Corporate Finance Outline – Mitchell – Spring 2011 I. Limited Liability’s Effect on Corporate Finance



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Corporate Finance Outline – Mitchell – Spring 2011
I. Limited Liability’s Effect on Corporate Finance

  • A. Introduction

    • Our study will entail the Corporate Structure and Financing

      • 2 Principle Sources of Financing:

        • Debt

        • Retained Earnings

        • Note:

          • IPO/Stock financing is not a predominate means

          • It may still apply with certain industries that take a while to generate Retained Earnings [Historically seen in Railroads]

          • But, modernly Retained Earnings make up much of Financing and Debt is the most




  • B. The Capital Structure and conflict between the parties involved: Creditors and Stockholders

    • The Creditor (Debtholder):

      • Want: Their $ back, with interest

      • Due to Limited Liability

        • The corporation and not the shareholder is the debtor

        • Assets then, barring a Pierce, are what creditor can be entitled to

      • Contract

        • Risks are ‘locked in’ and controlled by the contract

      • Lock in their risk and return profile at the date of the loan

        • More risk taken, or not taken does not benefit them in any way They have contracted for their interest already, and added risk may be negative

      • Priority

        • Creditors are ‘prior’ to claim of assets at liquidation then debtor

        • Hierarchy:

          • Creditor

            • Secured

            • Senior

            • Junior

          • Preferred Shareholder

          • Common Shareholder (Residual right to what’s left of liquidated entity)

      • Secured, Junior and Senior

        • Security Interest: the loan is backed by collateral, some asset of the debtor has lien

          • When debtor lacks $ to repay, creditor is secured by the asset—may sell to get back $

          • Prior to all other claimants

        • General Creditor: An unsecured Creditor

          • Senior:

            • A senior unsecured creditor is prior to Junior, or subordinated creditor/debt in hierarchy

            • Note:

              • If fully secured, seniority won’t be a concern, because they are prior

              • But, if not fully secured, and more then 1 creditor has claim to same asset, seniority will still be relevant

              • Contract for Seniority/Subordinate status

      • Convertible Debtors

        • Want to be able to convert to beneficial stock price, set in K

        • Assure ability to issue shares in AIC authorization and if not, require amendment to AIC

      • 4 Objectives of Creditor:

        • Happier the more assets Corporation has

          • Easier for him to recover

        • Restrict Corporation from incurring new debts, so doesn’t have to share asset-pot

        • Avoid assets that are already secured

        • Avoid having assets leave to junior claimants (shareholders)

    • The Shareholder:

      • Want: (1) Appreciation of Share-price and (2) Dividend Payment and (3) Residual Rights and (4) Voting Rights

        • Has calculated that he can make more by taking risk and giving up ‘priority to creditor’

      • Ability to Vote:

        • This does not mean that they have the ability or know-how to run a corporation

          • They probably Don’t

        • But, this is a check on directors…ability of SH to make sure the Directors are running corporation in the best way they can and if SH thinks they are not, removes and puts someone they think can do better

          • That Directors are taking risk that maximizes shareholder value

      • Conflict:

        • Shareholders are last in line in priority at liquidation, subordinated to Creditors… but are given the ability to vote/control the corporation

          • Based on risk taken—more risk they’ve taken to give up priority but gain control

          • Creditors are first in priority, and cannot vote to control

        • Shareholder may get a distribution/dividend…although he is junior claimant, the creditor is losing assets to him Creditor is losing assets to junior claimant

    • Preferred Shareholder

      • Want: Almost identical to that of creditor Want their principle back with dividend

        • Principle/Share-price is typically set at ‘liquidation preference’

      • Generally Cannot Vote

        • Why:

          • They are prior to shareholders in hierarchy and have less risk

          • Their dividend is fixed by contract

          • Because of this, control and added risk doesn’t benefit them

          • Get their dividend agreed to, but share price doesn’t change

      • Similarity to Creditors

        • Creditor By contract, legally required to be paid interest first

        • Preferred Shares Dividend is not required, but if cumulative is paid before common stock dividend

          • Cumulative Dividend:

            • Negotiate for the accumulation of all unpaid dividends on PS

            • That way, when one is declared, all PS dividends backed up must be paid

          • Right of Election:

            • May gain right to vote for Directors if dividend is missed

    • Directors:

      • Generally have the best interest of the corporation in mind

    • As Lawyers:

      • Our goal, as corporate lawyers, is to accurately deal with our positions’ Risk and return Profile

      • We want to draft according to our position taken

        • Articulate the risk taken and mitigated accurately into words




  • C. The Creditor and the Loan Agreement: Method to Avoid Conflict

    • General:

      • As we see above, there is a conflict between creditors and shareholders—however, as lawyers there are ways to draft agreements to mitigate these risks

      • The Loan Agreement is a Risk Management Tool Our main concern is RISK

        • It minimizes risk and articulates client’s position

          • Assure we get our Principle back + Interest

    • 4 Basic Attributes we want included to mange risk taken:

      • Require certain information disclosed

      • Asset Protection

      • Asset Dissipation

      • Maintenance of Business

    • How to Achieve Risk Management (Oil Can problem on p. 51:

      • Securitization:

        • Secure the asset we are loaning—take a mortgage

        • Specify in Contract, and be reasonable in what you seek for securitization

      • If Project is Ongoing:

        • Protect yourself throughout process

        • Create loan schedule, dispersing $ intermittently (Not all at once) ensuring that it is actually being done

        • Require inspection/information throughout process

      • Insurance

      • Covenants to require debtor to comply with all laws and regulations

        • Require notice of failure to comply

      • Limit other Debts taken on by Debtor

        • Risk profile is locked in…reducing added debt reduces chance that risk profile will chane to creditor’s detriment

        • Consent Clause”

          • Require consent to incur more debt

        • Note:

          • While general prohibitions on conduct are used, consent clauses are powerful tool

          • Charge for consent

            • Add BPs to loan for your consent and leverage your consent

      • Avoid asset Drain by dividend

      • Avoid sale of assets

        • Consent Clause”

          • Avoid a debtors sale of strong assets or illiquid that will service the loan

          • Lowers your risk that proceeds will be used elsewhere

            • EG:

              • Consent needed if not in normal course of business, or greater then $X sale”

      • Information

        • Prior to Making Loan:

          • Due-Diligence, Ratio Analysis, Evaluate Contract, Board Minutes

          • Get Guarantee, Warranty, Covenant of Truthfulness & Accuracy

        • Post-Loan:

          • In Contract, include the information you want and need at the increments you desire

            • EG: Engineer inspection, updates, etc…

  • D. Creditor/Lender Liability

    • 1. Generally:

      • Limited Liability is important to Creditor

      • As claimant, he is only entitled to what the corporation has and no more, barring a pierce which is unlikely

      • There are instances, however, when a creditor may be liable to other creditors/claimants for the liabilities of its debtor corporation

        • Concern: When can creditor be liable for its debtor to other claimants?




    • 2. Liability for Corporate Debts: Instrumentality Piercing :

      • Krivo Industries v. Nat’l Distillers Corp (5th Cir. 1973)

        • F: Brad’s Machine Corp was in munitions business. Its supplier was Bridgport, a division of the ∆ Nat’l Distillers. Brad’s owed Bridgport for past supply, and Bridgport eventually turned that into a note. As business deteriorated, Bridgport (supplier) eventually gave Brad’s more and more loans. It also sent one of its internal auditors to assist in Brad’s finances.

        • R: A corporation can be liable for debts of another in 2 ways:

          • Express or impliedly assuming responsibility

          • Instrumentality Theory:

            • When corporation misuses another corporation as a conduit for the dominant corporation’s business, it is liable as if the debts of subservient were its

              • An Equitable doctrine—put loss on party who should be responsible

            • Elements:

              • Dominant Must have Controlled subservient

                • Total domination of subservient corporation—so that subservient has no separate existence of its own

                • Mere stock ownership or a loan to debtor is not sufficient…must be total control

                • Not mere influence

              • Dominant must have proximately caused the harm (fraud or injustice) through misuse of control

                • Does not require intent to defraud

          • Here:

            • Auditor was not always required to approve things, ∆ may not have owned stock, and control that existed only applied to part of Brad’s operations. It was not Domination/Total control

            • The pressure inherent in creditor/debtor relationship not enough

            • Was not Total

          • Economic Argument: Arguably, suppliers don’t loan to their customers. Here, supplier did so to keep itself afloat as Brad’s was main customer. So here, because did loan substantial $, it showed other creditors (π) that Brad’s was ok. Furthermore, it was essentially using Brad’s as instrumentality to keep it afloat, its sole purpose. Arguably then Was instrumentality, economically speaking

      • Policy of Lender Liability:

        • This type of Piercing is uncommon

        • Lenders finance and loan money. If they were liable often it would chill any desire to lend




    • 3. Limited Liability and Environmental Liability under CERCLA

      • Generally: Shareholders and Parents of subsidiaries may need to worry about CERCLA liability. Additionally, Creditors who exert too much control may be liable for CERCLA too.

      • A. Owner and Operator Liability:

        • US v. Best Foods (US):

          • F: CPC wanted to buy OTT, a chemical plant. To do so, it created OTT 2, and had OTT 2 purchase assets of OTT 1 for stock (Why: shields CPC from OTT’s liabilities). Later, OTT 2 was sold to Aerojet, which had a subsidiary buy it as well. All the while, OTT was polluting ground water.

          • I: Can an Owner and/or Operator of a Facility be Liable under CERCLA?

          • R:

            • Owner (Indirect/Derivative Liability):

              • Subsidiary that owns polluting facility is directly liable…but is Parent?

