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A. Limited Liability
Shareholders enjoy limited liability
In effect shifted some of the risk of business failure to debtholders
More debt means higher expected returns to shareholders; and to the extent that debtholders expect risk to be shifted, higher interest rate as well
Limited liability also alters control over corporate assets
Shareholders with limited lability can more easily abandon responsibility for the obligations of the firm that goes bankrupt
Limited liability implies that creditors (rather than shareholders) will control the business over a broader range of circumstances in which it performs poorly
ABC manufactures carpet cleaning fluids, A is the CEO and own 75% of its stock, 25% owed by Tamara (A’s cousin). 7 years ago, T moved to Indonesia and doesn’t involve in management of ABC, but receives dividend every 3 months.
Company liquidated, valued at $4M + A and T both have personal assets of $3M each.
But ABC borrowed $5M from FC Bank due to poor business + $2M litigation debt owe to R + $50k owe to A + $500k due wages owe to employees.
Should A be able to recover a portion of the salary owed to her by ABC? Whether T deserves her dividend.
She worked for her wage, but wage decided by directors (herself) whether she deserve such amount?
Promote industry by permitting ABC to steal resources from others
What if it was intentionally paid immediately before company liquidate?
Intentionally to avoid paying creditors
Should the bank be paid?
Bank assumes/agree to the risk, as it is a sophisticated creditor who got into the deal, knowing the legal rule, don’t have a ‘no recourse’ clause in the contract
Should Rich be paid?
For suppliers to prevent non-payment, can protect themselves (e.g. to ask for guarantee, payment upfront, retention of title, no recourse). If they did not they assume the risk. But Rich didn’t assumed he risk that there would be an accident and ABC would not have money to compensate him
If A was negligent/ at fault personally/ could’ve done more Rich still sued her due to corporate veil
But cause of action: product liability (need not show negligent) only co. liable for its products
Corporate veil prohibits Rich to sue A, ABC is a separate entity – as we want to promote corporate activities
How is risk on bank and Rich different?
Risk is negative
For shareholders: amount owe to supplier is known no uncertainty = no risk
Shareholders don’t know amount owe to Rich yet uncertainty = risk
But ABC could have buy liability insurance ABC only need to pay insurance cost (cost of doing business)
Rich can also take out insurance
So who should get insurance? Whom should we impose burden on?
ABC in better position to control risk should impose burden on ABC
Rich can only buy comprehensive insurance (health, disability, against accidents) – whether insurance popular in the society
Would answer be different if ABC were publically held corporation?
How would you express the legal principal that should govern shareholder liability for corporate debts?
Separate legal entity shareholders should not be liable personally for corporate debt encourage corporate activities
But a business that yields enough profit is business we want to encourage + people should want to invest without limited liabilities.
Usually need limited liability because they are not profitable don’t need businesses that is not profitable
What kind of incentives would be created by such principles? Are these incentives desirable?
If company does well, A and T would benefit; if things go bad, R shouldn’t be responsible for it
Imposing cost creates incentive for A to exercise care
Commentator: Frank Easterbrook & Daniel Fischel
Publicly held co. is the most popular form of business
Facilitates division of labour, managerial skills and provision of capital may be separated
Holder of a diversified portfolio of investment is more willing to bear the risk that a small fraction of his investment will not pan out
Separation of investment and management comes with cost: agency problem
managers who do not obtain the full benefits of their own performance do not have the best incentives to work efficiently
costs generated by agency relations are outweighed by the gains from separation and specialization of function
Limited liability reduces
the costs of this separation and specialization; and
investors' potential losses are "limited" to the amount of their investment as opposed to their entire wealth, they spend less to protect their positions
limited liability decreases the need to monitor
many investors will have diversified holdings, who would have neither the expertise nor the incentive to monitor the actions of specialized agents
The price investors are willing to pay for shares will reflect the risk that the manager’s acts may cause them loss
Mangers therefore find ways to offer assurances to investors without the need for direct monitoring
the cost of monitoring other shareholders
Without limited liability, shareholders have incentive to engage costly monitor of other shareholders to ensure other shareholders are wealthy.
