (“MGM”).

• But MGM lacked sufficient working capital & was unable to pay off its $186 million working capital liability, so the Bank wasn’t obligated to fund a new $125 million working capital loan.

• Result: Creditors filed Chapter 7 bankruptcy proceedings within 5 months of the LBO.

• Solution: Paretti agreed to resign as CEO of MGM, to be replaced by Ladd & others nominated by Bank.


• Ladd & Kanter would serve as Executive Committee with full operating authority.

• Corporate Governance Agreement formalized this, with a Voting Trust Agreement that gave the Bank full power to vote controlling stock in both PCC and MGM.

• Paretti sought to subvert the Corporate Governance Agreement:

• He insisted employees report to him as well as to Ladd & Meeker, Ladd’s COO.


• June 14 - Paretti, Cecconi & Globus met as Board (without a quorum):

• They disapproved of Ladd’s nominees for various positions, and

• authorized Paretti to cause PCC to sell property to MGM over Ladd’s objections.

• Paretti then flew to Paris and informed Bank that the Corporate Governance Agreement was invalid.

• The Bank broke the escrow holding the Voting Trust Agreement, registered it with MGM and caused PCC’s shares to be transferred to it as Voting Trustee.


• The Bank then voted its shares to remove Paretti, Globus & Cecconi as directors & replace them.

Credit Lyonnais Bank Legal Issues 4-103

• Did Paretti violate Corporate Governance Agreement?


• Did Paretti violate Corporate Governance Agreement?

• Yes, by breach of Covenant of Good Faith and Fair Dealing by trying to deprive Bank of benefit of the bargain.

• (Interesting Public Policy issues in the foreign corrupt practice act and SEC order)


• Did Bank nominated directors breach their fiduciary duties by acting in the interest of the bank as opposed to the controlling shareholder?


• Did Bank nominated directors breach their fiduciary duties by acting in the interest of the bank as opposed to the controlling shareholder?

• Opinion acknowledges a conflict between Paretti and Bank.

• What are Fiduciary Duties of Directors?


• What are Fiduciary Duties of Directors?• See Corporations Class – Care and Loyalty• But to whom are they owed?


• What are Fiduciary Duties of Directors?• See Corporations Class – Care and Loyalty• But to whom are they owed?• Classic formulation “to the corporation and its

shareholders.”


• What are Fiduciary Duties of Directors?• See Corporations Class – Care and Loyalty• But to whom are they owed?• Classic formulation “to the corporation and its

shareholders.”• In normal circumstances court interprets the

phrase to mean the shareholders.


• Chancellor Allen holds that• “At least where a corporation is operating in the

vicinity of insolvency, a board of directors is not merely the agent of the residue risk bearers [i.e. shareholders], but owes its duty to the corporate enterprise [what is that?].”


• Chancellor Allen holds that• “At least where a corporation is operating in the

vicinity of insolvency, a board of directors is not merely the agent of the residue risk bearers [i.e. shareholders], but owes its duty to the corporate enterprise [what is that?].”

• Obligation is to “the community of interest that sustained the corporation [debt, equity, employees?], to exercise judgment in an informed [duty of care], good faith [loyalty] effort to maximize the corporation’s long-term wealth creating capacity [what is that?].”


• What is the vicinity of insolvency and what are the duties?

• Foreign laws are a little more precise– UK unlawful trading– Germany duties to the corporation not

shareholders.

Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Co. – Footnote 55 Example of a conflict 4- 113

• Outcome Value x Probability Expected To To Value Creditors Shareholders

• Affirmance $51 x .25 $12.75 $12 x .25 = $3 $39 x .25 = 9.75• Modification $4 x .7 $2.8 $4 x .7 = $2.8 0 x .7 = 0• Reversal 0 x .05 0 0 0 0 0

