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Corporate Finance Outline – Mitchell – Spring 2011
I. Limited Liability’s Effect on Corporate Finance
 A. Introduction
o Our study will entail the Corporate Structure and Financing
 2 Principle Sources of Financing:
 Debt
 Retained Earnings
 Note:
o IPO/Stock financing is not a predominate means
o It may still apply with certain industries that take a while to generate Retained Earnings
[Historically seen in Railroads]
o But, modernly Retained Earnings make up much of Financing and Debt is the most
 B. The Capital Structure and conflict between the parties involved: Creditors and Stockholders
o The Creditor (Debtholder):
 Want: Their $ back, with interest
 Due to Limited Liability
 The corporation and not the shareholder is the debtor
 Assets then, barring a Pierce, are what creditor can be entitled to
 Contract
 Risks are ‘locked in’ and controlled by the contract
 Lock in their risk and return profile at the date of the loan
 More risk taken, or not taken does not benefit them in any way They have contracted for their interest
already, and added risk may be negative
 Priority
 Creditors are ‘prior’ to claim of assets at liquidation then debtor
 Hierarchy:
o Creditor
 Secured
 Senior
 Junior
o Preferred Shareholder
o Common Shareholder (Residual right to what’s left of liquidated entity)
 Secured, Junior and Senior
 Security Interest: the loan is backed by collateral, some asset of the debtor has lien
o When debtor lacks $ to repay, creditor is secured by the asset—may sell to get back $
o Prior to all other claimants
 General Creditor: An unsecured Creditor
o Senior:
 A senior unsecured creditor is prior to Junior, or subordinated creditor/debt in
hierarchy
 Note:
 If fully secured, seniority won’t be a concern, because they are prior
 But, if not fully secured, and more then 1 creditor has claim to same asset,
seniority will still be relevant
 Contract for Seniority/Subordinate status
 Convertible Debtors
 Want to be able to convert to beneficial stock price, set in K
 Assure ability to issue shares in AIC authorization and if not, require amendment to AIC
 4 Objectives of Creditor:
 Happier the more assets Corporation has
o Easier for him to recover
 Restrict Corporation from incurring new debts, so doesn’t have to share asset-pot
 Avoid assets that are already secured
 Avoid having assets leave to junior claimants (shareholders)
o The Shareholder:
 Want: (1) Appreciation of Share-price and (2) Dividend Payment and (3) Residual Rights and (4) Voting Rights
 Has calculated that he can make more by taking risk and giving up ‘priority to creditor’
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Ability to Vote:
 This does not mean that they have the ability or know-how to run a corporation
o They probably Don’t
 But, this is a check on directors…ability of SH to make sure the Directors are running corporation
in the best way they can and if SH thinks they are not, removes and puts someone they think can
do better
o That Directors are taking risk that maximizes shareholder value
 Conflict:
 Shareholders are last in line in priority at liquidation, subordinated to Creditors… but are given the
ability to vote/control the corporation
o Based on risk taken—more risk they’ve taken to give up priority but gain control
o Creditors are first in priority, and cannot vote to control
 Shareholder may get a distribution/dividend…although he is junior claimant, the creditor is losing assets
to him Creditor is losing assets to junior claimant
Preferred Shareholder
 Want: Almost identical to that of creditor Want their principle back with dividend
 Principle/Share-price is typically set at ‘liquidation preference’
 Generally Cannot Vote
 Why:
o They are prior to shareholders in hierarchy and have less risk
o Their dividend is fixed by contract
o Because of this, control and added risk doesn’t benefit them
o Get their dividend agreed to, but share price doesn’t change
 Similarity to Creditors
 Creditor By contract, legally required to be paid interest first
 Preferred Shares Dividend is not required, but if cumulative is paid before common stock dividend
o Cumulative Dividend:
 Negotiate for the accumulation of all unpaid dividends on PS
 That way, when one is declared, all PS dividends backed up must be paid
o Right of Election:
 May gain right to vote for Directors if dividend is missed
Directors:
 Generally have the best interest of the corporation in mind
As Lawyers:
 Our goal, as corporate lawyers, is to accurately deal with our positions’ Risk and return Profile
 We want to draft according to our position taken
 Articulate the risk taken and mitigated accurately into words
 C. The Creditor and the Loan Agreement: Method to Avoid Conflict
o General:
 As we see above, there is a conflict between creditors and shareholders—however, as lawyers there are ways to
draft agreements to mitigate these risks
 The Loan Agreement is a Risk Management Tool Our main concern is RISK
 It minimizes risk and articulates client’s position
o Assure we get our Principle back + Interest
o 4 Basic Attributes we want included to mange risk taken:
 Require certain information disclosed
 Asset Protection
 Asset Dissipation
 Maintenance of Business
o How to Achieve Risk Management (Oil Can problem on p. 51:
 Securitization:
 Secure the asset we are loaning—take a mortgage
 Specify in Contract, and be reasonable in what you seek for securitization
 If Project is Ongoing:
 Protect yourself throughout process
 Create loan schedule, dispersing $ intermittently (Not all at once) ensuring that it is actually being done
 Require inspection/information throughout process
 Insurance
 Covenants to require debtor to comply with all laws and regulations
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 Require notice of failure to comply
 Limit other Debts taken on by Debtor
 Risk profile is locked in…reducing added debt reduces chance that risk profile will chane to creditor’s
detriment
 “Consent Clause”
o Require consent to incur more debt
 Note:
o While general prohibitions on conduct are used, consent clauses are powerful tool
o Charge for consent
 Add BPs to loan for your consent and leverage your consent
 Avoid asset Drain by dividend
 Require consent to raise dividend
 Require consent to buy-back stock
 Avoid sale of assets
 “Consent Clause”
o Avoid a debtors sale of strong assets or illiquid that will service the loan
o Lowers your risk that proceeds will be used elsewhere
 EG:
 Consent needed if not in normal course of business, or greater then $X sale”
 Information
 Prior to Making Loan:
o Due-Diligence, Ratio Analysis, Evaluate Contract, Board Minutes
o Get Guarantee, Warranty, Covenant of Truthfulness & Accuracy
 Post-Loan:
o In Contract, include the information you want and need at the increments you desire
 EG: Engineer inspection, updates, etc…
 D. Creditor/Lender Liability
o 1. Generally:
 Limited Liability is important to Creditor
 As claimant, he is only entitled to what the corporation has and no more, barring a pierce which is unlikely
 There are instances, however, when a creditor may be liable to other creditors/claimants for the liabilities of its
debtor corporation
 Concern: When can creditor be liable for its debtor to other claimants?
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2. Liability for Corporate Debts: Instrumentality Piercing :
 Krivo Industries v. Nat’l Distillers Corp (5th Cir. 1973)
 F: Brad’s Machine Corp was in munitions business. Its supplier was Bridgport, a division of the ∆ Nat’l
Distillers. Brad’s owed Bridgport for past supply, and Bridgport eventually turned that into a note. As
business deteriorated, Bridgport (supplier) eventually gave Brad’s more and more loans. It also sent one
of its internal auditors to assist in Brad’s finances.
 R: A corporation can be liable for debts of another in 2 ways:
o Express or impliedly assuming responsibility
o Instrumentality Theory:
 When corporation misuses another corporation as a conduit for the dominant
corporation’s business, it is liable as if the debts of subservient were its
 An Equitable doctrine—put loss on party who should be responsible
 Elements:
 Dominant Must have Controlled subservient
o Total domination of subservient corporation—so that subservient has
no separate existence of its own
o Mere stock ownership or a loan to debtor is not sufficient…must be
total control
o Not mere influence
 Dominant must have proximately caused the harm (fraud or injustice)
through misuse of control
o Does not require intent to defraud
o Here:
 Auditor was not always required to approve things, ∆ may not have owned stock, and
control that existed only applied to part of Brad’s operations. It was not
Domination/Total control
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 The pressure inherent in creditor/debtor relationship not enough
 Was not Total
o Economic Argument: Arguably, suppliers don’t loan to their customers. Here, supplier did so to
keep itself afloat as Brad’s was main customer. So here, because did loan substantial $, it
showed other creditors (π) that Brad’s was ok. Furthermore, it was essentially using Brad’s as
instrumentality to keep it afloat, its sole purpose. Arguably then Was instrumentality,
economically speaking
Policy of Lender Liability:
 This type of Piercing is uncommon
 Lenders finance and loan money. If they were liable often it would chill any desire to lend
3. Limited Liability and Environmental Liability under CERCLA
 Generally: Shareholders and Parents of subsidiaries may need to worry about CERCLA liability. Additionally,
Creditors who exert too much control may be liable for CERCLA too.
 A. Owner and Operator Liability:
 US v. Best Foods (US):
o F: CPC wanted to buy OTT, a chemical plant. To do so, it created OTT 2, and had OTT 2
purchase assets of OTT 1 for stock (Why: shields CPC from OTT’s liabilities). Later, OTT 2
was sold to Aerojet, which had a subsidiary buy it as well. All the while, OTT was polluting
ground water.
o I: Can an Owner and/or Operator of a Facility be Liable under CERCLA?
o R:
 Owner (Indirect/Derivative Liability):
 Subsidiary that owns polluting facility is directly liable…but is Parent?
 A Parent corporation of subsidiary is not liable beyond the assets of the
Corporation, unless a Pierce occurs
 CERCLA did not change this common, corporate law
 Only when Veil is Pierced No Direct Liability
 Operator (Direct Liability):
 For an operator to be liable—Parent—they must operate the facility in
question
o Not the Subsidiary: If it were subsidiary, that would make
Shareholder/Parent liable for owning subsidiary which is contrary to
above—that requires pierce
 Must Show that shared employees of Parent were acting in their capacity of
Parent while operating the subsidiary facility
o Look at the degree and detail of actions directed at facility by
agent of Parent that are eccentric under accepted norms of
parental oversight of subsidiary
 Presumption that they are acting as facilities/subsidiaries
employee
 Note:
 Basically, this test is impossible to prove—What is ‘eccentric’
 Furthermore, how could you possibly prove they were acting for the Parent?
 Unrealistic
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B. Successor Liability:
 North Shore Gas v. Salomon, Inc. (7th Cir. 1998):
o F: ∆ bought old Shattuck, and held liable per CERCLA. It went to find who else might be
liable. Baher owned N. Continent Utilities—it owned Coke Co. and Gas Co. Coke Co. owned
N. Continent Mines which contaminated the site. Due to financial difficulties, Coke Co sold all
assets except mines to Gas Co. Mines were sold to N. Continent Utilities.
 R:
 General Rule: Asset Purchasers do not automatically acquire liabilities of
seller
 4 Exceptions:
o Express or Impliedly Agreed to
o De Facto Merger
o Purchaser is ‘mere continuation’ of seller
o Transaction is effort to fraudulently escape liability
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Express or Impliedly Agreed to:
o Contract will specifically state what is and is not assumed
o Will except to “Contingent Liabilities and Undisclosed Liabilities”
De Facto Merger:
o When Assets are sold for stock, and seller dissolves. Then former
sellers shareholders are shareholders of acquirer
o Some Jurisdictions will treat this as a merger, instead of Acquisition
and
o Look at:
 ‘Continuation of Enterprise, including management,
personnel, location, assets’ and
 ‘Presumed obligations necessary for uninterrupted
operations’
o Here: argument is that De Facto merger occurred, so liabilities came
with the assets…
Mere Continuation of Seller:
o Factors Evaluated:
 Identity of officers, directors and stock between buyer and
seller
 Continuity of control and ownership
 Adequate Consideration (to determine if genuine or not)
o Here: Baehr owned North Continent, which owned Gas and Coke.
After coke was sold to Gas, North Continent still owned the single
largest block of shares in Gas…sufficient to ensure control
o Also, Directors from Coke went to Parent of Gas and Gas Co—
Practical effect was continued control of Gas
This case is lawless
It basically holds that Gas, who did not acquire the one asset in question did
own it
How—unclear how it jumped to that assumption, but applied the rules in an
extended way to meet its conclusion
Equity is beyond law—fairness, even if rule applies, is the decision fair?
o this is not an equitable opinion
Arguably, however, it is decided to avoid negating CERCLA. If Gas were not
liable, then no one from Baehr would have been—Coke was gone and North
Continent was an Owner, which would have required pierce—so perhaps
equitable?
C. Lender Liability in CERCLA:
 There is the possibility that a lender may be liable for the cleanup, CERCLA liability of a debtor.
 Monarch Title, Inc v. City of Florence (11th Cir. 2000)
o F: City bought land by selling municipal bonds to Bank, who gave mortgage on the land to
Monarch. Hazardous substances were released and CERCLA liability ensued. Monarch sues
city arguing contribution
o Note: Why is Transaction Occurring this wayWhy is middle man/City involved:
 Municipal Bonds are Tax Exempt. So when City issues bonds tax free, and uses
proceeds from bank to buy land, the yield is less, therefore when Monarch pays back
the bank for its bonds, it is less payment of Principal and Interest. That Savings is
passed on to Monarch.
 Capital Lease: A lease, where rent is paid towards the mortgage, and eventually gets
the option to buy the property.
o R:
o CERCLA Secured Creditor Exemption:
 Those, without participating in management, who hold indicia of ownership interest
primarily to ‘protect security interest’
 Hold Security interest to “Primarily to Protect”
 The City here held title to protect its security interest
o “when party holds title, and devotes lease revenue to pay off bonds,
it is security interest”
o Primary Purpose
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Note:
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Initially obtained to spur economic development
Retained title to ensure that Capital lease was paid on
Decision based on Economic Policy
o If Court did not decide that lender was not liable, no
lender/municipality would ever lend again or decide to spur
economic development
o The Case this court compared it to had facts where the π actually
held title, and City only held a mortgage
o Here, however, the City holds title Different, and is not ‘indicia’
of ownership…but the Policy reasoning behind the decision is clear
II. Valuation:
 Generally:
o As attorneys, we must understand the financial underpinnings of the deal, and interests of client to be able to effectively
structure and articulate the deal into draft documents
 A. Capital:
o Economics Version: Wealth accumulated by skilled labor, dedicated to the production of increases in material wealth
 For our purposes, this is too broad
o Accounting:
 Look at those things that can be quantitatively measured in $ terms
 “Human Capital” not recognized as cannot be broken down to $ terms
 Only looks at the value of company, but not where it comes from
 Does not look at who contributed or how it got there
 Only Current, snap-shot view
o Legal:
 The corporate law looks to define the rights and duties of those who own corporate property, and those who may
have a claim to it
 Legal Capital, then is in line with limited liability: Generally speaking, holders of Stock are not liable
 *The amount that can satisfy the corporate debts, is legal capital
o Business:
 All productive resources which are available for allocation in profit-making activity, from whatever source
 Doesn’t matter where it comes from, or if it can be neatly defined into a $ amount—includes many
things from all resources
 B. The Idea of Valuation:
o Generally:
 There are two theories of valuation:
 1. Firm Foundation Theory:
o An investment has intrinsic value, and valuation determines that value
o Value is based on the present value of all future dividends or income streams the shareholder is
entitled to, discounted back to present value
o Although past dividends is starting point, future must be carefully determined
o More Scientific and Objective
o Premise of Fundamental Valuation
 With calculations
 2. Castles-In-The-Air Theory:
o the idea that because of the market, or willingness to pay for a share, investors are willing to
pay a certain price for shares
o This idea is more emotion/psychologically filled, as it is premised on a rush or trend of the
market in determining “willingness to pay”
o Premise of Market based valuation
o Present Value, Future Value Basics:
 Future Value:
 FV = x (1+ K/M) ^ mn
 Where:
o X= principle amount
o K= Interest Rate
o M= number of times interest compounds
o N= Years
 So:
o Investing $100 with semi annual interest at 8% for 1 year =
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o 100(1+ .08/2) ^2*1
o =$104
 Present Value:
 Lump Sum:
o PV= Xn / (1+k/m) ^ mn
o Where:
 X=Principle
 K=discount rate
 M= number of times compounding
 N=Years
o So:
 100$ received in 2 years with 8% discount rate compounded semi-annually
 100/ (1+.08/2) ^ 2*2
 =85.48
 Annuity:
o Paid at the end of each period
o For Simple Interest:
 Xn/ (1+k)^n
o For Compounded Interest:
 1. Calculate Effective Annual Interest Rate (EAIR)
 (1+k/m)^m – 1
 2. Use PV formula, plugging EAIR into k
 Annuity Due:
o Paid at the beginning of each period
o So:
 [Xn/ (1+k)^n ] * [1+k]
o Risk and Probability:
 1. Generally, risk is a function of the probability of something occurring
 Risk: Quantifiable thing we know may occur
 Uncertainty: thing we do not know of
 2. A Portfolio or Expected return on a stock, then can be calculated by:
 The Risk weighted average return of a stock/portfolio =
o Sum of Weight of (Chance) of Economic Outcome or Return x Return
 3. Continuous Probability Distribution:
 Assign a probability of every possible state of economy and rate of return for stock in each economy
 Taking weighted average return of each gives us a distribution of returns
o Standard Deviation:
 Technically a probability weighted average deviation of expected return
 Way of quantifying expected deviation from the expected return
 Greater Standard Deviation= Greater Risk
 C. Quantitative Methods of Valuation:
o Generally:
 There are two types of valuation:
 Fundamental: Evaluating the particular aspects of a company, without regard to the market
 Market Value: Value comes from the market, and the ‘castles in the air’ theory
 See Smith Drug Stores I
o 1. Balance Sheet Valuation:
 Book Value:
 BV per Share = BV/# of shares
 BV= TA-TL
 Flaws:
o Restricted by the accounting conventions
o Historic Cost not reflective of current values
 Due to focus on Balance Sheet, which is ‘snap shot’
 Does not look at earnings or cash flow
 Does not include intangible value market attributes to it
o Overall Value is skewed
 focuses on the liquidation value instead of Going Concern (Income Generation and
earnings)
 Adjusted Book Value:
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Attempts to avoid focus on historic cost by increasing certain assets to reflect market value
Process:
o 1. Assets on Balance Sheet restated to show current market value
o 2.Then BV=TA-TL
 Flaws:
o Still focuses on liquidation value rather then the value of a going concern, or ability to generate
income
 Net Asset Value:
 Generally:
o Tries to avoid reliance on balance sheet and historic cost, by valuing as a going concern
o Considers the costs associated with establishing name recognition, training, developing
products, creating brands, customer base, earnings potential Reflecting “Going Concern”
 Goodwill:
o Reflects the value of a target company, and values as a going concern
o Some intangible value above and beyond the assets
o Typically arises in a corporate acquisition
o Process:
 If an acquirer purchases a company at greater then Book Value, there must be
something else they are acquiring, above the asset value
 that value is considered the going concern value of the future earnings
 Donahue v. Draper (infra):
 Goodwill = value above net tangible assets
 1. X= Earnings x Multple (representing goodwill value)
 2. Goodwill= X-Net Tangible Assets
 3. Good will= amount greater then net assets (BV)
 Market to Book Ratio:
o Use:
 An evaluation of the price of a share, and how much greater that share is above the
book value
 Can be used to give measure of how investors regard the subject company compared to
others
o Process:
 1. Calculate Book Value
 2. Calculate market Value
 3. Market Value per share / Book Value per share
 Comparison of Private to Public Corporation:
 Could take the M/B ratio of public company to determine comparison
 For instance, if industry average M/B = 5 and your BV=2…2x5= 10/share mv
 So, can be used for valuation purposes
o Meaning:
 > 1: shows a measure of market value that is greater then book value…and valuation
of a going concern and goodwill
 May show value above book value, and thus more accurately depict going concern
value
 Overall Flaws with Balance Sheet Valuation:
 Accounting Conventions reliance on historical cost
 Even with NAV, and Adjusted book value, unless we are valuing a company for its liquidation value, we
don’t want to know what the assets cost, or what the company is worth if sold now…
 We want to know what the corporation, going concern, can do for us in the future
2. Income Statement Valuation:
 1. Capitalized Earnings Method:
 Process:
o 1. Come up with earnings
o 2. Choose capitalization rate
 Earnings Estimate:
o Earnings may mean the bottom line
o Flaw:
 Accounting Conventions
 Earnings have, subtracted out of them, both cash and non cash items
 Non-Cash items= Depreciation and deferred taxes
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 Changes in accounting methods may significantly alter earnings
 Adjustments in a Close Corporation:
 Expenses of a corporation, such as executive compensation, can be too high
in some close-corporations…If they are too high, and method of self-dealing
is occurring these could be thought of as lost earnings for the company and
added back in to determine earnings value
o Focus on Past, Present Future:
 Past gives indication of, perhaps, what may occur in future
 But future is what will, if occurs, bring us earnings in the future
 So, forecast earnings into the future
o Adjustments to Earnings:
 Adjusted Earnings:
 In order to avoid accounting conventions that deal with non-cash items,
Restate:
o Add back all non-cash expenses: Deferred Taxes and
Depreciation
 Normalized Earnings:
 Process by which we take the average of earnings over the past x number of
years
o Avoids extraordinary, and abnormal earnings
Capitalization Rate (See Discount Rate, infra):
o Evaluates risks of company, and industry
o Used in order to discount the future value of earnings at a fixed percent to the present value
 Cap Rate is the rate of risk we determine a company represents, and rate we demand
to get the future earnings
o Premium, or interest rate you would expect to earn on that risky asset if you acquired it now
o Methods to Develop Capitalization Rate:
 1. Create your own
 based on risk profile, comparable companies, industry, specific company
issues,
o Make adjustments depending on future risks, or indicators in the
past of potential issues
 Low Risk: ~12.5%
 Moderate Risk: ~ 15-25%
 High Risk: >~ 25%
 Adjusted per your company specific issues
 2. Reciprocal of P/E Ratio:
 1/ P/E = Capitalization Rate
 P/E is a multiple of the price at which a share of stock is sold for, relative to
the earnings that share is worth
 Idea that current Price reflects risks, and issues with the future earnings
 Higher reflects market belief that positive events are to come
o Note:
 If a close corporation is in question, then the P/E of
comparable companies can be used to value a share
 Comparable Companies: Size, industry, growth rate,
history…
 Issue:
 Assure comparable companies when using P/E to determine
capitalization rate
 Finding a like company is key to accurately portraying a
share price
 Issues:
o Introduces market valuation into a fundamental approach
o However, argument should be that we should introduce market
valuation into it, at least some, to determine a fair market value
 3. CAPM
 See infra
 4. WACC
 5. Gordon Model: K= (D1/V) + G
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Formulas:
o 1. Value of Share= E/R
o 2. Value of Share = Earnings x P/E
 Flaws with Income Statement Valuation:
 1. Also limited to accounting conventions
o Non-cash items are excluded
 2. Prediction of Future earnings and capitalization rate make it subject to subjective interpretation
 3. Fails to address what will occur with the cash flows created from earnings
o Dividends and/ or Retained Earnings
 4. Comparison Issues are also subjective
3. Cash Flow Methods of Valuation:
 General:
 As income statement and balance sheet valuation methods fail to take into account the present value of
future dividend streams, what shareholder may be entitled to, cash-flow valuation fills this void
 A stock’s worth, and value derive from the expected stream of future dividends—paid in cash
 Premise:
o DDM assumes you will not sell, and are not trading day-to-day, but rather holding for the long
term
o Because earnings are made up of what can be plowed back and paid out, there is no
contradiction
 Earnings, thus, are not counted specifically—would double count—as you are
including the portion of the earnings a shareholder is entitled to…i.e., the pay out of
the earnings in the form of dividends…what part of earnings you receive
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1. The Dividend Discount Model (Gordon Model):
 Premise:
o That a share of common stock is equal to the expected flow of dividends it produces, discounted
to present value
 Process:
o Step 1: Forecast Future Dividends
 Remember:
 Payable at Board of Directors’ discretion
 Legal Capital Rules apply
 Growth, financial position and future prospects
 So predicting future dividends are not easy
o Step 2: Choose a Discount Rate
 Will incorporate, as aforementioned, a time value of money and adjusted risk for a
particular corporation
 Can Use:
 1. CAPM
 2. WACC
 3. Capitalization Rate
 4. Create your own
 5. Use DDM to do so
 adjusted for particular company in question
o Step 3: Apply No-Growth, Constant Growth, or Variable Growth Rate, per your model
 The Model of Equation:
o No-Growth Stock:
 Applicable if there is no expected growth in the dividend in the future
D
V= K
Where:
 D= Dividend
 K=Discount Rate
o Note:
 Discount Rate can be solved for
 K= D/V
Constant Growth Stock:


o
11



o
Applicable where a dividend of a company is predicted to grow at a constant rate in
future
V = D1 / (k-g)
Where:
 D1 = Dividend x (1+g) or Dividend of next year
 K= Discount Rate
 g= Rate of growth of dividend
 The Discount Rate:
 Again, there are methods that are different which can be employed to create
the discount rate:
o The discount rate is a premium, or interest rate you would expect to
earn on that risky asset if you acquired it now
o So, we discount the future value of a share, or dividend by that
‘interest’ rate, or discount rate
o A modified interest rate for that particular stock
 1. Create it
 2. CAPM
 3. Reciprocal of P/E
 4. Gordon Model to Calculate K
o K= (D1/v) + g
 Finding Value of the stock using comparable companies at
future point in time
 5. WACC
 The Growth Rate:
 A dividend is attributable to a board of directors’ decision of what to do with
Income
 Income can be
o 1. Pay Out Ratio
 Amount paid out, in % of earnings, to shareholders in form
of dividend
 Payout Ratio= Dividends /Earnings
o 2. Plow Back Ratio
 Plowing back means the amount of net income that the
board decides to reinvest in the company
 Ends up in Retained Earnings
 1-Payout Ratio
 Method 1 of determining Growth Rate:
o 1. Take the Payout Ratio
o 2. Take Return on Equity (ROE)
 ROE= EPS/BVS
o Growth then, means that the company will pay out a portion of its
return on the equity in the company to shareholders, while the
remaining portion is plowed back into the company
o Makes Sense BV=TA-TL, which = Shareholder’s Equity in
Balance Sheet equation (SE=TA-TL), so return on that is return on
shareholder’s equity
 Method 2:
o Calculate average change in dividend over last x number of years
Non-Constant Growth/Terminal Value Model/Horizon Model:
 Applicable when the growth rate of the future dividends is inconsistent
 General:
 When calculating DDM, there is inherently value left on the table from failing
to calculate the horizon value of all future dividends
 This formula establishes the dividends through a definite period of time, and
after that point, utilizes a horizon value to predict the value of all future
dividends
 Process:
 Step 1:
12
o
Calculate the present value of the expected future dividends
where there is inconsistent growth/non-constant growth



o
Step 2:
o Use Constant Growth rate DDM formula for time period you believe
constant growth will begin at
o Take Present Value of that
 Step 3:
o Add the two together
Formula:
 1. Calculate the present value of the projected dividends
o whether constant or non-constant growth
 2. Terminal/Horizon Value calculation
o [1 / (1+k) ^ n ] x [Dn / (k-g)]
o Where:
 n=the last year for which dividends have been discounted
 This calculation takes the present value of the terminal
value of stock
 Or
o Terminal Value can be calculated by:
 Vn / (1+k) ^n
 Which gives you the present value of future terminal value
 Where:
 n=
 Calculate Value at year n, by using comparable mature
companies P/E and multiplying by your projected earnings
in that year
 Flaws: this method succumbs to issues of Income statement
valuation, comparability, and prediction
 3.
o Add the present value of your projected dividends to your selected
terminal value
Flaws of DDM:
o 1. May miss out on future receipt of dividends throughout horizon time
o 2. Understates value then, as terminal value is not wholly accurate
o 3. May be subject to analyst’s subjective interpretations and judgment
o 4. Inapplicable to companies who do not pay dividends
 2. Discounted Cash Flow Analysis
 Applicable for many valuation forms, especially if company does not pay dividends
 Process:
o 1. Forecast company’s net cash flows
 each year into future and growth
o 2. Estimate a terminal value of the company at the end of your holding period
 Use same calculation for horizon value as DDM
 Terminal Cash Flow / (1+k)^n
o 3. Discount at an appropriate discount rate the present value of each
o 4. Add the discounted cash flows and discounted terminal value
 Flaws:
o Forecasting of future cash flows is subjective
o Choice of discount rate is subjective
o Estimating the terminal value is not wholly accurate
4. Capital Budgeting and Managerial Finance:
 General:
 The same concepts, above, are used by mangers daily to determine the value of projects and the return
and discount rates they will apply to these projects to determine their value to the company
 Two common methods: IRR and NPV
 Net Present Value:
 Simply forecast the future values of a project
 Discount all back to present value utilizing a discount rate
o Weighted Average Cost of Capital:
 [Weight x ROE] + [Weight x Debt]
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
o
Effect:
o If positive  the company should always accept the project as it adds value
o If negative  company should decline as it decreases value
 Internal Rate of Return:
 The rate of a return a series of projected future cash flows will produce
5. Market Based Valuation: Modern Portfolio Theory, Efficient Frontier, and CAPM:
 Market Based Valuation:
 While the above formulas largely deal with the fundamental quantitative data a particular going concern
exhibits, and the specific corporation’s attributes
o Note:
 Some market information (Such as P/E) does creep into fundamental valuation
 Market based valuation, in contrast focuses on the market
o The market assigns a value to the corporation based on all things that effect it
 Modern Portfolio Theory:
 Risk Profile:
o Generally speaking, the higher the risk an investment bears, the higher return an investor will
demand
 Risk Averse: Will not accept increased risk without increased return
 Risk Neutral: Solely focuses on the return, and does not care about risk needed
 Risk Seeking: actually accepts lower return for increased risk…small chance of big
success
 Diversification:
o The idea of creating a portfolio of stocks, which include different returns and probabilities in
different states of the economy—idea of combining securities to reduce risks of 1 security
 If you buy two securities, and both react exactly opposite, you’ve diversified
o 3 Beliefs:
 1. Expected return of a security is the weighted average of all possible returns
 2. Expected return of portfolio is weighted sum of return on individual securities
 3. The risk is not necessarily the weighted sum of all risks
 Systemic and Non-Systemic Risk:
o Out of Modern Portfolio theory, and diversification, we see that there are two types of risk we
need to worry about  Specific Risk to that company and risk of the system
o Firm-Specific Risk:
 Diversifiable, unique, specific, unsystematic risk
 Because we see that diversification can be done between particular stocks, the
particular risk can be, theoretically, negated
 So diversification can allow an investor to reduce unsystematic risks and only focus
on Systematic risks
o Non-Firm Specific Risk:
 Systematic Risk  ßeta
 Risk of the Market, of things we simply cannot predict or diversify against
 The risk of the system’s effect on your particular stock
 The risk that should be focused on, then, to maximize return
 The risk you seek return for
 Beta—ß:
 A statistical measure of how a particular stock reacts to market risk
 Correlation of stocks movement to markets movement
o ß of 1: There is a 1:1 return with the market
o ß of >1: Return will be Greater then market (More Risk)
o ß of <1: Return will be less then market (Less Risk)
 Efficient Frontier:
o A graphical showing of possible portfolios with different risk profiles
o Maximizes expected return for risk
 The Capital Asset Pricing Model (CAPM)
 Because we should only be compensated for systematic risk, or a companies sensitivity to the system,
the value of a share should show this
 See Smith Drug Stores V
o Components:
 ß (Beta): the measure of relationship between risk of individual security and risk of
system or market
14




o

Note:
o
o
A higher ß means a higher level of risk
Correlation is higher to market changes, so they are more sensitive
and varying
a (Alpha): A measure of the accuracy of CAPM
 =Stock’s Actual Return – CAPM Expected Return
o > 0: Shows greater then what was expected
o < 0: Shows less then expected
RF (Risk Free Rate):
 The return one could get risk-free, through for instance, T-bills
RM (Return on Market):
 The standard return of the market
CAPM:
 Expected Return= RF+ ß [Rm-Rf]
 Premium:
o Market Premium

Rm-Rf
 The premium return you are gaining above taking the risk
free rate
o Risk Premium for Particular Stock
 ß (Rm-Rf)
 The premium return you are gaining above the market
premium, proportional to particular stock beta
 Beta adjusted return on market for particular stock’s
correlated risk to the market
 The return on a stock should exceed the risk free rate by an amount proportional to
beta
Flaws of CAPM:
o 1. Assumptions:
 Assumes Risk averse investors measure risk in terms of ß
 Assumes all investors have a common time frame for investment
 Probably not true, as many people buy and sell often

So, if time horizons are different, return and risk would change too
 Assumes all investors have same expectations of future Systematic Risks
 No Transaction Costs, no taxes
 Assumes ECMH
 If these assumptions have issues, then CAPM has issues
o 2. Lack of use of fundamental valuation:
 Unlike fundamental valuation, here no fundamentals are used
 We only look at the stock price relevant to the market
 Does not look at what a company is doing as a going concern
 Even though Beta may reflect this somewhat, not largely included
 Counter Argument:
 CAPM merely gives you an ‘expected rate of return’ for a stock
o That rate, discount rate, or cap rate, can then be used in any of the
fundamental valuation equations to take a hybrid approach of
fundamental and market valuation
o 3. Fosters Irresponsibility:
 By focusing on market, and not on what a company does, who its composed of or what
it offers you don’t care about corporate responsibility, but instead stock price
 By focusing on CAPM, has increased volatility
 Stock turnover is much greater
 “Stock owners” are not common, and short term return is king
 Therefore, accountability of who is running corporation is hurt, and no one
really pays attention to who is running it
 Creates Corporate governance issues and consequences for overall market then
o 4. Business Judgment Rule:
 CAPM and Modern Portfolio Theory create an argument for BJR
15



But:

If an investor can diversify against any one particular stock’s or
company’s risk, then the law should encourage continued deference of courts
and weaker oversight by courts of director actions
Stock holders don’t need the protection, in essence—protect themselves
With removal of ‘stock ownership’ and care of what company is doing, as
focus is on market and return rather then fundamentals, leaves the issue of
who is actually running the company and what check there is on them
o So, weakens argument as CAPM also creates issues
 Professor Gevertz:
o Raises concern of if most are even capable of this calculation or do it
o Equations effect individual stock, but not mismanagement
o Do we want to tailor law around investment strategy?
 Should we build corporate law around a shareholder’s
diversifying or not of her portfolio?
o Presums formulas are accurate
 Empirical Testing and Anomalies:
o Testing has shown several anomalies with CAPM that cannot be explained
 1. Small Cap stocks have higher returns then predicted
 2. High dividend yield stocks have higher returns than expected from CAPM
 3. Low P/E ratio stocks
 4. Stocks trading at or below 2/3 net asset value
 5. Stocks followed by fewer analysts then larger number of analysts
 D. Valuation in Legal Context:
o 1. Appraisal Proceedings:
 Available to:
 Shareholders and Preferred Shareholders only
o Not convertible security holders
 Entitles them to become common shareholders, but they have not undertaken that
unless they exercise their conversion
 Generally:
 Appraisal proceedings, or dissenter rights allow the shareholder who disfavors a merger to seek out a
judicial determination of the fair value of the shares
 Once value determined, surviving entity must then pay that amount to dissenting stockholder
 Policy:
o Because shareholder voting is no longer unanimous, the law has used appraisal proceedings as a
method of protecting a minority shareholder
o Those who vote against now have remedy
o The shareholder is being forced to sell, involuntarily
 The Method of Valuation:
 A. Historic Valuation Model in Appraisal Proceeding:
 The Delaware Block Approach—Piemonte v. New Boston Garden Corporation:
o F: Bostong Garden Arena (BGA) was merging into New Boston Garden Corp (NBGC). BGA
owned 4 corporations, one of which owned NHL one of which owned AHL, the Boston Garden
Sports Arena and a corporation for concessions of the arena. The value of the merger of $75.27
was disagreed with.
o I: What is appropriate value of Target?
o R:
 The Delaware Block Approach
 Take the weighted average of:
o Market Value/share
o Net Asset Value (BV)/share
o Earnings/share
 Sum of each = Value/Share
 Market Value:
 1. When traded on an exchange, there is ability to estimate the market
value
o is efficient and accurate as market pays the worth of a share
o Potential Issue
 Must be liquid—enough trading to accurately price it
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


o

2. Reconstruction:
o If no market value can be determined, a judge may reconstruct
the market value of a share
o Not common application because it is somewhat redundant, as the
Earnings and NAV will also value the company
o Also difficult to accomplish (When close corp. or thinly traded)
 Here:
o Very thinly traded, as 90% was held by controlling parties…so
market value was not wholly accurate
o But, Judge has discretion to determine sufficiency of market
Earnings Value:
 Generally, court establishes earnings for past 5 years, and excludes certain
extraordinary gains and losses
 2 Methods:
o E/R
 R=Capitalization Rate
o P/E * E
 P/E based on market
 Earnings Multiple
o Reflects financial condition, risk factor inherent in corporation and
industry
o Will establish the risk and future potential of a company
o Can do it in 2 ways:
 1. Capitalization Rate: Rf+Rp (CAPM)
 2. P/E from looking to other comparable corporations
o Potential Issue:
 1. If closely held, there is no P/E available for the
corporations as no market of trading to determine
o Solution:
 What is typically done of non-public companies is to look
for comparable companies that are traded on public
markets, and apply a P/E, or
 You can construct your own capitalization rate
o Also, largely discretionary of Court if it is reasonable
 Here:
o Trial court acted within discretion
Net Asset Value:
 Process:
o Simply derive the value of the assets of the target corporation
o Here, calculated value of real-estate, assets, franchise organization,
Weighted Average:
 The Judge, through his discretion, then applies a weighting to each value
Issues:
 Case illustrates the massive discretion of the Judge at the Trial Court level to
determine non-legal issues, but instead purely financial issues
 He is not constrained to anything, but merely selects his view of what is accurate value
 Because of the financial expertise needed, however, it illustrates that Judge may be
heavily reliant on an expert opinion
B. Modernly:
 a. Weinberger v. UOP (Del. 1983):
o 1. Abandoned the Delaware Block Approach
o 2. New Valuation Approach for Delaware Courts:
 Proof of value by any technique or method which is generally considered acceptable
in the financial community
o 3. Interpretation of §262 Appraisal
 1. Fair Value of Corporation
 including all relevant factors
 Determine the Value of the whole corporation, and then pro-rata value of
shares, before merger
 2. Exclude element of value arising from merger
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


1. Elements of speculative future value from merger not included (i.e.,
synergy), but
2. However, elements of future value which are known or susceptible to
proof as of the date of merger may be considered
Post-Weinberger:
o Due to the more open standard Weinberger creates, valuation methodologies often lead to
“battle of the experts” as to what is accepted, and what the value may be
Le Beau v. M.G. Bancorporation (Del. Ch. 1998):
o F: Southwest owned 91% of MGB. MGB owned 100% of MBG Bank and 75.5% of WBC.
Southwest sought to merge with its partially owned subsidiary, MBG in a ‘short form’ or
upstream merger. Because of the >90% of stock ownership, no SH vote was needed, but rather
a mere board approval. Minority shareholders of MGB brought appraisal rights as they
disagreed with the value of $41 a share.
o Petitioner Expert Approaches Used:
 1. Comparative Public Traded Company
 1. Identify appropriate comparable companies
 2. Identify ratios that are comparable, multiples
 3. Compare using ratio analysis
 4. Adust—take average of several of them to assure more accurate
 5. Add control premium
o Premium added for buying a controlling interest in company
 2. Discounted Cash Flow Analysis
 1. Project future cash flows of company for 10 years
o 10 years is common time frame for industry
 2. Discount Future cash flows to present value
o Discount Rate is WACC
 3. Add Terminal Value
o After the final year of future value that is calculated, there are still
many more years afterwards which could generate value
o Terminal value is the period after your final calcuation into
perpetuity…so as to include that in the calculation
 4. Apply a Control premium
 3. Comparative Acquisition Model
 Use ratio analysis of company, and compare it to comparable companies that
had been sold with controlling block
 Does not add a control premium, because the comparison assumes the
premium is already included
o Respondent Expert:
 1. Discounted Cash Flow Analysis
 2. Capital Markets Approach
 1. Identify comparable companies
 2. Identify pricing multiples
 3. Use multiples to value the company in question
 4. Apply multiples to company in question
o R:
 1. Refused to accept either sides DCF approach disagreed with discount rates chosen
 2. Refused to accept the comparative public traded company approach
 Appraisal statute says: As of day before merger, but petitioner used 6 weeks
before
o Further away from merger may be more accurate, as
information tends to leak, and the closer to the merger date you
get, the closer the market price gets the deal value
 3. The Court refused to Accept the Capital Markets approach
 it was not shown to be accepted in Finance, per Weinberger
 Court Accepts the Comparative Acquisition Model:
 Issue with Control Premium
 The Appraisal statute states that value is determined as of the date of merger,
excluding post-merger value
18
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
o

The issue, then, is does a premium paid violate this as including $ that is
value due to the post-merger events?
o NO: the premium paid for shares is premium paid for their value that
is believed to exist now
 Control premium is an independent element of value that
can be taken into account to determine the fair value of a
controlling block of shares and value paid for control
Additionally, while acquirer is paying a premium, he would not pay a
premium that included the post-merger value he sees…that would be giving
away value, and money he expects to make
Remedy:
 Get share value deemed by court
 Per §262, interest may be awarded, that is compounded
 Reason:
o This makes sense, as the interest makes up for the lost value of the
added $, that could have been invested at a standard interest rate
C. Minority and Marketability Discount:
 Generally:
o 1. Marketability Discount:
 The idea that stock, due to its being illiquid for a certain reason such as it being a
private corporation, or thinly traded corporation, is worth less due to an investors
inability to realize Fair Market Value
 Illiquid
 No market
o May be more reasonable then minority discount, as doesn’t penalize
for being minority
 Issues:
 Increased time and expense to market shares of close-corporation
 Less people to market to
 They are buying an illiquid interest

