Corporate Finance Outline (Bratton, 6th Edition)

Class 1: Elements of Fundamental Value: Present Value, Future Value, Net Present Value:
Elements of Fundamental Value (38)

One year:  FV = PV (1+R)

Multiple years:  FV= PV (1+R) ⁿ (n= number of yrs)

Determine the PV (Present Value) of a future payment

PV = FV ÷ (1+R) ⁿ

NetPV = sum of present values of future inflows judged in accordance to cash outlay that the investment requires.

Discounting Future Value to Present Value

Amounts to be received in future must be discounted by some factor to determine their present worth;

1)  “Discount” refers to a finite set of future payments
(such as a 15 yr lease)

2)  “Capitalization” or “Capitalizing” refers to when future payments are expected to continue in perpetuity.
(i.e., dividends on a stock)

3)  “Multiplier” is the reciprocal of capitalization rate.

Example:  If rate is 8% (8/100) the reciprocal is 12.5 (100/8) -- multiply the payment in perpetuity by the multiplier to determine present value

Present value formula; For 1 year

        Future Payment ÷ (1 + Interest Rate)

        EX; $5 ÷ (1 + .07) = 4.673

Present value formula; multiple years

        Future Payment ÷ (1 + Interest Rate) ⁿ (n = number of yrs)

        EX; $5 ÷ (1 + .07)3 = 4.081

1.  The Time Value of Money (charts, 40, 41)
[Present Capital Value For Series of Future Amounts (chart: 43)]
Given Present Value; Determine Future Value

Formula; P (1 + Interest Rate) ⁿ (n= number of years)

           EX; $5 (1 + .07) 3 = 6.125

Present Capital Value for Series of Future Amounts

-Add present value of each future amount due; sum is present value of whole series of amounts due (even if due at various future dates).

-Present value of a series of amounts due is called “capital value” of future receipts

-The Role of Discounting in Bond Valuation (44)
Note; Discounting and Bond Valuation

3 Year Bond – 8% coupon → 8% rate of return

(see notes)

74.08/1000 x 1 + 68.56/1000 x 2 + 63.52/1000 x 3 + 794 x 3 = 2.788

Note; Discounting in Capital Budget Decisions pg 45
“Capital Budget Decision” refers to evaluation of particular investment projects which are under consideration by a firm/corp.): Issue is whether project is economically worthwhile and what form of evaluation should be employed in making the determination

1)   Net Present Value Method; (DISCUSSED) estimate expected returns from project and then discount returns to present value. Investment viewed as acceptable if present value of estimated returns exceeds cost (PV of estimated returns > cost)

a.    Management can resolve its decision problem if it is able to estimate future return; if it knows project cost and if it can apply an appropriate rate of return.

2)   Internal Rate of Return;

a.   Discussed: essentially what do I need the R to be to make this investment worthwhile, then compare that R to the market and determine if it’s a desirable return

3)   Payback Method; thought inadequate because it fails to take into account timing and ignores the need to discount.

-Under payback method, investment is deemed acceptable if w/in certain period arbitrarily set by management cash inflow equals/exceeds cash outlay.

Factor of Expected Returns
In determining valuation beyond the simple mechanism of discounting we must also determine

1)   quantity and duration of stream of expected returns, and

2)   discount rate

In relation to “returns” we must ask:

1)   what is meant by “returns”

2)   should we use a single-estimate for “returns” or should we attempt to use a range of estimated “returns” based on the various possible/foreseeable outcomes

Class 2: Valuation (cont'd): Expected Returns: Bratton, pp. 47-63
2. Expected Returns
Warren Buffett Article (48)
Deals w/ issue of on the street valuation and the practice of using “cash flow” figures improperly to “sell the unsellable”.
-True “owner earnings” should be reported earnings (a) plus depreciation, depletion, amortization (b) minus average annual amount of expenditures for plants and equipment required to maintain long-term competitive position (c)
-Even though, (c) is a guess (hard one at that) Buffet considered “owner earnings” to be best valuation method, b/c  firms need to spend more (c) than (b) to maintain competitive
-Crushes use of “cash flow” which is only (a) + (b) b/c it assumes that business is forever state of the art requiring no replacement, updates.
That use of “cash flow” only improperly inflates value and debt-service ability and if you buy into it your headed for trouble
Note: Accounting Earnings, Owner Financing, and Net Cash Flows (53)
1)   Depreciation

a.    Discussed the use of depreciation as the processes by which portion of an asset’s original cost is offset against firm operating revenue … this required to allow for determination of NPV

2)      Scrap Value

a.    If an asset has a scrap value upon its termination of usefulness; that scrap value must be discounted and taken into account when making a determination of the NPV of the asset

3)      Reinvestment

a.    If asset requires a reinvestment (upkeep, service, etc) during its lifespan that reinvestment must be accounted for as a negative in the NPV for the year in which that reinvestment occurs.

i.  EX: if inflow NPV of asset is 3;500 per yr and yr 3 requires a 3,000 service … use table 11-3 determine the NPV of that service and deduct if from the inflow in yr three to determine the accurate NPV … (this is Buffet’s argument; corporation fail to do this when churning out “cash flow” figures)

1.   Really all Buffet is arguing for is use of “net cash flow” over simple “cash flow”

4)   Valuing a Firm

a.    In valuing a firm you must determine future annual return and then treat corp as a perpetuity (discussed) where the PV = Future Cash Flow ÷ % r … you must then still account for projected capital expenditures for new/replacement plant/equipment necessary to maintain competitive (Buffet) to determine true PV.

5)   Adjusting for Growth

a.    If a company plans to expand you must deduct any expansion costs from net cash flow in the year they will be made prior to any discounting to PV; subsequently you must also keep in mind that cash flows will increase in years after expansion to reflect growth of the business

6)   Earnings and Dividends

a.    NPV is calculated on basis of “net cash flow”, so that for valuation purposes “earnings” refers to difference between cash flows realized from operations and amount retained by company both to replace existing assets and to acquire new income producing assets

b.   Earnings = amount of returns from operations which is not required by firm for plant replacement or reinvestment … thus “earnings” should be viewed as excess capital to be returned to shareholders in form of dividends

c.    Conclusion:  firm value should solely be equal to PV of what owners (SH) can expect to receive

Class 3: Valuation (cont'd): Risk, Diversification: Bratton, pp. 63-833.  Risk and Capitalization Rate (63)
Grayson Article
-At the heart of any capital budget decision is a forecast of future events.
-The best way to forecast is to create a probability distribution (range of estimates matched with their associated probabilities).
-This usually is based on long term recurring events (things like gambling, interest rates; etc).
-Business usually needs help in predicting singular events (new product launch, etc).
→ Apply probability theory through the use of subjective probabilities (all probabilities are personally subjective even all data is the same there is a level of subjective analysis involved)
-Once we have a probability distribution we can compute “expected monetary value” by multiplying the forecast w/ the corresponding probability and adding the sum (see below)

FORECAST            PROFIT                   PROBABILITY                  EMV
Optimistic                100k                         .30                                        30k
Most Likely              75k                           .60                                        45k  
Pessimistic                50k                           .10                                        5k
                    Total EMV = 80k
-Based on this EMV we can make best effort informed decisions
-Essentially attempt to certify guesswork in regards to expected return and then graph to display the probability returns.

-Lewellen, The Cost of Capital (64)
A vehicle for examining the nature of investor attitudes is a “utility function” representing the satisfaction investors can be thought of as deriving from different amounts of wealth.
-Typically two generalizations can be made about investors:

(1) the more $$ they have; the happier they are, and

(2) equal successive increments in wealth result in progressively smaller increases

to total utility.

-Look at utility function of gambling (take out possibility of social gambling sums so small they have no impact on utility function).
-Where the gain and loss are equal the loss in utility is greater than gain, so that to encourage the gamble there must be a “risk premium” which is a measure of “risk aversion”, and where the bet is larger the increase in the spread on the utility function requires a larger “risk premium”.
-The extent of the possible spreads involved is measured by the “variance” and is defined as sum of squares of deviations from mean weighted by respective probabilities; so that

OUTCOMES(x)                  PROBABILITY (Pr[x])                  x[Pr(x)]
$900                                     .25                                                    $225
$1,000                                  .50                                                    $500
$1,100                                  .25                                                    $275
                    Expected Monetary Value(mean outcome) = 1,000

OUTCOMES(x)      Pr(x) x-x    (x-x)(x-x)      Pr(x)[x-x(x-x)]
900                           .25    -100 10,000          2,500
1000                         .50    0       0                   0
1,100                        .25    100   10,000          2,500
                    Variance = 5,000     

-The point of calculating variance is that typical utility function depicts that the greater the range or consequences the less attractive investment becomes.
-The disadvantages of losing become progressively more severe than the benefits of profit.
-The variance is a convenient measure of the “risk premium”.
NOTES:  
-People dislike loss more than gain so we must be paid for the risk of loss beyond simply the reciprocal probable gain.
-Keep in mind if the risk is high the present value of an expected return is much smaller; thus it is integral to any calculation to ascertain the risk as best as possible.
-Discussed the statistical aspect of using variance and standard deviation to determine expected return (solely a method to determine if we can systematically measure risk).
Note: Risk and Return Characteristics of Different Securities (70)

1)   Variance and Standard Deviation

a.  Variance is defined (w/ respect to set of outcomes) as sum of squares of deviations from mean, w/ each sum of squares multiplied by the corresponding probability of occurrence

b.  Standard Deviation is the square root of the variance.

Appraisers quantify risk by reference to the risk which the market attributes to comparable enterprises and their securities.  Although this is less subjective that risk forecasting models discussed above there is still the subjective judgment of what company/companies are comparable.
Francis I duPoint & Co. v. Universal City Studios, Inc. (71)
NOTES:  Discussed short form merger
(If 90% control: then BoD of a parent can merge.  Only requires notifying minority SH who can elect for appraisal)
(if ask for appraisal: you get FMV as of day of merger and lose out on benefit of the synergy created by the merger)
-This case wouldn’t really happen today as a result of Weinberger v UOP.
-“multiplier” is inverse of R and is also referred to as price earnings ratio.
-Court: let's look at comparable companies to determine risk (return that investor demand from comparable companies).
PV ÷ earnings = 1 ÷ r = m (higher the R lower the multiplier)
PV = earnings ÷ r
R = earnings ÷ PV
Class 4: Valuation (cont'd): Capital Asset Pricing Model, Portfolio Theory: Bratton, pp. 83-120.
Note: Price/Earnings Ratios and Investment Strategy (83)
C.  Measures of Risk-The Capital Asset Pricing Model and Beta (83)1.  Portfolio Theory, Portfolio Selection (84)

Theory assumes that investor is willing to choose among portfolios solely on basis of two measures:

1)   Expected value

2)   “spread” of probability distribution:

Ep = expected (predicted) rate of return for a portfolio

Sp = standard deviation (uncertainty) of rate of return for a portfolio

Desirability is expressed in terms of Ep and Sp values w/ the assumption that investor would consider two portfolios w/ same Ep and Sp

How does an investor choose among alternative portfolios?

1)   Ep = good; so that all else being equal the higher Ep is preferred

2)   Sp = bad; all else being equal the smaller Sp is preferred

-Furthermore: the feelings of a particular investor can be represented by the use of an indifference curve.
-A set of indifference curves can summarize the investor’s preferences.

An investment decision can be broken down into three separate phases:

1)   Security analysis; requires predictions about future prospects of securities (taking into account uncertainty and interrelationships)

2)   Portfolio analysis; produces Ep and Sp estimates derived entirely from the predictions from the 1st phase

3)   Portfolio selection; given the Ep and Sp and knowing investor preferences you select the best portfolio

Think of if graphically where you would plot all the possible Ep and Sp points and then make a selection from the upper border (called the efficient frontier)

b.  Diversification as a means of reducing risk (91)

-Object of diversification: Eliminate any “independent variability”.

-A portfolio w/ “independent variability” means that owner is accepting risk that diversification could eliminate.

-Real World: this wouldn’t work because in addition to “independent variability” that diversification addresses there is “market variability” that cannot be avoided.

