ADW Draft 2/10/12
AP edits 2/19/12
Chapter 10. Capital Structure
Primary Sources Used in this Chapter
DGCL §§ 151(a), 152, 153, 154, 160
Slappy Drive Industrial Park v. U.S.
Equity-Linked Investors, L.P. v. Adams
Klang v. Smith’s Food & Drug Centers, Inc.
Little v. Waters
Kamin v. American Express Co
Concepts for this Chapter



Capitalizing the corporation
o Equity: common and preferred
o Debt: compare to equity (D/E ratio)
Tax attributes
Leverage: risk of insolvency
o Options
Legal capital
o Money in : legal consideration
o Money out: illegal distributions
Dividend policy
o Board discretion
o CHC vs PHC
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Introduction
This chapter gives an overview of the financial structure of corporations – how they are financed
(or capitalized) and what rights apply to equity and debt securities. It also looks at the effect of
leverage (or debt) on equity returns, the tax deductibility of interest, and the preference of debt
over equity in bankruptcy.
This chapter also considers how corporate law regulates the issuance of dividends to equity
shareholders – the “legal capital” regime which protects creditors from equity owners siphoning
away assets on which the creditors relied.
Finally, this chapter describes the fiduciary duties that apply to the corporation’s dividend policy
-- a matter that, under U.S. law, is left mostly to the discretion of the board of directors.
Question: What is Capital Structure?
Answer: Capital structure refers to the way that the company raised the money to get
started and to operate. It answers the question of where that money came from. For
example, a company may:
 Sell shares of stock (equity)
 Borrow money (debt)
 Issue more complex financial instruments
 Grant stock options
Question: Does capital structure matter?
Answer: Yes. Although theoretically (using the Modigliani-Miller Theorem
assumptions) in an efficient market with perfect information and no taxes or bankruptcy
costs, the value of a company would not be affected by how it was financed (the mix of
debt and equity), this is not true in practice. For example, the managers of a corporation
with a great deal of debt may worry about bankruptcy; managers of corporations financed
primarily by equity investments may feel pressure to make dividend payments.
Bonus Question: What is the Modigliani-Miller Theorem?
Answer: What is known as the Modigliani-Miller Irrelevance Theorem (M&M) is
actually composed of several propositions which Franco Modigliani and Merton H.
Miller explained in a series of papers in the late 1950s and early 1960s. The underlying
premise of the theorem is that the market value of a firm is determined by its earning
power and the risk of the underlying assets, and is independent of its capital structure.
M&M means that under certain conditions a firm’s financial decisions do not affect its
value. M&M relies on the assumptions that there are well-functioning markets, neutral
taxes, and rational investors.
Financial turmoil in recent years has led to some revival of interest in the question of
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efficient markets, and in M&M. For example,
John C. Coffee, Systemic Risk after Dodd-Frank: Contingent Capital and the Need
for Regulatory Strategies beyond Oversight, 111 Colum. L. Rev. 795 (2011)
(discussing arguments that contingent capital requirements are overly complex
substitutes for simply requiring the infusion of more equity capital into systemically
significant financial institutions)
Richard Epstein, How to Undermine Tax Increment Financing: The Lessons of City
of Chicago v. Prologis, 77 U. Chi. L. Rev. 121 (2010) (examining the appropriate
level of constitutional protection against outside governments that condemn property
located within a local municipality that uses tax increment financing to fund local
improvements)
Victor Fleischer, Regulatory Arbitrage, 89 Tex. L. Rev. 227 (2010) (identifying the
conditions under which regulatory arbitrage takes place, constraints on arbitrage, and
the ways in which it distorts regulatory competition, shifts regulatory costs, and
undermines the rule of law, and discussing M&M in the context of tax-avoidance
strategies)
Darian M. Ibrahim, Debt as Venture Capital, 2010 U. Ill. L. Rev. 1169 (2010)
(reviewing capital structure theories in the context of venture debt)
Michael Knoll and Daniel M.G. Raff, A Comprehensive Theory of Deal Structure:
Understanding How Transactional Structure Creates Value, 89 Tex. L. Rev. 35
(2011) (responding to Professor Fleischer’s account of how lawyers think about deal
structures in his Regulatory Arbitrage article, and laying out the “reverse” M&M
theorem)
For a more comprehensive summary of M&M, including concrete examples, also see
Robert P. Bartlett III, Taking Finance Seriously: How Debt Financing Distorts
Bidding Outcomes in Corporate Takeovers, 76 Fordham L. Rev. 1975
(2008)(analyzing bidder financing decisions in the pre-financial crisis takeover boom
years)
A.
Slicing up the Corporation: Some Details on Capital Structure
1.
The Drama of Widget, Inc
Hypothetical: JKL Corporation, made up of Justin, Kathy and Lorenzo, acquires Widget Inc
from the Widget brothers.
Seller Financing
 The Widget brothers agree to sell their business for $2 million
3
 The buyers do not have enough cash, and also want to have some extra cash for expansion
 Terms:
o
$1.25 million in cash
o
$750,000 10-year note from JKL to the Widget brothers at a 10% interest rate
(with all principal due at the end and acceleration upon default)
Bank Financing
 First National Bank will lend $500,000 to finance the acquisition and help recapitalize
 Terms:
o
10-year note at 10% interest rate with $100,000 repayment of principal
annually in years 6-10
Owner Financing
Justin
 Lacks cash, but wants some control
 Terms:
o
40% of the common stock
o
Pays $100,000 in cash and gives $100,000 note (shares escrowed)
Kathy
 Has more cash, and wants control
 Terms:
o
40% of the common stock
o
Pays $200,000
Lorenzo
 Less worried about control but wants steady income
 Terms:
o
20% of the common stock
o Pays $100,000
o
Preferred stock which pays a 10% cumulative dividend rate and is cumulative,
non-participating and convertible (note this could also be structured as a longterm loan instead of preferred equity)
 Pays $500,000
The following table summarizes the sources and uses for the financing in the Widget, Inc.
hypothetical:
Sources and Uses of Financing for Widget, Inc.
Sources of Capital
Sellers
Corp (expansion)
Loan (sellers)
Use of Proceeds
$2,000,000
$150,000
$750,000
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Loan (bank)
$500,000
Preferred (cash)
$500,000
Common (cash)
$400,000
$2,150,000
$2,150,000
TOTAL
Notice that the $100,000 note that Justin gave for half his shares (which were escrowed) was not
a source of financing. That is, Widget could not use the note to buy more inventory or rent new
office space. But as Justin pays off this note and receives additional shares from escrow, his
payments will constitute new financing to the corporation.
2.
Equity Securities
The basics of corporate securities were discussed in Chapter 2, Corporate Basics. This is a good
opportunity to review some of those concepts and the accompanying vocabulary.
Question: What is equity?
Answer: Equity is