The greater the wealth of other shareholders, the lower the probability that any one shareholder's assets will be needed to pay a judgment
limited liability makes other shareholders irrelevant and thus avoid these costs
Commentator: Henry Hansmann & Reinier Kraakman
Limited liability in tort create incentives for excessive risk-taking by permitting corporations to avoid the full costs of their activities
incentives: price of securing efficient capital financing for corporations
Some propose to limit such limit liability for some classes of tort claims/ type of corporations to control its worst abuses but all these proposals retains limited shareholders liability as the general rule
Limited lability: a firm owns a wholly-owned subsidiary undertakes investment create risk of tort liability exceeding corporation’s net value shareholder would have incentive to direct the co. to spend little precautions to avoid liability
Encourages overinvestment in hazardous industries co. engage in highly risky cavities can have positive value for its shareholders thus an attractive investment, even when its net present value to society as a whole is negative
C.f. Unlimited liability: shareholder would be personally liable for any tort damages that the co. cannot pay induce socially efficient level of expenditure on precautions
Agency Costs of Debt
The possibility that creditors are not assured to be repaid in full (increased by limited liability) results in potential conflict of interest between shareholders and creditors
Shareholders elects the board of directors that manages the company
Creditors fear that companies will act in the interest of the shareholders (when in conflict with creditors)
Agency costs of debt: issued caused by the agents (directors) do not take fully into account the interest of their principals (creditors) [c.f. agency costs of equity directors not fully taking shareholder’s interests into account]
3 kinds of agency costs
Actions by companies which are in the interest of shareholders, but not combined interest of shareholders and creditors
Costs of designing contracts or law designed to prevent manger from taking such actions
Costs of monitoring compliance with such contract/ law
Company runs for benefit of shareholders by managers, what maximise the benefit of shareholder is not always good for creditors and overall Conflict of interest between creditors and shareholders creates costs of the enterprise
One year from now, Alpha Corp. has to repay $120 million in principal and interest. Alpha Corp. is faced with two alternatives.
declare a special dividend of $50 million and invest the remaining assets in Project A. Project A is certain to yield one year from now $80 million.
not pay any dividend and invest all assets in Project B. Project B is certain to yield a year from now $150 million.
One year from now, Alpha Corp. will pay up to $120 million to its creditors and distribute any remaining assets to its shareholders. Assume that the risk-free discount rate is 5%.
What is the present value to creditors of the first alternative? What is the present value to creditors of the second alternative?
[Option A = $80M; Option B: $150M Creditors would not want the company to invest instead of giving out dividends would prefer to invest more under option B, where the company will get $120M. Creditors would not prefer option A as it will only get $80M]
Since there is now a 20% chance that project B will yield $200 million, creditors expect to get [20%*$50m + 80%*$30m]/1.06 = $32 million and shareholders expect to get 20%*$150m/1.06 = $28 million under project B.
Shareholders prefer project B, creditors prefer project A.
But now it is project B that yields the higher aggregate value.
What is the present value to shareholders of the first alternative? What is the present value to shareholders of the second alternative?
Shareholders would want prefer option A, where it will get $50 in shares and $80 in investment
Project A will always give creditors $80 million one year from now, with a present value (PV) of $76 million. Shareholders get the $50 million dividend.
Project B gives creditors $120 million one year from now (PV = $114 million); shareholders get $30 million (PV = $30m/1.05 = $29 million).
Shareholders prefer the first alternative, though the aggregate of what shareholders and creditors receive is higher under the second alternative.
Shareholders would not prefer option B as they will get no dividend
What would Alpha Corp. do if it tries to maximize shareholder value? What should it do in order to maximize the joint value of shareholders and creditors?
Alpha would give out all $120 as dividends and make no investments
Are shareholders led to prefer projects that involve more risk or less risk?