Market Variability: refer to fact that price will rise and fall w/ the ups and downs of the market as a whole.

-Some stocks are more sensitive to the market, others less sensitive.
-None are free of  “market variability”.

-Opportunity would not last long b/c as soon as market realized opportunity it would drive up price of both stocks until expected yield matched that of riskless securities.
-The person who stumbles across it and gets in 1st gets the benefit of the price increase.

Modigliani and Pogue, an Introduction to Risk and Return: Concepts/Evidence (99)
6. The Capital Asset Pricing Model (102)
-We can eliminate “independent variability”, but still have market risk which is unaffected by diversification.
-So that “market/systematic risk” of a portfolio is average “market/systematic risk” of all securities included therein.
-CAPM:  serves as a benchmark against which portfolio performance can be measured.

A.  Quantify “market/systemic risk” by dividing security return into two parts.

1)   Dependent on market return (systematic).

2)   Independent of market return (unsystematic: eliminated via diversification).

-Security return can be seen as beta(Rm) + epsilon
-Systematic return expressed as beta times the market return (Rm).
-Beta acts as a market sensitivity index indicating how sensitive the security return is to market changes.
-Unsystematic return expressed as epsilon.
Whatever risk cannot be eliminated by diversification is the remaining systematic risk (equal to beta times market risk).
-Further, portfolio systematic risk is the weighted average of security systematic risks.

-Portfolio systematic risk is a weighted average of the systematic risk of the individual securities;

-Security systematic risk is equal to security beta times standard deviation of market return.
-Makes beta useful as relative risk measure, w/ beta giving the systematic risk of a security/portfolio relative to market index risk

CAP-M is based on basic theory that assets w/ same risk should have same expected rate of return

-EX: investor who holds portfolio w/ same risk as the market (beta = 1.0) should expect same return as that of market portfolio.
-Investor who holds a riskless portfolio (beta = 0) should expect a return similar to riskless assets like treasury bills.

-In a mixed portfolio (risk and riskless),  just work out a weighted average of the beta of risk stuff and the beta of the risk-free stuff
-Thus “portfolio beta” is equal to fraction of money invested in risky stuff (keeping in mind that if investor is leveraged the portfolio beta is greater than 1.0)
-CAP-M says that expected return on portfolio should exceed riskless rate of return by amount proportional to “portfolio beta”.
-CAP-M further says that expected risk premium for an investor’s portfolio should be equal to beta multiplied by expected market risk premium (expected risk premium is the difference between the expected return on market and the riskless return)
-CAP-M requires certain assumptions involving investor behavior and market conditions; such as:

1)  market composed of risk-averse investors who measure risk in terms of standard deviation of portfolio returns

2)  all investors have common time horizon (allows measurements to be meaningful as comparative tool … remove Time Value)

3)  All investors assumed to have same expectations about future security returns and risks

4)  Capital markets are perfect (no transaction costs, differential taxes, borrow and lend at same %).

Note: CAPM (106)
Deriving Beta
-Assumption for CAP-M: All investors hold the “market portfolio”
-An asset’s beta depends on the correlation of its rate of return w/ the market’s rate of return and on the size of standard deviation (variability) relative to the market’s
        -Correlations of -1 implies asset’s returns move up when market’s returns are up.
        -Correlations of 1 implies asset’s returns move down when markets move up.
        -Correlation of 0 implies asset and portfolio moves independently of each other.
-CAP-M assumes that return on market equals risk free rate of return plus risk premium;
1)   Current return on treasury securities = risk free rate.
2)   Risk premium; determined by using historical averages so you take Average Return for S&P and subtract Average Return on Treasury Bills
-CAP-M assumes
(1) homogeneous investor expectations;
(2) no transaction costs;
(3) complete info.

Cede & Co. v. Technicolor, Inc. (108)Note: Shareholder Value, Risk Aversion, and Risk Neutrality (115)
2.  The Three Factor Model (117)
3.  Arbitrage Pricing Theory (119)
Arbitrage simply means finding two things that are essentially the same and buying the cheaper while selling (or selling short) the more expensive.
-Market eventually should identify the arbitrage and bring the two prices into balance.

Class 5: Valuation (cont'd): Efficient Markets, Bratton, pp. 15-38, 196-204; Supp. pp. 52-63
2.  Market Efficiency (15)
-An efficient market is one in which security prices always reflect available information.
A.  The Efficient Market Hypothesis (15)
-Price changes are random (random walk)
Three Forms of Market Efficiency

1)  Weak efficiency; prices reflect info contained in record of past prices.
Prices would then follow a random pattern.

2)  Semi-Strong efficiency; prices reflect past prices and all other published info.
Prices adjust immediately to public info

3)  Strong efficiency; price reflect all info that can be acquired via painstaking fundamental analysis of company and economy.
Would have only lucky/unlucky and would be no room for the “superior investment manager” who beats market.

Incentive Problems and Modifications

If market is efficient and reflects all info why would anyone expend cost to uncover info if it was already reflected in the market?

-This incentive problem lead to a reworking of the EMH theory so that:

-Prices only partially reflect info level of the most sophisticated trader and price becomes more “informed” as number of well-informed traders increases.

-Price is completely accurate only if all traders have full info

Joint Hypothesis Problem
Any testing of EMH cannot be done straightforwardly b/c every test requires an assumption (using some theory) about what “right price” is.
-Every test of EMH is really a test of both EMH and the asset pricing model used.
Empirical Case against the Hypothesis
B.  Behavioral Finance: The Noise Trading Approach (26)
Critics of EMH attack assumptions of the theory; focusing on three critical points

1)  EMH assumes investors are rational.

2)  That to extent they trade irrationally; trades are random and cancel out.

3)  That even to extent irrational trades do not cancel they are met in the market by arbitrage and their influence is eliminated.

-If these assumptions are disproven and EMH is wrong, question becomes: what factors affect stock pricing?
Responses focus on psychological factors, “noise trading” and investment fads
“Noise Trader Approach”
Makes two assumptions:

1)  Some investors are not fully rational and their demand for risky assets is affected by unjustified beliefs/sentiments

2)  Arbitrage is risky and therefore limited.

-Implies that changes in investor sentiment are not fully countered by arbitrageurs.
-Arbitrageur runs risk in form of that when he sells short (market may do well) and also risk related to unpredictability of future prices. This and fact arbitrageur cannot hold his position indefinitely (he borrows to arbitrage) illustrates the limits of arbitrage.
-Not all investors make rational decisions.  You also have “noise traders” or those who follow “popular models”.  Debunk argument that “noise traders exit market quickly”.
-Arbitrageurs counter the shifts in demand created by changes in investor sentiment; but they cannot eliminate those effects completely.
Limits of Arbitrage
-Arbitrage requires a mispriced security that has a close substitute that is correctly priced.
-Arbitrageur shorts overpriced and hedges position by purchasing correctly priced security.
-In doing so, runs risk of unexpected good news on short position or unexpected bad news on the long position.
-Also: “noise trader” driven by sentiment messed up the arbitrage b/c sentiment is unpredictable. -Lastly: a shock in “noise” might scare creditors (whom arbitrageurs rely on heavily) into cutting back.
Note: Bubbles and Crashes (34)

-During 90’s we had massive boom that saw the Dow Jones go from 3,600 in 1994 to 11,700 by 2000.

-According to Shiller: market was experiencing a speculative bubble driven by a natural investor driven Ponzi process based on cultural changes that were contributing to overvaluation.

Crash of 1987

-Discussion of bubbles and why they might collapse and the various theories developed to explain the 1987 burst.

3.  Systematic Risk and Transparency, Alan Greenspan (196)
Note: Unexpected Volatility (199)
UK Financial Services Authority, Turner Review (52)
-Efficient Markets can be irrational.
-Market efficiency does not imply market rationality.

-Individual rationality does not ensure collective rationality.

-Individual behavior is not entirely rational.

-Allocative efficiency benefits have limits
-Empirical evidence illustrates large scale herd effects and market overshoots.

Class 6: Review of Valuation Issues, Hedging, Bratton, pp. 1-15; 153-86; Supp. pp. 1-4.
Valuing the Firm and its Securities (1)
Firm should aim to maximize market price per share of its stock; b/c if market price is maximized then stockholder wealth is maximized.
-What does management need to do to maximize stock price?

-Legal Valuation:  an exercise in assimilating detailed economic data and in designing theoretical equipment with which data can be reduced to a defensible value figure seen as “intrinsic value”.

-A question: should market price be taken on face as best measure of that “intrinsic value” (think about info and EMH)?

-When judges undertake to legally determine “intrinsic value” they do so b/c of a belief that market does not accurately measure the value to which law attaches significance or that the market measures it inadequately.
-Various classes of claimants argue over value of a firm, equitable resolution is difficult so contract and fairness concepts introduced as a basis for allocating “pieces of the pie”
→ Valuation and Objective of the Firm (1)
-For the equity investor the objective of the firm is to maximize the firm’s value to its stockholders, subject to whatever constraints may be imposed externally. A.  Market Value and Fundamental Value (6)
Tri-Continental Corp. v. Battye (6)
Note: Funds (11)
Note: Merger Appraisal Rights and The Closed-End Fund Discount (13)
5. Risk Reduction Through Hedging (153)

Risk reduction through diversification works better for investors than for managers of going concerns.  For managers it requires arduous process of organizing a conglomerate firm, so they must employ hedging to reduce risks like:

1)  Prices of product sold may fall.

2)  Prices of product used may rise.

3)  Currency exchange rates rise and fall.

4)  Interest rates rise and fall.

-Some hedging instruments that contain these risks and thus increase value of firms net cash flows include: forward contracts, futures contracts, swaps and options.

A) Risk Exposure (154)
1.  Forward Contracts (156)

-A contract of sale at a price set presently with delivery and payment specified to occur at a future date.

-There are many risks facing a company.  "I am willing to give up some of the upside to reduce the downside."

-Limits the company's profit increase on a price rise even as it limits its exposure in the event of a price decline.

-I.e., you buy something with a maturity date.

-If it drops, you pay the difference.

-If it rises you receive the difference.

-The level of risk is due to extreme price shifts.  Management can use it has a hedge mechanism.

     1)  Sell the product in a forward contract with exercise price based on current prices.  If price falls below exercise price the company is protected.  If the price rises it limits the companies profit making ability but protects you.

-Need a stable counterparty.

2.  Futures Contracts (158)

-The seller of a future contract will profit if the spot price (current price of commodity) < exercise price.

-Buyer profits if spot price > exercise price.

-To limit possibility of default futures exchanges have developed two devices:

1)   Mark to Market - profits and losses on each K are calculated and netted out daily.

2)   Minimal Capital Requirements - If account falls below minimum, it is either replenished or closed out.

-Financial futures help financial institutions hedge risk in the same way as commodities futures help reduce risk for firms that deal in commodities.

Consider an insurance company w/ $200M portfolio that believes market will fall.  Instead of having to undertake transaction cost of selling off and reinvesting, they can sell (short) or buy (long) the S&P index.

-If market drops: short pays, a sum to cover losses in stock portfolio.

-If market rises: the rise in portfolio worth offsets the loss on futures contracts.

3.  Swaps (159)
           -Financial exchange over time between two parties of either cash flows or       amounts related to cash flows.

-I.e., a currency swap: protects exposure to exchange rate fluctuation.

The default risk is in between a forward K and a futures K.

-Not exchange traded.

-Can't trade or assign without consent

4.  Options (163)
          -Gives its owner a right to buy or sell an asset at a future date for a price specified on the date of origination.

        Call gives right to buy an asset in the future at specified “strike” (exercise) price

        Put gives right to sell an asset in the future at a strike price.

-Seller of a call option receives money up front in exchange for assuming an obligation to sell the stock at the exercise price if the option holder decides to purchase it.

-Profits if the stock price stays low.

-Holder (buyer) of a call option profits only if the stock price rises.

-Seller of a put profits if the stock price rises.

-(Holder) buyer of a put profits of the stock stays low.

-Options have an asymmetric payoff distribution due to the presence of  “option premium” that owner of option pays up front.