Marketability Discount and Liquidation
 Blake v. Blake Agency:
o The lack of marketability of shares is still appropriate
o Shares of closely held corporation cannot be sold on a market
o 2. Minority Discount:
 The idea that, due to shares being a minority, you are paying for a certain level of
control in the corporation
 Perceives that:
 Due to its being minority, it should be cheaper, and thus discounted
 Control element of value is absent so shares are less valuable and attractive
 Control Premium is opposite of Minority Discount
 Premium paid for shares that are a controlling block, whether buying a Parent
Corporation that owns controlling block in subsidiary (Le Beau) or shares that
are controlling block in corporation
 Per Le Beau: Control premium is an independent element of value that can
be taken into account to determine the fair value of a controlling block of
shares and value paid for control
 Perceives that:
o 1. Undervalued
o 2. Control is worth something
o The generally idea is that you pay for level of control you get
 Liquidation and Minority Discount:

Walter S. Cheeseman Reality v. Moore:
 While minority discount deals with level of control one is buying, and
discounting for lack of control—the minority discount is not relevant when
dissolution or liquidation of assets occurs
 No one has control anymore
o A minority share is no more or less valuable then any other then as
there is no control element
 Issues:
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
o
A minority discount inherently raises concerns of oppression and
unfairness
Unwilling seller is being forced to sell, and then applying a discount makes
him part with shares, unwillingly, and less price then expected
Overall:
 In Appraisal Proceeding:
 Majority says neither appropriate in Appraisal Proceeding
 Unwilling/Involuntary sale
 In Dissolution:
 Marketability may be appropriate in Dissolution
 In Voluntary Sale:
 More likely to be accepted

1. Delaware’s Rejection of Discounts in Appraisal Proceeding/Correct Method of Valuation:
o Cavalier Oil Corp. v. Harnett (Del. 1989):
o R:
 1. The Formula to Value a company in appraisal proceedings:
 Determine the value of the Corporation, as a going concern, and then prorates it over the shares
o Does not take into account the value of minority shares separately
from majority shares
 2. Delaware Rejects Marketability and Minority Discount in Appraisals
 Discounting then goes against the above formula
 Issues with such discounts:
o Minority discount actually penalizes for lack of control which is
contrary to the appraisal process (which tries to give fair value of
stock) and involuntary sale

2. Colorado Rejects Discounts in Appraisal Proceeding
o Pueblo Bankcorporation v. Lindoe, Inc (Colo. 2003):
o F: Pueblo wanted to merge with a wholly owned subsidiary to gain §S election. Because of
certain shareholders failing to meet §S requirement, it merged for stock with some, and cashed
others out. ∆, a shareholder of Pueblo sued, bringing appraisal proceedings—π offered
$341/share while ∆ sought $775/ share. The ‘battle of the experts’ showed the company worth
$638, but a minority and marketability discount to ∆ shareholders ended with value of
$344/share.
o I: How is fair value, in appraisal proceedings determined?
o R:
 1. Fair Value is determined:
 Appraisal is to assure proper compensation for an investment
o Assurance that the minority shareholder is properly compensated for
involuntarily losing investment
 So Value the corporation, as going concern, and pro-rate per share
 Because the shareholder does not want to sell, and is involuntarily being
forced to sell  Discounts will not apply
 2. Issues: Discounting is Inconsistent with this:
 Unnecessarily speculates
 Increases possibility that dissenter is undercompensated
 Buyer gets windfall by paying low price
 Majority of courts reject it
 Although Courts continue to have equitable powers—rejected
o Dissent:
 1. Without giving discount, shareholder may get windfall
 The market would actually discount minority and illiquid shares
 Penalizes the corporation, and gives windfall to shareholders
3. When Voluntarily Selling Shares:
o 1. When a shareholder is voluntarily selling, and not forced dissolution or appraisal is occurring
these discounts may be more likely to apply
 In voluntary sale—concerns of oppression are not as clear
o 2. An argument may lie in the fact that because he is deciding to sell:

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
o
o
Appraisal was concerned with shareholder’s investment being taken away, and low
price paid for it
 The idea that it is not a market transaction because seller is not willing seller
 But a Voluntary sale is more of a market transaction
 Willing seller selling into a market would be selling shares without control
that are not marketable
 The shareholder knows of the discount potential, and makes the decision to
sell into the open market (not unwilling/involuntary) and no concerns of
oppression or unfairness
3. Must focus on perspective of those buying it/outsiders
 They are getting minority/illiquid/non-marketable stock
 In this instance, the selling shareholder wants to sell, and wants to sell at the current
value of the shares
4. Distinguishable from involuntary
 Where he does not want to sell, being stripped from him at lower price
 Gives buyer windfall price
 In all—a voluntary sale may include marketability and minority discount

o
4. The Distinction between Minority and Marketability Discount:
o While the concepts are clear, they overlap
o A minority block of shares may be less marketable because of its minority status
 So, by using a marketability discount, the market may further discount
 D. Synergies and Benefits from Merger:
 Cede v. Technicolor, Inc (Del. 1996):
o F: A two step acquisition occurred, where step 1 acquired the stock of the target corporation,
and step 2 was a squeeze out merger. In between the two, assets were sold and updates occurred
to the divisions. Why Transaction done this way: Speedier then regular merger
o I: Is the value created prior to a merger attributable to the dissenting shareholders?
o R:
 1. The value added in the transient period, between acquisition and merger is
attributable to the going concern

 2. Because Appraisal values the going concern, and pro-rates it to the
shareholders, this value is the shareholders’ value
 See Weinberger:
 While speculative, future value is not within calculation, known or
susceptible to prove value as of the date of the merger, is within calculation
o Only look at facts at the time
o Future speculative plans do not matter
2. Valuation By Agreement:
 A. Generally:
 Because close-corporations resemble partnerships, personal relationships are important
 “Buy Sell” Agreement:
o A contract that governs the sale of stock of a close-corporation
o Typically used to insure:
 1. Stock ownership remains with select group and
 2. Liquidity to shareholders who choose to withdraw from the corporation
 3. Federal Securities Laws exemption remains intact, Corporate Selection
o Common Issues:
 1. What valuation method chosen
 2. Will it still be applicable in the future
 3. Predictability of cost to corporation
 4. Litigation potential over language chosen

B. Basics:
 Allen v. Biltmore Tissue Corp. (NY 1957):
 F: Allen was employee of corporation, and eventually acquired 20 shares. On each certificate was a
clause noting restrictions on transfer. He inquired about corporation buying, but in interim died. His
executors refused to sell to the Corporation. A buy-sell agreement stated that “whenever shareholder
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wants to sell, he must give other shareholders and corporation opportunity to buy shares first,” and if
its not exercised, he can then go resell to anyone.” Death also triggered the same.
 I: Whether restriction on transferability is illegal, unreasonable restrain on alienation?
 R:
o 1. The restriction must be stated on the certificate
 Must be seen, on the certificate
 Referring the reader to the bylaws is acceptable
 Gives stockholder notice of the restraint
o 2. The restriction on transfer must be reasonable
 Right of First Offer or Option:
 Where the shareholder must offer the stock to the corporation or
shareholders before offering it to others when he wants to sell it is generally
reasonable
 Difference between Restraint and Prohibition of Transfer:
 A restraint on transfer, where transfer is still possible to someone other then
corporation is more likely to be deemed reasonable
 When sale of stock is impossible to anyone except the corporation at what
price it decides is illegal and prohibition
 Look For:
 Is there a liquid market other then corporation, if it doesn’t buy?
 Price agreed to before hand?
 Overall:
o If can sell to others, and price is agreed to probably ok
o If one of these two is missing, will have to argue other is reasonable
o 3. Use of Formula is advisable
 Because a buy-sell is supposed to operate at some point in time in the future, an agreed
to formula is useful
 Policy:
o If not, excessive litigation would occur in every case to determine
price
 Fairness
 The formula, and restriction does not rest on ‘general notion of fairness’
 To be invalid, more then mere disparity between price and value must be
shown
 Note:
o In some contexts, when no outside sale is allowed, ‘fairness’ of price
may be more of an issue
o See Smith Drugstores IV
 Note:
 We got around this by using market based valuation, and
requiring the close-corporation shareholders to buy it prorata…so there was a market for the shares if someone did
want to leave
 In Close Corporation:
 When there is a FMV, that is easier to use…but in close-corporation
 There is no secondary market
 Shares are illiquid
 Formula needs to be agreed on
C. Duties owed in Close-Corporation:
 Helms v. Duckworth (D.D.C. 1957):
 F: Easterday, 70, entered into contract with Duckworth to form close corporation. Contract provided that
shares would be put in trust, and first to die would sell at $10, unless the price was modified.
Corporation was successful and in 1955 shares were worth about $80. Easterday died in 1956, and ∆
tendered $10 for shares.
 R:
o 1. Holders in a close corporation bear Fiduciary Relationship with fellow shareholders
 Duty to deal fairly, honestly, and openly making disclosure of all essential things
 Good faith is implied
 Meaning that you’re not just going through the motions or have a
predetermined position and refusing to budge
22
o


2. A lawyer, businessman in close-corporation context has a special duty to fellow SH
 Act in the utmost good faith to reveal any potential conflicts of interest
o Here:
 Duckworth was much younger, knew Easterday would die sooner and never ever had
intention to modify contract. As lawyer and business man against old man, who relied
on him, breached his fiduciary duty
D. Voluntary versus Involuntary
 In the Matter of Pace Photographers:
 1. Shareholders agreement fixing terms of sale voluntarily sought does not equally control when
sale is result of claimed majority oppression or wrongdoing
 2.
o There may be an issue with ‘voluntary’ sale, and the valuation formula used compared to
‘involuntary sale’ and formula used there
 Planning of drafting may need to include liquidation, death, retirement, etc…
 Defining what is voluntary and what is not
 ‘Involuntary’ such as death, incapacitation may require more ‘fair’ price
o Courts are less inclined to step in if it’s a voluntary sale
E. Notes from Smith Drug Stores IV and Buy-Sell Agreements:
 1. Effect of including Corporation and Employees in resale:
o Including corporation in close-corporation to buy back
 Creates Liquidity for selling shareholders (because there is no market)
 Creates Restriction rather then prohibition:
 Note:
o In this problem, corporation wanted to restrict resale to small group
o However, without someone to buy if they didn’t want to, or
secondary market, may have gone against Biltmore Tissue
o Get around by including executives and corporation
o Agreed Upon Formula
 May avoid argument that corporation is paying what it wants
 Including Market value may be seen as ‘more fair’
 2. Two Key Issues with Agreement:
o 1. When does “Transfer” occur:
 Death: We may not necessarily want to treat someone who voluntarily leaves and
someone who dies the same
 Dying, and getting shares at same price may be deemed unfair
 They didn’t have chance to wait for all value, etc…
 Voluntary versus Involuntary:
 We may want to consider differing treatment of death, retirement, and
quitting
 Supplement with Non-Compete
 Those leaving Involuntarily may require higher price for fairness
concerns
o 2. Valuation Method Chosen
 Book Value:
 Issues:
o 1. May be used to avoid employee leaving too soon
o 2. Low-ball so that they stay
o EG:
 If you leave before 5 Years  Get BV
 If leave after you get [some formula] (to give a higher
price)
 Note:
o Note that Biltmore Tissue deals with unreasonable restraint versus
restrictions, and this line will need to be addressed in drafting
valuation formulae
 Note:
o The issues with BV, including its being a lower value may create
issues of fairness given the corporation’s size and success
 Who picks the inputs and comparable companies:
 Could have parties agree to it
23



3. The Difference between a ROFR and ROFO:
o Right of First Refusal:
 When a chosen party has the right to inject themselves into a transaction, and they
have the opportunity to either accept an agreed to price between two other parties for
themselves, or refuse it—leaving the transaction to continue on
 Note:
 People in such a negotiation may low-ball an offer if they know the ROFR
party will refuse it
 In Voluntary sale, Offeror will rationalize by using marketability and
minority discount
 Corporation may then refuse, and buyer gets shares at a lower price
o Right of First Offer:
 You must offer the sale to the chosen party before anyone else
o
o
Could have parties involved each pick one, and have those pick a party to
choose
Overall, concern is that we don’t want personal interest involved that may
benefit one part or another
How to allow corporation to implement:
 “Notification Clause”: that seller must notify corporation of transaction
 4. Conflicts of Interest:
o See Model Rules 1.7 and 1.13
o Generally:
 Especially in a close corporation context, representing the shareholders and
corporation are not wholly distinguishable
 Disclose all conflicts to the parties
3. Goodwill, and other valuation issues:
 Courts may have to value the company in other contexts then just the sale of shares
 Valuation at Liquidation:
 Donahue v. Draper:
 F: Both created company, and were president and directors. Draper’s wife was other director. Eventually
Donahue was forced out, voted out, and fired. Sues for his entitlement to assets.
 I: Should leaving shareholder get portion of Goodwill?
 R:
o Goodwill:
 Is the value of an enterprise over and above the value of the net tangible assets
 Comes from allegiance of customers, favorable relations with banks, customer loyalty,
suppliers—anything that leads to continued success
o Calculation:
 In Public Corporation:
 Net Income x Multiple= Amount
 Net Tangible Assets-Amount = If Positive Amount—Goodwill
 A positive amount shows the companies goodwill that exists
 Adjustmens in the Close Corporation:
 Earnings leave the company in form of benefits and salaries to shareholders
o Enhanced Salary, Insurance, enhanced perquisites/benefits
 “Adjusting” and normalizing these earnings must occur add these back in
 Adjusted Net Income x Multiple=Amount
 Amount-Net Tangible Assets = Goodwill
o Goodwill is an asset of the company, and equally available to each shareholder
 It is not attributable to one person based on his contribution
 Cannot be reapportioned for own use
 When one party wrongfully takes to himself the goodwill of enterprise, the other is
entitled to his share of its value
 Corporations, divided among shareholders
o Application to Smith Drug Stores II:
 One could argue that in addition to the per share value that is come to by valuation
techniques, the value of Goodwill of an asset, in portion owned by shareholder is
deserved too
24

o
So get per/share price + portion of Goodwill asset
 Donahue was in liquidation context
4. The Use of CAPM in Court:
 Cede & Co. v. Technicolor, Inc. (Del. Ch. 1990):
 F: The Court evaluated the expert’s use of CAPM, and discount rate in valuation of appraisal
proceedings
 R:
o 1. CAPM is a generally accepted method of valuation
 While no method is uniquely correct, this meets Weinberger
 As with all methods, this is as good as the subjective judgments of the inputs
o 2. What point in time is Beta used in judicial proceedings:
 In certain contexts, the use of a Beta closer to transaction may not be the most accurate
measurement of a company’s Beta coefficient
 Beta will thus be affected due to its inherent measurement of the relation of
stock price to market volatility
 The closer to a transaction, the more volatile a stock is
 Here:
 Company had stable cash flows, yet had Beta of almost 2 near transaction
date, when 3 months before it was closer to 1
 Court accepted the earlier of the two
o 3. Court rejects small capitalization effect anomaly of CAPM
 For some unascertained reason, CAPM is unable to replicate, accurately, the historic
returns of stocks with the same historic betas
 Premium is paid by Small Capitalization companies
 Court Rejects it:
 Court says that because of lack of explanation for it, accurate price cannot be
said to be more accurate if small cap. Premium is included rather then
excluded
III. Derivatives
 Generally:
o While above we looked at valuation from the perspective of an outsider of a firm, derivatives are largely a tool of internal
management
o Corporate Management uses derivatives to hedge against risk
o Used as speculative tool for investors also
o Effect on Corporation:
 Derivatives are not a method of financing for the corporation—it gains no capital
 Solely a secondary market transaction
o A derivative is an instrument that derives its value from some other, underlying asset
o Counter Party Credit Risk:
 The risk that the other party will default, or be unable to perform on the derivative contract
 Can arise from nay factors, but leaves chance that because of their failure to perform, your derivative asset is
worthless
 A. Basic Derivatives:
o 1. Option Contracts:
 General:
 Options give the right, but not the obligation to buy (Call) or sell (Put) some underlying asset at or
before a date at a specified price
 Markets Used:
 Private/OTC Market:
o Individuals create options for particular parties, on custom basis meeting particular needs
 Public Market:
o Standardized Contracts, in line with Chicago Board of Options Exchange Guidelines
 Uses:
 Used to hedge or speculate in trading
 Attributes:
 1. The underlying asset
o General:
 While almost any asset can serve, Options are generally stocks
 2. Put or Call
o Call Option
25

o
Gives the holder the right to buy the security
 When Market Price> Strike price
o Put Option
 Gives the holder the right to sell the security at the strike price to the counterparty
 When Market Price is <Strike Price
o Sell at above market…making $
o Option Writer:
 The counter party the buyer is dealing with—the seller
 Write a Call:
 Hopes that price will go down
 Make the premium sold for
 Downside is unlimited, as price could go up and up
 Write a Put:
 Hope that price will go up
 Make the premium sold for
 Downside limited to the exercise price--$0 is lowest it could go
 3. Strike or exercise price
o The price the option above or below which becomes worth
o The price the option is written by the counterparty
o Dependant on the Market or Spot Price
o For Call:
 When Market is > strike  “In the Money”
 When Market is = strike  “At the Money”
 When Market is < strike  “Out of the Money”
o For Put:
 When Market is > Strike  Out of the Money
 When Market is = Strike  At the Money
 When Market is < Strike  In the Money
 4. Expiration or maturity date of option
o Date at which the option contract terminates
o American Style Option:
 *Applies to Public traded options
 can be exercised at or before the expiration date
o Non Public Company:
 Can be American Style
 European Style:
 Exercised at the maturity date
 Asian Style:
 Exercised at intervals, negotiated prior to
 5. Manner in which exercised
o Can be Cash or Physical Settlement
o Physical:
 The actual underlying asset must be physically purchased or sold if in the money
o Cash:
 Simply means that the value of the option must be paid for
 There is no physical transfer of assets
 Price Theory:
 Generally Based on:
o Change in value of underlying asset, strike price, volatility of underlying asset, interest rates,
dividends, and time to maturity
o See p.283 for table on effects of each on Call versus Put
 Distinction from Warrant:
 Similar attributes
 Only written by the corporation
 Unlike Option, which when called or putted uses secondary market shares, Warrant uses newly-issued
shares
o Dilutes Shareholders
2. Forward Contracts:
 Generally:
 The obligation to buy or sell some underlying asset at a fixed price
26



o
o
Physical delivery is common
o The underlying asset (Gold, Grain, Jet Fuel) must be bought or sold
o Settled at the maturity/termination date
Business Management:
o Forwards are used by business management to hedge against the decrease or increase of prices,
typically of COGS
o Ensures a predictable price
o Uses:
 More of hedging tool then speculative investment
Effect:
 Entering into a forward contract to buy, for instance, grain at a fixed price will protect the buyer from the
chance of grain price going up
 He pays, depending on forward contract, above or below market price, depending on the bet
 Price Theory:
 Depends on the Spot Price of underlying asset, Cost to store the asset, and Distributions from that asset
(if any)
3. Future Contracts:
 Generally:
 Futures are a type of forward contract, that are publicly traded
 The obligation to buy or sell an underlying asset on fixed date at price
 However, while there are similarities between forward and future, there are differences too
 At termination, someone will take physical delivery of the underlying asset
o However, prior to that point they are traded
 Differences:
 1. Cash Settlement
o Although someone will take physical delivery, most of the time they are settled by cash
throughout trading
 2. Standardized Contracts
o because they are publicly traded, Futures contracts are governed by standardized boards
o The CME or NYME affix standard terms to the contracts
o Ensures organized trading on public markets
 3. Daily Settlement
o Unlike forward contracts, futures contracts are settled at the end of each day
o Holdings are marked to market and proceeds are distributed
o The futures price then is reset to equal the closing price, so that at the end of each day the value
is restored to 0
o Margin:
 Margin account is a protection account that holds a fixed amount of $, based on the
holdings, that is a % of the holdings
 The amount needed in the account changes based on the value of futures
 Maintenance Margin: a minimum amount exchanges require to be in margin account
4. Swap Contracts:
 Generally:
 Swap contracts make a series of payments to another party, over a certain period of time, based on what
the contract stands for—what criteria it is dependant on
o Interest Rates, Default, Currency Rates and their corresponding fluctuations, Commodity
 Generally used to hedge risk
 Contract:
o Specifies obligations of each party, triggering “events”
 Uses:
 Hedge, Speculate, Reduce Costs
 Example:
 Company A
o Has a bond issue out yielding a fixed 10%
o Believes that interest rates will drop
 Company B
o Is paying a bond at LIBOR + 1% (Fluctuating)
o Believes that interest rates will go up, and wants to hedge against this
 Intermediary
o Pays fixed 10% to Company A in exchange for A paying it floating rate
27
o