A permanent commitment of capital.
Its return depends on corporate profits.
It has a residual interest in assets on liquidation.
Recall the following terms, introduced in Chapter 2, relating to the issuance of equity securities:




Authorized shares
Unissued shares
Outstanding shares
Treasury shares
Question: How much equity does a corporation have to issue?
Answer. Some, but there is not a rule about the precise number of shares that must be
issued. One class of equity securities, however, must have voting rights.
Question: What happens if you run out of authorized shares to issue?
Answer: The articles of incorporation have to be amended to authorize more. This may
be problematic or at least inconvenient.
Question: How important is the actual number of authorized shares?
Answer: The absolute number of shares is not as important as a shareholder’s percentage
ownership. The issuance of additional shares, therefore, may be important because of the
possibility of dilution.
Question: How might an existing shareholder protect herself from dilution of her ownership
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percentage?
Answer: Preemptive rights. This would give her the right to maintain her percentage
interest by purchasing a proportionate share of the newly issued stock. Preemptive rights
have to be provided for specifically.
Question: What are the typical characteristics of common stock?
Answer: Typically, common stock:

Holds exclusive power to elect the board of directors (making the common
stockholders the beneficiaries of the board’s fiduciary duties);

Has a residual claim on current income (after the corporation satisfies creditors
and senior securities), usually in the form of dividends, unless the board
determines that reinvestment would generate greater returns for the company

Has a residual claim on assets of the corporation in liquidation, after creditors and
senior securities have been satisfied; and

Is a permanent commitment of capital, with exit by sale.
Question: What are the typical characteristics of preferred stock?
Answer: Preferred stock varies more than common stock, and so it is harder to
generalize. Often, preferred stock:

Includes economic rights senior to common stock;

Pays dividends before (senior to) common stock. Dividends may be
o
o
o

Cumulative: If the dividend for a period is not paid, the right accumulates
and arrearages must be paid before the common stock may be paid; or
Non-Cumulative: if the dividend for a period is not paid, the right to a
dividend for that period expires; and/or
Participating: meaning that the preferred stockholders receive whatever the
common stockholders receive, or more;

Offers a liquidation preference: although still subordinate to debt holders,
preferred stock holders’ claims on the residual assets of the corporation comes
before that of the common stockholders;
Is sometimes a permanent commitment of capital (with exit by sale) but
sometimes not. Preferred stock may be redeemable, by either the stockholder or
the company, in an amount usually equal to the liquidation preference.

Has limited or no voting rights. Often the preferred stock will have a say only on
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matters such as changes in the corporate structure or situation in which its
dividend has not been paid.

May be convertible into common stock, or even debt, upon the occurrence of
certain specified events. This kind of preferred stock feels like a hybrid with both
common stock and debt characteristics. Note: if the preferred stock is convertible
into common stock then the corporation needs to have authorized sufficient
shares.
Question: Why is preferred stock the favorite way for venture capital firms to finance start up or
early stage businesses?
Answer: As explained in the breakout box on p. 262, a firm that provides “venture
capital” is providing money to start-up or early stage businesses that it thinks have longterm growth potential. For the start-up companies, venture capital financing is important
because, without a proven track record, they may have a hard time getting loans or
accessing the capital markets. VC firms often accumulate a fund or pool of capital from
sophisticated, wealthy and institutional investors. For the VC firms, start-up companies
entail above-average risk, but also the possibility of above-average returns.
Using preferred stock, VC firms may arrange for, for example, special dividend terms, a
say in certain company decisions and the possibility of converting their preferred stock
into common stock in the event that the start-up company is successful and goes public.
3.
Debt Securities
Question: What are the types and characteristics of common debt securities?
Answer: Debt securities:








Come in several flavors, including notes, debentures and bonds (which are more
long-term);
Typically do not offer voting rights;
May be secured or unsecured;
May be publicly traded or sold privately;
May be redeemable or callable for a fixed price at the option of the corporation;
May be convertible into common stock (note that convertible debentures may
resemble convertible preferred stock, discussed above):
May be issued by the corporation’s board of directors without shareholder
approval (unless the articles of incorporation specify otherwise); and
Typically have rights and obligations contractually specified.
Question: What are the arrangements typical of corporate bonds?
Answer: The bond is offered using a contract known as an indenture that specifies the
rights and obligations of the bondholders and the corporation. There is typically an
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indenture trustee, which is the agent of the corporation (the bond issuer) and handles all
the administrative aspects of the bonds, including making sure that the corporation, as the
borrower, complies with all of the terms of the indenture.
The debt contract (indenture) specifies terms such as:

Principal amount that the corporation must repay;

Interest (which must be paid at fixed intervals regardless of corporate profits);

Maturity date;

Events of default (which may cause acceleration, and the assertion of the
bondholders of legal remedies); and

Covenants (which require the company to refrain from taking certain actions that
might jeopardize the position of the bondholders)
4.
Options
Question: What are options?
Answer: An option is simply the right to buy or sell something in the future. Stock
options are the right to buy stock at a specified time and price. They are a right, not an
obligation. They are separate from the underlying stock, although they may derive their
value from that stock (options are, in fact, a kind of “derivative”). They cost a lot less
than the stock itself.
If, when the stock option is able to be exercised, the underlying stock is trading for more
than the price specified by the option, then the option holder will exercise the option and
buy the stock at the low option price (and make money on the difference). If, however,
when the option is able to be exercised, the underlying stock is trading for less than the
price specified by the option, then the option holder will not exercise the option. If he
wants to buy the stock, it would make more sense to buy it in the market for less. The
option in that case is essentially worthless, and is not exercised. The option holder is out
the cost of the option.
The price specified in the option contract is called the strike price or the exercise price.
The date when the option is able to be exercised is the maturity date or the expiration
date.
Question: What kind of stock options are there?
Answer: The two main kinds of stock options are

Call options: which provide the option holder with the right to buy shares at the
specified price

Put options: which provide the option holder with the right to sell the shares at the
specified price
Question: When are stock options used?
8
Answer: Options are used frequently. Investors may buy or sell options in public
markets designed for that purpose. Companies may purchase options to hedge (protect
themselves from losses) their risks. Another well-known use of options is as a
mechanism for executive compensation
Question: What are the pros and cons of using stock options as a form of executive
compensation?
Answer: The primary argument in favor of using stock options as a form of executive
compensation is that they give the executive a stake in the company, and put her in the
shoes of the shareholders. Options are often considered a kind of “pay for performance”
since the value of the options will increase as the value of the company’s stock increases.
The downside of using stock options as a form of executive compensation is that they
may cause the executives to focus on short term share price increase instead of other,
more long-term company concerns. In the mid-2000’s there was also a focus on false
dating (and thus setting the exercise price) of stock options for executive compensation
which led to a reexamination of the practice and the transparency of executive
compensation itself.
Executive compensation is discussed in detail in Chapter 21, Executive Compensation.
Points for Discussion, p. 266-267
The following table briefly summarizes the capital structure risk and return considerations. As
you go from top to bottom in the return column (from common stock to notes) the potential
return decreases. As you go from top to bottom in the risk column (again, from common stock to
notes) the risk decreases. Common stock has the highest potential return and the highest risk.
Short term debt (notes) has the lowest return and the lowest risk.
Capital Attributes
Common Stock
Return
Variable Dividends

From earnings

Board discretion
Preferred Stock
Fixed Dividends

From earnings

Before pay
common
Bonds
(long term debt)
Principal + Interest

From future
Risk
High

Growth
potential

Voting rights
Moderate/High

Participating
(growth)

Cumulative
(certain)

