Corporate Finance Outline – Mitchell – Spring 2011 I. Limited Liability’s Effect on Corporate Finance
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But: With removal of ‘stock ownership’ and care of what company is doing, as focus is on market and return rather then fundamentals, leaves the issue of who is actually running the company and what check there is on them So, weakens argument as CAPM also creates issues Professor Gevertz: Raises concern of if most are even capable of this calculation or do it Equations effect individual stock, but not mismanagement Do we want to tailor law around investment strategy? Should we build corporate law around a shareholder’s diversifying or not of her portfolio? Presums formulas are accurate Empirical Testing and Anomalies: Testing has shown several anomalies with CAPM that cannot be explained 1. Small Cap stocks have higher returns then predicted 2. High dividend yield stocks have higher returns than expected from CAPM 3. Low P/E ratio stocks 4. Stocks trading at or below 2/3 net asset value 5. Stocks followed by fewer analysts then larger number of analysts D. Valuation in Legal Context: 1. Appraisal Proceedings: Available to: Shareholders and Preferred Shareholders only Not convertible security holders Entitles them to become common shareholders, but they have not undertaken that unless they exercise their conversion Generally: Appraisal proceedings, or dissenter rights allow the shareholder who disfavors a merger to seek out a judicial determination of the fair value of the shares Once value determined, surviving entity must then pay that amount to dissenting stockholder Policy: Because shareholder voting is no longer unanimous, the law has used appraisal proceedings as a method of protecting a minority shareholder Those who vote against now have remedy The shareholder is being forced to sell, involuntarily The Method of Valuation: A. Historic Valuation Model in Appraisal Proceeding: The Delaware Block Approach—Piemonte v. New Boston Garden Corporation: F: Bostong Garden Arena (BGA) was merging into New Boston Garden Corp (NBGC). BGA owned 4 corporations, one of which owned NHL one of which owned AHL, the Boston Garden Sports Arena and a corporation for concessions of the arena. The value of the merger of $75.27 was disagreed with. I: What is appropriate value of Target? R: The Delaware Block Approach Take the weighted average of: Market Value/share Net Asset Value (BV)/share Earnings/share Sum of each = Value/Share Market Value: 1. When traded on an exchange, there is ability to estimate the market value is efficient and accurate as market pays the worth of a share Potential Issue Must be liquid—enough trading to accurately price it 2. Reconstruction: If no market value can be determined, a judge may reconstruct the market value of a share Not common application because it is somewhat redundant, as the Earnings and NAV will also value the company Also difficult to accomplish (When close corp. or thinly traded) Here: Very thinly traded, as 90% was held by controlling parties…so market value was not wholly accurate But, Judge has discretion to determine sufficiency of market Earnings Value: Generally, court establishes earnings for past 5 years, and excludes certain extraordinary gains and losses 2 Methods: E/R R=Capitalization Rate P/E * E P/E based on market Earnings Multiple Reflects financial condition, risk factor inherent in corporation and industry Will establish the risk and future potential of a company Can do it in 2 ways: 1. Capitalization Rate: Rf+Rp (CAPM) 2. P/E from looking to other comparable corporations Potential Issue: 1. If closely held, there is no P/E available for the corporations as no market of trading to determine Solution: What is typically done of non-public companies is to look for comparable companies that are traded on public markets, and apply a P/E, or You can construct your own capitalization rate Also, largely discretionary of Court if it is reasonable Here: Trial court acted within discretion Net Asset Value: Process: Simply derive the value of the assets of the target corporation Here, calculated value of real-estate, assets, franchise organization, Weighted Average: The Judge, through his discretion, then applies a weighting to each value Issues: Case illustrates the massive discretion of the Judge at the Trial Court level to determine non-legal issues, but instead purely financial issues He is not constrained to anything, but merely selects his view of what is accurate value Because of the financial expertise needed, however, it illustrates that Judge may be heavily reliant on an expert opinion B. Modernly: a. Weinberger v. UOP (Del. 1983): 1. Abandoned the Delaware Block Approach 2. New Valuation Approach for Delaware Courts: Proof of value by any technique or method which is generally considered acceptable in the financial community 3. Interpretation of §262 Appraisal 1. Fair Value of Corporation including all relevant factors Determine the Value of the whole corporation, and then pro-rata value of shares, before merger 2. Exclude element of value arising from merger 1. Elements of speculative future value from merger not included (i.e., synergy), but 2. However, elements of future value which are known or susceptible to proof as of the date of merger may be considered Post-Weinberger: Due to the more open standard Weinberger creates, valuation methodologies often lead to “battle of the experts” as to what is accepted, and what the value may be Le Beau v. M.G. Bancorporation (Del. Ch. 1998): F: Southwest owned 91% of MGB. MGB owned 100% of MBG Bank and 75.5% of WBC. Southwest sought to merge with its partially owned subsidiary, MBG in a ‘short form’ or upstream merger. Because of the >90% of stock ownership, no SH vote was needed, but rather a mere board approval. Minority shareholders of MGB brought appraisal rights as they disagreed with the value of $41 a share. Petitioner Expert Approaches Used: 1. Comparative Public