Passes Floating Rate on to Company B, plus small %, in exchange for Company B paying
fixed rate, plus small %
o Effect:
 Each party has hedged the risk they foresee
 A is now paying variable rate, hoping rates will go down
 B is now paying fixed rates, as it hopes they will go up
 Intermediary has hedged its exposure by balancing each party, carving out a
small % for itself to profit
 Risks:
 Credit Risk, that other party will default on payments
 Risks to individual party that their beliefs will not pan out
Credit Default Swap (Credit Derivative):
 Contracting with a party for a periodic payment, in exchange for their insurance to pay you your loss if
some specified “credit event” occurs
o Hedges against credit or default risk of company
o Insurance will repay your exposure (Principle, investment, etc…)
 Example:
o Bank A makes a Loan to IBM for $1M, at 10%
o Bank A is nervous that loan may be defaulted on, so it goes to a CDS dealer, and contracts to
pay BPs to CDS dealer in exchange for insurance that CDS dealer will repay if it defaults
o CDS and Loan:
 CDSs are a great tool to hedge loans and effective
 One bank making a large loan is exposed, on its own. However, the bank is
able to diversify, and hedge its risk by entering into a CDS with a counter
party
 However, as they are further removed from hedging, and more speculative, they may
not be as acceptable
 Effect:
o Eliminates the risk of a default of that company, thus protecting your investment
o Counter Party Risk:
 Now, unless your swap dealer fails to repay, you are protected
 To avoid Counter Party Risk
 Negotiate into Contract a requirement of collateral or margin that swap
dealer has to keep
Synthetic Credit Default Swap:
 Unlike above, where a CDS is used to hedge against a potential risk due to your ownership of an asset
 Synthetic CDS is merely taking insurance, or really gambling on the chance of some party defaulting on
a loan, or bankruptcy
o You have no ownership of asset you seek protection against
o It is Not hedging
o Merely gamble, speculation on potential default/failure
o You pay fee for counterparty’s obligation to repay whole amount
Dodd-Frank and Swaps:
 Regulation:
o CFTC regulates “Swaps”
o SEC regulates “Security based swaps”
o And if combination, both regulate
 New Regulatory Procedures:
o Swap Dealer:
 Any person that (1) holds itself out as a dealer, (2) makes markets, (3) regularly enters
into swaps as ordinary business on its own account, or (4) engages in activity causing
person to commonly be known as dealer or market maker
o Major Swap Participant:
o Clearinghouse:
 Dodd Frank requires that all swaps be cleared through them
o Trading:
 Dodd Frank requires all swaps cleared be traded on trade, securities exchange, or
“swap execution facility”
 Trading platform where ability to buy or trade swaps
 SEC must promulgate rules to disclose data
28
o
Swap Pushout Rule:
 Prohibits Federal Assistance (use of federal FDIC or $) to loan, purchase stock or
assets, guarantee
 However, Federal assistance is allowed to FDIC insured institution as long as swaps
are for hedging, or some that are cleared
 B. Advanced Derivatives and Issues They Pose:
o 1. Mortgage Backed Security:
 A Bond that is made up of a pool of mortgages
 The holder of this security is entitled to the principle and interest payments from the mortgage
 Tranches:
 The Bonds are sold, with an entitlement to a corresponding tranche of the pooled mortgages
 Bonds can be entitled to the AAA mortgage Payments, or Below investment Grade
 Their payment comes first, get less return, but less risk if default as payment first
 Vica-versa
 Effect:
 The pooling of mortgages “Diversifies”
 MPT theory seeped into MBS, and the thought is that although some of pooled mortgages will go bad in
one region in country, other regions and safer mortgages will diversify
 EG:
 Bank lends mortgage, sells it to party who then bundles it with other mortgages and creates a Bond
 This MBS now is sold
 Historical Genesis:
 Pre-80s and 90s:
o Banks would make and lend mortgages, after thoroughly evaluating the risk of the person they
lended to
o They would lend, and then would keep the mortgage as an asset on their balance sheet
 80s and 90s:
o Rules lobbied to be loosened, and gradually, the Mortgages were sold to Freddie Mack and
Fannie May
o This provided liquidity
 Banks could now sell mortgages to these agencies, who then would sell
 Banks left to lend more, and create more mortgages to more people to get home
 Post 80s and 90s:
o Grahm-Leach-Bliley Act
 Passed, and created more lax standards of lending of banks to people
 Stimulated home ownership, as now banks could lend quicker, sell mortgages and
repeat
 Specifically restricted SEC from regulation any Swap
o Effect:
 MBS are more aggressive and mortgages are sold quicker
 No concern for who mortgages are made to as they don’t stay on a banks books
 Lending standards lax more and more
 Alternative Mortgages Created
 These products—Sub-prime, for instance, made it easier to get a mortgage
further facilitating the mortgage and MBS process
 Incentive for Banks to do more and more:
 1. The Commission they receive
 2. Mortgage no longer on their books, as sold away
o 2. Collateralized Debt Obligation:
 The taking of the Bonds that make up an MBS, pooling the bonds, and creating 1 security out of them
 Re-rated, so though although a bond may be entitled to certain type of mortgage payments, i.e., AA, and others
entitled to BB, the pooling of many different types of bonds also diversifies against the risk of bonds defaulting,
and underlying mortgages defaulting
 Credit Enhancement Opportunity:
o In addition to the bonds now being pooled, they are re-rated and rating agencies give advice on
how to enhance credit
 Effect of CDO:
 The underlying Asset of the CDO is pooled bonds
 Pooled Bonds underlying asset is pooled mortgages
 Pooled Mortgages underlying asset is home owners
29

Overall:
o The CDO has a claim on a claim, and with so many people secured to one asset, creates issues
o 3. CDOs and CDSs:
 CDS can be used to ensure risk of an underlying asset, or can be synthetic and merely speculative
 Many parties used CDS to hedge their CDO or MBS position
 Some parties used CDS to speculate on CDO and MBS
 Synthetic CDO:
 A CDO, who’s underlying asset is a CDS
o Counter party in a CDS transaction pools them together to create Security—Synthetic CDO
 The Synthetic CDO holder is entitled to the payments from the CDS position
 However, if credit-event occurs, the CDO holders—counterparties to the CDS—must pay, although
there is no underlying asset involved
o Issues Implicated:
 1. Greed and Immorality:
 These types of instruments may give incentive to package a CDO, made up of MBSs that are not very
safe and sell them to a party
 Then, enter into a Synthetic CDS to gable on that party defaulting and the MBSs defaulting
 2. Speculation/Gambling versus Hedging
 The creation of synthetic CDS allows for speculation purely on risk of default of company
 3. Counter Party Credit Risk
 Counter Arguments:
 Creates liquidity
o This is true, that MBS and CDO create liquidity in the mortgage market to make more
 Adds Value
 Promotes Financial Innovation
 However:
 Creating liquidity for the sake of liquidity, in this case, enhancing the ability to sell more houses, loan
more, as standards become worse and worse, is a self perpetuating process
 The bubble created bursts hurting all
 C. Legal Issues and Derivatives:
o Contractual Interpretation:
 Eternity Global Master Fund v. Morgan Guarantee Trust:
 F: Appellant is fund that invests in emerging markets. To hedge risk it had with bounds—sovereign risk,
economic, social and political risks, it sought to hedge its Argentinean holdings. It purchased Credit
Default Swaps, with credit event of Argentina defaulting, restructuring, or putting moratorium.
However, counter party Morgan Trust thought the exchange of debt where old debt remained was not a
“credit event.”
 I: Contractual interpretation
 R:
o Contractual Ambiguity:
 An ambiguity exists when terms could suggest more than one meaning, viewed
objectively by reasonably intelligent person who has examined the context of the
entire agreement, cognizant of the customs, practices, and uses the terms generally
have in trade or business
o Fiduciary Duties:
 Brange v. Roth:
 F: Company was not doing well, so directors were told they should “hedge.” They authorized the then
CEO to hedge the grain they were losing money on. Sales of $7.3M existed, while manager only hedged
$20k. Eventually loses were $425k. Shareholders bring derivative action against the directors for breach
of duty of care.
 I: Whether the duty of care was breached or whether it was protected by the Business Judgment Rule
 R:
o 1. The Business Judgment Rule protects from informed decisions with mere errors in
judgment
 It does not protect:
 1. Fraud
 2. Self Dealing (Duty of Loyalty)
 3. Uninformed decisions (Duty of Care)
30
o
Here: Employing someone to hedge without monitoring them, or knowing if they are
qualified violated Duty of Care
 They employed a manager with no hedging experience, did not check on what he was
doing, did not monitor it
 These uninformed decisions, and lack of effort to become informed violated DOC and
were beyond merely errors in judgment
IV. The Rights of Contract Claimants—Debt:
 A. Generally: The Debt Contract defines the Lender’s Rights
o Shareholders:
 Treatment of shareholders is based largely on fiduciary duty, and has come to help shareholder
 They are treated as owners, and have focus of management’s concern
 See discussion, infra, on whether Shareholders are really “owners” in Simons v. Cogan
 Lack of ability to negotiate attributes leads to common law influence
o Creditors:
 However, Creditors and Preferred shareholders have paramount interest as well
 Their risk is not as obvious as shareholders, but they depend on management for return
 The Debt Contract:
 Unlike Shareholders, creditors negotiation for, and attainment of the Debt Contract is where they get
their protection from
o Note:
 See Discussion of “Conflict between shareholders and creditors” supra p.1-3.
o
Historical Chronology:
 1. Debt Financing has always been the main component of the Capital Structure
 2. Traditionally Stockholders had a small role
 Suits were brought under ultra-vires, legal capital rules, or corporate purpose
 The Shareholders did less, and the Board of Directors was not looked at as much as big component of
corporation
 3. The Underwriters of Debt and Lenders had more of a relationship
 As debt backed most of corporate America early on, the Underwriters had a strong relationship with the
debtholders
 In fact, some underwriters (J.P. Morgan) guaranteed his clients’ money to assure they were taken care of
 B. Public versus Private Debt:
o Private Debt:
 In a private debt deal, the borrower simply goes to the bank
 Negotiation
 Based on the terms desired, risks bank Determines, etc…
 Negotiation is to the benefit of both parties as each side has something the other wants
 Customize the terms
 Lawyers responsible for Drafting
 Covenants have Effect on Price:
o The more protection, and covenants involved the less risk involved
 The less protectionthe more % gain for Issuer of Debt
 The More protection  the less % gain
 Syndicate:
 If debt is large enough that 1 bank is worried about holding all risk, bank will include others in the
process
 Agency Agreement:
o Banks will negotiate to make 1 bank the “Lead Bank”
o In this instance, the borrower only has to deal with 1 bank then
o Public Debt:
 In a public debt offering, the Underwriter/Investment Bank drafts the bond contract
 Terms are largely standardized, due to the evolution over time (infa)
 Lender always drafts
 Contrast with Private Debt:
 1. Registration with SEC
 2. In Public debt offering, you want enough protection in the contract that it is salable, but not too much
so that your client/borrower is obligated too much and they come back to you
 3. This balance has slowly tipped in favor of the borrower
31
o
For this reason, Public Bond covenants have had protection erode, and Public Debt has
very few covenants
 4. The Underwriter is not a party to the contract
o In this case, the underwriter merely creates the contract so that it can be sold
o Wants:
 To be able to Sell the debt
 To get repeat customer, so that customer comes back for other debt needs ($fees$)
 C. Characteristics of Debt:
o Bond (Indenture) versus Debenture
 Bond is long term secured
 Debenture is long term unsecured
o Attributes:
 Yield, Coupon, Maturity, Face Value (typically $1,000)
 1/32 is a “tick”
 Pay Principle, receive interest, and at maturity received principal
 D. Legal Context and Debt:
o 2 Key Policy Points Regarding Debt Contract
 1. Courts demonstrate judicial restraint  Do not Interject Common Law (See Sharon Steel; Cogan)
 Common stock has a fixed set of legal attributes
o The Right to Vote
o Dividends when and if declared
o The residual right after all other claimants
o Appreciation in share value
 Common Stock has a common law backing because of its limited attributes
 Corporate Debt does not
o A Creature of Contract, based on contract to define it
o Courts Generally Don’t Interfere with CL:
 “Demonstrate Judicial Restraint”
 Debt is negotiated Contract (Cogan)
 Difference in Stock Attributes and Debt
 Courts largely look to the Contract to determine Debt’s rights
 “Self Protection” If you want it, you better negotiate for it has been largely
accepted
 2. Courts Interpret Boilerplate as a Matter of Law:
 Interpreted via Contract as Matter of Law, rather than jury (Sharon; Rudbart; Morgan Stanley)
o Promotes Consistency, Standardization, Avoids increase in cost of capital
o Strong Interest in Certain Capital Markets
o 1. “Bond Doctrine”: Creditors Not Owed a Common Law Fiduciary Duty:
Simons v. Cogan (Del. 1988):
 F: Hansac and Knoll merged, with Knoll surviving as wholly owned subsidiary. The merger cashed out some
debtors, and Simons was a convertible debt holder. In leiu of her stock conersion, the merger gave her a
conversion to $12 cash, for each 19.20 principal and a rate increase. She filed suit asserting breach of fiduciary
duty—that controlling shareholder set price with directors, conflicts of interest existed, and no other merger offers
were accepted.
 I: Whether Fiduciary Duty exists to convertible bond holders
 R:
 1. General Issues:
o 2 Possible Remedies:
 Restore conversion to stock or
 New fair value of price she gets
 Note:
o Remedies fashioned by Courts may be intended to do one thing, but
may be used for another purpose
o For instance, restoring conversion may give shareholder old right,
but she then can go and negotiate a new cash price of above $12
 2. No Fiduciary Duty exists to protect Bondholders
o Absent a showing of special circumstances of:

Fraud

Insolvency, or

Statutory violation
32

o
o
o
Parties are confined to the terms of their Indenture Contract
Reasoning:
 Fiduciary Duty requires an equitable, ownership, property interest
 Looking at convertible debt instrument, it is not equitable interest until conversion
occurs into shares—that is an expected, future event that isn’t applicable now
Issues with Opinion:
 1. What is a Fiduciary Duty
 Here, the Court looks at the debt instrument, while Fiduciary Duty, created at
common law, looks at relationships
 Incorrect interpretation
 Nature of Fiduciary Duty:
o Power disparity, where party made an agent, to exert power over
something on behalf of another party
o The dominant party does so for the benefit of the subordinate party
o Relationship between party of loyalty
o Fairness is more modern approach then loyalty
 2. Court Says the Focus is on Equitable Interest/Ownership that Stock Has and
Debt Does Not—But, Distinction is not that clear
 A. Stockholder is not really an “owner”
o Has Limited Attributes:
 Residual right
 Right to dividends, if declared
 Right to Vote
 Right to Sell for greater price then purchased
o However, these are it…these are the attributes
 Not that much of an equitable/ownership interest
 Shareholders, in reality, are not “owners” but entitled to
these limited attributes
o So: Court’s equitable interest analysis, in reality, does not apply
to shares
 B. Additionally, debt holder could have an equitable/property interest
o For instance, a secured/lien bond has an ownership interest
 Overall: The Court’s analysis and reasoning of “equitable interest” is flawed
What Reasoning supports Lack of Fiduciary Duty to Debt holders?
 1. Contractual Argument:
 Unlike Shares, which have these limited attributes and no more, Debt is a
creature of contract
o Lack of Ability: Shares are not able to negotiate the attributes, and
therefore a fiduciary duty is imposed at common law to bolster the
attributes they do have
o They are unable to negotiate for heightened protection
 In Debt The ability to negotiate for what you want is inherent
o In Public Placement:
 Perhaps less of ability to negotiate with company, but there
are variety of bonds available with different attributes
o In Private Placement:
 Able to negotiate on rather even level, as both parties have
something the other wants
 Self Protection
o Since you are able to negotiate, negotiate for what you want
o Ability to contract with party that will be in control of $ unlike
shares
 2. Shares more at Risk:
 Because shares are not contractually obligated to be repaid, and only have a
residual right—rather then required repayment, they have more risk
 Therefore, Fiduciary Duty imposed to support them
 Counter Argument:
o Depends on where risk and ownership are evaluated
33


o
During operation, risk of non-dividend payment is one
thing, but risk may be different between creditors and
debtors
 Could argue, debt, during operation more at risk w/o voting
 At liquidation, even though they have residual claim, both
creditors and shareholders are relatively in same position
 Both want repayment, and both trying to get it
3. Certainty in Bond Market is Needed:
 If we left each bond to be determined if breach of fiduciary duty on case by
case basis, certainty would leave the market
 Prices would be affected, and discounted
 Sharon describes it
 Therefore:
o Avoiding factual, fiduciary analysis outright is beneficial to debt
market
2. Key Provisions of an Indenture Contract
 Generally:
 Creditors lock in their “Risk Profile” When they enter this indenture contract
o These Provisions ensures adequate protection, and that they contracted for enough protection
 Note:
o See Page 4, infra, “Oil Can Problem” for example of how these provisions apply in indenture
o Use of Covenants and Indenture Contract to avoid “Fundamental Conflict” between
shareholders and creditors  see, infra, “Limited Liability’s effect…p. 1-3



1. “Promise to Pay and Supporting Provisions”
 A. Collateralize
o Secure the debt if the issuer defaults (See infra on securitization)
o Debtholder seizes asset as collateral, sells it, uses proceeds
o Almost any asset can be collateral
 B. Guarantee
o Debtholder is protected by the promise of a 3 rd party to pay if the issuer fails to
o Can be either

“Payment by 3rd party” or

“Equity infusion” by 3rd party
 May be premised on Debt/Equity Ratio altering too much
 C. Sinking Fund
o Period payments are put into a fund
o Assures creditor’s $ is available to repay when maturity occurs
o Issue:
 This locks of $ that could be valuably used by the corporation
2. “Ranking”
 While ranks among collateralized assets occur (Secure, Senior, Junior), different classes of debt can also
be ranked among each other
 Negotiated by the parties
 Hierarchy:
1. Senior Debt
First to be paid
Lower Risk/Lower
Return
2. Senior Subordinated
3. Subordinated
Last to be Paid
Higher Risk/Higher
Return
“Junk or High Yield
Bonds”
3. Covenants
 Purpose:
o Ensures an issuer continues to operate in a way most conducive to repaying debt promise due to
the fact that the creditor is “locked in”
 Affirmative Covenants:
34
o
o

A promise of specified affirmative acts the borrower will do
Examples Include:
 Maintain the property, pay taxes, deliver financials at periodic dates, allow inspection
by lender, get insurance, notify over certain events
 Negative Covenants:
o A promise to not do something
o 1. Limitation on Incurrence of Indebtedness
 This covenant will state that the borrower cannot undertake additional debt unless
 Consent
 Certain Cashflows generated
 Ratios met
 May be allowed for certain maximum levels
o 2. Restricted Payments
 This covenant will state the borrower cannot let cash leave company
 Dividend payments, repurchases of stock, buy back of debt…etc…
 May be based on ratios or if “reasonable”
 Keeps $ in company to service debt
o 3. Asset Sales
 Prohibits the isser from selling assets unless
 1. Will not cause default
 2. Consideration received is > FMV
 3. High % of payment is cash or cash equivalent
 Typically will have a carve out for “de minimus” sales
 May require that when sale occurs, proceeds be reinvested and if not debt accelerated
o 4. Merger, Consolidation, Sale of Assets
 Prevents issuer from consolidating, merging, or selling assets unless certain conditions
met
 1. Suviving entity must assume liabilities and obligations of indenture,
pursuant to a supplemental indenture
 2. No default after transaction
 This prevents transaction where the company doesn’t survive, or is too weak to pay off
debt
 See, infra “Successor-Obligor” clause
o 5. Payment Restrictions on Subsidiaries
 This may typically apply when 1 company, the borrower, reiles on its subsidiaries for
their $ coming to them
 Because the company uses them to service its debt, this covenant prevents holding
company from sending money back to subsidiaries
o 6. Restrictions on Liens (Negative Pledge Clause)
 When a secured loan is incurred, this covenant prohibits the issuer to allow additional
liens on that asset unless minimum conditions are in place
o 7. Line of Business:
 May restrict the issuer from leaving line of business which debt holder lent $ to
4. Redemption
 Generally:
o A bond, or debt has a maturity date, however, that bond or debt may be able to be redeemed
prior to that date
o Once a date for redemption is set, debt does not earn interest beyond that date (See Rudbart,
infra)
 It is in best interest to turn in debt security as quickly as possible to avoid not getting
return
 Optional Redemption
o The issuer receives the ability to redeem early
o As a compromise between issuer and lender, Option to redeem may only vest after Call Period
 Call Period: Vests after fixed minimum years, prior to which no redemption is allowed
o Will be negotiated as to what causes redemption and what payback is
 For Example:
 If interest rates may drop, this option to redeem will be negotiated by the
issuer, so that they can get another loan at more favorable rate
 Investors don’t want this, as they then lose their above-market return
35