(Holder/buyer always pays a premium, seller/writer always gets a premium)

-Always a danger that a counterparty will not always come through.

Call Option Valuation:

Value of a call option is current price minus exercise price so that when result is positive call option has “theoretical value” when result is negative, call option has zero “theoretical value”.

As long as option is exercisable on date after which it is being valued it is possible for “market value” to be greater than “theoretical value” b/c of possibility that price will rise

Five factors determine the value of a call options

1)  Stock Price; higher the price higher the value of call

2)  Exercise Price; higher the exercise price, lower the value

3)  Duration; longer period until expiration date; higher the value

4)  Risk Free Rate of Return; higher risk free rate
-Means higher discount rate making present value of exercise cash outflow lower and value of option higher

5)  Volatility of Stock; more volatile the stock higher the call value b/c market value can never go below zero (you can’t lose more than premium loss is capped but your gain isn’t) more volatile the higher the possible gain and higher the value.

Caiola v. Citibank, N.A. (174)

Delta Hedging:  Makes a derivative position, such as an option position, immune to small changes in the price of an underlying asset such as a stock, over a short period of time.

-How would Citibank hedge risk?

-  Buy the physical stock as a hedge.  However, this would leave a footprint.

-  They would get interest on the loan still if stock goes up, but have   physical stock.

P to Citibank: hedge a different way.  Buy underlying assets in limited amounts instead.

Note: Swaps - Enron and Equity Swaps (182)
-Equity swaps entered into between financial institutions and executives holding undiversified stakes in their own companies’ stock.
-Executive gets the benefit of diversification w/o having to sell stock and avoid the realization of a taxable gain. Bank covers itself via hedging.Enron - worried stock would go down in value, needs to hedge (protect self from loss)
-Could pay a premium in case the stock drops in value, but would be expensive.
-Instead sets up a special purpose entity to protect themselves.
-In reality, the special purpose entity was Enron, hedging themselves funded with their own stock.
Regulation of Derivatives/Equity Swaps (Supp. 1)

Class 7: Debt Financing, Basic Terms, Promise to Pay, Bratton pp. 240-67; Supplement pp. 64-78Basic Terms and Concepts (240)
-Security holder investment contract may be viewed as:

1)   A claim to share in the cash flow stream and in a liquidation.

2)   The right to affect conduct of enterprise and enhance value of your claim.

-Investment K states the amount of claim and prescribe priority of claims in regards to other claims.

-Senior (bondholder) > junior (preferred stock holder) > common stockholder.

-With priority placement also comes a ceiling.

-No one below you may be satisfied until you are.

-You may only be satisfied to the amount of your claim.

-This way a common stockholder has greater risk of getting nothing but also the chance of  greater reward of sharing in everything that might be left over once all other claims are satisfied.

Control Rights
Common stock also gets benefit of voting control which allows it to influence critical decisions respecting firm’s risk and growth of its cash flows and assets …
1)   ability to influence portion of cash flows or assets to be distributed
2)   enables common stockholder representative management to determine any new priority claims
3)   influence over determining of risk-return characteristics of business
4)   in distress enables common stockholder representative management to set terms by which existing claims are altered as a result of refinancing or recapitalization
Allocational Conflict
-Legal issues arise when junior security holders exercise control power so as to benefit themselves at expense of senior claimants.
-Legal rights are embodied in investment K: issue is initially an interpretation of contracts and statutes.
        What contract rights do senior claimants have?
2.  Corporate Trust and the Trust Indenture Act of 1939 (248)
Bond Holder Rights
Bonds, Debentures and Notes
Long-Term Promissory Notes

A Promise by the borrower to pay a specified amount on a specified date, together w/ interest at specified times on terms and conditions spelled out in a governing agreement.

-Promise to pay in debt:  Lend money to X, want a certain interest rate, r.
How do you determine r?
r = risk of the investment (risk of not receiving it.  What can you factor into risk?)
-How much risk is in the borrower's control (Covenants)
Indentures

-A contract between a borrowing corporation and a trustee.

-The trustee administers payments and monitors compliance on behalf of the bondholders as a group. -Indenture defines obligations of borrower, rights and remedies of holders and the role of trustee.

although more cost effective they usually require that enforcement actions be made via office of the trustee.

-Look at payment terms.  Property securing the loan?

-Lenders are sometimes diverse.

-Borrower's Covenants (promises that the borrower has made)

-How the lender can act.

-What the trustee can do.

Elliott Associates v. J. Henry Schroder Bank & Trust Co. (248)
          (Explains the purpose of the trustee.)
Note: The Trust Indenture Act of 1939 (251)
Trust Indenture Act
-Protects bondholders by requiring that publicly issued bonds be issued pursuant to a trust indenture conforming to specific standards.
-Trust Indenture Act Amendment:  Trustee's Conflict of Interest
Lender can be a trustee, but if trouble develops, may have to leave that role.
Terms of Indentures
Six important sets of provisions

1) Amount of $, date of payment, interest rate, time of interest payment, mechanism of prepayment

2)  Character and extent of property against which bondholder may levy to satisfy debt

3)  COVENANTS accepted by corp to ensure preservation of value or property during period of debt.

(Promises that protect the value of the promise to pay)

-Debentures which are unsecured have more restrictive provisions limiting ability to pledge assets elsewhere, incur additional debt make dividend payments)

-Covenants are the agreements or obligations of the issuer, they are contained in a document called the indenture.

-Once bonds have been sold to the public, the job of protecting the interests of the bondholders, of enforcing their rights under the indenture, will fall to an institution called the indenture trustee.

-General function of covenants = enhancement of equity cushion.

-Equity cushion: the amount of the equity, which can be thought of as protecting the lender from loss.

-The bigger the equity cushion, the less risk of default or of loss if there is a default, and the better off the lender is.

Types of Covenants:  Maintenance of Property, Restriction on Dividend Payments, Negative Pledge Clause (limits ability of issuer to issue new debt), Prohibitions or Limitations on Mergers and changes in voting control, Maintenance of Financial Condition or Equity Cushion, Same Business.

4)  The exact course bondholders must pursue in order to levy on the corporation.

5)  The duties and obligations of the trustee

6)  Covenant on the part of the bondholders that liens/claims will cease and corp will no longer be bound once indenture is paid off (face + interest).

Further notes on Covenants:

-All paperwork originates from the lender.  Lender is making an investment with a fixed upside risk of the loan, and determines the interest rate.

-Lender evaluates:  Who is the borrower?  What is the nature of the debt?  How long is the debt?

-The contract is to hold you to the evaluation.  "For the term I want you to stay how I evaluated you.  You can get better, though."

-Lender:  I am going to make you do the things you can control.  The lender wants to keep the borrower in a straight jacket.  After all, the risk of who the borrower is is in the borrower's hand.

3. The Bondholder and the Going Concern - The Promise to Pay (253)
Note: Redemption Rights and Duties (255)
Redemption-Price of debt fluctuates with interest rates.
-Lower rate: Company wants to redeem, lender does not.
-Higher rate: Lender wants company to redeem.
-Why does a company bargain for a redemption (call) right?
-Lower interest rate: want to get a cheaper rate of borrowing.
-Lender: I have a good deal, I don't want to be redeemed.
      -Doesn't like redemption (when interest rates down).

-When interest rates rise, debt not worth as much, lender wants to lend to someone else.

      -Premium: lender can say: "you can't prepay for x time, you can never prepay."
           -"once you repay, you give me a premium for your early payment."
-Bargain:  Lender v. Borrower - "We want the ability/option to redeem"
      -You have to pay for that option.
-Optional v. Mandatory Sinking Fund Redemption.
Sinking Fund: Bond prepayment provision under which the issuer must repay the principal in installments over the course of the issue's life.
-Prepayments of principal prior to maturity.
-Sending a signal as a borrower: "I am a responsible borrower" (safer than bonds without sinking fund provision).
-Mandated by the bond contract.
-Failure to make a payment is an event of default.
-Can satisfy by going into the market (i.e., $1000 bond, but $700 in market).  Company does whatever is cheaper.
Duration
-Be aware of “sinking fund” payments (prepayment of principal in advance of due date
-Also keep in mind the ability to “call” (redeem the bond) both of these have impact on valuations.
Variations

1)  Floating Rate: adjusted periodically to keep current w/ changes in lender short term cost of funds … might use the treasury bill interest … also usually subject to a floor or ceiling

2)  Zero Coupon: pay a lump sum at maturity and no interest at all.  Offered at deep discount.

3)  Convertible: can be changed at holder’s option into a specified number of common stock shares.  Have downside senior security protection and upside potential of common stock.

Morgan Stanley & Co., Inc. v. Archer Daniels Midland Co. (258)
         (Standardized Reading of Contract Provisions.)
Note: Refunding Cases (265)
Part II. Debt Financing (supp. 64)
Public Offerings and Private Placements
Publicly offered bonds must fulfill registration requirements of 33 Act.
-There is also “shelf registration device” in Rule 415 of 33 Act. (Allows issuer to register securities for future use and then it can sell them by filing an amendment w/ SEC)
-Issues too small to gain access to public debt market or to qualify for shelf registration can issue long term debt in private market.
-Possible b/c Rule 144 of 33 Act includes exemption from registration if offer and sale of bond is limited to small number of sophisticated institutional investors.
-These private placements usually involve tighter and more complex covenants.
Rule 144A
-Permits trading of private placement notes among institutional investors meeting stated qualifications.
-Has resulted in a third market squarely between public offering and private placement.  
-144A allows for sale at more advantageous prices, more favorable terms and at lower transaction costs than traditional private placement.
Junk Bonds
-Below investment grade investments with high yield and high risk.
Short Term Borrowing
-Borrowing for term of less than one year.

In re Merrill Lynch Auction Rate Securities Litigation (supp. 64)

Class 8:  Debt Financing, Basic Terms, Asset Securitization, Bratton pp. 268-304; Supplement pp. 78-102B. Promises that Protect the Value of the Promise to Pay (268)
a. Debt Contracts and Debtor Misbehavior (268)
b. Principal Covenants (270)
2.  Judicial Interpretation of Covenants (274)
Sharon Steel Corp. v. The Chase Manhattan Bank, N.A. (274)
-Successor Obligor Provision
Note: Boilerplate Indenture Terms (279)
C. Security and Seniority (281)
Mortgage Bonds
-Holder of Mortgage Bonds are secured as to payment by a pledge or mortgage of described assets of debtor and have a superior claim to payment against other creditors w/ respect to the mortgaged asset.
-Since property has a higher value as part of the going concern a mortgage bondholder is unlikely to want to go into foreclosure and would rather figure out some type of restructuring/reorganization.
-Mortgage bonds may be issued in different classes w/ different terms.
-Each class may be secured by a specific property or by prioritized liens on same property.

-Closed-End; no additional first mortgage bonds may be issued and only secondary liens are permissible

-Open-End; permits additional bonds to be issued as a first lien.
          This dilutes value of an existing lender's interest so usually some sort of limit is placed on # of new first mortgage bonds that may be issued

-Also have things like after-acquired property clauses (property to be acquired in future is added to mortgage), mortgage secured not only by property itself but by a pledge of income derived from property.
-Also, bonds have covenants as to ensure preservation and maintenance of property

2.  Leases (284)

-Where lessee is borrower and lessor is lender.
-Lessee gets tax benefit of deducting lease payments and lessor gets tax benefit of depreciation while maintaining title.

3.  Subordination (286)

-When a corporation’s debt structure is unable to support issuing additional senior debt need for long-term, capital can be met by subordinated debenture. -Operates as an unconditional promise to pay principal and interest at specified dates but due to subordination agreement payment of principal is deferred until senior debt has been paid off or the event of liquidation, bankruptcy, or reorganization

-Subordinated debt would be somewhere between prime senior debt and preferred stockholder w/ the interest rate higher than the 1st and lower than dividend interest rate of the 2nd

4.  Asset Securitization (287)

-A Form of debt financing secured through sale of accounts receivable (or another asset generating a predictable revenue stream).

        Examples: student loans, credit card receivables.