Contingent
voting
Moderate/Low

No growth
Tax
Double
Corporate tax
Double
Corporate tax
Interest deductible
9

operations
K – not
discretionary


Notes
(short term debt)
Principal + Interest

From current
operations

K – not
discretionary
potential
Sometimes
secured
Personal
guarantees
Low
 No growth
potential
 Not secured
Interest deductible
Bonus Question: Remember our Widget, Inc, hypothetical at the beginning of the chapter.
Assume that JKL Corporation has 1,000 authorized no-par common shares, which were issued to
Justin, Kathy and Lorenzo. If the company wants to issue new common stock, what must it do?
At what price must it sell the stock?
Answer: The company has issued all of its authorized stock. If it wants to issue more
common stock, it has to authorize more, which will require amending the company’s
articles of incorporation. If the stock is “no par” then the company may sell the stock at
whatever price it wants. Because this is a closely-held corporation (CHC) there is
unlikely to be a market price for the stock.
B.
Capital Structure in the Real World: Taxes, Bankruptcy, and Conflicts
1.
Taxes
Question: Does the Internal Revenue Code encourage companies to issue debt or equity?
Answer: Debt. The IRC allows a company to deduct the interest that it pays to its
bondholders from its taxable income. Stock dividends are not deductible.
Question: Given the fact that debt is tax-advantaged, why do corporations always issue bonds
(instead of stock)?
Answer: Debt can be inflexible because the corporation has to make fixed periodic
payments to the bondholders regardless of the company’s performance. Dividends are
more flexible and need not be paid during lean times (though in the case of some
preferred stock, they accumulate and must be paid later, when the company is in a
position to pay dividends). The optimal answer for corporations is probably a mix of
debt and equity.
Companies frequently offer securities that have some characteristics of both debt and equity.
Because of the favorable IRC treatment of debt, companies often argue that such hybrid
instruments are debt. The following case, discussed in the Breakout Box on p. 269, provided a
useful list of characteristics that may help determine whether debt really is debt.
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Slappy Drive Industrial Park v. U.S., 561 F.2d 571 (5th Cir, 1977)
Facts: Spencer C. Walden, Jr. organized and managed a number of closely held real estate
development corporations, including one organized to develop the Slappy Drive Industrial
Park. The corporations in question owed their shareholders a number of debts, arising
from transfers of land (ostensibly credit sales) and transfers of money (ostensibly loans)
that the shareholders made to the corporations. The recurring patter in regard to all the
loans was the corporations’ failure to adhere to the announced repayment schedules.
Although the corporations made some principal and interest payments, they did not
conform to the payment terms in the notes. In addition, court testimony established that
the creditor-shareholders did not view their situation the way that normal creditors would.
They did not object when the corporations failed to pay on payment dates, and requested
payments only when the corporations had “plenty of cash.” Walden testified that the
individuals were more concerned with their status as shareholders then their status as
creditors. The case in question arose from tax refund suits filed by the corporations against
the United States
Issue: Whether certain purported debts that the corporations owed their shareholders
should be treated for tax purposes as contributions to capital.
Holding: The transactions should be characterized for tax purposes as equity
arrangements.
Reasoning: the essential difference between debt and equity arrangements is that
shareholders place their money “at the risk of the business” while lenders seek a more
reliable return. The court looks to Estate of Mixon v. U.S. 464 F.2d 394, 402 (5th Cir.
1972) for a list of factors to help discern whether a transaction resembles the type of
arrangement for which Congress provided debt or equity treatment:
(1) the names given to the certificates evidencing indebtedness;
(2) the presence or absence of a fixed maturity date;
(3) the source of payments;
(4) the right to enforce payment of principal and interest;
(5) participation in management flowing as a result;
(6) the status of the contribution in relation to regular corporate creditors;
(7) the intent of the parties;
(8) “thin” or inadequate capitalization;
(9) identity of interest between creditor and stockholder;
(10) source of interest payments;
(11) the ability of the corporation to obtain loans from outside lending institutions;
(12) the extent to which the advance was used to acquire capital assets; and
(13) the failure of the debtor to repay on the due date or to seek a postponement.
The court found the most telling factors to be the corporate debtors’ consistent failure to
repay the debts on the due dates or to seek postponements, as well as the corresponding
11
absence of timely interest payments and Walden’s testimony regarding the parties’ view of
their relationships with the corporations.
2.
Bankruptcy and Leverage
Question: What is leverage?
Answer: Leverage is the amount of debt that a company uses to finance its business
activities, as compared to the amount of equity it has issued. A company with
significantly more debt then equity financing is “highly leveraged.
A company with more leverage will encounter substantial business risks, including the
risk of bankruptcy. However, a company will find it profitable to finance its operations
with debt whenever its income from those operations exceeds the interest it has to pay on
the borrowed money. The examples on pp. 270-271 compare the effects of financing
with debt or with equity in three scenarios (break even, negative and positive).
3.
Tension in the Capital Structure
The corporation’s choice between financing with debt and financing with equity inevitably
results in tensions among the stakeholders (managers, shareholders, lenders, employees etc.).
One of the most obvious tensions is between shareholders and bank lenders.
Question: Think back to our hypothetical purchase of Widget, Inc. by JKL Corporation,
including the bank loan from First National Bank (“Bank”). What tensions might exist between
Bank and the JKL shareholders (Justin, Kathy and Lorenzo)?
Answer: Some possible answers are:

Bank might want to limit dividends and other distributions to the shareholders.

Bank does not care how much profits exceed the required interest payment (as
long as the required interest payment is made).

