Creditor Protection -- Overview
1. Mandatory Disclosure
2. Capital Regulation
Distribution Constraints
Minimum Capital Requirements
Capital Maintenance Requirements
3. Fiduciary Duty Constraints
Director Liability
Creditor Liability: Fraudulent Conveyance
Shareholder Liability: Equitable Subordination &
Piercing the Corporate Veil
Shareholder Equity Accounts
BALANCE SHEET
Liab.
Assets
Stated capital
Shldrs’
Equity
Generally
not available
for distributions
Capital surplus
Retained earnings
“Net Assets” = Assets - Liabilities
“surplus”
Par Value
“Par value”
was the sales
price
Promoter
Subscriber
Subscription
Agreement
Par Value
Corporation
$
Stockholder
Par Value
Par value is
a “trust fund”
for creditors
Stockholder
Corporation
$
Creditor
“Legal Capital”
Distributions
to stockholders?
Stockholder
Corporation
Creditor
“Legal Capital”
Cannot impair
“legal capital”
Stockholder
Corporation
Creditor
“Legal Capital”
Capital = outstanding shares x par value
Stockholder
Corporation
Creditor
Disconnecting Par Value and
Price
• No law required par value to equal issue
price
• Promoters were reluctant to lower par
values because they didn’t want their
corporations to appear as “penny stocks”
• Once that inhibition was overcome, par
values and issue prices began to separate
• Today par values are set at a trivial amount
(usually $.01 or less)
–In the absence of par value, the board of
Distribution Constraints
New York Bus Corp. Law § 510 (capital surplus test): may only pay
distributions out of surplus (§510(b)), and distributions cannot render the
company insolvent. AND: NYBCL § 516(a)(4) allows board to transfer out
of stated capital into surplus if authorized by shareholders.
DGCL § 170(a) (“nimble dividend” test): may pay dividends out of capital
surplus + retained earnings, or net profits in current or preceding fiscal year
(whichever is greater). AND: DGCL § 244(a)(4) allows board to transfer
out of stated capital into surplus for no par stock.
Cal. Corp. Code § 500 (“modified retained earnings test”): may pay
dividends either out of its retained earnings (§ 500(a)) or out of its assets
(§500(b)(1)), as long as ratio of assets to liabilities remains at least 1.25,
and CA>=CL (§500(b)(2)).
RMBCA § 6.40(c): may not pay dividends if you can’t pay debts as they
come due (§ 6.40(c)(1)); or assets would be less than liabilities plus the
preferential claims of preferred shareholders (§ 6.40(c)(2)). BUT: board
may meet the asset test using a “fair valuation or other method that is
reasonable in the circumstances” (§ 6.40(d)).
Example: Alpha’s Inc. (p.139)
Current assets
Cash
1,000
Securities
650
Accounts receivable 6,000
Inventory
5,000
Property, plant and
equipment
3,000
Total assets
15,650
Liabilities
Current liabilities
Long-term liabilities
Total liabilities
Shareholder equity
Stated capital
Capital surplus
300
Retained earnings
Total shareholder equity
9,650
5,000
14,650
200
500
1,000
“Nimble” Dividends – Typical
Application (DGCL § 170(a))
Income Statement:
Net Sales
COGS
Fixed Costs
Net Profit
$500
$300
$100
$100
OR: make distribution
to shareholders
Balance Sheet:
Current Assets $200
PP&E
$200
Total Assets
$400
Current Liabilities
Long-Term Debt$300
Stated Capital
Retained Earnings
Liab + Equity
$200
$100
-$200
$400
Apply to
deficit in
retained
earnings
“Nimble” Dividends –
Double Dipping?
Period =>
1
2
Net Profits
+$200
-$100
Distribution
$200
$100
$0
-$200
End-of-Period
Retained
Earnings
When various procedural
maneuvers are taken into
account, therefore, the
insolvency test appears to
be the only real, ultimate
limit on management’s ability
to make distributions to
shareholders legally – even
when the governing statute
seems to impose a tougher,
“earned surplus” test.
Clark, Corporate Law at 616.
Credit Lyonnaise (pp. 141-2) Diagram
Payoff
to class
($MM)
Expected value
of judgment = $15.55
Settlement
offer @ $12.5
Settlement offer @ $17.5
equityholders
bondholders
$12
$12
Value of firm
($MM)
Credit Lyonnaise Payoffs
.
Scenario
Prob.
Total
Payoff
Payoff to
Bondholders
Payoff to
Equityholders
Affirm
25%
$51.0
$12.0
$39.0
Modification
70%
$4.0
$4.0
$0.0
Reversal
5%
$0.0
$0
$0
Expected Value
of Trial
$15.55
$5.8
$9.75
$12.5 million
settlement
$12.5
$12.0
$0.5
$17.5 million
settlement
$17.5
$12.0
$5.5
Fraudulent Conveyance & UFTA §4
(a) A transfer made . . . by a debtor is fraudulent as to a creditor,
whether the creditor’s claim arose before or after the transfer was
made . . . if the debtor made the transfer . . .
(1) with actual intent to hinder, delay, or defraud any creditor of
the debtor; or
(2) without receiving a reasonably equivalent value in
exchange for the transfer. . . and the debtor:
(i) was engaged or about to engage in a business transaction for
which the remaining assets of the debtor were unreasonably
small. . . or
(ii) intended to incur. . . or reasonably should have believed that he
[or she] would incur debts beyond his [or her] ability to pay as
they came due. . .
Example -- Leveraged Buyouts (LBO’s)
In the 1980s, unsecured creditors often attacked failed LBO’s
as a fraudulent conveyance.
