Corporate Finance Summary

PART I. INTRODUCTION

Leverage- As the equity portion of the capital invested in a enterprise increases (i.e. as the enterprise becomes less leveraged) the percentage return on your investment decreases. Similarily, the risk of failing to make the interest payments on the debt portion of your investment also decrease. - The more the enterprise is leveraged the greater the risk of failing to meet debt obligations but the greater the potential return on the equity investment. p1Too much debt bad, too little debt bad - the key is to have the proper balance.

Cogeco Cable Inc. v. CFCF Inc. (Que C.A)

Note to reader: the 2 Cogeco cases are based on the same set of facts, which are very detailed in the CSBK. I have set them out in a fair amount of detail, since the purpose of studying these cases, according to Barbeau, is to look at how a corporate transaction can develop from beginning to end. See the synopsis if you’re not interested.

Synopsis: Cogeco, a minority s/h of CFCF, who is trying to expand and buy up all of CFCF’s shares, applies for an injunction seeking to prevent the completion of a transaction between CFCF and Videotron. The transaction contemplates the sale of CFCF’s cable assets to Videotron in return for the acquisition of Videotron’s TV broadcasting assets. Cogeco objects on the grounds that the transaction represents a sale of “all or substantially all” the property of CFCF, as per s. 189(3) CBCA , and as such, requires s/h approval. The court orders a s/h vote since this deal represents, both in quantitative and qualitative terms, a fundamental change in the company’s profile.

Facts: 1. Who are the parties? • Cogeco: the plaintiff in both cases, Cogeco is a corporation involved in the cable distribution industry & a competitor of CFCF; Cogeco holds 9.4% (1.2 mil) of the subordinate voting shares (SVS) of CFCF that are traded on the market.• Oppenheimer: a US corporation operating in the finance industry which buys up 10% (1.2 mil) of the SVS of CFCF•Jevlam: A holding company owned by the Pouliot family which owns the majority of the shares of CFCF, including 100% of the multiple voting shares (MVS); in total, Jevlam owns 64% of all of CFCF’s voting shares and as such is the controlling s/h of CFCFBarbeau: These type of shares are commonly used by family owned private companies going public that want to ensure that the family remains in control of the company for a period of time. Also used for the purpose of fulfiling Canadian control requirements.•CFCF: is a CBCA corporation operating in the communications industry, focusing mainly on TV broadcasting & cable distribution; CFCF’s issued capital is comprised of 1.4 mil MVS (10 votes per share) & 255000 SVS (1 vote per share).•Videotron: is an international communications corporation involved in various media activities ; Videotron owns Telemetropole which broadcasts through 6 local TV stations

2. Sequence of events:

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• 1995: CFCF is reviewing its strategic corporate plans and is seeking to reorganize in order to meet the future demands of the communications industry; essentially, CFCF wants to improve its capital structure and create value for its s/h• Fall 1995: 1st request by Cogeco to acquire CFCF through a public bid for its shares @ $16.50 ($10 cash rest in shares of Cogeco) per share on the condition that Jevlam, as controlling s/h of CFCF, promises to accept the offer. • CFCF is more interested in entering into negotiations with Videotron regarding the purchase of Telemetrople, which will render CFCF the leader in the TV broadcasting industry and increase its share value• Oct/1995: CFCF & Videotron sign a confidentiality agreement (agree to treat information in confidence), whereby they will show each other various delicate financial information, perform due diligence on their respective companies. The idea behind the negotiations is that CFCF would acquire Telemetropole, and Videotron would purchase CF cable•Nov/1995: in order to conform to their disclosure obligations, CFCF and Videotron publicly announce that they are engaged in negotiations. Cogeco’s response is threefold:

1. It announces its opposition to the potential transaction, claiming that it is not in the best interest of the SVS holders of CFCF; 2. Cogeco insists that the size and importance of the transaction mean that it requires s/h approval & 3. Cogeco attempts to start a bidding war by improving its original bid to $18.50 per share with at least $10 in cash (the balance in SV shares of Cogeco).

Barbeau says that this type of cash offer with a share component is common, but difficult to valuate because it involves assigning a value to the shares of the bidding company and anticipating the effect of the completed transaction on the value of the shares - there is some risk involved in this type of offer. In this case Cogeco offering SVS so would have to value them on basis of becoming minority shareholder.•CFCF Board announces that it will not consider Cogeco’s counteroffer during negotiations with Videotron (the reasons are unclear but possibly because of an exclusivity arrangement with Videotron or for purposes of good faith). There is nothing in the confidentiality agreement that would prevent the parties from walking away from the proposed transaction.•Nov 18/1995: CFCF and Videotron sign a memorandum of Agreement, which basically represents a commitment on the part of the parties to bring about the agreement, but in and of itself, does not accomplish the transaction. The agreement contains the following elements:

1. CFCF sells its shares of CF cable to Videotron for $210 mil2. CFCF buys all shares of Telemetropole for $204 mil3. Pouliot family must stay in control of CFCF4. If the transaction must be submitted for s/h approval, the agreement allows for a

postponement of the closing date5. Break-up fees: if the deal does not go through, the party responsible for the breakdown must pay between 1-5% of the value of the transaction to the other party - Barbeau observes that this provides for a significant disincentive for 3rd parties like Cogeco to make counteroffers, because this can represent a huge outflow of assets from the corporation acquired. These fees are also a complicated issue for the CFCF board because if it recommends a competing offer, it is forced to pay the other party a significant amount of $; this $ is essentially compensation for reliance on completion of the deal

•What is NOT included in the agreement is a default clause or a “fiduciary out” allowing for withdrawal from the deal if

1) s/h approval is required and 2) in the event that a large number of dissenting s/h present themselves under s.190 CBCA (all s/h can opt out of the deal and receive FMV for their shares from CFCF) .

Essentially, both CFCF and Videotron assumed that s/h approval would not be required.

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Barbeau says this type of clause is crucial in a deal like this given the potential for a huge # of dissenting s/h, which ultimately could represent a huge liability for CFCF, rendering the transaction impractical and economically unfeasible. WRT out given a certain percentage of dissenting shareholders, they may have been hesitant to do this because Cogeco, with its holdings, could have essentially had a veto (also concern about Oppenheimer. Further, by acknowaging this BofD opening the door to some type of doubt.•Cogeco makes yet another offer of $11.50 cash per share coupled with a share component of Cogeco, on the condition that 90% of both classes of shares are tendered. •At this point, CFCF establishes an independent committee to examine all of the deals and to formulate a recommendation. Ultimately, it advises the s/h to reject the Cogeco offers•Cogeco then petitions the court as a minority shareholder for an injunction to prevent the completion of the transaction with Videotron, claiming that such a deal must be submitted for a s/h approval given that it represents a “sale of all or substantially all” of the property of CFCF under s. 189(3) CBCA. These are the circumstances of the first case.

Issue: Does the transaction between CFCF and Videotron represent a “sale of all or substantially all” of the assets of CFCF, as stipulated in s. 189(3) CBCA, thereby requiring it to be submitted for s/h approval?

Holding: Following an examination of both the quantitative and qualitative elements of CFCF, the C.A concludes that this transaction represents a fundamental change in the company’s profile and as such, requires s/h approval.

Ratio: Following an examination of American and Canadian jurisprudence, the C.A. develops 5 general principles regarding the interpretation of s. 189(3), which apply where it is clear that the sale involved is not an ordinary part of the business’ activities.

1. The interpretation of s.189(3) requires the examination of both quantitative and qualitative elements of the business.

2. This notion of the sale of “all or substantially all” of the assets has acquired a special meaning in corporate law.3. Typically, where the sale entails 75% of the value of the assets, s/h approval will be required.4. If the quantitative analysis is not conclusive, then must also consider the qualitative elements of the business.5. What is crucial is whether the transaction at issue represents a fundamental change in direction of the business which strikes at the heart of the corporation - does the transaction affect the existence and purpose of the corporation?6. It is important not to look at the qualitative elements in isolation, independently of the quantitative analysis; the greater the proportion of the assets that is sold in relation to the remaining assets, the easier it is to conclude that the transaction strikes at the heart of the corporation and necessitates s/h approval.

•Qualitative analysis: What kind of business activity is CFCF engaged in? - CFCF started out as a broadcasting business and expanded into cable distribution in the 1990s, which contributed significantly to the survival of the company- For many years, the emphasis was on the development of 2 parallel sectors: TV and cable distribution, with intentions to expand and upgrade the cable assets- Also, there was no evidence in the annual reports or in press releases of any intention on the company’s part to refocus on the broadcasting industry to the exclusion of cable distribution – this is important because this is the information available to and relied upon by the market•Quantitative analysis: What is the asset being sold worth in relation to the rest of the corporation?

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- The value of the cable assets is very important to the corporation and the cable sector has taken on greater importance in terms of how the company projects itself- The court found that the cable assets generated 78.9 % of the corporation’s revenues in 1995 and in terms of asset allocation, 66.5 % of the assets are cable-oriented- As such, 83% of the value of CFCF is attributable to its cable assets (vs. 16.9% attributable to broadcasting)•Together, these quantitative and qualitative factors indicate the importance of these cable assets to CFCF’s business and as such, selling them off will effect a fundamental change in the profile of the business•Conclusion: this transaction does constitute an extraordinary sale under s.189(3) and as such, a s/h vote is ordered •A secondary issue involves the voting requirements needed to approve the transaction, given the requirements of s.189(3) and those of the articles of incorporation of CFCF •C.A. decides that 2/3 of all s/h must approve the transaction, as per s.189(3), followed by a separate class vote which requires approval by simple majority of the s/h of each class, as per the articles of incorporation

Cogeco Cable Inc. v. CFCF Inc. (Que. S.C)

Synopsis: Cogeco claims that the decision of the CFCF Board to resiliate the original agreement with Videotron and to cancel the court-ordered s/h vote was unfair and oppressive. Cogeco argues that the controlling s/h owe a fiduciary duty to minority s/h in considering the sale of shares. The court disagrees and concludes that there is a mere duty of loyalty between s/h, and here the controlling s/h acted fairly; there is no obligation on majority holders to sacrifice their interest for those of the minority s/h.

Facts: Following the C.A decision, CFCF, Videotron and Cogeco initiate tripartite negotiations in order to reach a resolution that satisfies all parties •During the course of these negotiations, Cogeco improves its offer for the shares of CFCF on many occasions•Feb./1996: these negotiations break down & Videotron places renewed pressure on CFCF by making clear that it expects the original transaction to go through if s/h approval is achieved, even if CFCF is faced with a situation of massive dissent by its s/h (Videotron doesn’t care at this point because sale of assets).•March 1996: it looks as though s/h of CFCF will not approve the transaction; after the C.A decision, many CFCF shares were bought up by “arbitragers”, such as Oppenheimer and Leclerc, who do so in anticipation of being bought out; such s/h will not be in favor of a deal with Videotron whose purpose is longer term benefit to CFCF; ultimately, 600 000 s/h register their dissent to the original transaction with Videotron (Directors are in a tough position because have to call a vote and they know bigtime dissident shareholder - they distribute mail circular but make no opinion of whether shareholder should approve the transaction).•Jevlam and Videotron commence negotiations with the view of generating a long term deal while still giving CFCF s/h the opportunity to be bought out; Cogeco opposes this new alliance, and once again improves on its original offer ($16 + shares)•Board of CFCF recommends that s/h reject Cogeco’s newest offer•April 15/1996: Videotron suggests for the first time that it is prepared to make a public offer for all of CFCF’s shares to become CFCF’s parent, provided Jevlam agrees to a hard lock-up agreement: this is basically an agreement between the bidder and the controlling s/h whereby the latter obligates itself to tender its shares to the bid without any possibility of withdrawing (vs. a soft lock-up agreement,

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according to which the controlling s/h must tender its shares but is permitted to withdraw its shares or receive compensation where a competing bid offers a higher price) •April 19/1996: Jevlam agrees to the hard lock-up, and Videotron bids $21.50 cash per CFCF share; this new offer enables the CFCF board to resiliate the original November agreement with Videotron, which essentially saves CFCF from an important dilemma: CFCF was facing the possibility of having to follow through with the November agreement and having to reimburse the 6000 000 dissenting s/h, without the possibility of considering any alternative offers while this transaction was still in place. As a prospective shareholder Vidoetron wants the cancellation of this agreement.•The CFCF board then agrees to open up its books to all potential buyers, because it has an obligation at this point to consider competing offers•April 21/1996: Videotron launches a public bid for all of CFCF’s shares (MVS & SVS) for $21.50 cash per share, provided that 66% of each class of shares is tendered; as a response, Cogeco improves its bid again, offering $19 cash per share plus .5 SVS of Cogeco (which are trading at $7-9 on the market)•Board of CFCF makes no recommendation to its s/h: it recognizes that Cogeco’s offer may be superior from a strictly financial perspective, but that the Videotron bid is more secure (b/c of hard lock up): since it is an all-cash bid, it is easier to evaluate and represents a minimal future risk•April 29/1996: Cogeco challenges the hard lock-up clause as being unfair and oppressive conduct which compromises the interests of the minority s/h of CFCF, as does the failure of the Board to consider competing bids

Issue: Can the actions of the CFCF Board in resiliating the original agreement with Videotron, canceling the s/h vote, agreeing to a hard lock-up clause, and dismissing competing bids be regarded as unfair and oppressive conduct which compromised the interests of the minority s/h of CFCF? Holding: There is no evidence that the Board’s actions were unfair or oppressive, and the members acted in good faith, in the interest of ALL the s/h of CFCF. The controlling s/h do not have any fiduciary obligations to the minority s/h, but must simply act fairly and reasonably. The controlling s/h are not required to subjugate their interests in the name of those of the minority s/h.

Ratio: The general rule is that the courts will not interfere in the management or the internal conflicts of the corporation, except to remedy abuses•Court looks at the history and purpose of the oppression remedy, whose intent it is to balance the interests of those claiming rights from the corporation versus the ability of management to conduct business in an efficient manner•Court rejects Cogeco’s argument that the controlling s/h owes a fiduciary duty to the minority s/h., except in exceptional circumstances which is not the case here: the minority s/h are not vulnerable simply by virtue of holding subordinate shares (ie. Investment of capital with inferior voting rights) &Cogeco is not in any particular need of protection since it has experience with the particular implications of owning SVS shares•There is no fiduciary obligation on the majority s/h to represent its minority counterparts during the sale of shares, since every s/h has a free right of ownership and the free right to dispose of his shares •At best, the controlling s/h has a duty of loyalty to the minority s/h which means he must act fairly as stipulated in Goldex Mines v. Revill•Here, the decision by the CFCF Board to cancel the original Videotron deal and the court-ordered vote was in the corporation’s best interest; the deal turned out to be negative for the company and going through with the vote would have created great uncertainty •The hard lock-up clause is not problematic since such clauses are common and Jevlam owes no duty to minority shareholder; such compromises ensure that the bidder will put the best deal forward and was only agreed to after many negotiations; the desire of CFCF to accept a cash offer is also legitimate.

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-Jevlam coulf have been criticized by the fact that influenced BoD of CFCF but independent comm was setup

PART II. SENIOR SECURITIES & CREDIT AGREEMENTS

CCQ2312 - Two kinds of loans: loan for use and simple loan.2313 - Loan for use is a gratuitous contract whereby the lender hands over porperty to the borrower, for his use, under the obligation to retun it to him after a certain time.2314 - Simple loan is a contract whereby lender hands over money or other property that is consumed by the use made of it, to the borrower, who binds himself to return like quantity of property of same quality to lender after a certain time.2315 - Unless stated otherwise, simple loan for property presumed to be gratuitous while simple loan for money is presumed to be made by onerous title (bear interest).2316 - The beneficiary of a promise to lend is limited to a claim for damages on a breach of the promise.2327 - When simple loan, the borrower becomes the owner of the property loaned and bears the risk of loss.2329 - The borrower must return nominal amount of money received notwithstanding any variation in its value.

Currency Issues - currency act: prohibits judgement in currencies other than Canadian $.- there is nothing prohibitting parties to contract in other currencies.- formulaic judgements have been allowed in some provinces- judgement currency clause ?- hedging is possible, however, it is difficult to develop a hedging strategy when the date of the payment is unknown.In Relation to Banks- When a bank makes a loan/promise to lend it has to decide how much capital to put aside. - When the banks lend/promise to lend in Cdn $ they make this determination in Cdn $. When banks lend/promise to lend in US$ they make this determination in Cdn $ as well. As such, the banks must make adjustment in their commitment, determined in Cdn $, to allocate for exchange rate fluctuations.

- In loan agreements there are often Mark to Market provisions. These provide that when there is a loan outstanding in a foreign currency and there is a fluctuation in value of the foreign currency in relation to the Cdn $, the borrower will have to pay back some of its loan if the foreign currency increases in value and, in some circumstance, the lender will have to increase the loan (i.e. provide more foreign currency) where the value of the foreign currency decreases in value. (see handout)

Barbeau: These provisions are often not readily accepted. The banks will only invoke them when there is a significant change. Banks cannot hedge because they do not know where they will end up at the end of the day. Ussually any adjustment that is made is reflected in foreign currency loan value and not a change in the capital held by the Bank.

2330 - loan of money bears interest the day it is handed over to the borrower.1564 - Borrower must pay back to the lender nominal amount due in money (i.e. change in value is irrelevant)1565 - interest is paid at either the agreed rate or the legal rate.- when loans fluactuate on a daily basis the interest rate is calculated on a daily basis. Typically, interest is payable every monthDifferent Interest Rates

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CDN $ Prime - the rate at which Cdn banks lend to the best and most credit worthy commercial customers in Cdn $. This rate can change any day but must be announced.US$ Prime - What US borrowers pay for lending US$.US $ Base - the rate at which Cdn bank will lend to customer in US $.LIBOR (30/60/90/180/360) - the rate at which major banks in London are willing to lend Eurodollars to each other (assumes borrower with a perfect credit rating). Locked in for at least 30 days.

Interest Rate Act s.3 - when no interest rate agreed upon it is deemed to be 5% per annum.s.4 - when interest payable on a non-yearly basis the contract will indicate expressly the equivalent yearly rate - otherwise limited to 5%.

- lawyers worry about this because if leap year and stated on the basis of 365 days then not in compliance with the act.- must include a clause for the calculation of the yearly rate otherwise limited to the 5%.- assuming a prime rate of 12% on a $100 loan whereby interest payable monthly (i.e. pay $1 a month). The yearly effective rate is not 12% because do not have use of the $1 payments throughout the year. You are not required to provide the effective yearly rate. This would be problematic as no one knows at what rate the $1 could be re-invested in. The yearly rate that would have to be provided is 12%.

1511 - the benefit of a term is to the debtor unless it is apparent from the law, intent of parties or the circumstances that is to benefit the credittor or both parties.1512 - Where there has been no term determined after a reasonable time the court may on the application of the parties fix the term according to the nature of the obligation, the situation of the parties and the other circumstances.

1595 - If no term the creditor must give reas. delay for debtor to perform its obligation (e.g. calling a loan).

Matching- Banks match deposits with the loan they make. Since not guaranteed that the deposits will remain they are taking a risk in this repect. Often banks lend from other banks at LIBOR rates so as to fulfil request for loans. Lending bank makes a profit by charging a commitment fee to borrowing bank - to lend the money at such and such a date. Borrowing bank makes a profit by lending to borrower at a rate above prime.

Canada Deposit Insurance Corporation v. Canadian Commercial Bank (1992) SCC

Synopsis: This case is important since it reveals the approach to adopt in order to properly characterize a financing instrument as either debt or equity. Here, the fund infusion to CCB was in substance a loan and not a capital investment, despite the presence of an equity component in the agreement. Characterization of a financing instrument involves looking at the words of the agreement and the intention of the parties. The advances in this case were intended by both parties to be repaid, but only until the parties were fully reimbursed. The reference to CCB’s income was simply a method of identifying the sources for the those repayments and did not entail a right to share in the profits. The equity component was a mere “sweetener” to compensate for the significant risk undertaken, which did not transform this loan into a capital investment.

Facts: In 1985, CCB (a chartered bank) experienced a sharp decline in its loan portfolio and became insolvent; essentially many of the bank’s outstanding loans became non-performing and ½ of its loan

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portfolio, its main assets, had no value. This made it impossible for CCB to meet its obligations to its creditors (depositors, GIC holders)•Response is an “emergency financial assistance” program by the governments of Canada & Alta., CDIC and 6 major banks who participate in a fund infusion of $255 mil in CCB to prevent its winding up and to avoid loss of confidence in Canada’s banking system •The group basically purchases from CCB participation in a portion of CCB’s portfolio called the “syndicated portion” or the “portfolio assets”; the participation rights of each participant is proportional to its financial contribution •This fund infusion is undertaken according to certain conditions,as set out in the “Participation Agreement” and the “Equity Agreement” signed by the parties involved:

• $ received on the loans in the syndicated portion would be used by CCB to repay the participants on a proportional basis until such time as each participant is reimbursed the full amount advanced - The $ received was first to be retained by CCB until the CCB portion of the asset is completely

recovered and any excess was to be used to repay the participants’ advances.•Participants were also entitled to receive 50% of CCB’s pre-tax income or alternatively 100% of the pre-tax income (plus interest at the prime rate) until all sums advanced were repaidIt was agreed that these mechanisms would be used to repay the $255 mil advance (bearing no interest) and after full payment, the payments from the portfolio assets and the pre-tax income would cease.•CCB was required to indemnify each participant for any loss incurred, up to the amount advanced.•Upon insolvency, the agreement stipulates that the outstanding unpaid amounts “shall constitute

indebtedness of CCB to members of the support group”•The agreement also ranked the priorities on insolvency: the right of each participant to $ owing to it under the agreement ranks equally with the other creditors of the bank•Each participant is also entitled to receive on a proportionate basis, warrants to purchase 24 mil

common shares of CCB at $.25 per share; this right to purchase CCB shares would continue for 10 years after the participants were fully reimbursed (Equity Agreement). Currently, CCB had authorized capital of 10M shares. Outstanding were 6.5M c/s and 1.5M options on the same, 8M shares on a fully diluted basis.•This equity provision essentially entitled the participants to buy up 75% of CCB’s common shares (bank potentially selling itself, however, big distinction between this and beign equity holder); but, this could only happen once CCB obtained both s/h and regulatory approval to increase its authorized share capital; if such approval is not obtained, the participants’ right to receive 100% of CCB’s pre-tax income plus interest is triggered on the $255 million.

•Summary of these provisions: basically, the agreement provided for the repayment of the advances from various sources (portion of $ received on loans, pre-tax income) & the participants could only receive a return greater than their contribution in 2 ways: by exercising the warrants (which was a highly contingent right) or from the interest on the advances which was only available if the warrants could not be granted.

Barbeau: this is bailout structure, the inclusion of the warrants here is not surprising. Lender is taking a huge risk and wants this recognized in potential upside success.

•CCB was not told to record this transaction as a liability for accounting purposes •The plan failed and CCB was ultimately wound-up, and this occurred before any of the participants had exercised their warrants•The liquidator recovers $112 mil from CCB’s assets, of which $5 mil is attributable to the portfolio assets

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Issue: The liquidator asks the court for advice regarding the validity and ranking of the claims of the participants according to the agreements. Essentially, the court must engage in a characterization of the arrangement between the participants and CCB.

Holding: This advance was a loan and not a capital investment by the participants of CCB.

Ratio: Characterization issues must be decided by determining the intention of the parties, which in turn depends largely on the meaning of the words chosen by the parties•The words chosen in the agreements clearly support the conclusion that the assistance program involved a loan and not a capital investment . The agreements clearly provided for repayment of the advances, and the amounts to be repaid were never to exceed the sum advanced to CCB. Also, the agreements clearly identified the advance as indebtedness, and considered the participants to be creditors of CCB. •The inclusion of the equity component (warrants) did not alone change the fundamental nature of this transaction from a loan to an investment , and merely represent a “sweetener” to the deal.•The reference to the performance of the loans and the pre-tax income essentially reflects a sourcing issue: using this income to identify the source of the repayments of the advances, and reference to this income is irrelevant to the characterization of the transaction; this is not the same as sharing in the profits of the bank (Barbeau compared this to a prepayment provision, which is triggered by certain events, namely the receipt of big income in one year or sale of a bunck of assets)•There are characteristics of both debt and equity financing here: this is a hybrid agreement combining both elements but which in substance reflects a debtor-creditor relationship•So, debt and equity characteristics can co-exist as they do here, since we don’t necessarily attribute the same weight to all of the elements of the agreement: the equity agreement is a mere “sweetener” giving the participants a possibility of participating in the future success of the bank, as compensation for the huge risk they are taking in bailing out CCB. Therefore, the warrants are incidental features of this loan agreement.•The accounting treatment of this transaction is not determinative of its characterization because it does not involve a legal determination of whether the transaction involves debt or equity. It is dictated by an outside party and reflects only one party’s actions post-agreement•Conclusion: the participants are CREDITORS of CCB and can rank equally with the other unsecured creditors of CCB in the distribution of CCB’s assets (ie. entitled to a share of the balance of the $112 mil recovered by the liquidator, in addition to receiving the $5 mil recovered from the portfolio assets).

Section A - Bondholders Rights

-This section is about the rules that govern the distribution of risks and rewards between senior and junior security holders.-A senior debt claim has a right to payment (a share of the earnings stream or a distribution of assets in liquidation) which must be satisfied before the next most junior claim.-Preferred stock has a similar prior claim to dividends and in liquidation over common stock.-A corollary to the priority of the claim is the existence of a limit on its amount. The maximum amount of the prior claim must be met before the next most senior claim is entitled to any earnings.-Because common stock is exposed to greater risk (as it only receives distributions after senior claims are satisfied) it has the opportunity to reap the greatest rewards (it is entitled to ala amounts in excess of what was necessary to satisfy senior claims). Common stock also benefits from its control over the enterprise (these shares carry a right to vote, elect management, determine what kinds of new senior securities may be created etc.).

1. Debt Financing

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Overview

Bonds, Debentures, and Notes- Promise to pay at certain datess in the future principal and interest payment.-These are long term promissory notes. - Bonds tend to be unsecured while debentures tend to be secured-Today, notes are issued pursuant to indentures as unsecured long-term obligations. But they tend to be intermediate term securities, coming due in 10 years or less.-Debentures tend to mature in 10 years or more, in contrast.-In essence, all three are a promise by the borrower to pay a specified amount on a specified date, together with interest at specified times, on the terms set out in the indenture or agreement.-Bond is the generic term for all long-term debt securities.- Coupon is the interest rate on the bond (use to actually have coupons).- Maturity is the time at which principal is due.- Face value - is the principal payable upon maturity and the price for which the bonds were issued.- Market price - price at which security is sold in the market. Can be be greater or less than the face value of a bond depending on the change in factors related to its valuation since it was issued.- Yield (as defined on the handout) - This thing on the market today (given all its attributes) should have an interest rate of x. The market buyer would pay less for a bond (with the same attributes) if the interest rate is less than x. Yield changes based on other factors (duration and credit), not the interest rate. Yield on a Government of Canada bond is lower than on a corporate bond because less risky (corporation in the long run is more likely to go bankrupt than the government).- see p5 of notes for a discussion of the bond valuation handout.- Basis Point - 100th of one percent.Note: The government of Canada Bond market is a shrinking market, borrowing less and less. As a result, the corporate bond market is growing.- call option - option the issuer has to pay back the loan early. Gives the issuer more flexibility to cease paying out rates above the market rates. As a consequence, investor pays less for the bond with the call option. Markets generally values bonds at the callable date.- put option - issuer can demand payment (there are provisions for bankrupcy).- promise to lend is also valuable. Commitment fees compensate the lendor for loss of use of that $ until actually borrowed. At time of borrowing interest payments arise.

Debt vs Equity- Order of claims against assets of company: DEBT (Senior - Unsecured - Subordinate) - EQUITY (Preferred Shares - Common Shares).- Debt have fixed return and unqualified right to be paid.- Banks typically supply senior and unsecured debt but not subordinate.

Indentures

-Are contracts entered into between the borrowing corporation and a trustee.-The trustee administers the payments of interest and principal on behalf of the bondholders and monitors and enforces compliace with other obligations. A trust arrangement is used, as individual enforcement of the contract by single holders is not cost effective. The trustee can be an agent whereby it will have some ability to act on the bondholders behalf. The indenture sets out the role of the trustee.-Note the difference between bonds and indentures: bonds/debt instrument set out a promise to pay that runs to the holders (physically held by the debt holders) . Indentures set up other promises (e.g. to pay) that run to the trustee (Barbeau the indenture typically repeats the requirement under the bond). Bondholders are 3rd party beneficiaries of the indenture promises. Thus, the bonds are subject to the

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indenture and can only be directly enforced to the extent that the indenture allows. Prevetns enforcement of one small holder, the power of the bondholders is channeled through the trustee-Trust indenture facilitates borrowing in small amounts from a large number of investors by constraining the issuer against the holders, simultaneously protecting the issuer from individual holder claims.

Terms of Indentures

-There are six important sets of provisions that make up their content:1) Provisions summarizing the amounts of money, the future date of payment, interest

rate, and the time of interest payment.2) Provisions describing the character and extent of the property against which the

holder may levy to satisfy his debt.3) Special covenants accepted by the borrower, which ensure the preservation of the

value of the corporate property covered by the agreement.- pledge free assets to other creditors- to incur additional debt superior to the debt in question- to make dividend payments

4) Provisions that define the exact course holders must pursue to levy on the corporation for the security of the bonds.

5) Provisions describing the duties of the trustee.6) A covenant providing that when the corporation has satisfied its obligations, the lien

or claims of the holders will cease, and the corp. will no longer be bound by any of the bonds’ promises.

Note that covenants are ussually stricter when there is nothing securing the borrowing (e.g. debentures).

Duration

-The bond’s face states a due date.-Most bond issuers must make “sinking fund” payments – prepayments of he principal in advance of the due date. This is a disadvantage to the borrower.-Most borrowers may “call” the bond (the bond can be redeemed in advance of its due date by the borrowing corporation). This is a disadvantage to the lender.

Public Offerings and Private Placements

-The information in the text is American, but I will assume that for a public offering, the issuer must comply with registration requirements in Canada as well.-Issuers too small to gain access to the public debt markets can issue long term debt in the private placement market. Here, registration can be avoided if the sale of bonds is limited to a small number of sophisticated institutional investors. Negotiations are more personal, and can be concluded more cost effectively. -Priv. Placement note agreements contain tighter, complex covenants than do trust indentures governing public offerings. Why? Investing in a smaller issuer is a less secure investment than investing in public offerings. High risk. Thus, priv. Placement agreements provide for more extensive periodic reports.-For the borrower, the tight covenants can be contractual barriers to new investment. But, renegotiations with lenders is not uncommon, as these noteholders will likely be responsive to changes that the borrower sees as beneficial to its economic well being.

Convertible Bonds

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-These are debentures or notes that can be changed at the holder’s option into shares of the issuer’s common stock.