Expected value $15.55 $5.8 $9.75

Credit Lyonnais Bank Nederland, N.V. – 1 4-114

• 1. An electric utility that generates power at wholesale and sells it under long-term supply contracts to consumer utilities at a price related to market prices for wholesale electricity had entered into a long-term requirements contract for coal to fuel its generators. The price is fixed, at a price that seemed favorable when the utility signed it. Since that time, however, the price of natural gas, a substitute fuel for electric generation, has fallen, forcing the market price of coal down. With that downward shift, the measuring wholesale price for electricity that the company receives has declined. The company now loses money on all its power sales, and if the wholesale price remains low, the company will lose money for the balance of the term of its requirements contracts - the next 15 years. While its assets are currently in excess of its liabilities, and its current net worth is substantial, it seems probable that within the next ten years it will exhaust its net worth with operating losses. Is the company currently in the vicinity of insolvency? What advice would you give to the board if it is considering payment of a dividend? See Del. G.C.L. §§ 170, 173,174 and Rev. Model Bus. Corp. Act §§ 6.40 & 8.33.


1. Is the company currently in the vicinity of insolvency?

• Two definitions:• Equity – pay debts as they come due• Balance Sheet or Bankruptcy – Liabilities

exceed assets


1. Is the company currently in the vicinity of insolvency?

• Two definitions:• Equity – Not yet; at some point in the 10 years

if wholesale prices remain low• Balance Sheet or Bankruptcy – Difficulties.

Future losses if 100% certain would make it insolvent now [but what if NPV those losses? Maybe later.] What is the probability of wholesale price increase? Chance of vicinity of Insolvency


1. What advice would you give to the board if it is considering payment of a dividend?

More detail in later chapter but in general:

Del. G.C.L. Secs. 170, 173 & 174 4-118

• § 170. Dividends; Payment; Wasting Asset Corporations (a) The directors of every corporation, subject to any restrictions contained in its certificate of incorporation, may declare and pay dividends upon the shares of its capital stock ... either (1) out of its surplus, as defined in and computed in accordance with sections 154 and 244 of this title, or (2) in case there shall be no such surplus, out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. * * *

• § 173. Declaration and payment of dividends No corporation shall pay dividends except in accordance with this chapter. Dividends may be paid in cash, in property, or in shares of the corporation's capital stock. * * *

• § 174. Liability of directors for unlawful payment of dividend or unlawful stock purchase or redemption; exoneration from liability; contribution among directors; subrogation (a) In case of any willful or negligent violation of § 160 or 173 of this title, the directors under whose administration the same may happen shall be jointly and severally liable, at any time within 6 years after paying such unlawful dividend or after such unlawful stock purchase or redemption, to the corporation, and to its creditors in the event of its dissolution or insolvency, to the full amount of the dividend unlawfully paid, or to the full amount unlawfully paid for the purchase or redemption of the corporation's stock, with interest from the time such liability accrued. * * *

Rev. Model Bus. Corp. Act §§ 6.40 & 8.33 4-119

• § 6.40. Distributions to shareholders • (a) A board of directors may authorize and the corporation may make

distributions to its shareholders subject to restriction by the articles of incorporation and the limitation in subsection (c).

» * * *• (c) No distribution may be made if, after giving it effect: • (1) The corporation would not be able to pay its debts as they

become due in the usual course of business; or • (2) The corporation's total assets would be less than the sum of

its total liabilities plus (unless the articles of incorporation permit otherwise) the amount that would be needed, if the corporation were to be dissolved at the time of the distribution, to satisfy the preferential rights upon dissolution of shareholders whose preferential rights are superior to those receiving the distribution. * * *

• § 8.33. Liability for unlawful distributions • (a) A director who votes for or assents to a distribution made in excess

of what may be authorized and made pursuant to section 6.40(a) or 14.09(a) is personally liable to the corporation for the amount of the distribution that exceeds what could have been distributed without violating section 6.40(a) or 14.09(a) if the party asserting liability establishes that when taking the action the director did not comply with section 8.30. * * *

Credit Lyonnaise Bank – 2 4-120

1. Given personal liability be conservative about paying dividends!


• 2. Your client is a company that once produced products that contained asbestos. While it stopped using asbestos as an ingredient many years ago, in recent years a number of plaintiffs have brought suit alleging that the company’s products caused them injury. The incubation period on asbestos-related injury, particularly mesothelioma and lung cancer, is often 25 to 40 years. At the moment there are only a few hundred suits, but the numbers are growing rapidly. Nationally there are over 600,000 suits pending against other companies. A substantial number of defendant companies have already been forced into bankruptcy. Is the company currently in the vicinity of bankruptcy? The board of directors would like to engage in a spin-off, in which it would place an important segment of its business in a separate subsidiary, and then declare a dividend of the subsidiary’s stock to the company’s shareholders. What advice would you give the board?