Traded Company 1. Identify appropriate comparable companies 2. Identify ratios that are comparable, multiples 3. Compare using ratio analysis 4. Adust—take average of several of them to assure more accurate 5. Add control premium Premium added for buying a controlling interest in company 2. Discounted Cash Flow Analysis 1. Project future cash flows of company for 10 years 10 years is common time frame for industry 2. Discount Future cash flows to present value Discount Rate is WACC 3. Add Terminal Value After the final year of future value that is calculated, there are still many more years afterwards which could generate value Terminal value is the period after your final calcuation into perpetuity…so as to include that in the calculation 4. Apply a Control premium 3. Comparative Acquisition Model Use ratio analysis of company, and compare it to comparable companies that had been sold with controlling block Does not add a control premium, because the comparison assumes the premium is already included Respondent Expert: 1. Discounted Cash Flow Analysis 2. Capital Markets Approach 1. Identify comparable companies 2. Identify pricing multiples 3. Use multiples to value the company in question 4. Apply multiples to company in question R: 1. Refused to accept either sides DCF approach disagreed with discount rates chosen 2. Refused to accept the comparative public traded company approach Appraisal statute says: As of day before merger, but petitioner used 6 weeks before Further away from merger may be more accurate, as information tends to leak, and the closer to the merger date you get, the closer the market price gets the deal value 3. The Court refused to Accept the Capital Markets approach it was not shown to be accepted in Finance, per Weinberger Court Accepts the Comparative Acquisition Model: Issue with Control Premium The Appraisal statute states that value is determined as of the date of merger, excluding post-merger value The issue, then, is does a premium paid violate this as including $ that is value due to the post-merger events? NO: the premium paid for shares is premium paid for their value that is believed to exist now Control premium is an independent element of value that can be taken into account to determine the fair value of a controlling block of shares and value paid for control Additionally, while acquirer is paying a premium, he would not pay a premium that included the post-merger value he sees…that would be giving away value, and money he expects to make Remedy: Get share value deemed by court Per §262, interest may be awarded, that is compounded Reason: This makes sense, as the interest makes up for the lost value of the added $, that could have been invested at a standard interest rate C. Minority and Marketability Discount: Generally: 1. Marketability Discount: The idea that stock, due to its being illiquid for a certain reason such as it being a private corporation, or thinly traded corporation, is worth less due to an investors inability to realize Fair Market Value Illiquid No market May be more reasonable then minority discount, as doesn’t penalize for being minority Issues: Increased time and expense to market shares of close-corporation Less people to market to They are buying an illiquid interest Marketability Discount and Liquidation Blake v. Blake Agency: The lack of marketability of shares is still appropriate Shares of closely held corporation cannot be sold on a market 2. Minority Discount: The idea that, due to shares being a minority, you are paying for a certain level of control in the corporation Perceives that: Due to its being minority, it should be cheaper, and thus discounted Control element of value is absent so shares are less valuable and attractive Control Premium is opposite of Minority Discount Premium paid for shares that are a controlling block, whether buying a Parent Corporation that owns controlling block in subsidiary (Le Beau) or shares that are controlling block in corporation Per Le Beau: Control premium is an independent element of value that can be taken into account to determine the fair value of a controlling block of shares and value paid for control Perceives that: 1. Undervalued 2. Control is worth something The generally idea is that you pay for level of control you get Liquidation and Minority Discount: Walter S. Cheeseman Reality v. Moore: While minority discount deals with level of control one is buying, and discounting for lack of control—the minority discount is not relevant when dissolution or liquidation of assets occurs No one has control anymore A minority share is no more or less valuable then any other then as there is no control element Issues: A minority discount inherently raises concerns of oppression and unfairness Unwilling seller is being forced to sell, and then applying a discount makes him part with shares, unwillingly, and less price then expected Overall: In Appraisal Proceeding: Majority says neither appropriate in Appraisal Proceeding Unwilling/Involuntary sale In Dissolution: Marketability may be appropriate in Dissolution In Voluntary Sale: More likely to be accepted 1. Delaware’s Rejection of Discounts in Appraisal Proceeding/Correct Method of Valuation: Cavalier Oil Corp. v. Harnett (Del. 1989): R: 1. The Formula to Value a company in appraisal proceedings: Determine the value of the Corporation, as a going concern, and then pro-rates it over the shares Does not take into account the value of minority shares separately from majority shares 2. Delaware Rejects Marketability and Minority Discount in Appraisals Discounting then goes against the above formula Issues with such discounts: Minority discount actually penalizes for lack of control which is contrary to the appraisal process (which tries to give fair value of stock) and involuntary sale 2. Colorado Rejects Discounts in Appraisal Proceeding Pueblo Bankcorporation v. Lindoe, Inc (Colo. 2003): F: Pueblo wanted to merge with a wholly owned subsidiary to gain §S election. Because of certain shareholders failing to meet §S requirement, it merged for stock with some, and cashed others out. ∆, a shareholder of Pueblo sued, bringing appraisal proceedings—π offered $341/share while ∆ sought $775/ share. The ‘battle of the experts’ showed the company worth $638, but a minority and marketability discount to ∆ shareholders ended with value of $344/share. I: How is fair value, in appraisal proceedings determined? R: 1. Fair Value is determined: Appraisal is to assure proper compensation for an investment Assurance that the minority shareholder is properly compensated for involuntarily losing investment So Value the corporation, as going concern, and pro-rate per share Because the shareholder does not want to sell, and is involuntarily being forced to sell Discounts will not apply 2. Issues: Discounting is Inconsistent with this: Unnecessarily speculates Increases possibility that dissenter is undercompensated Buyer gets windfall by paying low price Majority of courts reject it Although Courts continue to have equitable powers—rejected Dissent: 1. Without giving discount, shareholder may get windfall The market would actually discount minority and illiquid shares Penalizes the corporation, and gives windfall to shareholders 3. When Voluntarily Selling Shares: 1. When a shareholder is voluntarily selling, and not forced dissolution or appraisal is occurring these discounts may be more likely to apply In voluntary sale—concerns of oppression are not as clear 2. An argument may lie in the fact that because he is deciding to sell: Appraisal was concerned with shareholder’s investment being taken away, and low price paid for it The idea that it is not a market transaction because seller is not willing seller But a Voluntary sale is more of a market transaction Willing seller selling into a market would be selling shares without control that are not marketable The shareholder knows of the discount potential, and makes the decision to sell into the open market (not unwilling/involuntary) and no concerns of oppression or unfairness 3. Must focus on perspective of those buying it/outsiders They are getting minority/illiquid/non-marketable stock In this instance, the selling shareholder wants to sell, and wants to sell at the current value of the shares 4. Distinguishable from involuntary Where he does not want to sell, being stripped from him at lower price Gives buyer windfall price In all—a voluntary sale may include marketability and minority discount 4. The Distinction between Minority and Marketability Discount: While the concepts are clear, they overlap A minority block of shares may be less marketable because of its minority status So, by using a marketability discount, the market may further discount D. Synergies and Benefits from Merger: Cede v. Technicolor, Inc (Del. 1996): F: A two step acquisition occurred, where step 1 acquired the stock of the target corporation, and step 2 was a squeeze out merger. In between the two, assets were sold and updates occurred to the divisions. Why Transaction done this way: Speedier then regular merger I: Is the value created prior to a merger attributable to the dissenting shareholders? R: 1. The value added in the transient period, between acquisition and merger is attributable to the going concern 2. Because Appraisal values the going concern, and pro-rates it to the shareholders, this value is the shareholders’ value See Weinberger: While speculative, future value is not within calculation, known or susceptible to prove value as of the date of the merger, is within calculation Only look at facts at the time Future speculative plans do not matter 2. Valuation By Agreement: A. Generally: Because close-corporations resemble partnerships, personal relationships are important “Buy Sell” Agreement: A contract that governs the sale of stock of a close-corporation Typically used to insure: 1. Stock ownership remains with select group and 2. Liquidity to shareholders who choose to withdraw from the corporation 3. Federal Securities Laws exemption remains intact, Corporate Selection Common Issues: 1. What valuation method chosen 2. Will it still be applicable in the future 3. Predictability of cost to corporation 4. Litigation potential over language chosen B. Basics: Allen v. Biltmore Tissue Corp. (NY 1957): F: Allen was employee of corporation, and eventually acquired 20 shares. On each certificate was a clause noting restrictions on transfer. He inquired about corporation buying, but in interim died. His executors refused to sell to the Corporation. A buy-sell agreement stated that “whenever shareholder wants to sell, he must give other shareholders and corporation opportunity to buy shares first,” and if its not exercised, he can then go resell to anyone.” Death also triggered the same. I: Whether restriction on transferability is illegal, unreasonable restrain on alienation? R: 1. The restriction must be stated on the certificate Must be seen, on the certificate Referring the reader to the bylaws is acceptable Gives stockholder notice of the restraint 2. The restriction on transfer must be reasonable Right of First Offer or Option: Where the shareholder must offer the stock to the corporation or shareholders before offering it to others when he wants to sell it is generally reasonable Difference between Restraint and Prohibition of Transfer: A restraint on transfer, where transfer is still possible to someone other then corporation is more likely to be deemed reasonable When sale of stock is impossible to anyone except the corporation at what price it decides is illegal and prohibition Look For: Is there a liquid market other then corporation, if it doesn’t buy? Price agreed to before hand? Overall: If can sell to others, and price is agreed to probably ok If one of these two is missing, will have to argue other is reasonable 3. Use of Formula is advisable Because a buy-sell is supposed to operate at some point in time in the future, an