-The quality of assets revenue stream depends on risks of payment delays & default

Note: Risk and Return (293)
In Re LTV Steel Company, Inc. (300)
Note: Subsequent Proceedings
B.  Promises that Protect the Promise to Pay (supp. 78)
Debt Contracts and Debtor Misbehavior
-Risks involved w/ being an unsecured lender can be made more manageable w/ provisions as to course and conduct of the borrower’s business.
-These provisions give lender the ability to call a default.
-Option of calling default does not assure payment; but it does have value in that lender has value of forcing borrower into a choice.
-It can cure default, seek bankruptcy proceedings or make lender an offer of substitute performance in exchange for a waiver
-There are exogenous events (dramatic shift in market or industry) and issue of debtor misbehavior, including:

1)  asset withdrawal

2)  risky investment policy

3)  claim dilution

4)  underinvestment

-As exogenous events adversely affect borrower and probability of debtor misbehavior increase (Equity cushion example: lower debtor’s equity cushion greater the probability that he will take some action that may harm existing creditors).
-Covenants designed to keep equity cushion in place:

1)  Restriction on dividends and other payments to shareholders

2)  Restrictions on additional debt

3)  Restrictions on mortgages and liens

4)  Restrictions on mergers and sale of assets

5)  Restriction on investments

6)  Maintenance of financial condition

7)  Maintenance of business and property

8)  Reporting provisions

Affiliated Computer Services, Inc. v. Wilmington Trust Company (79)
4.  Asset Securitization (supp. 86)
Concord Real Estate CDO 2006-1, LTD. v. Bank of America N.A. (91)

Class 9: Debt Financing (cont’d), Bratton pp. 304-59 (skim pp. 309-20); Supplement pp. 135-36D. High Leverage Restructuring (304)
Bonds w/out Covenants and High Leverage Restructuring
-LBO is an acquisition financed w/ borrowed funds where the target company assets are used to secure loans (think of management buyouts).
-LBO usually expect to pay back a large piece of the LBO debt in about 5 years by using cash flows.
-Once debt is paid off company can be taken public again using a reverse LBO.
-The LBO target emerges w/ a higher debt-equity ratio increasing default risk of any indebtedness incurred prior to LBO.
-LBO’s are the type of transaction which traditional covenant are directed.
Example: where LBO target has preexisting debt protected by covenants LBO is forced to redeem bonds in order to prevent triggering a “default event”. Where there are no covenants protecting existing debt there is no incentive to redeem and the bonds suffer a loss of value as a result of increased default risk (this loss is transferred to the SH whose interest was purchased at a premium in LBO)
-LBO boom of 80’s caused bondholder to insist on K protections such as “super poison puts” that would be “triggered” by defined events (mergers, acquisition [lbo])

Agency Costs of Free Cash Flow, Corporate Finance and Takeovers (306)
2.  The Rise, Decline, and Reappearance of Leveraged Restructuring (308)
3.  Event Risk and Bond Contracts (320)
Metropolitan Life Insurance Company v. RJR Nabisco, Inc. (323)
Note: Spin Offs (335)

Note on how a Marriott decision to split its business into two separately owned corporations crushed bondholder value b/c corp w/ lowest annual sales and operating cash flow of $350m was saddled w/ bonds requiring yearly interest payments close to $225m.

Note: Fiduciary Theory, Good Faith Duties, and Bases for Judicial Protection of Bondholders (336)
Fiduciary v Good Faith Duty
-Impossible to draft express provisions that protect against possible risks and at same time allow management to operate freely and attempt to maximize value.
-Therefore, risk of opportunistic behavior by management to advantage of equity at expense of debt remains large. Some argue that judicial imposition of good faith duty or creation of a fiduciary relationship would help to minimize that risk.
Nature of Good Faith Duty
Implied covenant derives from language of indenture and cannot give bondholders any rights inconsistent w/ those set out: where no K rights have been violated no breach of implied covenant can exist.  What does this mean about duty of good faith?
Supertrustee
Article proposing the creation of some sort of “supertrustee” to solve the problem of a dearth in protected bonds in the marketplace.
Note: Lender Liability Compared (339)
Good Faith Duty
KMC v Irving Trust held a lender violated good faith duty in course of performing its debt K when lender refused to advance (w/out notice) last 800k of a 3.5m line of credit to a debtor in a shaky position.
-Lender has right to refuse but agreement was silent on whether and how much notice was required.
-Decided that failure to give notice (and allow debtor to find other financing) violated lender good faith obligation and made lender liable for debtor collapse. Court of Appeals upheld holding that

1)  implied notice was necessary to give borrower time to find alternative financing; otherwise borrower was at mercy or lender’s whim

2)  lender needed valid business reason to avoid notice

3)  fact lender was fully secured weighed in favor of finding a good faith violation

Legislative Responses to Lender Liability
In most lender liability cases borrower alleges that lender breaches oral agreement to lend, refinance or refrain from enforcing a contractual remedy.
-Many states have since added statute of frauds making cases actionable only if “credit agreements” are in writing and signed by both parties
Liability as Controlling Party
Also; have possibility that lender can be held liable for losses sustained/liabilities incurred by borrower if lender is deemed to have been in “control” of borrowerE. Debtor Distress: Altering the Bond Contract-Amendment and Exchange, Coercion and Holding Out (341)
-Bond contracts can be amended or performance can be waived.
-Amendments and waivers are likely to be requested by issuers in financial difficulty. Various terms describe process of revising debt obligations to avoid distress (restructure, recapitalize). In short distressed issuer takes advantage of fact its debt obligations are selling at a discount from face value.
-If debt is publicly traded and issuer has some free cash flow it will buy debt on the market at below value and reduce its debt carrying cost.
-Most likely though issuer doesn’t have cash and must make an “exchange offer” (using new debt w/ scaled down rights, equity securities, cash or some mix).
-Any such “exchange offer” must be for a value higher than current trading value of bonds; if not no incentive for bondholders to accept
-Two problems can occur in “restructure/recapitalize” situations

1)  In context of “exchange offers” questions arise as to whether circumstances allow bondholders to make an effective choice (issuer can work elements of coercion into offer by determining the timing of such action and by overstating the consequences of failure to restructure/recapitalize)

2)  if restructure/recapitalization requires aggregate bondholder action there is a “free-rider” incentive to be in minority of bondholder and not accept offer (this way you keep all the rights to full principal and coupon in a healthier corp while carrying risk that things might still go bad)

a.   If too many hold out then restructure/recapitalization can fail and issuer might be stuck going into bankruptcy

Aladdin Hotel Co. v. Bloom (342)
Note: Amendment Under the Trust Indenture Act (346)
§316 of 1939 Act: restricts the power of a majority block of bondholders to defer or forgive principal and interest payments which is what happened in Aladdin. (does incentive to hold-out then increase?)  
-Any postponement of interest payment can be only for 3 yrs and must be authorized by not less than 75% holders of principal amount of indenture.

Katz v. Oak Industries, Inc. (348)
Note: Coerced Votes and Hold Outs (356)
Identifying Bondholder’s Problem
-Katz illustrates potential bondholder problem where issuer side-steps §316 by structuring payment terms as “exchange offer” and limiting amendments to non-payment provisions; can put issuer into position to “force/coerce” bondholder to accept
-Bond trading for $500; Issuer offers $550 along w/ Katz-like “amendments”; Holder feels intrinsic value is more like $625.  But if others accept at $550 and he doesn’t once protective provisions are stripped away value is only $425. What’s he to do but accept the “exchange offer”.  Holding out is a detriment.
-Flipside; a potential holdout creates problems for all other bondholders where debtor’s condition is so dire that a failure to “restructure” will result in insolvency and result in all bondholders being worse off than if “restructure” succeeded.
-Under what circumstances are potential holdouts likely to become real holdouts;

1)  few bondholders believe readjustment price is low and seek to raise it for all bondholders by holding out

a.   this what §316 is all about: allows for holdout like this.

2)  large bondholder who wants to holdout in order to seek some say/control in  reorganized entity.

a.   no §316 implication.

3)  bondholder who sits back and hopes enough other bondholders accept so that he gets bought out fully by issuer.
-or, worse, a corp. still goes into bankruptcy and its claim is still “senior” and for full amount under original bond as opposed to the potentially diminished and/or  “junior” reorganized security

a.   huge §316 implication - holdout is gambling at cost of others and increasing risk of insolvency in the process.

Note: Vulture Investors (358)
A market for trading claims has developed w/ actors in market termed “vulture investors”. Some are passive and seek to profit by identifying undervalued claims, others buy blocks of claims and then holdout in hopes of premium distribution in reorganizations, and third group seeks to profit by intervening into management.
        Q becomes do benefits of 3rd group outweigh costs of 2nd
Also, what about the legal treatment of someone who buys a deeply discounted bond just prior or even after default as compared to investors who bought at face?
Leverso v SouthTrust Bank (11th 1994): after district court approved a settlement agreement that would pay bondholders based on their bondholder cost (amount each paid for bond) so to allow those who bought at face a larger chunk. The appeals court reversed based on language of indenture that “unambiguously provides for each bond to be treated equal to every other bond”

Note: Hangover (supp. 135)
Class 10:  Preferred Stock Financing, Bratton pp. 485-511, 529-46; Supplement pp. 164-67
Financing With Hybrid Securities (485)

A. Preferred Stock Defined (485)
-A senior security offering the holder a constant payment stream resembling a bond’s while simultaneously holding out to the issuer the flexibility respecting periodic payments characteristic of common stock.
B.  The Preferred Stock Contract (487)
2.  Voting Rights (489)
-The preferred stockholder is an “owner” with an “equity” interest, like a common stockholder (look to charter).
Preferred stock is a "hybrid"
-Equity that has some features of debt.
-Gets a dividend (not interest)
-Has a liquidation preference.

A senior security offering the holder a constant payment similar to a bond while simultaneously giving issuer flexibility respecting periodic payments.
        Is a class of stock w/ a “preference” or “special right” as against common stock
Preferred stock is placed on equity side of balance sheet and preferred stock dividends are treated as a distribution of net profits as opposed to interest payments on debentures which are treated as a deductible cost of doing business.

Problems:  Conflict between another class (common stock has a conflict with preferred stock).
-Common generally controls management.  Often abuses preferred.
Does the preferred stock have protection in a transaction?
-Courts, as with debt, take a strict reading of the preferred (contract approach)
-Treated contractually under the law (generally: detailed contract - amendment under articles of incorp.)
-Common doesn't bargain, got what law and equity provided.  Preferred stock got to bargain: can't come crying about equity when it agreed on a contract.
-Preferred stock has a much more detailed contract than common stock.
-If the contract says liquidation but not merger, you get what is contracted: liquidation.

