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I: Limited Liability and the Rights Of CreditorsA. Limited Liability
Shareholders enjoy limited liability
In effect shifted some of the risk of business failure to debtholders
More debt means higher expected returns to shareholders; and to the extent that debtholders expect risk to be shifted, higher interest rate as well
Limited liability also alters control over corporate assets
Shareholders with limited lability can more easily abandon responsibility for the obligations of the firm that goes bankrupt
Limited liability implies that creditors (rather than shareholders) will control the business over a broader range of circumstances in which it performs poorly
- ABC manufactures carpet cleaning fluids, A is the CEO and own 75% of its stock, 25% owed by Tamara (A's cousin). 7 years ago, T moved to Indonesia and doesn't involve in management of ABC, but receives dividend every 3 months.
- Company liquidated, valued at $4M + A and T both have personal assets of $3M each.
o But ABC borrowed $5M from FC Bank due to poor business + $2M litigation debt owe to R + $50k owe to A + $500k due wages owe to employees.--Should A be able to recover a portion of the salary owed to her by ABC? Whether T deserves her dividend.
o She worked for her wage, but wage decided by directors (herself) whether she deserve such amount?
o Promote industry by permitting ABC to steal resources from others
What if it was intentionally paid immediately before company liquidate?
Intentionally to avoid paying creditors
Should the bank be paid?
o Bank assumes/agree to the risk, as it is a sophisticated creditor who got into the deal, knowing the legal rule, don't have a 'no recourse' clause in the contract
Should Rich be paid?
o For suppliers to prevent non-payment, can protect themselves (e.g. to ask for guarantee, payment upfront, retention of title, no recourse). If they did not they assume the risk. But Rich didn't assumed he risk that there would be an accident and ABC would not have money to compensate him
If A was negligent/ at fault personally/ could've done more Rich still sued her due to corporate veil
But cause of action: product liability (need not show negligent) only co. liable for its products
Corporate veil prohibits Rich to sue A, ABC is a separate entity - as we want to promote corporate activities
How is risk on bank and Rich different?
o Risk is negative
For shareholders: amount owe to supplier is known no uncertainty = no risk
Shareholders don't know amount owe to Rich yet uncertainty = risk
But ABC could have buy liability insurance ABC only need to pay insurance cost (cost of doing business)
Rich can also take out insurance
So who should get insurance? Whom should we impose burden on?
ABC in better position to control risk should impose burden on ABC
Rich can only buy comprehensive insurance (health, disability, against accidents) - whether insurance popular in the society
Would answer be different if ABC were publically held corporation?
How would you express the legal principal that should govern shareholder liability for corporate debts?
o Separate legal entity shareholders should not be liable personally for corporate debt encourage corporate activities
1 I: Limited Liability and the Rights Of Creditors
But a business that yields enough profit is business we want to encourage + people should want to invest without limited liabilities.
o Usually need limited liability because they are not profitable don't need businesses that is not profitable
What kind of incentives would be created by such principles? Are these incentives desirable?
o If company does well, A and T would benefit; if things go bad, R shouldn't be responsible for it
Imposing cost creates incentive for A to exercise care oCommentator: Frank Easterbrook & Daniel Fischel
- Publicly held co. is the most popular form of business
- Facilitates division of labour, managerial skills and provision of capital may be separated
- Holder of a diversified portfolio of investment is more willing to bear the risk that a small fraction of his investment will not pan out
- Separation of investment and management comes with cost: agency problem
managers who do not obtain the full benefits of their own performance do not have the best incentives to work efficiently
costs generated by agency relations are outweighed by the gains from separation and specialization of function
- Limited liability reduces
1. the costs of this separation and specialization; and
investors' potential losses are "limited" to the amount of their investment as opposed to their entire wealth, they spend less to protect their positions
limited liability decreases the need to monitor
many investors will have diversified holdings, who would have neither the expertise nor the incentive to monitor the actions of specialized agents
The price investors are willing to pay for shares will reflect the risk that the manager's acts may cause them loss
Mangers therefore find ways to offer assurances to investors without the need for direct monitoring
2. the cost of monitoring other shareholders
Without limited liability, shareholders have incentive to engage costly monitor of other shareholders to ensure other shareholders are wealthy.
