Corporate Finance FINAL
8/29/2010 11:04:00 PM
I. CAPITAL STRUCTURE, ACCOUNTING AND VALUATION
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Corporate Finance is about capital formation; people putting money
together in large pools and putting it to use in enterprises to create
more wealth
Sources of Capital
o Debt used for leverage purposes
o Equity interest would require sharing in the profits
o Line of credit may be drawn for working capital
o Venture capital – funds available from investment companies
that pool the funds of numerous investors and seek out
promising businesses in which to make substantial
investments
1. Present Day Value of Money: To earn $100 in ten years, that $100 is
not worth $100 today, its less
 R: Since interest rates are positive – a dollar in the future is always
worth less than a dollar today
o R: The higher the interest that can be earned on a riskless
investment, the lower is the current value of a right to receive
a future payment
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Seven approaches to valuation
o Scrap value – income? liquidation value
o One year’s income – future income?
o 15 years * one year’s income – present value? risk?
o Other offers: liquid market/Speculative component/Control
premium
o Book value – cost? Depreciated asset?
o Discounted cash flow
o Capitalized earnings
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Flaws with some of these approaches
o Risk - $100 in 10 years is worth less because it is a risk that
the production will not continue to pay out
 N: US Treasury bonds is the benchmark for risk
allocation of future money
 R: Value must be discounted to reflect risk
o Opportunity Cost - Value must be discounted for forgoing
other investments to enter into this deal
2. P/E Ratio: Price for which a SH would pay for Corporate earnings
 Ratio between market price per share and the earnings per share of
the publicly held stock for the last available accounting period
 Be careful in using P/E: If the P/E ratio is not extremely high and
has been reasonably stable over the last few years it is probably a
reliable indicator of the appropriate capitalization rate
 N: P/E of publicly held corporations reflect investment value of
securities and not any premium that represents control of business
 Same as inverse of multiplier or capitalization factor
 Ex: When P/E is high, the more you are paying for a dollar of
earnings
o 20/1 P/E = 5% Discount Rate
o 50/1 P/E means that there is an underlying future expectation
that it will go up b/c its at 2% now and that there is an
extremely low risk, seller would like this P/E
3. Discounted Cash Flow: Discount to the present value of future receipts
including salvage value, depending on rate of discount
 Use a higher discount rate than the government rate offered on
treasury bonds to compensate for risk
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Flaw: Easy to discount cash flows when steady, but not so helpful
when dealing with large expenses that do not recur
N: Different from earnings based valuation – earnings do not reflect
ability of the company to distribute cash to investors
o Possible for company to have increasing earnings but not
enough cash to pay its bills
N: Discounted cash flow takes into account in flows and out flows
when they are to occur in the future
o Where an accountant would be making depreciation
deductions over the next five years
4. Capitalization of Earnings: takes into account risk and uncertainty;
also the opportunity cost (other investments passed on for this investment)
 Must know two things to calculate:
o Size of payments each year AND
o Appropriate discount or interest rate by which the future
payments can be discounted to present value
 Fxn of Market interest rate of riskless loans AND Risk premium
o N: Earnings are what’s left over after depreciation has been
deducted; it is not free cash flow
5. Capitalization Rate/Discount Rate/Multiplier
 The riskier the business, the higher the discount rate, the smaller
the multiplier, and the lower the value place on the cash flow
A. Capitalization Rate/Multiplier
 Usually the capitalization rate/multiplier is established from the
actual relationships between average earnings and sales prices of
similar businesses in the recent past rather than from a Market IR
+ Risk premium
B. Discount Rate
 Interest rate v Discount rate
o When speaking of the earning power of a present amount
over time, one usually speaks of the interest rate
o When going the other way, computing present value of a
future payment, one usually speaks of the discount rate
o N: It’s the same calculation just in different directions
6. CAPM The capital asset pricing model is widely used to estimate a
company's value. The model is based on:
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Risk-free rate of return - Only things above this are worth investing
in
Rate of return for the market for securities of similar companies
o Other companies in same industry
Company’s beta
o measures the variance in the company's stock price relative
to the market for securities of similar companies.
Market risk premium - Higher the risk premium the higher return
demanded for taking on the risk
A. Formula: E(PR) = RF + Beta * (E(RM)-RF)
 E(PR) = return you are demanding; discount rate
 RF = risk free rate of return, assume 5%, derived from government
treasury obligations
 Beta = start at 1 and adjusted for discount rate for market
o Firm’s relative volatility of a subject firm’s stock price relative
to the movement of the market (market for that stock,
something to be argued!!!) generally
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B. Risk
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o If a stock has a beta of 2.0 then on average it swings twice as
far as the market
E(RM) = market risk
E(RM)-RF = market risk premium
GR: The model produces an estimated discount rate for the
company that, when divided into the company's earnings or cash
flow, provides an estimated value for the company.
S: Low discount rate => low risk; Low beta => low risk
Systematic risk – risk of the market for the particular company you
are valuating; also called market risk/Beta – captures the reaction
of individual stocks
Diversification cannot eliminate systematic risk
Non-systematic risk – risk from investing in the market in general;
can be eliminated by modern portfolio theory; this is not what is
being compensated for when a risk premium is made
Modern portfolio Theory – to the extent that stocks don’t move in
tandem all the time, variations in the returns from any one security
will tend to be washed away or smoothed out by complementary
variation in the returns from other securities
 Beta: CAPM model says that returns (and therefore risk premiums)
for any stock will be related to beta, the systematic risk that cannot
be diversified away
C. Litigation context - Majority SH’s squeezing out minority SH’s
 Minority SH opposed the merger and file an Appraisal claim
o Majority argues that the company is worth less than the
tender offer price it just made
o Minority agues that the company is worth more
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Issues to litigate – test the assumptions of the expert!!
What is the risk-free rate of return, what period to look at to
determine this, what kind of treasury instruments
D. Technicolor case
 F: Second step of two step cash out merger; 17% of target
company common stock now owned by acquiror was converted into
a right to receive $23. Minority holder dissented from the merger
and filed for an appraisal of the stock’s FMV.
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o Two experts used the discounted cash flow technique and
came to very different results
Debt. How is long-term debt incorporated into the valuation
process?
o The expert using the 10-K had the better figure; expert with
unaudited working paper is not as reliable
o The minority SH will argue for lower debt so there will be a
higher valuation; majority SH argues for higher debt
o Debt was deducted from the present value of the sum of
projected net cash flows and terminal value
o But, what about debt as ongoing expense that reduces
earnings?
Cash flow and residual value. The court discusses the experts'
projections of cash flow over time. What is its analysis?
o Majority SH expert used value growth duration which means a
period during which a company’s net returns can be predicted
to exceed its cost of capital.
 Does not mean there is no value after period is over
just mean no value growth
Residual value estimation
o Majority expert – capitalized a constant cash flow, assuming
no new value creation beyond the forecast period
o Minority expert – Increases the last forecasted year’s net cash
flow by 5% each year into infinity, then capitalized cash flows
o Difference: one expert believes there will come a time when
while it may make profits Target will not be increasing in
value
Cost of capital and beta (51 - 53): The court discusses the experts'
different estimates of the appropriate discount rate to use for
various business lines, as well as the appropriate beta.
o R: Cost of capital supplies the discount rate to reduce
projected future cash flows to present value
o CAPM – estimates the cost of company debt by estimating the
expected future cost of borrowing; it estimates the future cost
of equity and then proportionately weighs and combines the
cost of equity and cost of debt to determine cost of capital
CAPM estimates a firm’s cost of capital by attempting to
identify a risk-free rate of return and to identify a risk
premium that would be demanded for investment in the
particular enterprise
o Beta used by majority SH’s included short period of high
volatility that ensued after merger announcement
 Minority SH expert did not use this period
Small cap effect (52 - 53): The court briefly discusses the premium
that small capitalization companies have paid for capital
o The small cap effect is the CAPM inability to replicate with
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complete accuracy the historic returns of stocks using historic
beta, thus a premium is used to reflect the cost of equity
o Court did not use the small cap number b/c T was old and
stable, but when small cap is calculated the pool of companies
used are old and name recognized
o It had nothing to do with the basis of Rappaport’s analysis;
Court effectively made a argument for lower beta when
dismissing the small cap premium
Market price (53 - 55): How does the court view the role of market
price in the valuation of the company?
o The market price role is based on degree, one in which the
court must determine. The court was wary not to allow an
inflation of the market price value used to come from the
effects of the MAF tender offer
I: Why does person buy the stock, b/c its worth what it is now OR
what the expected increase in value to be realized in the future
o Different states have different standards
 DE – don’t get the future benefit
7. Efficient Market Theory
8. Risk premium – additional amount of interest dependent on the degree
of risk presented by specific transaction
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9. Dilution
Byrne v Lord - issuance of treasury stock effect on vote
 Treasury stock – after corporation issues shares to public then
decides to buy back shares
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o Shares allowed to be issued are authorized shares; issued
shares are those issued out of the pile of authorized shares
o Importance – treasury stock cannot vote with these shares,
prevents board from becoming self-perpetuating entity
 R: Treasury stock does not get voted
Π arg: dilution of corporate assets by issuing stock below par
R: Dilution is independent of par concepts
∆ arg: issued shares at a price to get capital, in desperate straights
Court: The issuance of treasury over authorized stock is arbitrary, it
makes no difference
Issuance of shares by a closely held corporation subsequent to the initial
issuance of shares upon formation necessarily involves dilution of the
interests of current SH’s unless the issue is distributing proportionally to the
current SH’s
 Dilution occurs IF voting shares are issued:
o to third persons
o some but not all the current SH’s
o to all the current SH’s but not in their pre-issuance
proportions
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Dilution also occurs when common shares are issued at bargain
price, original holders shares are dilute
 Watered stock – when SH pays too much for share, the stock is
watered
 Current application of this - when corporations want to raise funds
due to being in dire straights, normally would borrow money, but
when credit markets are frozen, the company will sell more stock
Katzowitz v Sidler – Two in closely held gang up on the third member
 F: S and L may an offer to K for all three to purchase more shares
in order to raise capital. Book value of one share at this point was
$1800 a share; originally $100 a share.
o N: IF all three buy in for $100 a share then there is no
change to voting and value
o K refuses and SL goes forward. SL own 30 shares each, K
only has 5. They paid $100 a share for the additional 25
shares. SL Ownership in corp went from 1/3 to almost 1/2.
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And only paid $2500 to get there. They have taken away
nearly all of K’s ownership
I: K’s interest in the corporation dramatically diluted
R: Pre-emptive rights has two interests
o Right to protection against dilution of their equity in the
corporation AND protection against dilution of their
proportionate voting control
 Closely Held Corporation angle
 Even if a SH could find a buyer for his shares the
value would be less then FMV, also if he is not
offered to buy more shares or he does not want
to invest additional funds his interest will be
diluted
Π’s Burden to show
o When the issuing price is shown to be markedly below book
value in a close corporation AND
o When the remaining SH-Directors benefit from the issuance
∆’s must show
o Directors must show that issuing price falls within some range
which can be justified on the basis of valid business reasons
∆’s arg: Even if the shares are purchased at less than FMV, as long
as all SH’s were given an equal opportunity to purchase additional
shares, no stockholder can complain simply b/c the offering dilutes
his interest in the corporation
Corollary: SH’s right to maintain his proportionate equity in a
corporation by purchasing additional shares is the right not to
purchase additional shares w/o being confronted with dilution of his
existing equity if no valid business justification exists for the
dilution
A: Circumstances combined to reach the outcome of protecting K
o Disparity in issuing price of the stock and its true value
o Nature of the corporation – closely held
o Business necessity for establishing an offering price at a
certain amount to facilitate raising new capital AND
o Ability of SH’s to sell their own shares
Remedy: Two theories
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o Take back the $5000 put in by SL and divide KSL interests by
three OR
o Take into account the economic benefit created by SL and
give it to them
o Court used the former method not the latter in order to serve
as a deterrence to other SL’s from entering the venture
Exit Strategy – how to avoid this
o How to protect K
 Get unanimous vote in writing for issuance of new
shares
o How to protect SL
 Discount the buyout for K; take 10% off the top of 1/3
ownership stake
o Remove the gun to the head incentive
 Also discount for illiquid assets listed at book value
 OR mirror right of K buying out the other 2 at 10%
discount
 “you cut, I choose”
10. Risk-Reward Characteristics of Debt/Equity
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11. Delaware Block Method
12. Motivations in an appraisal
 Gibbons: A higher capitalization rate (aka discount rate) would
mean that the investment was riskier and worth less, thereby
favoring the majority shareholders
II. INTERESTS IN CORPORATIONS
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Contractual/Fiduciary Duties
o Equity carries a fiduciary duty while debt carries K duties
Risk/Reward Characteristics
o The higher the risk the higher the reward
Entity Theory - Competing interests for claim on corporate assets
o Promoters/Management
o Subscribers
o Creditors
o Subsequent Investors