agreed to formula is useful Policy: If not, excessive litigation would occur in every case to determine price Fairness The formula, and restriction does not rest on ‘general notion of fairness’ To be invalid, more then mere disparity between price and value must be shown Note: In some contexts, when no outside sale is allowed, ‘fairness’ of price may be more of an issue See Smith Drugstores IV Note: We got around this by using market based valuation, and requiring the close-corporation shareholders to buy it pro-rata…so there was a market for the shares if someone did want to leave In Close Corporation: When there is a FMV, that is easier to use…but in close-corporation There is no secondary market Shares are illiquid Formula needs to be agreed on C. Duties owed in Close-Corporation: Helms v. Duckworth (D.D.C. 1957): F: Easterday, 70, entered into contract with Duckworth to form close corporation. Contract provided that shares would be put in trust, and first to die would sell at $10, unless the price was modified. Corporation was successful and in 1955 shares were worth about $80. Easterday died in 1956, and ∆ tendered $10 for shares. R: 1. Holders in a close corporation bear Fiduciary Relationship with fellow shareholders Duty to deal fairly, honestly, and openly making disclosure of all essential things Good faith is implied Meaning that you’re not just going through the motions or have a predetermined position and refusing to budge 2. A lawyer, businessman in close-corporation context has a special duty to fellow SH Act in the utmost good faith to reveal any potential conflicts of interest Here: Duckworth was much younger, knew Easterday would die sooner and never ever had intention to modify contract. As lawyer and business man against old man, who relied on him, breached his fiduciary duty D. Voluntary versus Involuntary In the Matter of Pace Photographers: 1. Shareholders agreement fixing terms of sale voluntarily sought does not equally control when sale is result of claimed majority oppression or wrongdoing 2. There may be an issue with ‘voluntary’ sale, and the valuation formula used compared to ‘involuntary sale’ and formula used there Planning of drafting may need to include liquidation, death, retirement, etc… Defining what is voluntary and what is not ‘Involuntary’ such as death, incapacitation may require more ‘fair’ price Courts are less inclined to step in if it’s a voluntary sale E. Notes from Smith Drug Stores IV and Buy-Sell Agreements: 1. Effect of including Corporation and Employees in resale: Including corporation in close-corporation to buy back Creates Liquidity for selling shareholders (because there is no market) Creates Restriction rather then prohibition: Note: In this problem, corporation wanted to restrict resale to small group However, without someone to buy if they didn’t want to, or secondary market, may have gone against Biltmore Tissue Get around by including executives and corporation Agreed Upon Formula May avoid argument that corporation is paying what it wants Including Market value may be seen as ‘more fair’ 2. Two Key Issues with Agreement: 1. When does “Transfer” occur: Death: We may not necessarily want to treat someone who voluntarily leaves and someone who dies the same Dying, and getting shares at same price may be deemed unfair They didn’t have chance to wait for all value, etc… Voluntary versus Involuntary: We may want to consider differing treatment of death, retirement, and quitting Supplement with Non-Compete Those leaving Involuntarily may require higher price for fairness concerns 2. Valuation Method Chosen Book Value: Issues: 1. May be used to avoid employee leaving too soon 2. Low-ball so that they stay EG: If you leave before 5 Years Get BV If leave after you get [some formula] (to give a higher price) Note: Note that Biltmore Tissue deals with unreasonable restraint versus restrictions, and this line will need to be addressed in drafting valuation formulae Note: The issues with BV, including its being a lower value may create issues of fairness given the corporation’s size and success Who picks the inputs and comparable companies: Could have parties agree to it Could have parties involved each pick one, and have those pick a party to choose Overall, concern is that we don’t want personal interest involved that may benefit one part or another 3. The Difference between a ROFR and ROFO: Right of First Refusal: When a chosen party has the right to inject themselves into a transaction, and they have the opportunity to either accept an agreed to price between two other parties for themselves, or refuse it—leaving the transaction to continue on Note: People in such a negotiation may low-ball an offer if they know the ROFR party will refuse it In Voluntary sale, Offeror will rationalize by using marketability and minority discount Corporation may then refuse, and buyer gets shares at a lower price Right of First Offer: You must offer the sale to the chosen party before anyone else How to allow corporation to implement: “Notification Clause”: that seller must notify corporation of transaction 4. Conflicts of Interest: See Model Rules 1.7 and 1.13 Generally: Especially in a close corporation context, representing the shareholders and corporation are not wholly distinguishable Disclose all conflicts to the parties 3. Goodwill, and other valuation issues: Courts may have to value the company in other contexts then just the sale of shares Valuation at Liquidation: Donahue v. Draper: F: Both created company, and were president and directors. Draper’s wife was other director. Eventually Donahue was forced out, voted out, and fired. Sues for his entitlement to assets. I: Should leaving shareholder get portion of Goodwill? R: Goodwill: Is the value of an enterprise over and above the value of the net tangible assets Comes from allegiance of customers, favorable relations with banks, customer loyalty, suppliers—anything that leads to continued success Calculation: In Public