Mortgage Bonds

-Two variations affecting the priority of bondholders’ claims are the mortgage bond and the subordinated debenture.-Mortgage bond holders are secured as to the payment of principal and interest by a pledge or mortgage of described assets of the debtor, and thus have a prior claim to payment against the other creditors with respect to the mortgaged asset or their proceeds.-The subordinated debenture has the opposite effect: it prescribes repayment of principal only after all other creditors to whom it purports to be subordinated are repaid in full.-The mortgage bond is an obligation secured by specified property – in the event of default; the mortgagee can foreclose on the mortgaged property, and may sell it to secure their payment.-Mortgages can be closed-end – which disallows the creation of any additional bonds issued against the mortgaged property with that property being the subject of a first mortgage. This deprives the borrower of the opportunity to borrow more on that property at the relatively low interest rates available for a first mortgage. -Open-end mortgages permit additional bonds to be issued as a first lien on property already subject to a first lien. The security of the first lender is diluted.-In some cases, lenders may also wish to have security on after-acquired property. -To avoid the restrictions of a clause covering after-acquired property, borrowers may redeem the bonds, or acquire new property through subsidiaries.

Leasing

-In a financial lease, the lessee is like the borrower. The lessor (probably a financial institution) is like the lender. Financial leases are used to finance large items of equipment.-The lessee gets use of the asset while promising to make rental payments. Payments are tax deductible as business expenses.-But, the tax benefits of depreciation flow to the lessor, as well as the security that comes with having title to the property.-In a “leveraged lease”, the lessor borrows part of the purchase price, and uses the leased property and its stream of rental payments as security for the loan.-“Sale and leaseback” transactions occur when a business wishes to realize cash on real estate it owns, but wishes also to continue operating the facility located thereon. The property is sold to the purchaser simultaneously with a long-term lease from the purchaser to the seller.-“Operating leases” are short term, cancelable leases where the lessor services the equipment (this is used by lessees to obtain small office equipment like computers).

Subordination

-When a corporation needs additional funds, but cannot support more senior debt; it may issue a subordinated debenture.-This is an unconditional promise to pay principal and interest, but payment is deferred until senior debt is paid, or in the event of liquidation. -As the debentures are junior to existing “borrowed” funds; it carries a higher risk and thus offers higher interest rates.

Short Term Borrowing

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-Firms need financing to cover periods where cash outflows are greater than cash inflows.-Solution: short term borrowing, which if borrowing for a term of less than one year.-This can be done through a line of credit with a bank, where the borrower may have to pay a commitment fee, and commit to a loan of up to a year. The interest rate will probably float at a percentage over the prime rate.-This may be secured by a “floating lien” on the borrower’s inventories or accounts receivables. On default, the bank can collect the proceeds.-Large highly rated firms can get short term financing by issuing commercial paper, which is a promissory note maturing within 270 days. Rates are lower than bank lines of credit.

The Law of Corporate Trust- The trustees (in Canada) agree to act in the best interest of the bondholders - basically the same fiduciary relationship as the directors. In US a distinction is made between pre and post default duties: the duties of a trustee crystalizes upon default and thus there is no duty to act in best interest of holders pre-default.- That being said, the trustee’s most important responsibility is to act on behalf of holders at the time of bankruptcy

Elliot Associates v. J. Henry Schroder Bank & Trust Co. (1988) USCA.

Facts: An indenture required the issuer to give the trustee of an issue of convertible debentures 50 days notice before redeeming the debentures, unless a shorter period of notice is satisfactory to the trustee. If the trustee required less time to handle the mechanics of sending notice to the debenture holders, it was authorized to waive the 50-day period. Here, if the trustee did not shorten the 50-day period, redemption would occur after a date on which the issuer had to make an interest payment on the debentures. But, the trustee shortened the notice period, thus depriving holders of the interest payment. They sue.Issue: Did the trustee’s waiver of the 50-day period constitute a breach of a duty of loyalty owed to the holders?Ratio: No. The indenture trustee’s pre-default duties are limited to those terms and duties expressly provided in the indenture. As the trustee has a special relationship with both the issuer and the debenture holders, they are not subject to the ordinary trustee’s duty of undivided loyalty. If the obligations under the indenture are fulfilled, a court will not read in additional implicit duties except to avoid conflicts of interest. There is no implied fiduciary duty to advance the financial interests of the debenture holders.- Basically duties limited to those set out in the trust.

-This American case stands for the principle that contract principles dominate over the trust aspects of indenture trustees’ duties. The view in Elliot has not been universally accepted.

CBCA Provisions 82-9382(3)- apply only where distribution to the public91 - duty of care

NB: on default there is a issue of who will fund litigation should it arise. On liquidation, any fees incured will be reimbursed to trustee, however, this could be ten years down the line. Often the trustees negotiate prepayment into the trust indenture, however, often times they are unrepresented and sign a clause providing for their payment on liquidation.

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Conflicts of Interest-In the event of default, the trustee must not have inconsistent loyalties between the issuer and the debenture holders.-The Trust Indenture Reform Act of 1939 (an American act irrelevant for our purposes) disqualifies a trustee from service if a conflict exists, without regard to default or the character of the trustee’s duties. See CBCA for Canada.-As an example, a conflict may exist in the case of a creditor relationship. Trustees are normally banks in these relationships. A clear conflict would exist if the trustee were an interested party by having made loans to the corporate borrower. In the event of default, the trustee would end up being a competitor for funds, which would put them at odds with bondholders.

2. The Bondholder and the Going Concern

The Promise to Pay

Value of a Promise to Pay- The value of a promise to pay is dependent on:

1) the time between when the promise is paid - generally, the longer away the payment date the less valuable the bond 2) the market rate of interest - An increase in the market rate of interest decreases the value of a promise to pay.3) the credit rating of the issuer4) the issuer’s financial condition5) leverage - lenders prefer more equity because they have a better chance of being paid in the event of bankruptcy. The lender may ask borrower to respect certain ratios.6) currency risk7) legal risk that the obligation to pay is valid - see Hammersmith.

Bankers Acceptance - promise to pay by an issuer the principal of which is guaranteed by a bank.The bank puts these on the market for sale.Stripped Bonds - coupons stripped off and package a number of the principal payments together.*** see art. 2316 of CCQ.

Dewing, The Financial Policy of CorporationsAttitude Toward Bonded DebtThe difference between bonded debt and bank loans is merely the period during which the loan shall remain outstanding.-Management may see bonds (corporate debt), as the evidence of borrowed capital – implicit in this is the fact that the equivalent in money must be returned later.-The other point of view regards bonds as a device to give investors favored participation in the fortunes of the enterprise in exchange for the willingness to accept a low fixed return.-New debt can be incurred to fund the old.-In the event of failure, debt holders take their fortunes along with stockholders, except that they will be paid first out of the proceeds of liquidation.

Van Horne, Financial Management and Policy

Call Provision and Refunding-A call gives the corporation the right to buy back its bonds at a stated price before maturity. -The call price is usually above the par value of the bond, and decreases over time.

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-2 types of call provisions:1) Immediately Callable – the instrument may be bought back by the issuer at the call

price at any time.2) Deferred – the instrument cannot be called immediately, there is a deferment period

during which the investor is protected from a call by the issuer.-The call allows flexibility in that the corporation does not have to wait until maturity to refinance if interest rates are favorable.

Value of Call Privilege-The call is a detriment to investors, so the call privilege does not come free to the borrower.-Its cost is measured at the time of issuance by the difference in yield on the callable bond and the yield that would be necessary if the security were noncallable.-When interest rates are high and expected to fall, the call feature has significant value. Investors are compensated for assuming the risk that the bonds will be called.-When interest rates are low and expected to rise, the call feature has negligible value, with companies paying similar yields as if there were no call privilege.-The key factor is that the borrower has to be able to refund their bond issue at a profit, which can only be done if interest rates drop significantly to allow them to cover the premiums involved in calling the issue, as well as costs of refinancing.

Brigham and Gapenski, Financial Management: Theory and Practice

The Sinking Fund

-A sinking fund is a provision providing for the systematic retirement of a bond issue, with a firm retiring a portion of its bonds each year.-Usually there is a mandatory fixed amount that must be retired, although a company could tie the amount to earnings of the current year. If the fixed amount in not met, the bond issue is thrown into default.-Two ways to handle the sinking fund:

1) The firm can call in for redemption at par value a certain percentage of the bonds each year.

2) The firm may buy back the required amount of bonds on the open market.-The firm may choose whichever is the least costly method.-The sinking fund protects investors by ensuring that the issue is retired orderly.-But, it can also work to their detriment. E.g. if the bond carries a rate of 13% interest, and yields on similar bonds fall to 9%, this bond will be selling above par. But, it the firm calls the bond, and pays par (as in (1) above), the bondholders whose bonds are called will be disadvantaged.

Morgan Stanley & Co., Inc. v. Archer Daniels Midland Co. (1983) US District Ct. NYFacts: Case is about planned redemption of $125 million in 16% sinking fund debentures. In 1981, ADM issues 125 mil of 16% Sinking Fund Debentures due in 2011. There is a pre-established table of optional redemption prices, should ADM redeem bonds before their due date of 2011. Before 1991, ADM is not allowed to redeem debentures under their option from the proceeds of the issuance of any new indebtedness for money borrowed by the company if the interest cost to do so is less than 16.08% per year. ADM does raise money through public borrowing at rates less than 16.08% on at least 2 occasions after the debentures are issued. Also, ADM raises money through 2 common stock offerings. MS buys some debentures in 1983 for prices which exceed ADM’s optional redemption price for 1983, and ADM announces the redemption of those the next day, the source of funds to come from their common stock offering. Thus, MS will experience a loss. MS claims that the redemption is barred by

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the terms of call provisions. MS claims that the 2 public borrowings at rates less than 16% are at least indirectly funding the redemption, and that the stock issuance is a means to circumvent the protection afforded investors by the call provisions (even though the stock issuance raised sufficient funds to cover the redemption). MS claims that the court should interpret the call provisions as barring redemption at any time when the issuer has borrowed at a lower rate than 16.08%.Issue: Should the court interpret the provisions to mean that there is an absolute restriction on redemption of the debentures if the borrower has borrowed any funds at amounts less than the interest rate in the debentures of 16%?Held: No. The source of funds is the key factor in determining the availability of redemption to the issuer. Funds for borrowing can become available from sources other than borrowing (like a stock issuance). MS arguments of bondholders being unprotected if ADM can redeem while borrowing at lower interest rates are overstated. The redeeming issuer would have to fund a redemption by sources other than low-cost borrowing, so holders are still protected substantially from situations where there is continuous short term refundings during times of falling interest rates. This is what the language of the provisions was intended to prohibit. Also, the provisions are standard in contracts of this type. MS knew of the possibility of an early call when they bought the debentures. MS’ expectations were thus not upset by the call. BOTTOM LINE: the clause does not amount to saying that can’t redeem when interest rates above x.Barbeau: If the issuances of debt had been done in contemplation of future redemption there may have been a diferent result.

Harris Note: The case of Harris v. Union Electric Co. (also a U.S. case) is similar, although more extreme.Facts: There was a refunding limitation as above, but there was an exception that allowed redemptions from a “maintenance fund”. The fund was set up under an earlier indenture. The earlier indenture did not limit the source of the money that went into the fund, nor the occasion for its use. The issuer sold a new issue of bonds at a lower rate, put the proceeds in the fund, and redeemed the original bonds out of the fund. The issuer effectively avoided the refunding limitation (practically the bonds were subject to an open call).

Held: The court found that the language in the provisions and the indenture to be unambiguous, and thus ruled for the issuer. But, the bondholders did successfully pursue an antifraud remedy under securities law. As the maintenance fund could be used in any case, the listing of redemption premiums was misleading. They would never be paid, given the unchecked use of the maintenance fund.

The Make Whole Premium

-Private placement lenders have averted the problem for bondholders in ADM by revising the form of the call provision.-The issuer can make a call at their option without any refunding limitation, but there is a “make whole” premium that compensates the holder for declines in interest rates if their bonds are redeemed. -This also assumes that the make-whole amount cannot ever be less than zero.

PROMISES THAT PROTECT THE VALUE OF THE PROMISE TO PAY (P. 187)

BUSINESS COVENANTSBarbeau: - Makes a distinction between affimative (promise to do something) and negative covenants (promise not to do something).- Failure to meet convenant = event of default.

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- The better your credit rating the less restrictive the convenants.- Covenants are generally written in std form. It is ussually the underwriter counsel’s responsibility.- Short convenant package is not necessarily to the benefit of the issuer as the covenants ussually prohibit conduct and then provide for a number of exceptions. Each exception is designed to meet some particular purpose. Issuer counsel will lobby hard for exceptions as a change in the future may require the approval of a lot of bondholders.-

I. Debt Contracts and Debtor Misbehaviour1. Unsecured lenders are exposed to heightened risk because they do not possess

security interests in the borrower’s assets. Consequently, they are dependent on the borrower’s conduct in meeting the lender’s expectations. This risk carried by the lender can be reduced through provisions of a debt contract that govern the course and conduct of the borrower’s business.

2. These provisions enable the lender to call a default if the business has a reversal of fortune or if the borrower is acting in an opportunistic fashion.

3. The borrower is left with three alternatives if a loan is called in default:a) it can cure the default;b) seek the protection of a bankruptcy proceeding; orc) make the lender an offer of a substitute performance in exchange for a

waiver.4. The right to call a default can be a substantial guarantee of performance,

especially if this threatens to push the firm into bankruptcy. 5. Similarly, if a default does occur a lender is afforded an opportunity to enhance

its contract rights in the event of a recapitalization outside of bankruptcy.

II. Fischel, The Economics of Lender Liability 99 Yale L.J. (1989)A. This excerpt describes the interrelated problems of business failure and debtor

misbehaviour.B. Debtors have an incentive to engage in several types of misbehaviour once a loan has

been made:1. Asset Withdrawal- Borrowers (B) have an incentive to remove loan moneys

outside of the firm (e.g. through dividends to shareholders (s/h)). This problem is exacerbated in situations where funds are loaned to limited liability companies.

2. Risky investment policy- B may invest in riskier projects because it is the lender who will face the downside risk if the project fails. Whereas if the project is successful, it is the B. who stands to benefit. May invest in projects whose npv is negative because they have very high upside.a) The potential for this to occur depends on the amount of equity that

exists in the company (equity cushion). The greater the Debt/Equity ratio the greater the likelihood of this type of policy.

3. Claim dilution - Value of debt is a function of the amount of other debt. If the B issues more debt of equal or greater seniority, the the value of the lender’s (L) debt will decrease. This dilutes the claims of existing creditors.

4. Underinvestment- Creation of debt creates an additional claimant on the firm’s income stream. If too much of the benefit from a project accrues to the L, the B may not invest in such a project. This reduces the value of the outstanding debt.

C. Often exogenous events and debtor misbehaviour are closely related (the more the latter the more likely the former will occur. If adverse market conditions(exogenous event)

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make the profit of Xco.’s widget division shrink from $1000 to $100 and this barely pays off the debt obligations to the L, the B may invest in a more risky project to boost its chances of higher return (misbehaviour). With no signs of profit, B’s incentive to continue with its widget production has been reduced.

D. The probability that misbehaviour will occur is dependent on the value of the business that is not represented by debt. Further, the less equity (lower the equity cushion) there is the more the misbehavior is likely to hurt the creditors.

E. The unsecured lender finds its ultimate protection in the B’s equity cushion. As such, debt covenants are designed to keep the equity cushion in place and make it available to generate payments on the loan. Covenants cover all areas of mis behavior.

III. Principal Business Covenants:A. Restriction on dividends and other payments to s/h’s:

1. This provision restricts transfers of corporate assets to s/h’s by reference to the B’s level of profits. Only a certain proportion of profits may be distributed to s/h’s (through dividends etc.).

2. This provision prevents against asset withdrawal and underinvestment.B. Restriction on Additional Debt:

1. This protects against claim dilution.2. Debt covenants regulate rather than prohibit incurrence of new debt based on

the economic state of the enterprise.3. Prohibits financial leases and guarantees which are functional equivalent of

borrowing.4. Distinctions are made between:

a) short- and long-term debtb) subordinated and unsubordinated debt

5. This provision indirectly discourages risky investments and risky debt.C. Restriction on mortgages and liens

1. Also reduces claim dilution.2. Ensures that secured creditors do not gobble up B’s unencumbered property.3. Two modes of drafting:

a) Direct and sweeping prohibition subject to negotiated exemptions.b) Negative pledge covenant stating that no lien will be created unless that

lien also equally and ratably secures the debentures or notes covered by the provision.

D. Restrictions on mergers and sales of assets1. Mergers can lead to claim dilution if merged entity is highly leveraged.2. May also lead to a detrimental shift to a risky investment policy.3. Covenants of this nature are usually very flexible 4. Piecemeal sales of assets present problems of asset withdrawal and risky re-

investment policy.E. Restrictions on investments

1. L may impose a prohibition against some varieties of risky investment such as common stock or futures contracts so that capital is devoted to the B’s going concern.

2. This may address the underinvestment problem3. B’s are likely to resist such restrictions, accordingly these provisions are more

likely to appear in private placement transactions in which the lender has substantial bargaining power.

F. Maintenance of financial condition

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1. Some L’s impose ratio tests such as level of net worth or net working capital, to ensure that the equity cushion is not eroded. These provisions act as early warning signals of distress or liquidity problems.

G. Maintenance of business and property1. These covenants contain affirmative promises to stay in the same line of

business and keep property insured and in good repair.H. Reporting Provisions

1. Debt contracts facilitate ongoing monitoring by the holders by requiring the B to provide periodic financial reports to the L along with certification that the B is complying with the contract’s terms.

IV. Judicial Interpretation of Covenants

A. Sharon Steel Corp. v. The Chase Manhattan Bank, N.A. Facts:

1. UV Industries had $155 million of long-term debt outstanding pursuant to 5 different indentures. Each indenture allowed redemption at a premium prior to maturity and contained a “successor obligor” clause allowing UV to assign its debt to a corporate successor purchasing all or substantially all UV’s assets. Trying to avoid liquidation agreement.

2. UV operated 3 lines of business:a) Federal Electric- generated 61% of revenues, 81% of profits, and 41% of

book value of co.b) Oil and Gas properties-generated 2% revenues, 6% profits, 5% book

valuesc) Mueller Brass- generated 38% revenues, 13% of profits and 34% book

value3. In 1979, UV submitted plan to s/h’s, which was later accepted, to sell Federal for

$345 million and w/i 12 months sell the rest of assets and liquidate. UV sold oil and gas for $135 million and issued an $18/share dividend after agreeing with the trustees of the bonds to set aside $155 million to pay down bonds.

4. November of 1979- company takes u-turn; It enters into agreement with Sharon Steel (SS) pursuant to which SS would buy remaining assets of UV (Mueller Brass and $322 million in cash) in exchange for $107 million and $411 million face amount of Sharon’s subordinated debentures.

5. Sale to SS included agreement that Sharon assume all of UV’s debt obligations. UV and SS interpreted that SS was purchasing “all or substantially all” of UV’s assets wihin the meaning of the successor obligor clauses. Therefore, they believed that they could transfer debt.

6. Trustees disagreed and issued notices of default and brought actions for redemption of the debentures.

Issue 1: The Successor Obligor Clauses (SOCs):1. Court finds that SOCs are boilerplate contractual provisions susceptible to

standardized expression. As a result, they do not depend upon the particularized intentions of the parties to an indenture.a) Uniform language is essential to the effective functioning of financial

markets. Uncertainty surrounding boilerplate provisions would decrease the value of all deventure issues.

2. SS argues that since it bought everything UV owned, the transaction was a sale of all of UV’s assets. Court disagrees stating that if proceeds from earlier piecemeal sales are “assets” then UV continued to own “all” its “assets”

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even after the SS transaction. Using this literalist approach, UV’s assets were not sold and the ensuing liquidation requires the redemption of the debentures by UV. Essentially, the court is saying that because Federal Electric was sold previously to another buyer, the remaining sale only constitutes a piecemeal sale of assets.

3. Court states that SOCs are intended to protect L’s. Thus, a borrower which sells all its assets does not have an option to continue holding debt. It must either assign the debt or pay it off. B.S.F. Company v. Philadelphia Natl. Bank held that one purpose of the SOC is to insure that the principal operating assets of a B are available for satisfaction of the debt. Thus, in this case since only one asset being sold, the protection L’s had previously would no longer exist.

4. Court finds that the purpose of SOC’s is to enable B to sell entire businesses and liquidate, to consolidate or merge, or to liquidate operating assets and enter a new field free of public debt. In this process L’s are assured a degree of continuity of assets.

Held: Ruling in Favour of Chase Manhattan. Accepting SS’s point of view would severely impair the interest of L’s. As a result, the court held that the SOC does not permit assignment of the public debt to another party in the course of a liquidation unless “all or substantially all” of the assets of the company at the time the plan of liquidation is determined upon are transferred to a single purchaser. The sale to SS did not constitute a sale of “all or substantially all” of the assets. AS SOON AS LIQUIDATION UNDERTAKEN ON PIECE MEAL BASIS DISQUALIFIED.

Issue 2: The Redemption PremiumHeld: The redemption premium must be paid by UV to debenture holders. The purpose of a redemption premium is to put a price upon the voluntary satisfaction of a debt before the date of maturity. This provision was triggered by UV’s voluntary actions to liquidate.

Stone Consolidated Notes- senior secured notes - 7 yr notes due in December 2000 at interest of 10.25% payable semi-annually- the trustee Norwest Bank in this case did not qualify as a trustee under the CBCA and therefore had to apply for an exception.** S. 212(1)b(iii) of the ITA provides that a Canadian paying a non-resident interet is required to withhold 25% of that interest. This insures that income earned in Canada is assessed. Obviously, no US investor likes this. There are a number of exceptions:

- 5/25 rule - if you have debt with a term of five years or more and not more than 25% of the debt is required to be paid back within the first five years, the interest paid on the debt is exempt. The purpose of the exception was to allow Canadian to raise money in Canada.THE IMPORTANCE OF THIS RULE IS THAT IT HAS A DIRECT BEARING ON THE COVENANTS THAT ARE WILLING TO BE NEGOTIATED.

Covenants under these notes:1. Ranking : The notes will be secured, and will rank pari passu in rt of future payment with all

existing an future Senior indebtedness and senior to all subordinated indebtedness. Description of the security which is fixed and floating charge on a number of assets and

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mortgages. Description of future permitted indebtedness and the assets which can be used to secure the same.

2. Payment Terms : Principal amount, time of payments, calculation of interests etc.3. Limitation on Indebtedness : Starting point is that no indebtedness to be incured by Stone or

restricted subsidiaries. Can incur additional debt if Interest Coverage ratios is satisfied. Notwithstanding the general prohibition, 13 common exceptions follow.

a) the notes in questionb) convertibel subordinate debenturesc) indebtedness of company or existing sub which in some way has started to come into existence prior to issue date of Senior notes... see p.48

4. Limitation on Restricted Security Indebtedness : On the liquidation of Stone, if there is mucho dedt in subsidiary, debtors will not see any money from the subs (which are significant assets). The parents realtion with the subsidiary is ownership (i.e. equity), therefore last to claim on liquidation. STRUCTURAL SUBORDINATION.

5. Limitation on Ownership of Capital Stock: If there is ever a problem the debtors would want to assure that Stone has 100% ownership in the subsidiary. Otherwise, Stone claim is diluted. Subject to a couple of exceptions.

6. Limitaion on Restrcited Payments: Payments by the Restricted Subsidiary are limited if after the time of such payment:

- an event of default will or will continue to occur- the Company would not be able to incur one more dollar of debt without going over its interest coverage ratio- the sum of restricted payments to date (since issue) exceeds allowable amount: This allowable amount was the sum of 50% of Stone consolodated net income since January 1994 + .. +...Restricted Payment: This is defined as: 1) payment of dividend other than... 2) retire any debt junior to the notes 3) investments other than in restricted subs.Restricted Subsidiary: As described by Barbeau, Stone in negotiating these notes wanted to exclude some of its subsidiaries from the “box” of companies that the indenture was to cover. The subs that fall outside of the box are unrestricted. Payments to these unrest subs will be grouped together and will not be allowed to exceed a certain amount. NB that the subs are unrest for the purpose of incurring additional debt etc.

7. Negative Pledge : Non Collateral property - no lien will be give on such unless permitted lien or unless senior notes are secured equally and ratably on the property. Collateral Property - no lien except for permitted lien (see p.59 CSBK) - these are designed to deal with obvious stuff.NB: The credit ranking will play a role in determining what type of liens are permissible. Typically, when a low ranking creditor will find the clause saying that no collateral on the rest of the asset base (lender wants to be sure that no one is in front of them). Any future permissible debt will be unsecured and rely on the capability to pay back through operations. Investment grade companies on the other hand will allow for security on non-Collateral assets to be granted to the lenders equally.

8. Limitation on Liens Collateral 9. Limitation on Sale-Leaseback Transactions 10. Limitation on Distributions from Restricted Subsidiaries : This is somewhat of a peculiar

transaction, the noteholders wanted to assure that the subs are a able to freely distribute assets to Stone via dividends, repayment of indebtedness owed to Stone, and make loans to Stone, transfer any property to Stone.

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11. Limitation on Transactions with Affiliates : 12. Limitation on Business: Limited subs area of business - pure play. Noteholders are relying

on the fact that the company is doing one thing. This is important because a change of industry chanes the risk assesment.

13. Limitations on Consolidations, Mergers, Conoveyances, Transfers and Leases : The company and restricted subs will not enter into any series of transactions to consolidate, amalgamate, or merge with any other person (other than wholly owned rest. sub of course) or directly/indirectly sell, convey, assign, transfer, lease all or substantially all its property unless:

a) either 1) the company or restricted sub be the continuing person in the case of a merger or 2) the surviving entity (which is not the company or sub) is a company incorp in cdn or us (do not want to learn the implications of foreign law) and expressly assumes in a supplemental indentuer all of the obligations of the company uner the indenture (under Cdn law where there is an amalgamation the liabilities shift to the amalgamated entity automatically),b) before and after the transaction no event of default shall have occured or be continuing to occur (especially in relation to the surviving entities indebtedness becoming an obligation of the same as a result of the series of transactions - i.e. being treated as debt incurred by the company),c) immediately after the transaction the surviving entity would be able to incur $1 of additional debt pursuant to the limitation set forth by the Interest Coverage ratio (testing the merged companies ability to meet the interest payment),d) Compay/surviving entity will have a considated net worth not below that of company immediately before the transaction,e) trustee sends a notice/certificate indicating that the series of tranactions comply with indenture and that the first ranking linen remains. Any one covenant that is not fulfilled will prevent merger/amalgamation (e.g. not in the rt area of business)NB: b), c), and d) based on a pro forma analysis - this is an extremely significant exercise.

NB that in Canada, tax consequences make disposition of assets to another company other than by amalgamation pratically impossible.NB on amalgamations: only a couple of sections in CBCA dealing with amalgamations. An amalgamation agreement is put to the shareholder and requires 2/3 majority. The articles of amalgamation are filed by the directors and a separate corporate existence is subsumed into one company, assets are not transferred but rather are continued into a new entity (new name, single head office, share capital property described). Amalgamations do increase the assets, however, there may be more debt this is the concenr of the noteholders.

14. Change of Control 15. Classificaiton fo restricted and unrestricted Subsidiaries 16. Limitation on the Sale of Assets : The Company or any of its rest subsidiaries will not

permit any asset sale. If they do there will be an event of default unless:a) FMV (as determined in good faith by a majority of the Board) is received for the property,b) 75% of consideration is in cash (the reason for this is a valuation issue and to avoid structural subordinaiton), and c) within a year of the sale the proceeds are applied in total or in combination to the following purposes:

1 - purchase other assets

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2 - repay senior indebtedness other that the notes (reduce other claims agaisnt the company)3 - make the senior note holders an offer ( this is neither a call or a put, they have the option of tendering).

- notwithstanding the above the if the sale of asset worth more than $5M US and the company gives notice to trustee and enters into a binding agreement to replace property, then they have 24 months to do it.

The Company or rest sub will not permit sale of any collateral assset. If they do then there is an event of default unless:

a) sale of one of the Mills in its entirety (there are obvious valuation reasons for this)or sale of other Collateral not exceeding $25M US (partial collateral sale),b) consideration for sale received concurrently at least equal to FMV,c) wrt sale a notice to trustee no more than 30 days from consumation of sale indicating that sale complies with a) and b) and the FMV determined in good faith by the BofD (whose opinion based on independent appraiser)d) wrt to partial collateral sale, notice from appraiser that the value of the part of the asset being sold and the remain part combined is not less than value of the total asset,e) 100% cash (there is a heightened valuation concern)f) the $ is paid into the Deed of Trust until a determination is made under h),g) the trustee will take actions to release the Collateral property from lien and ensure that the notes have first ranking on proceeds,h) within a year the company will buy more assets or make a senior note offer (less options because this is collateral for the debt).

The company or the subs will not suffer or permit a Collateral loss event (a condmenation or casaulty involving an actual or constructive total loss of all or substantially all of any Collateral Mill) (NB: Company deal with the possibility of extraneous events causing loss to Collateral property by 1) having insurance payable directly to trustee for the benefit of noteholder and 2) treating with the event as an asset sale). Such will be an event of default unless:

a) money paid to the trust directly by party providing net sale proceeds (e.g. insurance proceeds),b) trustees ensures that notes have first randing lien on the proceedsc) within a year the company uses money to:

1) purchase other collateral 2) make senior secured note offer 3) restore the relevant collateral.

Barbeau: the noteholders have an interest in both collateral and non-colateral property. If there is a sale of assets, the noteholders will want to assure that the bet value is received by the company. Typically, the directors use their best business judgement to carry out a transaction, they owe duties to the shareholders of the company. This does not offer sufficient protection to the bondhlders, however, because there are many transactions that may tend max shareholder value while prejudicing the noteholders postion (e.g. need cash fast to max value so sell a collateral asset for less. - The more credit worhty the company the more power it will have in negotiating these agreements. - There is nothing in asset sales covenant probiting the sale of all or subs all of assets. See restrictions on mergers etc.

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Gross Up Clauses(Additional Amounts): These are clauses that protect the noteholders form withholding taxes if the exception of 5/25 is not met. The company must increase the payment to the noteholder so holder gets what would have received had there been no withholding. If this clause is trigerred the issuer has the rt under the optional redemption section to redeem the notes at %100 of principal amount plus any accrued interest. This is a no fault redemption b/c nothing was done by the issuer to precipitat the redemption.

Events of Default: This are the circumstances under which the trustee can demand immediate payment of the notes. There are 4-5 categories:

1. Payment Defaults: Interest and principal amounts not paid. There is a 30 day grace period for interest payments.

2. Covenant Default: Failure to perform a covenant under indenture or Security Documents (essentially any applicable covenant) and continuance of such failure for thirty days after the Company has received written notice from the trustee or bondholders representing 25% of outstanding principal amount.

3. Cross Default: Payment defaults under revoling credit agreement or other indebtedness that have resulted in the accelration of payments under the same greater than $10M. (Company would argue that you should not get this because did not bargain for it; noteholders argue that it does have an effect on them and they want to be at the table)

4. Subject to Judgement: Judgements against company for more than $25 M that remains outstanding for more than 60 days.

5. Force of Documents and Liens: When any security document ceases to be in full force or any lien created by documents no longer valid or priority contemplated.