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o No general reverse preemptive right in closely held
corporation
 Corporation made distributions and salaries to exclusion
of minority SH. Minority SH low balled by corporation
for her shares. Remedy was not an appraisal and
forced purchase. The remedy was a derivative
proceeding on behalf of the corporation to require the
majority to return to the corporation payments that
comprise constructive dividends
Claim/Bankruptcy Priority
o Law protects creditors before stated capital goes away;
indenture would help trigger this protection – demanding
repayment giving them control of corporation
o Secured creditors, unsecured creditors, preferred, common
o Bankruptcy – everything in finance has an eye on bankruptcy;
how much of the business’s risk are you exposed to; end
game planning
o GR: Risk/Reward potential on your money is inversely
proportional to priority in bankruptcy
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Tax Considerations
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1. Closely Held Companies
A. What is a Closely Held
 Donahue – closely held corporation is one in which there is no ready
market for shares and that a minority SH in a closely held
corporation depends on the GF of the majority in order to
participate financially in the corporation
B. Business Judgment Rule (No-Win)
C. Entity Tax Considerations
 Double Taxation for Corporations
o Taxed at corporate level as ordinary income and taxed at
shareholder level when dividends are issued
o Taxable: Dividends paid to SH’s
 Dividend – pro-rata basis of paying out to SH’s
o Deductible – expenses at the corporate level
 Interest…debt
 Compensation…put owner on payroll
 Pass-through entity – LLC
o Owners are liable for the tax when income is recognized by
the firm
o Squeeze out may be effective here, minority holder forced to
pay taxes on income that has not been actually received
D. Adequate Capitalization – Fazio
 F: bankruptcy proceeding, shareholder being attacked by creditor
o Three equity holders: 43/6/2 among three when it was a
partnership
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o 43k person held a great risk but took greater portion of the
profits
o Pre-incorporation: Three holder split equity at 2/2/2. Two
equity holders loan partnership 41/4k.
o Incorporated and business went south
Court’s findings
Inadequate capital –
o Archaic and old rule that there is some concept of adequate
capitalization
o IF F knew corporation would fail and withdrew then you might
have inadequate capitalization but the lenders still should
have protected themselves
Fazio acted for his own benefit
o Lenders complain that Fazio is taking a place in lender line in
bankruptcy; lenders knew of the corporation’s financing post
corporation
o Lenders knowingly walked into 45:6 Debt to equity ratio
Good reasons for doing this
o Equalize risk amongst the equity holders
o Tax angle – company better off paying the interest on debt
and getting tax deduction for it.
o F wanted to rearrange the Risk-reward characteristics of his
investment
Time component
o Restructuring business with an eye on bankruptcy is good not
manipulative
o Although if it were on the eve of bankruptcy then it may have
been recaptured
E. Preemptive Rights – Closely held
 Mechanically gives existing SH the right to purchase a proportionate
part of any new issue of shares (default rule in absence of statute)
 Generally laws for preemptive rights does not cover options given
to employees meaning not applicable to shares given for services
o More likely to be applied to closely held corporations
o Does not apply to preferred stock
 N: Even if a corporation has preemptive rights, they afford
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protection against dilution only if all the SH’s are able and willing to
exercise their rights and pay for the shares in order to preserve
their proportional positions
MBCA - provisions provide for board freedom to opt in or opt out
Toner – Management group of 50/50 closely held caused the
corporation to repurchase most of the shares of the other group.
Member of the management group family sued to have her shares
bought out, lost the claim.
o Court used Wilkes test, the need for flexibility in pursuing the
legitimate business objectives as well as the fact that the
corporation had not elected formal closely held status
F. Employment Rights – Closely Held
Wilkes – In a closely held corporation, a SH may depend on employment in
order to participate financially in the corporation but it may also recognized
that the corporation and the controlling SH’s must have discretion in
managing the corporation and must ultimately have the authority to hire and
fire employees
 Two step test
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o Controlling SH must demonstrate that there is a legitimate
business purpose for the action in question AND
o The minority SH may demonstrate that there was a less
harmful alternative way to achieve the result
A: IF you have a coherent business reason to buy out the patriarch
then you will be allowed to do so
o Comes down to distributions, if there is a history of low
balling the minority SH and not having good reason for
buying out majority SH then the transaction is no good
 N: Never litigate these issues!
o An entity with normally privately held information will become
very public and IRS looks at these groups with great interest
to find tax issues.
Merola v Exergen Corporation
 F: π was minority SH with corp, alleged that corporation was closely
held and CEO as majority SH violated his fiduciary duty to the π by
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terminating his employment w/o cause
∆ arg: Not closely held, corporation provided a ready market for its
stock by repurchasing stock at SH’s request
o Court: The corporation is acting through the controlling SH to
buy back stock does not constitute a ready market
 Ready market is an active trading market
I: Was there a legitimate business purpose in terminating π
∆ arg: Fiduciary obligation does not arise absent evidence of a
nexus between the π’s investment of capital and his employment in
the corporation
 R: Reasonable expectations, when found means there is a breach of
duty owed to minority SH when not honored
o Π accepted full time employment and invested his money in
the corporation with the reasonable expectations that he
would receive a return in his investments with continued
employment and with opportunities to become a major SH
Merola II – majority SH did not breach his fiduciary duty to minority SH
 R: Principles of employment law permit the termination of
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employees at will, with or without cause excepting situations within
a narrow public policy exception
R: Minority SH typically depends on his salary as the principal
return on his investment since the earnings of a close corporation
are distributed in major part in salaries, bonuses and retirement
bonuses
A: There was no general policy regarding stock ownership and
employment, and there was no evidence that any other
stockholders had expectations of continuing employment b/c they
purchased stock
o Never required to buy stock as a condition of employment,
also no evidence that the corporation distributed all profits to
SH’s in the form of salaries
 H: There was no legitimate business purpose but neither did the
termination violate public policy, not every discharge of an at will
employee who owns stock in close corporation gives rise to
successful breach of fiduciary claim
G. Dissolution
Balvik v Sylvester  F: Originally formed as P’ship, one guy with money and other with
muscle. S puts up 25, B puts up 10. 70/30 split. Equal voting
rights is default rule in P’ship. They incorporate as W.
o B was fired after a period of time
o B expected employment with company as economic benefit
o B collected unemployment, S argues that this is evidence of
not a return on investment but he was a terminable employee
o S used 70% control to reduce directors from 4 to 3, and
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quoroum from 3 to 2, then voted S, wife and brother to board
I: Balvik brought action seeking dissolution or payment of true
value of shares b/c he lost benefit of his 30% ownership
o Whether S’s actions amounted to oppressive conduct under
statute sufficient to justify forced dissolution of W.
R: Oppressive conduct does not necessarily have to be illegal or
fraudulent
o Freeze-outs are actions taken by the controlling SH’s to
deprive a minority SH of her interest in the business or a fair
return on her investment
 Techniques
 Withholding of dividends
 Terminating employment
 Removal of SH from Board
R: A minority SH who reasonably expects that ownership in the
corporation would entitle him to a job, a share of corporate
earnings, and a place in corporate management would be
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oppressed when majority seeks to defeat those expectations and
there exists no effective means of salvaging the investment
H: Effect of S’s actions is that B clearly has been frozen out of a
business in which he reasonably expected to participate
o Payment of true value ordered, dissolution is too extreme in
this case when a viable alternative exists aside from
dissolving an ongoing business
N: The changing of the number of directors and quorum
o Just like in PGA, just because you have the power to make a
change does not mean its fair
H. Distributions
 Whether or not to make a distribution involves business judgment
as to whether it is prudent to conserve cash for future needs or
whether a distribution should be made and in what amount
o Court typically defer to corporations via BJR
o BUT, directors and controlling SH’s owe a fiduciary duty to all
the SH’s and the decision to pay or to omit dividends or
distributions may give rise to a claim of breach of fiduciary
duty
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Remedy – compulsory dividend will be ordered when minority SH
can demonstrate that actions by the majority SH appear to be
taken in bad faith and are designed to injure minority SH rather
than for a business purpose
I: Informal distributions (economic instances of ownership) to
favored SH’s such as:
o Salaries
o Loans
o Cash advances
o Or liquid assets in the corporation in excess of the apparent
needs of the corporation
Donahue – closely held corporation is one in which there is no ready
market for shares and that a minority SH in a closely held
corporation depends on the GF of the majority in order to
participate financially in the corporation
o R: Strict equal treatment in connection with distributions by a
closely held corporation, not good law anymore!
o Contrast with entity theory of corporations – there is no
fiduciary duty owed between SH’s
Tax Aspects of Distributions
 Capital Structure Issue – allow shareholders to get investment out
of the corporation via salary as employee; tax angle is murky, it
can be advantageous but there is still FICA and workmen’s
compensation required
o I: Implications differing between LLC/S-Corps and C-Corps
o In close C Corp. SH’s often favor informal distributions in the
form of tax deductible salary, rent or interest payments
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Smith v
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rather than formally declared dividends => minimizes federal
income tax
I: Informal distributions of this type open the possibility of unfair
treatment of minority SH because they may not receive a
proportional share of the informal distribution even though the
controlling SH may have no intention of excluding the minority from
financial participation in the corporation
o Strict proportionality could trigger IRS penalties
o Informal distributions could be used as a way to squeeze out
the other SH’s
R: IRS provision calls for penalty tax against unreasonable
accumulations of surplus b/c the assets will pile up and SH’s will sell
shares to corporation subject to lower capital gains taxes.
N: In S-Corps, if the business fails to distribute cash when it has
income, the SH’s must nonetheless pay tax on their share of the
income, sometimes used to oppress minority SH’s
Atlantic Properties
F: 4 SH’s with ¼ interest; 80% voting required. W wanted to use
retained earnings to reinvest in the business, the rest wanted
distribution. The unreasonable accumulation of corporate earnings
and profits triggered IRS penalty in multiple years.
R: In a close corporation, majority SH’s may ask for protection from
a minority SH.
A: W has been able to exercise a veto concerning corporate action
on dividends by the 80% provision. Provision has the effect of
reversing the roles of the majority and minority
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I: Extent to which such a veto power possessed by a minority SH
may be exercised as its holder may wish, w/o a violation of the
fiduciary duty
Balance of Factors
o W refused to vote dividends in any amount adequate to
minimize that danger
o W failed to bring forward, w/in relevant taxable years a
convincing program of appropriate improvements which could
w/stand IRS scrutiny
H: Risks W generated were reckless and not consistent with duty of
GF and loyalty
o N: When IRS taxes the excess of retained earnings its a triple
tax
o The penalty, the corporate tax and the SH tax on forced
distribution of dividends
Lerner v Lerner Corporation - Settlement to force SH out of the business
 F: T and L had 74/26 split in control in S-Corp
o Undistributed earnings
 T has leverage over L, T has ability to afflict on L tax
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liabilities w/o making distributions of income to either.
 T would likely be on the payroll and gets compensation
that way, L needs distribution to pay tax liability and
without it gets squeezed out
I: First round of disputes where L gets settlement with preemptive
right to purchase stock
o Right to buy and maintain ownership level
 In dilution keep ownership dilution from economic
dilution
o Gets proportionate share of management income
 Sounds like a dividend, its not a settlement for L alone
its almost a forced distribution
 Entity angle – it’s the corporation paying L when it
should have been T
I: If only Lawrence receives a distribution then the transaction in
effect would create a separate class of shares from the common
class that would in turn destroy the S-corporation.
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o T gets law firm opinion on distribution is a dividend that if T is
not paid would create a second class of shares for L and
destroy S-Corp status
o Arg for L: The settlement was a punitive measure against T.
Minority got cheated by Majority
A: Theodore forces a pro-rata distribution to be made to him as well
in order to maintain the S-corp status and acquires legal
statements to support this action
o Result: Company goes out & borrows money needed to pay T
o The borrowing triggers issuance of new shares to cover loan
that was a dividend payment that was triggered by L
o Now the preemptive right L has means he will buy the new
shares
o After paying tax liability on his dividend payment L gives it all
back to the corporation to maintain his pro-rata share
S: Argument should be made that this is a closely held and L should
have been protected from T violating fiduciary duty owed to L
o But, Lower court said there was a way where discord in
closely held could reach a point where eliminating a dissonant
minority interest would not violate the majority’s duty to the
minority, particularly where business judgment is involved
and discord is impairing ability to conduct business
N: Part of the distribution to T made the corporation insolvent, L
could not challenge this unless he brought a SH derivative claim, he
did not.
o §2-311 did make directors liable for parts of the transaction
approved that makes the corporation insolvent
o T defended the transaction b/c the future stock sale and
additional capital raised later covered the bank loan.
Chesterton – disgruntled minority SH may seek to undo an S Corp election
as a way to pressure the controlling SH’s
 S-Corp status destroyed when SH puts shares in a shell corporation
 R: Minority SH owed a duty of good faith and loyalty to the
corporation
 A: Duty breached by the transfer of shares to shell companies
I. SH duties – Majority SH owes fiduciary duty to minority in closely held