The greater the wealth of other shareholders, the lower the probability that any one shareholder's assets will be needed to pay a judgment
limited liability makes other shareholders irrelevant and thus avoid these costs
Commentator: Henry Hansmann & Reinier Kraakman
- Limited liability in tort create incentives for excessive risk-taking by permitting corporations to avoid the full costs of their activities
incentives: price of securing efficient capital financing for corporations
- Some propose to limit such limit liability for some classes of tort claims/ type of corporations to control its worst abuses but all these proposals retains limited shareholders liability as the general rule
- Limited lability: a firm owns a wholly-owned subsidiary undertakes investment create risk of tort liability exceeding corporation's net value shareholder would have incentive to direct the co. to spend little precautions to avoid liability
Encourages overinvestment in hazardous industries co. engage in highly risky cavities can have positive value for its shareholders thus an attractive investment, even when its net present value to society as a whole is negative
- C.f. Unlimited liability: shareholder would be personally liable for any tort damages that the co. cannot pay
induce socially efficient level of expenditure on precautions
2 I: Limited Liability and the Rights Of Creditors
Agency Costs of Debt
- The possibility that creditors are not assured to be repaid in full (increased by limited liability) results in potential conflict of interest between shareholders and creditors
- Shareholders elects the board of directors that manages the company
- Creditors fear that companies will act in the interest of the shareholders (when in conflict with creditors)
- Agency costs of debt: issued caused by the agents (directors) do not take fully into account the interest of their principals (creditors) [c.f. agency costs of equity directors not fully taking shareholder's interests into account]
- 3 kinds of agency costs
1. Actions by companies which are in the interest of shareholders, but not combined interest of shareholders and creditors
2. Costs of designing contracts or law designed to prevent manger from taking such actions
3. Costs of monitoring compliance with such contract/ law
- Company runs for benefit of shareholders by managers, what maximise the benefit of shareholder is not always good for creditors and overall Conflict of interest between creditors and shareholders creates costs of the enterprise
1. One year from now, Alpha Corp. has to repay $120 million in principal and interest. Alpha Corp. is faced with two alternatives.
1) declare a special dividend of $50 million and invest the remaining assets in Project A. Project A is certain to yield one year from now $80 million.
2) not pay any dividend and invest all assets in Project B. Project B is certain to yield a year from now $150 million.
One year from now, Alpha Corp. will pay up to $120 million to its creditors and distribute any remaining assets to its shareholders. Assume that the risk-free discount rate is 5%.
What is the present value to creditors of the first alternative? What is the present value to creditors of the second alternative?
o [Option A = $80M; Option B: $150M Creditors would not want the company to invest instead of giving out dividends would prefer to invest more under option B, where the company will get
$120M. Creditors would not prefer option A as it will only get $80M]
o Since there is now a 20% chance that project B will yield $200 million, creditors expect to get
[20%*$50m + 80%*$30m]/1.06 = $32 million and shareholders expect to get 20%*$150m/1.06 = $28 million under project B.
o Shareholders prefer project B, creditors prefer project A.
o But now it is project B that yields the higher aggregate value.
b) What is the present value to shareholders of the first alternative? What is the present value to shareholders of the second alternative?
o Shareholders would want prefer option A, where it will get $50 in shares and $80 in investment i. Project A will always give creditors $80 million one year from now, with a present value (PV) of $76 million. Shareholders get the $50 million dividend.
o Project B gives creditors $120 million one year from now (PV = $114 million);
shareholders get $30 million (PV = $30m/1.05 = $29 million).
o Shareholders prefer the first alternative, though the aggregate of what shareholders and creditors receive is higher under the second alternative.
o Shareholders would not prefer option B as they will get no dividend
3 I: Limited Liability and the Rights Of Creditors
2. What would Alpha Corp. do if it tries to maximize shareholder value? What should it do in order to maximize the joint value of shareholders and creditors?
o Alpha would give out all $120 as dividends and make no investments
Are shareholders led to prefer projects that involve more risk or less risk?
- More risk
- Shareholders have a 10% chance of getting $150 million (PV = $14 million).
- Shareholders prefer project B, though the aggregate of what shareholders and creditors receive is $10 million higher under project A.
Are creditors led to prefer projects that involve more risk or less risk?
- Less risk
- Project A will always give creditors $50 million one year from now (PV = $47 million). Shareholders get $20 million if the project yields $70 million (40% chance), otherwise they get nothing (PV = $20m*40%/1.06 = $7.5 million).
- Under project B, creditors have a 10% chance of being paid in full and a 90% chance of getting merely $30 million (PV = [10%*$50m + 90%*$30m]/1.06 = $30.2 million).
(Remember, in the example all risk was diversifiable. How are the answers affected by this assumption?)
What other actions can companies take that benefit shareholders and harm creditors?