Corporation: Net Income x Multiple= Amount Net Tangible Assets-Amount = If Positive Amount—Goodwill A positive amount shows the companies goodwill that exists Adjustmens in the Close Corporation: Earnings leave the company in form of benefits and salaries to shareholders Enhanced Salary, Insurance, enhanced perquisites/benefits “Adjusting” and normalizing these earnings must occur add these back in Adjusted Net Income x Multiple=Amount Amount-Net Tangible Assets = Goodwill Goodwill is an asset of the company, and equally available to each shareholder It is not attributable to one person based on his contribution Cannot be reapportioned for own use When one party wrongfully takes to himself the goodwill of enterprise, the other is entitled to his share of its value Corporations, divided among shareholders Application to Smith Drug Stores II: One could argue that in addition to the per share value that is come to by valuation techniques, the value of Goodwill of an asset, in portion owned by shareholder is deserved too So get per/share price + portion of Goodwill asset Donahue was in liquidation context 4. The Use of CAPM in Court: Cede & Co. v. Technicolor, Inc. (Del. Ch. 1990): F: The Court evaluated the expert’s use of CAPM, and discount rate in valuation of appraisal proceedings R: 1. CAPM is a generally accepted method of valuation While no method is uniquely correct, this meets Weinberger As with all methods, this is as good as the subjective judgments of the inputs 2. What point in time is Beta used in judicial proceedings: In certain contexts, the use of a Beta closer to transaction may not be the most accurate measurement of a company’s Beta coefficient Beta will thus be affected due to its inherent measurement of the relation of stock price to market volatility The closer to a transaction, the more volatile a stock is Here: Company had stable cash flows, yet had Beta of almost 2 near transaction date, when 3 months before it was closer to 1 Court accepted the earlier of the two 3. Court rejects small capitalization effect anomaly of CAPM For some unascertained reason, CAPM is unable to replicate, accurately, the historic returns of stocks with the same historic betas Premium is paid by Small Capitalization companies Court Rejects it: Court says that because of lack of explanation for it, accurate price cannot be said to be more accurate if small cap. Premium is included rather then excluded III. Derivatives Generally: While above we looked at valuation from the perspective of an outsider of a firm, derivatives are largely a tool of internal management Corporate Management uses derivatives to hedge against risk Used as speculative tool for investors also Effect on Corporation: Derivatives are not a method of financing for the corporation—it gains no capital Solely a secondary market transaction A derivative is an instrument that derives its value from some other, underlying asset Counter Party Credit Risk: The risk that the other party will default, or be unable to perform on the derivative contract Can arise from nay factors, but leaves chance that because of their failure to perform, your derivative asset is worthless A. Basic Derivatives: 1. Option Contracts: General: Options give the right, but not the obligation to buy (Call) or sell (Put) some underlying asset at or before a date at a specified price Markets Used: Private/OTC Market: Individuals create options for particular parties, on custom basis meeting particular needs Public Market: Standardized Contracts, in line with Chicago Board of Options Exchange Guidelines Uses: Used to hedge or speculate in trading Attributes: 1. The underlying asset General: While almost any asset can serve, Options are generally stocks 2. Put or Call Call Option Gives the holder the right to buy the security When Market Price> Strike price Put Option Gives the holder the right to sell the security at the strike price to the counterparty When Market Price is Sell at above market…making $ Option Writer: The counter party the buyer is dealing with—the seller Write a Call: Hopes that price will go down Make the premium sold for Downside is unlimited, as price could go up and up Write a Put: Hope that price will go up Make the premium sold for Downside limited to the exercise price--$0 is lowest it could go 3. Strike or exercise price The price the option above or below which becomes worth The price the option is written by the counterparty Dependant on the Market or Spot Price For Call: When Market is > strike “In the Money” When Market is = strike “At the Money” When Market is < strike “Out of the Money” For Put: When Market is > Strike Out of the Money When Market is = Strike At the Money When Market is < Strike In the Money 4. Expiration or maturity date of option Date at which the option contract terminates American Style Option: *Applies to Public traded options can be exercised at or before the expiration date Non Public Company: Can be American Style European Style: Exercised at the maturity date Asian Style: Exercised at intervals, negotiated prior to 5. Manner in which exercised Can be Cash or Physical Settlement Physical: The actual underlying asset must be physically purchased or sold if in the money Cash: Simply means that the value of the option must be paid for There is no physical transfer of assets Price Theory: Generally Based on: Change in value of underlying asset, strike price, volatility of underlying asset, interest rates, dividends, and time to maturity See p.283 for table on effects of each on Call versus Put Distinction from Warrant: Similar attributes Only written by the corporation Unlike Option, which when called or putted uses secondary market shares, Warrant uses newly-issued shares Dilutes Shareholders 2. Forward Contracts: Generally: The obligation to buy or sell some underlying asset at a fixed price Physical delivery is common The underlying asset (Gold, Grain, Jet Fuel) must be bought or sold Settled at the maturity/termination date