6. Insolvency: certain events such as bankruptcy and insolvency.These vary significantly between notes, subject to intense negotiations.

Modification and Waiver: This set out what supplemental agreements or ammendments the trustees can engage in without the consent of the bondholder, with the consent of a majority of the bondholders and what expressly requires unanimity. If there is a fundemental change need consent of 100% if not fundemental change can be by makority or whatever negotiated.

1. The trustee can, without notice or consent of holder, enter into supplemental indenture or modity security documents to:

a - evidence succession of another person to company and their assumption of obligationsb - add covenants for the benefit of the holders or surrender rt of company under indenturec - add events of default or collaterald - evidence the succession of trustees or add covenants necessary for the admin of more than one trusteee - cure any ambiguity in favor of holdersf - other things related to administration of the trust

2. The trustee can, with consent of majority (in principal amount) of holders, enter into supplemental indenture to waive or modify a rt of the holder under the indenture or security documents provided that:

a - change maturity, principal amount and interst payableb - reduce the percentage of holders require to make modificaitonsc - modify the obligaiton of company on sale of asset or change of control or collateral loss eventsd - subordinate the notese - allow for a lien on property or terminate one of note’s liens.

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Barbeau: If the requirements for ammendments is not specified all bond holders must consent. In the US, the trust indentures Act provides some guidance as to how trust indentures should be ammended. In Cdn, ammendment provisions are completely left to negotiation.

Leveraged Buyout- If acq co wants to acquire a company for $100M from target co. not likely that they will have the cash around, it will have to borrow (often through junk bonds). -In Cdn, acq co which is paying all of the interest (interest expense) cannot apply this to the income of the target co. In a perfect situation only the net amount would be taxed. If acq co has 100% of the shares of of target co can do a short form amalgamation. All assets and debts of the two companies become those of the amalgamated entity.

BONDS WITHOUT COVENANTS AND HIGH LEVERAGE RESTRUCTURING

The Disappearance and Reappearance of Covenants

I. Bratton, “Corporate Debt Relationships: Legal Theory in a Time of Restructuring”A. Restructurings enable equity to gain at the expense of management and debt-holders.

1. Varieties of Recapitalizations (R):(1) friendly mergers(2) Hostile tender offers followed by:

(a) mergers;(b) leveraged buyouts; or(c) defensive recapitalizations

2. Recapitalizations entail the payment of a bonus to equityholders, financed by substantial borrowing that injures bondholders. In effect, they transfers value from securities to the equity’s premium.

B. Restructuring and Bondholder Wealth Transfers1. High D/E ratios enables the initial return of capital to the equity.2. Increased leverage reduces the cost of capital because of tax savings from

deductibility of interest payments.3. Leverage also encourages management discipline because interest payments on

debt are mandatory unlike discretionary nature of dividends..4. Increasing leverage causes preexisting debt to become riskier and fall in

price as the issuer’s D/E ratio rises.C. The Facilitating Conditions: the Disappearance of Business Covenants and the Limited

Force of Reputation.1. Increased leverage was a direct consequence of the removal of covenants

prohibiting additional debt. Debtholders decided that they could rely on the reputation of companies that acted conservatively to ensure that debt financing costs would not increase. Then came the LBOs of the eighties . . .

2. To protect against “event risk” bondholders began insisting on covenants known as:a) poison-puts: which gave bondholders the right to demand that the issuer

repurchase the debt securities at the initial offering price upon the occurrence of certain events generally limited to unfriendly takeovers.

b) super poison puts: are triggered by a number of events-- recapitalizations, LBOs, major dividend distributions that substantially affect the underlying value of the company, purchase of a controlling

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interest, and stock repurchase programs. These provisions are often triggered by downgrading of the credit rating of the debt securities.(1) sometimes these provisions allow for the alteration of the

coupon rate of the bonds to a higher rate of interest to better represent the increased level of risk caused by recapitalization.

Fiduciary and Good Faith Duties in the Absence of Covenants (RJR)

I. Metropolitan Life Insurance Company v. RJR Nabisco (1989).A. Facts:

1. CEO of RJR, F. Ross Johnson, proposed a $17 billion LBO of the company’s s/h’s at $75/ share. Rival firm Kohlberg, Kravis, Roberts (KKR) offered $24 billion at $109/share. Board of Director’s accepted KKR’s offer.

2. LBO would saddle RJR with $19 billion in new debt, through a merger with KKR.

3. Bondholders (Metlife) claim that RJR’s actions have drastically impaired the value of the bonds in order to finance the LBO. This results in an enormous windfall to the company’s shareholders.

4. The indentures were standard boilerplate clauses that were known to plaintiffs. Indentures contain no restrictions on the creation of unsecured short-term debt, unsecured funded debt, or dividends. No debt limits were imposed because it was assumed that debt would be used for productive purposes.

5. Court found that Metlife was aware of the deficiencies in its indentures and thus could not plead ignorance.

6. Metlife claims that the LBO undermines the foundation of the investment grade debt market, and that, although debt covenants did not limit issuance of new debt and dividends, it was assumed that as a blue-chip company, the covenants were deemed unnecessary. Also, the buy-out was not in the contemplation of the parties at the time of purchase of the bonds. Essentially, Metlife was induced into purchasing the bonds on reliance of RJR’s status as a blue-chip, investment grade investment. These representations were both explicit and implied from the CEO’s speeches etc..

NB: From the pre-existing debtholders perspective this debt comes into the company although it does not see the benefit of the investment of the money. Pro-rata participation in the event of default has seriously been reduced.

B. Issue: Is Metlife entitled to some sort of fiduciary protection?1. The Implied Covenant:

a) The court’s inquiry begins with the determination of the “fruits of the agreement” between the parties. In other words, were the plaintiffs’ contractual rights violated?

b) Court finds that the plainfiffs’ complaint nowhere alleges a breach of contractual obligations - as such there is no reason to believe that interest payments won’t continue or that principal will not be repayed.

c) The plaintiffs are not alleging an implied breach of a good faith covenant to protect a legitimate, mutually contemplated benefit of the indentures. Rather they are asking the court to create an additional benefit for which they did not bargain.

d) The plaintiffs are asking the courts to ensure that they have made a good investment. Court is only willing to ensure that the contract is properly performed.

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C. Held: Judgment for RJR Nabisco. Before a court will recognize a fiduciary type duty, it must be certain that the complainant is entitled to more than the “morals of the market place”. As a sophisticated investor, Metlife is not entitled to such protection.

II. Note: Fiduciary Theory, Good Faith Duties, and Other Bases for Judicial Protection of Public BondholdersA. It is impossible to draft express protection against all “event risk” contingencies

while leaving management free to carry on business of maximizing value.B. One solution is to apply judicially imputed covenants of good faith to govern the

parties in their ongoing contractual relationship, or by judicially imposed fiduciary restrictions on the behaviour of management and the equity holders vis-a-vis the debt holders.1. While this is a novel idea, it requires us to make difficult determinations of what

constitutes opportunistic behaviour.C. Alternatively, bondholders could resort to antifraud strictures under securities laws to

require ex ante disclosure of risks of strategic behaviour to which the bondholders are exposed. (See Wherehouse infra.)

D. Another possibility is to give bondholders voting rights over any changes in corporate structure that might adversely affect them.

Re Canadian Pacific Ltd. (1996) 30 B.L.R. (2d) 297Facts:- Canadian Pacific Ltd. (CPL) wishes to carry out a corporate reorganisation with the view of positioning itself more competitively in today’s business environment. The reorganisation includes a plan of arrangement under the provisions of the CBCA and, as such, requires the approval of the Court.- Opposition to the arrangement comes primarily from certain holders of a type of non-voting CPL stock known as Consolidated Debenture Stock (CDS), an antiquated security issued between 1898 and 1937. There are 50M of CDS issued in pounds sterling and 65M issued in U.S. currency. There is no contract or CBCA provisions for dealing with the CDS in existence.- The arrangement, as originally proposed, was faced with unanimous opposition from the CDS holders. Following negotiations and amendments, it is only certain US CDS holders that oppose the re-organisation.THE RE-ORGANISATION:

- CPL’s non-rail are to be transferred to a new corporation (new CPL) of which CPL (to be renamed Canadian Pacific Railway) will become a subsidiary. Prior to the re-org CPL’s assets totalled $16 billion $5.8 billion of which are rail assets.- CPL preferred shareholders will exchange their shares for common shares of CPL. The CPL shareholders (all common shares) will then transfer their common shares to new CPL for common shares in that company.-The CDS holders may either:1. exchange their stock for cash at 80% of their par value; 2. exchange their stock for ordinary shares having a value equivalent to the cash amount in 1.;

or 3. retain their stock with no change in the terms governing them with the additional security

of a letter of credit from a major Canadian chartered bank guaranteeing the payment of interest and principal.

- Pursuant to the CBCA’s dissenting rights provision, all of the above stockholders are given the option to dissent and to have their shares valued and bought by company.

Holding:

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Some U.S. holders oppose the plan on the basis that it is not fair and reasonable. The Court holds that the plan is fair and reasonable.Ratio:- Corporate arrangements are provided for in s.192 of the CBCA. Arrangements are used when it is not practical to effect a fundemental change (wrt one of enumerated types).- Step 1 - go to the court and submit a plan of arrangement, judge is to determine if it fair.- Step 2 - get requisite shareholder authority- Step 3 - go back in front of the judge so he can determine fairness- Arrangements are a forum for anyone to launch complaints re garding the proposal - do not have to be an interested party and bring a separate action.- The advantage of an arrangement is that the complicated series of transactions which can be ordered in a very precise way. In this case, a simple sale would involve masisve capital gains to be realized.

The principles to be applied by the Court in approving a plan of arrangement under this section are well established. The Court must be satisfied:

1. that all statutory requirements have been fulfilled;2. that the arrangement is put forward in good faith and that the statutory majority who

approved the scheme were acting bona fide; and,3. that the arrangement is fair and reasonable (not whether oppresive).

1. STATUTORY REQUIREMENTS:Considering that:- CPL is not insolvent pursuant to s.192(2); - the proposed plan meets definition of arrangement in s.192(1); and,- as a result of the complexity of the re-organisation, it is not practicable for the corporation to effect a fundamental change in the nature of the arrangement (as defined in the section) under any other provision of the CBCA,the statutory requirements have been met.

2. SHAREHOLDER APPROVAL:- At the shareholder meeting the requisite 2/3 majority approval was obtained.

3. FAIR AND REASONABLE - The CDS provides its holders with a 4% annual interest payment in perpetuity (i.e. there are no redemption or retraction provisions) secured by a first charge over the whole of CPL’s assets. The CDS have been characterised as a “preference stock with a special preference” as they have no voting rights (except in the event of default) and no residual rights in the equity of the company. The first charge over the assets is a floating charge that does not crystallise unless there is default in the interest payment and does not preclude the Company from dealing with its assets in any way in the meantime.- There are three (for our purposes) submission advanced as to why the plan is not fair and reasonable.1. The transfer of approx. 63% of CPL’s assets to new CPL unfairly and unreasonably erodes the security underlying the CDS.- The nature of the first charge security is a floating charge crystallising in the event of default. As such, with the exception of a default situation, CPL is free to deal with its assets as it sees fit (the nature of this security was the subject of previous litigation and determined by the SCC in that case).- The Court finds that the “security” issue has been amply addressed by the plan as approved by shareholders. The CDS obligation will be reduced as approx. 62% of the CDS holders will exchange their CDS for cash. The remaining assets of CPL old ($5.8 billion) and the letter of credit from the bank will be sufficient to secure the principal and interest payment of the

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remaining CDS. The Court also points to the fact that the CDS will receive a more favourable rating from industry professionals.2. The preference shareholders of CPL received more by way of premium in consideration for the transaction that the DCS holders. The conversion price is not high enough for the CDS holders and the plan should be amended accordingly.- The Court indicates that comparison of premiums received between two classes of shareholders is inappropriate. There are many factors that must be considered and one person or group may weigh certain factors differently than others - the benchmarks for comparison are not the same. For example, here the preference shareholders receive a higher premium, however, they have no choice but to convert their shares. The CDS holders, on the other hand, receive a lower premium but have a choice. - A substantial vote in favour of the proposed pan or arrangement by shareholders affected is an important factor in the Court’s considerations. The “business judgment” of the shareholders affected is to be given great weight- While shareholders within the same class must be dealt with accurately and equally, it is not accurate to say that all shareholders as between classes must be treated proportionately or equally.- The Court must find (and is in this case) that the arrangement is fair and reasonable having regard to the interest of the company and shareholders taken as a whole.3. There was a failure to permit a proposed amendment to be put at the meeting of the CDS holders, therefore the Court should amend the plan accordingly.- Based on the proxy procedures, the proposed amendment should have been heard and voted on. - Practically, allowing the amendment to have been put forward would have not change the result as management held sufficient proxies to defeat it anyway. The Court is not willing to vary the plan on the ground of some material oversight or miscarriage.- The Court’s jurisdiction under the CBCA to amend a plan at the time of the fairness hearing should be exercised sparingly as this will effect the delicate balance that was previously negotiated by the Company and the various stakeholders. There is a risk that frequent amendments by the Court will give rise to more frequent arguments by stakeholders in favour of varying the plan. This will undermine the voting and negotiation process which precedes the courts approval.

The Unprotected Bond and the Antifraud Rules of the Federal Securities Laws

I. McMahan & Co. v. Wherehouse Entertainment, Inc. (1990) A. Facts:

1. W offered 6 1/4% convertible subordinated debentures whose key feature was a right to tender the debentures back to W upon certain triggering events including:a) an acquisition of 80% or more of voting power by person or group

unless approved by majority of independent directors;b) consolidation or merger unless approved by majority of independent

directors;c) incurrence of debt which violates D/E ratio of .65 : 1.0, unless ratified by

majority of independent directors.2. Independent Director defined as a director of company who is not a recent

employee who was a director on the date of the offering of the securities or was subsequently elected to the Board by the then-Independent Directors. This was aimed to protect bondholders from certain forms of take-over attempts including LBO’s.

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3. W entered into a merger agreement with WEI through a LBO which left W with debt approaching 90% of capitalization ( 9:1 D/E ratio)

4. This reduced value of the bonds by 50%. The plaintiff attempted to exercise its right to tender but the company refused claiming that the Board of Directors had approved the merger.

5. Plaintiffs claim that W knew that the right to tender was illusory, as a result, their representations of the right as valuable and protected had misled investors. This they claim is against federal securities laws.

6. The District Court held that the rights were not misleading or illusory.B. Issue: What is the meaning of the limitation placed on the right to tender by the role of

“Independent Directors”.C. Held: In Favour of the Plaintiffs

1. W’s representations taken together in context would mislead a reasonable investor about the true nature of the debentures.

2. Disclosure required by the securities laws is measured not by literal truth, but by the ability of the material to accurately inform rather than mislead prospective buyers.

3. Section 11 of the Securities Act of 1933a) states that any signer, officer of the issuer and underwriter may be held

liable for a registration statement containing an untrue statement of a material fact or omission of a material fact.

b) Plaintiffs claim that offering materials misstated the right to tender and omitted material information. A reasonable investor would have believed that the right was valuable because it was presented as a right to be exercised at the holder’s option and as a protection against takeovers affecting value of bonds. In truth, it was designed to be exercised at the option of management.

c) The Court agreed stating that all but one of the Independent Directors were normal directors of the board. These Directors had a legal obligation to act in the best interests of the s/h’s in a takeover situation. The Independent Directors had no independence to act in the interests of debtholders. Therefore, the rights given to bondholders were illusory.

D. Dissent: Sand J. did not believe that this right was worthless because it did have the deterrent effect of preventing hostile takeovers that would be contrary to the interests of s/h’s and debenture holders. The plaintiffs were sophisticated investors who should have understood the ramifications of the debt covenants.

Altering the Bond Contract - Coerced Votes and HoldoutsBarbeau:- Ussually when dealing with major transactions some ammendments to the Trust Indenture will be required. When this is required and bondholder consent is needed the bondholders will attempt to value the worth of their consent and extract a consent premium from the issuer. Issuer are often in a bad position in this respect as they have already anounced the major transaction.- There are few options to the consent soliciation process: could call in bonds, however, given call premiums there will significant refinancing cost.

-Promises in bond contracts can be amended or their performance can be waived. Amendments and waivers are most likely to be requested by issuers in financial difficulty. If granted, the financial distress can be diminished without resorting to expensive bankruptcy proceedings.

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-The process of collecting bondholder consent for amendments or waivers is much less onerous with private placements than with public issues. Note that when a private placement is involved face to face negotiations will often be involved.- When in situations of distress, issuers take advantage of the fact that its debt obligations are trading at a deep discount to revise its debt obligations. - Issuers can repurchase the publicly or privately held bonds at a discounted price, however, the issuer does not usually have the spare cash to accomplish this. Most often the issuer will deal with its debt by means of an exchange offer. This is an offer to the holders of the debt, the consideration for which is new debt with scaled down rights, equity, cash or a mix of the three. To induce the debt holder to waive a contractual right (e.g. timely payment), the issuer must offer the bondholders a package with a value higher than the current trading value of the bonds.- Two problems arise in these “workout” situations:

1. Issuers can work elements of coercion into exchange offers or amendment processes (by determining the timing of the restructuring or by overstating the gloomy consequences of a failure to acquiesce) whereby questions arise as to whether bondholders had an effective choice.

2. A bargaining arrangement that permits holdouts creates an added possibility of the failure of the readjustment even though it may increase the debtor’s offering price to the bondholders. If the necessary majority exchanges its bonds or consents to the amendment a benefit may flow to the non-consenting minority - they retain a right to full principal and coupon. There is thus an incentive not to exchange or consent but at the risk that the necessary majority is not achieved. If the necessary majority is not achieved a bargaining impasse results, the recapitalization fails and a costly bankruptcy process ensues.

Alladin Hotel Co. v. Bloom, U.S. CA, eighth circuit, 1953Facts:- This is a class action taken on behalf of owners of a minority in value of certain bonds issued by Alladin. - The bonds in question were issued in 1938 maturing 10 years later (1998) with an annual interest payment of 5%. If the principal was not paid on maturity (1948) an interest payment of 8% was payable from maturity until paid. The bonds were secured some property owned by Aladdin. - The governing documents provided that bondholders of not less than 2/3 principal amount could modify and extend the date of payment provide it applied to all bonds equally.- Owners of more than 2/3 principal amount of the said bonds also owned a majority of the stock in Aladdin, were controlling members of the Board of Directors, and dominated and controlled the acts of Aladdin.- Pursuant to the governing documents’ requirement of a 2/3 majority, the sock/bondholders extended the maturity date of the bonds by ten years (1958) without notifying the other bondholders and without seeking their consent.- It was contended that the amendment was not made in good faith and was not for the equal benefit of all holders as it deprived them of their rights and property. The TJ awarded a money judgment to the plaintiff. On appeal the defendant/appellant argues that the modification was made in strict compliance with the provisions of the contract.Holding:- The appeal was allowed.Ratio:- The amendment was made in strict compliance with the contract which violated no principle of public policy nor private right.- The only limitation in the contract was that the modification apply to all bonds equally and this was satisfied. The contract did not require that such modification affect all of the bondholders similarly.

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- Aladdin and its shareholders will benefit from the amendment, however, it does not automatically follow that such an amendment is prejudicial to the bondholders.- The rights of the bondholders are to be determined by their contract and courts will not make or remake a contract merely because one of the parties thereto may become dissatisfied with its provisions.- There was no provision in the contract requiring notice to be given. Notice in this case could have served no possible purpose as the amendment was legal. Notice would not have permitted the bondholders to block the amendment.

Trust Indenture Act of 1939, as amended 1990s. 316 (a)(1) The trust indenture shall be deemed (unless expressly stated that such provision is to be excluded) to contain provisions authorising the holders of not less than a majority (in principal amount) of the indenture (or other) security to:

A. direct the time, method and place of conducting any proceeding for the exercise of any remedy or power available to the trustee under the indenture;

B. consent to the waiver of any past default and its consequences. (2) The indenture may contain provisions authorising the holders of 75% (in principal amount) of the indenture (or other) securities to consent to the postponement of any interest payment for a period not exceeding 3 years from its due date.- For the purpose of this subsection, any securities owned by any obligor (or by any person directly or indirectly controlling or controlled by or under direct or indirect common control with any such obligor) of the indenture securities shall be disregarded.s.316 (b)Notwithstanding any provision of the indenture to be qualified, the right of an indenture security holder to receive payment of principal or interest (or to institute a suit to receive the same) shall not be affected or impaired without the consent of the holder, except as to a postponement of interest under s.316(a)(2) and except to the extent that the indenture may contain a provision denying or limiting such a right to the extent that such a suit would result in the surrender, impairment, waiver, or loss of the lien of such indenture upon any property subject to such lien.

Section 316 restricts the power of majority bondholders to defer or forgive principal and interest payments. Historically, majorities were often induced to make modifications which were seriously detrimental to the bondholders without a comparable sacrifice made by shareholders. The modifications were also sometimes unnecessary.

Katz v. Oak Industries Inc., Court of Chancery of Delaware, 1986.Facts:- Oak is in serious financial difficulty. As such, it is undertaking a complex re-organisation part of which involves an agreement for the sale of part its business to Allied-Signal (AS) and an agreement to sell to AS 10 million common shares and warrants to purchase additional common shares of Oak (the Stock Purchase Agreement).- The Stock Purchase agreement provides as a condition that at least 85% of the aggregate principal amount of all Oak’s debt securities shall have tendered and accepted the exchange offer. If the 85% is not achieved AS has an option to buy the shares and warrant but no obligation to do so.- NB there is no redemption provision for these securities otherwise would have been used.- The exchange offer (which represents the subject matter of this lawsuit) has as a condition that:

1. a minimum amount of debt securities be tendered pursuant to another exchange agreement; 2. a minimum of each class of debt be tendered under the exchange offer in question; and

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3. those tendering under this exchange offer consent to the proposed amendments of the relevant indenture securities.

- The proposed amendments for which consent is being sought would have the effect of removing significant negotiated protection to the debt holders. This gives rise to the plaintiff’s claim of breach of contract. Debt holders who elect not to tender may be adversely affected. A preliminary injunction is sought.- The cash that will be exchanged for the debt securities represents a premium over the market price for the debt.- It is contended by the plaintiff that combining the consent solicitation and exchange offer constitutes a contractual breach of an obligation owed by Oak to act in good faith (NB if sufficient consent those who did so will get bought out). Typically the tender period is open for ten days and at the end of the period if there is sufficient consent the exchange occurs automatically.- The plaintiff claims that no free choice is provided to the bondholders as a “rational” bondholder is “forced” to tender and consent. If the bondholder does not, he/she would be left holding debt securities stripped of all its financial protection (i.e. convenants) and for which there would be no ready market. It is claimed that the bondholders are being coerced.Holding:The plaintiff’s application for a preliminary injunction is denied.Ratio:- The relationship of a corporation and a holder of its debt securities is contractual, not fiduciary. This is not to say that under contract law a corporation owes no duty to its bondholders to act in good faith. - The arrangements under which debt is issued are typically thoroughly negotiated and massively documented. The rights of the various parties should be spelled out therein. It is the contractual relationship agreed to and not broad concepts of fairness that define a corporation’s obligation to its debt holders.- The fact that the purpose and effect of the exchange offer is to benefit the shareholders at the expense of the bondholders does not in and of itself give rise to a cognizable legal wrong. Corporate restructuring designed to maximise shareholder values may in some instances have the effect of requiring bondholders to bear greater risk of loss and thus in effect transfer economic value from bondholder to stockholder. If protection against this is to exist it must come from the indenture provisions.- Some coercion is legally unproblematic. Whether the coercion in this context is wrongful will be derived from the law of contracts. Under contract law parties are required to act in good faith towards the other with respect to the subject matter of the contract - sometimes it will be necessary to consider the substance over the form of the agreement. - When considering whether the doctrine of good faith should be invoked courts will look to see if the parties had expectation or understandings that were so fundamental that they did not need to negotiate them. The test is this: is it clear from what was agreed upon that the parties who negotiated the express terms of the contract would have proscribed the act later complained of as a breach of the implied covenant of good faith had they thought to negotiate with respect to that matter.- The court considers the provisions of the contract in applying the aforementioned test to the combining of the exchange offer to the consent solicitation. Specifically, the plaintiff pointed to provisions which:

1. establish that consent of a stated majority of the bondholders was required to modify the terms of the various indentures;

2. restrict Oak from granting consent from securities it holds in its treasury; and3. establish the price at which and manner in which Oak may force bondholders to submit their

securities for redemption.- The court finds that there is nothing in the indentures that restricts Oak from providing the bondholders with an inducement and nothing that gives bondholders the right to veto proposed modifications.

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- The court finds that linking the consent solicitation and exchange offer is not tantamount to Oak voting its securities on the proposed modification (as is restrict by provision 2. above). No one (other than the bondholders) with a financial interest in the modification is voting - there is no financial conflict of interest.- The court finds that the agreement is not tantamount to a unilateral redemption and therefore not a breach of provision 3 above. Not being forced to tender - simple inducement.- The inducement provided in this agreement does not breach an express term of the indenture nor does it breach an implied obligation of good faith. Barbeau: indicates that when there is a lower threshold (e.g.) this gets more complicated because the issuer obviously can offer a lower price (need less to tender). - Two step tender consents are possible whereby at day 10 all those who have tendered will share in the consent premium. The debts are exchanged on day 20 and those who did not consent (if the majority was acheived) can tender their debt but will not share in the consent premium. This is an even more coercive process.

- Practically speaking this is not done much because do not want to put institutions under thsi kind of pressure.

Note: Coerced Votes and Hold Outs- It is argued by some that s.316(b) should be repealed because denial of the sufficiency of majority action to alter core terms of indenture provisions is unnecessarily costly in contemporary markets dominated by institutional investors. It is also argued that the evils to which the unanimity requirement is addressed - inadequate info, inside control of bond issue and unsophisticated investors - no longer exist in sufficient force to be worth the cost of precluding inexpensive pre-bankruptcy workouts by majority action without judicial supervision.- Unanimity under s.316 creates holdout potential which exacerbates the bondholder’s problem. As was seen in Oak, however, the bondholder’s problem can occur where the issuer side steps s.316. - The potential to holdout under s.316 is beneficial to bondholders in certain circumstances, for example, where bondholders feel that the readjustment price is too low and they seek to raise it for all bondholders by holding out. In others circumstances it gives rise to conflicting incentives that may costs all bondholders in the end. For example, where the bondholders expects a majority to tender and hopes to be bought off at a higher price in the market by the issuer. In these types of situations the workout may fail at a cost to all bondholders.- The costs of the section must be weighed against its benefits to determine whether or not it should be repealed.

Lender Liability- As we have seen the law displays no affirmative commitment to affirmative lender protection - with the exception of cases of misrepresentation and material non-disclosure lender. Lender must protect themselves through contract. Should the same principles apply to borrowers?- Usually, lenders do not attempt to extract concessions from borrowers after the debt contract is executed and delivered. Lenders have reputations to worry about and can find substitute lenders elsewhere. There are two general situations in which lenders may be induced to dishonour a commitment:

1. when interest rates rise sharply2. where the borrower relies on the lender and their close relationship and the lender attempts to

extract concessions by threatening to withhold advances in timely situations.

KMC Co. v. Irving Trust Co.

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- A bank refused to advance the last $800,000 of a $3.5 million line of credit to a company that was fully secured but on shaky grounds. - Under the agreement the bank had the discretion to refuse to advance but the contract was silent on the issue of the amount of notice was required prior to the refusal.- A jury found that the failure to give notice was a violation of the obligation of good faith. The Court of Appeal upheld the decision based on the following:

1. without the good faith obligation of notice giving the debtor the time to secure alternate financing the debtor’s very existence was at the whim of the bank;

2. the debtor needed a valid business reason to avoid the notice requirement;3. the good faith provision also covered the loan’s demand provisions; and4. the fact that the lender was secured weighed heavily in the decision.

NB: An opportunistic borrower could, between the time of notice and cut off date, draw down the line of credit.

Kham and Nate’s Shoes v. First Bank of Whiting- A bank agreed to provide the company undergoing bankruptcy restructuring proceedings a $300,000 line of credit which was to be given super priority under the relevant act. The agreement provided that the bank could terminate the line of credit at its discretion with five days notice. After a month’s time, when the company had only drawn $75,000 from the line of credit, the bank exercised its discretion and terminated the credit agreement. - The company claimed that the banks conduct was inequitable and that the $75,000 it had drawn from the bank should not be given super priority status. - The court found for the bank holding that the conduct was not inequitable. The court indicates its unwillingness to require participants in commercial transactions to do more than is required of them under the contract. Unless contracts are enforced according to their terms, the institution of contract is jeopardised.- Good faith in contracts is an implied undertaking not to take opportunistic advantage in a way that could not have been contemplated and was therefore not resolved explicitly at the time of drafting the contract. The fact that the literal enforcement of the contract gives rise to some mismatch between the parties’ expectations and the outcome does not imply a duty of kindness in performance.- In this case the bank did not use the debtor’s position to demand improved terms. Bank did not create the debtors need for funds. It was entitled to advance its own interest and did not need to put the interest of the debtor first.- The debtor stresses that the full line of credit would have been secure, however, the court indicates that ex post assessments of a lender’s security are no basis for varying the negotiated terms. Deference is paid to the lenders ex ante credit assessment by the lenders.- The fact that the banks refusal to advance the remaining line of credit frustrated the debtor later efforts to obtain financing is irrelevant so long as the bank kept its promises under the contract.

Section A.1 Credit Agreement and Related Matters

Credit Agreement Form- Many of the provision contained therein are similar to the bond contract, however, some difference because of the nature of the lender and the nature of the relationship.- These agreements can be somewhat complicated because the straight advance of funds is often combined with the committment to lend.- Typically a credit agreement is divided into several facilities - ways in which credit can be drawn upon:

Term Facility - most similar to bonds or notes in that the money advanced is due after a specified period of time (ussually 5-7 years)

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Reducing Term Facility - like the term except that there are intervals when money is due (requred o bring $ down over the term)Revolving Credit Facility - Provides that borrower can borrow under facility up to a maximum and repay at leisure - this deals with the day to day capital needs of a company. BIG DISTINCTION: Once borrow and payback can reborrow. Will involve a stand by fee.

Bridge financing: short temr facility to put together some form of recapitilization (a take over) and replaced by long term loan once the recapitalisaiton is achieved

Conditions Precedent: Even once a credit agreement singed not necessarily the case that can draw on the money. These are mostly documentary (e.g. provision of financial statements) or relate to the provision of proof of proper security established for the loan or that someone (equity or debt) has injected at least $100,000 - this is very important to the lender as it goes to the core of the commercial issue.