• 2. This is the same question. Can they declare a dividend?

• It depends on the value of the contingent asbestos liabilities.


• 2. Look at the disclosures of contingent asbestos liabilities by Owens-Illinois in Appendix 2-A (pages 54-56).

• Note the last sentence – despite growing numbers of asbestos claims and a prediction that it will have to set aside more funds for them:

• “...based on all the factors and matters relating to the Company’s asbestos-related lawsuits and claims, the Company presently believes that the ultimate resolution of its asbestos-related costs and liabilities will not have a material effect on the Company’s financial condition.”


• 2. Last sentence is a judgment call – the same judgment your board has to make in deciding on the spin-off?

• What help can lawyers give other than quoting the law and saying you are liable if you get it wrong ?

Directors’ Liability When Relying on Experts 4-125

• Del. §141(e):• (e) A member of the board of directors, or a member of any

committee designated by the board of directors, shall, in the performance of such member’s duties, be fully protected in relying in good faith upon the records of the corporation and upon such information, opinions, reports or statements presented to the corporation by any of the corporation’s officers or employees, or committees of the board of directors, or by any other person as to matters the member reasonably believes are within such other person’s professional or expert competence and who have been selected with reasonable care by or on behalf of the corporation.

• RMBCA §8.30(e):• (e) A director is entitled to rely, in accordance with subsection

(c) or (d), on: * * *• (2) legal counsel, public accountants, or other persons retained

by the corporation as to matters involving skills or expertise the director reasonably believes are matters within the particular person’s professional or expert competence or (ii) as to which the particular person merits confidence; * * *


2. What help can lawyers give other than quoting the law and saying you are liable if you get it wrong ?

If reasonable can assist in defending that decision was not negligent or willful under DGCL.

But is a lawyer an expert on predicting rate of cases of this disease int eh future?

Creditor Liability 4-127

• Opposite of Credit Lyonaise Duties case.

• Equivalent to piercing corporate veil for shareholders.

• Still a vague standard.

• “total control” “dominance” as opposed to “active management”

Creditor Liability 4-128

Capital Structure

Investor A Debt $1,000,000 at 15% coupon

Investor B Equity $100

Expected profits of $150K a year

Investor A gets contractual right to elect 4 of the 5 directors

Full debt covenants package

Board never meets just rubber stamps by written consent decisions of Investor A

Krivo Industrial Supply Co. v. Nat’l Distillers 4-129

• Corporate entities are disregarded where they are “misused.”

• There are two ways to become liable for the debts of a corporation:

• (1) Express or implied assumption of the debts;

• (2) Dominating a corporation for your own purposes.

• Two theories of liability:• (1) The “identity” theory where both separate

entities are disregarded & treated as one.• (2) The “instrumentality” theory (which

includes “agent, adjunct, branch, dummy, department or tool” of the dominant corporation.


• Alabama has adopted “instrumentality” theory, which requires:

• (1) Control of the subservient corporation,

• (2) The misuse of which control proximately caused harm to plaintiff.

• Stock ownership is neither critical nor dispositive on its own.

• Lack of stock ownership doesn’t preclude a finding of dominance and control.


• Suit by 10 creditors of Brad’s Machine Products sue National on Brad’s debts.

• Bradford & wife owned all stock of Brad’s Machine Products, a Calif. machine shop w/25 employees.