LBO’s exchanged debt for stock. Question was whether the
companies overpaid to retire stock, and whether the equity
that was left was unreasonably small. Courts came out both
ways.
Usually not possible to recover purchase price of shares
bought from public shareholders, but bankruptcy trustees
successfully went after investment banker fees on the deals.
BUT: should fraudulent conveyance doctrine be extended to
LBO’s? Baird & Jackson (1985): “a firm that incurs
obligations in the course of a buyout does not seem at all like
the Elizabethan deadbeat who sells his sheep to his brother
for a pittance.”
Costello v. Fazio
Leonard Plumbing & Heating
Supply Co. (a partnership)
Secured Debt:
(Amer.
Trust Co.)
Unsecured
Debt
Leonard: $2K
Ambrose: $6K
Capital
Accounts
Fazio: $43K
Sept 1952
Leonard Plumbing & Heating
Supply Inc. (a corporation)
Some
equity
converted
into notes
and P’ship
interests
then
transferred
into
corporation
Secured Debt:
$41K (Amer.
Trust Co.)
Unsecured
Debt
Fazio Note
$41K
Ambrose Note
$4K
Leonard: $2K
Ambrose: $2K
Fazio: $2K
June 1954
Higher
Priority
Lower
Veil Piercing Doctrines
•
Tests go under various names: “agency test;”
“instrumentality of the individual”; “alter ego of the
individual;” etc.
•
Generally consist of two components:
•
–
Evidence of “lack of separateness,” e.g.,
shareholder domination, thin capitalization, no
formalities/co-mingling of assets (“Tinkerbell test” –
to be protected, shareholder must believe in the
separation)
–
Unfair or inequitable conduct – this is the wildcard
in veil-piercing cases.
Probably no piercing: against public corporation; against
passive shareholders; minority shareholders; if all
formalities are observed and nothing “funny” with the
accounts.
Formulations of the Doctrine
Lowendahl test (NY): veil-piercing requires (1) complete
shareholder domination of the corporation; and (2) corporate
wrongdoing that proximately causes creditor injury
Van Dorn test (7th Circuit – applied in Sea Land): (1) such unity
of interest and ownership that the separate personalities of the
corporation and the individual [or other corporation] no longer exist;
and (2) circumstances must be such that adherence to the fiction of
separate corporate existence would sanction a fraud or promote
injustice.
Laya test (applied in Kinney Shoe): (1) unity of interest and
ownership such that the separate personalities of the corporation
and the individual shareholder no longer exist; and (2) would an
inequitable result occur if the acts were treated as those of the
corporation alone. BUT: if both prongs satisfied, there is still a
potential “third prong” -- D might still prevail by showing assumption
of risk.
Sea-Land Services
Sea
Land
Andre
$87K
judgment
Marchese
50%
Tie-Net
PS
Caribe
Crown, Inc.
Salecaster
Distributors, Inc.
Jamar
Corp.
Pepper
Source
Marchese
Fegan Asc.
District Court pierces to Marchese and reverse pierces to other corps.
Appeals Court reverses grant of summary judgment.
Jingle Rule vs. 1978 Act
First Priority
Second Priority
UPA § 40(h) & (i)
(a.k.a. “Jingle Rule”)
‘78 Act (§ 723(c)),
RUPA § 807(a)
Partnership
Assets
Individual
Assets
Partnership
Assets
Individual
Assets
Partnership
Creditors
Individual
Creditors
Partnership
Creditors
Individual
Creditors
Kinney Shoe
Kinney
Polan
Polan Industries,
Inc.
Industrial
April 1985
50% sublease
Dec. 1984
sublease
Kinney obtains judgment against Industrial for $166K in unpaid
rent, then sues Polan individually to collect. District Court holds
for Polan, finding that Kinney had assumed the risk. 4th Court
reverses, refusing to apply “third prong” of Laya.
Huntington, West Virginia
Walkovszky v. Carlton
Other
shareholders
Carlton
Seon
Each corp. has two cabs, no assets, and minimum insurance. Walkovszky
struck by a cab owned by Seon Corp (driven by Marchese), and seeks to
hold Carlton personally liable. Court of Appeals dismisses the complaint
w.r.t. Carlton for failure to state a claim, with leave to serve an amended
complaint.
Successor Liability
DGCL § 278 & § 282: shareholders remain liable pro rata on
their liquidating dividend for three years.
RMBCA § 14.07: same as Delaware, provided that
corporation publishes notice of its dissolution.
Successor Corporation Liability: Product line test in some
jurisdictions may hold acquiror liable if it buys the dissolved
corporation’s business intact, and continues to manufacture
the same line of products => any sophisticated buyer who
buys the business as a going concern will contract for
indemnification for tort liability, or pay less.
So only way for shareholder to escape long-term liability
through dissolution is to sacrifice the going-concern value of
the business and keep only the piecemeal liquidation value.
Corporate Form – Key Benefits
Benefits of Limited Liability:
1. Reduces need to monitor agents (managers)
2. Reduces need to monitor other shareholders
3. Makes shares fungible (which also facilitates takeovers, see
below)
4. Facilitates diversification (without LL, minimize exposure by
holding only one company)
5. Enlists creditors in monitoring managers (because creditors
bear some downside risk)
Benefits of Transferable Shares:
1. Permits takeovers => disciplines management
2. Allows shareholders to exit without disrupting business
3. And because of LL, shares are fungible => facilitates active
stock markets, increasing liquidity
Derived from: Easterbrook & Fischel, The Rationale of Limited Liability, 52 U. Chi. L. Rev. 8 9(1985)
Limited Liability in Tort? Cemex Example