2. Common Stock
A. Claim/Bankruptcy Priority
 Common Sh’s are the ultimate owners of a corporation
o Common SH’s vote on board, the vote is a quid pro quo for
being last in line to be paid
o Residual claim – last in line to be paid after creditors and
preferred stockholders are paid
o CS SH’s are too numerous and scattered to exercise control
o Management controls access to proxy machinery and controls
nomination process of directors
 Even though management owns far less than a majority
of shares
 Leaves corporation vulnerable to tender offer
 Tender offer – outside bidder may buy control from CS
SH’s
B. No Win Situations & Duty to Maximize SH wealth
Kamin v American Express
 F: AMEX owns 2M shares of DLJ, brokerage firm. Bought it at 30M



and now worth 4M. Choice is to sell the asset and take loss or
distribute the shares to the SH’s and lose the losses that could have
offset capital gains. AMEX issued dividend instead of taking loss
SH Derivative Claim – declaration that a certain dividend in kind is
a waste of money
I: Exercise by the board of directors of business judgment in
deciding how to deal with the DLJ shares
R: BJR - A presumption that, absent SD or other breach of the duty
of loyalty, directors acted in GF, on an informed basis, in an honest
belief that the action taken was in the best interest of the
corporation
o Presumption: π must overcome the presumption for the court
to review substantive merits of decision
 Higher than negligence standard
o N: in litigation BJR is often the only litigated issue
 IF you survive SJ, you will most likely settle