Business Management: Forwards are used by business management to hedge against the decrease or increase of prices, typically of COGS Ensures a predictable price Uses: More of hedging tool then speculative investment Effect: Entering into a forward contract to buy, for instance, grain at a fixed price will protect the buyer from the chance of grain price going up He pays, depending on forward contract, above or below market price, depending on the bet Price Theory: Depends on the Spot Price of underlying asset, Cost to store the asset, and Distributions from that asset (if any) 3. Future Contracts: Generally: Futures are a type of forward contract, that are publicly traded The obligation to buy or sell an underlying asset on fixed date at price However, while there are similarities between forward and future, there are differences too At termination, someone will take physical delivery of the underlying asset However, prior to that point they are traded Differences: 1. Cash Settlement Although someone will take physical delivery, most of the time they are settled by cash throughout trading 2. Standardized Contracts because they are publicly traded, Futures contracts are governed by standardized boards The CME or NYME affix standard terms to the contracts Ensures organized trading on public markets 3. Daily Settlement Unlike forward contracts, futures contracts are settled at the end of each day Holdings are marked to market and proceeds are distributed The futures price then is reset to equal the closing price, so that at the end of each day the value is restored to 0 Margin: Margin account is a protection account that holds a fixed amount of $, based on the holdings, that is a % of the holdings The amount needed in the account changes based on the value of futures Maintenance Margin: a minimum amount exchanges require to be in margin account 4. Swap Contracts: Generally: Swap contracts make a series of payments to another party, over a certain period of time, based on what the contract stands for—what criteria it is dependant on Interest Rates, Default, Currency Rates and their corresponding fluctuations, Commodity Generally used to hedge risk Contract: Specifies obligations of each party, triggering “events” Uses: Hedge, Speculate, Reduce Costs Example: Company A Has a bond issue out yielding a fixed 10% Believes that interest rates will drop Company B Is paying a bond at LIBOR + 1% (Fluctuating) Believes that interest rates will go up, and wants to hedge against this Intermediary Pays fixed 10% to Company A in exchange for A paying it floating rate Passes Floating Rate on to Company B, plus small %, in exchange for Company B paying fixed rate, plus small % Effect: Each party has hedged the risk they foresee A is now paying variable rate, hoping rates will go down B is now paying fixed rates, as it hopes they will go up Intermediary has hedged its exposure by balancing each party, carving out a small % for itself to profit Risks: Credit Risk, that other party will default on payments Risks to individual party that their beliefs will not pan out Credit Default Swap (Credit Derivative): Contracting with a party for a periodic payment, in exchange for their insurance to pay you your loss if some specified “credit event” occurs Hedges against credit or default risk of company Insurance will repay your exposure (Principle, investment, etc…) Example: Bank A makes a Loan to IBM for $1M, at 10% Bank A is nervous that loan may be defaulted on, so it goes to a CDS dealer, and contracts to pay BPs to CDS dealer in exchange for insurance that CDS dealer will repay if it defaults CDS and Loan: CDSs are a great tool to hedge loans and effective One bank making a large loan is exposed, on its own. However, the bank is able to diversify, and hedge its risk by entering into a CDS with a counter party However, as they are further removed from hedging, and more speculative, they may not be as acceptable Effect: Eliminates the risk of a default of that company, thus protecting your investment Counter Party Risk: Now, unless your swap dealer fails to repay, you are protected To avoid Counter Party Risk Negotiate into Contract a requirement of collateral or margin that swap dealer has to keep Synthetic Credit Default Swap: Unlike above, where a CDS is used to hedge against a potential risk due to your ownership of an asset Synthetic CDS is merely taking insurance, or really gambling on the chance of some party defaulting on a loan, or bankruptcy You have no ownership of asset you seek protection against It is Not hedging Merely gamble, speculation on potential default/failure You pay fee for counterparty’s obligation to repay whole amount Dodd-Frank and Swaps: Regulation: CFTC regulates “Swaps” SEC regulates “Security based swaps” And if combination, both regulate New Regulatory Procedures: Swap Dealer: Any person that (1) holds itself out as a dealer, (2) makes markets, (3) regularly enters into swaps as ordinary business on its own account, or (4) engages in activity causing person to commonly be known as dealer or market maker Major Swap Participant: Clearinghouse: Dodd Frank requires that all swaps be cleared through them Trading: Dodd Frank requires all swaps cleared be traded on trade, securities exchange, or “swap execution facility” Trading platform where ability to buy or trade swaps SEC must promulgate rules to disclose data Swap Pushout Rule: Prohibits Federal Assistance (use of federal FDIC or $) to loan, purchase stock or assets, guarantee However, Federal assistance is allowed to FDIC insured institution as long as swaps are for hedging, or some that are cleared B. Advanced Derivatives and Issues They Pose: 1. Mortgage Backed Security: A Bond that is made up of a pool of mortgages The holder of this security is entitled to the principle and interest payments from the mortgage Tranches: The Bonds are sold, with an entitlement to a corresponding tranche of the pooled mortgages Bonds can be entitled to the AAA mortgage