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 = corp’s 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 issued
and 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 don’t
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
 • 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: doesn’t specify what happens to the rest if there is more than
3M  doesn’t 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 B
no 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
 ○ 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 doesn’t 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
 It’s 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:
 ○ If company wants to issue preferred
stock to raise capital; enables BoD
flexibility to do this  generally SH
rights advocates don’t have big problem
with that b/c preferred stock raised for
capital raising purpose are very much
like bonds
○ Most companies traded don’t have
preferred stock – b/c preferred stock is
WEIRD; are used as an element of anti-
takeover device; don’t 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.
• 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 + accrued
and 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 the
Preferred 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
  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 of
shares 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???? Shouldn’t 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 to
purchase 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 or
declared 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
  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 Company’s 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 can’t 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:
○ What’s the difference between “paid” and “declared and provided for”? (7(c))
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 don’t HAVE to pay dividends on PS but paying
these dividends is a condition for paying dividends on the Common Stock
d. If Company doesn’t pay dividends on Preferred Stock  Can’t pay dividends on
Common Stock either

2. T will receive $3.07/4 * 1M each 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 = company’s assets after all the
company’s 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 = ¼ of total CS issued and outstanding
Net Assets Hold on to PS Convert to CS
10M 10M 2.5M
25M 25M 6.25M
50M 25M 12.5M
100M 25M 25M
150M 25M 37.5M
200M 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
 a.No more assets or liabilities
b.First take: stock splits don’t 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 < ¼ of the total
e.Section 6(C)(i):
i. Time lag – between when event happens and when ppl participate  but this
doesn’t 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 = ¼ 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 outstanding
a. 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 isn’t 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 [newly
purchased 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
 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 CS
issued 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. T’s proportion = 1.82M/7.82M
vi.= 1/4.314 (~one quarter T would have had prior to
warrant)
vii.215M * ¼.314 = 49.8M  about 50 M, like before
viii.* note* Net assets of company remain at 215M b/c
converting PS to CS doesn’t 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
  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: won’t pay any dividends
○ Int’l: 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 don’t 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 Desig’s 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 wasn’t 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 it’s doing is because after distribution of the dividend the
preferred holders will be in a position to convert and control a majority of Host’s
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.
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 M’s actions as coercion.
Court says coercion was not involved and that this is essentially
a contract action, as the case involves the construction of the
rights 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 by
charter, bylaws or statute, but those cases were based
on existence of fiduciary duty of directors with respect to
transaction under review
ii. This is not a fiduciary duty case though, but one of
construction of rights and duties set forth in the
certificate of designation
iii.The PSH’s protections against suspension of
dividends lie in the charter, and are several:
1. Cumulative dividends
2. Liquidation preference
3. Redemption price adjusted to reflect accrued
unpaid dividends
4. If prolonged suspension of dividends get right to
elect 2 directors
5. Conversion right
6. Restriction on the proportion of net worth that
may be distributed
a. This restriction is inherent in the formula
used to revise the conversion ratio:
formula doesn’t work if you give so
much away that new net worth is less
than PS’s share of net worth before the
dividend
iv.These provisions are a recognition of
1. The risk that dividends might not be paid.
2. The correlative right of directors to discontinue
dividends
b. 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 faith
that commercial contractor’s are entitled to expect
2. Court: More important claim is based on Charter Section 5(e)(iv) when
the assets of the firm are depleted through a special distribution to SH’s,
the preferred will be protected by the triggering of a conversion price
adjustment formula.
a. The # of shares into which the preferred can convert will be
proportionately increased in order to maintain the value of the
preferred’s conversion feature.
b. In a narrow range of extreme cases, the provision will not work to
preserve the pre-dividend value of the preferred’s conversion
right. (see examples on p. 24-25)
c. If this case fell within that narrow range, Marriot could be
prevented from declaring dividends of a proportion that would
 deprive the PSH of the protection this section was intended to
afford, which would violate the rights of the PSH created by the
certificate of designation’s conversion feature. But this is not one
of those cases.
d. Rule: If, when declared, the dividend will leave the
corporation with sufficient assets to preserve the
conversion value that the PSH possesses at that time, it
satisfies the limitation that such a protective provision
implies
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 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 doesn’t work if you give so much
away that new net worth is less than PS’s share of net worth
before 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
 • Cap on how high PS will go once it becomes redeemable
• Redemption = forced repurchase of the shares; repurchase can also be on the market