o
Protection:
 What may be used to redeem Bond/What may not be (Morgan Stanley)
 Mandatory Redemption
o Due to certain, negotiated events
 Examples include:
 Cash flows > Then what was thought pay back early
 Asset sales: if proceeds have not been reinvested by certain time frame, may
require mandatory redemption
 Change in Control:
 A common event that creates mandatory redemption, if the company’s control
changes, issuer may have to buy back all debt at 101% + unpaid interest
o May be:
 Sale of all or substantially all of the assets
 If any person becomes a beneficial owner to specified %
 Any time continuing directors, or directors who were
members at the issuance date, do not comprise a majority,
may trigger this clause
 5. Events of Default
 The Indenture Contract will define, and specifically list the events contemplated
o Result: “Automatic Acceleration:” The debt principal and interest due immediately
 Typical Examples Include:
o 1. Default in Payment or Principal
 Triggers “Acceleration Clause”
o 2. Breach of Covenant, Representation or Warranty
 If any of the Covenants or Representations or Warranties are not met, may trigger
accelaration clause
o 3. Bankruptcy or Insolvency
o 4. Cross-Default:
 If the issuer has any other debt, and defaults on it, this loan will be in default
 Acceleration Clause
3. Judicial Interpretation of Debt Contracts and Key Provisions:
 “Successor/Obligor Clause” in Covenants Section
Sharon Steel Corp. v. Chase Manhattan Bank (2d Cir. 1982)
 F: UV issued debt to Chase. It had a “successor/obligor” clause which allowed UV to assign its debt to
any one who purchased “all or substantially all” of its assets. If it was not assigned, UV had to pay it off.
UV engaged in a liquidation of its assets. It sold several lines of its business. Then, it sold the final line
and remaining assets to Sharon Steel. Sharon bought all remaining assets and assumed liabilities, paying
$578M for assets and cash. It then tried to invoke the “successor/obligor clause” but lender Chase
rejected.
 I: Whether interpretation of the clause is matter of law, or factual inquiry for jury?
 R:
o The original borrower will borrow money from lender, entering into:
 (1) Indenture Contract: With the lender
 (2) Debenture Contract: with the individual bondholders
o The Successor/ Obligor Clause
 A very common clause that is in boilerplate, that allows a successor company to step
into the shoes of the original borrower if merger, acquisition, asset sale…
 Contents:
 “Nothing in the indenture or debenture shall prevent any merger, transaction,
sale of assets…provided that
o Any transaction, or “sale of all or substantially all of assets” leads to
the assumption of liabilities by the successor corporation
o Just as if successor was original party to transaction
o Novation occurs, where successor steps into shoes
 Except, does not step into liability of debentures
 Effect:
 1. Successor steps into the Shoes of the indenture
o The successor/new borrower has the same terms as if it had been the
original party
 Note:
36

o
While there may be additional terms, standard context is
that same terms apply
 2. However, the Former Borrower is not entirely off the hook:
o The former borrower is still liable for the debentures, or the original
debt owed if not repaid
o The former essentially becomes a guarantor if new party defaults
 Reason:
o The successor steps into the shoes of the indenture because both
parties—the successor and lender agree to it
o However, the debenture is with each individual bondholder, and you
cannot, as a matter of basic contract law, unilaterally change a
contract
 How does Novation occur:
 (1) A Purchase of Asset Contract will be entered into
o Between the buyer and seller/original borrower
o Will contain successor/obligor clause
 (2) Supplemental indenture entered into:
o Between the Buyer and the Lender is entered into
o Amends the original indenture
 Use:
 1. Protects Lender:
o Assures there are assets to service the debt
 2. Protects Borrowing Company:
o Allows them to enter into transactions, and not worry about what
will occur with debt—Certainty
o Allows them to subsequently continue their operations, or move on
free of debt
 Note:
o The lender could prohibit the transaction to occur, thus avoiding any
worry
 But—this would lead the borrower finding someone to give
it more beneficial terms
 Also, transaction may be beneficial to lender giving it (1)
better party with better credit, (2) may lead to better
viability of the borrower, making easier to repay debt
depending on transaction structure
Why Transaction Occurred:
 Sharon wanted the debt as interest rates were climbing. They could have borrowed, but
would have been much higher interest rate then current debt
 To make sure, it purchased assets and cash to be “all or substantially all”
 Bondholders disagreed, as worried about ability to repay
o
**Because Clause is common, uniformity is needed and decided as a matter of Law
 1. This standardization and Certainty are necessary to the Capital Markets
 Uniformity is necessary for comparison of investments
 2. Uncertainty would decrease value of all debenture issues
 The case-by-case analysis of debenture contracts would create uncertainty,
and this would decrease their value as they would be discounted
 Price to finance debt would increase—cost to borrow increases
o
Interpretation: “All or Substantially all of Assets”
 At the time the plan of liquidation is determined upon are transferred to a single
purchaser
 Here:
 All of remaining assets on date purchased were transferred, but they
amounted for about 51% of book value of total assets, and 38% of revenues
and 13% of profits
 This was not “all or substantially all”
Redemption premium and Acceleration Provision applies:
 UV said that it no longer had an obligation and did not pay—defaulted
o
37


Here:

Default “Acceleration Provisions” and the “Redemption” provisions apply
together
o Are not exclusive of other remedies
 Because it was a voluntary sale of assets, albeit unsuccessfully
 The Purpose of Redemption provision is to price the voluntary satisfaction of
debt before maturity
o Cannot be avoided because debtor made a mistake and defaulted
 The Redemption Provision may not be owed if involuntary
Redemption Provision and Notice:
Rudbart v. NJ District Water Supply (NJ 1992)
 F: The Commission operates a Public Water system and authorized the issuance of $75M in new notes.
Fidelity bank bought $73.8M of them, selling them for $75M, making the 1.2M spread. The bonds had a
callable redemption option, with clause specifically listing terms of redemption payment. “Notice
Provision” only required they be put in Newspaper of their redemption. In 1985, wanted to redeem them,
and put notice in newspaper. Redemption Date was June 23rd. However, not all debenture holders got
notice of the redemption in Newspaper. Fidelity hand-notified its own customers, however by phone.
 Π’s Argument: They argue that from redemption date of June 23 rd until it was actually redeemed they
should be owed interest, as they didn’t redeem and otherwise its free money. They argue that they didn’t
get to negotiate notice terms so it is a Contract of Adhesion
 R:
o 1. Contract of Adhesion is:
 A take-it-or-leave-it contract, with standard form, and inability to negotiate
 Look at:
o Economic Pressure
o Disparate Bargaining Positions
o Public Interests
o Economic necessity of contract
 The Bond Indenture and Debenture Contracts fit this
o 2. Policy Ramifications make it unwise to call Bonds/Debt Adhesion Contracts
 1. There is no economic pressure:
 There are many investments that can be chosen, and none are forced
 Many different debt, and equity investments have many different attributes
 2. This is not Economic Necessity
 This is unlike consumer goods, which are necessary for daily life
 Rather, it is an investment which can or cannot be undertaken
 Counter Argument:
o Debt is vital to the capital markets and every day life
o Effects cars, homes, etc…
o If it were stripped away, the Capital markets would simply cease to
operate…
 3. No Disparate Bargaining Position
 because it was not necessity, and there are many variations which can be
bought from many parties without pressure, there is no disparate bargaining
position
o 3. Why we want Indenture Contracts to be Enforced
 1. Standardization is beneficial to Securities Markets
 We want debt, which is common, to be standard and common so that people
get what they know and are familiar with
 Allows for comparison of debt to debt, with standardized forms and terms
 2. Certainty in Debt creates stability in Capital Markets
 3. If each contract was susceptible to judicial interpretation on factual inquiry:
 Increases risk/uncertainty in debt
 Raises cost of debt, as each debt contract would price this risk in
o Raises costs to borrower
 Raises Risks to the lender of toss-up interpretation
o In turn, increasing cost to borrow
o 4. Notice Clause of Publication is Fair:
 Newspaper notice is common form, standard in Debt Contracts
 For policy reasons, Judicial Interference is not warranted
38




Notice Provision is Fair
 Note:
o Court will differentiate between lack of contract’s informing parties
of “the type of notice that will be given” for redemption
o But, notice provision that is within a contract will be enforced
Issues:
 Seems concerned with slippery slope of judicial inquiry into indenture
contract
 “Restraint of judicial oversight in publically held securities” needed
No Interest after Redemption Date

Dissent:
o Indenture Contract is contract of adhesion
o The uncertainty, standardization, and worry of the Court is not warranted
o Issue is Fairness and reasonableness of Notice Provision
 Dissent argues Court is not interpreting the substantive, financial provision of the
debentures
 Only Interpreting the Notice fairness
o Here:
 Indenture Trustee informed its own customers, but not non-customers
 Mailing is encouraged by the SEC and practice
o Overall:
 Because Fairness of Notice does not interfere with substantive, financial provisions,
and is restricted to this case:
 Should require fair notice, individually to each party
Redemption Provision Vesting Period: Covenant restricting repayment with new debt:
Morgan Stanley v. Archer Daniel Midland:
 F: ∆ issued bonds at 16%, allowing for early option redemption. However, there was a vesting period,
before which the bonds could not be called if the funds used to call were from new debt at rate less than
the interest rate on the bonds. In year proceeding, ADM borrowed twice at <16%, and then issued IPO.
Within 1 day of Morgan Stanley buying the bonds, ADM called as interest rates plummeted.
 I: Whether the IPO and juggling of funds to redeem is allowable, or ∆’s construction applies
 R:
o 1. Preliminary Injunction Sought:
 Requires:
 1. Irreparable harm, and either:
o a) Liklihood of success or
o b) serious question of merits and balancing of hardships tipping
torwards relief requesting party
o Note:
 No irreparable harm will be found when $ damages are
adequate
o 2. The Provision:
 “Company may not redeem debentures from proceeds, or in anticipation of debt if the
interest rate or cost of debt is less than __%”
 The Purpose of the Provision:
 Protects the creditor/bondholder from being called when interest rates drop
 Unlocking of return by using cheaper debt, at which point in time the creditor
must then go and issue debt at a lower rate
o 3. Interpreted as a matter of Law
 Per Sharon Steel, need to interpret language as matter of law for consistency
 Avoid jury case-by-case inquiry of contractual provision interpretation
 Would bring intolerable uncertainty to Capital Markets
 Cost of Capital would increase
 Paramount interest in uniform construction of boilerplate
o 4. The “Source Rule”
 The Contract language is interpreted:
 Redemption is barred when the direct or indirect source of the funds is a debt
instrument issued at a rate lower than that it is paying on the outstanding debentures
39



When can point directly to a non-debt source of the funds, the general
redemption schedule applies
 However:
 Still need to make finding of the true source of the proceeds
 Look at facts to show when prohibited debt was source of proceeds
 Look at what directly funded the redemption
 Here:
 Clear that proceeds from bond offering were used for other purchases
 Facts show no debt was used, but instead was equity
Issues with the Opinion and Alternative Arguments:
o a) Judicial Restraint to overbroadly interpret
 Better be clear and unambiguous in indenture or else you won’t get it
 While Court does not want to get into factual inquiry of where $ comes from, Source
rule does get into this
o b) Leads to added and more demanding provisions by the creditor
 For instance:
 Demand debt and equity be in separate accounts so that you can trace where
the redemption proceeds came from
o c) Finding where the $ comes from is almost impossible
 It is unlikely that you can point to exactly where the funds used to repay are coming
from
 Proving it is unlikely, as you simply cannot begin to argue that all of the $ came from
only equity or part debt, vica-versa
 May only be probable if separate accounts used
 However: While court interprets construction consistently, the factual inquiry into
proving the “source” rule is almost impossible
o Alternative Argument:
 WACC:
 [Weight x ROD] + [Weight + ROE]
 The provisions seeks to protect creditors from being unlocked from higher
paying debt
o It does this by prohibiting redemption with lower cost of capital
 We could simply look at if the WACC changed
o If the WACC, after redemption is > rate prohibited in provision
 The redemption would be allowed
o If the WACC, after redemption is < rate prohibited
 The redemption would not be allowed
 This would mean that after the redemption, cost of
redemption lowered the debtor’s interest rate
 Effect:
o Avoids need to check blend of $, where funds came from
o Protects both parties adequately
o Rather then going into factual inquiry of blend of $
 Flaws:
o ROE changes quarter to quarter, and may taint the equation, in
addition to the weight of debt lowering due to another issuance
maturing…leading to a lowering WACC, and in breach of the
negative indenture covenants
Synopsis of Courts’ interpretation of boilerplate and avoidance fiduciary duty:

Retains the idea of negotiability (Avoids Factual Inquiry and Sticks to the Contract)
o Simons says no “equitable” interest of creditor
 But, see infra, as shareholders really don’t own anything either
o Creditor/Issuer
 Freedom of Contract protected
 Bargains for protection in best way to structure relationship in their opinion
 Most efficient manner of allocating resources to each other
o Allows allocation of risks efficiently
40
o

o
Adequate protections
 Negotiate for self-protections
o Avoids arbitrary limitations
 Parties may flexibly exercise their discretion in order to maximize wealth
o Unlike Stock, with limited attributes
o Assumes Parties are financially sophisticated
 Thus, because sophisticated, no need for court to interject
 Because of this, there is not as much need for Court to interject fiduciary duty
Construe Boilerplate Narrowly: Narrows Courts Equity and Factual Analysis
o Promotes certainty in contractual terms
 Avoids jury determination on case-by-case basis—which would create uncertainty
o Predictability in Contract Language
o Standardization of Terms for comparison
o Lowers cost of debt
o Construing consistently in “hands off” judicial restraint approach
4. Implied Covenant of Good Faith and Fair Dealing:
 Generally:
 Many courts accept the Delaware Test of implied covenant
 Katz v. Oak Industries, Inc (Del. Ch.):
 F: Oak has 3 segments, and is doing terribly financially. To correct itself, seeks to reduce annual debt
payment. Exchanged old debt for new recapitalization of stock, warrants, and debt. However, the
debentures have condition that “Cannot issue new debt.” So, Oak must get their consent to amend this to
issue new debt to save company. Amendment would end protective covenants
 Π: argue that breach of implied duty of good faith because the offer and consent was forcing debenture
holders to consent. Failure to do so would have risked owning a security without any protections. So,
smart thing, and in reality only thing would be to consent and tender for new recapitalization. Collective
Action Issue
 R:
o 1. Preliminary Injunction sought of the Offer and Consent
 Court will not grant injunction, an extraordinary remedy, when:

To do so threatens enjoined party with irreparable harm that is > then injury
π seeks to avoid
 Note:
 What really is going on is that the debtholders want the company to go
bankrupt because they think they will get more that way
 Judge knows this, and does not want to let happen—π cannot win
 Judge makes his own judgment that bankruptcy is not right, that duties and
laws in bankruptcy should not apply, actively avoids it by denying π claim
o 2. Because Contract, There is Implied Covenant of Good Faith:
 Reason:
 Because Contract, contract law applies
 Some things are so fundamental, that parties need not negotiate them or write
them
 When Court invokes implied covenant, it is saying that spirit of that bargain,
the unspoken term, cannot be violated
 Test:
“is it clear from the express terms that parties would have agreed to
proscribe the act later complained of had they thought to negotiate it?”
o Look at provisions to determine what would have been agreed to
 Here:
 Not clear they would have agreed to otherwise
 Grant would create harm > then that sought to be avoided
 Issues with the “Implied Covenant of Good Faith” Test:
o 1. Judicial Activism: Test may include determination of what Contract’s Economic Efficient
Result is, and meaning is in Determining what is implied by the terms in determination
Indenture should Control:
 Belief that the efficient allocation of resources is best interest of parties
 Each gives up something the other wants, and believes it is efficient
 Economically efficient argument
41
o
 As Judge determines what this is, it can guide his analysis
o 2. Subjectivity of Test:
 This determination is solely discretion of Judge
 Here, judge determines that because it is economically efficient to keep company in
business, this is what they would have agreed to
 Therefore, it is not “clear from the terms” they would have proscribed the
recapitalization
 Essentially, you can argue anything is more or less economically efficient
o 3. Creditors have priority and should be protected But Court holds otherwise
 The creditors have every right to be protected
 At insolvency and bankruptcy, equity is already wiped out, and now their
capital is at risk
 Law is designed to protect them at this point
 Also Note: Inherent Conflict between Creditors and Shareholders (See infra)
 Here, The Corporate restructuring is to protect shareholders at the expense of
debtholders
o Transfers loss and risk of loss from shareholders to creditors
 At this time, the creditors should be primarily in line—but, conflict benefits
shareholders, and need to get around covenant protections to do so
 However, Judge makes his own subjective determination otherwise
 Judicial activism
5. Other Parties, The Indenture Trustee and Right to Sue of Debenture Holders:
 A. The Underwriter/Investment Banker:
 Traditional Role:
o Places the debt into the public markets for a commission
o “Spread”
 Policy Arguments:
o Underwriter May protect the debt holders
 1. Incentive to negotiate to increase indenture protections, allowing it to sell for a
higher price
 2. Incentive to protect its own reputation
o May not Protect debt holders:
 Underwriter is selected by the issuer
 Underwriter wants to gain business, appease issuer, and have repeat
customer
o Probably What Occurs:
 This characteristic has led to the slow erosion of indenture
protections over the years and marks the reason that
Underwriters/Investment Bankers probably will not protect
the debt holders in public debt more then it needs to
 B. The Rating Agency:
 Generally:
o The Issuer will pay to have its debt rated
 Why:
 Assesses liklihood of repayment
 That repayment will be (1) on time and (2) full amount
o Not required, but practical necessity so that risk of debt can be quantified and priced into the
value of the debt issuance
o The legal protections of Indenture Contract do not affect rating typically
 Historically:
o AAA rated bonds have declined in occurrence
o Why:
 Deregulation, Competition, Leveraged transactions
 Companies belief that it can operate at a more optimal level with a higher level of debt
that may not put it in AAA rating
 Ratings Effect Shareholder:
o Analyst downgrades due to debt condition lead to market reaction, and sell off
 Federal Regulation:
o May register as Nationally Registered Statistical Rating Agency
 Include:
42

o

Performance, statistics, procedures, methods, conflicts, lists of issuers
customers
SEC oversees
 Once Registered:
 Maintain files, records, financial reports filed with SEC annually
o Post-Dodd Frank
 Mandates new SEC office to oversee, with new SEC rules governing
 Compliance, Conflicts of Interest, Liability, Methods Used, allowing Private
Cause of Action (Scienter of Knowing or Reckless)
C. The Indenture Trustee:
 General Attributes:
o A party in between Issuer and debenture holders with administrative ability
o Represents the Bondholders
o The Court, as we see above, will not interject the common law in a reaching manner into
interpreting the contract and the Underwriter/Investment Banker probably won’t protect either,
although there is some argument they may…So someone needs to represent the Debt Holder
 Reason for Existence:
 Collective Action Issues:
o As individual holders of debentures are dispersed, the trustee eases
issue of collective action—lack of communication, and collaboration
o The Trustee is the party who oversees the issuance on behalf of debt
holders
 However, Modernly Institutional Investors are holders of debt
o Because of lack of collective action issue, and their sophistication:
 Use of Trustee is in question: Not as Needed
 Leads to narrow construction of contracts
 Narrow duties and responsibilities apply
 Unlike a typical trustee:
 Typically does for the convenience of the clients
 Does not mandate large fee
 Very limited duties and obligations
 But, the “Trustee” title has remained over the years, causing confusion about
duties and responsibilities
 The Right to Sue:
o A. Generally:
 Under the Debenture Contract:
 Debenture Holders can sue under Debenture Contract for payment when
it is due
 Absolute Right of Debenture Holder
 To Bring Suit under Indenture Contract
 Debenture Holders must Demand Trustee to Sue
 The Debenture holders cannot sue individually under indenture unless:
 1. Contractual conditions precedent, like below, are met or
 2. In narrow instances can bypass conditions precedent
o B. Model “No Action Clause” Am. Bar Foundation Model Debenture Indenture Provisions:
 No debenture holder can sue under indenture unless
 (1) Given written demand notice to trustee of default
 (2) Holders of at least 25% of debentures have made written demand to sue
 (3) Indemnity offered to trustee
 (4) Trustee has failed to bring suit for at least 60 days
 (5) No other request, inconsistent with demand of suit, made by majority in
60 days
o C. Purpose:
 1. The restriction on individual debenture holders bringing suit under indenture is
 a) To avoid unjustifiable, unreasonable, and frivolous claims
 b) Limits suits to those that are meritorious, as if it is, it’s likely that 25% will
agree
 c) Avoids 1 bondholder causing expense to company, diminishing assets at
expense of all
43