Payments, or Below investment Grade Their payment comes first, get less return, but less risk if default as payment first Vica-versa Effect: The pooling of mortgages “Diversifies” MPT theory seeped into MBS, and the thought is that although some of pooled mortgages will go bad in one region in country, other regions and safer mortgages will diversify EG: Bank lends mortgage, sells it to party who then bundles it with other mortgages and creates a Bond This MBS now is sold Historical Genesis: Pre-80s and 90s: Banks would make and lend mortgages, after thoroughly evaluating the risk of the person they lended to They would lend, and then would keep the mortgage as an asset on their balance sheet 80s and 90s: Rules lobbied to be loosened, and gradually, the Mortgages were sold to Freddie Mack and Fannie May This provided liquidity Banks could now sell mortgages to these agencies, who then would sell Banks left to lend more, and create more mortgages to more people to get home Post 80s and 90s: Grahm-Leach-Bliley Act Passed, and created more lax standards of lending of banks to people Stimulated home ownership, as now banks could lend quicker, sell mortgages and repeat Specifically restricted SEC from regulation any Swap Effect: MBS are more aggressive and mortgages are sold quicker No concern for who mortgages are made to as they don’t stay on a banks books Lending standards lax more and more Alternative Mortgages Created These products—Sub-prime, for instance, made it easier to get a mortgage further facilitating the mortgage and MBS process Incentive for Banks to do more and more: 1. The Commission they receive 2. Mortgage no longer on their books, as sold away 2. Collateralized Debt Obligation: The taking of the Bonds that make up an MBS, pooling the bonds, and creating 1 security out of them Re-rated, so though although a bond may be entitled to certain type of mortgage payments, i.e., AA, and others entitled to BB, the pooling of many different types of bonds also diversifies against the risk of bonds defaulting, and underlying mortgages defaulting Credit Enhancement Opportunity: In addition to the bonds now being pooled, they are re-rated and rating agencies give advice on how to enhance credit Effect of CDO: The underlying Asset of the CDO is pooled bonds Pooled Bonds underlying asset is pooled mortgages Pooled Mortgages underlying asset is home owners Overall: The CDO has a claim on a claim, and with so many people secured to one asset, creates issues 3. CDOs and CDSs: CDS can be used to ensure risk of an underlying asset, or can be synthetic and merely speculative Many parties used CDS to hedge their CDO or MBS position Some parties used CDS to speculate on CDO and MBS Synthetic CDO: A CDO, who’s underlying asset is a CDS Counter party in a CDS transaction pools them together to create Security—Synthetic CDO The Synthetic CDO holder is entitled to the payments from the CDS position However, if credit-event occurs, the CDO holders—counterparties to the CDS—must pay, although there is no underlying asset involved Issues Implicated: 1. Greed and Immorality: These types of instruments may give incentive to package a CDO, made up of MBSs that are not very safe and sell them to a party Then, enter into a Synthetic CDS to gable on that party defaulting and the MBSs defaulting 2. Speculation/Gambling versus Hedging The creation of synthetic CDS allows for speculation purely on risk of default of company 3. Counter Party Credit Risk Counter Arguments: Creates liquidity This is true, that MBS and CDO create liquidity in the mortgage market to make more Adds Value Promotes Financial Innovation However: Creating liquidity for the sake of liquidity, in this case, enhancing the ability to sell more houses, loan more, as standards become worse and worse, is a self perpetuating process The bubble created bursts hurting all C. Legal Issues and Derivatives: Contractual Interpretation: Eternity Global Master Fund v. Morgan Guarantee Trust: F: Appellant is fund that invests in emerging markets. To hedge risk it had with bounds—sovereign risk, economic, social and political risks, it sought to hedge its Argentinean holdings. It purchased Credit Default Swaps, with credit event of Argentina defaulting, restructuring, or putting moratorium. However, counter party Morgan Trust thought the exchange of debt where old debt remained was not a “credit event.” I: Contractual interpretation R: Contractual Ambiguity: An ambiguity exists when terms could suggest more than one meaning, viewed objectively by reasonably intelligent person who has examined the context of the entire agreement, cognizant of the customs, practices, and uses the terms generally have in trade or business Fiduciary Duties: Brange v. Roth: F: Company was not doing well, so directors were told they should “hedge.” They authorized the then CEO to hedge the grain they were losing money on. Sales of $7.3M existed, while manager only hedged $20k. Eventually loses were $425k. Shareholders bring derivative action against the directors for breach of duty of care. I: Whether the duty of care was breached or whether it was protected by the Business Judgment Rule R: 1. The Business Judgment Rule protects from informed decisions with mere errors in judgment It does not protect: 1. Fraud 2. Self Dealing (Duty of Loyalty) 3. Uninformed decisions (Duty of Care) Here: Employing someone to hedge without monitoring them, or knowing if they are qualified violated Duty of Care They employed a manager with no hedging experience, did not check on what he was doing, did not monitor it These uninformed decisions, and lack of effort to become informed violated DOC and were beyond merely errors in judgment IV. The Rights of Contract Claimants—Debt: A. Generally: The Debt Contract defines the Lender’s Rights Shareholders: Treatment of shareholders is based largely on fiduciary duty, and has come to help shareholder They are treated as owners, and have focus of management’s concern See