Repayment Provisions: There are mandatory repayment provisions that are frequently intensely negotiated:

- under a term facility at the end of of term specified or on the occurrence of a number of possible trigerring events (e.g. sale of a major assets, loss events, earnings - allows lender to share in good fortune of company, however, company will often object to this as they may have use for the cash)- 5/25 rule: All of the mandatory provisions will be subject to the the ITA’s 5/25 rule whereby if borrower is required to repay more that 25% of $ borrowed within first five years of the loan, loans by non-residents lenders will be subject to the withholding rules. This often creates a hardship to the lenders. One response has been to separate out the US and CDN lenders. When floating rate the rule is not invoke. It is invoked in the circumstances where there is revolving credit agreement (do not want to enter these with US banks). - The exception is not available and the withholding applies where there is a possibility, no matter how slight, that may repay 25% within 5 years (e.g. if there is an event of default- Often buit into the credit agreement whereby the borrower will pay the amount that was to be withheld.

Voluntary repayment may be associated with some type of fee.

Interest Provisions: Mechanics for calculating interest payments based on Prime, LIBOR or Base

Bankers Acceptances; LIBOR Loan Options; Standby Fee (charged for making $ available); Committment Cancellation (Similar to Voluntary Repayments)

Changes in Circumstances: e.g. Cost of Capital - if the rules change in the market (e.g. regulation) for everyone whereby the cost to the bank has increased we are going to change the cost to you. e.g. Illegality- where change makes the loan illegal the borrower has a couple of options.

Representation of Waraties to the Bank: Different from covenants in that the borrower is telling the lender where it stands on certain facts (e.g. not in default, is incorporated, no hazadous materials).

Affirmative/Negative Covenants: Continuing promises specifying what the company should do/not do (e.g. delivery of financial stmts, maintenance of financial ratios/entering into mergers, assume further encumbruances on the assets). When have these spend much time determining if they have been fulfiled. Most contentious issue when negotiating).

Events of Default: Permitting the lender to call the loan (e.g. insolvency or default on other indebtedness).

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Syndicated Loans- Loan syndication (formation of groups of lenders) occurs when a lender wants to share the risk of a particular borrower or industry. Lenders will want to diversify their holdings so as to reduce systematic risk. BIG E.G.:

- want to acq a company for $100M and under take over rules you require committed financing before making a bid.- approach a bank and negotiate a committment letter whereby major terms of the proposed financing are set out (pricing, covenants etc.) - there is typically a commitment fee of about 2% of the loan for simply signing the letter also charged standby fees.- at the time of closing, the committment letter is replaced by loan agreement- once the commitment letter is signed the bank starts worrying about syndicating the loan - often times the lead bank and the borrower discuss who will be invited to join the syndicate.- once the syndication is arrange about 60% of the loan is syndicated; at this time each bank has a direct relationship with the borrower - liability is not joint and several- under the syndication agreemtent there will be provisions allowing for the assignment of the loan by the syndicate banks; these will require the assignee to: 1) be Cdn, 2) be a financial institution, and 3) limit the size of the assignment (there may be restrictions on the lead bank’s assignment).- Assignee has no direct legal relationship with the borrower - not even known by the borrower.- The Lead lender act as the paying and receiving agent. There are fees received for the performance of these services.- In the event of bankruptcy the lender share prorata.- If the B wants to have an ammednment, the loan agreement will provide for ammendments prociedure - votes of the lenders proportional to amount lended. For reason B wants few lenders in the synducate and would prefer assignement (assignment has no say). Depending on the ammendment sought the B may need to get consent from %100 of lenders. Concessions in the loan agreement will often be a matter of solvency vs insolvency.

Chemical Bank and National Westminister Bank v. Security Pacific National Bank(9th cir. 1994)(C.A.)

Facts: Security Pacific (SP) was lead bank in a credit agreement which provided a $25 million credit facility to the borrower. SP provided 60% of the funds, while the two other banks--Chemical and National Westminister (the plaintiffs) provided the remaining 40%.

The credit agreement specifically stated that SP was to be the agent for the three banks and was to undertake certain duties on behalf of the syndicate. The agreement limited SP’s liability however, to only “gross negligene or wilful misconduct.”

SP had advanced its share of the funds four months before the transaction at bar, so it had already filed a financing statement perfecting its security interest. At the time of the transaction, SP decided not to file a new financing statement naming the three banks (with SP as agent) as holders of the security interest under the new line of credit. The effect of this decision was that SP was fully secured, and the plaintiffs were unsecured.

The borrower went bankrupt several months later, and SP recovered 100% payment (i.e. 60% of the $25 million). In accordance with the credit agreement providing for pro rata sharing of satisfaction of the loan, SP turned over 40% of its recovery (i.e. 40% of 60%). The plaintiffs seek

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recovery of the remaining monies advanced (approx. $2 million each) and allege gross negligence and breach of fiduciary duty.

At issue: (1) Did SP breach its fiduciary duty to the plaintiffs? (2) Was SP grossly negligent?

Held: (1) Yes. (2) No. According to the terms of the credit agreement therefore, no liability for SP.

Ratio: (1) The credit agreement clearly established that SP owed a fiduciary duty to the plaintiffs by unequivocally naming SP as “agent bank.” This duty was clearly breached when SP deemed it unnecessary to file a new financing statement, because “any prudent lawyer would have anticipated the possibility that a bankruptcy court would find the existing financial statement insufficient to perfect the plaintiffs’ security interest....SP created a real risk for its principals when it failed to file.”

(2) The above omission constitutes negligence, but it does not constitute gross negligence, since the parties involved were sophisticated institutions represented by knowledgeable counsel. Even though it was industry practice for the agent bank to file financing statements for the benefit of each participant in a multi-bank loan, and the cost attached was a mere $10, and SP’s omission was intentional, this still does not constitute gross negligence nor wilful conduct.

Sumitomo Bank Ltd. v. Banque Bruxelles Lambert (1997)(Q.B. Comm. Ct.)Facts: Banque Bruxelles Lambert (BBL) was lead bank and agent for a syndicate of banks in two separate credit facility transactions. The loans were underwritten by an insurance co. named Eagle Star (Eagle). The policy stated that in the event of a default by the borrower, Eagle would indemnify BBL (as agent for the syndicate) for any shortfall in sums recovered upon realization of the banks’ security.

The borrower defaulted. The banks realized on their security, but there was a substantial shortfall. BBL called upon Eagle to indemnify the syndicate for the shortfall. Eagle refused, claiming that BBL had failed to comply with its disclosure obligations under the insurance policy.

The syndicate banks--the plaintiffs--now seek indemnification from BBL on the basis that BBL, as arranger of the loans, was responsible to them for performance of the disclosure obligations under the policy. The “essence of their claim” is that BBL owed the plaintiff banks a duty of care to exercise reasonable care to discharge the disclosure obligation.

(note: whether or not BBL actually failed to comply with the disclosure obligations is yet to be decided...this case concerns only whether BBL owed a duty to the plaintiff banks to make such compliance).

At issue: Did BBL owe a duty of care to the plaintiff banks to discharge the disclosure obligation?(note: There are actually over a dozen issues in this case. The court focuses on this one, and I have deemed it the most relevant for our purposes. For a succint review of the issues, see the headnote).

Held: Yes.

Ratio: Although the loan agreements included no express warranty that BBL would discharge its disclosure obligations under the insurance policy with Eagle, the court found that BBL had “assumed” that responsibility. In the court’s own summary: “BBL was the arranger of the facility. It assumed as such the obligation to negotiate the (insurance policy) with Eagle. It did so on terms whereby it and it alone was the insured under the policy and it and it alone had and could perform the disclosure obligation provided for in it which depended on its own

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expert procedures and its skill and judgment in deciding what should be disclosed to Eagle. BBL knew the validity of the policies depended on its proper performance of that obligation. It knew the policies were vital to the interests both of itself and the banks and that the banks were dependent upon it for the performance of the disclosure obligation which effectively was entrusted to it in all their interests. The banks relied on BBL accordingly as BBL knew they would. Loss to the banks if the duty was not performed was foreseeable and indeed foreseen by BBL. The duty arose in the context of the specific purpose of the loan transaction.”BOTTOM LINE: There is a heavy responsibility on the lead lender.

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SECTION B -- PREFERRED STOCKHOLDERS’ RIGHTS

1. Preferred Stock Financing

Re Central Capital Corp. (1996)(Ont. C.A.)

Facts: Two vendors (the plaintiffs) sold shares to Central Capital (CC). In exchange, they received cash and preferred shares in CC. These preferred shares, complete with voting and dividend rights, contained a retraction clause which entitled the holders to require CC to redeem the shares at a fixed price.

CC became insolvent. A plan of arrangement was authorized. CC informed the plaintiffs that no redemption of their shares would be possible because this would be contrary to s. 36(b) CBCA (no redemption allowed if company insolvent--debt ranks prior to equity!).

The vendors claim they are debtholders and therefore have a claim as creditors of CC.

At issue: Do the plaintiffs’ preferred share holdings constitute debt or equity instruments? i.e. are they creditors or shareholders?

Held: 2-1: The plaintiffs are in substance shareholders and not creditors of CC.

Ratio: All three judges agree that the instruments are clearly of a “hybrid nature” but they part company in their characterizations of the “true substance” (Canada Deposit) of the relationship between CC and the plaintiffs:

Weiler J.A.: The court must look to the surrounding circumstances to determine the true nature of the relationship. When the vendors sold shares in one company in exchange for shares in CC, they were simply transferring their investment from a smaller entity to a larger entity. Once shareholders of CC, they chose to remain shareholders, taking the accompanying risks and deciding not to sell their shares on the open market. Further, they had rights to dividends and had priority in asset distribution upon a liquidation. “Risk-taking, profit-sharing, transferability of investment and right to participate in asset distribution are the hallmarks of a shareholder.” As well, the common features of a debtor-creditor relationship are not present: no express provision that the redemption is in repayment of a loan; CC not obliged to create any fund or debt instrument to ensure it could redeem the shares on retraction date; no indemnity in event money not repaid on retraction date etc.

Laskin J.A.: The substance of the transaction is determined from the parties’ intention. What the parties here intended is reflected mainly in (i) the share purchase agreements--the vendors agreed to take preferred shares instead of some other instrument (bond or debenture for example) that would obviously have made them creditors; (ii) in the conditions attaching to the appellants’ shares--the rights to receive dividends and to vote are well-recognized rights of shareholders, as is the right to priority in any asset distribution; (iii) in CC’s financial statements--the preferred shares were recorded as “capital stock” and not debt nor contingent debt.

Once the vendors are characterized as shareholders, their rights of retraction do not create a debtor-creditor relationship. They simply enable them to call for the repayment of their capital on a specific date and for a fixed sum, provided the company is solvent.

Finlayson J.A.: (dissent) The character of the instrument is revealed by the language creating it and the circumstances of its creation. The shares were not issued to investors, but to vendors of property. The vendors were entitled to receive a fixed sum at a specified time in payment therefor. Pending payment, the vendors were entitled to receive dividends which were the equivalent of interest on the unpaid

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balance. Although the instruments remained in place as shares until actually redeemed, the retraction clauses constitued promises by CC to pay fixed amounts on definite dates and therefore evidenced debt to the vendors. The fact that the vendors were shareholders did not affect their rights as creditors.

1. Preferred Stock Financing

Barbeau: - The CBCA provides for 3 basic rts in the CBCA 1) rt to vote, 2) rt to share in liquidation, 3) rt to share in profits. The CBCA does not indicate what is meant or provide a definition for ps. The law does what the shares of a corporation provide for so long as some class of shareholder or combination thereof hold the three rts.- A typical ps has no voting rts with a fixed issue and redemption price and dividend payment which participates in priority over the cs wrt dividends and on liquidation.- Since preferred shares have no upside benefit and lower ranking than debt any value attaching thereto will have to do with dividend streams. Since rank behind debt when trouble lurking their value drops bigtime.

A. Introduction· The preferred stock takes a classification similar to that of the common stock.· Preferred stock considered as a permanent investment for the life of the company. Unlike the bond,

the preferred stock does not contain any promise of repayment of the original investment , nor is there any legal obligation to pay a fixed rate of return on the investment.

· The rights and responsibilities of shareholders differ between preferred and common stock: common stockholders agree that preferred stockholders shall have "preference" or first claim to dividends.

· Straight Preferred Stock: most frequent type of preferred stock -- non-participating, extent of priority represents a fixed percentage of the par value of the stock or a fixed number of dollars per share in the case of stock without a nominal/par value.

· In most cases, the prior position of the preferred stock also extends to the disposition of assets upon liquidation of the business. Such priority is only with reference to common stockholders and not creditors.

· The pressure for a regular common dividend assures the holder of a preferred stock that his regular dividend will not be interrupted for it is damaging to the reputation of the common stock (and therefore its price) if preferred dividend arrearages (i.e., unpaid past dividends) stand before it.

· Why not use bonds instead of preferred stock? · The case for bonds:

1. The dividend rate on a preferred stock is typically higher than the interest rate on a comparable bond and may have the additional disadvantage of not developing a tax shield.

2. The deductibility of interest payments give debt a relative advantage over preferred from the issuer’s point of view. This tax differential has contributed to a relative decline in the use of preferred as a financing vehicle in the post-war era.

· The case for preferred stock:1. Additional equity (i.e. preferred stock financing) increases the equity cushion and thus

creates room for cheaper debt.2. The cost differential between a preferred stock and an alternative debt issue can be

considered a premium paid for the option of postponing the fixed payments. The closer a company gets to its recognized debt limits, the more management is likely to

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appreciate the option to defer the dividend on a preferred stock issue and be willing to pay a premium for this potential defense against a tight cash position.

3. Tax Advantage: the intercorporate dividend exclusion results in preferred stock dividends attracting less federal income tax than bond interest when the preferred is held by a corporation, partially offsetting the disadvantages of the lack of issuer deduction for dividend payments. Hence preferred stock can offer a more attractive investment opportunity than unsecured bonds to insurance companies and other corporate institutional investors, and thus may cost the issuer less.

· Preferred stock is most often employed by government-regulated public utilities (to satisfy their legally mandated debt equity ratios), banks (to expand their equity capital base), and recapitalizing firms having difficulty meeting the obligations assumed in high leverage restructurings undertaken during the 1980s (to increase the firm’s equity cushion with the minimum possible dilution of the upside potential of the common stock).

B. The Preferred Stock Contract· Like bonds and debentures, preferred stock is essentially a security combining priority with a

ceiling on the claim to income and principal. Unlike bonds and debentures, however, the preferred stock’s claim is to priority in payment, but not to an unconditional right to be paid.

(1) Financial Terms · The provisions for current dividends may vary greatly in the force of their compulsion to make

payments, ranging from the mandatory and fully cumulative dividend to the discretionary and wholly non-cumulative dividend.

· The preferred stock contract generally provides, in the event of the dissolution of the enterprise, for payment prior to any distribution to the common stockholders, of a specified sum plus an amount equal to all dividends in arrears, and if dissolution is voluntary, often a premium.

· The contract also provides for redemption at the option of the corporation at a specific price plus an amount equal to all dividends in arrears and a premium.

· The preferred stock contract may contain protective provisions designed to minimize risk of non-payment: e.g. sinking fund provisions, requirements for the maintenance of a minimum working capital, prohibitions against creation of a prior preferred stock without the consent of the existing preferred, class voting for alterations, etc.

· Preferred stock may also embody an opportunity to share in the growth of the enterprise. The usual device is the conversion privilege – the right of the stockholder to exchange a share of preferred stock into a specified number of shares of common stock, or at a designated value for as many shares of common as may be purchased at specified prices.

(2) Voting Power · Preferred stockholders have an entirely different interest in the enterprise than do common

stockholders who are the residual claimants of the benefits of operations and the first to sustain the burdens of loss.

· The preferred stockholder is an "owner" with an "equity" interest, like a common stockholder, and, therefore may be entitled to vote like the holder of a common stock.

· In some states (Delaware, New York), the preferred stock may be denied the vote if the corporate charter so provides. Since the matter is effectively left to the common stock to decide in the first instance, the preferred is not generally given voting power, except as statutes may require with respect to specially prescribed measures: i.e., preferred stockholders are generally entitled to a class vote on charter amendments which adversely affect them – altering the

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par value or aggregate number of authorized shares or altering the powers, preferences, or special rights of the shares adversely

· The corporate charter may provide that the preferred stock shall vote for the election of directors upon the occurrence of default in the payment of dividends for a specified period. Default is defined as the failure to pay an aggregate (rather than a consecutive) number of quarterly dividends.

· This voting power is bestowed upon the preferred by class, rather than by share, in recognition of the possibility that the number of preferred shares will be significantly smaller than the number of common shares, even on those occasions when the investment of the preferreds is considerably larger than the investment of common stockholders.

(3) Authorization and Amendment · The terms of the preferred stock contract are contained in the corporate charter, and may also

appear on the stock certificate. · However, both the initial terms of the preferred stock contract and any alterations to those terms must

find authorization in the State’s corporation law. Disputes over the meaning of the contract will often turn on the statutory language and the contract’s language.

· A considerable body of case law has developed in response to efforts to amend or alter the preferred stock contract. Such efforts are made, normally, when the common stockholders desire to shift the initially agreed-upon allocation of risks and returns, to the disadvantage of the preferreds. This usually occurs when the preferred’s arrearage priority consitutes an insurmountable obstacle to the flow of dividends to common stockholders, the preferred’s dividend rate seems unduly high, or the protective features of the investment contract (sinking fund obligations, working capital restrictions, liquidation price, call premium) becomes burdensome.

· Inevitably, such attempted reallocations by the common stockholders invite substantial changes in the economic dimensions of the enterprise -- infusion of new capital or an arm’s length merger. The question then arises whether the proposed alterations of the investment contract are equally necessary and appropriate.

2. Claims to Dividends

Re Canadian Pacific Ltd. (Ont. HCJ, 1990)F: CP wants to spin off the assets of Marathon Realties to its ordinary shareholders in order to obtain maximum value for the subsidiary under a “triple butterfly” arrangement (192(3) CBCA). The preferred shareholders argued that their rights were not expressly different than the common shareholders wrt distribution of property and that this transaction was equivalent to a distribution of assets or winding-up situation. Accordingly, the preferred shareholders claimed to be entitled to participate in this distribution.I: Is this transaction a normal dividend distribution or a distribution of assets?H: Normal dividend distribution, therefore preferred shareholders were not entitled to share in the distribution.R: Was is a dividend? The nature and substance of the distribution was a distibution of profits. The distribution was viewed by CP as excess profits and thus could not be characterized as anything different than a normal dividend distribution. The accounting effect of the transaction was a reduction in net earnings of the corp.

What are the rights of ps? Under the Construction Rule, the Court must interpret the Articles of Incorporation on a case-by-case basis. Here, the Court concluded, by the language of the corporate charter, that the drafters intended the rights of the preferred shareholders to be limited to the annual cash dividend (4% per annum and nothing more - limit on dividends applied to dividends in

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cash and in kind). Since the preferred shareholders had no other rights “at any time”, they were not entitled to equal rights with common shareholders on the property dividend.

Further, a dividend for one purpose may not be a dividend for another purpose: although CP claimed non-dividend for tax purposes, this means little in the corporate context (if had been a dividend for tax purposes there would have been huge tax ramifications).

A. Preferred Stock Dividend Provisions· Since the income priority of preferred stock is a matter of contract, a great variety of delineations of

priority may occur -- ranging from a requirement that dividends shall be paid if appropriate surplus exists to a non-cumulative priority (i.e., a priority that only blocks dividends to common during the current payment period; past skipped dividends do not accumulate as arrearages even if the enterprise was profitable).

· Intermediate forms most frequently encountered are the fully cumulative preferred (i.e., the failure to pay dividends in any period, whether or not the enterprise had earnings during that period, does not relieve the enterprise of the obligation to pay those unpaid dividends before common dividends can be paid) and the preferred which is cumulative only if earned (i.e., unpaid dividends only cumulate or accrue if they have not been paid for periods for which there were earnings).

B. Board Discretion to Withhold Payment· In all cases other than that of mandatory dividend preferred, directors have discretion to withhold

payment of dividends.· The question is whether courts or legislatures should fashion standards limiting the exercise of board

discretion?

(1) Noncumulative Preferred · Here, the discretion question has been litigated extensively.· The typical scenario: No dividends are paid on either the noncumulative preferred or the underlying

common for many years. During this period the corporation may be profitable, but because the business is capital intensive, management retains all earnings available for dividends. Then, when times improve, management starts the dividend flow again. The noncumulative preferred is paid its limited annual dividend, and the common, the dividend to which is not subject to a limitation once the preferred is paid, is paid a much larger dividend. The preferred argues that, on these facts, “noncumulative” does not have its literal meaning.

· The leading cases, Wabash Railway v. Barclay and Guttman v. Illinois Central R. Co., rule against the preferred, opting for literalism.

Guttman v. Illinois Central R. Co. (US Fed.,1951)H: Since the directors did not “abuse” their discretion in withholding dividends on the noncumulative preferred for any past years, (a) no right survived to have those dividends declared, and (b) the directors had no discretion whatever to declare those dividends subsequently.R: Preferred stockholders are not wards of the judiciary. The bargain the preferred stockholders made may have been undesirable, but the courts are not empowered to practice such preventive legal medicine, and must not try to revise extensively contracts freely made by competent adults.

NOTE: Some commentators have interpreted the noncumulative feature to bar accruals only for years in which the corporation has no earnings. Under this approach, retained earnings serve to create a dividend credit for preferred stockholders which must be satisfied before dividends can be paid on the common stocks. Such an interpretation was taken by the New Jersey court in Sanders below.

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Sanders v. Cuba Railroad Co. (NJ, 1956)H: If the common stockholders, who generally control the corporation and will benefit most by the passing of the dividends on the preferred stock, may freely achieve that result without any dividend credit consequences, then the preferred stockholders will be substantially at the mercy of others who will be under temptation to act in their own self-interest.

(2) Board Discretion and Voting Control · The usual scenario: Suppose the holders of a class of cumulative preferred stock gain the right

under the charter to elect a majority of the board of directors if the issuer defaults in the payment of six quarterly dividends. The defaults occur and the preferred holders elect themselves to the board. The new board returns the corporation to profitability. But the preferred’s board members never declare the payment of the preferred dividend in arrears. So doing would cause the vote to revert to the common stock and possibly cost them their control. Would the common stockholders at some point have a right to have these board elections declared invalid?

Baron v. Allied Artists Pictures Corp. (Del., 1975)F: Holders of preferred stock had been electing the board for 10 years when a class of common stockholders sought avoidance of the election. As of the 1974 election, preferred arrearages exceeded $280,000. Kalvex held 52% of the preferred, thereby controlling the corporation even though the holding amounted only to 7.5% of total equity. The board had been disabled from paying dividends for a number of years under the terms of a tax deficiency settlement with the IRS. The common stockholders asked for a ruling that the board had an absolute duty to pay off all preferred dividends due and return control to the common shareholders as soon as funds become legally available for that purpose.H: The Court sustained the 1974 election, subject to an ultimate limit on the preferred stockholders’ hegemony.R: In effect, the common stockholders would have the court limit the board’s discretion given by the certificate of incorporation, making the decision to pay arrearages mandatory upon the emergence of a lawful financial source even though the corporate charter does not require it.

When the yearly hit-and-miss financial history of Allied from 1964 to 1974 is considered along with the IRS obligation during the same time span, I cannot conclude, as a matter of law, that Allied’s board has been guilty of perpetuating itself in ofice by wrongfully refusing to apply corporate funds to the liquidation of the preferred dividend arrearages and the accelerated payment of the IRS debt = deference to the board.

It is clear, however, that the present board does have a fiduciary duty to see that preferred dividends are brought up to date as soon as possible in keeping with prudent business management. The board cannot be permitted indefinitely to plough back all profits in future commitments so as to avoid full satisfaction of the rights of the preferred to their dividends and the otherwise normal right of the common stockholders to elect corporate management.

Barbeau: Payments of dividends by the board present interesting issues because the duty of the director is to max value of corporation for shareholder: how could the distribution to shareholder be in the best interest of the corporation.

The failure to make a dividend payment can have serious consequences in the market. This is why there has been a move in the market for cs to receive, not regularly scheduled dividends but rather unscheduled dividend payments.

Because ps rank ahead of cs, the cs would like to see a limited # of authorized ps that could be issued.

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3. Claims to Principal, Including Arrearages

(A) Alteration by Amendment

CBCAs. 173: amendment of articles by special resolution (2/3 or more if defined as such in articles) for enumerated matters d) - n) share provisions

- some thing so fund need approval to amends. 176: class vote: holders of a class/series are, unless articles of incorp’n provide other-

wise in certain cases, entitled to vote separately on proposals to amend articles (when specific impact on the class

s. 190: (1) right to dissent under a s. 173 amendment resolution(2) right to dissent under a s. 176 amendment resolution

Barbeau: Most corporation now have an unlimited # of cs and ps. The CBCA allows for the issue of shares in series, this is important from the point of view of the public corporation. When creation of an additional class need special resolution under the above mentioned sections (176(1)e), not so for a series. All shares of series within a class rank equally as if they are single share class. Can be created equally.

1. Liquidation Provisions · preferred shares (p/s) usually provide for entitlement to payment of specified amount upon

liquidation, etc. before any distributions to common shareholders (cs/hs) or junior ps/hs· such principal amounts usually = par value/value of original consideration on issue

Goldman v. Postal Telegraph (1943)(U.S.D.C.)FACTS: Delaware corp PT agreed to transfer to Delaware corp WU all of its assets - p’ff G owned 500 non-cumul p/s of PT entitling him to $60/share on liquidation.

- PT proposed three resolutions: sale of assets; amendment of charter to give ps/hs one WU share instead of $60; dissolution of PT

- all approved under agree’t, PT received 300K WU shares valued at less than the total liquidation preference for PT p/s - the latter would have caused PT cs/hs to come away w/ nothing, and Delaware law req’d majority approval of the sale by all outstanding PT s/hs

- G argued PT could not agree to sell its assets conditional on power to amend its charter

ISSUE:Was PT right to amend restricted?HELD:No - able to be used at any timeRATIO: Statute allows amendment at any time w/ no limitation on the exercise of the

amending power - there is no reason why a Delaware corp cannot agree to sell assets conditional on amendment of charter as part of transactionIndeed, as here, such a condition may be necessary: w/o amendment, the $60 dissolution preference would remain, leaving PT cs/hs w/ nothing and very unlikelyto then approve of the transaction.

NB: This would never happen in Cdn based on CBCA section 176.

Orban v. Field (1997)(Del. Ch.)FACTS: corp OM had 3 series of shares outstanding: A conver p/s (23%); B conver p/s (63%); commons (14%) - majority of c/s held by O, OM’s original promoter

1990: OM offered ps/hs secured notes & c/s warrants to raise capital - notes fell into arrears and more warrants were offered as ‘compensation’ for the default

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1991: OM cancelled notes, replacing them w/ C non-conver p/s and more c/s - however, OM did not have enough authorized capital to do that issue and maintain reserve of c/s in the event of warrant exercises - OM Board decided not to amend charter, and asked O to surrender 800K of his c/s - O refused

1992: OM announced share-for-share merger w/ S - S’s c/s would be distributed to OM’s A,B,C ps/hs, exhausting the S c/s consideration w/ nothing for OM cs/hs - however, 90% approval from each class was req’d for the merger - O demanded $4M for his shares (greater than 10% holding) - OM Board refused, and instead diluted O’s c/s holding to < 10%: 1. amended authorized capital

2. reduced warrant exercise price3. redeemed some C p/s, the $ from which was used by the s/hs to exercise the c/s warrants

O argued OM Board had destroyed the value of his shares conferred by the 90% req’t and had thereby committed a fiduciary breachISSUE:Had OM Board committed such a breach?HELD:NO.RATIO: Board clearly exercised corporate power in an act directed against cs/hs - Board may do so, but should be able to show it did so in good faith and reasonably - MAY SEEK TO ACCOMPLISH THE GREATER GOOD BY ACTING AGAINST SOME SH.

No evidence of desire to deny cs/hs participation in merger; recapitalization process done legally: appropriate and fair

O had tried to use his leverage to block a lucrative transaction that Board had decided was in the best interests of OM - cannot see that Board has a duty to cs/hs to ignore its obligations to its other s/hs - here, Board decided to respect rights of ps/hs: no breach of loyalty, as they had existing legal preferences and the cs/hs did not.

BASICALLY: BOFD CAN DO ANYTHING PERMISSIBLE BY LAW AS LONG AS FAIR AND REASONABLE

2. Redemption Provisions

· power to redeem shares is function of investment K authorized by corporate statutes; redemption is effected according to the terms of the share K

· p/s fixed claim on earnings becomes onerous when interest rates fall below p/s rate; in corp’s best interest to replace those shares w/ lower interest-earning instruments: redemption

· redemption price unlikely to be < issue price; as redemption right is viewed w/ disfavour by investors, a premium over issue price is usually offered

· exercise of redemption right = distribution of assets to s/hs, triggering stated capital req’ts

(B) Alteration by Merger

CBCAs. 181: amalgamations. 182: details of amalg’n agree’t

-name of new entity- location of h office- new board- share capital. NB: In negotiations for amalgamation counsel of each trying to get best deal for shareholder.- typically agreement willprovide for number of shares old co can be converted into number of shares of amalg co. - when only want shareholder of one co to be shareholder of amalg, ps are issued and made immediately redeemable merger cash out

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s. 183: (1) s/h approval - holders of each class or series of each corp (2) notice of meeting (3) right to vote: each share of amalg’g corp carries one vote (4) class vote (5) amalg’n agree’t adopted by special resolution

s. 184: (1) VERTICAL SHORT FORM: corp & one or more sub - no need for ss. 182 & 183- can be resolved by the resolution of bofd- name of amalg = name of holding- dir/article of amalg = dir/aricle of holding- share and issue capital of holding become same of amalg- as a matter of law matter of sub and holding becoming matters of amalg-there is no surviving entity

(2) HORIZONTAL SHORT FORM: two or more subs of corp - no need for 182 & 183- similar to above however issue as to whose stated capital is adopted.

s. 185: articles of amalg’n to Director after s/h approval or Board approval -- amalg’n certificate issued

s. 186: effect of amalg’n cert: amalg’n effective as of certificate dates. 192: ARRANGEMENTS

Barbeau e.g SQUEEZE OUT:- when trying to take over a company and get 90% of shares you can institute CBCA procedure whereby remaining 10% of shareholder are required to sell.- if only 70% of the shares are received then can proceed through a long form amalgamation whihc will provide for the conversion of the remaining shares.- cross ownership is cancelled and the 30% remaining can be converted into ps and then later redeemed. - AQ can only proceed with the vote to the extent that the shares (70%) were acquired as part of the t/o squeeze out (if acquired shares earlier no good.- OBCA permits these while CBCA does not yet (as long as min/maj rules under security law is complied with - these are incorporated into the OBCA).

Re FLS Holdings (1993)(Del.Ch.)FACTS: FLS underwent LBO in 1988 & performed poorly thereafter - unable to meet debt Obs in

1991 - c/s closely held by mgmt, emp’ees, Goldman Sachs & Citibanknew class of p/s had been issued on back end of LBO: $53 liquidation pref.; 17.5% dividends payable in kind until 19941992: bankruptcy looming - GS looking for buyer - KS offered $43M - negotiations ensued, during which the price for FLS c/s increased while the price for FLS p/s remained steady - final product was $9M for the c/s and $29M for the p/s - total investment in p/s was $80M - ps/hs argued this transaction treated them unfairly

ISSUE:Had FLS ps/hs been treated unfairly?HELD:YES.RATIO: FLS Board owed fiduciary duties to both cs/hs & ps/hs - obligated to treat ps/hs

fairly - no independent agency was allowed to consider the transaction w/rt the ps/hs given the obvious interest of the Board/cs/hs - for Board to show allocation was fair to ps/hs, and this it has not done

Marriott Corp (1993)(Del.Ch.)