Bank obligations are senior to shareholder’s (residual) claims and so in the event
of bankruptcy the more debt there is the less likely there is to be anything left over
for the shareholders.
Equity-linked Investors, L.P. v. Adams (705 A.2d 1040 (Del. Ch. 1997)
Facts: This case involved a conflict between the common and the preferred shareholders
of a corporation. Genta Incorporated (“Genta”), a bio-pharmaceutical company, was on
the verge of insolvency and deciding whether to borrow in an attempt to continue
operations or to liquidate. Genta was worth less than the $30 million liquidation
preference held by its preferred stockholders. The preferred stockholders, a few
institutional investors led by Equity-linked Investors, sought to cut their losses and force
liquidation and the distribution (to them, because of the liquidation preference) of
Genta’s assets. The common shareholders, and the board, wanted to borrow additional
funds to continue operations in the hope of future improvement and profits.
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Economically if Genta took on debt to continue, the preferred risked losing its liquidation
payout to the new senior stakeholders but the common stockholders had nothing to lose
(since without new financing, the company would be bankrupt and all its assets would be
distributed to the preferred).
The contractual rights of the preferred did not give them the legal power to force
liquidation. The Genta board arranged secured debt financing from the Aries Fund
(“Aries”). The preferred stockholders sued, challenging the loan transaction.
Issue: Did the Genta board breach its duty to the preferred stock holders by forcing the
(continuation of) the economic risks of insolvency upon them by arranging new, senior
financing to continue its operation instead of liquidating?
Holding: No The decision by the board to seek and obtain debt financing did not
conflict with any special right held by the Series A preferred stock holders, and the board
made an independent and informed decision based upon good faith. “While certainly
some corporations at some point ought to be liquidated, when that point occurs is a
question of business judgment ordinarily and in this instance.”
Reasoning:
 The special protections offered to any preferred stock holder is contractual in
nature, and the board has an obligation in contract to respect those rights.
 However, generally it will be the duty of the board, where discretionary judgment
is to be exercised, to prefer the interests of the common stock
 The preferred stock holders had no right established in their contract that allowed
them to force liquidation.
 The board was justified in its belief that Genta had an opportunity to prosper in
favor of its equity holders, and therefore, made a good faith business judgment
decision to continue operations.
Where does this tie in?



In the capital structure picture, it highlights the preferred stock holders obligation to
negotiate the terms and conditions of their choice to invest in the corporation.
Also, it highlights the board’s supreme obligation to consider the interests of its common
stock holders in the absence of any provisions that would violate other duties created by
contract.
Of course, any provision that may cause eventual conflict of the board acting in the
interest of the common stock must have been created in the board’s pursuance of its
supreme obligation in regard to the common stock holders.
Points for Discussion (p. 277)
13
1.
Resolving Tensions
Question: If you could have anticipated the problems at Genta, how might the capital structure
problem have been avoided?
Answer: With the benefit of 20-20 hindsight, what kinds of provisions might the
preferred stockholders sought in their contractual arrangement? Some examples might
be:




C.
The right to force liquidation when insolvency was approaching;
The right to approve more senior (debt) financing;
The right to appoint a certain percentage of the board of directors (though the
board would still have had a fiduciary duty to the common shareholders); or
The right to convert their preferred equity into debt.
Capital Structure Law and Policy
This section focuses on three law and policy issues related to capital structure:

The notion of legal capital

The payment of distributions to shareholders and

The law and policy implications of dividend payments (a type of distribution)
1.
Legal Capital
Question: What is meant by the “legal capital” of a corporation?
Answer: Historically legal capital (or stated capital) referred to the amount of capital the
corporation had – a kind of “cushion” that helped creditors feel confident that the
company would be able to repay its obligations. Calculation of legal capital was easy:
# of shares outstanding X par value of shares = legal capital
“Par value” in this context was the initial price paid for the shares.
The idea was legal capital , based on par value, represented the amount contributed by the
shareholders and thus a rough approximation of the firm’s assets.
Lenders might then rely on the company’s legal capital as indicating the value of the company’s
assets and by extension the amount they might expect to be repaid/
This was not true. As demonstrated by the late Bayless Manning, former Dean of Stanford Law
School, par value is an arbitrary number that had no economic value, and creditors did not rely
on par value/legal capital calculations in making loan decisions.
14
In an essay dedicated to Manning on the occasion of the 60th anniversary of the Model Business
Corporations Act, his co-author on the third edition A Concise Textbook on Legal Capital, James
J. Hanks, Jr., explained:
THE EXPOSURE OF “LEGAL CAPITAL”
The MBCA followed faithfully from the early nineteenth-century
emergence of par value, stated capital, surplus, and the later enactment of statutes
employing those concepts to limit the corporation’s power to make payments to
its shareholders on account of their stock. For the MBCA’s first thirty years, its
distribution provisions contained both an equity solvency test and the traditional
stated-capital or earned-surplus test.1 That is, a corporation could pay a dividend
only if, after payment of the dividend, the corporation could pay its debts as they
became due and the corporation’s assets exceeded the sum of its liabilities and
stated capital. This was the case even though stated capital was a nominal,
arbitrary, and economically irrelevant number.
Bayless Manning first identified and revealed the vacuity of traditional
legal capital statutes in the first two editions of his celebrated book, Legal
Capital.2 Then, during the 1980s, he served on the American Bar Association’s
influential Committee on Corporate Laws, the author and continuing overseer of
the MBCA. His three most important insights during this period were:
First, all pro rata payments to shareholders on account of their shares—
whether by dividend, redemption, other reacquisition, or partial liquidation—have
the same economic effect on the corporation (a decrease in its assets, typically
cash) and on the shareholders (no change in each shareholder’s percentage of
shares owned). Therefore, there should be no difference in their legal treatment.
Even a non-pro rata share acquisition by the corporation offers no more
opportunity for board misbehavior than issuing shares in exchange for a parcel of
land or a computer-software program of uncertain value.3
Second, it makes no economic sense to base, even in part, the amount of
assets that a corporation has the power to distribute on arbitrary and economically
irrelevant figures like par value and its derivative, stated capital.4
Third, there is no difference between “treasury shares”—shares that the
corporation issues but later reacquires (whether through redemption or
1
MODEL BUS. CORP. ACT §§ 45–46 (1969) (amended 1980).
See generally BAYLESS MANNING, A CONCISE TEXTBOOK ON LEGAL CAPITAL (2d ed. 1981);
BAYLESS MANNING, A CONCISE TEXTBOOK ON LEGAL CAPITAL (1st ed. 1977).
3 See BAYLESS MANNING WITH JAMES J. HANKS, JR., LEGAL CAPITAL 12–16 (3d ed. 1990) (discussing
payouts to shareholders).
4 See id. at 92 (“A corporation’s ‘legal capital’ is a wholly arbitrary number, unrelated in any way to any economic
facts that are relevant to a creditor. . . . [F]rom his standpoint the stated capital is simply a fortuitously-derived
number that could as well have been taken from a telephone directory as from a series of unconnected and irrelevant
historical events.”).
2
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repurchase)—and shares that are authorized but never issued. Therefore, treasury
shares serve no conceptual purpose and should be abolished.5
___________________________
James J. Hanks, Jr., Legal Capital and the Model Business Corporation Act: An
Essay For Bayless Manning, 74 WTR Law & Contemp. Probs. 211 (Winter 2011)
Nevertheless, state laws still require corporations to state a par value for their shares, and many
(including Delaware) still maintain traditional rules prohibiting corporations from distributing
more than their legal capital to their shareholders.
Remember the hypothetical company, JKL Corporation, set up by Justin, Kathy and Lorenzo to
buy Widget, Inc. Justin, Kathy and Lorenzo contributed a total of $500,000 for the common
stock of JKL Corporation. Assume that JKL, a Delaware corporation, issued 5,000 share of
common stock, with an initial price of $100 a share. The sales of common stock therefore are:
Kathy
Justin
Lorenzo
$200,000 cash
$100,000 cash
$100,000 note
$100,000 cash
2,000 shares
2,000 shares
1,000 shares
Question: Does JKL have to set a par value for its shares?
Answer: No. DGCL §151 (reprinted on p. 281) allows for stock with or without par
value
Delaware General Corporation Law § 151(a). Classes and Series of Stock
(a) Every corporation may issue 1 or more classes of stock or 1 or more
series of stock within any class thereof, any or all of which classes may be of
stock with par value or stock without par value . . .
Question: What happens if JKL sets par value of its stock at $100? What about $1?
Answer: Setting the par value of the stock at $100 may limit the company’s
ability to sell common stock for a lower price in the future. Setting the par value
at $1, as a kind of “floor”, may allow the company to retain the most flexibility.
DGCL § 153 (reprinted on p. 281) sets forth the consideration to be paid for
common stock. In addition, low-par stock creates more "capital surplus" from
which the corporation can later pay dividends and make other distributions to
stockholders.
See id. at 190–92 (“[T]he concept of ‘treasury shares’ was a makeshift ameliorant to the artificial paralysis of ‘par,’
offering a way to permit shares to be sold at their market value. . . . [F]orgivable or not at the time of their inception,
‘treasury shares’ are today simply humbug.”).
5
16
AP note: Yes, under Del. GCL §170 - should we include this as question when we get to