A: π’s had opportunity to present case for tax advantage to the
board and the board considered it
H: Directors entitled to exercise their honest business judgment on
the information before them, and to act within their corporate
powers. A mistake or choice of alternates might benefit some SH’s
more than others, but this is no basis for BJR.
N: Only prohibition on issuing dividends is that that dividend be
paid out of surplus
N: Self Interest – execs compensation was based on earnings, if the
loss was realized then earnings go down. The Compensation to
them would be less
o Distributing shares had no adverse effect on the execs
o The economic effect to the corporation is the same but the
accounting means to do this have different consequences
Joy v North – No win situation
 F: SH brought derivative claim on behalf of parent whose sub lent
money to K. K kept running a bad building project and in order to
get K to the completion Sub kept loaning money and even
guaranteeing lenders loans to K. SLC backed up board’s decision.




I: The protection of BJR to the SLC’s decision
R: SLC enjoys protection of BJR
I: No win decision - how could you loan more and be right?
o If you loan no more you lost everything, but if you loan a
little more you have a 10% chance of recovery.
o Use expected returns principles to show this
 Ex: Investment A had more volatility but higher
expected return; B had less volatility but lower
expected return
 IF non-diversified SH you want board to choose B
 IF diversified SH you want board to choose A
A: K venture was risky and increasingly so. By continuing
extensions of substantial amounts of credit the bank subjected the
principal to those risks although its potential gain was no more than
the interest it could have earned in less risky, more diversified
loans. In a real sense, there was a low ceiling on profits and
distant floor for losses
Litwin v Allen
 H: Bank purchase of bonds with an option in the seller to
repurchase at the original price, the bank thus bearing the entire
risk of a drop in price with no hope of gain beyond the stipulated
interest
 F: Bank purchased bonds at $100 at par, but they granted seller
option to repurchase them at $100 in the next six months.
 What could be the upside in this
o Bonds at the time of payment were worth $1060 later.
o What would cause the value of a bond to rise, its because


prevailing interest rate have fallen
o Think of buying bonds as buying an income stream
 If rates go up, you would pay less to get a certain
income stream
 The reason that bonds prices go down is because
interest rates are going up
I: When everyone was getting 5.2%, it went and got 5.5%
o Business tried to get .3% improvement on return
A: Defending the board – there was a low probability of the value
going down
o IR’s were going down at time of the deal
o Also IR would have to rise above 5.5% to the point where the
.3% gain is lost
C. Payment of Dividends
 Timeline
o Declaration date is self evident
o Ex-dividend date – if you buy SH’s on this date then you are
not entitled to dividend

 Ex-dividend date is before Record date
 Ex-dividend is the contract date
o Record date – date SH’s are determined to be entitled to
dividend
 Record date is like settlement date
o I: Some rulings turn on whether act took place on transaction
date or settlement date
What goes into thinking about payment of dividends
o Where will the money generate the highest returns
o IF issuing dividend and having SH’s pay taxes on it and letting
them reinvest is better THEN pay out
o IF reinvestment in corporation is better THEN no dividend
 Often there is incentive for board to retain dividends within the
corporation
 Ford case of forcing board to issue dividends is VERY RARE and
would not exist today
D. Share Repurchases - Repurchase of CS by a corporation results in a
disproportionate distribution