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FACTS: holders of convertible p/s asserted breach of fiduciary duty by M Board in the spin-off of income-producing assets

ISSUE:Had M Board breached fiduciary duty to ps/hs?HELD:NO.RATIO: Duty of Board to ps/hs may exist or it may not depending on the facts: here, it is

better to look at it as a matter of contract law - M ps/hs had a contractual protection against M’s conduct: able to convert their shares into c/s prior to spin-off and thereby participate in the transaction’s upside or choose to hold the shares and benefit from the conversion price adjustment following the transaction.

- Not always necessary for BofD to look out for the economic interest of p/s - can do what they want under the law.

(C) Other Modes of Alteration and Elimination

1. Repurchase

Eisenberg v. Chicago Milwaukee Corp. (1987)(Del.Ch.)FACTS: corp sold most of its business in 1985, leaving it w/ $300M cash & $90M real estate -

2.5M c/s & 464K p/s outstanding: p/s non-cumul; $5 dividend pref.corp stopped paying dividends on p/s, entitling ps/hs to elect 2 directors; other 8 owned 41% of the c/s - p/s prices declined, and Board caused corp to make $55/share offer for them, declaring an intention to delist the shares - ps/hs claimed this was unduly coercive

ISSUE:Was offer unduly coercive?HELD:YES.RATIO: - Ps/hs argue offer coercive in that (a) timed to coincide w/ lowest p/s price in 4

years; (b) occurs while corp claims inability to pay p/s dividends; (c) declared intention to delist p/s- As to timing, dividends etc, Board likely made business judgment, and these alone are not inequitable coercion - however, the declared intention to request delisting of the p/s is coercive, otherwise why notify the ps/hs if not to have them feel a need to tender in order to realize any returnBoard is fiduciary for ps/hs - declared intention is to eliminate valuable attribute of p/s, namely listing on exchange, that adversely affects the interests of non-tendering ps/hs - no claim that this is taken to protect paramount interests of corp; only apparent reason is to induce ps/hs to tender - unduly coercive

2. Dissolution

Burton v. Exxon Corp. (1984)(SDNY)FACTS: -Exxon owned all first p/s & 90% c/s of Eurgasco - no dividends ever paid, such that by

1977, first ps/hs had $6.5M dividend arrearage - B owned second p/s w/ arrearage of $2.3M-Between 1977-1980, large dividends declared, all paid to Exxon, leaving $2.8M in Eurgasco at the end - its Board (all Exxon nominees) then proposed to dissolve Eurgasco, and Exxon would receive the $2.8M under its first dissolution preference - however, a 2/3 approval of the second ps/hs was needed, and this was not reached - Exxon sought judicial dissolution; B sought injunction stopping it on grounds of breach of fid. duty

ISSUE:Had Board breached fid. duty?HELD:YES.

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RATIO: Dividend payments were self-dealing on Exxon’s part - Board has a fiduciary duty to see that p/s dividend arrearages are brought up to date ASAPQuestion to ask: Were minority s/hs excluded from or damaged by the self-deal-ing transfer to the majority s/hs? if so, breach.

(D) Canadian Case Law

Re Canadian Pacific (1990)(OHCJ)FACTS: CP sought approval for arrangement under CBCA to transfer CP’s shares in MR to its

cs/hs – opposed by ps/hs who stand to receive nothing under the arrangement, claiming that they are being treated unfairly by CP’s Board who all own c/s of CPcourt found transaction to be in the nature of a division of profits or a dividend to cs/hs of CP; that ps/hs were entitled to their 4% dividends and no moreps/hs now ask court to declare arrangement not to be fair and reasonable

ISSUE: Was arrangement fair & reasonable?HELD: NO.RATIO: - The lower the degree of necessity for the arrangement, the higher degree of

scrutiny as to fairness and reasonableness a court will apply to it – this arrangement does not arise out of necessity; CP simply seeks to put a major asset directly into the hands of its cs/hs- C/s saying that complied with process and there are ample assets to support p/s rts - not risk of insolvency resulting from trans. Most shareholder voted in favor of arrangement.- C/s argue that there is no suggestion that transaction = sham – ps/hs are not being forced out, but merely being treated unequally – that is normal given that transaction = dividend and ps/hs’ right to dividends is limited where cs/hs right is not- Ps/hs alleges prejudice and unfair because: (a) losing vote w/rt assets & governance of MR; (b) having fewer assets generating income for the dividend pool; (c) having fewer assets for the liquidation pool; (d) decrease in value of p/s as a result of spin-off ***Also,arrangement w/out precedent, this has never been done before and we ps purchased on this basis - Barbeau likes. see p172 CSBK for further reasons.Court is not bound to approve an arrangement, and approval is not a matter for the balance of probabilities – this arrangement is not a necessity; no benefit for CP; cs/hs enriched while ps/hs suffer prejudice à onus on applicant to make out the case for court approval, and CP has not done so here

Barbeau: There are reasons for these spinouts. Investors looking to invest in specific type of business. Diversification as is the case with CPL makes it more difficult to be an attractive investment. In this case CPL becomes a “pure play”, therefore it could be argue that beneficial to them. - Reasons for not simply selling: no buyer and tax reasons.

Palmer v. Carling O’Keefe Breweries (1989)(ODC)FACTS: appeal from dismissal of oppression remedy action under OBCA in connection w/ Elders

takeover of Carling brought by Carling ps/hsp/s: $50 par value, redeemable on dissolution, premium on voluntary dissolution; A: $2.20 dividend; B: $2.65 dividend – shares had traded below $50 since 1974, being at $27 A & $31 B at time of transaction1987: Elders made t/o bid – 95% successful – then sought to reorganize in order to marry the carrying costs for the $400M it borrowed for t/o w/ Carling’s income-earning

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assets – Elders not interested in paying redemption prices for p/s – attempted amendment to reduce redemption price failedBoard then passed resolution amalg’g Elders & Carling – no s/h approval req’d (under the CBCA shareholder approval would be required – left ps/hs w/ shares in new entity w/ $400M more debt but no new assets – Elders did execute support agree’t in favour of ps/hs w/rt the increased debt TRIAL: amalg’n w/o redemption = prudent business decision made by a competent Board acting in good faith according to best business judgment in the best interests of the corp as a whole – paying full redemption price when shares were valued much lower was not in best interests of corp – no prejudice to ps/hs, as there was no deprivation of rights and p/s rating actually increased as a result of the support agree’t

ISSUE: Was the transaction oppressive w/rt ps/hs?HELD: YES.RATIO: Amalg’n clearly of benefit to Elders (debt carrying costs removed) but of no real

benefit to ps/hs – but for the support agree’t, amalg’n decision was for the exclusive benefit of Elders and a detriment to ps/hs – indeed, w/o agree’t, it cannot be argued that the Board did not act oppressively and prejudicially in unfairly disregarding the interests of the ps/hsSupport agree’t sets up Elders as liable to pay p/s dividends or redeem p/s on liquidation, etc. – such a covenant to pay represents substantial security for the additional debt that the ps/hs have been forced to incurHowever, that agree’t is only as good as Elders, an Australian corp, in which these ps/hs did not invest; no legitimate corporate purpose for Carling to assume Elders’ debt à ps/hs should not be obliged to accept a claim in a wholly different corp from the one they originally invested inSuch treatment was conduct unfairly prejudicial to the interests of ps/hs. Order the redem at $53 - cannot undo an amalgamation.

Barbeau: Under these type of agreements shift in value from debt holders and ps holders to old cs holders who were bought out. - Since this transaction was going to proceed without the vote of the ps, especially important for the Board to consider their interest.*** this has significant implications for all LBOs in Canada, if there is an interested party you better consider their interest.**In this case ps may as well have been debt.

Westfair Foods v. Watt (1991)(ACA)FACTS: - WF a prosperous corp – had policy of retaining significant amount of earnings while

paying some dividends to cs/hs – in 1985, WF decided to distribute all net earnings as dividends-cs would take the dividends and lend them back to the company. cs were raising their priority, stripping the co of all earnings and coming back in as lender.- WF had two classes of shares: c/s (rt to vote, liquidation, dividend etc.) and A p/s (entitled to $2 dividends in preference w/ no other claim on profits beyond the dissolution preference)- ps/hs brought action claiming unfair dealing in favour of cs/hs: new policy advantaged cs/hs and disadvantaged ps/hs who had an interest in preserving a retained earnings pot until the liquidationTRIAL: agreed w/ ps/hs

ISSUE: Was dividend policy unfair to ps/hs?HELD: YES (procedurally if not substantively)

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RATIO (CA): S/hs & corps enter into rel’ships voluntarily – primary regulation of such rel’ships comes from the expectations raised by the words or deeds of the other party, a very fact-specific test- Trial judge found that ps/hs had purchased the shares w/ the expectation of sharing in the business of WF – however, ps/hs have no reasonable expectations beyond the $2/year dividends and the preference on WF’s assets upon dissolution – purchased special access to earnings and sacrificed ability to share in larger profits- Liquidation preferences = shields, not swords: offer assurance of a return on corp’s failure but not an assurance of profit if corp succeeds – no voluntary liquidation is a reasonable expectation (co. did not lead this impressions either). In fact corp under a duty to forestall that event.- Court can protect s/hs from unfair actions by corp, but cannot stop action an action that impairs an already unreasoned expectation of advantage. Defference paid to the business judgement of directors - this is successful corp and has been for long- Court not willing to give more than the fixed dividend payment. Co wanted to pay all dividends out and the court is unwilling to interfere with the BofD discretion.Barbeau: up to this point the reasoning has the effect of significanlty reducing the value of the shares because saying not reasonable expectation to participate in the surplus - value of ps comes from small dist of div and priority at dissolution. BUT is going to base valuation on the div and assumption of no liquidation than cs would be worth very little. Barbeau would have liked to have seen more balanced decision.- However, here WF did not behave properly w/rt the procedure of the dividend payments – that behaviour demonstrates an unfair disregard for the interests of the ps/hs - they did not send in report to exchange reagarding the listing of ps - acting extremele (no notice, intention to delist p/s, etc.) Barbeau: It is the shares that are listed and not the company - can have number of classes but only one listed. Listing on exchange is voluntary. There is a min number of shareholders in order to be listed. Once listed and do not comply, exchange has discretion to delist, however, this rarely happens. When delist your shares go into a grey market where they lose value and become difficult to sell and value.

- IT IS EXTREMELY IMPORTANT TO CONSIDER THE INTEREST OF ALL SHAREHOLDERS (PS AND CS). DOES NOT MEAN THAT CANNOT DECIDE EITHER WAY, SIMPLY MUST CONSIDER THEIR INTEREST AND HAVE APPROPRIATE PROCESS.

- MAY WANT TO HAVE SEPARATE COUNSEL REPRESENTING EACH SIDE.- IF IND COMMITTEE SAYS CANT DO TRANS MUST EITHER RENOGOTIATE

ACCEPTABLE OR ASK THE COURT FOR DIRECTION.- NB: RULES ARE MUCH MORE FLEXIBLE IN THE US.

4. Limitations on Permissible Alterations

Class Voting(1) Class Voting Provisions and Their Limitations

· State business corporation laws now ordinarily require class voting as a condition to certificate amendments that alter preferred stockholders’ rights and preferences.

· However, state corporation statutes are less thorough going in their provision for preferred class votes in respect of mergers and acquisitions.

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Warner Communications Inc. v. Chris-Craft Industries, Inc. (Del., 1989)F: Warner illustrates a more extreme version of how class voting is avoided through merger proceedings. Here, the merger consummated without class voting adversely affected the rights of a class of preferred shareholders. The Court considered two class voting provisions: (1) 2/3s vote of particular preferred class necessary for issuer to amend, alter, or repeal Certificate of Incorporation so as to affect preferences, rights, powers or privileges of the preferred class adversely; (2) 2/3s vote of all outstanding shares of preferred necessary to alter any rights, preferences, or limitations of the Preferred stock so as to affect the holders of all such shares adversely.H: Neither class voting provision applied to merger votesR: The Court ascribed to the drafter the “general understanding” that Delaware’s merger and certificate amendment provisions operated separately under the “bedrock doctrine of independent legal significance.” Therefore, it was “extraordinarily unlikely” that the provision could have been intended to apply to mergers.

NOTE: The court’s reading of the charter language in Warner should be questioned. It is plausible to interpret the phrase “alter or change any rights so as to affect the holders of all such shares adversely” in the Warner certificate to include mergers. In Levin v. Mississippi River Corp. (US Fed., 1967), the Court applied a class-vote provision to a railroad consolidation wherein the preferences and rights of the preferred were affected adversely. Given the Levin ruling, it is plausible to assume that the drafters of the subsequent generation of preferred stock contracts would have seen no reason to include more specific language respecting merger votes.

· Apart from the legal question whether a class vote is available or required in mergers is the practical question whether the availability of the vote offers the class much protection if its members are dispersed and unorganized. Possibly the requirement of a class vote stimulates the common, ex ante, to offer a higher price for a cashout or alteration of the preferred’s rights than it would offer in the absence of a class vote.

(2) Drafting Practice

· 14% of preferred stock issues in a Delaware-chartered corporations survey had provisions for class votes regarding mergers.

· NYSE maintains a listing requirement of a 2/3s supermajority class vote for adverse certificate amendments, but exceptions to the policy are granted liberally.

Equity-Linked Investors, L.P. v. Adams (Del., 1997)F: Case involves conflict between the financial interests of the holders of a convertible preferred stock with a liquidation preference, and the interests of the common stock. Preferred stock issued at $50 per share with a $50 per share liquidation premium. In the event of a “fundamental change,” holders of preferred stock would have an option to have their shares redeemed by the company at $50 per share, plus accrued dividends. Conflict arises because the company, Genta Inc., is nearly insolvent and in liquidation it would be worth substantially less than the $30 million liquidation preference of the preferred stock. Yet Genta, which has never made a profit, has several promising technologies in research, the value of the products that might be developed from those technologies could be very great. Consequently, the Genta board approves a financing arrangement with Aries Corp. to ensure the future of the company rather than wind-up the corporation and distribute the proceeds. However, a large part of the “upside” gain from the Aries deal would accrue to the benefit of the common stock, in equity the residual owners of the firm’s net cash flows. The preferred stockholders claim that the board “transferred control” of the company and that in such a transaction it is necessary that the board act reasonably to maximize the current value of the corporation’s stock (Revlon). The preferred

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stockholders argue that a special Revlon duty arose because (1) Aries has a contract right to designate a majority of the Genta board and (2) Aries acquired warrants that if exercised would give it the power to control any election of the Genta board.I: (1) Does the Aries transaction constitute a “change in corporate control” that triggers special directorial duties and that requires enhanced judicial review, under a reasonableness standard? YES

(2) If so, do the facts found constitute either (1) bad faith or insufficiently informed action or (2) unreasonable action given the type of transaction that was under consideration?H: The Genta board concluded in good faith that the corporation’s interests were best served by a transaction (Aries) that it thought would maximize potential long-run wealth creation and that in the circumstances, including the potential insolvency of the company and the presence of a $30 million liquidation preference, the board acted reasonably in pursuit of the highest achievable present value of the Genta common stock, by proceeding as it did.R: The Revlon test is illustrated in Paramount v. QVC:

(1) where a transaction constituted a “change in corporate control,” such that the shareholders would thereafter lose a further opportunity to participate in a change of control premium, (2) the board’s duty of loyalty requires it to try in good faith to get the best price reasonably available and (3) in such context courts will employ an (objective) “reasonableness” standard of review to evaluate whether the directors have complied with their fundamental duties of care and good faith.

The ultimate choice for the board was correctly understood. The real choice was between (1) a transaction that attempted to finance a future for the company in which products might be developed and brought to market, and (2) a transaction that treated the enterprise as a failed effort and would therefore involve the sale of its assets and a distribution of the proceeds, largely if not entirely, to the preferred stock. After a lot of effort, the board saw this as the choice between accepting the Aries transaction, on the one hand, which offered meaningful enhancement of the prospects of the company for survival, product development, and ultimate financial success, and, on the other hand, accepting the final, take it or leave it proposal of the preferred stock, which meant that the common would get essentially nothing and the corporation would never see the future benefit of the exploitation of its intellectual property.

What is clear is that the Genta board was striving to maximize the possibility of the common stock participating in some “upside” benefit from the commercial development of the company’s intellectual properties. = a legitimate purpose.

It is clear too that the course it took to do that was arguably superior to an alternative in which the preferred acquired control, because the preferred had a financial incentive to liquidate the firm immediately, thus depriving the common of any current value. Generally, it will be the duty of the board, where discretionary judgment is to be exercised, to prefer the interests of common stock -- as the good faith judgment of the board sees them to be -- to the interests created by the special rights, preferences, etc. of preferred stock, where there is a conflict.

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Section C: Convertible Securities and Warrants

Barbeau: - s.29 CBCA permits the issuance of convertibles, warrant, options etc.- When conversion exercised move from debt to equity on the balance sheet.- note that when buying an option not required to put up as much money to realize in big gain as if buying a stock, however, if ep is > market price lose the whole cost of the option, you are left with nothing (e.g. option to buy a stock $1 versus the price of the stock). aside from the cost of option risk free period to buy. Warrant - long term option on the common stock of a corporation granted for consideration by the corporation itself.Convertible Bond - a bond that incorporates the privilege of conversion into the common stock of the corporate issuer. The privilege of conversion (exchanging one class of securities for another) can attach to preferred shares as well as bonds.- Convertibles and bonds with attached warrants are hybrids as they combine features of debt and equity in a single security. As such, these securities give rise to distinct problems of valuation. It is necessary to value the debt characteristic and its claim as an option, and then combine the variables.

Valuation (Barbeau himself knows very little about this stuff; it is unlikely we will be tested on it; I have been brief)Call Option - Gives the option holder the right to buy securities at a specified price, the exercise price, for a specified period of time. The 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 holder decides to purchase the same. The seller profits if the price of the stock stays below the exercise price.Put Option - Gives the option holder the right to sell securities at a specified price for a specified period of time. The sellers of a put option receives money up form in exchange for assuming an obligation to buy the stock at the exercise price if the holder decides to sell the same. The seller profits if the stock price increase above the exercise price.- The theoretical value of a call option is the current price of the stock on which it has a claim less the exercise price of the option. When the exercise price is greater than the value of the stock, the call option has a theoretical value of zero. So long as the option continues to be exercisable after the date on which it is being valued, it is likely that its market value will be greater than its theoretical value. The option has some value because of the combination of the possibility that the price of the stock will rise while the option is exercisable and the impossibility of the option ever being worth less than zero.- Five factors determine the value of a call option:

1. Stock Price - the higher the stock price, the higher the value of the call.2. Exercise Price - the higher the exercise price, the lower the value of the call.3. Duration - the longer the time to the expiration date the higher the value of the call.4. Risk Free Rate of Return - the higher the risk free rate of return the higher the value of the

call (do not worry about the reason underlying this relationship).5. Volatility of the Stock - the more volatile the price of the stock, the higher the value of the

call. Since the downside value of the option is zero, the more volatile the stock the greater the possibility for a large upside potential.

Bratton, The Economics and Jurisprudence of Convertible Bonds (1984)- Convertible bonds combine the desirable features of straight bonds, such as fixed income payments and principal repayment, with the upside potential of the common stock . In exchange for this future equity claim bondholders customarily accept a coupon rate lower than that of an equivalent

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straight bond. Convertibles are attractive to issuers as they have advantages over issuing straight debt. These include cost savings, increased capacity to incur future senior debt and greater flexibility to advance the interest of the common stockholders.- There are three constituent elements of value of a convertible:

1. Debt Value - this is the value of an equivalent straight bond with the same coupon rate. 2. Conversion Value - this is the value of the amount of common stock into which the bond can

be converted. The conversion value depends on the market value of the underlying stock and the conversion price. If the conversion price is constant the conversion value fluctuates in lockstep with the stock price.

3. Conversion Premium - this is the amount by which market value of the convertible exceeds the higher of the debt or conversion value. If you characterise the conversion privilege as an option, the conversion premium represents the option value. This value reflects the expectation that the issuer’s stock value will increase substantially during the early years of the bond.

- The more the stock price increases above the conversion price, the more the market behaviour of the convertible increasingly mirrors the underlying common stock. As the stock price increases above the conversion price the conversion premium decreases.- As the stock price decreases substantially, the market value of the convertible mirrors the debt value of the convertible. This is because the conversion value has decreased substantially with the decrease in the stock price and the price of the stock is unlikely to ever increase above the conversion price - there is thus no (or a very small) conversion premium.- Sorting out the variables that effect the conversion premium is the central problem of convertible bond valuation. Some of the variables include:

1. The advantage arising from the bond’s limited downside risk - the debt value provides a floor should the issuer’s stock values decline. The relative importance of the “floor” decrease with increases in the issuer’s value.

2. The upside potential of the convertible. The relative importance of the upside potential decreases as issuer value decreases.

3. The convertible’s income stream. So long as the coupon rate on the bond is greater than the dividend rate on the underlying common stock, the convertible is a more desirable holding than the common stock - a conversion premium exist as a result.

4. The value of the conversion privilege is also sensitive to the convertibles duration. As with call options, the longer its life, the greater its value. Obviously, if the issuer retains the right to shorten its duration the conversion privilege with be less valuable

- Most convertibles have provisions that allow the issuer to call (buy back) the convertible at a specified price. This essentially forces the convertible holder to convert when the conversion value exceeds the call price.

Klein, The Convertible Bond: A Peculiar Package (1975)- The author points out the rather bizarre kind of gamble on the market rate of interest taken by those who invest in convertibles. Unlike bonds that have warrants attached, convertibles will change in value as the market rate of interest changes in value only if the value of the common stock has not risen to the point where conversion would be appropriate. This has a number of implications:

1. The random relation between interest rate fluctuations and the price of the common stock injects a variable that make convertibles increasingly difficult to value.

2. This variable can be eliminated by the use of a bond with an attached warrant.3. Rational investors would not invest in convertible and assume this bizarre gamble unless

they are obtaining the investment at a lower price than that at which separate elements of the investment could be obtained.

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4. The corollary to 3 is that the potential proceeds to the company are lower than if the investment elements were sold separately. Selling a package like convertibles deprives the seller the opportunity to obtain the best possible price by fully exploiting the separate demands of each product.

- A couple of reason are suggested as to why than companies issue convertible bonds:1. Convertibles are debt financing with a conversion privilege as a “sweetener” to reduce

the interest cost. Klein argues that the cost of capital is not decrease but simply disguised by receiving a payment for a gamble on the common stock.

2. Convertibles is a form of equity financing whereby the company believes that the current price of the common stock is too low. The company issues convertibles with the view that conversion will occur when the value of the stock rises. Klein wonders why let the investors and not the company benefit from this windfall. Why not issue common stock when the price increases and secure alternate financing in the meantime.

Note: Convertible Bond Valuation and Investor Protection - Conversions require the company to issue stock at a price lower than could be receive through a public offering and dilute the equity of existing shareholders. Because of the difficulty in predicting future market fluctuations and measuring the dilution that will arise, it is unlikely that current stockholders are being adequately compensated for the dilution in the price the company charges for the convertibles or warrants.

CONFLICTS OF INTEREST

Protective Contract Provisions-if a convertible bond (or warrant) is issued without any K provision for the adjustment of the terms of the option in the event of changes in the issuer’s capital structure, then the conversion value is destroyed when

1) the issuer increases the number of common shares outstanding without proportionately increasing their value2) the issuer disgorges assets for less then equivalent consideration3) the issuer, the underlying common, or both cease to exist altogether; any number of voluntary issuer actions can accomplish this: recapitalization, merger, or liquidation and dissolution.

As a matter of law, the conversion privilege is diminished or lost in all of these cases if the K doesn’t provide for its survival

-these dilutive or destructive actions are so easy to effect and impair the bond’s conversion value so substantially (in the case of a warrant they can destroy the security’s value completely) that provisions protecting against them are universal in convertible bond and warrant Ks

-“anti-dilution” provisions:- protect against dilutive and partially destructive actions by triggering proportionate

reductions in the conversion price; conversion value remains unaffected by the action as a result-protect against destructive events such as mergers, recapitalizations and liquidations by creating a right to convert into the securities or participate in other consideration being distributed to the common s/hs in connection with the particular transaction

-often provide for advance notice of dilutive and destructive actions (so holder can realize on bond’s conversion value prior to the consummation of the issuer action)

NOTE: CONVERTIBLE BOND CONTRACTS

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(1) Gardner and Florence Call Cowles Fdn. v. Empire Inc. (NY, 1984): anti dilution provisions give rise to endless interpretive problems. The issue is often whether a particular issue/action is within a particular contingency provided for in the K, and thus protected or unprotected-Other cases raise the question of whether the agreement is to be read to

1) preserve the option holder’s proportionate interest in the enterprise by altering the price or rate at which his security is convertible to stock to reflect proposed alterations in the structure of the enterprise (e.g. stock splits, capital distributions, etc.) , OR 2) to force him to elect either to exercise the option or to suffer the dilution when an alteration in capital structure is proposed (this latter alternative is effected by providing, instead of an adjustment or conversion rate that the bondholder shall receive notice of the proposed alteration and be required to exercise his conversion option or forego the proposed dist’b within the notice period)

Barbeau: Forcing conversion thus allowing participation as a remedy not just because effectively forcing holders to shorten the bargain.

(2) Good Faith Provisions: many private placement debt Ks contain a so-called “good faith” anti-dilution provisions; this catches all actions not otherwise covered which “materially and adversely affect the conversion rights of the holder”. This shifts risk of dilution and destruction back to issuer

(3) Call: integration of conversion privilege with redemption provisions is a constant source of problems. At the time of the call, the bondholder is generally forced by the terms of the security to opt either to convert and lose the benefit of seniority or to accept the cash call price and terminate his investment

(4) Issue of Additional Common Stock: How should the convertible bond K deal with a subsequent issue in an arms length transaction of common stock for a price lower than the conversion price? The current theory is that the K should (a) protect not a % claim on earnings but the current market level of conversion value and conversion premium, and (b) operate only when stockholders receive a benefit at the bondholder’s expense (which is impossible if the offering is made at the market price) and that otherwise there should be parity of treatment

HB Korenvaes Investments v. Marriott Corporation (Delaware, 1993)Facts: -holders of Series A Cumulative Convertible Preferred Stock of Marriott Corp. seek to enjoin a planned reorganization of the businesses owned by that corp.- Harvard hedging strategy causes them to worry about the value of the preferred shares.-the reorganization involves:

- the creation of a new corporate subsidiary, Marriott International, - the transfer to International of the greatest part of Marriott’s cash-generating businesses, - followed by the distribution of the stock of International to all the holders of Marriott common stock, as a special dividend - i.e. a spin-off (designed to separate Marriott’s real estate and other capital intensive businesses from its management and services businesses)

-so, Marriott’s remaining assets will consist of large real estate holdings and airport and tollway concession business; the assets retained by Marriott have a value of several billion dollars but will be burdened with great debt and produce little cash flow after debt service-the preferred stock is convertible at the option of the holder into common stock at a conversion price set forth in the certificate-*the agreement provides a mechanism to adjust the conversion price “in case the Corporation shall, by dividend… distribute to all holders of common stock… assets (including securities).” = protective provision

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-after the spin-off, Marriott announced that it was going to suspend dividend payments on its preferred sharesIssue: Has Marriott breached the agreement?Held: NoRatio: -whenever Marriott distributes assets to its common s/hs (as it has done with the spin-off), the certificate protects the value of the preferred conversion right by reducing the conversion price; what is apparent, however, is that in a narrow range of cases, a dividend or property may be so large relative to the corp’s net worth, that following the distribution the firm, while still solvent, will not represent sufficient value to preserve the pre-dividend value of the preferred’s conversion right-in light of this provision, Marriott has voluntarily and effectively bound itself not to declare and distribute special dividends of a proportion that would deprive the preferred s/hs of the protection the provision was intended to afford-in providing a mechanism to maintain pre-distribution value, the issuer impliedly but unmistakably and necessarily undertook to refrain from declaring a dividend so large that what is left in the corp is itself worth less than the pre-distribution conversion value of the preferred stock -thus, the right of preference provisions are to be strictly construed-if, when declared, the dividend will leave the corp with sufficient assets to preserve the conversion value that the preferred possesses at the time, it satisfies the limitation that such a protective provision necessarily implies (i.e. the provision doesn’t grant the preferred a right to assurance that any increase in the value of their conversion rights following the authorization of a special dividend be maintained)-here, plaintiffs have failed to introduce evidence that establishes a r’ble probability of their proving that the net value remaining in Marriott after distribution of the special dividend is or is r’bly likely to be insufficient to maintain the pre-distribution value of the preferred’s conversion right

- the crt found that 196M was necessary value to protect ps and experts predicted a range of 500M to 170M. The crt finds that the possibility of below 196M too remote to consider

Barbeau: mechanics of a dividend:- Pursuant to s.134 of the CBCA, the directors set the record date for the purpose of determing the shareholder entitled to the dividend.NB -under CBCA board can decide not to pay dividends. s.42

ACP = cp * (cmp - fmv)/cmpacp - adjusted conv pricecmp - convertible market pricecp - original conversion price = 17.40FMV - of assets spun

wrt determing cmp:- ps say that the 30 day average should be calculated on the basis of post announcement share price - they should be able to take advantage of post auth share price. CRT 2 problems

- at the time of distributing will be unable to determine the value of assets dist, would not be able to determine if FMV is greater that cmp.- 1 or 2 day value may not be representative

- Barbeau likes this based on the plain words of the contract - otherwise, should have said CMP before the anouncement. - Crt says that the only expectation of ps was in the pre-auth price.

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wrt determing FMV:- ps wanted to look at the “when issued market” as the best indicator of FMV of assets. This is grey market where by a certain number of days prior to the issuance dealers start trading. They contend this is as close as can get to the real value.- boards method was to detemine the intrinsic value of the assets to determine a proportionate value of the assets being distributed to the assets remaining and multiplyin this time the cmp - this way the FMV will never be less than the cmp and the formula will always be valid and could never distribute to great of assets.CRT: pays deference to the boards determination, they are given discretion to adopt reasonable means of making the calculation.