2. Standard indenture provision
o

When can Debenture Holder bypass provision, Bringing Suit under Indenture:
Rabinowitz v. Kaiser-Frazer (NY):
 F: π owned debentures of Graham-Paige. BOA was trustee. Covenant in indenture
required “Successor obligor” assume debt, and that a sinking fund be paid into. KaiserFrazer bought Graham-Paige, agreed in contract to pay back debt, but did not enter
into supplemental indenture—This bypassed sinking fund—Effect was to get money
cheaper, even though bondholders now had more risk as their sinking fund was gone.
Then, BOA—Trustee leant $ to Kaiser, and developed its own sinking fund for it. Π
argue that trustee should have gotten supplemental indenture, and breached duty. ∆
argues that they lack standing as didn’t demand through correct provisions
 R:
 1. Debenture Holder can bring suit under indenture if:
o Trustee acts in bad faith
o Abdicates its function or
o Declines to act at all
 2. Demand Futility Creates this Ability:
o If the debenture holders had demanded that the trustee bring suit,
they would have been demanding that the trustee sue itself as it was
the wrongdoer alleged
o So, in this instance, can bypass the “No Action” provision
The Trust Indenture Act of 1939:
o Generally:
 In 1930s, financial industry had much financial regulation shoved down its throat
 To fully complete the regulatory scheme, debt was regulated under TIA
 Purpose and Effect of TIA:
 The main problem:
o Trustee often times was aligned with issuer, and not debt holders
o Because of Collective Action problem of individual holders, nothing
could be done about it
 1. Provide standards of Trustee, and disclosure to debt holders
 2. Ability to organize by the debt holders, to protect themselves
 3. Ensure disinterested trustee provides services

o
Application:
 Only applies to Public Debt
 Requires registration
 1990 Amendments: Trust Indenture Reform Act:
 **Assumes that the TIA is incorporated in indentures whether actually
explicitly listed or not
TIA Provisions:
 §315:
 Duties Prior to Default:
o (1) Trustee is only liable for performance of duties in indenture
 Note: because of this, very few provisions and duties of
Trustee will be included
 1. The Demand of Suit Provision
 2. Obligation to Authenticate Debentures by comparing an
exhibit attached to the indenture to the actual debenture to
make sure it’s accurate
o (2) Trustee can rely on indenture and exhibits therein
 Can rely on the exhibits as accurate
 Duty of Notice of Default:
o (1) Indenture Trustee must give debenture holders notice of defaults
known to trustee within 90 days after occurrence of default of
payment of principal or interest or sinking fund only
 Otherwise, trustee may withhold notice if “in good faith
determines in best interest to not notify”
 At Default:
44
o



(1) Trustee must act as reasonable person, in circumstances
would, with duties in the indenture
 Note: because only liable for those duties, won’t be many
Overall Responsibility:
o Trustee cannot include provision in indenture that “relieves trustee
from liability of negligent action, willful misconduct” except that:
 1. Only liable for duties in the indenture (which will be nill)
 2. Not liable for error in judgment if good faith by officer of
trustee unless “negligent in ascertaining facts”
 3. Not liable if action taken or omitted was at direction of
majority of holders
Overall:
 The Trustee has relatively little duties and liability
 The duties are restricted to those in the indenture
Judicial Interpretation of Trustee and Use of the Indenture Contract:
o Overall:
 The Trustee solely needs to fulfill the indenture contract
 Nothing more need be done
 However:
o As the TIA limits liability to what is in the contract, the duties are
minimal—there is not much required
o So, Trustee takes position of Stakeholder/Administrator but not more
 Pre-Default:
 Indenture is only thing that matters
o But There Cannot be Conflict of Interest
 Post-Default
 May be fiduciary duty that is implied in and around Indenture Contract
o Pre-Default:
1. Trustee as Competing Creditor is Allowed
 Morris v. Cantor:
 F: Company issued debentures, with Bank as Trustee. Indenture agreement
provided that if trustee becomes creditor, it is subordinated like all debt.
Bank, however, then lent $90M line of credit to issuer, which was senior to
debentures. Π argues breach of fiduciary duty and “willful misconduct.”
 R:
o 1. There is Private Cause of Action for Substantive Duties TIA
mandates
 The contract does create liability for provisions mandated
 Common Law claim is also a Cause of Action
 TIA is not sole cause of remedy
o 2. TIA Allows Trustee to Become Creditor in certain scenarios
 It is ok if : “ trustee who is also creditor within 4 months
prior to default of bonds or after, who receives preferential
treatment, hold proceeds for the bondholders”
 This is an accepted Conflict of Interest by Congress
 Congress new it may be good at times for trustee, who is
also bank, to lend to company in order to keep it afloat
 May be preferred or senior as well
o 3. Still may be liable for Willful, Intentional Misconduct Though
 Conflict of Interest still can be actionable
 If circumstances show it is intentional, or willfully against
the interests of the debenture holders
2. Trustee Only Needs to Fulfill Indenture: No More
 Broad v. Rockwell:
 R:
o A Trustee has no duty to do anything other then contracted for
o Does not have to do anything greater then indenture contract
3. Pre-Default, Unless Conflict of Interest Trustee limited to terms of the Indenture
 Elliot Assoc. v. J. Henry Schroder Bank:
45





F: Elliot held convertible debentures of Centronics. The indenture required
that the company, to redeem early, had to give written notice to the trustee
and debenture holders. It had to give trustee “50 days notice unless shorter
notice was satisfactory to trustee.” It had to give debenture holders 15 days
notice. Company discussed redemption with Trustee—who said less than 50
days was satisfactory. Company offered conversion day before next interest
payment, and said redemption would occur as well. Conversion made
debenture holders much more $ then holding for redemption.
Πs Arg: πs argue that Trustee breached fiduciary duty by failing to use full
50 days, which would have gotten them another interest payment, worth
$1.2M.
I: Did Trustee have fiduciary duty to weigh financial interests and benefits?
R:
o 1. The Indenture Contract is strictly defined and duties limited
to it
 §315 states “only liable for what’s in it”
 There are no additionally duties, as long as fulfills express
obligations
o 2. However: Trustee must not engage in “Conflicts of Interest”
 Intentional, Willful Misconduct
 Preferring its interests over that of the debenture holders
 Absent Conflict of Interest, Trustee is only bound by
indenture contract
o 3. The Notice Requirement
 Indenture required Notice to Trustee
 This is intended for trustee’s benefit
 If Complete redemption than company can simply make
call to debenture holders
 But, if partial redemption—trustee must perform
administrative tasks in preparation (select which ones,
etc…)
 Determination of time required is for Trustee
 Here: was satisfactory to do in less than 50 days.
Note:
o We see the consistent thinking of the Court that the Trustee does not
need to do anything above and beyond which Indenture Contract
States
o Not even if, as above, could simply wait a few more days to increase
wealth of debenture holders
o More like a stakeholder
o However: There is a Conflict of interest, as the issuer is probably
paying the trustee’s bills, and he, in essence, preferred the issuer’s
interests over that of the debenture holders
o
Post-Default:
1. US Trust of NY v. First National:
 F: Trustee eventually issued a line of credit to the issuer. Trustee was under duty, by
indenture, to give notice of default to debenture holders, and to accelerate the
payments putting them in default. However, the trustee only accelerated its line of
credit but did not accelerate the debentures until afterwards.
 I: Did the ∆ breach a fiduciary duty, post-default—willful misconduct or negligence?
 R:
 1. Post-Default, a fiduciary duty exists for the Trustee
o This conflict of interest was actionable
o
Overall Duties of Trustee Synopses:
1. Harriet & Henderson v. Castle:
 F: Company financed a new company, Star with help of IB. It was a combination of 2
old companies. Law firm was trustee. New notes were issued in the new firm, and the
old creditors were told they would have an additional lien on the equipment—senior
to, and secured above the new creditors. However, the lien was never filed and Star
went bankrupt.
46

I: πs argue that the trustees breached a fiduciary duty by failing to correctly file the
lien.

R:


1. The Indenture Trustee is Unique, and Different than Ordinary Trustee
o A. The Indenture Trustee arises out of contract
 Unlike ordinary one, which is common law creature
o B. Indenture Trustee must consider interests of the issuer and
debenture holders
o C. Purchasor of debt is offered, voluntarily accepts security
 The terms are highly specific
 Thus, common law injection of factual, abstract “fiduciary
duty” do not have constructive role when contract is
Negotiated, and Commercial in nature
2. While the Indenture Contract controls the Indenture Trustee, and
there are no implict duties: There are 2 narrow exceptions:
o 1. Post-Default:
 The loyalties of indenture trustee are to the debenture
holders
 Fiduciary duty exists
o 2. Pre: Indenture Controls: But Avoid Conflicts of Interest:
 Elliot
 a) When trustee sacrifices interests of debenture holders for
his own

must be clear possibility based on evidence

not just hypothetical or assertions without fact
o Here:
 Neither of these were apparent, and there was no express
duty to perfect the lien in the indenture contract
 E. Bankruptcy:
o Generally:
 As we see above, during operation and solvency, there is no fiduciary duty owed out of common law to the
creditors and limited standing to sue
 However
 At Bankruptcy, the situation changes
 Equity prevails to avoid the inherent conflict between creditors and shareholders
 Reorganization Agreement will be entered into:
 (1) Must Be Fair, Equitable and Feasible
o Fair and Equitable:
 Agreement
 If disagreement, Cram Down can occur if:
 (1) Get full value or
 (2) Absolute Priority Rule: No lesser claimant gets anything
o

o
Feasibility:
 Will company continue as a going concern based on this plan. Going forward,
bankruptcy’s point is to reorganize so that the corporation is still viable
 Viability means that it will not need to liquidate, or reorganize again
Overall Goal:
o To reorganize, and clean up the capital structure so that the new structure consists of securities
that company can afford
o Adjust payments so that Corporation can afford costs of capital
o Feasibility of Corporation continuing as a going concern viability
o Continued viability of stakeholders who rely on bankrupt firm
Background:
 What Options are available at Bankruptcy:
 1. Non-Bankruptcy Restructuring
o 1. Exchange offer of new security for old debt
 Exchange for new debt, equity, higher ranking, higher rate of interest,
47




Does not bind non-exchanging debt holders
Debtor cannot require them to accept offer
Delaware Exception:
 If put in AIC, Chancery Court may oversee meeting of creditors, and if
minimum amount agree to exchange offer, may bind all
o 2. Consent-Solicitation
 Solicitation of creditor consent to modify the indenture contract
 Note:
o What we saw in Katz
 Purpose:
 Avoid the default or acceleration provisions
 To Do:
 Indenture will typically have:
o Non-Key Provisions:
 “Majority vote of debt” to consent to a modification
o Key Provisions:
 Principal, interest, maturity
 “Unanimous vote”
o Pre-Package Chapter 11 Plan:
 Plan of bankruptcy reorganization developed before chapter 11 is filed, in negotiation
with creditors
 Lower Voting Requirements:
 Approval by creditors holding 2/3 of amount of debt and ½ in number of
claims
 See In Re Zenith Corp, infra
2. Chapter 11 Bankruptcy Reorganization
o Voluntary:
 Debtor may file without regard to financial condition
o Involuntary:
 3 or more creditors may file
 Allege: failure to pay
o Effect:
 “Debtor in Possession”
 Old management will continue to operate business, unless creditors request
trustee be appointed
 Court will only displace for cause
o Fraud, dishonesty if “in the best interest of creditors”
 Automatic Stay
 Debtor gets time to make operating decisions
 All actions against debtor are enjoined, except governmental actions
 Secured creditors are stayed from demanding repossession
o They can appeal if “not adequately protected”
 Reorganization Agreement
 Can be negotiated by parties
 Generally debtor has exclusive period of 120 days to come up with and
negotiate
 Approval:
 Approved by:
o Majority in number and 2/3 actually voting accept it
o Negotiated for Agreement is acceptable
o If negotiated for agreement, APR not applicable
o Or, If No Approval: “Cram Down Rule”
o “fair and equitable” by being”
 (1) Paid in full of claim or
 (2) Absolute Priority Rule: no junior claimant will receive
anything under the plan
 Solicitation:
o Must be adequate with adequate disclosure of information
o Pre-Package: Disclosure is adequate if compliance with nonbankruptcy law regulating disclosure
48
o
o
After Filing: Disclosure must be certified by the court that it was
“adequate”
1. The Debtors in Possession Owes Fiduciary Duty Which is Enforceable at Bankruptcy:
 Pepper v. Litton (US 1939):
 F: Litton was sole shareholder of Dixie Corp. He caused it to confess to judgment that it owed him and
withheld salary. He then transferred all the assets to another corporation, leaving just enough money in
Dixie to satisfy his judgment creditor position. Pepper, a creditor, thus had nothing to recover and
brought suit.
 I: A jurisdictional issue over bankruptcy court’s power…But develops fiduciary duty as well.
 R:
o 1. The Bankruptcy Court has the power to Equitable Subordination
 Court has equitable power to subordinate based on equity/fairness
 If Fairness concerns arise
 Bankruptcy Court may subordinate claims to ensure equity is reached
o 2. Fiduciary Duty is Owed to Creditors, Enforceable at Bankruptcy
 A fiduciary duty is owed by controlling shareholder, officer or director at
bankruptcy for protection of the entire community of interests –creditors and
shareholders
 Test:
 “It is sufficient that violation of rules of fair play and good conscience
occurs”
o Whether an arms length transaction occurs
o Good Faith, fairness of transaction,
o Generally Is what occurred Fair?
 A question of pure equity
o Burden:
 On the ∆
 When Does Fiduciary Duty become active?
 A Fiduciary duty exists in inchoate fashion before bankruptcy
o The conduct occurred before the bankruptcy filing
o This means that a fiduciary duty must exist before bankruptcy, but
we know from Simons v. Cogan, the Corporation does not owe
fiduciary duty during that time absent special circumstances (Only
Indenture matters)
 At Bankruptcy there is a special circumstance
 Enforced:
 Enforceable at bankruptcy
 A Court of equity has the power to go back to “sift through the circumstances
surrounding the claim” to avoid unfairness
 Why is fiduciary duty enforceable at Bankruptcy:
 1. Merely a Function of Contract
o The Creditors negotiated for priority at bankruptcy, and thus because
of giving up, and limited liability structure, fiduciary duty to fulfill
 2. At Bankruptcy, Economic Circumstances have Changed
o Equity Ownership:
 Equity has been wiped out of the company
 Because the Debt is what is risk capital left, the debt
holders own the company
 A-L = (SE)
 Thus Simons requirement of “equitable” interest is met
o Even though the Indenture Contract has not changed, the economic
substance and reality of the event does
 Thus, because the creditors are the owners of the
corporation, a fiduciary duty to act in their best interest
kicks in
o Here:
 What occurred was unfair, even though each was technically legal
 Was a fraudulent scheme which makes breach almost automatic
 Note: Judgment creditor paid prior to all
49
o
o
Issues with Opinion
 1. Pure Equity
 While each of the actions that occurred were “legal,” Douglas believes that
are unfair, and as a matter of pure equity, Court may overturn or subordinate
 2. No precedent, authority, or facts
 Douglas makes up law out of thin air
 He synthesizes general corporate law, to create a duty here to promote the
pure equity
 3. More of literary essay than applying law to facts
 Be weary of judicial opinions that are gray, and literary
o
Overall Concept of Fiduciary Duty:
 Following Pepper v. Litton, fiduciary rights do exist “to the community of interests,”
including all parties, but are only enforceable by creditors at bankruptcy
 (1) This is In Line with Simons v. Cogan:
o Premised the concept of a “fiduciary duty” on equitable interest but
did have carve out for “insolvency”
 (2) At bankruptcy, the only equitable interest that exists is the creditors
o Shareholders equity has been wiped out
o So this does meet Simons “Equity” interest argument
o So, fiduciary duty must exist pre-bankruptcy because you are suing
for conduct that occurred pre-bankruptcy
 (3) What Creditors Negotiated for
o Primacy at Bankruptcy
 The Confusion stems from Factually Specific Case Law:
 Because of case law, with fact-specific shareholder claims of breach in 80s,
that were such land-mark cases, their holdings of owing fiduciary duty to the
shareholders was read as meaning only to the shareholders...
 Fiduciary Duties Exist to All “The Community of Interests” of the Corporation
 Just a matter of when they are enforceable
 Pre-Bankruptcy: By shareholder/Inchoate duty to creditor
 Post-Bankruptcy: By creditor
2. Valuation at Bankruptcy, The Absolute Priority Rule and “Cram Down” Rule:
 Consolidated Rock v. Du Bois (US):
 F: Consolidated held stock of subsidiaries Union and Consumers, Inc. They had issuances outstanding of
1.87M at 6%, and 1.358 @ 6%. Consolidated had common and preferred shareholders. Agreement that
subsidiaries would pass all earnings to parent holding company. Subsidiaries also gave $5M to
Consolidated.
 Plan of Reorganization: New Company created. All assets transferred. Gave old bondholders 50%
bonds, and preferred shares. Cancelled their interest owed, and lowered rate paid. Preferred shareholders
given warrants to buy shares, and common shareholders split 5:1. The $5M claim was cancelled, the new
bonds were only income bonds—payable if earnings.
 I: Was this Reorganization plan Fair, Equitable and Feasible?
 R:
 1. The Cram down and Absolute Priority Rule:
o 1. The Reorganization agreement must be Fair, Equitable, and Feasible—Met If:
o When Agreement:
 When negotiated for agreement, what claimants agree to is accepted
o When Disagreement/Dissenting Party:
 Cram-Down Rule:
 Courts will “cram down the throats of creditors” an agreement if
o (1) They are paid the full value of their claim or if not repaid in full
o (2) The Absolute Priority Rule:
 If no junior claimant receives anything at all on account of
their junior status
 Every cent owed is paid before any cent is given to junior
claim
 Reason:
 1. Fulfills Absolute Priority Rule
50





o Is fair, and equitable
 2. Prevent Opportunistic Holdout
o Avoids holding out by creditors, to get purely opportunistic behavior
of more $ for them
o Prevents “feasibility” from being negated—otherwise, if creditors
could hold out, the plan may then not be feasible, may lead to
liquidation which is not the most desired result
 3. Promotes Social Interest and Broad Concerns of Bankruptcy:
o 1. People lose their jobs, suppliers go bankrupt, customers are
effected
 Feasibility is broadly interested in continued going
concern
Hierarchy:
 Debt (in order of seniority)
 Preferred Shareholders
 Shareholders
Value Received:
 Creditors must get their “superior rights recognized”
 (1) They can get their full value back, of exactly what they were owed
o OR
 (2) Get less back with additional, alternative compensation, for the rights they
surrendered
o As long as they are still, net, at their superior level, APR met
 Determination by Judge:
o Case by case analysis to determine if they were fully compensated
Reason for APR:
 This is what they contracted for
 So, Court is merely giving them what the contract stands for
 In Limited Liability structure, they gave up control, and locked in risk, so
they would have priority at bankruptcy
2. To Determine Fairness, Equity, Feasibility of Reorganization Plan, Valuation of Company As
Going Concern Must Occur:
o Must Value the Corporation as a Going Concern:
 (1) The assets the are continuing
 Must determine what assets exist, and will be used as part of the going
concern for feasibility of continued existence
 (2) Going concern and capitalized future earnings of company
 Valuation:
o Capitalized Earnings of Future Earnings is required to determine
Feasibility and Fairness
 Reason:
 That is the only way can determine if fair to new security
holders and if the company can feasibly pay them back
 Only way to ensure absolute priority rule is met
o Book Value, of Physical assets, without regard to earning capacity is
inadequate
o Why:
 1. Determines if fair, and absolute priority rule met
 2. Only way to determine if what is given for exchange is fair and correctly valued
 If valuation done is not correct, there is a chance that creditors are given
inadequate value (and not fully compensated)
 The effect would be to give them less then full value, and if junior claimants
receive something—violate the absolute priority rule
 3. Only way to determine feasibility of corporate continued viability
Here:
o Bondholders treated identically, although both had different claims
o Inadequate valuation occurred of the new company—leading to inability to judge fairness and
feasibility of the reorganization plan
o Absolute Priority Rule Violated:
51



o
Inadequate Valuation
Bondholders given less than full value without additional compensation
Shareholders, junior claimant, given piece—junior claimants
 Violates APR
 Not Fair or Feasible
3. The New Value Exception to the Absolute Priority Rule:
 Generally:
 In the event that a dissenting creditor exists, an agreement may be forced upon them if the cram-down
rule is met
 The “New Value” exception is a rule that may, if it exists, allow for the absolute priority rule to not be
met
o So, junior claimant can get value of firm even if senior claimant hasn’t been fully compensated
 No clear answer
 The New Value Exception:
o Investors who put up new capital for interest in firm equal to new contribution
o Consideration is “money or money’s worth”
 Reason:
 This still fulfills the absolute priority rule, as no claim junior to creditors is
received from company, but instead is new value added
 There is argument over what “on account of means” in the BOA case, but
Supreme Court has not decisively ruled
 Kham & Nate’s Shoes v. First Bank:
 F: Bank had been lending money to Kham store to buy goods. The loan was secured by supplier’s
goods. Issues arose, and debtor store could not repay. Bank lent it a line of credit, and then default
occurred. Overall, total debt owed was 42,000 loan+47,000 letters of credit + 75K Line of Credit=164.
 PH: The lower court allowed a “new value” exception, because the stockholders “guaranteed” debt
repaid.
 I: What is the significance of the new value exception?
 R:
o 1. The Cram-Down Rule must be met if Creditors do not approve plan
 However here
 Class of unsecured, subordinated creditors are getting property—the option to
buy the property, the stock—while senior claimants are not fully
compensated, and junior claimant is getting something
o Violates the Absolute Priority Rule
o 2. The New Value Exception
 Purpose:
 Makes sense as some firms depend on success of the entrepreneurial skills or
special knowledge of managers
 If they contribute new vale to retain interest, may benefit firm feasibility and
future viability
 In Creditor’s interest to have managers with this experience
 Genesis:
 Case v. Los Angeles
o Shareholders may retain interest for money or money’s worth
o Non-monetary value insufficient
 Bankruptcy Code of 1978
o Did not specifically include it, and legislative history didn’t include
it
o While some believe the rule didn’t survive the new code, court
doesn’t rule on this
 Consideration that is “money or money’s worth”:
 May acquire interest equal to, or less than consideration given
 What does not suffice:
o Promise of labor, experience,
o Intangible, unenforceable items that have no place in balance sheet
o Guarantees
 Are not enforceable, and not certain
 What may suffice:
52


o
o Balance sheet asset
o $ and some intangible item like promise, labor, etc…
o 3. State law survives Bankruptcy and Supplements Throughout
 Generally:
 In addition to the Federal Bankruptcy Structure, state law must be complied
with
 Here:
 Consideration of guarantee, per state law, would not have been sufficient to
buy stock
 Therefore, Guarantee is not sufficient to meet New Value Exception
Bank of America v. 203 N. Lasalle St. Partnership (US):
 F: Bank lent the partnership some $93M, secured by 15 stories of a building in Chicago. Default
occurred, and foreclosure ensued. To avoid personal tax liabilities, due to pass-through taxation,
partnership partners wanted to keep title. The value of the mortgaged property was less than mortgage.
Assets available were $54.5M, but owed $93M, leaving 38.5M remaining. In the reorganization plan,
among repayments, the partners would pay $6.125M over 5 years to retain full ownership of property.
 PH: The bank objected to their plan, arguing that cramdown had not been met.
 I: Does the New Value Exception still apply?
 R:
o 1. The Court does not rule, but assumes the exception exists:
 Interprets “on account of” in the cram-down language of statute 1129
 “if the holder of claim that is junior will not receive or retain under the plan
on the account of such junior claim
 Does not rule
o 2.Otherwise cognizable property interests are treated as valuable for recognition for
Bankruptcy Purposes
 The option to partnership equity and title is property
 The opportunity the partners got this property from is based on its old interest
 Therefore: they got this “on account of” their old position
 Violate the Absolute Priority Rule, as lesser claimant is getting something
while dissenting Creditor is not fully compensated
o 3. Market Valuation of Equity
 Court advocates that the equity should be subject to a market test, requiring offering of
competing plans
 Valuation Issue:
 Because it was exclusive right, and offer, value may be off
 May not have been top dollar for the equity interest
 Should subject equity to a market valuation
 Assuming the new value exception, plans that provide junior interests exclusive
opportunity, free from competition, without benefit of market valuation do not meet
1129 Absolute Priority Rule
 Effect:
o May force parties to put interest on open market
o Payment for the position may be much higher
o Huge $ for position, but may be more in line with bankruptcy law of
fair and equitable as creditors thus have more compensation
o May force parties to negotiate the deal up front to avoid exposure to
market and increased cost
Modern “New Value Exception”
 Some Circuits accept it
 Supreme Court has not explicitly accepted it, but “assumed” its existence and continued vitality
 Of those that do continue to recognize it:
o Requires at least equal consideration as to interest received
o May require “substantial” consideration, especially in light of BOA
4. “Pre-Package” Plans of Reorganization” for Chapter 11:
 Generally:
 The plan will be negotiated by Board of Directors with creditors and interested parties before bankruptcy
is filed
53