Contracts define preferred stockholder rights.
-Note that DCL §151(a) permits new classes of preferred stock be issued and hence new preferred stock contracts. (so may have multiple preferred classes w/ various rights)

Financial Terms
1)  Preferred Stock K can vary greatly in means they force dividend payments
2)  Less variance in respect to liquidation rights w/ K generally providing that in event of dissolution preferred is paid b4 common at a specified sum, plus back interest and if liquidation is voluntary an added premium
3)  Redemption is usually at issuer option at a specified price, plus interest and a premium
4)  K may contain protective provisions designed to minimize risk of nonpayment such as business covenants and protective voting provisions
5)  K may also allow an opportunity to share in any growth
a.   Conversion.
b.  Preferred participation
-in event of a dividend or liquidation K may allow for preferred stock holder to participate in what is divvied up among common stockholder (after obligation to preferred has been met, so a double-dip)

b.  Voting on Amendments (491)
Voting Rights
§151(a) gives drafter of charter complete discretion respecting assignment of voting rights among classes of stock

Voting and Contingent Voting
Many charters provide preferred holders full voting rights on a share by share basis; but real voting power does not necessarily follow (usually common stock far outnumbers preferred so no real effect on outcomes)

Other charters address this issue by providing preferred stock holders w/ a class vote for election of specified number of directors upon occurrence of failure to pay a specified number of preferred dividends

Default in payment is not only contingency upon which voting rights might be based … violation of other protective provisions in preferred stock contract may provide class voting rights
Note: case form the Supplement FGC Holdings v Teltronics (pg 68) addressing voting and BoD seats and how they should be filled; etc

Voting on Amendments
Preferred stock K is located in corporate charter. thus statutory provisions governing corporate charters are incorporated in preferred stock K.
Leads to wacky results in that if common stockholders are larger class statutes allow them to amend charter and restructure preferred stock K allocation of risk and returns to disadvantage of preferred stock class.
A considerable body of law addresses efforts to amend or alter preferred stock K; typical risks against which preferred is protected to the disadvantage of the common
1)  low earnings over a period of yrs has caused preferred dividends to be unpaid and have piled up so high as to crush any common stockholder value
2)  merger or sale of all assets may greatly benefit common stockholders but some provision of preferred stockholder K is interfering w/ feasibility of merger/sale
In court, management will contend that proposed transaction/amendment is necessary for enhancement of firm value.
-Q then becomes whether alteration of preferred stock K is equally necessary/appropriate (results vary)

-Corp codes try to address problem by granting preferred stockholders the right to vote as a class on charter amendments that may adversely affect their interests … some statutes add an express provision for class voting where stockholder approval is sought for a merger that may have effect of adversely affecting preferred stockholder rights.
If merger statute does not make such a provision … q becomes can class vote on merger be implied from right to class vote on charter amendments
-Note; under DCL §151(a) in conjunction w/ §242 and §251 preferred class voting protecting rights created in charter can be vested in the charter itself


C.  Issuer Motivations and Holder Expectations (493)
2.  Claims to Dividends (495)
Preferred Stock Dividend Provisions
A huge variety of types of dividend priority exists in preferred stock contracts;
1)  One is a promise to pay (provided a certain surplus exists enterprise can’t defer)
2)  Other is preferred w/ no cumulative priority (only blocks payment to common during current pay period … and no cumulative aspect even if corp was profitable in periods where no dividend was paid to preferred)
3)  Middle ground would be something like a fully cumulative preferred and a preferred which is cumulative only if earnings (unpaid dividends only accumulate for periods in which earnings were achieved)
-Further; preferred may be able to participate w/ common in any residual earnings/assets w/ the extent of the participation based on the K (Zahn v. Transamerica).
-If no K; the majority of courts rule that preferred is limited to what is provided in K and not entitled to residual
Note; case Shintom v Audiovox (supp pg 70) where Del SC held that a corp can create a class of preferred w/ no dividend right and limited only to payment preference in event of liquidation

B.  Board Discretion to Withhold Payment (496)
1.  Cumulative Preferred (496)
2.  Noncumulative Preferred (497) Noncumulative Preferred
Extensively litigated w/ the facts working as such; no dividends paid on either noncumulative preferred or on common for many years (b/c business is capital intensive management holds on to all earnings). Then sometime in future management starts dividend flow by paying noncumulative the required yearly dividend and then giving a massive dividend to common (who isn’t capped yearly). This results in pissed off preferred arguing that “noncumulative” does not have a literal meaning based on these facts …. Two schools of legal opinion
1)   Preferred Lose:  Guttman v Illinois Central R. which rules against the preferred holders claiming that a “k is a k is a k” and since director did not “abuse” the discretion to withhold dividend there is neither a right to have the past dividend declared nor do directors have the right to declare a past dividend. If it sucks it’s on the legislature to provide noncumulative preferred holders with better protections and the role of courts to revise outstanding K freely made by adults
2)   Preferred Win: some court interpret noncumulative as barring accrual of dividend only for years in which corp has no earnings.
-Thus retained earnings create a dividend credit for preferred holders that must be paid prior to any dividend for common holders.

Board Discretion and Voting Control
Baron v Allied Artists Pictures (Del. Ch. 1975)
-Case where after class of cumulative preferred gained right to elect the majority of BoD after issuer defaulted in payment of quarterly dividends. Preferred took over BoD and took company on massive run of prosperity but never paid dividends in arrears and thus never had to give back control. 10 years into this common bring action to have BoD elections declared invalid.
Court said:  P asks for holding that BoD elected by preferred whose dividends are in arrears has absolute duty to pay off all preferred dividends due and return control to common shareholders as soon as possible. Based on financial condition of firm up to that point it hasn’t been possible, but the BoD does have fiduciary duty to bring preferred dividends up 2 date as soon as possible as it “cannot be permitted to indefinitely plough back all profits into corp; avoid making preferred whole and denying common the right to elect corp management


Eisenberg v. Chicago Milwaukee Corp. (498)
3.  Claims to Principle, Including Arrearages (502)
A.  Alteration by Amendment (502)
Liquidation Provisions
Preferred K typically provides that on “liquidation, dissolution” of corp that preferred is entitled to payment of specified amount b4 any assets are distributed to common or other junior securities. In addition, K usually provides priority payment of all dividend arrears and if dissolution is voluntary a premium; significance of liquidation provision is diminished by fact that if it is used it usually means corp is broke;
Legal Q revolve around what conduct/acts invoke liquidation and is liquidation voluntary or involuntary

1.  Liquidation Provisions (502)
Goldman v. Postal Telegraph (504)
Note: Junior Hold Ups (506)
Rothschild International Corporation v. Liggett Group Inc. (529)
Note: Drafting (533)
Note: Preferred Class Voting in Respect of Mergers (536)
Class Voting Provisions and their Limitations
State business corp laws that require class voting help to eliminate problems of fairness respecting adjustments of preferred SH rights, however; the statutes are not as thorough in respect to preferred class voting in mergers/acquisitions
Warner v Chris-Craft
Delaware case that permits merger consummated w/out class vote that adversely affected rights of preferred class (pg 397) (court disregarded the two provisions that preferred holders tried to use in support of their claim)
Elliot Associates v Avatex
Distinguished Warner, preferred issuer (D) was in bad shape and it effected a recapitalization by creating a wholly-owned sub and merged w/ sub as surviving corp. D charter was eliminated and D preferred where given common in new corp. Under D charter preferred had no right to vote except on
“amendments, alterations or repeals whether by merger, consolidation or otherwise that materially and adversely affected preferred holder rights”
Preferred claimed a right to vote on merger and D relied on Warner to state that conversion of stock that adversely affected was as result of merger and not “amendment, alteration”
Court says unlike Warner here the charter includes “whether by merger”, and that in Warner it was conversion of preferred for preferred here it’s a conversion of preferred to common and a destruction of the charter that provided preferred w/ protections.

Dissolution
Burton v Exxon Corp (SDNY 1984) Exxon held all common and all 1st preferred and the holders of second preferred tried to enjoin dissolution on ground that continuance of corp eventually would result in dividend payments on second preferred.
Court stated that test was to decide if dividend decision was “intrinsically fair”.
-P argued reinvesting at current high % would grow larger than arrears and eventually everyone to be paid. Court said no guarantee rates stay high and even then would take 40 yrs and that further BoD owed fiduciary duty to first as well as second and that by holding funds BoD may have breached duty to 1st as BoD has fiduciary duty to see that preferred arrearages are brought up to date ASAP.

Dalton v. American Investment Co. (541)
B.  The Preferred Stock Contract - Debt or Equity? (supp. 164)
3.  Claims to Principal, Including Arrearages (166)
Class 11:  Convertible Securities and Warrants, Bratton pp. 547-96, Supp. pp. 167-86
-You can have a convertible security (can convert in different ways from bond to something, from preferred to something.
-Can be holder option can be issuer option, can convert into a lesser security or from junior to senior “upstream”)
Creates problems as per valuation and contract drafting, creates litigation in which holders ask judges to protect them from issuer opportunism

Convertible Securities and Warrants (546)
Variables Respecting Convertible Bond Value
For investors convertibles have advantage of combining desirable features of bonds w/ upside potential of common stock where in exchange for a future equity claim bondholder accept subordinated status and a lower coupon rate. To issuers these concessions give convertibles advantage over straight debt (cost savings, increases capacity to issue future debt).
The aspects of valuation
1)   debt value: value of equivalent straight bond w/ same coupon rate (sensitive to same variables % and the issuer equity cushion)
2)   conversion value: value of common into which bond can be converted (depends on market value of common and price {conversion price} at which bonds are convertible)
3)   conversion premium: amount by which market value exceeds debt or conversion value.

Valuing conversion premium is a matter of valuing conversion privilege, various variables affect premium
1)   downside risk, premium in that downside risk is limited in comparison to common
2)   upside participation … ability to participate in gains w/out same risk as traditional common
3)   income stream … so long as convertible bond pays more than any common dividends there is more value in holding convertible until as close to maturity as possible. If dividend payments surpass the bond % then premium evaporates and you convert
4)   durability … longer the option to convert the more valuable the premium
Issuer call rights work to reduce size of conversion premium depending on likelihood that issuer will actually exercise right. Issuer call policies depend on factors such as bond k provisions; market restrains on management; management awareness … ideally they want to call when market price is above call price (but significantly large in event that market drops between announcing call and actual call date)

1. The Value of a Call Option (547)
2.  Conflicts of Interest (559)
Protective Provisions
Conversion value can be diluted or destroyed by issuer (dilute; when issuer increases # of common outstanding w/out proportional increase to value causing market value to tank … destroy; when issuer/common or both no longer exist via merger, dissolution, liquidation). These dilutive or destructive actions are so easy to instigate that almost all convertible bond K’s have provisions protecting against them

Additional Issues of Interpretation
1)   many cases are concerned w/ whether a particular issuer action is w/in particular contingency provision provided for in the K
2)   Other cases raise q of whether agreement is to be read to preserve option holder proportionate interest by altering price or rate of conversion to reflect alterations of corp structure (stock splits, distributions) or should they be read to force convertible holders into either using their option (provided notice of capital structure alteration) or suffer the dilution
Issue of Additional Common Stock
How should convertible bond K deal w/ issue of common stock for lower price than conversion price?
K provide for downward adjustment of conversion price only in response to below market offerings of new stock to existing holders… theory is based on notion that K should
1)  protect current market level of conversion value and conversion premium
2)  operate only when stockholders receive benefit at bondholder expense (impossible if offering is made at market - no effect on convertible holders value)

HB Korenvaes Investments, L.P. v. Marriott Corporation (563)
-Look at protection provisions
B.  Duties Implied in Law (579)Van Gemert v. Boeing Co. (579)
Broad v. Rockwell International Corp. (584)
Note: Fair and Unfair Dividends (592)
Is there any difference between cases involving mergers and large cash dividends?
Harff v Kerkorian (Del Supr 75) where after a dividend to common; holder of convertible which lacked anti dilution protection respecting dividends brought
1)  class action alleging dividend was declared for personal gain of D and impaired debenture conversion value
Court allowed the suit to proceed based on allegation of fraud
Argument is that dividend was wrongly declared for personal benefit (a tort) and tort claims are unrelated and unaffected by any contract rights or provisions

Pitt Terminal v B&O Rail (3rd Cir 1982) No notice was given to holders of convertible nor was notice required
Court stated controlling SH owes fiduciary obligation not to exercise control at disadvantage of minority … scope of obligation depends on nature of interest of beneficiary … if beneficiary needs info the w/holding of info is a breach.