(A) Duties Implied in Law

HARFF v. KERKORIAN (Court of Chancery of Delaware, 1974)Facts: -Plaintiffs held 5% convertible subordinated debentures (due in 1993) issued by MGM Inc.-on Nov. 21, 1973 the Bd. of Directors of MGM declared a cash dividend (the first cash dividend since 1969) in the amount of $1.75 per share of common stock-Plaintiffs allege that dividends were declared improvidently and for the financial benefit of the defendant (a member of Bd. and the controlling s/h). - Plaintiffs allege that the declaration of cash dividends:

(1) damaged MGM by depleting its capital, thereby endangering its future prospects, and (2) damaged the debenture holders in that it impaired the value of the conversion feature and

caused a decline in the market value of the debentures themselves-Plaintiffs instituted a derivative action on behalf of the corporation, as well as a class action on behalf of all holders of MGM’s convertible debentures-importantly, the plaintiffs are not alleging that the defendants breached any specific terms of the indenture agreementIssues: (1) Do the plaintiff’s have standing to bring a derivative action? (2) Did the declaration of the dividend constitute a breach of the defendant’s fiduciary duties?Held: (1) No, they are only creditors of the corp (not s/h) and don’t have the standing to bring a derivative action; (2) No. A fiduciary duty isn’t owed and the rights of the debenture holders are confined to those in the Indenture AgreementRatio: (1) –holder of an option to purchase stock isn’t an equitable s/h of the corporation. Debenture holders are not s/h and their rights are determined by their Ks. A holder of a convertible bond doesn’t become a s/h, by his K, in equity any more than at law. The convertibility feature of the debentures doesn’t change things here. The plaintiffs are CREDITORS of MGM and don’t have the standing to maintain a derivative action(2) –unless there are special circumstances which affect the rights of the debenture holders as creditors of the corp. (e.g. fraud, insolvency, or violation of a statute), the rights of the debenture holders are confined to the terms of the Indenture Agreement pursuant to which the debentures were issued-with this investment runs no guarantee that the market value of the common stock will appreciate; the fact that the market value of the common stock is not sufficiently attractive to make conversion profitable at a particular time doesn’t give rise to a cause of action against mgmt.; rather, the legal payment of large cash dividends is valid means by which a corp. can discourage convertible debenture holders from exercising their right to convert their debentures into common stock-no fiduciary duties existed b/w the parties; rights are confined to those in the Indenture Agreement On Appeal:HARFF v. KERKORIAN (Supreme Court of Delaware, 1975)

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-Court agreed with the ratio of the lower court. It held, however, that the issue of fraud was sufficiently asserted to require a trial on the issue. (i.e. no fiduciary duty is owed and relationship is generally determined by the Indenture agreement; however, the special circumstance of fraud takes the relationship beyond the strict terms of the agreement).

Consider: What limits, if any, does “fairness” impose on the commons’ right to dilute or frustrate the expectations of the convertible holder whose K doesn’t forbid all dividends? (see case below)

Pittsburgh Terminal Corp. v. Baltimore & Ohio Railroad Co. (U.S. C.A. 3rd Cir, 1982)Facts: Baltimore and Ohio Rail Co. (B&O) operated a railroad co. and also owned substantial non-rail assets, such as real estate, timber and mineral reserves. B&O had outstanding, and listed on the NYSE, both common stock and debenture convertible into common stock (due in 2010). Prior to 1977, the Chesapeake and Ohio Railway Co. (C&O) acquired over 99% of the B&O common stock. Since all the B&O common stock was owned by C&O and 13 individuals, it was de-listed from the NYSE. The convertible debentures, however, continued to be listed and traded on the NYSE. Because B&O didn’t pay dividends after 1961 and there was no market for its common stock after C&O acquired 99% of it, there was no incentive for the holders of the convertible bonds to convert.-Under gov’t regulations, railroad corps were prohibited from engaging in non-rail business; therefore, B&O’s and C&O’s assets not used in rail transportation remained undeveloped-beginning in 1973, C&O segregated its own non-rail assets and placed them in a separate corp. so they could be developed free from gov’t constraints. With the same objective, C&O created a restructuring committee in 1977 to plan the transfer by B&O of its assets to a wholly owned subsidiary of B&O (called MAC), and then to distribute the MAC stock as a dividend to B&O’s 14 common s/hs (i.e. a “spin-off”)-to avoid having to file a registrations statement, the restructuring committee sought to distribute the MAC stock as a dividend before the many B&O debenture holders could convert B&O common stock, and while there was only a total of 14 common s/hs of B&O. This distribution had the effect of depriving the holders of the convertible debentures of any share of that dividend.-in order to preclude conversion by the debenture holders, the restructuring committee decided to avoid giving notice of the MAC transaction to the convertible debenture holders-SEC Rule 10(b) prohibits the use of manipulative or deceptive devices or contrivances in connection with the purchase or sale of any securityIssue: Did B&O violate its duty to the debenture holders?Held: Yes. It had a duty to inform them of the transactions so that they could intelligently excretes their right of conversion (a violation of Rule 10(b))Ratio: JUDGE GIBBONS (GOOD FAITH AND SECURITY VIOLATION) -the MAC distribution was a dividend of a security, and that dividend related to the convertible debentures since it was material to a decision about exercising the conversion option; the convertible debentures weren’t simple debt securities, for which the info about dividends ordinarily wouldn’t be material (i.e. these securities have an equity option feature)-the scope of the obligation of the fiduciary depends upon the nature of the interest of the beneficiary; if the beneficiary of a fiduciary duty needs info in order to intelligently protect that interest, the withholding of it, especially when withholding it confers advantage upon others, is an obvious breach of duty-the Indenture agreement was a NY K; the law of the state is that in every K there is an implied covenant that neither party shall do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the K-in this case, the defendants took steps to prevent the bondholders from receiving info which they needed in order to receive the fruits of their conversion option should they choose to exercise it; as a matter of NY K law, B&O had a duty to speak

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-the transaction, designed to deprive the bondholders of timely notice in order to exercise their conversion option if they should so desire, was a manipulative or deceptive device or contrivance in violation of SEC Rule 10(b)JUDGE GARTH, CONCURRING (SEC VIOLATION): -this judgment addresses whether the declaration of the MAC dividend was an action “relating to” the publicly traded convertible debentures within the meaning of Rule 10(b)-a stock dividend declared on common stock clearly falls within the ambit of Rule 10(b) -in the context of Rule 10(b), a dividend “relates to” a security if the declaration of that dividend makes the security significantly more or less valuable, whether by directly increasing or decreasing the value of the security or by enabling the holder of the security to take steps which would either augment the security’s worth or prevent the diminution of its value-here, prior to the declaration of the MAC dividend, the debentures included the right to convert to B&O common stock which represented both rail and non-rail assets; after the dividend, however, the debentures were convertible into B&O common stock which no longer included the non-rail assets-therefore, the declaration of such a dividend in which the convertible debenture holders could share in both categories of assets by exercising their conversion option, is an action which clearly “relates to” this class of securities-defendants had a duty to give advance notice to the debenture holders (under Rule 10(b))JUDGE ADAMS, DISSENTING: -the traditional view is that convertible debenture holder is a mere creditor until conversion, whose relationship with the issuing corp. is governed by K and statute; traditionally, the debenture holder had no right, apart from K, to object to corporate actions that dilute or destroy the value of the conversion option-the indenture in question here addresses a variety of potentially diluting acts (e.g. change in par value of outstanding common stock, change of outstanding common stock from par to no par, possible consolidation, merger or sale of the co.); it doesn’t, however, address the situation where the company spins off a portion of its assets to a subsidiary and distributes those assets, in the form of a stock dividend, to its common s/hs-had the B&O Indenture contained a more broadly inclusive notice clause, B&O might have been required to inform the debenture holders prior to the declaration of the MAC dividend-therefore, the plaintiffs CAN’T rely on the Indenture as the source of B&O’s duty to speak-he disagrees with Judge Gibbons holding that such a duty can be justified on the basis of NY K law (i.e. implied covenant not to injure the other party’s rights); this principle only applies when one party infringes the other’s RIGHTS “to receive the fruits of the K”; here, the plaintiffs had no RIGHT under the K to receive advance notice of the MAC dividend b/c no anti-dilution provision to that effect had been included in the indenture – therefore, no advance notice required-Re: Rule 10(b): the dividend declaration did not “relate to” the class of debenture securities; this rule was not intended to override the c/l and accord debenture holders significant additional substantive rights: it was designed to require companies whose securities are publicly traded to furnish public investors with timely advance notice of the right to receive dividends and other rights which accrue to holders of (i.e. to ensure that purchasers receive all the fruits of the transaction to which they are legally entitled)-can’t ignore what is set forth in the indenture agreement

NOTE: SUBSEQUENT PROCEEDINGS IN PITTSBURGH TERMINAL-doubt was cast on the authority of the discussion of issuer duties in Judge Gibbon’s plurality opinion in Pittsburgh Terminal-Lorenz v. CSX Corp. (1990): the indenture is designed and intended to be an all-encompassing document; if there is an independent fiduciary duty owed to debenture holders, it is satisfied it the defendants comply with the terms of the Indenture; there can be no breach of fiduciary duty without a predicate breach of the Indenture

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Gardner & Florence Call Cowles Fdn. v. Empire Inc. (NY, 1984):Facts: -Plaintiffs owned 9% convertible subordinated debentures issued by Empire in January, 1981(due in 2005); debenture holders had the right to convert to Empire common stock at the ratio of 20.51 shares of stock for every $1,000 face value of debenture (i.e. a conversion price of $48.75 per share)-when debentures were issued, approx. 3million shares of Empire common stock were outstanding; both the debentures and the common stock were listed on the NYSE-immediately prior to the issuance of the debentures, Empire common was trading at $49 share (i.e. just over the conversion price); in August 1982, the stock trades as low as $9.50 share-in October 1982, Empire announced that it was merging with Exco Corp. – Empire emerged as the survivor. At the time of the merger, stock was trading at $20 share, and at $27 share just prior to the occurrence of the merger (well below the $48.75 conversion price)-On June 9, 1983 Exco merged into Empire-Following approval by 96% of the Empire s/hs, each share of outstanding Empire common could be exchanged for $22 cash and one new $9 face amount subordinated debenture with a market value off $5-Empire s/hs thus received $27 (i.e. cash + one new debenture, upon surrender of each share of Empire) – this amounted to a $7 premium over the then $20 market price-following the repurchase of the outstanding stock, each share of Exco was converted into one share of Empire-prior to the merger, each debenture holder was given the opportunity to convert, under the above formula, and receive the same consideration received by Empire s/hs in the merger; debenture holders were also informed that following the merger their debentures would continue to be convertible into Empire common; none of the debenture holders took advantage of this opportunity, presumably b/c the debentures were trading at a higher price than the consideration they would have received had they chosen to convert -plaintiffs claim that the merger as orchestrated by the Defendant directors resulted in a financial windfall for the common s/hs, at a cost to the plaintiffs who now bear the risk that Empire may not be able to pay the debentures when due; plaintiffs further allege that the defendants’ actions effectively destroyed the value of their conversion right b/c the new Empire stock into which they are now entitled to convert is worth considerably less than the old Empire stockIssue: (1) Did the defendants breach an implied covenant of good faith and fair dealing? (2) Did the Directors owe the plaintiffs a fiduciary duty?Held: (1) No, there is no such implied covenant (2) The only fiduciary duty owed is that which derives from the wording of the K. Here, the K was not breached so the fiduciary duty was met. Ratio: (1) an implied covenant derives its substance directly from the language of the Indenture and can’t give the debenture holders any rights inconsistent with those set out in the indenture-since the plaintiffs Kual rights weren’t violated, there was no breach of an implied covenant(2) –fiduciary duties in a debenture K don’t exist in the abstract, but are derived from the Indenture itself-since defendant fully complied with its obs under the Indenture, the defendant can have no liability for breach of fiduciary duty-a purchaser of debentures takes the risks inherent in the equity feature of the security; one of those risks is that the issuer might merge with another company; this is simply a risk inherent in this type of investment-defendants were under a duty to carry out the terms of the K, but not to make sure that plaintiffs had made a good investment

NOTE: Judicial Fairness Standards and Convertible Bonds

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-the approach whereby courts decline to intervene against a merger limiting or eliminating the value of a conversion privilege, on either fiduciary or good faith grounds, now appears to be authoritative (therefore, Harff v. Kerkorian no longer appears to be good law)-underwriters of convertible securities do have an interest in negotiating protections on points regarded as material by ultimate purchasers of those securities; the dev’t of elaborate anti-destruction and anti-dilution provisions in indentures attests to the relative effectiveness of this mechanism of defining rights and obs of issuers-introducing the powerful abstraction of “fiduciary duty” into the highly negotiated and exhaustively documented relationships b/w issuers and holders risks great uncertainty

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Section D. Corporate Law Legal Capital RulesLook at ss. 26, 34, 36, 42, 44 and 189 of the CBCA

1. The Stated Capital Requirement

State corporation statues contain provisions that regulate capital structure for the benefit of creditors and senior security holders. These Alegal capital@ rules restrict the corporation=s discretion to make distributions to equityholders for the purpose of protecting seniors= equity cushion. However, they are generally understood to be ineffective as a shield to protect creditors from debtor opportunism.

In theory, the legal capital rules serve the function of a dividend covenant in an indenture, note agreement or preferred stock contract. But, in fact, the rules do little more than block distributions to the shareholders of insolvent corporations. Today the prevailing view is that creditors= and preferred stockholders= interests are better left to regulation through negotiated contracts than to regulation by positive law.

The corporation statues of all states contemplate:1. That some consideration will be paid by stockholders for the stock issued to them2. That the consideration will be of a quality which is acceptable under statutory specifications, 3. That the amount of consideration will be Asufficient@ or Aadequate@ as tested by some standard.

The Aadequacy@ of the consideration paid by a stockholder for his stock is measured by the amount of capital stated to be represented by the issued shares. If the amount of the consideration is equal to par or the capital stated, the stockholder has fulfilled not merely his contract, but such obligations as external policy (either legislatively or judicially defined) imposes. If, however, the amount of the consideration is less than par or the stated capital, then, notwithstanding the fact that he may have complied with his contract with the corporation, the stockholder has failed to meet his legal obligations to relying creditors. The problems which such failure has generated have not been satisfactorily solved by the courts. Solutions of the problems requires:

1. Identifying the nature of the misrepresentation or misleading appearance created by the inaccurate statement of the transaction on the corporate books.2. Determining who shall be liable and in what amount.3. Determining to whom they shall be liable and in what amount.

2. Dividends and Distributions

(A) Traditional Statutes

Historically, there have been two methods of defining the funds available for dividends:1. Balance Sheet Test: Traditional legal capital schemes employ the balance sheet as the basis for regulation distributions of corporate assets to shareholders. In general, under the Balance Sheet test, distributions are prohibited if, after giving effect to the transaction, the firm=s total assets would be less than the sum of its liabilities and its stated capital amount. Stated capital is a dollar figure representing the number of outstanding shares multiplied by their Apar value@.Distributions are permitted out of Asurplus@ accounts C whether additional paid in capital or retained earnings C but may not be made out of stated capital. The surplus accounts thus equal total assets minus the sum of liabilities and stated capital.

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2. Earned Surplus Test: Under this test, dividends and distributions are limited to amounts carried in the enterprise=s balance sheet as Aearned surplus@ or Aretained earnings@.

Nimble Dividends: Many states provide a significant exception to the rule against distributions where stated capital is impaired. This allows dividends to the extent of the firm=s earned profits during the dividend year or the previous year, regardless of the absence of a surplus.

Insolvency: Most corporation laws include an equity insolvency restriction against dividends and other distributions to shareholders. The statutes provide, first, that a firm already insolvent in the equity sense may make no distributions to shareholders, and second, that a solvent firm may not make a distribution if, as a result, the firm would be left insolvent in an equity sense.

The statutory restrictions on dividends and distributions are troublesome for many reasons. In large part the rules are infected by the intrinsic ambiguity of the terms used in the statutes, which predicate dividends and distributions to stockholders on determination of a firm=s Aassets@ or Aliabilities@ or Acapital@ and the existence of Asurplus@. Therefore, it is possible for management to reduce stated capital, and thereby create some form of distributable surplus, or to write up the value of assets of the books so as to create a form of distributable surplus.

The net result is to create a flimsy shield for seniors against the distribution of assets to juniors.

(B) New Model Statutes

Wide recognition of the shortcomings of the legal capital rules has prompted a law reform movement. California, for example, removes the legal significance from a stock=s par value. Additionally, corporations making distributions to junior shareholders must maintain assets in excess of liabilities in an amount equal to or greater than the aggregate liquidation preferences of senior stock.

Nelson v. Rentown Enterprises Inc., [1993] 2 W.W.R. 71 (Alta Q.B.)

Facts: The defendant corporation agreed to purchase shares held by the plaintiff in the corporation by exchanging certain land and premises held by the corporation for the shares. At the time of the agreement the corporation was solvent, but at the time the deal was to close at least 16 months later, the corporation was solvent.S. 34 of the CBCA prohibits a corporation from purchasing its own shares if it is insolvent.

Issue:Section 34 does not say whether the solvency test is to be applied at the time of the contract when purchase is made or when it is to be performed. The parties applied to determine this issue.

Held: Test should be made at both times.

Ratio:Section 34 is intended to ensure that shareholders of a corporation do not recoup their investments to the detriment of creditors or other shareholders by exchanging their shares for company property or money where, after the payment for the shares, the company would be insolvent.

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This policy can only be realized if the solvency test is applied both when the contract is made and when it is to be performed. The word payment is not restricted to money payments and includes transfers of property. Were that not the case a shareholder could agree to exchange shares for land with closing to occur in the future, giving the shareholder an opportunity to strip the corporation of a valuable asset at the future time to the detriment of creditors and other shareholders.

Clarke v. Technical Marketing Associates Ltd. Estate (1992), 8 O.R. (3d) 734 (Ont. Crt. (Gen. Div.)

Facts:

1. In order to effect a leveraged buyout of TMA, the plaintiffs, all senior managers of TMA, incorporated 780076 Ontario Ltd. There were four holding corporations that together owned TMA. This new corporation, 780076, purchased the shares of the four holding corporations, which was essentially, the shares of the Daniels Group who owned all the TMA=s shares through the four holding companies.

2. The purchase price for the shares was $2,000,625, of which $1,091,250 was payable in cash and $909,375 was payable by way of promissory notes from 780076.

3. For the completion of the purchase, TMA advanced $304,100 to 780076 and TMA guaranteed 780076's obligation to pay the promissory notes to the defendants. The giving of TMA=s guarantee was approved by all the directors.

4. Later, the various holding companies, TMA and 780076 were amalgamated into an amalgamated corporation under the name of TMA. A short time later, TMA was adjudged bankrupt. After payment of the indebtedness owed to TMA=s banker, the bankruptcy yielded a surplus which was the subject of a contest by the parties as to their respective security interests in the amalgamated corporation.

Issue:The plaintiffs sought a declaration that the security given by TMA to the Daniels group was unenforceable because (1) the amalgamation had the effect of dissolving the guarantee or because (2) the guarantee was invalid for contravening s. 44 of the CBCA.

Held:For defendant on both arguments.

Ratio:Please note: It is important that you look at s. 44 of the CBCA in order to fully understand the judgement.

As per the first argument:While there must be separate legal entities of principal, surety and creditor to give a guarantee and while it was true that the TMA guarantee of 780076's obligations would Adisappear@ in the amalgamation, this did not affect the general security agreement in favor of the Daniels group. It would be different if the creditor were part of the amalgamation in which case the security given would also merge; however, here the Daniels group remained separate.

As per the second argument:The effect of the share purchase transaction, was that TMA was a Asubsidiary body corporate@ under s.2(5) of the CBCA. It did not matter that individually the four corporations of the Daniels group did not

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control TMA since a single entity (780076) owned all the shares of the four corporations which collectively owned all the shares of TMA. Therefore, the financial assistance given by TMA were permitted by s. 44(2) CBCA as financial assistance to a holding body corporate by a wholly owned subsidiary.

Even though the defendants won on this point, the court went even further proving that it did not violate any other section of s.44 as well.

If the financial assistance in this case did not fall within s.44(2)(c), then it was necessary to determine whether it was permitted as provided by the liquidity test of s. 44(1)(c) and the solvency test of realizable value under s. 44(1)(d). These provisions did not require the assumption that the corporation has had to make payment of the financial assistance; rather, the likelihood of being called upon had to be assessed. ie. Is there reasonable grounds to believe that the company had the financial means for lending?There was no cogent evidence to demonstrate that the transaction would offend the provisions of s. 44(1)(c) because at the time of giving the assistance, there were no reasonable grounds for believing that the guarantee would be called upon so as to constitute a liability that would affect liquidity.

Section 44(1)(d) did not contemplate an assessment of realizable value at liquidation or distress prices unless at the time financial assistance was given that was the reasonable expectation. Rather, implicit in this analysis is that the assets would be valued as if sold on a going concern basis. (Ie. Best price)The price which the plaintiffs paid for the shares of TMA was the gauge of the realizable value absent any evidence to show they were deceived or foolhardy. There was no such evidence. The evidence indicated that the s.44(1)(c) and (d) could be met on a reasonable basis.

Part III Capital Structure and Leverage

Section A. The Leverage Effect

1. The Cost of Capital and the Value of the Firm

The term Acost of capital@ is widely used in the literature of investment decision-making and generally refers to the minimum rate of return which a firm requires as a condition for undertaking an investment. Everything suggests that this return must be based on an opportunity cost, and furthermore, that the opportunity cost in question must be that borne by the firm=s owners in foregoing alternative use for the funds.

Internally generated funds, then, often are considered by mgt as low in cost. ie. The opportunity cost of putting earnings back into a firm rather than distributing them as dividends to stockholders generally is not thought to be great. While such a view may be defensible from a managerial perspective, it at least raises a question regarding whether or not stockholders value dividends differently from capital gains.

The question of cost of capital also can become intermingled with the measurement of risk. Conventional wisdom tells us that additional debt financing, other things being equal, will increase a firm=s risk. Thus, lenders tend to insist at some point that additional debt be balanced by additional equity.

Durand, Costs of Debt and Equity Funds For Business: Trends and Problems of Measurement

Earnings per share from current operations 2.50$

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Multiplier (Capitalization rate) 8Investment value per share 20.00$

Projected earnings after expansion 2.90$Multiplier 62/3Investment value 19.33$

The preceding example show that the risks incurred in borrowing may discourage investment even though the rate of return on the new investment exceeds the interest cost of borrowed money.

To get a better idea of what the hell I=m talking about, your best bet is to turn to pgs. 454-455 and read those two pages. It=s impossible to summarize, and I don=t feel like retyping those two pages. Thank you, Merci.

II. The Problem of Security Appraisal

It should be clear that any practical application of the principles of the rate of return necessitates a sound, effective, and generally acceptable system of security appraisal. There are currently two major systems used, however, they lead to fundamentally different results.

First method: NOI MethodIt capitalized net operating income and subtracts debt. The essence of this approach is that the total value of all bonds and stock must be the same C regardless of the proportion of bonds and stock.See pg. 457 for numerical example

Second method: NI MethodIt capitalizes net income instead of net operating income. The total investment value does not remain constant, but increases with the proportion of bonds in the capital structure.Se pg. 457 for numerical example

The NI Method is more liberal than the NOI method. The NI Method results in a higher total investment value and a higher value for the common stock except for companies capitalized entirely with stock.

3. Leverage and Management Discipline

(A) Management=s View of Optimal Capital Structure

Top management=s commitment to continuous growth means that it must have a matching strategy for providing the requisite funds. Nowhere is this necessity more apparent than in the funding of existing product markets. As mgt considers the flow of funds for strategic investment in established product markets, corporate managers prefer sources that most nearly satisfy certain conditions. These include:‚0 availability on an open-ended and continuous basis‚1 compatibility with the level of mgt.=s perceived needs‚2 a high degree of certainty as to amount and timing.

Limitations of the Public Capital Market

Many often wonder why industrial managements do not use new external equity more extensively to fund the normal growth of established businesses. No single answer suffices. The first is corporate leaders= inevitable disposition to regard their equity as undervalued. Expectations for next year=s sales and

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earnings always look better to the insiders who have responsibility - and the self confidence- for delivering them. Consequently, next year always promises to a better price. A second deterrent to the use of equity in funding ongoing investment is management=s preference for continuous, reliable, and predictable sources of funds. In a mature organization the necessity to turn to the public equity market for supplemental funds is often seen as a public admission of mismanagement. Thus, many mgrs attach a negative connotation to the market signal associated with a new equity issue.

Consequently, mgrs made it a practice to live within the standards of an A credit rating. As a result, they were in a position to regard debt as an automatic extension of internally generated funds and to treat it as though it were an assured, off-balance sheet, liquid asset reserve. Most managers, nonetheless, preferred debt policies that were characterized as conservative. They pointed out that debt was easy to increase and hard to cut back. Consequently, debt policy, reflects a primary emphasis on freedom C that if the debt limit is maintained as was set by mgt, then the mgrs will be free from bank restrictions and the banks will not inhibit their activities.

A Strategy of Self-Sufficiency

The financial strategy that emerges from the above discussion can be best characterized as one of self-sufficiency. The price for such a strategy is that corp=s need to live within limits. Mgt. must order its strategic investments to fit the available capital at the available time. Thus, the possibility of spontaneous or opportunistic investment is greatly diminished.

(B) Debt as Discipline

The tax-adjusted MM proposition suggested that the high bond ratings of such companies, in which the mgt. took so much pride, may actually be a sign of their incompetence; that the managers were leaving too much of their stockholders= money on the table in the form of unnecessary corporate income tax payments, payments which in the aggregate over the sector at large, publicly held corporations clearly came to many billions of dollars. Stated broadly, mgt=s desire to be self sufficient and secure comes at the cost of maximum return on capital invested.

As a Mr. Donaldson points out, outside debt financing gives rise to mgt. insecurity. The inference arises that debt financing can cause mgt to perform more productively. The threat caused by failure to make debt service payments serves as an effective motivating force to make such organizations more efficient.

SECTION B. CAPITAL STRUCTURE, PUBLIC POLICY, AND LEGAL STANDARDSHigh Leverage (textbook 487-498)The 1980s saw dramatic increases in the uses of debt or “leverage.” The national debt equity ratio had started rising in 1983, until it reached 181% in 1988 which was a level not seen since the Depression (it had remained relatively stable since). Much of this increase stemmed from the joint appearance of the “leveraged restructuring” and the “junk (high-yield) bond”. This chapter examines whether this was a beneficial or detrimental experience for the economy at large. If detrimental, how to regulate them? Or

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would the cost of regulation outweigh the benefits?1 The levered companies that survived began to issue stock to pay down debt and balance sheets began to approximate normal levels of debt.The Governance DefenseJensen, “Eclipse of the Public Corporation” (Harvard Bus. Rev. 1989)The point of this article is to defend the use of high leverage and the most common instrument to get there: the junk bond.

A new model of general management is coming out of the buyout funds (KKR, Perelman, etc.) and the merchant banks. The model is built around highly leveraged financial structures, performance-related pay structures, equity ownership for managers and directors, and contracts with owners and creditors limiting cross-subsidization across business units and wasting free cash flow. The underlying goal is to maximize value with a strong emphasis on cash flow, not to maximize earnings per share (EPS).

In a public corporation a source of waste in the public corporation is the conflict between shareholders and managers over the payout of free cash flow.2 The problem is that even when FCF exists, senior managers have few incentives to distribute the funds, and few mechanisms exist to compel distribution.

Critics of high leverage, the “defenders of the public corporation” miss important 3 important points:1. Trebling of public company equity over the last decade necessarily means corporate borrowing had to

increase to avoid a major deleveraging.2. Debt creation without retention of the proceeds helps limit the waste of FCF by compelling managers

to pay out funds they would otherwise retain. In a sense, debt is a substitute for dividends – except interest payments are not discretionary.

3. Debt as agent for change/debt as discipline. Overleveraging creates the crisis like atmosphere required to slash unsound investment programs, dispose of assets more valuable outside the company, etc. The proceeds generated by these overdue restructurings can be use to reduce debt loads to model a more efficient and competitive organization.

The last claim is that the relationship between debt and insolvency is perhaps the least understood aspect of this organizational evolution. New hedging techniques mean the risk associated with a given level of debt is lower that it was 5 years previously.Objections to Leveraged Restructurings1. “High” pessimists assert that the high debt itself creates a risk of financial crisis. The contention that

as debt levels continue to rise, creditors will eventually lose confidence and withdraw their funds from the credit markets drastically curtailing economic activity. Essentially the argument is that the “is something wrong with borrowing” it stems from weakness and creates risk.

2. “Guarded” pessimists argue that the incremental effect of a higher debt load will exacerbate a cyclical downturn in the economy. Debtors’ distress will contribute to a decline in nonfinancial activity.

1 It should be noted that by the early 1990s the recession of 90-91 changed these patterns of financing. Essentially the downturn reduced cash flow threatening interest coverage. Many of these restructurings or LBOs were forced into bankruptcy or provided negative returns. Today leverage is still used as is the high-yield bond (the HY bond market has been flourishing since Spring of 97), contrary to what some articles in the book predicted. However the equity demanded in an LBO is much higher than the 5-10% which was permitted in the late 80s.2 Free cash flow (FCF) is cash flow in excess of that required to fund all investment projects with positive net present values (NPV) when discounted at the relevant cost of capital. In plain English: corporate managers are faced with operational decisions everyday. In order for a corporation to choose to undertake a project it must have a positive return (profit) when the cost of the project (which includes cost of borrowing if the funds are not internally generated) is factored in. If the managers cannot find projects that meet these criteria, financial theory says those CFs are FCFs and should be distributed (usu. through dividends) to shareholders.

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The downturn will cause CF problems for debtors, causing CF problems for creditors when they fail to make interest payments. Further curtailment of economic activity will be the result. Forced asset sales by debtors in distress will depress asset prices, followed by waves of bankruptcies.

3. In late 1986 $125Billion of HYBonds were held as follows: $40B insurance companies; $40B mutual funds; $10-15B pension funds; $10B S&Ls; $15B individuals. The argument was raised as to whether many of these holders could be relied on to monitor managers at all.

Regulatory ResponsesThe 1980s restructuring movement prompted a number of changes to corporate law, state antitakeover and constituency statutes. However the topic of high leverage per se, although discussed, resulted in very little legislation. The principal legislative responses were as follows:Legal Investment Laws and Other Regulation of Lending InstitutionsCongress passed Financial Institutions Reform, Recovery and Enforcement Act (FIRREA)of 1989, mandated the divestment of thrift (S&Ls) of junk bonds and provided that thrifts may only acquire investment grade debt securities. The states tightened credit standards. For example, Connecticut revised its legal investment laws for insurance companies, defining high yield obligations as below investment grade and restricting such obligations to 10% of an insurance company’s assets.Tax LawsFederal income tax law responsive to M&A activities began in the conglomerate merger movement of the 1960s. As national tax policy is often designed to induce alterations in business practices, the key to understanding the policy rationale is the notion of “disguised equity.”

Congress added s. 279 to the Internal Revenue Code, limiting the deductibility of interest on “corporate acquisition indebtedness” where such interest exceeds $5 million/a. “Corporate acquisition indebtedness” includes obligations used to provide consideration for the acquisition of the stock or operating assets of another corporation if:1. the indebtedness is subordinated to the claims of general creditors or of other unsecured creditors2. the indebtedness is convertible into stock of the issuing corporation3. the debt:equity ratio exceeds 2:1 or projected earnings interest coverage is less than 3x

The last 2 criteria refer to disguised equity. Disguised equity is the biggest problem with “thin incorporation” and closely-held ventures where the line between debt and equity is blurred. Imagine a situation where 3 friends start up a company with 10% equity and lend the company the other 90%. Interest payments must be made, but these are tax free. Often this is not true debt, but disguised equity…a taxable dividend disguised as tax-deductible interest payment to the shareholder/bondholder.