Purpose:
o Get through Chapter 11 as quickly and easily as possible
o By getting agreement before hand, and quick court assessment
 Continue Process
 Less time hurting stakeholders
 Feasibility of company is more quickly realized
 No costly litigation, complaints, or judicial inquires
Fiduciary Duty still owed to shareholders:
 Because this plan is pre-bankruptcy
o Fiduciary Duty still owed to act fairly in shareholders best interest
o Revlon duty to maximize best price of deal exists
 Post-Bankruptcy
o Fiduciary Duty owed and enforceable to creditors
In Re Zenith Corporation:
 F: Zenith had losses in 12 of 13 years. LG was a dual creditor and controlling shareholder. It attempted
to attract bids, and sell assets to no avail. Finally entered into a pre-package deal with LG, to restructure
debt and equity. Disclosure was made, approved by SEC, and distributed. 97% approved. Zenith filed
the pre-package plan, and sought approval.
 I: Was the pre-package plan adequate?
 R:
o 1. Disclosure:
 If Chapter 11 filing Court must approve disclosure before made
 If Pre-Package it is acceptable if it complies with non-bankruptcy law or had
adequate information
 Here:
 Proxy was approved by the SEC and was adequate
o 2. Cram down Rule:
 Shareholders object to plan, arguing it is not fair or equitable
 Here:
 Crammed down because no junior claimant to shareholder gets anything
 Cramed down because they get their fair value  nothing
o 3. Agreement existed:
 Agreements are beneficial
 Avoid cram-down fights
 Within the purpose of the bankruptcy code of “Fair and Equitable” if they
agree
 Cram Down is not needed if there is an agreement and it is accepted by vote
o 4. North Lasalle Does not Apply:
 LG is a creditor at bankruptcy, and is getting equity by agreement
 In N. Lasalle, shareholders kept in their own plan, exclusive right to equity, without
giving creditors right or market ability to bid and creditors disagreed
 Violated the Absolute Priority Rule, as creditors were not fully compensated
o 2 Potential Equity Claims:
 Disallowance of Creditor Claim:
 A claim will be disallowed if it has no legitimate basis for it
 Recharacterization or Equitable Subordination
 A claim will be recharacterized or subordinated if inequity is done
o See Pepper v. Litton
o
State Law must by Complied with During Bankruptcy Proceedings:
 Delaware “Entire Fairness Test”
 A transaction with a company and a controlling shareholder must be entirely
fair
o Fair price and process
o Here was fair:
 Using bankruptcy code is acceptable
 Committees were made to determine value
 Attempts to sell were made
54

o
Price was fair as LG was relinquishing greater amount of
debt for all stock in company
 No other suitor could be found
Effect of Dual Shareholder and Creditor:
 Fact Specific Inquiry to determine which claim is really being compensated for
 May be an issue:
o If acting like shareholder, would violate Absolute Priority Rule
o Obviously in their interest to act as debtor at bankruptcy
 Look at:
o Do they have more debt than equity?
o Act more like creditor than shareholder?
 Note the Controlling Shareholder Fiduciary Duty owed
V. Preferred Stock:
 General History and Attributes:
o History:
 In late 1800s, railroad activity began to increase and needed method of financing
 1. Debt was heavily relied on (See supra)
o Investment banks attracted European investors to buy the debt
o Secured, so they were safer in their investment
o However:
 Fixed costs of railroad combined with fixed cost of interest payments were increasing
as Railroads expanded rapidly
 Needed lots of $ all the time, as growth was explosive
 Increased debt was not option
 Would increase fixed costs
 Equity was not an option
 Were not many public companies
 Not many individuals bought it and institutions in Europe wanted safe
investments
 When did exist, families held it, to hold control
 2. Retained Earnings
o Have historically been a method of financing
o But railroads didn’t really have them
 Preferred Stock Born:
 Combined safety, risk averseness of European investors with a higher rate of return then debt
 As a result of
o M&A boom in 1890s-1900s created need for some alternative financing
o Railroad need of financing
 Early 1900s
o Common stock not really used
o Bonds were predominate source
o Preferred Stock increased in use
 Individuals used it
 Post-Crash of 1929:
 Many Bankruptcies
o Debt default and
o Preferred Stock arrears
 Courts role in its deterioration
o In desire to allow businesses to continue, the importance of debt to the capital markets—didn’t
want to impair debt as main source of financing
o Courts began to dump on Preferred Stock
 This is where we see the erosion and formation of its attributes
 1940s and 50s:
 Institutional investors began to buy it as a result of the ORP standard some states required of them
o Because no ORPs were buying common stock, as a result of the crash, ORP bought preferred
 This is where Institutional Investors began to buy Preferred
 Modernly:
 Preferred is predominately owned by Institutional Investors
o Attributes:
 Generally:
55

A Hybrid of Debt and Equity
 At Bankruptcy:
o Junior to Debt
o Senior to Common Stock
 Dividends:
o Only paid at the discretion of the board declaration
o Non-Cumulative: If not paid, no accumulation, expire—lose them if unpaid
o
Cumulative:
 1. $ accumulates
 2. If BOD declares dividend, no Common Stock can be paid a diviend until
cumulative dividends are paid first
 Liquidation:
o Get liquidation preference, typically set at par
o Get cumulative dividends, before any common shareholder gets their interests
o Cannot demand dividend—as BOD Discretion
 Voting:
o Generally have no voting rights of Board
o Right of Election:
 May be in contract
 Typically:
 If fixed number of dividends are not paid (6), Preferred shareholders will get
to elect a certain number of Directors
 Formation:
o 1. Articles of Incorporation
 From inception of corporation, articles of incorporation will have the preferred, the
attributes
o 2. Amendment to the Articles of Incorporation
 If the AIC do not originally have the preferred shares, an amendment can occur with
shareholders voting to include preferred
o 3. Board of Director Discretionary Provision
 Provision may exist that gives the BOD the discretion to issue a certain number of
preferred shares
 Board will declare a resolution, file it with SOS, and this will amend the AIC
o Note on Negotiation:
 Preferred shares have similar attributes to debt in that the Contract Controls
 In Private negotiation:
o Similar negotiation of parties, that are sophisticated, to negotiate a
package of preferred shares in each interests
o Courts will restrict to the contract
 In Public Offering:
o We see the same issues as public debt
o The erosion of the UW as protecting the interests for the same
reasons, supra
 A. Cumulative and Non Cumulative Dividends and Voting Rights of Preferred Stock:
o Gutman v. Ill. R.R.
 F: Preferred shares outstanding were non-cumulative dividends. The Board failed to declare dividends to
preferred, and subsequently, years later, declared a dividend to the common shareholders.
 I: Can directors declare a dividend on common shares without paying non-cumulative dividend to preferred?
 R:
 1. Non-Cumulative Preferred’s arrears expire when not paid
o A. Non-Cumulative preferred stock means that if directors decide, in their discretion not to pay
it, it expires
o B. Arrears do not accumulate for payment later, but expire
o C. Directors have discretion to pay or not
o Π Argument:
 Π argued that non-cumulative dividend should be limited to if money is used to
reinvest. And if not, should be accumulated and paid
56

o
o
But this doesn’t work…because there are other plowbacks other than capital
improvements that need to occur, which would, under π’s vew, cause accumulated
dividends
 Goes back to historical view of dumping on Preferred—as here, Court distinguishes
that Companies need to be able to reinvest in the corporation to maintain it, at
detriment to preferred
 2. Contract Controls:
o Similar to Debt in this manner
o Contract will control, and Court largely will not interject
o Courts will not revise contracts entered into by competent, sophisticated parties
BOD Fiduciary Duty to Common Shareholders and Payment of Preferred Dividends
 1. Contract will Control:
 When Non-Cumulative Dividends of Preferred
o There is an inherent conflict between common shareholders and preferred stock when noncumulative dividends
o Effect:
 Board will likely not pay the non-cumulative
 Will most likely pay the common dividend
 Wants to avoid being voted out
 Wants to avoid fiduciary duty suit
 If they did pay it in addition to or instead of common stock dividend
 Duty of Care Question:
 Protected by Business Judgment Rule
 May bypass by arguing waste, uninformed decision
 Duty of Loyalty Question:
 If board is also preferred shareholder, or controlling shareholder has preferred
shares
 Entire Fairness inquiry
o Much more heightened judicial scrutiny
o If they do not own, no duty of loyalty question
 When Cumulative
o The contract controls
o Meaning, by contractual obligation, the Board of Directors must pay preferred cumulative
dividend before any goes to common shareholder
o Must pay arrearages before any goes to Common Shareholder
 Will be no fiduciary duty issue, as BOD is contractually obligated to pay
 Overall:
 Contract Controls, and Courts adhere to this notion (similar to debt)
 So contract for the protection and covenants you want
Right of Election Clause, and Board of Directors Elected by Preferred Shareholder
Baron v. Allied Artists Pictures Corp
 F: Allied was film company, having hard financial times. Needed capital, so amended AIC to allow 150K of
preferred. Had Right of Election clause, to vote for majority of directors if 6 quarterly dividends missed. Default
ensued, and preferred controlled board due to vote. Subsequently, had 2 hit movies and made lots of $
 I: Whether the Directors, elected by preferred must pay off as soon as sufficient funds exist to return control to
common shareholders, or whether they have discretion?
 R:
 1. The Right to Election Clause:
o The right of election does not end once sufficient funds exist
 Not simple mathematical equation
 Directors still have discretion (unless clause provides otherwise)
 Purpose:
 Right to vote, and control to try new management due to the failure of
previous management to meet contractually obliged payments
o When Terminates: Right of election continues until dividends can be made current, but once
funds “clearly available” to satisfy cumulative dividend, Right of Election Terminates

2. Preferred elected Board owes Fiduciary Duty to Corporation / Business Judgment Rule Applies
57
o
o
o
The boards duty, even elected by preferred, is fiduciary relationship to corporation and
shareholders
 Must deal fairly with both
 While one of the reasons they are there is to repay it, repayment when sufficient funds
is not sole reason they are there…in doing so, may not fulfill duty to others…
The Board of Directors has Discretion in Acts, protected by Business Judgment Rule:
 One of these powers is discretion to declare dividend based on informed judgment
 Only avoided by showing of:
 1. Fraud or
 2. Uninformed Decision Making
Here:



Board acted within its discretion, as earnings were volatile, to not declare dividend to
preferred shareholders…no fraud or abuse of discretion
Within its informed discretion
Note:
 Warns that, right of election is not indefinite, and Board does have fiduciary
duty not to stay in forever, abdicating payment when it could clearly do so
 But: doesn’t limit it clearly, as Business Judgment Rule gives it discretion to
repay when possible, while still prudent to corporation
 B. Repurchases, Redemptions, Recapitalizations, Liquidations:
o Generally:
 This is an inquiry into what effect these transactions have on the Preferred Shares
 What the Corporation may do to avoid preferred arrearages
 What protections the Preferred Shares have
 Corporate Actions:
o Merger/Recapitalization
o Asset Sale
o Repurchase of shares
 All avoiding the preferred share obligations
 Preferred Share Arguments:
o Implied Covenant of Good faith
o De-Facto Merger, etc…
o Contractual Interpretation
o Fiduciary Duty
 Delaware Court Tools used:
o Doctrine of Strict Construction of Special Rights, and Preferences
 Contractual provisions don’t have fiduciary duty
o Independent Legal Significance Doctrine
 Delaware does not accept the de facto merger doctrine
o No Fiduciary Duty to Contractual Provisions
o Fiduciary Duty owed to the non-contract portion of preferred shares (See Jebwab)
o
The Doctrine of Independent Legal Significance:
Rauch v. RCA:
 F: GE and its new subsidiary were merging with RCA. RCA would merge into the subsidiary, and all RCA stock
was converted to cash. Preferred shares were converted to ~$40. The shares had a liquidation preference of $100.
The preferred shareholders argue that the merger was akin to a liquidation, and thus she should have gotten her
$100 liquidation preference.
 R:
 1. The Doctrine of Independent Legal Significance:
o Rule:
 When an action is taken under 1 section of the DGCL, is legally independent of, and
will not be construed under another section of the DGCL.
 Both are legally independent of one another
o Reason and Purpose:
 1. Equal Dignity:
 The DGCL provisions are equally created, by legislature to be independent
 2. Pro-Corporation and Transaction:
58

o
o
Predictability and Certainty
o 1. Allows corporations to choose an appropriate transaction for their
needs, choose the appropriate provision and know that is what will
occur
o 2. Ensures that what they planned is what will occur
 Price-Certainty
o 1. Price is based on transaction chosen
o 2. This rule allows for economic efficiency, and certainty that price
is accurate for transaction
o 3. Otherwise:
 Prices for Business transactions, which are important,
would be altered, discounted, for uncertainty, and this
would be negative for markets
Here: Was a §251 Merger, and not a liquidation—ILS Doctrine applies
Repurchase of Shares
 Reason:
 Company repurchasing avoids having to pay arrearages as it now owns the stock; no need to pay itself
In Re Sunstates Litigaiton:
 F: Clause in preferred share contract prohibited Sunstates from acquiring shares of itself, common and preferred,
however the clause did not specifically say that its subsidiaries could not do the same. Sunstates was owned by a
controlling shareholder. Subsidiaries ended up purchasing much of preferred. Π, a preferred shareholder argues
that the contractual provision must mean Sunstates and its subsidiaries.
 I: Does the repurchase of shares clause include subsidiaries?
 R:
 1. Doctrine of Strict Construction of Special Preferential Rights:
o The Rights and preferences of the preferred must be expressed clearly in contract
o Court will not broadly imply or impute any terms
o The Rights in Question were Contractual from Preferential ContractNo Fiduciary Duty
 Contract displaces any fiduciary duty, as terms were contracted for
 The Contract controls and is strictly construed
 The Board owes no Fiduciary duty to preferred on Contractual Provisions

Issue:
o
*So Fiduciary Duty will depend on whether argument involves
preferred contractual provisions, or non-contract equity portion*
o


Here, was clearly a duty of loyalty fiduciary duty issue, as
controlling shareholder is self-interested…but no fiduciary duty is
owed on the contractual portions, and that is what was being
interpreted
2. Implied Covenant of Good Faith and Fair Dealing:
o Is it reasonable to infer that the parties would have proscribed the conduct in question had they
negotiated it?
 Note:
 Identical Inquiry to Bond Doctrine
 No fiduciary rights in contract either, with respects to contractual portion
 IMCGF argued then
o Here:
 No, Contractual provisions were clear, and no inference could be drawn otherwise
3. The Doctrine of Independent Legal Significance:
o Applies from contractual provision to contractual provision
 Extends away from merely the Legislative purpose it was created for
 Now, a rule of contractual interpretation
o Here:
 Says that the contract says corporation, but subsidiaries did it
 Restricted to each clause provisions
 Note:
59
o
This is redundant with the doctrine of strict construction of
special rights
Preferred Contract Right to Vote if AIC “Amended” And a Merger:
Elliot Assoc. v. Avatex:
 F: Avatex formed a subsidiary—Xetava. It announced that it was merging into its subsidiary. Preferred Contract
had a clause that said “Vote of Preferred required if amendment, alteration, or repeal, whether by merger,
consolidation, or otherwise, of the Articles of Incorporation that materially adversely effects preferred rights.”
Preferred argue that the merger amends, alters, or repeals the AIC, as they will be eliminated, and therefore—they
should have a right to vote.
 Why Did Transaction Occur:
 Stock was almost worthless, and arrears owed to the preferred was essentially all Avatex was worth.
 By reorganizing, and issuing common stock to all, moved the arrears from preferred, and put it back in
the equity.
 This by-passes the Absolute Priority Rule at bankruptcy: a junior claimaint is receving something,
even though senior claimant is not fully compensated
 I: Does the K give right to vote, as merger constituting and amendment, repeal or alteration of AIC?
 R:
 1. The merger caused the adverse effect, and was an amendment, alteration or repeal:
o The AIC being terminated fits into at least one of the three listed in K
o The merger is the cause of this, as the merger results in the AIC terminating
 2. The rights meet the Doctrine of Strict Construction of preferential Rights:
o The rights were explicitly within the contract
o This is likely the consequence they had in mind
 Overall:
o This is boilerplate and must be construed consistently as a matter of Corporate Finance
 1. When a certificate says “amendment, alteration, or repeal”
 The preferred have no vote in a merger
 A merger, per the Doctrine of Independent Legal Significance, is a merger
 In this scenario, the amendment may be caused by the merger, but it is the
merger that causes the adverse effect, not the amendment…therefore, no vote
in merger
 2. When certificate adds “by merger, consolidation, or otherwise”
 If merger causes “amendment, alteration, or repeal” preferred vote
 3. Broadest is “Preferred may vote in any merger or where preferred receive
junior security”
 Note:
o This is a contractual portion of the Preferred Contract
 So, equitable power of the court is not as strong, as if common stock, fiduciary issue
 This is consistent with idea that Contract controls, and boilerplate will be construed
consistently, that Delaware has continuously demonstrated
 Fiduciary Duties owed to Preferred Shareholders:
o Generally:
 While there may be a duty of loyalty issue, or duty of care issue, it must be preceded by the existence of a
Fiduciary Duty
 Determine if the K is silent or not, to determine Fiduciary Duty
 Then apply scrutiny level
Jedwab v. MGM Hotels
o F: MGM had bad fire, killing many people. Suits for wrongful death sought $2.65B. The stock price tumbled, and in
response, company sought to exchange 1 share of common for 1 share of preferred. Kerkorian owend Tracinda
Corporation, which owned >50% of MGM. Preferred was cumulative, and right of election, with liquidation preference of
$20. Kerkorian exchanged 5M shares, and in total 9.3M tendered into exchange. Kerkorian announced tender for all
remaining shares at 18, but then Bally’s offered 18-CS and 14-PS. Because this combination was >440M, the value agreed
to in total, Kerkorian took a cut on his shares—getting 12.29/common + property like rights to MGM name.
o ∏: argues that apportionment of 18 for common and 14 for preferred was unfair, in breach of Fiduciry duty owed to
common, and breach of duty of loyalty by Kerkorian, a controlling shareholder.
o Why did Transaction Occur:
 Kerkorian entered into because of financial difficulties
 The dividends are cumulative, so he will have to be paid, unlike common stock holders, on back
dividends
o
60

o
o
Liquidation preference was response to common stock price it used to trade at
 Preferred tried to resemble common as much as possible with same dividend and similar trading price
 Like stock buy back, raising market price of common
 Defers dividend payments to future, when more money may be available
I: Whether a fiduciary duty is owed to the Preferred Shareholders?
R:
 1. Fiduciary Duty is owed to Preferred Non-Contractual Provisions:
 Generally:
o All stock, common and preferred begin as common stock with same attributes
o Contractual provisions may create additional preferences, above and beyond the common
equity
o The Preferred shares “crawl out of” the ooze, or to put it into other words, are ratcheted above
the common stock with preferential, contractual rights
 1. Matters relating to Contract, preferences, or limits in preferred stock
o The Contract Controls and No Fiduciary Duty Exists
 Solely defined by contract portion
 Contract supersedes the common equity characteristics, and fiduciary duty
 2. Matters relating to Silent, Non-Contractual portion, shared by all equity:
o Fiduciary Duty exists
 Issues with Jedwab Rule:
o 1. Contract is ambiguous
 Must interpret it, and therefore, it will not be clear what exactly the provisions include
or don’t
o 2. Unclear provisions, then, lead to fiduciary duty
 Will not owe fiduciary duty to those things clearly stated
 Ambiguous terms may be owed fiduciary duty
o 3. How do you advise the Board
 The board will be interpreting the contract
 If it is clear, they must interpret as a fiduciary in aspects contracted for the
preferred shareholders
 But, if ambiguous, creates issues of how they are interpreting the contract
 May breach their fiduciary duty
o Creates a default of Fiduciary Duty owed unless contract supersedes