Also; that under NY law “implied covenant that neither party shall do anything which will have effect of destroying/injuring right of other to receive fruits of k”
Dissent took same position as Broad … good faith cant give right that contrasts the indenture … notice would be such a given right … yrs later 3rd agrees w/ dissent


Note: Fair and Unfair Mergers (594)
Prevailing View
Declined to intervene against merger by use of fiduciary or good faith arguments …Simon brings Delaware in line w/ that approach stating
To introduce “fiduciary duty” into highly negotiated and high documented commercial relationship of issuer and holder would risk greater uncertainty than can be justified by any small gains in fairness

B.  Convertible Securities and Warrants (supp. 167)
A.  Protective Contract Provisions (supp. 167)
LC Capital Master Fund, Ltd. v. James (171)
Note: Appraisal Rights (supp. 184)

Class 12:  Venture Capital Finance, Bratton pp. 596-617, Supp. pp. 186-99
Venture Capital Investment

Securities and Documentation
Discuss the type of securities usually issued (convertibles) and the various terms and protections involved (want to share in upside; while making sure when company goes public that venture capitalist is paid off and that so is entrepreneur while protecting downside and making sure entrepreneur can't just walk easily)

Control Arrangements
Pg 471 … how arrangements are handled when entrepreneur is so in need of capital that in addition to massive outlay of equity stake he cedes control of BoD … entrepreneur does this w/ assurance that at IPO venture capitalist will cash out but risk exists that IPO may be delayed
        Only small numbers of venture capitalist situations entail BoD control
Exposure to Opportunism

Change of Control
Fait v Hummel (7th 2003) … shows how properly drafted K can allow venture capitalist investors to take over control in event of substandard performance;
“agreement” gave venture capitalists preferred stock; 1st refusal on any newly issued stock and the ability to take 4 of 5 seats in event covenants were broken … covenants were broken and founder-entrepreneur and another dude were forced out . Venture capitalists then issued 4m new shares at $1 then they exercised 1st refusal right so as to acquire these shares and dilute holdings of entrepreneur $ friend
Court held that Fait (the entrepreneur) failed to meet burden of proving offering was not fair

Case for Comparison
Blackmore Partners v Link Enegery limits Orban duty; if BoD take action directed against class of securities the BoD should be required to justify actions … is limited to circumstances where BoD uses corp power against own shareholders in order to achieve some higher end;
In Link … BoD did not act “solely or primarily for express purpose of depriving SH of effective enjoyment of right conferred by law”
Even if Orban applied … BoD met standard; Link was insolvent and no better deal could be made

Equity Linked Investors, L.P. v. Adams (596)
C. Venture Capital Finance (supp. 186)
ThoughtWorks, Inc. v. SV Investment Partners, LLC (supp. 187)
In re Trados Incorporated Shareholder Litigation (supp. 191)
Capital Structure and Leverage, Bratton pp. 214-40
Intro
Debated issue in financial theory is whether value of firm can be enhanced through different capital structures … debate addressed three distinct but related areas
1)   debt policy: should capital structure make use of leverage (debt)
2)   dividend policy: impact on market price
3)   equity ownership: does widely dispersed common depress firm value.

Capital Structure and Leverage
Traditional View; bonds and other senior securities when kept w/in appropriate limits increase total value of firm beyond some point you get diminishing returns and even negative impact on firm value

Modigliani – Miller View; firms is independent of capital structure and is determined solely by capitalizing expected operating income at discount rate appropriate to business risk

A.  The Cost of Capital and the Value of the Firm (215)
1.  M-M Thesis and Its Assumptions (220)

Theory is famous for two propositions
1)  market value of firm debt and equity add up to total value of firm
2)  Cost of equity increases w/ Debt/Equity … rate of increase in cost of equity depends on spread between cost of capital and cost of debt
Argument is that attempt to swap cheap debt in for expensive equity fails to lower cost of capital b/c remaining equity becomes more expensive (enough so to keep cost of capital constant)
Van Horne
1)  Traditional Approach
a.   Assumes there is an optimal capital structure and that firm can increase total value of firm through use of leverage (debt) … however as more leverage (debt) occurs investors penalize equity capitalization rate until it offset the effect of “cheaper” debt
2)  M-M
a.   Based on idea that no matter how you divide up capital structure of firm the total investment value depends on underlying profitability and risk and is not affected by changes in capital structure
b.  Based on arbitrage - whatever capital structure might be if firms have same total value then arbitrage can be used and eventually
                                                         
2.  Relaxing M-M’s Assumptions (225) Relaxing M-M
Consensus has developed that M-M does not accurately capture reality and so its conclusion is incorrect, but in being incorrect its assumptions form the foundation of modern corporate finance
B/C if capital structure can affect value of firm it must work through one of 4 M&M assumptions so that only ways capital structure can increase value are by
1)  lowering taxes
2)  provide access to cheaper borrowing
3)  releasing valuable info
4)  improving cash flow
Called; Reverse M&M
Taxes
Interest payments are deductible as an expense … so that total amount of payment available to debt holders and stockholders as a group is larger is debt if used

Bankruptcy Costs
More highly leveraged the firm the greater the bankruptcy risk … creating significant bankruptcy costs; (1) direct costs … out of pocket; legal fees); (2) indirect costs … operating inefficiencies; (3) liquidation cost … selling assets at beneath cost

So that a leveraged firm’s value declines by the present value of these bankruptcy costs and then w/ higher leverage the larger these costs get and the less of a positive impact any tax benefit may have. Eventually may be so levered that all of tax benefit is swallowed


Agency Costs
Agency cost of debt rise as leverage increases and eventually it can outweigh the tax benefit of debt , in addition to bankruptcy costs (above) their also
1)  Asset Substitution: equity holders based on high level of indebtedness will want firm to switch to investments w/ higher upside (higher risk) those equity holders can increase value of their position at expense of debt (like equity cushion stuff)
2)  Underinvestment: equity holders who may be the ones deciding on what investments firm will make may decide to pass on certain kinds of profitable ventures … may only want to invest in projects whose net present value is larger than the face value of debt (any project that isn’t only benefits creditors)
3)  K and Monitoring Costs - lenders invariably pass on the costs associated both w/ contracting debt and monitoring debt back to the borrower via higher %

Market Imperfections
1)  Corporate v “Investor” Leverage - M&M assumes that if it’s the corporate in debt or the investor who goes in debt to arbitrage it’s the same thing … in real world not true b/c investor is more likely 2 be risk averse (their liability is larger so their naturally more averse)
2)  Signaling - M&M assumes perfect info - real world has info asymmetry where investor is at disadvantage to issuer; this allows issuers to send messages about firm via their capital structure (debt = good news no fear of meeting any debt obligation … new common = bad news need $ but worried about being able 2 pay note)

Governance Benefits – Leverage and Management Discipline
Essentially … management w/ low leverage have a lot of discretion and a desire to maintain low leverage capital structure might mean profitable but costly projects are turned down … whereas high leverage management requires that to keep up debt payments and keep your job you run tight, efficient organization



Class 13 Dividends
Dividends and Dividend Policy: Bratton pp. 619-39
Equity Capital Structure-Payout Policy and Ownership Stakes (619)
A. Payout Policy-Dividends, Repurchases, and Retained Earnings (620)
1.  Dividend Capitalization Model (621)
Dividend Capitalization Model
What do investors really capitalize when they buy shares; dividends or earnings?
Lewellen says we buy firm’s dividends not earnings b/c individual investor cannot spend a firm’s retained earnings can only spend what they receive (cash dividend). Retained earnings are relevant only to extend they generate higher future dividends
Consider the cash income expectations of investor who purchases a share of stock w/ intention of holding for X years and then selling it … in return for cash outlay he expects series of annual dividends and ultimately a sale of share at an increased price.
The decision to acquire share is then question of does present value of these dividend payments and eventual sale price equal or surpass my current purchase price …
In truth though the future sale price is what value “buyer” places on dividends he will receive plus what he will eventually resale for … and so on and so on so that PV is really just a string of discounted future dividends

Dividend Capitalization Model assumes present value of share of stock I equal to value of all future dividend payments capitalized as rate reflected market view of risk associated w/ firm’s income stream
How to calculate for PV while taking into account retained earnings is explained on pg 547 … w/ formula in box

2.  The Retention Ratio (623)
Question of how much of annual earnings should firm retain? Is their a rate at which retention maximizes shareholder wealth?
Retention is justified if proposed investment offers a yield in excess of dividend capitalization rate (if not then hurts shareholder to retain; if = then no impact on shareholder retention or distribution is same)


B.  The Role of Dividend Policy (624)
Traditional view; investors prefer stable patter of dividends and dividend increase can cause firm value to increase …M&M; dividend policy has no affect on firm value (same justification as in capital structure) …Reverse M&M; low dividends maximize firm value

Traditional Dividend Practice
Lintner; (1956) belief on part of management that stockholders prefer a reasonably steady rate and that market puts premium on stability was strong enough that most management seeks to avoid making changes in dividend policy that might be reversed later. Results in policy of changing dividends only in small step w/ any increase in earnings and create a cushion to allow steady dividend in event that earnings decline.

Management believed that unless other reasons to contrary their fiduciary responsibility require them to distribute a part of earnings increases to stockholders as dividend and in same token stockholders can understand a reduction in dividend in event of substantial or continued earnings decline … and that good management would always plan ahead to avoid being placed in financial position where dividends have to be cut.

This is done by being more liberal w/ liquidity policy than w/ dividend policy … so that investments are judged based on funds available after dividends. Thus any project that couldn’t be invested in was then analyzed in terms of success using outside capital (will present value of investment cash flows equal or surpass present value of debt costs)

M-M Dividend Policy (630)
Asserts dividend payout ratio is irrelevant in valuation process … value depends on earning power of assets and is unaffected by how firm chooses to finance activities (retain earnings or pay dividend and issue new securities 2 raise capital).
Argument is that net wealth is same under either financing procedure and dividends should simply be means of disposing residual cash (funds left over after all financing needs re met)
Illustrates how it would have same net worth regardless of how investment is financed (pg 555)
If total wealth is same than SH is indifferent to dividend policy … (discussed regardless of investor preference and regardless of what action firm takes … SH can do was he pleases pg 556 top)

Taxes, Imperfections and Low Payout Hypothesis
M&M theory depends on strong assumptions;
1)  perfect market w/ no transaction costs, doesn’t apply in real world b/c transaction costs to external finance …
2)  also notion that shareholder can create own dividend by selling share or using margin account, doesn’t take into account brokerage fees
3)  assumption that investors have perfect info and act rationally, debunked by whole bird in hand notion that investor would rather have the $ now even if the rate of return for an internal investment exceeds the dividend capitalization rate
4)  No Taxes assumption - big one,  in real world tax code has effect on financing patterns so that retention beats external debt which beats new equity.

Myers; Capital Structure
Whole thing about announcement of stock issue having immediate drive down effect on stock prices where announcing debt has smaller downward impact so that if debt is an open alternative then any attempt to sell shares reveals internal belief of management that shares are not a good buy (their overvalued they won't issue new shares at undervalued price and hurt existing shareholders). Thus equity issue occurs only where debt has become extremely costly …Leads to pecking order theory
1)  prefer internal to external financing
2)  dividends are “sticky” (remain same) so that changes in net cash are reflected more in changes to external financing
3)  if external funds are required firm will use safest security first (debt b4 equity) and if cash flows exceed investment then surplus used 2 pay down debt not equity. If external finance is still needed then work way down list debt, convertible debt, preferred, finally equity
Also explains why more profitable firms borrow less … they have more internal financing options available
Note; Signaling Effect of Dividends
Dividends said to have signaling effect … increase in dividends signals management’s favorable expectations about future profitability … decrease signals unfavorable expectations

Note; New Issues and IPOs
Study showing that issued equity only occurs at overvalued prices (pg 562)

Management Dividend Policies and Agency Theory
Pecking order theory rests on assumption that managers design capital structures in order to maximize value for existing shareholders … whereas agency theory looks at management as maximizing of own welfare and says corporate governance is required to minimize the costs associated

Legal Standards: Bratton pp. 639-56

Legal Standards
M&M and Pecking Order Theory assume firm in which interest of stockholder are perfectly aligned w/ interest of management if agency theory assertion that management fends for self not shareholder the assumptions are debunked.
If interests are mutual then disputes reflect differences over business judgment and the business judgment rule should allow for management discretion

From legal standpoint; dividend policy is almost always w/in discretion of management … nevertheless law is not w/out some impact on dividend policy when such policy is suspected of manipulative or illicit goals

Berwald v. Mission Development Company (641)
Wertheim Schroder & Co. Incorporated v. Avon Products, Inc. (645)
Note: Special Dividends (651)

Note: Dividends and Conflicts of Interest (653)
Scope of Problem
As suggested in Mission case a controlling SH who has power to modify dividend policy may prefer a dividend policy that reduces share price but saves them tax or allows them to buy minority SH at reduced price

Different issue arises when ownership and control are separate … here agency suggests that management incentive to “live quiet” and lower risk level can lead to dividend and investment choices that are suboptimal for shareholders