• Brad’s was a mini-conglomerate, owning:• Brad’s got a government contract in 1966 to make fuses from

brass.• Brad’s moved to Alabama and expanded to 500 employees.• Brad’s bought brass from Bridgeport Brass, a division of

National Distillers.• March 1969:• Bridgeport is shipping $400,000 - $500,000 of brass rod

monthly to Brad’s.• Brad’s was in arrears by $1,000,000.• Bridgeport agreed to take note for arrears - $40,000

monthly payments, plus a balloon payment for the balance in one year, unless Brad’s got its government contract extended.


• July 1969: Arrears increased by another $630,000• Aug. 1, 1969: New deal:• If National provides new $600,000 working

capital and reassures the federal government about financing, Bradford will pledge all company & personal assets.

• “National Distillers agreed that any income or proceeds from these unassigned assets would be used for certain designated purposes in aid of Brad’s other creditors and then either would revert to Brad’s or would belong to National Distillers outright.” - page 265

• National was to provide internal financial management assistance to eliminate waste;


• National was to defer existing arrearages of $630,000;• National agreed to help Brad’s liquidate unprofitable

holdings to provide more capital.• Rudd, a National internal auditor, moved to Brad’s to

oversee finances & establish control procedures for managing cash and investments.

• Rudd monitored cash - no purchase orders to be issued without his approval (not always observed in practice);

• Rudd didn’t interfere in normal business matters; he only objected to expenditures that were unrelated to the machine shop business.

• His co-signature required on all checks.• Salisbury, a National lawyer, assigned one of his

assistants to help him and Brad’s dispose of assets.


•Facts not enough to prove dominance under instrumentality doctrine.

Krivo Industrial Supply Co. v. Nat’l Distillers – 1 4-135

1.Why does Bridgeport Brass keep shipping brass to Brad’s on open account?


• Opinion does not say

• The sales managers probably made the initial decision and wanted to keep selling (and collecting commission) because Brad’s is a high-volume customer, and this allows the sales manager to meet quotas.


• Remember accounting rules from Chapter 2

• As long as Brad’s isn’t so far gone that Bridgeport Brass has to write off these accounts as uncollectible, it can report them as completed sales, taking only its normal allowance for doubtful accounts, and show increased sales and profits.

• At some point this accounting may become misleading. This is why auditors will loko at A/R aging.


2.While the court does not reach the question of whether dominating a corporation so it becomes a mere “instrumentality” proximately caused injury to plaintiffs, what kinds of injury can you imagine would persuade a court that dominance caused injury?


2. Typical Examples• Some form of fraudulent conveyance or voidable

preference - favoring the dominant corporation as creditor. (Sea-Land Services, Inc. v. Pepper Source, 941 F.2d 519 (7th Cir. 1991) (sole shareholder caused debtor corporation to pay his personal expenses)

• The dominant corporation misleads other creditors into thinking they can deal safely with the subservient corporation. (A. Gay Jenson Farms Co. v. Cargill, Inc., 309 N.W.2d 285 (Minn. 1981) (dominant corporation reassured prospective creditors that there would be no problem with payment).


2. Typical Examples• Dominant corporation may deceive third

parties into thinking that they are dealing with the dominant corporation, or that the dominant corporation is monitoring or vouching for the servient company. In re Silicone Gel Breast Implants Products Liability Litigation, 887 F. Supp. 1447 (N.D. Ala. 1995) (Bristol-Myers Squibb’s name and logo were on subservient corporation’s packaging, and BMS issued press releases about its research into product safety).


3. As part of the August 1, 1969 deal, Brad’s pledged its plant and equipment to National Distillers, thus giving National a priority over general creditors. Why wouldn’t a court focus

on this as inequitable conduct that constituted an abuse of National’s dominance of Brad’s?


• National was still dealing at arm’s length - it hadn’t even obtained the management influence yet (that was part of the same deal).

• Granting of the Security was likely not a fraudulent transfer

Uniform Fraudulent Transfer Act, § 4(a) 4-143

• § 4. Transfers Fraudulent as to Present and Future Creditors

• (a) A transfer made or obligation incurred by a debtor is fraudulent as to a creditor, whether the creditor’s claim arose before or after the transfer was made or the obligation was incurred, if the debtor made the transfer or incurred the obligation:

• (1) with actual intent to hinder, delay, or defraud any creditor of the debtor; or

• (2) without receiving a reasonably equivalent value in exchange for the transfer or obligation, and the debtor:

• (i) was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or

• (ii) intended to incur, or believe or reasonably should have believed that he [or she] would incur, debts beyond his [or her] ability to pay as they became due.