              • A Parent corporation of subsidiary is not liable beyond the assets of the Corporation, unless a Pierce occurs

              • CERCLA did not change this common, corporate law

              • Only when Veil is Pierced No Direct Liability

            • Operator (Direct Liability):

              • For an operator to be liable—Parent—they must operate the facility in question

                • Not the Subsidiary: If it were subsidiary, that would make Shareholder/Parent liable for owning subsidiary which is contrary to above—that requires pierce

              • Must Show that shared employees of Parent were acting in their capacity of Parent while operating the subsidiary facility

                • Look at the degree and detail of actions directed at facility by agent of Parent that are eccentric under accepted norms of parental oversight of subsidiary

                  • Presumption that they are acting as facilities/subsidiaries employee

            • Note:

              • Basically, this test is impossible to prove—What is ‘eccentric’

              • Furthermore, how could you possibly prove they were acting for the Parent?

              • Unrealistic




      • B. Successor Liability:

        • North Shore Gas v. Salomon, Inc. (7th Cir. 1998):

          • F: ∆ bought old Shattuck, and held liable per CERCLA. It went to find who else might be liable. Baher owned N. Continent Utilities—it owned Coke Co. and Gas Co. Coke Co. owned N. Continent Mines which contaminated the site. Due to financial difficulties, Coke Co sold all assets except mines to Gas Co. Mines were sold to N. Continent Utilities.

            • R:

              • General Rule: Asset Purchasers do not automatically acquire liabilities of seller

              • 4 Exceptions:

                • Express or Impliedly Agreed to

                • De Facto Merger

                • Purchaser is ‘mere continuation’ of seller

                • Transaction is effort to fraudulently escape liability

              • Express or Impliedly Agreed to:

                • Contract will specifically state what is and is not assumed

                • Will except to “Contingent Liabilities and Undisclosed Liabilities”

              • De Facto Merger:

                • When Assets are sold for stock, and seller dissolves. Then former sellers shareholders are shareholders of acquirer

                • Some Jurisdictions will treat this as a merger, instead of Acquisition and

                • Look at:

                  • ‘Continuation of Enterprise, including management, personnel, location, assets’ and

                  • ‘Presumed obligations necessary for uninterrupted operations’

                • Here: argument is that De Facto merger occurred, so liabilities came with the assets…

              • Mere Continuation of Seller:

                • Factors Evaluated:

                  • Identity of officers, directors and stock between buyer and seller

                  • Continuity of control and ownership

                  • Adequate Consideration (to determine if genuine or not)

                • Here: Baehr owned North Continent, which owned Gas and Coke. After coke was sold to Gas, North Continent still owned the single largest block of shares in Gas…sufficient to ensure control

                • Also, Directors from Coke went to Parent of Gas and Gas Co—Practical effect was continued control of Gas

            • Note:

              • This case is lawless

              • It basically holds that Gas, who did not acquire the one asset in question did own it

              • How—unclear how it jumped to that assumption, but applied the rules in an extended way to meet its conclusion

              • Equity is beyond law—fairness, even if rule applies, is the decision fair?

                • this is not an equitable opinion

              • Arguably, however, it is decided to avoid negating CERCLA. If Gas were not liable, then no one from Baehr would have been—Coke was gone and North Continent was an Owner, which would have required pierce—so perhaps equitable?

      • C. Lender Liability in CERCLA:

        • There is the possibility that a lender may be liable for the cleanup, CERCLA liability of a debtor.

        • Monarch Title, Inc v. City of Florence (11th Cir. 2000)

          • F: City bought land by selling municipal bonds to Bank, who gave mortgage on the land to Monarch. Hazardous substances were released and CERCLA liability ensued. Monarch sues city arguing contribution

          • Note: Why is Transaction Occurring this wayWhy is middle man/City involved:

            • Municipal Bonds are Tax Exempt. So when City issues bonds tax free, and uses proceeds from bank to buy land, the yield is less, therefore when Monarch pays back the bank for its bonds, it is less payment of Principal and Interest. That Savings is passed on to Monarch.

            • Capital Lease: A lease, where rent is paid towards the mortgage, and eventually gets the option to buy the property.

          • R:

          • CERCLA Secured Creditor Exemption:

            • Those, without participating in management, who hold indicia of ownership interest primarily to ‘protect security interest’

            • Hold Security interest to “Primarily to Protect”

              • The City here held title to protect its security interest

                • “when party holds title, and devotes lease revenue to pay off bonds, it is security interest”

                • Primary Purpose

                  • Initially obtained to spur economic development

                  • Retained title to ensure that Capital lease was paid on

            • Note:

              • Decision based on Economic Policy

                • If Court did not decide that lender was not liable, no lender/municipality would ever lend again or decide to spur economic development

                • The Case this court compared it to had facts where the π actually held title, and City only held a mortgage

                • Here, however, the City holds title Different, and is not ‘indicia’ of ownership…but the Policy reasoning behind the decision is clear

II. Valuation:
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