Reasons for repurchase
o Acquire treasury shares that may thereafter be available for
share option or incentive plans for employees, or to finance
future acquisitions that involve the exchange of shares for
assets
o Manage the dilution that results from large grants of stock
options to employees
o View toward obtaining shares that may later be used for
share dividends
o Corporation believes the stock is undervalued in the market
and therefore a good investment
 I: Any repurchase, in order to be valid, would have to be preceded
by effective disclosure, including disclosure of management’s
judgment
Grobow v Perot – Repurchase of Board Members shares
 F: Deal Prohibitions
o Public criticism of GM management
 Or pay 7.5M

o Purchase GM stock
o Proxy contest for 5 years
o Competition with EDS for 3 years
 Non-compete
o Recruiting EDS employees for 18 months
 Non-compete
H: SLC got BJR presumption


I/PH: π brought SH derivative claim but did not make demand upon
the board via SLC, claimed futility
R: Demand futility doctrine
o The two pronged approach required a showing of reasonable
doubt as to the director's disinterest based on entrenchment.
The plaintiffs did not show that Perot's comments threatened
the board's position but merely embarassed them. There was
no reasonable belief of entrenchment as the plaintiff alleged
conclusory allegations.
 Path of challenging the preceding suit w/o making a
demand on the board, must show that it would be futile
to make a demand on the board
 Argument for futility will by nature be closely related to
argument to overturn BJ of the board.
Heckman v Ahmanson – opposite outcome as Perot
 F: Steinberg Group is that it used its tender offer and the Arvida
litigation to obtain a premium price for its shares in violation of its
fiduciary duties to Disney and the other SH’s
o Steinberg Group began acquiring Disney stock in March 1984.
In May 1984 the Disney directors announced Disney would
acquire Arvida and its $190M debt. Trying to make the target
company appear less attractive is a well-organized defensive
tactic by board seeking to retain control. Furthermore, the
Steinberg Group announced its tender offer for 49% of the
outstanding Disney shares on June 1984. Immediately
following this announcement, the Disney directors began
negotiations to repurchase the Steinberg Group’s stock and
reached an agreement on the repurchase two days later


o Takeover bid rebuffed b/c target took on enough debt to ward
off the acquiring team, the team’s shares were bought out at
50% premium. SH brought derivative suit to have team give
back the buyout money.
I: Whether the transaction carries the earmarks of an arm’s length
bargain
R: Once it is shown a director received a personal benefit from the
transaction, which appears to be the case here, the burden shifts to

the director to demonstrate not only the transaction was entered in
good faith, but also to show its inherent fairness from the viewpoint
of the corporation and those interested
o Only evidence presented by the Disney directors was the
conclusory statement of one of its attorneys that, the Disney
objective in purchasing stock was to avoid the damage to
Disney and its SH’s which would have been the result of the
announced tender offer
A: IF the Disney directors breached their fiduciary duty to the
stockholders, the Steinberg Group could be held jointly liable as an
aider and abettor. The Steinberg Group knew it was reselling its
stock at a price considerably above market value to enable the
Disney directors to retain control of the corporation
o Acts of Disney directors are difficult to understand except as
defensive strategies against a hostile takeover
3. Preferred Stock
 Callable: – if company issues preferred at 5% IR, IR then drops to
4%, company has incentive to call the stock and then re-issue at
lower dividend preference based on lower IR


o Another factor to take into account when determining value of
bonds or preferred
Dividend preference: % of face value of preferred stock owed to
holder before any can be paid to common
Compare PS to debt
o Unlike debt, it can be perpetual, no time limit inherent to
preferred stock
o Like debt, as interest rate fluctuate dividend preference
fluctuates also
o Tax angle
 Dividend payment: SH taxed at low rate (capital gains),
Company taxed
 Interest payment: SH taxed at high rate (ordinary),
Company gets deduction
Valuation of PS
 Value of preferred goes up as interest rates go down
 The board’s likelihood of issuing dividends

Board could drive down price by announcing policy of
reinvesting in corporation rather than pay out dividends
A. Fiduciary Duties
 Obligations and rights are dictated by contractual terms
 Directors owe a fiduciary duty to preferred as well as common SH’s
o There may be conflicts between owing a duty to preferred and
owing a duty to common
B. Cumulative/Noncumulative
 IF Preferred stock is cumulative, then the obligation to pay the
dividend preference will build year by year

IF preferred stock is non-cumulative, then there is no obligation to
pay the dividend preference every year and it does not build
 I: Why would anyone want to be non-cumulative preferred
 The voting rights trigger that allows preferred to force board to
issue dividends or sack the board
 Gutman - B/c SH’s had non-cumulative preferred with no ability to
trigger voting rights, there had no recourse to force the board to
issue dividends
C. Liquidation Preference - when company goes bankrupt, preferred gets its
money back before common SH’s get residual
 F: Big pile of cumulative preferred…then common decides to
liquidate the company. What does it mean to be cumulative when
liquidation can circumvent the requirement to pay dividend
preference
 I: What if the company liquidates and does not pay cumulative
dividends, b/c the common SH’s were not issue dividends
 R: Wouk – language of the K, because the dividends were not
declared the SH does not collect the “cumulative” dividends
o R: Dividend preference is not a fixed right upon liquidation
 R: Hay – PS will get the cumulative dividends that pile up upon
liquidation
o I: Upon liquidation the PS gets liquidation preference, but
what happens next, do PS get dividends cumulated or do CS
get liquidation preference
o R: Dividend preference becomes a fixed right upon liquidation
D. Participating/Nonparticipating

Participating – another participation in profits, after dividend
preference is paid out, then after common gets its cut then both
participate on one to one deal
 When preferred is participating – the motives of the preferred SH
have changed, you are really a common SH with some positional
benefit
E. Convertibility - allows preferred to participate in the upside
 Pre-determined price allows the holder to convert over to common
stock
F. Dividend Credit Rule – implied dividend credit for years where there was
money laying around but not paid out; treatment of non-cumulative PS
 Sanders - essentially as long as there are profits at all the preferred
right is cumulative
 Dome - but if money was spent by corporation then that will not
help preferred
o Business exercised discretion to spend money
o Inchoate right to dividends when not spent by board
o I: do you get what was available OR full amount of dividend
preference

Gutman – Preferred SH gets nothing if board does not declare
dividends; Majority
G. Summary of debt v equity
Gutman – company did not pay dividends for years
 Sugg’d arg: Could have argued fiduciary duty, board is taking
preferred for a ride, this was not argued, how could a duty be
fulfilled when board continuously refuses to issue dividend
o Counterargument: they were given a fair rate, the parties
knew the risk and cannot fault board for risk being realized
Eurgasco - How to play with the tensions between the 2 parties, or 3 parties
 F: Liquidated trust exists to collect claims and disperse them, its in
an endgame, it will run out of money at some point
o exxon owns 90% of common
o 1st PS 100% owned by Exxon
o 2nd PS 26% owned by Exxon
 A: Significant that BJR is overcome, even though intrinsic fairness
test was not met and π loses




Paper the File: must provide BJ reasons for paying out a dividend
that only pays 1st Preferred
Solution to COI: get independent review
A: Is BJR going to apply
o Not many business issues w/r to liquidating entity
o How long is it reasonable to keep it running just to get second
preferred paid
A: Benefit/detriment analysis
o How could there not be a scenario where 1st gets paid and not
the 2nd.
o The law found for the π, but every decision to pay dividends
discriminates between classes of shares
2 tests used to determine the limits of fairness in parent-sub or majority SHsub’s business dealings
 Intrinsic fairness applied when fiduciary duty is accompanied by self
dealing
o Self dealing occurs when the majority SH or parent, by virtue
of its domination of the sub, causes the sub to act in such a
way that the dominant party receives something to the
exclusion and detriment of the minority SH’s
 IF intrinsic fairness is used then ∆ has burden of proof
of showing fairness
o IF there is no proof of self-dealing, BJR is the standard to
evaluate the transaction
 BJR: A presumption that, absent SD or other breach of
the duty of loyalty, directors acted in GF, on an
informed basis, in an honest belief that the action taken
was in the best interest of the corporation
Presumption: π must overcome the presumption
for the court to review substantive merits of
decision
 Higher than negligence standard
4. Debt – Contractual rather than fiduciary relationship
 Since equity relationships entail fiduciary duties owed from
directors to SH’s, when dealing with debt there is no fiduciary duty
and the relationship owed is a contractual one


