Chapter 8Financial Structure of the Corporation

Chapter 8Financial Structure of the Corporation

Outline

(last updated 19 Sep 06)

Chapter 8Financial Structure of the Corporation

Corporate Securities
Introduction
Equity Securities
Common stock
Preferred stock
Debt securities
options
Corporate Capital Structure
In general
tax consideration
leverage and the allocation of risk
options and capital structure

Equity – Linked Investors, L.P. v. Adams

Regulation of Legal Capital

1.A concise history of legal capital and par value

legal opinion
(1) "validly issued"
(2) "fully paid and non-assessable"
type of consideration
director liability

2.The issuance of stock and stockholders’ liability

Legal capital under a traditional regime
Legal capital under the revised Model Act
Dividends and other distributions
The rationale for regulating distributions to shareholders
The traditional approach to regulating distributions to shareholders
legal capital rules
assets > liabilities + dissolution preference
when measure? debt payments to SHs
Klang v. Smith’s Food & Drug Centers, Inc.
Protection against excessive distributions under the Model Act
equity insolvency rules
Stock Dividends
Liability for unlawful distributions

Corporate Dividend Policy: Legal and Economic Issues

Dodge v. Ford Motor Co.: dividends in the close corporation
Kamin v. American Express Co.: dividends in the public corporation

Class Notes

A. Corporate Securities
Capitalizinga business
Michael, Jessica and Bernie agree to buy Precision Tools, Inc from Stern and Starr for $2,000,000. Here are the sources of financing and what each source gets in return:
Michael - manager
salary + growth potential / $100,000 cash
$100,000 note / 40% common
Jessica - bookkeeper
salary + growth potential / $200,000 cash / 40% common
Bernie - financier
assured return
growth potential / $600,000 cash / 20% common
$500,000 note (10%)
OR
preferred stock (10%)
Columbia National Bank
assured return / $500,000 cash / $500,000 10-yr note (12% interest / $100,000 principal - years 6-10)
Stern & Starr (sellers)
good price
assured return / $750,000 seller financing / $750,000 10-yr note (12% interest / accelerated upon default)
TOTAL / $1,250,000 cash
$750,000 seller financing / 100% common
$500,000 preferred stock OR inside debt
$1,250,000 outside debt
Trade-offs (return and risk):

What are the rights of --
common shareholders?
preferred shareholders
debt holders?
Why did Stern and Starr not take all cash?
why didn't they take common? why not all preferred/debt?
why not take preferred? compare participating / cumulative / redeemable preferred
what happens if not paid - debt is like "owner"?
Why didn't Bernie want to take all common shares?
how does debt protect him?
compare debt and preferred - why is debt better? too much at beginning?
could preferred have voting rights?
why might Jessica and Bernie prefer that he take preferred?
Why didn't CNB --
take common?
preferred? won't participating, redeemable, cumulative preferred be better than debt?
what other protections will it want?
Jessica and Bernie
why accept that Bernie not pay all up front?
why not make it all debt? tax advantages? assured repayments?

B. Corporate Capital Structure
Leverage:
Assume that Michael, Jessica and Bernie are considering two capital structures. First, under an "All Equity" capital structure they put in $1,000,000 of their own money. Second, under a "Leveraged" structure, they put in $200,000 and borrow the remaining $800,000 at 10% annual interest from CNB (Bernie is a friend of the bank president). Why is the second called "leveraged financing" - here's why.
Good results
All Equity
(no leverage) / Debt-Equity (80-20)
Operating income / $200,000 / $200,000
Interest / ---- / $80,000
Net income (dividends) / $200,000 / $120,000
Return on investment / 20% / 60% (hurray)
Weak results
All Equity
(no leverage) / Debt-Equity (80-20)
Operating income / $100,000 / $100,000
Interest / ---- / $80,000
Net income (dividends) / $100,000 / $20,000
Return on investment / 10% / 10%
Bad results
All Equity
(no leverage) / Debt-Equity (80-20)
Operating income / $40,000 / $40,000
Interest / ---- / $80,000
Net income (dividends) / $40,000 / ($40,000)
Return on investment / + 4% / - 20% (ouch)
Tax advantage of debt
Assume the same capital structures, but this time assume that Michael, Jessica and Bernie are considering how to allocate their $1,000,000 investment: 100% equity OR 20% equity and 80% debt.
All Equity
(no leverage) / Debt-Equity (80-20)
Operating income / $200,000 / $200,000
Interest / ---- / $80,000
Income before tax / $200,000 / $120,000
Corporate tax
(15% tax rate) / $30,000 / $18,000
Net income
(pay dividends) / $170,000 / $102,000
Total return to investors (interest + dividends) / $170,000 / $182,000
Return on investment / 17% / 18.2%

Why not make it 1% equity and 99% debt? if the company can't meet its debt obligations, they'd just forgive it

C. Regulation of Legal Capital
"Validly issued, fully paid and non-assessable"

Validly issued - where do you look?
Fully paid - how much must be paid? What consideration is valid?
Non-assessable - what is par value?