Shareholders have a 10% chance of getting $150 million (PV = $14 million).
Shareholders prefer project B, though the aggregate of what shareholders and creditors receive is $10 million higher under project A.
Are creditors led to prefer projects that involve more risk or less risk?
Project A will always give creditors $50 million one year from now (PV = $47 million). Shareholders get $20 million if the project yields $70 million (40% chance), otherwise they get nothing (PV = $20m*40%/1.06 = $7.5 million).
Under project B, creditors have a 10% chance of being paid in full and a 90% chance of getting merely $30 million (PV = [10%*$50m + 90%*$30m]/1.06 = $30.2 million).
(Remember, in the example all risk was diversifiable. How are the answers affected by this assumption?) What other actions can companies take that benefit shareholders and harm creditors?
Give dividends, take more risk
Note: You must first calculate how much creditors and shareholders get if the projects does well or badly and then figure out the expected value to creditors and shareholders
Limited liability creates opportunities to shift risks and withdraw assets in ways that creditors do not anticipate other than contractual protection (can be arranged by creditors themselves) law compensate and protect creditors:
Standard capitalisation requirement
State corporation codes do not fix meaningful capitalization levels
but restricts dividend payments to shareholders when it appears that the firm is nearing insolvency ensure creditors get a min fund of corporate assets yet not effective protection to creditors in practice
Fraudulent conveyance law
Variety of equitable doctrines:
Equitable subordination: insiders’ debts are subordinated to outsiders debts in bankruptcy
Pierce of the corporate veil: court will set aside entity statutes of co. and permit creditors to hold shareholders liable directly [to prevent fraud/ injustice]
B. Fraudulent Conveyance Law P. 45
Voiding any transfer made for the purpose of delaying, hindering, or defrauding creditors
Source: Federal Bankruptcy Code S548, USA v Gleneagles, adopted in almost all states law covers every company
Creditor challenges to "leveraged buyouts" (LBOs)
Permit acquirer to borrow a sum to repurchase most of the corporation’s publicly held stock at a large premium, using the corporation’s assets as collateral.
Acquirer would own all of the corporation's remaining equity;
the bulk of the corporation's capital would consist of debt incurred to finance the deal; and
public shareholders would receive an enormous premium for their shares
Amount to acquire a property is financed by debt, the debt is owed not by the buyer but the target
If the acquirer successfully pay off the co.’s debt load they would own the whole co.
Shareholders would get 50% premium over the market value of their shares
LBO lender would receive a security interest in the co’s assets, huge up-front fees, and/or extremely high interest rates
But unsecured pre-LBO creditors’ relative safe debt became subjected to a significant risk of default
If the co. failed after LBO claims that the LBO amounted to a fraudulent conveyance would be made
These actions are not aimed at recouping the purchase price paid to public shareholders, but at subordinating the debt claims of LBO lenders (e.g. the banks) + recouping fees and other benefits paid to LBO professionals
Implicit policy argument of these pre-LBO creditors: LBO insider group, investment bank, lenders ought to have screened deals more carefully and prevented transactions that had a high probability of subsequently ending in bankruptcy
LBO: USA v Gleneagles Investment Co P.46
Raymond C is a coal mining company: target company
Many subsidiaries, directly owns (100%):
Blue Coal: wholly own Minindu and Glen Nan
Powderly owned by Blue Coal and Carbondale
Carbondale: wholly own Maple City, Northwest, Powderly Machine, and Clinton
Powderly owned by Blue Coal and Carbondale