Stock Dividends: Bratton pp. 656-68
Lewellen, The Cost of Capital (656)
Lewellen, Cost of Capital (1969)
Is it possible for firm to increase total market value simply by changing number of shares outstanding? It should make no difference; why then do firms split stock or offer stock dividends … and why does after a split the combined value surpass the previous value
1)   lower price opens up investor pool … people are odd wont buy 50 shares @ $60 but will be 100 @ $ 30
2)   splits have positive effect on investor expectations … viewed as firm telling investors were splitting to bring value down to reasonable level b/c good news is coming

Note; Stock Dividends as Info and the Regulation of Disclosure
Stock dividends are often intended to express the distributing corp optimistic outlook … “business is good and getting better, but were holding on to our cash to expand in lieu take stock.
Suppose opposite … suppose everything was bad but you decide to issue stock dividend to communicate optimism and increase investor interest … how does NYSE regulate such conduct
Spin Offs
Spin off entails a parent corp divesture of a sub through declaration of dividend of sub common to parent shareholders Explanations of spin offs focus on two points
1)  Management incentive - before CEO was judged on size of firm now judged on performance of stock - spin off of a lagging department is great way 2 increase stock price
2)  Tax effects - under the IRS Code a spin off can tax free to both corp and shareholders if it meets certain standards (spin is for valid business purpose and included 80% of common of sub owned for at least 5 years) many firms get IRS notification of tax-free status before proceeding w/ spin-off
Spin offs also can have problems in that if spin is considered weak stock price will dive

Class 14 Repurchase of Outstanding Shares
Economics: Bratton pp. 668-75
A.  The Economics of Share Repurchases-Repurchase Transactions (668)
Repurchase Transactions
Dividends are not only way to distribute excess cash to SH … corp can repurchase won shares at which point they can keep them in “treasury” where they may be reissued or “retire”. Three types of transactions pursuant to which shares may be repurchased
1)  Open Market Repurchase …corp announces intent to repurchase shares in open market by stating

a.   Time period it will be buyer; rough estimate of shares that it expects to repurchase; qualifying repurchase by stating number of shares actually repurchased will depend on market conditions

2)  Repurchase Tender Offer - corp makes public offer to shareholders to repurchase a set number of shares at a premium over market; then shareholders decide to tender or not (short period §13(e) of 34 at least 20 days)
a.   Today most such tender offers use “Dutch Auctions” (pg 589)
3)  Directly Negotiated Repurchase - corp negotiates in private to repurchase all or part of shares held by a shareholder w/ a large block at a price that is at a premium over market.
a.    “Greenmail” when seller of block has acquired shares in open market in attempt to threaten takeover ... corp will directly negotiate to diffuse threat
Theoretical Irrelevance Between Dividends and Repurchases
Assuming perfect markets and no taxation; it makes no difference to value of firm to shareholders where firm chooses to distribute a dividend or distribute funds via share repurchase … complex series of calculations on pg 590/591 used to illustrate point that
Give the assumption shareholders are in exact same present value situation whether or not firm is making a dividend or a repurchase and whether shareholder tendered or not
Tax and Other Imperfections
As we relaxed the assumptions … situations arise in which repurchase can have an effect on total value …
Example; privately negotiated repurchase w/ premium going to insider shareholder transfers wealth from nonselling shareholders to selling shareholder
Also tax differential looms large… a dividend would be taxed as ordinary income (rate as high at 39%) where repurchase would be taxed as capital gains (no higher than 20%) … so look at difference in value being transferred to IRS as opposed to shareholders
Flexibility – Repurchases v Dividends
B/C of management pattern of keeping dividends smooth they tend to represent a permanent commitment made from what management deems as permanent and reliable cash flows … conversely repurchases are used to give shareholders chunk of positive cash flow which management views as temporary and thus creates no future expectation (u might expect the same dividend yr in and yr out … but you don’t expect repurchase)

Management Motivations
Something more in this for management that simply satisfaction of transferring wealth to investors w/ a tax advantage to explain increase in repurchases need to look at three additional aspects of such transactions
1)   Stock Price Undervaluation - to repurchase is to invest in own corp stock and give indication that management believes stock is undervalued.
a.    Note that announcing doesn’t mean you actually have to repurchase so announcing an open market repurchase doesn’t have the signal strength of say a repurchase tender offer (clear commitment)
2)   Leverage Ratio Adjustment repurchase reduced firms equity capitalization and increases the debt/equity ratio in essence taking wealth from creditors and transferring to equity holders
3)   Stock Price Dilution and Management Stock Options stock compensation for management is supposed to align its interests w/ those of shareholders … but repurchase also adds a dark element
a.    A dividend reduces value of option b/c option holder doesn’t participate; a repurchase however keeps stock price relative (if not slight bump) and protect the option holder (management). Further now that firm has repurchased there is enough stock in treasury were one could exercise option and not fear any dilution of share price (ur nor exercising and having new shares created you exercise and take existing shares from treasury)

Regulation: Bratton pp. 675-97, Supp. pp. 200-202
Repurchases-Fiduciary and Disclosure Obligations (675)
Scope of Problem
Repurchase is an economic distribution of assets to stockholders … so that restrictions comparable to those that apply to dividends apply to repurchase (contractual and statutory)

Legal questions raised by repurchases by large firms stem from fact that unlike dividends they do not put income into hands of all stockholders and create potential for unequal treatment and concealment of info. Issues of fairness, process and disclosure arise and the severity depends on type of transaction (private negotiation, repurchase tender, open market)
1)   private negotiation carry high risk of abuse by virtue of overpayment and the “side deal”… is this someone who is bailing out of hostile attempt and BoD is willing to pay them premium to preserve their own control
2)   repurchase tender carry smaller risk b/c they are more transparent and open to all SH … however following article claims that firms choose repurchase tender offers over open market (cheaper to implement) b/c of fact management own shares

Fried; Insider Trading and Repurchase Tender Offers (2000)
RTO is equivalent to tendering SH selling shares to remaining SH at the repurchase price. So that by setting a repurchase price below actual stock value and not tendering insider can participate in transfer of wealth from tendering SH to non tendering SH. Conversely, by setting repurchase price above actual value and tendering, insider participates in transfer of wealth from non tendering SH to tendering SH.
Explained in greater detail pg 597-598 … including how “Dutch Auctions” work to further increase the ability of insider to grab wealth based on info he has that public does not

Note; Comparing Open Market Repurchase
Lower risk of abuse as the risk of overpaying/underpaying is decreased by use of market to set price also practice of making an OMR announcement lets sellers know that by purchasing on market firm is implying belief that stock is undervalued. Also, on flip can argue firm may be nuts and overpaying but if that’s the case and shareholder isn’t happy he can take advantage and sell in the inflated market
        OMR do create substantive problems

Kahn v. United States Sugar Corporation (677) - Fiduciary Duties
Note: Regulation of Repurchases (683)
Coercion
Any tender offer at premium over market price entails an application of pressure on … but what makes one RTO “coercive” as in Kahn and another “uncoercive”
Cottle v Standard Brands (Del Ch 1990) … claim for coercion must state that P “was wrongfully induced by some act of D to sell shares for reasons unrelated to economic merits” (examples pg 606-607) also Cottle found no coercion b/c P  (unlike in Kahn) failed to make adequate allegation that offering price was unfair

Investment Companies
Repurchases by closed-end investment companies present a sufficient opportunity for abuse that §23(c) of 1940 act prohibits such repurchases expect by public tender or on the open market (w/ advance disclosure)

Note: Greenmail and Defensive Repurchases (684)
Defining the Problem
Fiduciary problem respecting high price repurchase where management spends to purchase stock and preserve control by buying off a “raider” … question goes beyond over or under payment but goes to whether stockholders are denied benefit of raider; whether loss (in form of premium transferred to raider) is worth gain of preventing raider from taking control … whether surviving stockholders are worse off than they would have been if they could have sold their shares to “raider” via “raider tender”

Courts have permitted decision to turn on whether management reasonably believed raider would have caused more damage to corp than cost of repurchase; even w/ burden on management to justify purchase it is easily met if court defers to director business judgment

Unocal Review v Business Judgment
Kahn v Roberts (Del 1996) concerned privately negotiated repurchase of voting stock where P claimed repurchase was a defense act and therefore breach of fiduciary duty; Court rejected claim;
Unocal standard applies if directors initiated repurchase in response to threat relating to control. Here circumstances do not indicate such a threat … where no threat actions of BoD are judged under business judgment rule. Rule is satisfied b/c repurchase was approved after BoD established independent committee consulted w/ experts and considered its options over course of several meetings

3.  Federal Securities Laws-Repurchase Tender Offers (686)
Repurchases during 3rdParty Tender Offers
Rule 13e-1 applies to issuers whose shares currently are subject to 3rd party tender … issuer is prohibited from market repurchases unless it files / SEC an info disclosing terms of transactions, purpose and source of funds

Disclosure of Projections and Soft Info
Plaintiff sells under tender offer and then when earnings grow 30% and stock price rockets sued under Rule 13e-4 claiming issuer failed to disclose internal projections regarding earnings … does rule require such disclosure?
Coyne v MSL … known facts and plans had to disclosed but not projections; insiders need not give investors benefit of expert financial analysis, educated guesses or predictions
Walker v Action … Rule 13e-4 does not require disclosure of projections


4.  Laws-Open Market Repurchases (689)
Manipulation – 34 Act §9(a)(2)
Pg 613-615 (huh)
Stabilization – 34 Act §9(a)(6)
SEC took position that section empowered it to regulate OMR’s, it never adopted the amendment though

Safe Harbor for Potentially Manipulative Repurchases under Rule 10b-18
SEC decided that safe harbor is best way to regulate repurchase programs so that if issuer effect repurchases in compliance w/ conditions of rule it will avoid risks of liability under general anti-manipulation provisions of federal securities law
Note; Safe Harbor is not exclusive means to effect repurchase; repurchase not w/in Safe Harbor does not create presumption of §9(a)(2) or Rule 10b-5 violation
Coverage and other general stuff about rule (pg 617-618)

5.  Dividends, Repurchases and Corporate Governance (694)
Safe Harbor for Potentially Manipulative Repurchases (supp. 200)
Class 15 Mergers and Acquisitions
Introduction: Bratton pp. 765-78
Intro
Decision rests upon expectation that future returns (discounted to present value) will exceed amount invested … where the projection of expected returns and the calculation of appropriate discount rate each has its difficulties.
        Decision also entails financial, tax and legal factors/elements

From point of view of acquiring corp the question is whether the consideration flowing from acquiring firm is greater than sum of
1)   acquired corp’s value (apart from merger)
2)   value added to resulting corporation as a result of merger
From point of view of acquired corp inquiry concerns whether enough is being received for value given and whether synergistic gains are being appropriately divided among the parties

A.  The Move to Merge (767)
Kraakman; Taking Discounting Seriously
Discussed: why do ppl enter mergers and what are the justifications
Belief that you know something that market doesn’t; or can accomplish something that the existing target company management has not or cannot take advantage of.
Some look at acquisitions as a question of survival acquire or die

Overview or Acquisition Gains
Three possibilities can explain why acquiring corps pay such large premiums for the assets of target firms
1)   “Traditional Gains”; acquirers identify more valuable uses for target’s assets
2)   “Discount”; share prices undervalues target corps assets
3)   “Overbidding” acquirer is overpaying

Traditional Gains Hypothesis
Works due to the use of tactics such as redeployment or better management of assets, reorganization of assets to take advantage of synergies, maybe slashing operating costs; ultimately it serves to create gains for the participating parties and create a social gain

Also keep in mind “private info” theory that assumes gains are a result of market being uninformed about real value of target corps assets … and a “tax savings hypothesis” where value created by transferring valuable operating loss carryovers or increasing interest deductions by borrowing against target corps assets creates incentive for the payment of an acquisition premium

Discount Hypothesis
Assumes that acquisition premium reflects existing value of target assets, (value that may be higher than the pre-bid market value) … two explanations can be used to explain why value is discounted … either “misinvestment hypothesis” or “market hypothesis”
Misinvestment hypothesis works by locating discrepancies between share price and asset value due to lack of faith in current management's investment decisions