Precision Tools Corporation
Balance Sheet
(3 years after acquisition)
Assets
Cash / $ 200
Accts receivable / $1,400
Inventories / $1,300
Prepaid expenses / $ 600
Total current assets / $3,500
FIxed assets
Land / $ 600
Buildings / $1,700
Machinery / $1,000
Total PP&E / $3,300
Notes receivable / $ 100
Goodwill / $ 100
Total Assets / $7,000
/ Liabilities & Equity
Current liabilities / $2,650
Long-term liabilities
Note (old one) / $2,000
Note (sellers) / $ 750
Note (bank) / $ 500
Debentures (Bernie) / $ 500
Total liabilities / $6,400
Common stock (5000 shs) / $ 500
Retained earnings / $ 100
Total equity / $ 600
Total Liabilities & Equity / $7,000
Issuance of shares

must corporate shares have par value?
What if the par value had been set at $1.00 and shares are sold to Michael, Jessica and Bernie for $100.00 per share?
if the company issues no-par stock must he board do anything more?

Consideration for shares

can PTC accept Michael's note for $100,000 as payment for 1,000 shares?
Does the question of validity of consideration depend on whether stock is par or no-par?
instead of a note could Michael give his promise to work for the next five ears?

Delaware
Del GCL § 152
The consideration ... for ... the purchase of capital stock ... shall be paid in such form and such manner as the board of directors shall determine. In the absence of actual fraud in the transaction, the judgment of the directors as to the value of such consideration shall be conclusive.
... The capital stock to be issued shall be deemed to be fully paid and non-assessable stock, if
(1) the entire amount of such consideration has been received by the corporation in form of cash, services rendered, personal property, real property, leases of real property or a combination thereof ....
/ MBCA (North Carolina)
NC Bus Corp Act § 55-6-21 Issuance of shares.
(b) The board of directors may authorize shares to be issued for consideration consisting of any tangible or intangible property or benefit to the corporation, including cash, promissory notes, services performed, contracts for services to be performed, or other securities of the corporation.
(c) Before the corporation issues shares, the board of directors must determine that the consideration received or to be received for shares to be issued is adequate. The determination by the board of directors as to the adequacy of consideration is conclusive as to whether the shares are validly issued, fully paid, and non-assessable.
Payment of dividends / repurchases

Assuming PTC had net profits last year of $90,000, can it pay a dividend of $200,000 cash?
Assuming PTC could borrow the money, can it buy Bernie's 1,000 shares for $500,000?
Can PTC revalue its assets to create sufficient surplus? See Klang v. Smith's Foods & Drug Centers (Del. 1997)

Delaware
Del GCL § 173
No corporation shall pay dividends except in accordance with this chapter.
Del GCL § 170
(a) The directors of every corporation ... may declare and pay dividends ... either (1) out of its surplus ..., 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.
Del GCL § 154
... The excess, if any, at any given time of the net asset of the corporation over the amount so determined to be capital shall be surplus. Net assets means the amount by which total assets exceed total liabilities.
Del GCL § 154 [paraphrased]
Capital is --
(1) "the aggregate of par value of shares issued having par value"
(2) "that part of consideration [in dollars] specified by the board to be capital, for shares issued without par value"
If the board does not specify, "the capital ... shall be ... the amount of the consideration for such shares without par value."
Del GCL § 160. Corporation's powers respecting ... redemption.
(a) Every corporation may purchase, redeem, ... or otherwise acquire its ... own shares; provided, however, that no corporation shall:
(1) Purchase or redeem its own shares of capital stock for cash or other property when the capital of the corporation is impaired or when such purchase or redemption would cause any impairment of the capital of the corporation, / MBCA (North Carolina)
MBCA § 55-6-40 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.
MBCA § 1.40. ACT DEFINITIONS
In this Act:
(6) "Distribution" means a direct or indirect transfer of money or other property (except its own shares) or incurrence ofindebtedness by a corporation to or for the benefit of its shareholders in respect of any of its shares. A distribution may be in the form of a declaration or payment of a dividend; a purchase, redemption, or other acquisition of shares; a distribution of indebtedness; or otherwise.
Liability

What if the directors to decide to pay themselves all the company's cash, accounts receivable and inventory as a "special dividend"?
If PTC pays dividends that impair capital, are the directors liable? Are the shareholders who take the dividends?
Who can bring suit?