Pre LBO Owners/ shareholders of RC: Gillens and Clevelands
Creditors of RC
Great American (company): acquiring vehicle
Shareholders: Dorkin, Green, Hoffa, Zaff
Option to buy RC stocks from Gillens and Clevelands, want to purchase but don’t have enough money need borrow money from IIT
Lends money to RC and some subsidiaries (including Blue Coal) most money then lent to GA GA pays to Gillens and Clevelands to purchase stock
Who has the cash? GA
Who owes the debt to IIT? RC
Lent 7M: 4M to RC and 3M to BC as a result of the loan, RC has repay principal + interest; subsidiaries have to return the amount they borrowed
To protect itself:
IIT made RC and its subsidiary guarantee for the full amount of 7M loan (4M it owe and also 3M owe by BC)
RC cannot pay dividend before repaying loan
All companies give security interest in all assets
E.g. RC give security interest on the 4M it borrowed and 3M it guaranteed
Structure of LBO in Gleneagles
Different structure but same end result as typical structure:
Shareholder/ pre-LBO owners (Gillens & Clevelands)
Buyer: Dorkin, Green, Hoffa
Cash flow from IIT (lender) to RC (target) and some subs
Most of money then lent to Great American (acquisition vehicle)
Great American pays money to Gillens and Clevelands to purchase stock
END RESULT: B owns the target, shareholders get the money, lender lends money, entity obligated to pay the target
Who has the cash? Shareholders
Who owes the debt to IIT? RC
Terms of IIT Loan
Secured by assets of borrowing companies
Guarantees by guarantors
Guarantees secured by assets of guarantors
Typical Structure of LBO (Leverage buy-out) not used in this case
Buyers incorporate a company (shell) to function as an acquisition vehicle
Lender makes loan to acquisition vehicle
IIT lends to Great American GA buy stock of RC (target) from Buyer
Acquisition vehicle is contractually obligated to
effect a merger with target after purchase - merge GA (acquisition vehicle) with RC (target)
provide security and guarantees post-merger
Assets of RC same, but the debt owe to the lender becomes obligation of RC
Effect of Transaction Structure
Compare transaction structure used in Gleneagles to IIT lending money straight to GA
Benefit LBO lenders and screw pre-LBO creditors
Two companies in target group: Raymond Colliery and Blue Coal (subsidiary)
BC has $6m in assets and $4m in pre-LBO liab.
RC has stock of BC, no other assets, and $1 pre-LBO liability
IIT lends $4m, all of which is paid to G+C
IIT lends $ to GA to buy RC which owns BC
Case 1: IIT lends to Great American
In liquidation of Blue Coal, BC has 6M assets
its pre-LBO creditors are paid in full 4M; and
2M is paid to its shareholder RC
In liquidation of RC, has 2M asset from BC
pre-LBO creditors are paid in full 1M; and
$1M paid to its shareholder GA
When GA is liquidated IIT receives $1M of its $4M debt from GA
Pre-LBO creditors gets 0% debt back
IIT gets 25% of debt back
Case 2: IIT lends to $4M to RC unsecured. Loan proceeds handed to GA
In liquidation of Blue Coal, BC has 6M assets
its pre-LBO creditors are paid in full 4M and
$2m is paid to its shareholder RC.
In liquidation of RC, it has 2M from BC + obligation 5M (4M to IIT and 1M pre-LBO)
IIT and RC’s pre-LBO creditors get pro rate share of 2/5 = 40%
So IIT is paid 40% of 4M = $1.6 million [more than Case 1]
Pre-LBO creditors: $0.4M
Case 3: IIT Lends to $4M to BC unsecured. Loan proceeds handed to GA
In liquidation of Blue Coal, BC has 6M assets (4+4)
IIT and BC’s pre-LBO creditors get pro rate share of 6/8= 75%
IIT gets $3m out of 4M
BC’s pre-LBO creditors get $3m out of 4M
In liquidation of RC,
RC’s pre-LBO creditors get $0
IIT is paid $3 million of its $4 debt.
RC gets nothing, creditor of RC gets nth
Case 4: IIT lends $4M to BC secured by its assets. Loan proceeds handed to GA
In liquidation of Blue Coal,
IIT gets $4m (as it is secured over collateral that worth 4M)
BC’s pre-LBO creditors gets leftover 2M (50%).