Debt as EquityWith respect to disguised equity as discussed above, economists have offered indirect support for this approach of the Internal Revenue Code noting that financial innovations have caused traditional distinctions between debt and equity securities to collapse.

Legal Standards that Affect Capital Structure (Supplement 72-96)Regulation of Derivative InstrumentsDerivatives were designed for risk management. In general terms, this means hedging against unsystematic risk in the market. For instance, you are buying wheat for delivery in September, but in order to lock in the price that you can sell it at you buy a futures contract (this is a derivative) obligating the counterparty to the contract to buy at a specified price. Hence, you have taken the market risk out of your eventual transaction. Replace the wheat with any foreign currency, interest rate, commodity, etc…and you get the meaning of derivative used for hedging purposes.

The regulatory problem is multifaceted:

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1. The first aspect concerns “plain vanilla” hedging (like I described above). The question concerns the impact of risk reduction activities on shareholder value and its attendant implications for the corporate law duty of care.

2. Outside of “correct” risk reduction - there are other problems - hedging can create unforeseen and unintended risks if done improperly or where the counterparty is headed toward financial distress

3. Derivatives can also be used for speculative use - speculation is not illegal however one must realize that for active traders, activities in derivatives entails the assumption of tremendous risk (of course with the possibility of extraordinary returns) (recall what happened to Barings).

Risk Reduction through Hedging and the Duty of CareBrane v. Roth C.A. Indiana, First District, 1992The shareholders of a grain co-op successfully sued the directors for losses in 1980 due to the director’s failure to protect its position by adequately hedging in the grain market. The directors are appealing.

Approximately 90% of the co-op’s revenues came from buying/selling grain. The Co-op manager handled the buying/selling of grain. Directors met monthly with the co-op’s bookkeeper to review financial reports, discussed maintenance issues and authorized loans. Directors rarely requested additional info on these reports, and in 1980 they didn’t make any specific inquiry as to the losses sustained.

Profits had been steadily decreasing since 1977. In 1979, the co-op’s CPA (equivalent to a Cdn. CA) recommended hedging the grain position to protect against future losses. Directors authorized manager to hedge. But only a minimal amount was hedged, the value of the hedging contracts were less than 1% of total annual grain sales. In 1982 the CPA realized he had made mistakes in the 1980 financials. The directors consulted another accounting firm, who said that the losses (understated before) were primarily caused by failure to hedge. This was found as fact at trial as well.

The directors were found liable for the losses as a result of: (1) breach of duty by retaining manager inexperienced in hedging; (2) failing to maintain reasonable supervision over the manager; (3) failing to attain knowledge of basics of hedging to be able to direct the hedging activities and supervise the manager.

Although the directors argued that they relied on their manager and should be insulated from liability, the business judgment rule protects directors from liability only if their decisions were informed ones. A director cannot blindly take action and later avoid the consequences by saying he was not aware of the action he took. A director has some duty to become informed about the actions he is about to undertake. Here, the evidence shows that the directors made no meaningful attempts to be informed of the hedging activities and their effects upon co-op’s financial position. Their failure to provide adequate supervision of the manager’s activities was a breach of their duty of care to protect co-op’s interests in a reasonable manner. The business judgment rule does not shield the directors form liability. Directors are not liable for mere errors of judgment (business judgment rule) but as here, they are liable for losses occurring through their gross inattention to the business or their willful violation of their duties.

NOTE: Hedging, Shareholder Value, CAPM, and the Irrelevance HypothesisBrane v. Roth read broadly implies that a well-advised board of directors should take a proactive stance toward hedging the risks of enterprise. However there is some question as to hedging actually enhances shareholder value:(1) to the extent that risks to be hedged are unsystematic, shareholders can eliminate them through

diversification

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(2) shareholders can deal with aversion to residual systematic risk by including riskless securities in their portfolios

(3) to the extent that a particular source of systematic risk can be identified within the firm, shareholders not willing to bear the risk can construct their own “home-made” hedges with the result that the unhedged frim and the hedged firm have the same long-run value. (I disagree with the last point because in practice, the futures/forwards market cannot be accessed by the average retail investor, at least without significant cost disadvantages to that of the firm).

(4) Another argument is that hedging in fact is in management self-interest. The use of hedging provides managers with a stable institutional environment. If hedging is used not to protect against disruption of actual financial transactions but to protect annual earnings pursuant to GAAP (cash flow vs. accounting income) then management self-interest may be motivating the hedging activities without concern for shareholder value.

The supplement goes on with more theoretical arguments, which really have little relevance for us. However an important note is that there is no conclusive empirical evidence on the connection between hedging and firm value. One suggestion is disclosure policy. This is based on the insightful premise when mentioning shareholder value, shareholder expectations are key. If shareholders in a natural resource company are seeking to speculate on volatile commodity prices they do not want the firm to hedge (i.e., the company’s purpose in the portfolio is a play on oil&gas prices), but some shareholder may differ in expectations and expect the firm to be hedging those risks. Thus a disclosure policy could better inform investors of the hedging policy of the firm and allow those shareholders to decide whether this fits into their portfolio or not.Counterparty RelationshipsIn the Matter of BT Securities Corporation (January 4, 1995)This case involves violations of the reporting and antifraud provisions of the federal securities laws in connection with transactions in derivatives sold by BT Securities to Gibson (and where BT acted as counterparty to each). Gibson had $50 M of senior notes out with a high coupon, interest rates declined and Gibson wanted to refinance. However, because they could not be prepaid for a number of years, thus Gibson wanted to reduce interest expense by purchasing derivatives (i.e., swaps).3

The problem with swaps is that they are private agreements, and as such not traded on any exchange, and therefore have no public market valuations. BT had to use computer models to explain to its client, Gibson, the values of the swaps they were buying (from BT). Gibson, lacking the expertise, fully relied on BT for the value of its derivative positions to evaluate transactions and to prepare its financial statements.

1. Provision of Inaccurate Valuations to Gibson

3 A Swap is a private agreement by two parties with a financial intermediary in the middle. In this case the financial intermediary was the counterparty (this is also not unusual). There are literally hundreds of kinds of swaps, but here the relevant contract is the interest rate swap. In simple terms, you trade cash flows from your asset with cash flows from someone else’s asset. In an interest rate swap, these cash flows are interest payments on debt. One firm wants to convert its floating rate interest rate into a fixed rate interest rate, and the other firm wants the opposite. So in this case, BT pays Gibsons’ fixed rate payments, while Gibson pays BT a payment linked to another underlying asset (which floats). There are many reasons why a firm may enter into an interest rate swap. The most common is that one firm can achieve a more favourable fixed rate then it can in a floating rate or vice-versa. The next logical question becomes, in a case like Gibson, if the interest rate they are paying on the senior notes is so high, why would anyone want to trade with them? When entered into, a swap, like other derivative contracts both parties have significantly different views of future conditions or have different concerns about future conditions, in a sense one is gambling that their vision of the future is more likely.

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For roughly 2 years, BT misled Gibson regarding the value of its derivatives positions by understating the magnitude Gibson’s losses (sometimes off by as much as 50%). Gibson was unaware of the losses and continued to purchase derivatives from BT. These misrepresentations also caused Gibson to make material understatements of the losses in its financial statements. BT thereby caused violations of S. 13(a) of the Exch. Act and Rule 13a-1 and 12b-20 thereunder.2. Offer and Sale of Securities to GibsonMost of the derivatives were securities within the meaning of federal securities laws. BT made material misrepresentations and omissions in the offer and sale of these securities. Selling these securities in that manner, BT violates s. 17(a) of the Sec. Act, s. 10(b) of the Exch. Act and Rule 10b-5.3. Failure to SuperviseBT failed to take reasonable steps to supervise its representatives, violating s. 15(b)(4)(E) of the Exch. Act which allows the SEC to impose sanctions where the firm “has failed reasonably to supervise, with a view to preventing violations of federal securities laws, another person who commits such a violation, if such other person is subject to his supervision.”

BT settled and must follow the compliance order set out by the SEC which demanded:(1) BT had to hire a consultant at is own expense to review and recommend compliance procedures and

improper conduct and disciplinary actions(2) BT has to comply fully with consultant, BT must require consultant to prepare a report at BT’s

expense setting out his/her findings and recommendations - and must be approved by SEC and then BT must adopt all recommendations within 6 mos.

NOTE: The Regulation of Swaps1. Swaps DealersBecause swaps are agreements between private parties governed by the law of contract, and they are not traded on any market, it is arguable that they implicate neither fed sec laws or fed commodities trading laws. Critics have been reproachful of SEC’s assertion of authority over the BT swaps.2. The Proctor & Gamble LitigationP&G found themselves in a similar situation to Gibson. Before the settlement, the federal court issued a contradictory findings to that of Gibson. (1) the swaps were not and “investment contract” because the element of common enterprise was lacking; (2) swaps not “options” because the entailed a mandatory exchange of interest payments rather than a choice as to the exercise of a right; (3) no fiduciary relationship existed between counterparties. However it did not dismiss the claims of CL misrepresentations and breach of the k law good faith duty.Systemic Risk and TransparencyRegulatory Possibilities and ResponsesRegulation is a difficult task because the subject-matter itself is difficult to grasp. The value of an OTC derivative at any given point in time is ascertained by a theoretical model. These theoretical models are continually being refined and transacting parties have little incentive to make their techniques public. Regulators have been taking steps to address some of these problems.

1. DisclosureRules are only at an embryonic stage. Income statements of securities firms only began separately reporting results of derivative activities in 1993. GAAP has standards only for futures. For other derivative products inconsistent accounting practices have developed in the absence of comprehensive rules.FASB now imposes derivative reporting requirements on all firms. One important requirement is the disclosure in notes to financial statements of off-balance sheet risk (risk of accounting losses exceeding any amount recognized in the balance sheet. The reporting company must also disclose the purpose for which it holds the instrument (trading vs. hedging)

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The SEC has its own rule for mandatory disclosure of derivative information. Outside of the financial statements must be qualitative and quantitative information about derivative instruments if either their FMVs are material at the end of the period or reasonably possible market movements could lead to a material loss in future earnings, CFs, or FMVs. Industry response has been negative. The Senate Banking Securities Subcommittee has taken up the industry’s case arguing that the rules force disclosure of sensitive information and discourage the use of derivatives for risk reduction purposes.

2. GovernanceThe highly publicized spectacular losses from derivative activities have caused calls for regulatory oversight of OTC derivatives activities by securities firms be brought up to the level applied to banks. Suggestions that the SEC be assigned responsibility for these agencies and that an interagency commission be established to set standards for each financial regulator.The threat of new regulation of course has prompted a series of preemptive self-regulatory initiatives by the banking and securities industry. The SEC has take a 2 pronged position:(1) With respect to investment companies (buy-side funds) has recommended that a quantitative risk

measure must appear in mutual fund prospectuses; reducing the amount of illiquid securities in mutual funds; reexamination of leverage restrictions and their applicability to derivative instruments; recommendation to Congress of legislation to enhance its power to monitor derivatives activities of mutual funds.

(2) With respect to large securities firms, SEC has recommended forbearance by Congress while the SEC pursues self-regulatory solutions with the firms.

Swaps: Appendix A to Judgment of the Divisional Court (1990) (CSBK 227)I am not going to brief this one page explanation of swaps and FRAs. It takes 5 minutes to read and is a good summary of what you need to know about these instruments. In the footnote to the brief of BT Securities case, I explained briefly what an interest rate swap was and why it might be done. Please note that although this Appendix A says “Swaps” it is really only discussing interest rate swaps. There are tons of other kinds, the most common of which is the currency or exchange rate swap.Hazell v. Hammersmith and Fullham London Borough Council and others LBC [1991] 1 All ER 545 (HL)Facts: A London borough incorporated by Royal Charter established a capital market fund to play the interest rate market. Between 87 and 88 it traded extensively in derivatives (primarily interest rates swaps, swap options, etc.). In most of the positions, the local authority would benefit if rates fell and incur losses if they rose. These activities were challenged in 1988 (by the auditor - Hazell) because they were essentially speculative trading for profit (the authority was not using these instruments to hedge the value of assets). The authority stopped all swap transactions and limited the activity to 7 contracts which were contingent on counterparties exercising options (i.e., obligations could arise on the part of the local authority if the counterparty decided to exercise the option).Held:Trial Ct:(1) The local authority was ultra vires its power because it could not rely on incorporation to give it the

capacity of a natural person to contract, because its capacity was limited to those conferred on it by statute

(2) The implied power to do anything in furtherance of the discharge of its functions did not catch the swap transactions

At the CA:- allowed in part - in that the 7 transactions were lawful because they had been carried out for the lawful purpose of mitigating potential loss to the ratepayers.At the HL:(1) Local authority had no power to enter into the swap agreements (whether speculative or not) with the

object of making a profit because such action is inconsistent with the borrowing powers as defined

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in the Local Government Act and were not caught by the saving provision which allows such activities if they “facilitate” or were “conducive or incidental to” the discharge of its borrowing functions as limited by the Act. Furthermore, since the transactions were unlawful, the fact that there was a different intention to the remaining 7 transactions is immaterial. The remaining 7 are unlawful as well.

(2) Although the Royal Charter incorporating the borough gave it all the powers of a natural person, it did not confer any greater power than the powers of a statutory corporation. It follows that the council had no power to carry out the swap transactions either in its own name or in the name of the borough.

Corporate Finance Summary:

Part IVK. Brown

Text: Part IVDIVIDENDS AND RETAINED EARNINGS: INTRO

-11 The relationship of dividend policy to share valuation is one that is much debated. The question is whether the company dividend policy is a variable that affects positively the share price or is it a means of distributing funds for which the management has no competitive employment. If it is an active factor , then the company must search for an optimal dividend payout rate. If dividend policy has no impact on share price, the policy is a mere detail to be determined by the availability of competitive investment projects.

-12 Dividend policy question has agency costs, as the manger has incentive to reinvest suboptimally, thus giving rise to lower payout from shareholder point of view.

Dividend capitalization model of share valuation:-13 this model assumes the present value of a share of capital stock (c/s) is equal to the value of its

future dividend payments (D), capitalized at a rate that reflects the markets assessment of risk associated with the firm’s expected income stream.(k)

-14 Assuming that all earnings will be constant and that all earnings will be paid out -15 Value of a stock (V) is calculated as follows: V= D/ k.

-16 When earnings are retained, they are reinvested in income producing investments, thus shareholders can expect a growing dividend: The value of a share in such a scenario must take into account the growth factor and thus the valuation formula is calculated as follows:

-17 V= D/ k-br whereD is the expected dividendK is the dividend capitalization rate

BR is the expected growth rate of the firm, where r is the rate of retained earnings to total earnings and b is the rate of rate of return on these reinvested earnings.

The Retention Ratio-18 In order to get larger dividends in the future the firms must forgo the payment of current earnings in

the form of dividends. The firm must determine the retention rate that maximizes shareholder wealth.

-19 Retention rate is determined by the relationship between the firm’s internal rate of return obtainable from investment opportunities (IRR) and the rate at which the firm’s dividends are capitalized by the market(k)

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-20 When IRR> k, the share value of the firm is maximized when all earnings are reinvested into available investment opportunities. Thus there will be a zero dividend payout. This is what one would expect to happen in growth companies. Such companies would be expected to trade at high multiples of current earnings, reflecting the expectation of super-normal profits.

-21 If IRR<k then, share price is maximized when retention of earnings is zero and all earnings are distributed as dividends.

-22 If k=IRR then the market price would be insensitive to the retention ratio. Funds distributed can be reinvested at the firm’s IRR by the shareholder either by reinvesting in the firm or by purchasing different shares. In such a case retention brings about an expansion in earnings, yet the firm has no investment opportunities. Thus, in this case the market value of the share remains the same irrespective of the firm’s retention policy.

DIVIDENDS AS A FINANCING DECISION-23 the traditional view of security analysts is that share values react positively to generous and stable

dividend policy and unfavourably to the converse. Thus a departure from the preferred pattern will result in a non-optimal market price for the company’s shares.

-24 Modigliani and Miller(M-M) take a different view. They assert that once the firm’s investment decision is made known to investors the dividend payout ratio is irrelevant. Why: because the value of the firm is solely based on the earning power of the firm’s assets. The value is unaffected by how the firm finances its activities- by retained earnings, which means withholding dividends or selling securities, either shares or bonds, which enables the company to keep paying dividends. They argue the net wealth of the shareholder is the same under each financing option. Note: that this assumes that the shareholder is indifferent to $1 of dividend income vs. $1 of capital gains.(which may not be so when tax considerations are factored into the analysis) . Thus dividend payout is not an independent policy decision but a means of disposing the firm’s residual funds , once its financing needs have been met. Thus is called the irrelevance of dividends thesis.

-25 The following is a brief analysis of what is going on under each financing option: Assume the following : Current earnings: $1MM, through investment of $1MM, an additional $200k in earnings will be generated, assume a k of 10%.

-26 Financing through retained earnings: Current year dividends are foregone, but the reinvestment of earnings into the firm will yield increased dividends in future years. Thus the present value of the share will be increased from its current value of $100 to $120. Thus, the shareholder wealth is calculated in terms of capital gains and not current dividend income.

-27 New stock issue: Current dividends will be paid and new shares will be issued at $110. So for each share presently owned the present shareholders will have $10 cash dividend and $110 in share value. Thus total wealth is $120.

-28 Bond issue: Current dividend is paid. New investment is financed by issuing a $1MM bond at 5% interest rate. If market continues to capitalize dividends at 10% , the shareholder will be better off under this example, because the stock would be valued at $115, thus combined with current income of $10 gives shareholder wealth of $125. However, M-M argue that the dividend capitalization rate in such a scenario would rise to reflect the increased risk resulting from the bond issue, thus increase in k would offset exactly the dividend increase, thus the share value

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would be the same as with an all equity structure- $110. Thus shareholder wealth is once again $120.

-29 Thus, assuming that corporate leverage has no advantage the manner in which the firm’s earnings stream is split between dividends and retentions does not affect the value of the firm, even when investor preferences for saving or consumption are taken into account.

-30 Yet, when factoring in tax consideration, a corporation that finances using bonds, has less income tax to pay, as interest expense is tax deductible and thus more earnings to distribute than a company who finances through equity. Thus everything else being equal, a levered corporation is certain to be worth more than an unlevered corporation, even if one assumes M-M position that leverage in and of itself has no impact on the value of the firm.

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VAN HORNE, FINANCIAL MANAGEMENT AND POLICY

Investor Clientele Neutrality:-31 Investors with different tax situations will have preferences for dividend paying versus non-dividend

paying stocks. -32 If companies pay out dividends that do not match investor clientele preferences, this will create an

excess demand for those shares of those companies who have a dividend payout matching investor preference. Thus companies must adjust dividend payout in order to increase their share prices. Thus, dividend payout match the desires of investor groups, the excess demand will be eliminated. At this point, no company is able to alter its share price by altering its dividend. Thus dividend payout will be irrelevant.

Influence of other factors on dividends:Flotation costs:

-33 irrelevance of dividend payout is based on the notion that each dollar of dividends paid out is matched by a corresponding dollar amount is replaced in the form of external financing. To the extent the firm must pay flotation costs, every dollar of dividends yields less than one dollar of external financing. This favours the retention of earnings in a firm.

Transaction Costs and divisibility of securities:-34 brokerage costs involved in the sale of securities vary inversely with the size of the sale. Thus, a

shareholder who desires current income ( consumption desires) in excess of the current dividend would prefer a company to pay additional dividends rather than incur the brokerage fee on the sale of stock to satisfy this consumption desire.

-35 Divisibility of shares: the lowest integer is one share, thus they are not infinitely divisible. This acts as a deterrent in the sale of stock in lieu of dividends.

-36 Further shareholders who do not desire dividends and wish to reinvest their dividends are also faced with transaction cost, brokerage fees in the purchase of additional shares of the firm and divisibility problems with respect to reinvesting this dividend .

Institutional restrictions:-37 some institutional investors and trusts have prescribed investments that are based in some part on the

dividend payout policy of the firm.

Signaling effect of dividends:-38 an increase in dividends is said to signal management’s favourable expectations about the future

profitability of the firm, a decrease in dividends is signals the opposite.-39 The efficacy of dividends as signals based on the fact that dividends are backed by cash. No matter

what the company says in other statements, the announcement of a dividend is followed up by the payment of cash. This is viewed as a future oriented decision.

-40 However, there is a puzzle within the signaling effect of dividends. That is, an increase in dividends may mean the forgoing of a better use of funds or the fact that there are no opportunities available to the firm. Thus, the signaling affect of dividends, while perceived positively could be a sign opposite to its perception, if the dividend is being paid out because the firm has no better use for the funds.

-41 Similar obscurities occur when the company withholds dividend payment, a situation which except in growth company situations is negatively viewed by the market.

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-42 When the dividend signal is misread by the market, is management misleading (to the point of being culpable) if it does not state that is foresees something different from what the market perceives?

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Applicable legal standards:-43 from a legal standpoint the selection of a dividend policy is almost entirely within the discretion of

management. There are statutory requirements, such a solvency tests, however, the law has a further impact on corporate distribution policy, when the dividend policy is suspected of having manipulative or other illicit goals in mind.

Dodge v Ford Motor CompanySuit by plaintiffs, who owned 10% of Ford to compel the declaration and payment of a dividend out of the corporation’s accumulated surplus. The lower courts decreed a dividend payment. Ford appealed. The lower court decision including the amount decreed to be paid was upheld on appeal.

Facts: -44 Ford had a dividend policy of paying out regular cash dividends of 60% of its stated capital of

$2,000000. Further, it paid special dividends over the course of 4 years (1911-1915) of $40MM.

-45 In 1916, Henry Ford ( who controlled the board) declared no further special dividends would be paid out, as the earnings were to be put back into the business for the purpose of extending operations and increasing the number of its employees. This business decision would lower the profitability of Ford.

-46 His motives for reinvesting in the company were based on philanthropic reasons: he felt Ford’s profits were too large and he wanted to share these profits with the public, by lowering the price of cars and increasing employment.

-47 At this point the company had surpluses of $112mm and in addition $54mm in cash and treasury bills.

-48 Ford continued to pay the regular dividend based on the above formula, which meant that in 1916, it had $58MM to reinvest in the company.

Ratio:-49 Corporations are organized and carried on primarily for the profit of the shareholders. The discretion

of the directors (in the decision to pay dividends) must be exercised in the choice of means to attain this end, and does not extend to a reduction of profits or the non-distribution of profits to devote them to some other purpose.- i.e. philanthropic purposes.

-50 If the directors are in breach of their duty to the shareholders by conducting the corporation for the benefit of others and the benefit of the shareholders is only incidental to the board’s decision making , then the courts can step in to protect the interests of the shareholders.

-51 The courts are not willing to interfere with the business judgment of the board as it related to the proposed expansion of the business of Ford.

-52 However, the court assessed whether the expansion plans justified the non- payment of dividends. They calculated that even by taking into account the proposed expenditures, there was still ample cash surplus from which dividends could be paid. Thus, it was the duty of the directors to pay out a large sum of this surplus to the shareholders.

Dividends and Corporate Opportunity:

Sinclair Oil Corp. v. Levein-1 A minority shareholder of Sinclair’s 97% owned subsidiary, Sinven , brought an action for damages

and an accounting on the grounds that Sinclair had injured Sinven by causing it to pay out excessive dividends in order to finance Sinclair’s worldwide exploration activities .

-2 The plaintiff was successful in obtaining an accounting order from the lower court.

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-3 The lower court used the intrinsic fairness test in reviewing: 1 extraordinary dividends being paid out and 2. the absence of any serious efforts made by Sinclair to expand Sinven. It held that the large cash dividends combined with the absence of any serious effort to use the corporate resources of Sinven was motivated by the interests of Sinclair and not for the benefit of all shareholders. Thus, while it is unusual for the courts to override the board’s decision with respect to the payment of dividends it will when the fiduciary has failed to apply the corporation’s assets for the benefit of all the shareholders.

-4 This decision was overturned on appeal.

Ratio:-5 In parent -subsidiary dealings, the intrinsic fairness test is not invoked unless the fiduciary duty that

the parent owes to the subsidiary is coupled with self-dealing. -6 A dividend does not fall within this definition, thus the decision of the board to pay dividends

should be subject to the business judgment rule.-7 Under the business judgment rule, the judgment of the directors will not be reviewed by the court

unless there is a showing of gross and palpable overreaching. -8 The court held that the dividend payment complied with the business judgment standard. The

plaintiffs to succeed would have to establish the dividends resulted from improper motives or constituted waste. The plaintiffs were unable to show improper motives.

-9 RE corporate opportunities, as they were unable to show that Sinven received corporate opportunities independently . Thus Sinclair usurped no business opportunities belonging to Sinven. Thus this board decision also passed the business judgment rule.

Berwald v. Mission Development Company Plaintiff owns 248 shares of the defendant company and brings suit to compel the liquidation of the company and the distribution of its assets to it shareholders .

Held: Plaintiffs failed to get a liquidation order.

Facts:-10 Mission is a holding company, whose sole asset is a block of 7MM common shares of Tidewater Oil

Company. Tidewater is controlled through Mission and Getty Oil Company by JP Getty.-11 Mission was formed to hold the shares of Tidewater. Its sole purpose was to invest in and increase

its shareholdings of Tidewater. -12 At some point Tidewater discontinued paying cash dividends, thus discontinuing Mission’s income.-13 Tidewater, however continued to pay stock dividends on an annual basis. Mission chose not to pay

out the stock dividends, because this would result in a decrease in its proportionate ownership of Tidewater.

-14 In 1960, Tidewater stopped issuing stock dividends. -15 It was in 1960 that the liquidation order was sought by the plaintiffs.

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Ratio: -16 Winding up order is only granted in extreme cases, where imminent danger of great loss through

fraud or mismanagement can be shown. This is not the case here.-17 Plaintiff then argues as follows: The minority shareholder and the controlling shareholder of Mission

, Getty have different interests with respect to the dividend policy of Tidewater. Getty, because of his high tax bracket is not interested in getting dividends from Tidewater on an annual basis, and he was able to get Tidewater to adapt its dividend policy so as not to pay out any dividends for the next five years. This has reduced the market price of the Mission shares and enabled Getty to acquire more shares at low prices. Thus, Getty and Mission have inflicted a serious wrong on the minority shareholders.

-18 While it is true that shareholders can have varying interests with respect to the desire to receive dividends, due to their different tax positions, the court held that this was not the case here.

-19 The plaintiff’s argument turns on whether Tidewater’s dividend policy was designed to serve the needs Getty or whether it was adopted pursuant to its own corporate objectives. If this latter position is the case, then there is no actionable wrong by Mission and Mr. Getty’s purchase of additional Mission shares is not relevant.

-20 There was sufficient evidence furnished to establish that Tidewater was truly in capital expansion and modernization mode. Further, there was evidence that cash was being used in this project and that in the opinion of management, funds were not available for dividends.

Cochran v. Channing Corp.Plaintiffs are shareholders of Agricultural Insurance Corporation. They are bringing a complaint under rules of Security Exchange Act against the Defendant Corporation as a corporation who has dominated the policies of Agricultural. The individual defendants are directors of both Agricultural and Channing. Two of the three have been so during the entire period of the complaint.

Facts:-21 It is alleged that Channing wanted to acquire shares of Agricultural at the lowest possible prices. To

this end, it is alleged that Agricultural directors reduced the quarterly dividend payout to depress the price of the shares, thus facilitating the Channing acquisition program. Further it is alleged that in order to carry out this program at the lowest possible prices, Channing withheld the details of its purchase program from the public. Because of this dividend reduction, and lack of disclosure as to Channing's stock acquisition plan, the plaintiff sold shares of Agriculture stock that he would not have otherwise sold, and at a depressed price that reflected the dividend reduction and at a price that was lower than what they could have received later after the disclosure of the Channing stock purchase program.

Held: Defendant’s motion to dismiss each cause of action is dismissed.

Ratio: -22 If the dividend was reduced only to depress the price of the stock, then the plaintiff would be in the

class of persons expected to rely on the reduction as evidence of decreased valuation.-23 Active concealment by the directors is the legal equivalent of fraud. The defendant’s intended to

and did in fact deceive the plaintiff into parting with his shares when disclosure of the truth would have dictated a different course of action.

Dividends and Conflict of interest:

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-24 the legal norm for assessing the propriety of a particular investment/dividend policy may involve traditional fiduciary consideration as well as business judgment. Should there be a rule requiring management to justify its earnings retention decision on a case by case basis or should there be a categorical rule which would compel the periodic payment of all or a stated percentage of earnings ?

-25 This question is in its most acute form when it is the controlling shareholder who is determining dividend policy. They are less likely than outside shareholders to be concerned with the impact the dividend policy will have on the price of the shares and are less likely to be dependent on the cash dividends. Controlling shareholders may prefer a dividend policy which reduces near term share prices, due to the tax benefits that accrue .

-26 When dealing with non-owner managed firms, management’s aversion to risk and preference for the “quiet life” may lead to sub-optimal distribution and reinvestment decisions from the point of view of the shareholder. Further, management stock options may cause management to make decisions that would decrease dividend payouts and thus reinvest earnings, causing share values to increase.

-27 If management is forced to pay out all or a substantial designated portion of earnings, there is a need to develop the economic and legal norms by which to determine and measure the mandated payout.

-28 Economic theory has not yet provided a determinate answer to the question of the proper amount, when less than full payout is required. There is the further issue as to whether the law can be successful in imposing adequate restraints on management’s powers with respect to dividend policy.

Corporate Restructuring by Dividend- Spin Offs and Tracking Stock

-29 1990’s have seen the unbundling of the conglomerate. Mangers are focusing on core business and divesting themselves of peripheral lines of business.

Spin Offs:-30 a method of effecting conglomerate unbundling. -31 It is effected as follows: the parent divests itself of a subsidiary, by declaring a dividend of the shares

of the subsidiary’s common stock to the shareholders of the parent co. The net result is the shareholder now owns shares in two public companies. (Assuming the parent is publicly owned).

-32 In some cases it is the institutional investor pressure campaigns that precipitate the spin offs.-33 Management incentive for the spin off: 1. The rise in stock price that follows a spin off tends to

enhance the reputation of the CEO. 2. Often, management compensation is tied to stock performance. 3. Often the subsidiary spun off has been a poor performer. The spin off usually comes with a program of reorganization . Either way, the CEO has divested himself of a problem.

-34 Spin offs have tax advantages. Often this is the only way to divest oneself of assets without triggering capital gains. In Canada, the butterfly divisive reorganizations, if done properly, can be done on a tax- deferred basis.

-35 However, if the market perceives the spun off company to be weak, its stock will decline. The withdrawal of free cash flow from the other companies in the conglomerate may pose problems for the spun off company.