Cont’d 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 don’t 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 couldn’t 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 Big’s shares less attractive, and forces
PSHs to convert
○ Court’s 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?
• Isn’t 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, that’s 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 delisting
case)
○ 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, that’s 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 didn’t 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
 ○ 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
 Let’s say, in the past, no company has spun off such a
huge profit-making part of its operations, so PSHs didn’t
anticipate 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 wouldn’t 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 what’s the proper structure of
the remedy?
○ Ideally, want parties to provide for it; judge doesn’t 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 don’t 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
isn’t 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, don’t get it
• In this part of the opinion:
 ○ Student: K tells us what to do, but if Conversion Rate becomes
negative, then can’t 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 conversion
rate negative)
○ When court says “the formula doesn’t work” court doesn’t
mean formula becomes negative – means that you can’t 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 doesn’t work in that you don’t get stock
with a sufficient value; but IN FACT, it will still be
implementable
• CAN execute the formula  just that result that
we get won’t 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 company’s financial condition
○ Two columns – one year beforehand, year end (compare the two)
○ Three segments
 Assets: what co owns
 Liabilities: what co owes
 SHs equity: what’s 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
 ○  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 rec’d 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 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)
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 or affirmative reqs on the way the
company 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 doesn’t 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 isn’t 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
○ Won’t talk more about this: limited exceptions all listed in the
Bankruptcy Code
○ Equitable subordination – will discuss later
• Secured debt and subordination
○ Secured debt 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)
  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 secured
creditors. 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: doesn’t involve any assets ( no collateral)
○ Involves deal between two types of creditors
 Subordinated creditors
• Subordinated say to the senior: if the company
doesn’t 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 doesn’t get paid in full even
when subord hands all over  that’s 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
didn’t exist
•  Get pro rata distribution
○ How do you figure out how 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
  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
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: won’t pay any dividends
○ Int’l: 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 don’t 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 Desig’s 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 wasn’t 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 it’s doing is because after distribution of the dividend the
preferred holders will be in a position to convert and control a majority of Host’s
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.
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 M’s actions as coercion.
Court says coercion was not involved and that this is essentially
a contract action, as the case involves the construction of the
rights 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 by
charter, bylaws or statute, but those cases were based
on existence of fiduciary duty of directors with respect to
transaction under review
ii. This is not a fiduciary duty case though, but one of
construction of rights and duties set forth in the
certificate of designation
iii.The PSH’s protections against suspension of
dividends lie in the charter, and are several:
1. Cumulative dividends
2. Liquidation preference
3. Redemption price adjusted to reflect accrued
unpaid dividends
4. If prolonged suspension of dividends get right to
elect 2 directors
5. Conversion right
6. Restriction on the proportion of net worth that
may be distributed
a. This restriction is inherent in the formula
used to revise the conversion ratio:
formula doesn’t work if you give so
much away that new net worth is less
than PS’s share of net worth before the
dividend
 iv.These provisions are a recognition of
1. The risk that dividends might not be paid.
2. The correlative right of directors to discontinue
dividends
b. 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 faith
that commercial contractor’s are entitled to expect
2. Court: More important claim is based on Charter Section 5(e)(iv) when
the assets of the firm are depleted through a special distribution to SH’s,
the preferred will be protected by the triggering of a conversion price
adjustment formula.
a. The # of shares into which the preferred can convert will be
proportionately increased in order to maintain the value of the
preferred’s conversion feature.
b. In a narrow range of extreme cases, the provision will not work to
preserve the pre-dividend value of the preferred’s conversion
right. (see examples on p. 24-25)
c. If this case fell within that narrow range, Marriot could be
prevented from declaring dividends of a proportion that would
deprive the PSH of the protection this section was intended to
afford, which would violate the rights of the PSH created by the
certificate of designation’s conversion feature. But this is not one
of those cases.
d. Rule: If, when declared, the dividend will leave the
corporation with sufficient assets to preserve the
conversion value that the PSH possesses at that time, it
satisfies the limitation that such a protective provision
implies
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 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 doesn’t work if you give so much
away that new net worth is less than PS’s share of net worth
before 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.

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 rec’d 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 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)
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 or affirmative reqs on the way the
company 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 doesn’t 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 isn’t 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
○ Won’t talk more about this: limited exceptions all listed in the
Bankruptcy Code
○ Equitable subordination – will discuss later
• Secured debt and subordination
○ Secured debt 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)
  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 secured
creditors. 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: doesn’t involve any assets ( no collateral)
○ Involves deal between two types of creditors
 Subordinated creditors
• Subordinated say to the senior: if the company
doesn’t 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 doesn’t get paid in full even
when subord hands all over  that’s 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
didn’t exist
•  Get pro rata distribution
○ How do you figure out how 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
  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:
 • 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
○ Let’s say, this project involves a 100 units of risk
 When we have all equity capital structure: for each 1000 dollar inv’t  1 unit of
risk
 Mixed structure:
• Debt: for each 1000 dollar inv’t  0 risk (always gets 5000 in each case)
• Equity: for each 1000 dollar inv’t  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
 ○ 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 doesn’t 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
• Rich’s 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 what’s 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
• 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 rec’d 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 won’t get claimed  big deal. Don’t 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?
○ It’s 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 doesn’t get profits, only suffers!
○ Even with incentives issue, still can’t 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