In liquidation of RC,
its pre-LBO creditors get nothing not paid
IIT is paid in full
Difference between 3 and 4: effect of priority structure within companies (secured/ unsecured)
No need subordinate creditor’s affirmative consent (unlike in contractual subordination)
Difference between case 1 and 3: structural subordination – priority in a group of company
With a holding company structure: 1) holding company, 2) intermediate holding company and 3) operating company, creditors are better off if co. hold real assets (i.e. assets other than stock of other company in the structure)
Creditor of upper tier (without real assets, only shares of subsidiaries) gets less than the lower tier (with real assets)
1) IlT got paid 25% 2) IlT got paid 75% 3) IlT got paid in full
1) Other creditors get paid in full 2) 75% 3) 0%
% of payment depends on which company are you a creditor of
Creditor of the target is better off than creditor of the buyer structurally subordinated
Typical Holding Company Structure: Holding Company owns Operating Subsidiaries, no other assets
Creditors of sub are paid from assets of sub
Creditors of parent are paid from assets of parent, i.e. equity in subsidiary
“Real” assets (i.e. excluding stock in subs) are used first to pay off sub creditors
Effects resemble those of contractual subordination
To generate obligations:
Lend money to RC (instead of GA)
Target vs. acquisition vehicle better off to be creditor of the target as it has assets
Methods to create priority
One company: common stock, preferred stock, debt
Within debt: different layers (e.g. senior and subordinated, usually no more than 3 layers)
Holding company structure: creditors of holding company is structurally subordination to creditors of operating sub
Through multiple layers of holding companies, one can create infinite layers of priority
Why did IIT not lend the $4 million to Great American, rather than lending it to Raymond Colliery which relent it Great American?
The further down the company structure, the company would owe real assets lender will recover more money upon liquidation of the lender
Which aspects of the LBO structure hurt the creditors of Raymond Colliery? The mortgages? The guarantees? The use of the loan proceeds? Did any of these aspects hurt creditors of the subsidiaries of Raymond Colliery?
How can the court conclude that the borrowing companies did not receive "fair consideration"? Didn't IIT give them $7 million in cash? Is it fair to deprive IIT of the benefit of the mortgages even though it lent the borrowing companies good money?
In the following excerpt, Professors Baird and Jackson argue that fraudulent conveyance law should not be applied to leveraged buyouts. Do you agree? What does their argument remind you of?
You are counsel to a bank asked to finance a leveraged buyout. What advice would you give to your client?
In essence: Pre-LBO creditors v. IlT
Gleneagle purchased IlT’s debt
US is acting as a bankruptcy trustee, stand in shoes of pre-LBO creditors
Pre-LBO creditors want assets of RC are distributed, IlT should get less, should not receive what it contractually is entitled to
Remedy: fraudulent conveyance – set aside the conveyance/ obligation of the benefit of other creditors whatever
FC Law – to be fraudulent to the creditors, the company is
S.354: Fraudulent to the creditors, if a person (including a co.)
who made the conveyance/ incurred obligation;
becomes insolvent right after; AND
without fair consideration
s.354 "every conveyance made and every obligation incurred by a person who is or will be thereby rendered insolvent, is fraudulent as to creditors . . . if the conveyance is made or the obligation is incurred without a fair consideration."
S.355: Fraudulent to the creditors, if a person (including a co.)
Is engaged/ about to engage/ in a business or transaction for
Not an individual not engaged in business, preventing to repay his creditors
The property remaining in his hands after the conveyance is unreasonably small capital; AND
Narrower in scope, only covers conveyance/ transfer or property
Does not incurring obligation/ debt
without fair consideration
S.355 is easier to kick in earlier insufficient money come before insolvent
S.335 any "conveyance made without fair consideration, when the person making it is engaged, or about to engage, in a business or transaction for which the property remaining in his hands after the conveyance is an unreasonably small capital, is fraudulent as to creditors. . . ."