Risk/Return Characteristics
o Lower Risk than Equity => Lower Return than Equity
 Debt holders assume less risk than equity investors and
are willing to accept a lower return
 Sinking Fund: Loan that has provisions requiring the borrower to
set aside funds each year to retire the indebtedness
 Rolling over the Debt: Repayment of short term loans by obtaining
another loan
 Indenture: Loan agreement setting forth terms of debt securities
A. Characteristics of publicly traded debt instruments

Bonds are issued in $1,000 denominations, each bond has a right to
receive a stated amount of interest every half-year
 Coupon Rate: Ratio between this fixed amount and $1,000
o Ex: 9% coupon rate means that the holder is entitled to $90
(9% of $1,000) every year
 Once bonds are issued, market develops and price changes based
on IR
B. When interest rates rise, bond prices fall
 Since valuation of debt is like valuating a stream of income
payments, when the income payment is $5 the prevailing interest
rate will determine how much the income stream is worth
o So, if IR is 5%, then the bond price is $100 to get $5 income
stream
 IF IR is lower than coupon rate THEN bond sells at a
premium
o And, if IR is 10 then the bond price is $50 to get $5 income
stream
 IF IR is higher than coupon rate THEN bond sells at a
discount
C. Zero Coupon Bonds
 Bonds issued at deep discounts form par value and do not pay
interest; interest is paid in a lump sum when bond matures
o B/c there is no current interest paid there is no current yield
o Zeroes created by stripping interest-bearing coupons from
long-term government bonds and selling the stripped bond
and interest coupons separately
D. Yield, Yield-to-Maturity
 Yield: Accounts for the interest payments on the bond but not the
principal; Yield is coupon rate/price of bond (price could be trading
at discount or premium based prevailing IR’s)
 Yield-to-Maturity: Takes into account both interest and principal
o IR that in a present value calculation would make all the cash
payments over the life of a bond equal to the bond’s market
value
 Relationships - ???
o IF no change (trading at par)
 YTM = Current yield = coupon rate
o IF Higher rate (trading at a discount)
 YTM > Current yield > coupon rate
o IF Lower rate (trading at a premium)
 Coupon rate > Current Yield > YTM
E. Advantages/Disadvantages
Advantages
 Tax Deductible Interest
o Company pays interest on its debt with pre-tax dollars




Lower Cost: Debt is cheaper than equity
o b/c the rate of return that must be paid is lower
Leverage: for benefit of common SH’s
o IF a company can borrow money at an IR that is lower than
its overall rate of return on its entire capital, the excess
return attributable to the debt insures to common SH’s
No Sacrifice of Control
o Debtholders may not vote on directors or other SH issues
(they may vote on changes to terms of debt)
No Fiduciary Duty
o Board owes no fiduciary duty to debt holders
 Generally Unlimited
o No statutory limitation on amount of debt incurred
Disadvantage
 N: For every advantage there ought to be a clause in the indenture
to push back on the advantage

Prepayment Risk: Call option where the issuer may elect to pay off
the bonds’ principal and interest after a certain period
 Interest rate risk: IF IR’s rise the value of the bond falls because
the bond continues to a fixed IR which is now below the IR which
newly issued bonds would pay
 Credit Risk: Economic downturns by the bond issuer increases the
risk that it will default on its bonds
F. Morgan Stanley Case – Planned redemption of Bonds
 F: When a debenture issuer unexpectedly redeems the debenture,
the holder sues to enjoin redemption
o ADM issued $125M of 16% Sinking Fund Debentures due in
30 yrs. Indenture says: company may not redeem the
debentures from proceeds or issuance of any indebtedness IF
interest is <16.08%.
 Indenture agreement has call feature
 Must not use the newly borrowed fund at lower
rate to call the bonds
 Idea is the prevent issuers from issuing new
bonds at lower rate to raise the money needed to



call the bond holders
Π arg: $137M raised in bond offerings at IR lower than 16.08%
violated indenture, and that amount raised through $146M in CS is
irrelevant juggling of funds used to circumvent redemption
provisions of Indenture
Court: Redemption barred only where the direct or indirect source
of the funds is a debt instrument at a rate lower than that it is
paying on the outstanding debentures
R: Source Rule – Redemption directly funded through equity
financing was not prohibited despite contemporaneous borrowing
by the issuer
o A: An issuer contemplating redemption would still be required
to fund such redemption from a source other than lower-cost
borrowing, such as reserves, the sale of assets or proceeds of
a CS issue
 Bondholders would be protected against the type of
continuous short term refunding of debt in times of



plummeting IR’s that the language was intended to
prohibit
Way for debt holder to protect himself
o Bond holder should have had a call feature with a provision
that simply did not allow calls b/c rates are going down
 Don’t get cute with the source of funds
I: The high price that Debentures were trading at prior to
redemption announcement
o Π arg: Reflection of investor’s belief that Debentures were not
currently redeemable
o ∆ arg: Reflection that ADM or interested buyer might seek to
purchase the Debentures through a tender offer or other
financial transaction
o Tension - At some value other than the assigned value the
right to receive income stream can disappear
S: IF a bond indenture prohibits redemption with proceeds from
newly issued lower cost bonds, the issuer may redeem with
proceeds from other sources even if it simultaneously issues lowercost bonds, and need not disclose its intent to redeem
III. CORPORATE TRANSACTIONS
A. Mergers can be performed in 1 of 3 Ways
1. 2 Corporations can merge or consolidate into one corporation
 1st: Negotiations between acquirer and target boards
o Target is driven by execs wanting money and job security
o BJR scrutiny
 2nd: Board may approve the merger
o Board then decides what to tell the SH’s about it, the terms

will be disclosed to them
o SH’s of target will be sent proxy solicited by target board and
the acquirer will set up a new sub
rd
3 : Merger approved by SH’s
o THEN 100% of target will go to sub
o Money and securties will go to target
o Target will distribute money and securities to SH’s and
dissolve
4th: This triggers appraisal for SH’s
o As laid out in DE §262
 SH must make a demand and then sue
 Litigation will be about whether money and securities
package was enough
 SH’s of Target are being squeezed out here
2. A corporation can sell all or substantially all of its assets to a second
Corporation
3. A corporation can purchase all or a majority of the outstanding stock in
another corporation