Market Hypothesis is view that share prices discount asset value to do the assumption that share prices are best guesses … theory asserts that discounts arise b/c share prices are poor estimates of the expected value of corporate assets.
There are objections to the identification of share price w/ asset value … the most prominent one challenges the price setting role of informed traders and claims “mispricing” occurs as a result of biases, “noise” or speculative trading

Case for Discounts
Market Discounts must satisfy three conditions to be meaningful
1)   must be able to form a reliable asset (break-up) value for the firm “as is”
2)   share price must be significantly below the asset value
3)   acquirers must believe that appraisals serve as useful estimates of what target assets will be worth to acquirer or to bidders if spun-off.
Discussed how and why discounting theory provides an attractive explanation for the sheer size of acquisition premiums and the prominence of break-up acquisitions

Discounts as an Acquisition Motive
Most significant way in which discounts can prompt takeovers is in combination w/ other sources of acquisition gains …
Such that small gains from operating changes or private info can push a modest discount into an attractive target (provided ancillary benefit is uniquely available to acquirer)

Merger Waves (771)
Andrade, Mitchell … New Evidence/Perspectives on Mergers
Discussed … aspect of how M&A comes in waves … that in some way the buyer is purchasing the target (chart of 685) … (think about corp classes like Unical and Revlon and how they coincide w/ wave) …

Went into aspect of industry shocks  (technology)
Discussed growth in use of stock as a form of acquisition currency
Believes that
1)   merger occur in waves
2)   mergers cluster by industry
Suggests that mergers occur as a reaction to unexpected shock to an industries structure
Industry shocks include technological innovation. Supply shifts, and deregulation … looking at deregulation it believes this shock is a major player in merger waves



Note; Mergers and Value Creation
Merger Waves of 80’s and 90’s
Discussed the changed in the how and why of mergers between the 1980’s (cash buy-outs where their was “restructuring) and the 1990’s (stock swap mega mergers to attain growth via economies of scale) (pg 688)

Do Mergers Create, Destroy or Merely Transfer Value?
Discussed the empirical Data discussing if it makes sense to merge
Various studies discussing if use of cash or of stock to finance a merger is better … results based on short-term and long term periods … (page 691)


3. Management Motivations (775)
Management Motivations (discussed)
1)   Hubris; big onions small brain
2)   Bounded Rationality; belief that pressure to imitate the competition, then press feeds momentum by use of hyperbolic terms leading to a wave of momentum that carries along financial professionals and investors for the ride
3)   Self-Interest; managers more likely to overbid where they detect the potential for personal gain

Regulatory Implications
If merger transactions should be regulated; who should do the regulating (courts or SH)?
In a L.J article Fanto suggest that system of mandatory disclosure be adjusted to address the cognitive limitations of corp decision makers … require enumeration of reasons for and against and have investment bankers that provide opinions take into account negative consequences

Accounting: Bratton pp. 778-86
1.  Purchase, Pooling, and Accounting for Goodwill (778)
Taxes: Bratton pp. 786-90
Accounting
Used to be interesting … w/ the whole difference between purchase and pooling methods … don’t really worry about it anymore …
When you buy you usually pay a premium either visa $$ or via shares … accounting asks how we allocate that purchase price (why did I pay that price) … (looking at the depreciating value of the assets acquired or the expensing of goodwill) …so then you had the mentality of attempting to acquire the company w/out taking on the expenses (liabilities). So “pooling” by recognizing the assests but not the expenses … (makes sure that your earnings report looks a lot better … not a tax thing; a earnings report thing) … only worked in US and only w/ stock for stock mergers …
Now you must use purchase accounting … must step up and account for the goodwill and depreciation w/ the exception that you don’t have to amortize the goodwill if you can show that the value hasn’t been loss
Have to understand how the accounting of a transaction can have a major impact on earnings per share …

TAX
Acquisitions can be tax driven …
        Does corp want immediate tax benefits or do they want to delay any such impact

Merger Agreement: Bratton pp. 791-805, Supp. pp. 221-47
Discussed the element of the agreement and the aspect of wanting a return in the event that you are not what you represented yourself has  (you negotiate a time period w/in which you can evaluate the business)
Discussed and Looked at pg A-105 (what you draft when you are acquiring via use of stock) …Looked at §2 of the Appendix agreement

Seller making obligation to Buyer that they don’t sell the shares is to avoid the SEC coming after them for an unregistered distribution … (you can make an unregistered private placement but if that person turns around and sell them the SEC still goes after the initial transactor)

Volk; Negotiating Business Combination Agreement (Seller’s POV)
Seller is most concerned about provisions of merger agreement that could allow purchaser to walk based on events/circumstances beyond seller's control … Buyer wants to make sure that business it acquires is one it expected. Provisions below are among most heavily negotiated

Material Adverse Change
Parties sign merger agreement months (or maybe even longer) before closing of transaction so risk exists that during this period seller will lose some value … Purchaser seeks to condition obligation on absence of a “MAC” whereas seller would like to force purchase to accept all risk of such a change

Due Diligence Issues
Seller should resist provisions that permit acquirer to forgo closing based on results of due diligence or investigation after signing of merger agreement … do give buyer that power creates an option to buy more than an agreement to buy; buyer can then use that as leverage to change deal at last minute or worse walk away and leave smell of “damages goods”
Seller would want agreement to state buyer had opportunity to perform due diligence investigation prior to merger agreement and is satisfied

Antitrust Issues
Pg 708 … small blurb … basically seller wants a buyer commitment to go through w/ merger even in event that DOJ or FTC wants deal restructured; buyer wants to avoid any such commitment as to avoid having balls cut off in negotiations w/ DOJ or FTC

C.  The Seller’s Point of View (791) Material Adverse Change

-Seller will be most concerned about provisions of the merger agreement that could allow the purchaser not to close the transaction based on events or circumstances that are not within the seller’s control.

-Purchaser will want to make sure that the business it acquirers is the one it expected.
IBP, Inc. v. Tyson Foods, Inc. (793) MAC

-Overoptimistic buyer.

Hexion Specialty Chemicals, Inc. v. Huntsman Corp. (supp. 221)
Formal Aspects: Bratton pp. 806-12
1.  The Mechanics of the Process (806)
Mechanics
Mechanical process for completing mergers under state corporate codes … statutes allow for combinations through use of any of three techniques
1)   merger
2)   purchase and sale of assets
3)   purchase of shares
Statutes also allow for different types of consideration to be paid to shareholders … note that rights and duties can differ depending on mode of combination and the type of consideration paid

Classic Mergers
Stock for Stock
Acquirer (A) combines w/ Target (T) where T disappears and the consideration paid to T holders is A common (1-1);
Under DCL §251(c) BoD of each A and T must submit merger for shareholder approval … under §262 no appraisal right to shareholder who dissent if their shares are listed on a national exchange or Nasdaq
RMBCA; slight difference page 721

Small Scale Merger
A acquires a close corp (CC) whose shares are not publicly traded; w/ consideration to CC holders is “A” common (1-1);
Treatment of A SH; under §251(f) gets no vote unless common shares of A issued and outstanding increases by 20% … and if no vote; under §262(b)(1) no appraisal

Treatment of CC SH; most vote to approve under §251(c) and under §262 they receive appraisal rights

Classis Merger w/ Cash Consideration
A shareholders lose vote and appraisal rights b/c under §251(f) acquiring firm SH get vote only when merger either
1)   increases common stock by more than 20%
2)   effects a charter amendment
3)   affects status/rights of shares immediately outstanding b4 merger
T shareholder continues to have a vote under §251(c) and b/c consideration is cash they have appraisal rights

Parent w/ Subsidiary Merger
§253 (short form merger) where parent owns more than 90% of each class of subsidiary outstanding shares it can merge by BoD resolution; under §253(d) minority SH have always have appraisal rights (even if minority shares are sold on public exchange)

Sale of Assets; Alternative to Classic Merger
Instead of stock for stock … have a “sale of assets and assumption of liabilities”.
A and T enter “asset purchase agreement” where T agrees to sell all of its assets to A for A common ... (if that was all T would emerge as an investment company holding massive block of A common) …to avoid T being a massive stockholder of A; A will require T dissolve and distribute the A common to T shareholders w/ A taking all of T’s liabilities
A holders get no vote under DCL… b/c the purchase of assets is really an investment and under §141(a) investment decisions are allocated to the BoD

T holder is required under §271(a) b/c “all or substantially all” assets are being sold … but have no appraisal rights as §262 covers “mergers” only (if consideration were in cash then T holder always get appraisal)
Model Act treatment differs (pg 723 and 724)

Share Purchase and Share Exchange
Approaches stock-4-stock acquisition differently w/ a direct appeal to T shareholders to exchange shares of T for shares of A; if successful T becomes a subsidiary of A (maybe then short form merger) reducing costs and limiting A’s liability so far as T
        Delaware; voluntary stock-4-stock requires no formal shareholder approval

Triangular Mergers
Merger consideration via use of shares/securities of any corp; thus you get 3 party mergers in which A sets up a shell subsidiary and places A shares (along w/ any other consideration to be used) in the subsidiary in exchange for all of subsidiary shares. Target then merges w/ shell. Can be in two forms
1)  Forward; T shareholders receive parent shares (or other consideration) held by sub and then sub changes name to T
2)  Reverse; (tax considerations require T stay in continuous existence) sub merges into T … share thing kinda complex (pg726)

D. Triangular Mergers (810)
Class 16 Mergers (cont'd)
Appraisal: Bratton pp. 826-30
Governed by §262 of DCL: also article on pg 741-745 discussing history of appraisal and how it has moved from a took giving shareholders liquidity (get out when disagree w/ majority decision) to use as a remedy against opportunistic behavior by majority

Exit, Liquidity, and Majority Rule (826)
Freeze-outs: Bratton pp. 832-33, 843-49, 898-905
1.  Freeze-Outs and Buyouts: Fair Dealing, Fair Price, and The Appraisal Remedy (832)
2.  Fiduciary Duties (843)
Coggins v. New England Patriots Football Club, Inc. (844)
Appraisal Exclusivity (898)
-Exceptions: outright fraud or deception, unlawfulness or illegality.Cede & Co. v. Technicolor, Inc. (902)
Buy-outs: Bratton pp. 905-19
B. Management Buyouts (905)
In re Topps Co. Shareholders Liquidation (907)

Class 17 Mergers: Fiduciary Standards: Bratton pp. 865-98, Supp. pp. 247-50
Note: Clarifying Weinberger (865)
Note: Kahn v. Lynch Communication Systems (869)
In Re Siliconix Incorporated Shareholders Litigation (873)
Glassman v. Unocal Exploration Corp. (881)
In re Pure Resources, Inc., Shareholders Litigation (884)
Subramanian, Freezing Freezeouts (892)
Berger v. Pubco Corporation (supp. 247) Fairness and Disclosure
Fairness: Duty of Care, Bratton pp. 919-33, Supp. pp. 251-52
2.  The Duty of Care (919)
Cede & Co. v. Technicolor, Inc. (920)
Note: Duty of Care and Merger Negotiations (931)
McFadden v. Sidhu (supp. 251) Duty of care and asset sales.

Class 18 Tender Offers
Background: Bratton pp. 977-91
F.  The Tender Offer (977)
A.  The Proponents View (979)
B.  The Opponent’s View (983)
C.  The Intermediate View (989)
Tactics: Bratton pp. 991-98
2.  Bidder Tactics, Policy Alternatives, and the Williams Act (991)
A.  Bidder Incentives (991)
Williams Act: Bratton pp. 998-1024
C.  The Williams Act (998)
Flynn v. Bass Bros. Enterprises, Inc. (1000)
Note: Bidder Disclosure (1004)
Note: Target Disclosure (1006)
Gerber v. Computer Associates International, Inc. (1011)
Class 19 Tender Offers (cont’d)
Defenses and Jurisprudence, pp. 1024-44, 1052-58, 1098-1124, Supp. 252-55, 257-73