Same dimension: relating to the financial state and likelihood that the borrowing co. (Raymond Colliery) will not be able to repay
Both s.354 and s.355 are applicable to Raymond Colliery
Made a conveyance/ incurred obligation
Incurred obligation: Incurred debt to IlT
Conveyance: Transfer of property by RC:
Money lend to GA undo the transaction by suing GA to get money back
RC is the person
Mortgage (transfer of property to secured an interest) to IlT
Financial state: portion omitted
unreasonably small capital s.355
Fair consideration = fair equivalent + in good faith
IlT has 7M less in cash cash went to RC
Court: not analyzing the loan and security agreement, but the LBO (comparing the starting point and ending point Whether the promissory note RC received from GA a fair equivalent)
Fair consideration is given for property or obligation: (a) When, in exchange for such property or obligation, as a fair equivalent therefor and in good faith, property is conveyed or antecedent debt is satisfied
Court should analyze whether there is a fair consideration from the perspective of the creditors of RC: No, RC receive note of GA has no value from RC creditor’s perspective
Since GA’s only asset is the stock of RC the promissory note only has value if the stock of RC has value
If other assets is insufficient to cover the debt note would be relevant note would have value
But if other assets enough to cover the debt note would be irrelevant but note would have no value
Have value when creditors of RC care about the note; when creditor or RC care about the note, the note would have no value
Including the loan agreement, lending of loan proceeds to great American, purchase of stock by GA
Fair Consideration: Was there “fair equivalent”? Was there “good faith”?
Financial State: Portions omitted
Implications for LBOs
Why blame IIT? They parted with good money? Who else engaged in/received a fraudulent conveyance? Why not sue them? Why not leave it to contract, as suggested by Baird and Jackson?
Creates incentive for LBO lenders like IlT, which combine a number of desirable properties, to
Try to ensure the company is solvent
Since no fair consideration is inherent in LBO – target would usually have more debt than assets (the end result of LBO) would not have fair consideration
Cannot have LBO without
a lender: gatekeeper to LBOs need their stamp to get transaction) liability imposed on the lender will stay around and will have money most likely to respond to the incentive
incentive: don’t leverage buyout if court will later find out that the co will late find the company is unreasonably insolvent
a LBO buyer (GA) is also an essential power not responsive to incentive as they will go bankrupt
a LBO seller (Gillen and Cleveland) economic beneficiaries can go away
Lender should have protect themselves with contract
Similar to the first part of Marriot
Court open to the argument that the Creditor should get extra, because the fraudulent conveyance law gives extra to the creditors
E.g. FC Law in Marriot
Marriot is insolvent after paying dividend to shareholders, but shareholders paid no consideration but they cannot make this argument, since preferred shareholders are shareholders and not creditors
Shareholders are secured holders with more senior entitlement, and co. make transfer to common shareholders (junior claimers) without fair consideration which would hurt their interest
Issue: Stock may not be seen as property of company, and so it is not a conveyance
Creditors of the Raymond Group allege:
Mortgages and guarantee mortgages are fraudulent conveyances under the Act s.354 “rendered insolvent” and s.355 “property remaining in his hands after the conveyance is an unreasonably small capital” are fraudulent as to creditors
the Act require a creditor seeking to set aside a conveyance as fraudulent to show lack of fair consideration, insolvency or under-capitalization
under the Act, conveyance will not be set aside as fraudulent if it was made for fair consideration
which depend on the financial condition of the transferor at/ immediately after the time of transfer
Act s.353: fair equivalent and in good faith, property is conveyed or antecedent debt is satisfied
Whether transferee (IIT) transferred its loan proceeds in good faith under s.353(a)
transferee knew/ strongly suspected that the imposition of the loan obligations secured by the mortgages and guarantee mortgages would probably render the Raymond Group and each individual member insolvent no good faith Cohen v Southerland
transferee was fully aware that no individual member of the Raymond Group would receive fair consideration relevant to good faith Epstein v Goldstein
Whether obligation received by transferee was fair equivalent of the loans to the borrowing companies
As a whole, the benefit received by them was not a fair equivalent of the obligation they gave to transferee (IIT)
Financial condition of the transferor (Raymond Group)
At the time of and immediately after the challenged conveyance was made or obligation incurred
S. 354: inquiry into whether the transferor was insolvent at the time the obligation was incurred or conveyance made or was rendered insolvent thereby
S.355: inquiry as to whether property remaining in the transferor’s possession after the conveyance was an unreasonably small amount of capital for the business in which it was engaged
Found: Raymond Group was insolvent and left with unreasonably small capital at the time of the conveyance in question
Baird & Jackson, Fraudulent Conveyance Law and its Proper Domain, 38 VANDERBILT L. REV. 829 (1985)
If fraudulent conveyance law is not limited to cases in which debtor intended (or presumed to have intended), what are its limits?