1st: Assume negotiations between Target and Acquirer fail
o Target will put in defensive measures targeted at acquirer,
point is to get them to up the compensation
nd
2 : Acquirer makes tender offer to SH’s
o Tender offer has two parts
 First stage: acquire shares for money and securities;
acquirer seeks >50% of shares
 Dissenting SH’s are those that decline to tender
shares in the target
Second stage: Acquirer has >50%, in some states if
they have >80% then they can squeeze out minority
 Then negotiations will ensue between minority
SH’s and subsidiary (sub was once the target)
 These are not necessarily any more arms length
than the first set of negotiations
rd
3 : Board will recommend approval of merger via proxy solicitation
o Acquirer will set up sub to merge target/sub with
o Sub/target sends share to new sub, new sub send money and


securities to sub/target who distributes it to SH’s
 Then SH’s have appraisal right
B. Freeze-out/Squeeze-out/Take-out/Cash Mergers
 When a merger is effected, the surviving corporation generally
issues its own stock to the SH’s of the acquired corporation
o There is usually no restrictions on the nature of the stock to
be issued in the surviving corporation
Ziebarth – Minority SH sues over merger that was used by the other SH’s to
nullify his power to object to a proposed transaction with another company
 F: Z Controls 81% and M controls 11%, Z controls board, dividend
payments. M had job with Z Corp. GS offers to buy Z Corp, and
will pay salary to Z to stay on with new company. All SH’s but M
vote for the merger.
 M arg: Refuses to vote for it b/c Z is getting compensation that all
SH’s should received as well.
o Flaw: M wanted 25% of $16k payment to Z when his shares
in the corporation were only 11%



o Modern arg: this payment is a bribe of management or COI
Deal: SH’s of Z Corp received 20% of one callable PS in Snowy for
each share owned in Z Corp.
R: Any two or more domestic corporations formed for any purpose
for which a corporation might be formed may be merged into one
domestic corporation
o So, a corporation may be formed for any lawful purpose
R: Freeze out Transactions
o Statute does not proscribe an allocation of callable preferred
stock (redeemable at board’s pleasure) in the surviving
corporation, even though it may result in the ultimate ouster
of the recipient of such stock from any interest in the newly
formed business
 M elected not to pursue the appraisal right
 S: Merger circumvents 100% SH approval; appraisal is available
Farris – De facto merger Doctrine in a sale of assets transaction in an
attempt to circumvent the requirement that there will be SH approval
 F: Arguing that the transaction constituted a de facto merger for

which he should have been notified of his appraisal rights under
Penn law, a SH sued to enjoin the execution of an agreement
between two corporations under which one of the corporations
agreed to purchase all of the assets of the other corporation in
return for its stock and the other corporation agreed to dissolve and
distribute the acquirer’s stock to its SH’s
R: Where a corporation purchases the assets of another corporation
which then dissolves and distributes the acquirer’s stock to its SH’s,
achieving the same substantive result as if the two companies had
merged, the SH’s of the acquirer must be given the same rights
that the SH’s of a merging corporation would have received in a
statutory merger
 S: Asset sale circumvents appraisal triggered by merger; appraisal
not available
o Applies a business purpose test
C. Business Purpose Test
 Example of application in Parent-Sub Merger
o Parent corporation’s actions should be measured by reference
to its status and interest as a SH
o Facilitating long term debt financing is a valid purpose
Singer – Sole purpose of merger is to freeze-out minority is not allowed
 F: Second step freezeout merger following a tender offer at a
premium over market value
o Premiums are paid b/c acquirer believes that it can manage
the assets of the firm more profitably than current
management
 I: Whether a merger may be accomplished only for a valid business




purpose
R: Majority SH owes to the minority SH a fiduciary obligation in
dealing with the latter’s property
o Dominant corporation as a majority SH standing on both sides
of a merger transaction has the burden of establishing its
entire fairness to the minority SH sufficiently to pass the test
of careful scrutiny by the courts
∆ arg: Met obligation by offering fair value for shares
o Court: Cannot meet fiduciary obligations simply by relegating
them to a statutory appraisal proceeding
H: Just as minority SH may not thwart a merger without cause,
neither may a majority cause a merger to be made for the sole
purpose of eliminating a minority on a cash-out basis
o Sole purpose cannot be a freeze-out of minority SH’s on a
cash out basis
S: Squeeze out merger must have business purpose; appraisal is
available

N: Fischel criticism of Singer court: Unlikely that SH’s value their
shares at more than market price.
o Court must think that a premium for shares is not enough,
nor is an appraisal remedy, the SH’s must be entitled to more
than FMV, but also a share of the gains resulting from the
merger
 B/c you bought the shares at undervalued price and its
unfair to squeeze out the SH who has not realized the
value the SH anticipated getting
o Counter arg: if you thought the company was worth more,
why did you not keep buying shares
 The amount the share is going to realize cannot be
realized unless management has 100% of the shares
 NOT GOOD LAW – Weinberger overturns it
D. Right of Dissent and Appraisal Right
 When a merger is going to take place, the law allows a dissatisfied
minority SH who is unable to block the merger to obtain a judicial
appraisal of the value of his shares of stock and demand from the
corporation payment of the value of the stock in cash
Weinberger – Squeeze out merger need not have business purpose;
appraisal is the remedy
 F: A class of minority SH’s of a sub corporation challenged the
terms of a cash out merger of the sub into its parent asserting that
the terms of the merger were unfair
 R: Majority SH in a cash-out merger has the burden to show that it
completely disclosed to the minority SH’s all material facts relevant
to the transaction, in order to uphold a majority vote of the
minority SH’s approving the merger
o Where corporate action has been approved by an informed
vote of a majority of the minority SH’s, we conclude that the
burden entirely shifts to the plaintiff to show the transaction
was unfair to the minority
o BUT, first minority SH attacking the transaction must show
some basis for invoking the fairness doctrine
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o Fairness doctrine: corporate parent has a fiduciary duty to
any minority SH’s of a sub it seeks to merge into itself, to
ensure that the terms of the merger are fair to the minority
 Plaintiff in challenging a cash out merger must allege
specific acts of fraud, misrepresentation or other items
of misconduct to demonstrate the unfairness of the
merger terms to the minority
R: Individuals who act in a dual capacity as directors of two
corporations, one of whom is parent and the other a sub, owe the
same duty of good management to both corporations and in the
absence of an independent negotiating structure or directors
abstention from participating in the matter, then the duty is to be
exercised in light of what is best for both parties
o Fair dealing includes: timing of transaction, how it was
initiated and structured, disclosed to the directors, and how
approvals were obtained
H: Fairness is owed to the minority, Signal did not disclose material
information about the price to the minority SH’s and therefore the
vote to approve by the minority could not stand. The parent does
not have to disclose the best price but it cannot have a feasibility
study known by some board members but not all
o Bullard: Court was wrong to insist that the information was
wrongly withheld, the conflicted board members should have
stepped away
I: Fairness argument of the deal v withholding the information
about the deal
o Court seemed to reach decision on basis of feasibility study
 But there are Van Gorkem issues here: Timing, lack of
independent committee to make recommendations,
misinformation
o Court was wrong to insist that the information was wrongly
withheld, the conflicted board members should have stepped
away
Del §262: Appraisal
o Shall appraise the shares, determining the fair value exclusive
of any element of value arising from the accomplishment or
expectation of the merger
 S: Fraud, misrepresentation, misconduct leads to any remedy not
just appraisal
o Otherwise, appraisal is the only remedy
o Burden on plaintiff to show unfairness
o Burden on defendant to show vote was informed
E. Defensive Measures
 Needed to counter Tender Offers
o Cash tender offer – public invitation to the target SH’s to
tender their shares to the bidder for cash
o First stage: acquire shares for money and securities; acquirer
seeks >50% of shares
 Dissenting SH’s are those that decline to tender shares
in the target
o Second stage: Acquirer has >50%, in some states if they
have >80% then they can squeeze out minority
 Then negotiations will ensue between minority SH’s and
subsidiary (sub was once the target)
 These are not necessarily any more arms length than
the first set of negotiations
o Board will recommend approval of merger via proxy
solicitation
 Acquirer will set up sub to merge target/sub with
 Sub/target sends share to new sub, new sub send
money and securities to sub/target who distributes it to
SH’s
 Then SH’s have appraisal right
 This is the basis of defensive tactics
o Why its bad to be a minority SH in post tender offer
 Before Sh had to be concerned with execs on board
using company in their own interest but not majority SH
cause there wasn’t one. Post tender offer there is both
Williams Act - protect minority SH’s from stampeding to the exits
 Tender offers