Klang? That is, could the corporation have issued cash to shareholders as dividend,
rather than repurchase their shares? Yes, same legal capital rules apply to dividends as
apply to repurchases.
Delaware General Corporation Law § 153. Consideration for Stock
(a) Shares of stock with par value may be issued for such consideration,
having a value not less than the par value thereof, as determined from time to
time by the board of directors, or by the stockholders if the certificate of
incorporation so provides.
(b) Shares of stock without par value may be issued for such consideration as
is determined from time to time by the board of directors, or by the
stockholders if the certificate of incorporation so provides.
Question: Remember that Justin paid $100,000 in cash and gave a $100,000 personal note for
his JKL shares. Kathy and Lorenzo paid cash for theirs.. Was Justin’s note lawful
consideration? What if Justin promises to serve as president of JKL for the next five years?
Answer: Either one will likely work. Although some states prohibit corporations from
accepting promissory notes as consideration for stock, unsecured notes may be accepted
if they are guaranteed by an appropriately creditworthy party. DGCL §152 (reprinted on
p. 281) allows companies to accept “any benefit to the corporation” and in practice the
board’s determination that adequate consideration has been received is usually enough.
The substitution of Justin’s promise to serve as future president of JKL is also likely to
work.
Delaware General Corporation Law § 152. Issuance of Stock; lawful
consideration
The consideration, as determined pursuant to § 153(a) and (b) of this title, for
subscriptions to, or the purchase of, the capital stock to be issued by a
corporation shall be paid in such form and in such manner as the board of
directors shall determine. The board of directors may authorize capital stock
to be issued for consideration consisting of cash, any tangible or intangible
property or any benefit to the corporation, or any combination thereof. In the
absence of actual fraud in the transaction, the judgment of the directors as to
the value of such consideration shall be conclusive. . . .
2.
Distributions to Shareholders
The concept of legal capital also shaped the laws relating to when a corporation can pay money
to its shareholders. Another source of conflict within corporations, shareholder distributions may
pit debt holders (who want to preserve a substantial cushion with which the corporation can
repay its loans) against shareholders (who would like the corporation to distribute cash in the
form of dividends or share repurchases). Although states vary, they generally prohibit
17
corporations from making distributions that leave them unable to repay their debts (insolvent).
In those cases, the directors who authorized the unlawful distributions may end up liable to
creditors for their losses. However, corporations can often reduce the par value of their
outstanding stock or revalue their assets to avoid unlawful distribution problems.
Klang v. Smith’s Food & Drug Centers, Inc. 702 A.2d 150 (Del. 1997)
Facts: Smith’s Food and Drug Centers, Inc. (SFD) owned a chain of grocery stores and
was looking to be acquired. In 1996, Smitty’s Supermarkets, Inc., (“Smitty’s) a whollyowned subsidiary of Yucaipa Companies (a California partnership), decided to acquire
Smith’s. According to the agreement, Smitty’s would merge into Cactus Acquisition, Inc.
(a subsidiary of SFD) and in exchange SFD would give Yucaipa just over 3,000,000,
newly-issued SFD shares. As part of the agreement, SFD would recapitalize, taking on
new debt, retiring old debt, and offer to buy-back over 50% of its outstanding shares (that
were not issued to Yucaipa) at $36/share.
SFD hired Houlihan Lokey to look at the deal and give a solvency opinion. Houlihan
issued a solvency opinion, stating that the deal would not endanger SFD’s solvency and
would not impair SFD’s capital in violation of DGCL § 160 which does not allow a board
to inter into a transaction, unless expressly authorized, that would render the company
insolvent (i.e unable to pay its debt holders).
Delaware General Corporations Law §160(a) Corporation's powers
respecting ownership, voting, etc., of its own stock; rights of stock
called for redemption
No corporation shall purchase … its own shares … when such purchase …
would cause any impairment of the capital of the corporation
DGCL §154 defines insolvency as occurring when the amount used in a re-purchase of
company stock exceeds the “surplus.”
Delaware General Corporations Law § 154. Determination of amount
of capital; capital, surplus and net assets defined.
[The board may] determine that consideration … received by the
corporation for … its capital stock … shall be capital... The excess … of
the net assets of the corporation over the amount so determined to be
capital shall be surplus. Net assets means the amount by which total
assets exceed total liabilities.
SFD released a pro forma balance sheet before the transactions which showed that the
merger and self-tender offer would result in a deficit to surplus on SFD’s books of over
$100 million (which was confirmed in the balance sheet issued by the board after the
transactions). SFD, however, argued that it should have the right to revalue its assets and
liabilities to comply with §160.
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The Plaintiff, an SFD public shareholder, brought suit seeking rescission of the merger,
alleging that the board breached DGCL. § 160 in deciding to re-purchase its own stock.
The Plaintiff made two claims – 1) DGCL§ 160 requires the corporation’s board, in
determining solvency, to use its balance sheet in making its determination; and 2) the
solvency opinion offered by Houlihan did not use the proper method of calculation.
Issues:
(2)
(1)
Does DGCL § 160 require the corporation to use its
balance sheets in determining its solvency with respect to a
transaction?
Did the solvency opinion fail to abide with DGCL § 154 by failing
to render an opinion that took into account “total assets” and “total
liabilities” as separate variables?
Holding: No violation of DGCL §160 or DGCL §154.
Reasoning:
 (1) “Plaintiff advances an erroneous interpretation of Section 160. Among other
factors, unrealized appreciation or depreciation may render book numbers
inaccurate. It is unrealistic to hold that a corporation is bound by its balance
sheets for purposes of determining compliance with Section 160…Allowing
corporations to revalue assets and liabilities to reflect current realities complies
with the statute and serves well the policies behind the statute.”