discussion, infra, on whether Shareholders are really “owners” in Simons v. Cogan Lack of ability to negotiate attributes leads to common law influence Creditors: However, Creditors and Preferred shareholders have paramount interest as well Their risk is not as obvious as shareholders, but they depend on management for return The Debt Contract: Unlike Shareholders, creditors negotiation for, and attainment of the Debt Contract is where they get their protection from Note: See Discussion of “Conflict between shareholders and creditors” supra p.1-3. Historical Chronology: 1. Debt Financing has always been the main component of the Capital Structure 2. Traditionally Stockholders had a small role Suits were brought under ultra-vires, legal capital rules, or corporate purpose The Shareholders did less, and the Board of Directors was not looked at as much as big component of corporation 3. The Underwriters of Debt and Lenders had more of a relationship As debt backed most of corporate America early on, the Underwriters had a strong relationship with the debtholders In fact, some underwriters (J.P. Morgan) guaranteed his clients’ money to assure they were taken care of B. Public versus Private Debt: Private Debt: In a private debt deal, the borrower simply goes to the bank Negotiation Based on the terms desired, risks bank Determines, etc… Negotiation is to the benefit of both parties as each side has something the other wants Customize the terms Lawyers responsible for Drafting Covenants have Effect on Price: The more protection, and covenants involved the less risk involved The less protectionthe more % gain for Issuer of Debt The More protection the less % gain Syndicate: If debt is large enough that 1 bank is worried about holding all risk, bank will include others in the process Agency Agreement: Banks will negotiate to make 1 bank the “Lead Bank” In this instance, the borrower only has to deal with 1 bank then Public Debt: In a public debt offering, the Underwriter/Investment Bank drafts the bond contract Terms are largely standardized, due to the evolution over time (infa) Lender always drafts Contrast with Private Debt: 1. Registration with SEC 2. In Public debt offering, you want enough protection in the contract that it is salable, but not too much so that your client/borrower is obligated too much and they come back to you 3. This balance has slowly tipped in favor of the borrower For this reason, Public Bond covenants have had protection erode, and Public Debt has very few covenants 4. The Underwriter is not a party to the contract In this case, the underwriter merely creates the contract so that it can be sold Wants: To be able to Sell the debt To get repeat customer, so that customer comes back for other debt needs ($fees$) C. Characteristics of Debt: Bond (Indenture) versus Debenture Bond is long term secured Debenture is long term unsecured Attributes: Yield, Coupon, Maturity, Face Value (typically $1,000) 1/32 is a “tick” Pay Principle, receive interest, and at maturity received principal D. Legal Context and Debt: 2 Key Policy Points Regarding Debt Contract 1. Courts demonstrate judicial restraint Do not Interject Common Law (See Sharon Steel; Cogan) Common stock has a fixed set of legal attributes The Right to Vote Dividends when and if declared The residual right after all other claimants Appreciation in share value Common Stock has a common law backing because of its limited attributes Corporate Debt does not A Creature of Contract, based on contract to define it Courts Generally Don’t Interfere with CL: “Demonstrate Judicial Restraint” Debt is negotiated Contract (Cogan) Difference in Stock Attributes and Debt Courts largely look to the Contract to determine Debt’s rights “Self Protection” If you want it, you better negotiate for it has been largely accepted 2. Courts Interpret Boilerplate as a Matter of Law: Interpreted via Contract as Matter of Law, rather than jury (Sharon; Rudbart; Morgan Stanley) Promotes Consistency, Standardization, Avoids increase in cost of capital Strong Interest in Certain Capital Markets 1. “Bond Doctrine”: Creditors Not Owed a Common Law Fiduciary Duty: Simons v. Cogan (Del. 1988): F: Hansac and Knoll merged, with Knoll surviving as wholly owned subsidiary. The merger cashed out some debtors, and Simons was a convertible debt holder. In leiu of her stock conersion, the merger gave her a conversion to $12 cash, for each 19.20 principal and a rate increase. She filed suit asserting breach of fiduciary duty—that controlling shareholder set price with directors, conflicts of interest existed, and no other merger offers were accepted. I: Whether Fiduciary Duty exists to convertible bond holders R: 1. General Issues: 2 Possible Remedies: Restore conversion to stock or New fair value of price she gets Note: Remedies fashioned by Courts may be intended to do one thing, but may be used for another purpose For instance, restoring conversion may give shareholder old right, but she then can go and negotiate a new cash price of above $12 2. No Fiduciary Duty exists to protect Bondholders Absent a showing of special circumstances of: Fraud Insolvency, or Statutory violation Directory: outlines outlines -> Chabot College Fall 2010 Course Outline for Computer Application Systems 60 business software applications/general accounting outlines -> Adil Khan Contracts Midterm outline- waldron outlines -> Remedies for breach of promise (1) The Interests Protected outlines -> Basic Process for Assessing Damages: 97 Select interest that deserves vindication 97 a. Restitution 97 outlines -> Chapter Five: Written Documents 1 Unsigned Documents 1 outlines -> Cases and Materials on Contracts outlines -> College of Science and Health outlines -> Evidence outline outlines -> 2. Act, Omission, Status or Circumstances 4 Consequences and Causation 8 Introduction to Mens Rea and Intent 10 Levels of Fault 11 Download 0.63 Mb. Share with your friends:
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