Delaware
Del GCL § 174
In case of any wilful or negligent violation of §§ 160 [redeeming shares] or 173 [paying dividends] the directors ... shall be jointly and severally liable, at any time within 6 years after [unlawful redemption or dividend] to the corporation and to its creditors in the event of its dissolution or insolvency ....
Del GCL § 280
(a) (1) After a corporation has been dissolved in accordance with the procedures set forth in this chapter, the corporation or any successor entity may give notice of the dissolution, requiring all persons having a claim against the corporation other than a claim against the corporation in a pending action, suit or proceeding to which the corporation is a party to present their claims against the corporation in accordance with such notice.
(2) Any claim against the corporation required to be presented pursuant to this subsection is barred if a claimant who was given actual notice under this subsection does not present the claim to the dissolved corporation or successor entity by the date [stated in the notice, which shall be no earlier than 60 days from the date thereof].
/ MBCA (North Carolina)
NC BCA § 55-8-33 Liability for unlawful distributions
(a) A director who votes for or assents to a distribution made in violation of G.S. 55-6-40 ... is personally liable to the corporation for the amount of the distribution that exceeds what could have been distributed without violating G.S. 55-6-40 or the articles of incorporation if it is established that he did not perform his duties in compliance with G.S. 55-8-30. In any proceeding commenced under this section, a director has all of the defenses ordinarily available to a director.
(b) A director held liable under subsection (a) for an unlawful distribution is entitled to:
(1) Contribution from every other director who could be held liable ... and
(2) Reimbursement from each shareholder for the amount the shareholder accepted knowing the distribution was made in violation of G.S. 55-6-40 ....
(c) A proceeding under subsection (a) is barred unless it is commenced within three years after the date on which the effect of the distribution was measured under G.S. 55-6-40(e) or (g).
D. Corporate Dividend Policy: Legal and Economic Issues
Dividend policy in the close corporation
Dodge v. Ford Motor Co. (Mich 1919)

What did Ford do? Why?
Was there money to pay special dividends? What was balance sheet?
What was argument not to pay?
Why did court compel payment of dividends?

/ Balance Sheet
Assets / Liabilities / $18
Cash / $54 / Equity
Non-cash / $78 / Stated capital / $2
Surplus / $112
Total assets / $132 / Total Liabilities + Equity / $132
Dividends in the public corporation
Kamin v. American Express (NY Sup 1976)

What was effect on financial statements of
distributing DLJ stock?
selling stock and paying cash dividend to shareholders?
Wouldn't the corporation's shareholders be better off having an extra $8 cash flow (tax savings) rather than misleading stable earnings?
Will stock market be confused by lower earnings (on income statement) if company sells stock to realize tax savings?
What protections do shareholders have against such abysmally wrong decisions?

Balance Sheet (before)
Assets / Liabilities
DLJ stock $29.9
Equity
Retained Es $29.9
Balance Sheet (distribute DLJ stock)
Assets / Liabilities
DLJ stock $0
Equity
Retained Es $0
Balance Sheet (Sell DLJ stock)
Assets / Liabilities
Cash $4
DLJ stock $0 / Equity
Retained Es $4
/ Income Statement (distribute DLJ stock)
Revenues / same
Operating income / same
Capital losses / none
Taxable income / same
Taxes / same
Net income / unchanged
Income Statement (sell DLJ stock)
Revenues / same
Operating income / same
Capital losses / $25.9
Taxable income / less (by $25.9)
Taxes / less (by $8)*
Net income / lower (by $17.9)
* This lower tax bill results in corporation keeping more cash (increase in cash flows)
Control over free cash flow

According to Warren Buffet, what is "free cash flow"?
what should it be used for?
what is danger?
Why don't public companies pay more of earnings as dividends?
taxes
information asymmetries
agency costs

/ Why doesn't corporate law compel the board to declare all free cash flow as a dividend?
Or at least leave the decision to shareholders?
Restructure public company

What is the "LBO firm"?
Is it a good idea for managers to have heavy debt obligations?
Why is equity soft and debt hard?
A bit of history - Michael Jensen, KKR

Corporations: Law & Policy Page

Chapter 8 – Financial Structure of the Corporation