4. Note that part of the August 1, 1969 agreement provided that “National Distillers agreed that any income or proceeds from these unassigned assets would be used for certain designated purposes in aid of Brad’s other creditors and then either would revert to Brad’s or would belong to National Distillers outright.” (emphasis supplied) If National sells assets of Brad’s that aren’t pledged to it, and retains the proceeds, what kind of claim might other creditors of Brad’s make?


4. Does this sound like a fraudulent conveyance of assets without fair consideration?


4. Does this sound like a fraudulent conveyance of assets without fair consideration?

• Probably not, because it was part of the Aug. 1 deal in which National extended new credit. [that is when the transfer occurred not on sale of the assets]

• And in any event all “proceeds were returned to Brad’s to provide working capital.”


5. If you represented National Distillers in the August 1, 1969 negotiations, exactly what would your goals be in committing to “provide internal financial management assistance to help Brad’s eliminate costly waste”? In order to avoid potential charges of domination of the debtor sufficient to make it a mere instrumentality, what would you like the agreement to provide in this area?


• Goal: That all the powers of Rudd will be negative powers. “Rudd’s power s were essentially negative in character.” - page 267

• That Rudd can advise about changes, but cannot control them and the matters about which he can advice are not infinite. - The court states that Rudd’s activities “were narrowly restricted to safeguarding its interests as a major creditor . . .” - page 267


6. What does the court think that National’s credit manager, Zimmerman, meant when he said that National could fire Bradford adn “had the power, authority to fire Bradford and run him off”? [question is referring to statement on p. 266 final paragraph which is not as the question implies an exact quote.]


6. Only that by controlling further advances and credit sales, National could put Brad’s out of business and into bankruptcy at any time.

This is the problem clients can cause by not using precise language and by exaggerating!


7. Would it have mattered if the August 1, 1966 agreement had given National Distillers the power “to fire Bradford and run him off”?


7. This fact in and of itself is likely not enough to show total domination of Brad’s

And for this court at least it would not matter if National never actually exercised this right.


• 8. The court notes that Rudd’s powers “were essentially negative in character.” Why would this matter if he had a veto power over all purchase orders and all checks? Isn’t the veto power the substantial equivalent of the power to make affirmative decisions?


8. Because these appear to be merely the power to prevent waste that would hurt National (and others) as creditors not to benefit National.

Note that if negative control is too great it might turn into positive control or if actually used to “blackmail” for benefits.


9. Suppose you represent a bank that propose to lend to a corporation already in some financial difficulty. The bank proposes to lend by obtaining a security interest in the debtor’s accounts receivable. Each day the debtor will report its sales and deliver a form of assignment of the account to the bank, giving the bank the right to collect the account. As customers pay their bills, the borrower deposits the funds into a specialized “lock-box” account under the bank’s control, which the bank can use to reduce the size of the loan. New sales by the debtor increase the amount the debtor can borrow, by as much as 80% of the face amount of the account. Does this arrangement give the bank life and death control over the debtor? Should you worry that this is a form of dominance?


9. The debtor has already received a loan against the account when the sale occurred. “equivalent value”

• So this is no different than any other form of secured financing – when the asset is sold, the collateral disappears and the debtor must pay up.


10. Rudd, who had to approve all purchase orders and had the power to veto checks by refusing to co-sign, apparently allowed Brad’s to purchase a home, a Mercedes and racing boats for Bradford. Why does the court reject the argument that this is an abuse of Brad’s corporation in which National Distillers was complicit?


10. The court concludes that Rudd never really had power over Bradford.

• This is odd, since he had power over the checkbook.

• But it is clear Rudd did not exercise that power, and the exercise of dominant power is the key, not possession of latent power.

• Note this does not mean Bradford or other officers authorizing this have not breached their duties. Rudd had no duty to stop them.

Documents

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