Fraudulent conveyance law benefit creditors by retraining the debtor:
give creditor power to set aside transfers by insolvent debtors that harm the creditors as a group
Nonetheless, creditors want to give freedom to debtor to do business
Not all transfer by debtor that make creditors worse off can be set aside, since many ordinary transfer would also make creditors worse off
often transaction might or might not injure creditors, e.g. leverage buyout
Creditors rely on existing legal rules and contractual terms to limit unwarranted risk-taking by their debtor
Difficult to contract out rule that prohibits conduct (e.g. fraudulent conveyance law needs consent of all creditors; even if so, trustee in bankruptcy could still seek to upset the transfer)
Debtor-creditor relationship is essentially contractual:
Creditor acquires rights to control the debtor’s actions
The more rights the creditor acquires, the lower its risk and lower the interest rate
Not all rights can be bargained, as some are subjected to legal constraints (which represents what creditors would generally want to impose and what debtors would generally agree to accept)
If creditors are owe 4M unsecured debt
Firm’s manager decide to acquire it, old shareholders agree to sell their shares for 1M
Manager paid 200K own money + borrowed 800K from bank gave bank security interest in all firm’s assets manager buy all stocks from shareholders, old shareholders cashed out and firm has 4.8M debt (4M + 800K) general creditors has lower priority than Bank = the pool of assets available to satisfy their loan is 800K smaller
Ways to structure the transaction so that the money the managers borrow actually goes to Firm and not managers, e.g.
Dividing transaction into 3 separate deals:
Managers acquire a few shares of firm’s stock
Firm borrows 800K
Firm reacquires all stock in hands of non-manager shareholders
Firm received 800k in return for incurring 800k secured obligation
But court would still construe such transactions as one deal
Firm issue new preferred debt use proceeds as dividend for existing shareholders
Debt instruments commonly control this conduct
If creditors who were in a position to control this conduct did not they cannot set aside the contract
If creditors were not controlling the debt behaviour through other kinds of monitoring devices, other creditors should not be able to set it aside either
If creditors who bargained did limit the ability of the debtor to incur preferred debt to create dividends for shareholders fraudulent conveyance remedy is an appropriate term that creditors should presumptively have
But fraudulent conveyance remedy is very hard to contract out of, even in cases where it is in everyone’s interest that the leverage buyout take place
Trustee had power to set aside the entire transaction in bankruptcy, even if all creditors waived their rights to do so
Easier to contract into: in cases unclear whether creditors would want to prevent the activity, all creditors may be protected if a single one prohibits the transaction
C. Equitable Subordination
Permits bankruptcy courts to set aside the claims of shareholders or other insiders against a bankrupt corporation until the claims of outside creditors are satisfied.
Vague guidelines for invoking equitable subordination, but generally: the unlucky insider must be held to have behaved unfairly or wrongly toward the corporation and its creditors
C. Equitable Subordination
Costello v. Fazio
Heating supply business
Partnership - Partners’ contribution: Fazio, $43,169.61; Ambrose, $6,451.17; and Leonard, $2,000 in 1948
They decided to incorporate the business file certificate + pay fee to incorporate a corporate entity
Partners become Shareholders (by transferring assets from partners to the company – corporation assumes liabilities from the partnership, who also remains liable)
Since contracts were made with the...
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