“We adhere to the principles in Morris v. Standard Gas & Electric Co. …
allowing corporations to revalue properly its assets and liabilities to show a
surplus and thus conform to the statute.”

(2) “We believe that the plaintiff reads too much into DGCL § 154…The statute
is merely definitional…We are satisfied that the Houlihan opinion adequately
took into account all of Smith’s assets and liabilities.”

“8 Del.C. § 154 does not mandate a facts and figures balancing of assets and
liabilities to determine, if any, total assets exceed total liabilities…It does not
require any particular method of calculating surplus, but simply prescribes factors
that any such calculation must include.”
Question: What is the end result of the holding in Klang?
Answer: Klang allows flexibility to a corporate board when determining the solvency of
its corporation. It allows a corporation to use methods that reflect changed
circumstances, such as the passage of time, to reflect the new value of assets.
3.
Corporate Dividend Law and Policy
Dividends are the most controversial types of corporate distributions, especially when the
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corporation is in financial difficulty. Although directors aee primarily responsible for dividend
decisions, which are protected by the business judgment rule, there are some exceptions,
especially in the context of closely held corporations
Question: What is a closely held corporation (CHC)?
Answer: CHC’s are usually small corporations in which the stockholders also perform
management or other tasks for the corporation. There is no market for the company’s
stock, so without distributions there is no meaningful economic return. In addition, the
majority shareholder is often powerful, and may oppress or otherwise disadvantage
smaller, minority interest holders.
Litle v. Waters, 18 Del. J. Corp. L. 315 (1992)
Facts: Litle and Waters owned two companies together: Direct Order Sales Corporation
(DOSCO) and Direct Marketing Guaranty Trust Corporation (old DMGT). Waters
provided both companies with capital. Litle provided management services. Waters
owned 2/3 of the stock of both corporations, and Litle owned 1/3. They elected to treat
both corporations as S-corporations, with flow-through tax status. They had no agreement
about whether the corporations would pay dividends.
Waters fired Litle as president and CEO of both companies, and then merged the two
companies into DMGT Corp (new DMGT). Waters became CEO and chairman of the
board of new DMGT and as the entity began to make money, used the profits to repay the
debt that DOSCO owed him. The earnings, however, resulted in $560,000 in tax liability
for Litle, who still has a 33% interest in new DMGT. New DMGT has not distributed any
dividends to its shareholders. Litle sues to get new DMGT to pay a dividend, alleging that
Waters and other directors of new DMGT breached their fiduciary duty to the stockholders
by pursuing a course of action that favored one group of stockholders to the detriment of
another.
Issue: What standard should be used to evaluate the new DMGT board’s actions – entire
fairness or (as argued by the defendants) the business judgment rule?
Holding: The fairness standard.
Reasoning: An interested director is one that stands on both sides of a transaction or
expects to derive personal financial benefit from the transaction in the sense of selfdealing, as opposed to a benefit which devolves upon the corporation or all stockholders
generally. The decision as to whether a director is disinterested depends on whether the
director involved had a material financial or other interest in the transaction different from
the shareholders generally.”
Waters served his own personal financial interests in making his decision not to have new
DMGT declare a dividend. This also let Waters pressure Litle to sell his shares to Waters
at a discount. Waters is was an interested director, so the entire fairness standard applies
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and the burden shifts to the defendants to show that the decision not to declare dividends
and instead to repay the debt to Waters was intrinsically fair
Note: this case demonstrates the “oppression doctrine” which requires that the board not
frustrate the “reasonable expectations” of the minority. The majority shareholders cannot use
dividend policy to coerce the minority to sell their shares at a discount.
Kamin v. American Express Co., 383 N.Y.S.2d 807 (1976), aff’d on opinion below, 387
N.Y.S. 2d 993 (1st Dept. 1976)
Facts: American Express owned almost 2,000,000, shares of Donaldson, Lufkin &
enrette, Inc. (DLJ) which went from almost $30 million in value in 1972 to about $4
million in value in 1975. American express announced that it would distribute the DLJ
stock as a dividend. Two shareholders sued to stop the distribution of the stock, arguing
that if American express sold the DLJ stock then American Express would reduce its
taxable capital gains by its $26 million loss and save about $8 in taxes. Then, they argued,
American Express could distribute the $4 million proceeds and the $8 million in tax
savings to the shareholders. The American Express directors met and considered the
shareholders’ suggestion, but decided to go with the dividend plan anyway .
Issue: How should the court evaluate the board’s distribution decision?
Holding: The business judgment rule controls (board decision stands).
Reasoning:
 There is no claim of fraud or self dealing, and no contention of bad fath or
oppressive conduct.
 “Courts will not interfere with such discretion unless it be first made to appear
that the directors have acted or are about to act in bad faith for a dishonest
purpose. It is for the directors to say, acting in good faith of course, when
and to what extent dividends shall be declared. The state confers on the
directors this power, and the minority stockholders are not in a position to
question this right, so long as the directors are acting in good faith”
 “The directors room rather than the courtroom is the appropriate forum for
thrashing out purely business questions
Points for Discussion (p. 294-295)
Question: What accounts for the difference in the courts’ approaches to dividend declarations in
these two cases/
Answer: It is not completely clear. Some possibilities are:
 Closely held corporations vs large publicly traded corporations
 Board offering business reasons for the decision
 Board domination by a single shareholder
 The remedy being sought (paying dividend or blocking a payment)
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Summary
The main points of this chapter are:

Equity (ownership interests) comes in two basic flavors:
o common stock
 arises in articles
 right to pro rata dividends (subject to board discretion)
 voting rights
 last-in-line (most junior)
 risk
o preferred stock
 terms found in articles (set by board)
 preferred right to discretionary dividends (before common)
 can be participating, cumulative or convertible
 may have contingent voting rights

Debt comes in two basic flavors:
o short term notes
 principal and interest paid according to contract (authorized by board)
 low risk because of short term
 not secured (such as commercial paper < 9 months)
o long-term bonds
 principal and interest paid according to contract (authorized by board)
 higher risk given longer term
 unsecured called debentures

Leverage is debt’s effect on equity
o debt is hard
 must be paid
 if insufficient business returns to pay debt, business may become
insolvent/bankrupt
o equity is soft
 dividends need not be paid
 if insufficient earnings to pay equity, no problem
o debt/equity ratio affects risk
 if debt is higher, equity is riskier (positive $$ when business profitable,
negative $$ when not)
 if debt is lower, equity is safer (smaller debt burden)

Tax effects of debt/equity mix
o disadvantages of equity: dividends are not deductible
o advantage of debt: interest is deductible (no double corporate tax)
o owners will want to characterize their capital contributions as debt (but the IRS
will not allow too much – Slappy Drive factors)
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
Dividend policy
o usually matter of board discretion (Business Judgment Rule)
o closely-held corporations
 no-dividend policy can be a form of oppression
 judicial intervention to protect minority from overreaching majority
o publicly held corporations
 dividend policy can be set to appease market
 even when doing so is financially foolish
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