Here:
o Preferred Contract was silent on Mergers
o Therefore, preferred shareholders owed a fiduciary duty in mergers
2. What Standard of Review Applies, if Fiduciary Duty Exists :
 Fiduciary Duty Owed by Directors, and Controlling Shareholders
o Business Judgment Rule Presumption:
 Rebutted by Uninformed Decision or
 Interested transaction in breach of Duty of Loyalty
 Burden on the ∆ to prove Entire Fairness
 Duty of Loyalty:
o Is transaction interested:
 Interested: Does the fiduciary receive something to detriment of shareholders /do not
o If Transaction is interested
 Rebuts Business Judgment Rule
 Not per se liability, as simply alters scrutiny, and burden
 Entire Fairness Test utilized
 Shifts burden to ∆ to prove fairness
 Here:
o Controlling Shareholder received less share value, but added property
o Invokes Entire Fairness Test
 But, although unequal, it is fair:
 Here, he gets paid less, and thus is giving up $ allocated to the stockholders
 The difference between the common and preferred then, is out of his pocket
 So not unfair to preferred as the greater value to the common was out of his
own pocket
o No right to “equal” Treatment if fair
61

Issue:
o
o
o
Preferred shares at the outset had the economic reality of being almost identical to the common
That was the intended consequence of the preferred shares
So unequal treatment was unfair treatment perhaps, based on what they had agreed to
In re FLS Holdings, Inc. Shareholders Litigation:
o F: Preferred bring claim against Directors that price in merger was unfairly apportioned and allocated, breaching fiduciary
duty to them. In merger negotiations, eventually agreed to a merger, which gave preferred 62% of its value and common
54% of its value.
o Why Done:
 Another transaction done to avoid bankruptcy and the absolute priority rule
 Could have reorganized, or gone bankrupt….by reorganizing, it avoided bankruptcy
 The Common, a junior claimant to preferred were paid, avoiding absolute priority rule
o R:
 1. Was an interested transaction by the Board of Directors—Duty of Loyalty Issue
 There were no procedural safe guards of independent committee
 No preferred vote
 Ex-Post Fairness Opinion was inadequate
o No comparable size of the investments in comparable transactions
o Rights may not have been comparable
o Other transactions may not have been interested ones
 Because Duty of Loyalty Implicated
o The Contract must have been silent on mergers
o Therefore, the common portion must still exist, and fiduciary duty must still exist
 Overall Preferred Shareholder Fiduciary Duties:
o Generally:
 Jedwab is clear that fiduciary duty exists when Contract is silent
 When not silent, specifically dealing with something, contract supersedes fiduciary duty and common
attributes
 Question becomes:
 What does the contract consist of
o Has only been applied, however, in few contexts:
 When there is Silent Contract and:
 1. Interested Board of Directors/Controlling Shareholder-Duty of Loyalty Question
 2. Allocation of $ from
 3. An organic transaction (merger, reorganization, asset sale)
 Horizontal and Vertical Conflict:
 Horizontal: There is always a horizontal conflict between the common and preferred shareholders as
both are competing for pieces of the corporate pie
 Vertical:
o When corporate directors conflict with corporate shareholders/constituency
o Duty of Care and Loyalty Implicated
o When Independent Board
 Business Judgment Presumption
 Preferred must rely on their contract
o If the 3P is the allocating party of capital
 3P owes no fiduciary duty
 Probably ok
o If the Board is Interested and Allocates
 Fiduciary Duty Issue if the contract is silent, or can be read not to discuss a particular transaction
VI. Convertible Securities:
 General Attributes:
o Convertible securities permit a holder, while remaining in the outstanding position, to exercise a conversion option
into another security of the issuer corporation
 Specified Number of Shares and Prices
o **Key Concern is protection of the conversion right
o Conversion Right:
 Converts to shares at pre-set price
 Issues more shares into the market, with dilutive effects (like a warrant)
62
o
o
o
o
o
o
o
o
Effect of Conversion Right:
 1. Lower interest rate than paid on bond
 Because the conversion right has value
 2. Subordinated
 3. Indenture for Conversion is less restrictive
Benefit to Purchaser:
 1. Downside Protection:
 Benefit of debt protection at bankruptcy
 Fixed, legally mandated interest rate payment
 2. Upside Potential of Stock:
 If shares appreciate in value, you may exercise conversion
Benefit to Issuer:
 1. May use when stock is undervalued
 IPO of shares would be less then optimal/undervalued financing
 2. Poor Credit
 If you are unable to borrow, convertible securities give another option to access method of financing
Redeemable/Callable:
 Issuer will call:
 As method of avoiding dilution to existing shareholders, limiting the costs of conversion
o 1. Lessens dilutive impact
o 2. Eliminates interest payments or dividends that would have been paid if outstanding still
 For Instance:
 Convertible Bond at 1,000 and Conversion price of $50/share, FMV stock = 60, callable at 1050
 1,000/50=20
 Value = 20 x 60=1,200
 If bond is called at 1050
o In the best interest of convertible security holders to convert at higher price then call price
Issues:
 1. Dilution
 Exercising the conversion rights dilutes the existing shares outstanding
 2. Destruction
 If the underlying shares that may be converted into are merged, reorganizd, etc…the conversion right is
destroyed
Conversion Ratio:
 Issue:
 If outstanding shares are split, reverse split, or take dive in value otherwise, the conversion right can be
eradicated
 Adjustments needed:
o Must contract for and draft adjustment protection
 If no adjustment
o Stock split could wipe out value of shares, well below conversion value—eradicates value of
conversion
Anti-Destruction:
 If merger occurs, or other transaction that the shares cease to exist, without contracted for protection
 Conversion right ceases to be of value
 Contract for and draft protection
Example of Conversion Calculation:
 Convertible Debenture:
 Convertible Bond with Face Value of $1,000, and conversion price of $36/share
 Total Shares convertible into = 1,000/36=27.7 shares
o Or:
 Conversion Price= Face Value/Shares Convertible into
 Value of Conversion= Shares convertible into x Market Value
 Convertible Preferred:
 Conversion Price = Price of Preferred/Shares Convertible into
 Value of Conversion = Shares convertible into x market price
 For instance:
o Convertible preferred at $100, convertible into 6.5 shares, FMV of $10
o 100/6.5 = $15.38 conversion price
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o
Conversion value = 6.5 x 10 = $65
o
Overall:
 Contract controls for convertible security Holders
 Fiduciary Duty owed to Convertible Debenture Security Holders:
o Debt
Simons v. Cogan:
 R:
 1. No equitable interest in conversion exists
o Expecting to gain the equitable interest of stock is not having that interest
o Contract Controls
o No Fiduciary Duty owed to Convertible Debt holders
o Convertible Preferred:
Jedwab:
 R:
 1. Same Jedwab bifurcated duties approach applies
o Fiduciary Duty owed on silent portions
o No Fiduciary duty owed on contractual provisions
 Notice of Redemption Provision:
o Generally:
 The convertible contract will give an optional right to redeem by the company, after which the convertible
security holders may not convert
 If the conversion value is greater than the redemption price Security holder loses $
 Notice of redemption is essential
o Van Gemert v. Boeing:
 F: Convertible debentures were offered. They were convertible into 2 shares per $100. Indenture K had
provisions of notice and debentures referred to this indenture. Within the indenture, it required “publication at
least twice in newspaper.” If registered bondholders, they could receive mail notice. A call/redemption occurred,
and news release in 2 newspapers was given. Both parties stipulate the K was met.
 R:

1. Debenture holders must know what type of notice of the redemption: must be adequate:
o The type of notice that a debenture holder will receive must be adequate
o Must tell the debenture holders in some way what type of notice they will get in event of
redemption
o Here:
 Notice was inadequate and knowledge of the type of notice was inadequate
 Referring to a 113 page debenture was not adequate
 Breach of Implied Covenant of Good Faith

Implications of Case:
o Per Katz, the notice of a debenture redemption, if provided should be sufficient and should end
the inquiry…Contract Controls
 There, newspaper notice was adequate
o Here: More Expansive view of Contractual Good Faith:
 Court stands for proposition that the notice in contract was inadequate
 Violated Implied Covenant of Good faith with method of notice chosen
 Test:
 The Courts will patrol the outskirts of acceptable behavior in contract, or
impute a floor
 It is implied that the parties may assume certain risks in a contract
o But, the risk of the contracting party acting opportunistically, to
the detriment of the other party is unacceptable
 Extremes of behavior will not be tolerated
o Contrast with Katz (Neo-classical):
 Narrower test, of what parties would have agreed to proscribe had they negotiated it
 Evaluates the economically efficient outcome of a decision, and implies it
 Ignores the fact that debenture holders don’t really negotiate themselves
 Assumes that if the parties contracted for something, and contract is not
silent, contract controls
 Reason for Narrow Construction:
64



o
Certainty in debt markets, Capital Markets
Interpretation of Contract by law
This maximizes overall societal wealth even though particular litigants may
lose
Overall:
 While notice is acceptable, for the most part, under a Katz view of narrow good faith
and the contract controlling
 There is jurisprudence that may require more in the contract to be “fair” to the
debenture holders
 Anti-Dilution and Anti-Destruction:
o Generally:
 These provisions protect the conversion holder from companies behavior with the underlying stock
 If the stock is diluted (Stock Split, Reverse Split, Stock Dividends), the conversion must be adjusted to reflect the
value the conversion holder had prior to the split
 Changes price
 Changes number of shares
 Forward Stock Split:
 Splits, in general, add no value, but merely adjust number of the shares you own in the company
 The total value is still the same
 Everyone’s shares go up proportionally
 Increases number of shares
 Decreases price per share
o Purpose:
 Adds liquidity to the market
 Signals company’s confidence in a stock by encouraging ownership
 More affordable on per share basis
o Why may not do it:
 From managerial standpoint, no split encourages stagnant ownership
 Less liquidity means more predictable stock holder base—easier to manage
 EG:
o 2:1 Forward Split
 Pre-Split shares x 2
 Pre-split price ÷ 2
o 3:2 Forward Split
 Pre-Split shares ÷ 2, then x 3
 Pre-Split price x 2, then ÷ 3
 Reverse Stock Split:
 Decreases number of shares proportionately
 Price increases per share
o Purpose:
 If you feel price is too low/under representative
 May create attraction to a higher share price
 Preserve an NYSE listing requirement
 May be a negative sign from management as stock isn’t at appropriate price
 EG:
o 1:2 Reverse Split
 Pre-Split shares ÷ 2
 Pre-Split price x 2
o 2:3 Reverse Split
 Pre-split shares ÷ 3, x 2
 Pre-split price x 3, ÷ 2
 Overall:
 The Conversion Price/Ratio of the convertible securities must be adjusted appropriately
o Pre-Slit Conversion Ratio/Price must be multiplied or divided per split ratio calculation
o Example of Anti-dilution provision in Convertible Contract
Reiss v. Financial Performance Corp.
 F: ∆ authorized issuance of warrants to π, enabling them to purchase up to 1.2M shares at .10. Neither of the
warrant contracts required an adjustment to price or amount of stock based on underlying stock being
diluted/increased. However, a similar warrant contract with another party entered into did have price-adjustment.
When reverse split was announced, π sought to exchange their warrant for 5x value it was before. ∆ denied it.
65


o
o
I: Should the court impute a term that is missing?
R:
 1. A contingency’s omission does not automatically lead to a Court implying a term:
o Here:
 parties agreed to contract without adjustment
 Had a forward split occurred Warrant would be eviscerated
o Price would have gone extremely low, killing value
 Had a Reverse split occurred  Warrant price would increase
o Court refused to imply the term:
 The Company entered into this agreement
 Evidence existed that company had price adjustment in other agreements, but not this
 Company decided to perform the reverse split knowing of this warrant
o Court disagreed with “Implying Essential Term that is missing”
 A term can be supplied if by logical deduction from agreed terms, if Essential Term
 Court may supply a term that is reasonable if essential term is missing to define parties
rights and duties
 Overall:
o The reason the clause was not in the Contract is probably mistake
o CAREFULLY Draft to assure the desired outcome is reached and do not simply take form
contracts and use them
Cheap Stock:
 Anti-dilution provisions also cover issuance of stock below market value (Cheap Stock)
 Effect:
 Dilutes the value of the company’s existing common stock
 So, Convertible security holders deserve to receive more shares to compensate/make them whole
 Forumla:
 Adjusted Conversion Price= CP x [OCS + ((NCSxOP)/CMP)]
OCS+NCS
 Where:
o OCS=Number of outstanding shares of common
o NCS=Number of new shares of common (cheap stock issued)
o OP=Offering price of new cheap stock issued
o CMP= Current market price per share of common
o CP= Conversion price in effect at time of adjustment
Distribution of Assets and Indebtedness:
 Generally:
 Adjustments will be made to the conversion price when the company distributes assets
o For instance:
 Spin-off shares distributed as a dividend
o Excluded:
 Cash dividends
 Warrants
 Formula:
 Adjusted Conversion Price= CP x (CMP-D/CMP)
o Where:
 CP=Conversion price at time of adjustment
 CMP=Current Market price per share of common
 D= Per share value of the distribution being received by common shareholders
 HB Koreneveas v. Marriot Corporation:
 F: Marriot was hotel and food concession business. It had 200M Preferred Convertible, 2B in Common
and 2B in Debt. Marriot announced it would restructure. It would create a subsidiary of Marriot
International, and would spin off shares to common shareholders. It would put most profitable assets
(hotels, properties generating cash) in International. Then, remaining assets (tollway road conessions
restaurants/rest stops) in Host Marriot. Host would be burdened with most of the debt. Host would lost
44M/Year based on the transaction. Host had a subsidiary of HMH. Bondholders sued, and settled for
exchange of debt and new debentures in HMH, with higher interest rate. Preferred Shareholders were
told their dividend would not be paid. Plaintiffs bring suit, arguing that the transaction was coercive, and
done so that they would convert prior to record date of special dividend, not getting spin-off. Argue
coerciveness, fiduciary duty, and that anti-dilution provision applies.
 R:
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o
o
o
o
1. Court may step in to abate coercive action when fiduciary duty exists
 However, fiduciary duty must exist to do so
 Here:
 Contract of preferred controls
 Many protections exist (cumulative, right to vote in certain situations)
 So, per Jedwab, no Fiduciary duty exists as contract supersedes
2. Implied Covenant of Good Faith:
 The contract was performed in good faith
 The postponement of dividend was for a business reason as subsidiary would have no
income to pay dividend with
 So, under either view of good faith—this was within acceptable behaviors
3. Anti-Dilution Provisions which require “Sufficient value of net assets remain”
 Purpose:
 Protect against dilution of the conversion component, by adjusting conversion
price
 Certain dividends of property, or assets may be so large that following the
distribution, the firm may not have sufficient value to preserve the predividend conversion right
 Interpretation:
 Refrain from declaring dividend of assets so large that leaves the
company worth less than pre-distribution value of assets
 Value Judged:

At the time the Board declares the special dividend
o If, when declared, corporation will have sufficient assets to preserve
the conversion value, satisfies clause
o Conversion Value:
 Shares Convertible into x FMV
 Contract has Clause saying that “As determined by Board of Directors”
 Therefore, the Board’s calculation and valuation formula it decides to use, the
Court holds, is controlling in this circumstance
Anti-Destruction:
 When the stock that is convertible into is impaired, something must occur to fulfill convertible security holder’s
value
 If eliminated, the “anti-destruction provision” will allow convertible holder to convert into
 The same consideration paid to the common
o May be stock, cash, etc…
o Whatever it is, convertible security holders get to convert into it
 Note:
 This is where “flip over” poison pill provisions stem from
 Wood v. Coastal States:
 F: Coastal was reorganizing its business, and spinning off its subsidiary. The shareholders would be the
sole party to get the spun-off shares. The preferred were not entitled to this spun off dividend. The
preferred argue that the “spin off” is a recapitalization, within the meaning of the anti-destruction clause.
 I: What is a recapitalization
 R:
o The Contract failed to define recapitalization:
 Drafter error
 Define it the way you want it to be defined
o Court held a spin off is not a recapitalization:
 A recapitalization does not occur if the same shares were available after event
 After this event, he may not receive what was available to him before, but instead, is
given something “in lieu of” common
o Alternative Arguments to bring:
 Could have argued that Contract did not address a “spin off” specifically
 Based on the doctrine of independent legal significance, and a fiduciary duty—because
k is silent—preferred may have been able to bring a breach of fiduciary duty claim
 Other Court’s Interpretations:
o Lohnes v. Level 3:
 A Stock split did not constitute a “substantial change” in the corporate structure
 Merely a different proportional representation of the same aggregate amount
67
VII. Ownership Claimants:
 Redemptions and Repurchases:
o Generally:
 These two methods are methods to return to shareholders, value they may participate in
 Redemption:
o Typically based on a preexisting agreement, which is set forth in the Articles of Incorporation
 Repurchases:
o Typically made upon the decision of the board of directors

o
o
o
o
Purpose:
 Generally:
o Arguably, repurchases serve the same purpose as a dividend, distributing value to shareholders
by purchasing their stock above value, raising the overall value of the corporations stock
 Gives Corporation Flexibility
o Unlike Dividends:
 Once a company begins doing so, must continute, as shareholders will see the end of a
dividend policy as a negative sign
 Long Term
 Dividends are viewed as a long term, permanent commitment by the
corporation
 Once corporation reaches mature business cycle, may undertake dividend
policy
o Has cash flow to payout
o Steady and reliable revenue stream
o A Repurchase:
 Can be a one time occurrence
 Is not viewed as permanent
 Done to raise value of shares seen as undervalued
 As this is seen as a “bullish” sentiment, price may increase further
 Reduces number of shares in the market, increasing EPS
 Negative Effect:
 While both dividends and repurchases deplete cash
 Repurchases reduce equity in corporation
 Increases D/E ratio
Kayn v. US Sugar:
 F: π is class of common stock, alleges a breach of the duty of candor. That in a Tender Offer by company, the
company failed to disclose that an independent bank did not conduct its own analysis, but merely approved its
selected price, and that representations to shareholders were coercive.
 R:
 The Duty of Candor Requires that when shareholder action is sought:
o Must disclose all material facts relevant to the shareholders
o Stems from Duty of Loyalty:
 If pleaded, Entire Fairness Analysis ensues
Katzowitz v. Sidler:
 Preemptive rights in close corporation
 Meant to protect voting and dilution
 Gives you ability to buy proportion of shares offered, if shares offered
Frantz v. EAC:
 Courts will protect voting rights, requiring a “compelling justification” to infringe on them
 This is shareholder’s right, and the board has no right to infringe on their ability to vote
 Director, whose imminent retirement is known to other members of board does not violate fiduciary duties
in corporation by tendering his resignation at time he sells stock to corporation
Jones v. Ahmanson:
 Controlling shareholders have a fiduciary duty owed to the corporation and shareholders
 Entire Fairness Analysis Applies
 When majority receives premium over market for its shares:
 If reflects payment for corporate asset, all shareholders may demand share proportionately
o Not Widely Followed, as holds sale of corporate governance/control is corporate asset
o More Equitable Opinion
68

o
Absent inequitable behavior, or freeze out behavior, Controlling shareholder may
sell at premium without issue
Leader v. Hycor:
 Fiduciary Duty is owed in a close-corporation
 Controlling shareholder/Director must act “utmost good faith and loyalty”
 Framework:
o 1. Can controlling shareholder demonstrate legitimate business purpose?
 If yes  π bears burden to establish that objective could have occurred with legitimate
alternative with less harm to minority
 Reverse Stock Split as freeze out:
 Reverse split in such a proportion that minority shares are left with fractional shares
 Cash out the fractional shares, freezing them out