Tracking Stock

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-36 Used to unlock shareholder value.-37 Tracking relates to a class of common stock that is linked in the charter to the earnings and cash

flows of a particular division or subsidiary of the issuer. -38 This linking of the performance of certain divisions to a given class of stock, gives the outside

investment community a view of the issuers operations that was previously not visible to the outside world.

-39 No dividend is required. The issuer carves out a new class of its common shares by amending its corporate charter. Following amendment, a stock dividend is issued.

-40 Disclosure of dividend rights are very broad- the charter limits the upper amount available. The board retains discretion over both the tracking class and the other classes of common shares of the corporation. Liquidation rights tend to be defined in terms of the relative market capitalization of the different classes of the firm’s stock at the liquidation. Normally unequal voting rights apply to these shares. The rights are based on relative market capitalization of the various classes of shares.

-41 The advantages of stock tracking can be seen in the context of a diversified parent corporation that is operating one or more growth business and one or more declining, out of favour or even stable businesses. Absent stock tracking the financial community is placing too much emphasis on the declining business and not enough on the growth business.

-42 With stock tracking the financial market will value the tracked classes as if they stand alone corporations operating in the business of which the particular class of shares is linked.

-43 The expectation is that the combined trading value of the tracked classes will be greater than the value of the conventional common stock .

-44 However, it should be noted that stock tracking has not been very popular with the investment community.

Stock Dividends:

Lewellen, The Cost of Capital

Stock Dividends and Splits-45 Logically one would not expect a firm to be able to increase its total market value by changing the

number of shares it has outstanding- by way of stock split or stock dividend-46 In the case of a stock split: 2 shares valued at $5 each should not trade at amounts higher than 1 share

at $10. -47 However, firms on occasion split their stock and/ or pay stock dividends and the share prices do not

drop in the exact same proportion .-48 This is explained by psychological factors surrounding the split. Many feel that once a stock is

priced above a certain amount, say $50 it becomes too expensive to buy. Thus, a stock split allows the firm to attract a broader market, i.e. that of the smaller investor.

-49 A more rational explanation involves the effect of stock splits on investors’ expectations. The market may interpret the act of splitting, as an indication on the part of the firm that subsequent earnings and dividends are likely to be higher. This is a signal from the firm that the company has a bright future. Thus, the resultant price increase makes sense.

-50 Often with stock dividends there is also a cash dividend. If the stock dividend is paid and the cash dividend is not adjusted downwards, this is a good justification for the market’s confidence in the stock and thus hold the price of the share steady.

Explaining Stock Splits and Stock Dividends:

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Stock Splits-51 two explanations as previously stated: 1. Signaling and the return of the stock price to normal levels.

Signaling:if the split is a signal that the company is overvalued, then there must be a cost for false signals, otherwise one couldn’t distinguish between under and over valued stock splitting. However, no such cost appears. In rebuttal, some commentators say that some signaling occurs. Splitting firms have higher dividend growth than non-splitting firms, during pre and post split periods. The dividend growth occurs in the first quarter after the split. Thus, the growth advantage diminishes after this period. Thus splits are a signal of mildly good news.

Stock Dividends:-52 Pre announcement earnings growth of firms issuing stock dividends are only slightly higher than

other firms. Stock appreciation tends to occur around the announcement date. This is explained by the finding that the announcement tends to be followed by a relatively large cash dividend increase. Management, however, believes that the market does not reduce stock prices even if cash dividends are not increased upon distribution of a stock dividend.

While stock spits are used frequently, the use of stock dividends have been declining.

Re Sabex Internationale Ltee Que. SC.

Application by two minority shareholders, who own 44% of the Class B shares of Sabex under three sections of the CBCA: 1. s. 229 (Investigation) 2. s. 241 Oppression Remedy and 3. s. 248 Summary application to Court ) alleging the respondents (Vallieres and Gosselin ) acted fraudulently, that the business of Sabex and its affiliates was carried on in a manner that was oppressive or unfairly prejudicial to the interests of the applicants and that the proposed rights issue of the Class B common shares would have diluted the value of their holdings significantly.

They claimed relief under the following categories:

1. an investigation into the administration of the affairs of Sabex under s. 229 with the additional object of establishing the value of the Class B shares

2. payment to Sabex by the respondents of $427,000 . This amount was on the Sabex balance sheet as representing the value of shares owned by S. Inc, a shareholder of Sabex. (i.e. Shares of a company, whose value is derived from the value of Sabex appeared as an asset on Sabex financial statements)

3. order prohibiting the proposed rights issue to Class B common shareholders

4. forced purchase of the applicants’ shares at a price of $0.563 per shares, which represents the book value of the shares excluding the investment in S Inc. shares of $427,000, per #3 above.

Held: The application was dismissed with respect to categories 1,2 and 4. Re #3, the court ordered that the rights offering not be proceeded with.

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Facts: Sabex was formed as a result of the combining of two businesses, one owned by one of the applicants, and the other owned by the respondents. At the point of formation, both parties had the same share ownership in the shares of Sabex. Further transactions, however lead to the situation whereby the respondents gained control of Sabex, as it owned 54% of the shares.

A shareholders’ agreement was signed whereby S Inc.(the vehicle through Vallieres hold his shares) appointed 4 of the 8 directors, the applicants appointed 2 of the directors and Medifar,( the company whereby one of the applicants held his shares of Sabex) appointed the remaining 2 directors.

Sabex underwent reorganization and required financing. Its bank required an equity injection of $100,000 as a condition of extending additional financing .

Sabex board decided to raise the equity through the issuance of a rights offering to the existing Class B shareholders, permitting them to subscribe for up to 3million shares at a price of $0.05. This would bring in equity of $150,000.

Ratio:

1. Claim for an investigation of Sabex :

To succeed to have an investigation, the applicants would have to show mal administration or abuse of the applicants’ rights which unfairly disregards their interests. They could not make such a case. While the applicants were able to provide incidents of irregularities these were held not to be mal administration. On the contrary, the management enjoyed the confidence of the lenders, (SDI and bank) , who were willing to extend additional financing and a line of credit of $600,000 and only required $100,000 of additional equity.

2. Claim relating to the payment by respondents to applicants of the $427,000 representing shares in S Inc. on Sabex balance sheet.

-2 Sabex acquired this asset as part of the combination of businesses that resulted in its formation.-3 S Inc. has no assets other than its holdings of Sabex, thus the value of these shares are derived from

the value of Sabex, thus from the point of view of third parties, this $427,000 is a meaningless number, as this asset has no value. There is no recourse under CBCA, as transaction took place before coming into force of the Act. Any recourse would be in the civil law, relating to fraud However, there is no indication of an intent to defraud or misrepresent, further this financial statement presentation was generally accepted (GAAP), and finally there was no evidence that the applicants relied on the existence on this fictitious asset in entering into the combination that resulted in the formation of Sabex.

1. Claim for and injunction prohibiting the rights offering -2 the applicants alleged that the rights offering as proposed by the board of directors was oppressive

because it forced the minority shareholders to subscribe for the shares: 1 in order to avoid dilution and 2. because the original investments were made on the understanding that the two groups would control the company equally. (this situation was no longer the case).

-3 The evidence indicated that there would be dilution as even when based on the only tangible net asset of Sabex, the value of the Class B shares would drop from $0.125 to $0.045 a share . When comparing the subscription price of $0.05 to the book value, excluding the “fictitious” asset of $427,000, of $0.56 the dilution is even more dramatic.

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-4 Even though the company was losing money the respondents were of the view that it had a promising future. If the applicants did not subscribe, they would be seriously disadvantaged in their ability to participate in any of this future growth. New investors would enjoy the increased participation at the expense of the original investors.

-5 It must be noted that the granting of remedy in such a situation may lead to very different results if the corporation in question were listed on an exchange and any holder who did not want to exercise his subscription rights could dispose of them at their market value and thus recoup the value these rights represent.

-6 Court held that as the two groups at the outset shared equally in control and decision making, (even though this was not set out in writing) the doctrine of incorporated partnership (borrowed from English law) should be used here. Respondents tried to defend their position by saying the bank required the additional equity financing. The court rejected this argument as : the bank did not specify the actual form of the equity participation. Further, they were unable to justify the subscription price.

-7 The respondents tried to defend their position by stating that the QSC did not interfere in the rights issue because the offer was the same to all shareholders. The fact that the Offer satisfies other statutes does not make it immune from the application of the CBCA., which takes into account shareholder rights.

1. Claim for repurchase of shares -1 The other categories were based on events happening before the CBCA applied to Sabex, this would

require retroactive application of CBCA, which requires the exercise of extreme caution. The courts must be satisfied with the appropriateness of the relief sought. In this case the courts are not satisfied for the following reasons: 1. There was no evidence of mismanagement, 2. The business prospects were improving, the applicants were assured of their directorships for the time being, 3. The applicants themselves recognized that Sabex should continue as they requested to be bought out, not for the liquidation of the company. The court found that there would be no prejudice in the applicants remaining shareholders given the threat of rights offering was removed by the granting of the injunction.

PART IV: DIVIDENDS AND DIVIDENDS POLICY

Section B. Stock Dividends

Text pg. 587-592:

The section riases the question whether it is possible for a firm to increase its total market value simply by changing the number of shares it has outstanding? In first answering this question, the author observes that logically, a stock split should not affect the total value since the corporation in principle has exactly the same assets, the same profit prospects etc. as it had before the stock split. In other words, it should not make any difference how many pieces of paper it happens to hand out to its owners. Following this logic, the value of a share post stock-split will simply decrease in proportion to the change in shares (i.e. if the stock was split in 2 – the share price should drop by a half).

The article then raises the question why would firms split their stock and pay dividends? The author points out that, in reality, the value of a share does not often fall in direct proportion to the number of shares created by the stock split. He then provides two potential explanations for this. First, he notes that by having a stock split, the share price is lowered which has the effect of broadening the market to include more investors who might be willing to invest in those shares. By including a greater pool of investors, the stock is said to experience a benefit from the increased interest. A second explanation is based on the effect that stock splits have on investors’ expectations. In particular, it is suggested that the

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market may interpret the act of splitting in itself as an indication that the firm’s subsequent earnings and dividends are likely to be higher than were previously anticipated. In this context, a stock split may be said to contain implicitly some useful information about management’s confidence in the firm’s prospects.

On a parallel note, the author similarly suggests that stock dividends (declared dividends that distribute to the shareholders shares of the company instead of cash) are also intended to express the distributing corporation’s optimistic outlook. Often stock dividends will be distributed when the company seeks to retain its cash assets for specific business activities but would still like to distribute something to its shareholders. On a practical note, stock dividends function in an identical manner as cash dividends – i.e. just like cash dividends, stock dividends do not decrease the value of the stock since all the company is doing is simply providing its shareholders a portion of its retained earnings (whether you give a $5/share cash dividend or one share worth $5, neither action will lower the value of the shares themselves).

Section C. Repurchases of Outstanding Common Shares Note: Repurchase – Volume and stated purpose (pg. 606-609)

In this section of the text, the authors look at a series of empirical studies that examine when companies use the repurchasing of stock as an investment strategy. When reviewing this section, it is helpful to keep in mind the context of this section – i.e. the section immediately prior to this one (it was not assigned) dealt with valuation issues relating to the repurchasing of stock by a corporation. One basic conclusion flowed from that section:

(1) there are firms that have limited internal investment opportunities available, and if internally generated funds cannot be invested profitably, then it is sometimes better to distribute the excess funds by buying up outstanding shares rather than by paying dividends.

In the assigned section, the authors simply note that a “distribution procedure” involving the repurchasing of shares has become increasingly popular amongst corporations. This “distribution scheme” simply refers to the practice whereby corporations repurchase stock, which reduces the number of shares outstanding among which future dividends will have to be divided (i.e. the dividends will be larger per share). This amounts to a new “distribution scheme” in relation to the standard one in which corporations simply distributed any surplus earnings to all shareholders as dividends. This new technique is significant to the extent that it represents another mechanism to distribute profits to shareholders.

Regulation of Repurchases – Fiduciary and Disclosure Obligations (Pg.609-616):Publicly held corporations repurchase their outstanding sock for a wide variety of reasons.

Generally, unless the repurchasing is related to a refinancing of the organization, the repurchasing of shares has the effect of “contracting the size of the enterprise” and involves a distribution of assets to the selling shareholders. Due to these consequences, the authors note that a repurchasing of shares essentially amounts to a form of partial liquidation.

The authors proceed to note although a repurchasing is a distribution of assets, the motivating reasons behind such a decision are different from the reasons that justify the other major form of distribution - a dividend. First, they state that a repurchase is not a device for putting income pro rata into the hands of stockholders on a continuing basis. Nor is it as explicit a device as dividends in terms of conveying to the market a signal about future earnings.

Repurchases create a variety of “fairness” problems because of the potential for unequal treatment of stockholders and for the concealment of information. In the remainder of this section, the authors discussed the fiduciary duties related to repurchases. In particular, they identify the difficulties associated with repurchases that are not pro rata and where the repurchase price is high.

(A) Selective Repurchase at High Prices - Fiduciary DutiesSituation 1 – Traditional Fiduciary Duties are sufficient

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The authors first identify a series of situations in which “traditional fiduciary strictures seem sufficient to underpin relief against the decision makers”. Such situations are: where the corporate assets are paid for the sole benefit of management or a controlling stockholder – ex. when outsiders are deliberately given a premium over the market value in order to solely preserve management’s control.Situation 2 - Traditional Fiduciary Duties MAY NOT be sufficientThe authors observe that in many situations, it may be difficult to prove that the outsider is bought off solely to perpetuate management’s control. Such repurchases may put at issue the scope of management’s traditional fiduciary obligations to the remaining stockholders because “too much” is being paid and because other use of corporate cash would have been more profitable even if the repurchase occurred at market value. Situation 3 – Other potential Conflicts of Interest RaisedThe authors note that the management’s expenditure of corporate funds to purchase corporate

stock in order to preserve its control – ex. by defeating a tender offer – raises other conflicts of interest aside from those described above. Specifically, the authors note that in situations where management uses repurchases to preserve control during a takeover battle, the stockholders are denied the benefit of at least one potential tender offer or new controller. If the repurchase rights equal or exceed the market price, the question that follows is whether the loss to non-selling stockholders is worth the gain to them from the prevention of the “raider’s” success? In addressing this question, the authors note that courts have been willing to make the answer turn on whether management could reasonably have believed that the “raider” would have caused more damage to the corporation than the cost of buying the raider off. In such cases, the test that is used is the business judgement rule. The business judgment rule protects all lawful actions of a board of directors PROVIDED THAT:

a) the decisions were made in good faith;b) there was a reasonable deliberative process; andc) there was an absence of conflicts of interest.

Thus, where the management can show “good faith and reasonable investigation” by the board and “reasonable grounds for believing that a danger to corporate policy” arose by reason of the raider’s stock ownership, the court are likely to find the repurchase legitimate. The authors, however, note that in some case, reasonable investigation requires the involvement of an independent committee to review the repurchase offer. Finally, in situations where an independent board can not be formed, the authors note that “the courts seem to assess the behaviour by reference to a some standard of fairness.”

In the context of this discussion, the authors raise one case, Heckmann v. Ahmanson (1985). In Heckmann, the stockholders of a company sued the company’s directors to recover a payoff to a major shareholder. Specifically, in seeking to fend off a takeover, the management had placed a heavy debt burden on the company. This was achieved by first making an allegedly unfavourable purchase of another company and then by buying off a major shareholder that had sought to prevent the company from making the acquisition. In its judgement, the court issued a preliminary injunction imposing a trust on the profit made by the major shareholder when he sold his shares back to the company. The court noted that while there may be many reasons why corporate directors would repurchase its shares, the desire to simply retain their positions of power and control over the corporation is not one of them. Finally, the court stated that once it was shown a director received a personal benefit from the transaction, the burden shifts to the director to demonstrate that not only was transaction entered in good faith, but also to show its inherent fairness from the viewpoint of the corporation.

The Problem of the Low Priced Repurchase (Pg. 617-631):Basic Issue/Context:

The previous section dealt with situations in which the non-sellers were disadvantaged when the repurchase price was too high or where it was made to preserve control. The correlative of such situations is the possibility that the sellers may be wronged if the repurchase price is too low – in the

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sense that – had the seller been made aware of all the information which the buyer had, the seller would not have sold at such a low price.

Thus, where it can be shown that the repurchase was knowingly and intentionally engineered solely in order to favour the management or controlling stockholders, the repurchase could be challenged as a breach of management’s fiduciary duties. The problem with such an approach, however, stems from the ease with which management could assert that the repurchase was not solely for its benefit by suggesting corporate purposes, such as, there were no other investment opportunities or the stock was needed for future acquisitions.

The following case addressed these concerns:Kahn v. United States Sugar Corporation (Del. Ct. of Chancery) 1985:Facts: (the facts are somewhat complicated so I’ve tried to simplify them as much as possible)

The plaintiffs in this case were a class of minority, public shareholders of US Sugar (the “company”) which claimed that the board had breached its fiduciary duties of disclosure in connection to a leveraged cash tender offer made by the company and its employees trust fund. Its important to note here that the tender offer itself arose from the desire of the company’s principal stockholder to reduce its holdings in the company while still retaining sufficient shares to exercise majority control over the company. A leveraged tender offer was thought to be the most effective mechanism to effect this change because the company’s stock had already been depressed due to a glut of sugar in the market. As a result, management believed that a tender offer for 75% of the outstanding shares could achieve the major shareholder’s objective without further depressing the market value of the stock.

One of the problems that flowed from the tender offer was the board’s conflict of interest between providing the highest possible price for the shares (of which the majority shareholder was going to sell a substantial portion of its shares) while ensuring that the company remained viable and not unduly burdened with debt.

In terms of the measures taken by the board leading up to the tender offer, the board did not have any independent director’s on its board which precluded the possibility of forming an independent committee of directors to review the tender offer and to negotiate on behalf of the public shareholders. In light of this, the plaintiffs asserted that the management had simply arrived at the proposed tender offer price by only considering the ability of the company to finance the leveraged tender offer and that management failed take into consideration of the true value of the shares.Court’s Finding: The court found that there was a breach of the fiduciary duty owed by the board because the disclosures made in the tender offer solicitation materials did not fully disclose all the material facts a stockholder needed to make a fully informed decision as to whether to accept the tender offer. In particular, the court noted that the tender offer failed to disclose the methods used to reach the tender price. Although that is the specific holding in the decision, this case at its core appears decided on the fact that management arrived at a tender offer price by simply ascertaining what the corporation could afford to pay to service the loan obtained to finance the tender offer. In this context, the court essentially found that the highly leveraged nature of the transaction was coercive to the extent that the shareholders only had the choice of accepting the offer or retaining their shares in a highly indebted company.

The authors of the textbook then proceed to state in a note after the case that any tender offer at a premium may over the market price entails an application of pressure on the offeree. Moreover, they ask the question, what differentiates a coercive issuer tender offer (as in Khan) from a permissibly uncoercive offer? In response they cite, Cottle v. Standard Brands Paint Co. (Del.Ch. 1990) which held that a coercive offer implies that “the stockholders were wrongfully induced by some act of the defendants to sell their shares for reasons unrelated to the economic merits of the sale” – i.e. “actionable coercion does not exist, however, simply because a tender offer price is too good pass up.” Federal Securities Laws (pg. 626-631):Coyne v. MSL Industries, Inc. (1976) US Dist. Ct.

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FactsThe plaintiff was a former shareholder in the defendant company who claimed approx. 1 year

after he had tendered his shares that the offering circular was false and misleading at the time it was issued. The plaintiff had asserted three different bases upon which he could ground his claim – only one was seriously considered by the court (the other two were completely without merit). The plaintiff claimed that the company knew or should have known but failed to disclose that the company’s earnings for the year during which the tender offer was made would be substantially greater than the last year that had been reported. The whole basis for the complaint stemmed from the fact that the tender offer (at the beginning of 1974) was for $25 (market price immediately before tender offer was $21); by the end of 1974 (several months after the plaintiff had tendered the shares) the shares had a market value $50 share on the basis of improved performance and an unrelated takeover contest. Given this set of facts, the plaintiff contended that the management breached its duty to disclose by failing to include in the offering circular, material facts which would have influenced a reasonable seller’s actions – i.e. the circular should have indicated the expected improvement in the performance of company.Court decisionThe court sent this case to trial (the specific motion at issue in this case was motion for summary judgement by the plaintiff) noting that it could not determine without further evidence whether the failure to include a statement about the future expected performance dealt with known facts or mere predictions. This was important because the court noted that corporate insiders do not need to give investors the benefit of expert financial analysis or educated guesses and predictions. – insiders do not need to volunteer economic forecasts. However, a present plan of future activity based on known facts is a material fact that would have to be included. This distinction therefore establishes the test that should be used in determining whether the board had breached its duty to disclose.

Regulation of Stock Repurchases to Correct the Market Price (pg. 636-645)In this section, the authors of the text deals with the situation where stock is repurchased in order

to:(1) increase the market price of the stock;(2) to peg the stock at current levels.

It is important to note that these two situations can be distinguished from other situations where an overpayment is acceptable. Such situations arise where the repurchase is made to raise the stock so that it may more profitably be used as currency to purchase new assets or to induce conversion of convertible debt.

With respect to using repurchases to increase the market price of the stock, the authors ask whether management should have the right to do this where it believes the stock is legitimately undervalued. In particular, they ask “if management’s judgement – whether as a faithful fiduciary or as an errant fiduciary” is a legitimate pricing factor comparable to the judgements of buyers and sellers seeking to advance their economic interests as investors? There does not appear to be a clear-cut answer. In response to this question, the authors appeal to legal scholarship which notes that in theory management is precluded from distributing assets to some members and not to others. In this context, a market repurchase is just such a skewed distribution. As a result, the authors seem to suggest that the more appropriate means to increase the value of the stock is to improve the dissemination of information to the market.

With respect to the practice of pegging a stock to a fixed level, the authors cite sections from the 1934 Securities Act which prohibit stock price manipulation. Stock price manipulation is defined as:

“actual buying with the design to create activity, prevent price falls, or raise prices for the purpose of inducing others to buy is to distort the character of the market as a reflection of the combined judgements of buyers and sellers.”

The authors proceed to note that instances of manipulation well likely involve non-disclosure, which is in violation of the acts general anti-fraud provisions. Disclosure requirements are meant to prevent market

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manipulation (ex. by providing investors with information that would indicate whether one group was controlling the selling/purchasing of shares). The authors, however, question the efficacy of disclosure requirements as a mechanism to prevent stock manipulation. They discuss various proposals that have been suggested, but no action has yet been taken by legislators.

One other issue raised by the authors in this section deals with the relation between stock repurchases and disclosure of dividend policy. The authors note that a program of corporate repurchases is related to the disclosure of relevant information to the extent that the repurchase is a substitute for dividends. In this context, a repurchase is in essence an extra dividend that, however, avoids the exposure of management to unfavourable inferences if not repeated. In this light, repurchases, may conceal the uncertainty of the payout. They proceed to note that in larger terms it may conceal the fact that management has no better investment use for the corporation’s funds.

SUPPLEMENT Pg. 106-112:Kahn v. Roberts (Sup. Ct. Delaware) 1996Context:

This case appealed a lower court decision which held that the board of directors had not breached their fiduciary duty of disclosure in relation to the decision of the board to repurchase approx. one third of a company’s outstanding shares. Essentially, the case stems from a complaint by a minority shareholder who claimed that the board had:1. breached its duty by failing to disclose all material facts surrounding the repurchase of the shares;2. approved an excessively high repurchase price; and3. acted with the intent to entrench themselves in officeIn regards to the conduct of the board, it should be noted from the onset that the board took the following measures in connection with the purchase:1. repurchase was approved after the board established an independent committee2. consulted with legal and financial advisors3. considered the various alternative options that were available.Decision

Court affirmed decision of trial court noting that the plaintiff failed to show any material omissions or misstatements. Therefore, the board had not breached its duty to disclose. This case is significant because it identifies the standard of judicial review to which the board will be held in connection with its decision to repurchase shares. In particular, the court applied the business judgement rule(BJR) to assess whether the board had breached any of its duties (see summary for pg. 609-616 for summary of BJR).

However, the court also stated that the business judgement rule SHOULD NOT BE APPLIED where the decision to repurchase shares occurred within the context of an actual threat to the board’s corporate control. More specifically, where the repurchase is adopted as a defensive strategy to entrench the board’s position during a hostile takeover fight, the business judgement rule will not apply. This makes sense to the extent that the board is put in a potential conflict of interest during hostile takeovers. In such instances, the court should apply the Unocal test. This test provides that the board can only be accorded the protection of the business judgement rule where the board first establishes satisfies a prior 2-part burden:

1) the board must show that it had reasonable grounds for believing that a danger to corporate policy and effectiveness existed; and

2) that the board of director’s defensive response was reasonable in relation to the threat posed.

Corporate Finance Summary GroupJaime Levine

Text pages 1129 - 1142, Supplement pages 239 - 267

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Note: Legal Uncertainty and Corporate Politics (page 1129)· Jurisprudence, at least in Delaware, is premised on 2 notions:1. it is desirable not to prevent management from taking many kinds of defensive actions against 3P

bids or threats of bids;2. it is undesirable (or impossible) for common law courts to fashion rules that will assure stockholders

of the “best” price or other stakeholders of substantively “fair” treatment.

(C) The Duty of CareImportant consideration in tender offers is whether management has complied with procedures and informed stockholders sufficiently, and the extent to which board has informed itself of the transaction re the bid, the bidder, and the value of target, quality of report of the investment banker and other independent financial experts.

In Smith v. Van Gorkom (Del. 1985) Delaware Supreme Court ruled that · “gross negligence” is the test of propriety of Board action· that the Board did not sufficiently inform itself of the intrinsic value of the company or the “fairness”

of the merger price (no outside opinion),the Board had failed to sufficiently inform the shareholders....

Hanson Trust PLC v. ML SCM Acquistion, Inc. USCA 2nd Circ, 1986Hanson had tender offer for ML SCM at $60/share. SCM directors did not like the offer and found Merrill Lynch, Pierce, Fennder & Smith Incorporated (“Merrill”) to outbid SCM at $70 in a leveraged buyout. Hanson came back at $72. SCM then really sweetened the deal for Merrill: As an incentive to Merrill, SCM agreed to give them a $6m “hello again” fee, a $9m break-up fee, and the lock-up option (the major problem), which consisted of an option for Merrill to purchase 2 divisions of SCM: Pigments and Consumer Foods for $350m and $80m respectively, substantially below their value.Judges:· According to New York law there is a presumption of directors’ propriety & a corresponding initial

burden on the plaintiff.· Some lock-up provisions benefit shareholders.· Where decisions of directors are likely to affect shareholder welfare duty of due care requires

reasonable diligence in gathering and considering material information - otherwise they may be liable.

· SCM was not grossly negligent as the directors were in Smith v. Van Gorkom but did not take the due care steps outlined in Treadway.

· Directors had no written opinion from their banker - Goldman Sachs.· And they decided in a late-night 3-hour meeting that the final Merrill offer was acceptable - quick

time and minimal information suggests a breach of due care. Required more thought and time.· This was enough to establish a prima facie breach. So they looked at the facts.· Clearly the Crown Jewels of the firm were being sold for well below value in the lock-up option.· In the end, if the deal does not go through, those that did not tender their shares will be left with 1/2

the company sold for inadequate consideration.· If deal does go through, the 20% that does not tender will be left out of the 2nd part of the package.· CONCLUSION: As in Revlon, board for some reason wanted Merrill as an LBO partner and were

prepared to do anything to get it.· Injunction granted.

5. STATE ANTI- TAKEOVER LEGISLATION (PAGE 1142)

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Shark-repellent provisions now in corporate laws of 35 states. Lack the uniformity of Blue Sky law provisions.

Supplement pages 239 - 267Paramount Communications Inc. V. QVC Network Inc., Supreme Court of Delaware, 1994, 637 A.2d 34, pParamount was unsuccessful in its bid for Time so hooked up with Viacom. Viacom offered 0.1 share of class A voting, 0.9 share of class B and $9.10 cash. Paramount agreed to a no shop clause, a termination fee of $100m if the bid was not approved or otherwise terminated, and an option to purchase 19.9% of Paramount at $69.14/sh to be paid for with a senior subordinated note of “questionable” marketability (i.e. wouldn’t have to pay for it for a while).

Delaware law: courts will take notice of directors’ activities in 2 cases:1. approval of a transaction resulting in the sale of control, and2. adoption of defensive measures in response to a sale of control

because minority shareholders get hit - since majority is generally required for election of directors, amendments to certificates of incorporation, mergers, consolidation, sale of substantially all the assets, and dissolution. For example, a cash-out merger will deprive minority shareholders of equity interest. Therefore, minority shareholders are entitled to receive a control premium and protective devices. Otherwise, directors’ only concern should be maximizing value.

Since Viacom would become the major shareholder in Paramount, courts will look at directors’ activities.Directors’ job: · to get the best value reasonably available and to exercise their fiduciary duty to that end (Revlon).· And to be adequately informed(Smith v Van Gorkom).· Role of outside independent directors important - to offset others’ potential interests.

Test for Enhanced Scrutiny (Unocal):a) Review of the decision-making process, including directors investigation and use of information,b) reasonableness of directors’ actions - directors have burden of proof to show acted as in (a).

Enhanced Scrutiny is found to be appropriate because:· diminution of shareholder voting power· assets being sold that will never again be available· impairment of shareholder rights

Breach of Fiduciary Powers by Paramount Board, page 253 of textObligations of Directors:· diligence and vigilance in examining affairs· acting in good faith· gathering and using information· negotiating actively and in good faith· every aspect must be reasonable and in best interests of the shareholders, including stock option

agreements, termination fees and no shop agreements

NO-SHOP AND OTHER CONTRACTUAL PROVISIONS MAY NOT BE USED TO LIMIT FIDUCIARY DUTIES; TO THE EXTENT THAT THEY DO, THEY ARE INVALID AND UNENFORCEABLE. Page 255

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COURT FOUND: Paramount Process was not reasonable. They paid insufficient attention to potential consequences of defensive tactics. Stock option was draconian. Paramount had been put in a powerful position when QVC entered bidding. It should have been obvious at that time that the stock option, termination fee and no-shop (lock-ups) impeded best value. November 12 1993 - QVC offer was $1 billion over the Viacom offer. Directors missed opportunities. They may not have acted against their fiduciary duties and they did.

Commentary:Case stands for:1. Where a transaction constituted a “change in corporate control”, such that the shareholders would

thereafter lose a further opportunity to participate in a change of control premium,2. the board’s duty of loyalty requires it to try in good faith to get the best price reasonably available,

and3. in such context courts will employ an (objective) “reasonableness” standard of review to evaluate

whether directors have complied with their fundamental duties of care and good faith.

LOCK-UPS in general:· beneficial when used in moderation, detrimental when used to excess (be careful with them... it is

controversial as to whether stock options are detrimental, for example - see page 261 - and distinguish between 1st bidder and 2nd bidder lock-ups page 262);

· business judgment scrutiny obtains where the total value of the benefits provided to the lockup recipient falls below 10%;

· suggested that target board must conduct a Revlon auction before entering into a binding lockup .agreement where total value exceeds the 10% line

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