o Offer must remain open 20 days
o Withdrawal right for entire offer period
o Must pay same price
 Everyone gets same price for shares tendered
o Must buy pro rata
 Removes need to be first come first serve
 Accept at any time and if all SH’s accept then tender
offer will purchase 51% of your shares
o Open to all holders of a given class
Disclosure – essentially a defensive tactic
o 5%+ offerors must file disclosure statement
 Target must respond after tender offer commences
 Essentially gives warning to target that tender offer is
coming
 Target Boards must respond to offer
o 5%+ acquirers must file disclosure statement
 This is a clear example of FG intrusion into state corporate law
o SEC will say that this is procedural
Types of Defensive Tactics
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Staggered board – prevents majority SH from taking over in 1 year
Non Cumulative voting - Cumulative voting gives greater weight to
majority
Limits on SHs ability to call meeting, ability to control proxy
machinery
Poison Pills: Supposed to prevent second stage of merger;
supposed to occur if there is a tender offer so minority SH’s will not
be squeezed out
o Issuing diluted stock - Destroys value of company
o Flip in - Issue right or warrants to existing SH’s to allow them
to convert them to stock upon a trigger of someone buying
10% of the company
 TO THE EXCLUSION OF THE 10% SH
 Sometimes bonds can be used, triggers massive debt
that is fixed
 In this case it does not have to be to exclusion of
acquirer to work
o Dead hand provision – terms of poison pill cannot be changed
by the election of a new board
 DE does not permit this
o No hand – once plan is in place no one can change it
 Not clear if this is good
o Chewable poison pill – board leaves open option of changing
terms of deal before poison pill is triggered
 Includes ability of the board to buy back warrants at a
de minimus amount
o Green mail – deplete the company’s assets to make acquirer
o
o
o
o
o
to go away
White knight – acquirer who is more attractive to you
 Willing to give exec bigger parachute
White squire – person buys enough to not control it but make
it unattractive to original acquirer
Employee stock plan – can be a pile of stock that is hard for
acquirers to get at
Execs go out and get own money
Scorched earth tactics
Sale of crown jewels – selling off best parts of business
for a pittance
 Take on huge amounts of debt
 Enter into merger to create anti-trust problems for
acquirer
Unocal Rule: Two part test used to supplant BJR
 What is the Threat?
o There has to be a threat to the company w/r to which the
defensive tactics are a reasonable response

Inadequacy of price offered
Nature and timing of the offer
Questions of illegality
Impact on constituencies other than SH’s
Risk of nonconsummation
The quality of the securities being offered in the
exchange
How is the response to the threat balanced
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o How reasonable is the response to the threat
 Example of an aggressive takeover justifying aggressive tactics
o Tender offer of cash on front end was under value,
subordinated securities to be issued on the back end were
junk bonds worth far less than tender offer => classic
coercive measure to get stampeding SH’s.
o Plus, the corporate raider had national rep of greenmailer
Revlon – Defensive Measures used to allow merger with preferred acquirer
 F: A hostile bidder for a target corporation sued to enjoin certain
defensive measures taken by the target’s board against its bid and
to enjoin a competing bid by another corporation that had been
approved by the target board
o Board used poison pills to fend off a hostile bid to purchase all
of the target’s shares
o Board employed white knight and gave competitor access to
information blocked from original acquirer.
o Poison pills included:
 Lock-up option: If another bidder acquired 40% of
target’s shares, target will sell off two divisions to white
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knight at bargain price
 Cancellation fee: Penalty awarded to original acquirer
when another bidder takes target
 No-shop agreement: Target will not negotiate with
another bidder
S: Once it is clear that a corporation will be sold, a board is not
simply able to engage in defensive measures meant to protect the
corporation’s existence, but is under an affirmative duty to engage
in action that will obtain the best sale price for the benefit of the
corporation’s SH’s
Paramount
 R: Management of the business and the affairs of a DE corporation
is entrusted to its directors, who are duly elected and authorized
representatives of the SH’s
 R: Under normal circumstances, the courts nor the SH’s should
interfere with the managerial decisions of the directors

o BJR embodies the deference to which such decisions are
entitled
R: There are rare situations which mandate that a court take a
more direct and active role in overseeing the decisions made and
actions taken by directors
o In these situations, the court subjects the director’s conduct
to increased scrutiny to ensure that it is reasonable
o Example circumstances
 The approval of a transaction resulting in the sale of
control AND
The adoption of defensive measures in response to a
threat to corporate control
Rhetoric of the SH argument
o In the sale of control context, the directors must focus on one
primary objective: to secure the transaction offering the best
value reasonably available for the SH’s and they must
exercise their fiduciary duties to that end
Rhetoric of the Corp argument
o In determining which alternative provides the best value for
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the SH’s, a board is not limited to considering only the
amount of cash involved, and is not required to ignore totally
its view of the future value of a strategic alliance
8/29/2010 11:04:00 PM
1. Investor A buys 51% of the shares of Company A for $200. Company A
generates positive annual cash flow of $40. Investor B buys one share of
Company B for $50. Company B generates positive annual cash flow of
$6.00 per share. If you had to choose who made the better investment
based only on these facts, whom would you choose and why?
 B has better P/E ratio, but A has control of A corp.
 N: Higher the discount rate the more riskier the investment, thus
the less it is valued
 We would want to know the diversification of B or A as that would
further drive the analysis
o P/E Price to earning. A: $200 price for $20 earnings
2. Company A has no debt outstanding and a market value of $10 million. It
has a 50% chance of a 20% return and a 50% chance of a negative 10%
return. It is considering borrowing $50 million at 5% to increase production
capacity. Should it do so? Yes or no. Illustrate your answer with an
example (assume facts as necessary)
 Does the expected return yield a higher number that the interest
rate on servicing the debt – NO
3. Shareholder A buys shares of Company A, which has a price/earnings
ratio of 9/1. Shareholder B buys shares of Company B, which has a
price/earnings ratio of 25/1. Which shareholder expects a greater increase
in the company's earnings in the future? Explain why
 Why pay more for $1 in growth? High P/E ratio indicates that the
market believes there will be more growth in the future, hence the
higher amount to be paid for the $1 in earnings
4. The court is considering two discount rates for purposes of valuing a
company's shares: 10% or 20%. Your client wants the highest valuation
possible. For which discount rate do you argue and why (provide an
illustration assuming that the company's earnings are $1/share)?
 Argue for the 10% discount rate, because the lower the discount
rate the higher the present value of the company. This also
indicated less risk in the inherent. $1/.10 is much greater than
$1/.20.
o 20% is 5 multiplier and 10% is 10
5. Why might a company's investment grade $1,000 face value bonds have
a coupon rate of 10% and a yield of 25%. Explain the difference. Illustrate
your answer with an example
 Interest rates have changed since the day the bond was purchased.
Because the yield is greater than coupon rate you know that
interest rate have gone up since the issuance of the bond and the
bond is trading at a discount.
 Yield = Dividend/price; as interest rates go down the price goes up,
as IR’s go up the price goes down. If the price goes down then the
yield goes up.
6. Closely held Company A is financed with contributions from three
persons: $50,000 from Joe, $5,000 from Sam, and $5,000 from Jill.
Company A is on shaky financial ground and needs an infusion of cash. This
will require that Company A incorporate. Joe wants each of the three
owners to contribute the same amount of capital ($5,000 each), with the
excess of his contribution being issued to him in the form of unsecured debt
(a $45,000 note). If Company A becomes bankrupt, will Joe's debt be
treated as debt that is entitled to a pro rata share of liquidation proceeds
along with other unsecured creditholders?
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Why Fazio analysis is wrong
8/29/2010 11:04:00 PM