- Give dividends, take more riskNote: You must first calculate how much creditors and shareholders get if the projects does well or badly and then figure out the expected value to creditors and shareholders
- Limited liability creates opportunities to shift risks and withdraw assets in ways that creditors do not anticipate
other than contractual protection (can be arranged by creditors themselves) law compensate and protect creditors:
o Standard capitalisation requirement
State corporation codes do not fix meaningful capitalization levels
but restricts dividend payments to shareholders when it appears that the firm is nearing insolvency ensure creditors get a min fund of corporate assets yet not effective protection to creditors in practice
Fraudulent conveyance law
Variety of equitable doctrines:
Equitable subordination: insiders' debts are subordinated to outsiders debts in bankruptcy
Pierce of the corporate veil: court will set aside entity statutes of co. and permit creditors to hold shareholders liable directly [to prevent fraud/ injustice]B. Fraudulent Conveyance Law P. 45
Voiding any transfer made for the purpose of delaying, hindering, or defrauding creditors
Source: Federal Bankruptcy Code S548, USA v Gleneagles, adopted in almost all states law covers every company
Creditor challenges to "leveraged buyouts" (LBOs)
o Permit acquirer to borrow a sum to repurchase most of the corporation's publicly held stock at a large premium, using the corporation's assets as collateral.
Acquirer would own all of the corporation's remaining equity;
the bulk of the corporation's capital would consist of debt incurred to finance the deal; and
public shareholders would receive an enormous premium for their shares
Amount to acquire a property is financed by debt, the debt is owed not by the buyer but the target
4 I: Limited Liability and the Rights Of Creditors
If the acquirer successfully pay off the co.'s debt load they would own the whole co.
Shareholders would get 50% premium over the market value of their shares
LBO lender would receive a security interest in the co's assets, huge up-front fees, and/or extremely high interest rates
But unsecured pre-LBO creditors' relative safe debt became subjected to a significant risk of default
If the co. failed after LBO claims that the LBO amounted to a fraudulent conveyance would be made
These actions are not aimed at recouping the purchase price paid to public shareholders, but at subordinating the debt claims of LBO lenders (e.g. the banks) + recouping fees and other benefits paid to LBO professionals
Implicit policy argument of these pre-LBO creditors: LBO insider group, investment bank,
lenders ought to have screened deals more carefully and prevented transactions that had a high probability of subsequently ending in bankruptcy
LBO: USA v Gleneagles Investment Co P.46
1. Raymond C is a coal mining company: target company
Many subsidiaries, directly owns (100%):
1. Blue Coal: wholly own Minindu and Glen Nan
Powderly owned by Blue Coal and Carbondale
2. Gillen Coal
3. Carbondale: wholly own Maple City, Northwest, Powderly Machine, and Clinton
Powderly owned by Blue Coal and Carbondale
5. Olyphant Premium
Pre LBO Owners/ shareholders of RC: Gillens and Clevelands
Creditors of RC
2. Great American (company): acquiring vehicle
Shareholders: Dorkin, Green, Hoffa, Zaff
Option to buy RC stocks from Gillens and Clevelands, want to purchase but don't have enough money
need borrow money from IIT
3. IIT: lender
Lends money to RC and some subsidiaries (including Blue Coal) most money then lent to GA
GA pays to Gillens and Clevelands to purchase stock
Who has the cash? GA
Who owes the debt to IIT? RC
Lent 7M: 4M to RC and 3M to BC as a result of the loan, RC has repay principal + interest;
subsidiaries have to return the amount they borrowed
To protect itself:
IIT made RC and its subsidiary guarantee for the full amount of 7M loan (4M it owe and also 3M owe by BC)
RC cannot pay dividend before repaying loan
All companies give security interest in all assets
E.g. RC give security interest on the 4M it borrowed and 3M it guaranteed
Structure of LBO in Gleneagles
- Different structure but same end result as typical structure:
- Lender: IIT
- Target: RC
- Shareholder/ pre-LBO owners (Gillens & Clevelands)
- Buyer: Dorkin, Green, Hoffa
5 I: Limited Liability and the Rights Of Creditors
Cash flow from IIT (lender) to RC (target) and some subs
Most of money then lent to Great American (acquisition vehicle)
Great American pays money to Gillens and Clevelands to purchase stock
END RESULT: B owns the target, shareholders get the money, lender lends money, entity obligated to pay the target
• Who has the cash? Shareholders
• Who owes the debt to IIT? RC
Terms of IIT Loan
• Secured by assets of borrowing companies
• Guarantees by guarantors
• Guarantees secured by assets of guarantors
Typical Structure of LBO (Leverage buy-out) not used in this case
1. Buyers incorporate a company (shell) to function as an acquisition vehicle
2. Lender makes loan to acquisition vehicle
IIT lends to Great American GA buy stock of RC (target) from Buyer
3. Acquisition vehicle is contractually obligated to
effect a merger with target after purchase - merge GA (acquisition vehicle) with RC (target)
provide security and guarantees post-merger
Assets of RC same, but the debt owe to the lender becomes obligation of RC---Effect of Transaction Structure
Compare transaction structure used in Gleneagles to IIT lending money straight to GA
Benefit LBO lenders and screw pre-LBO creditors
Two companies in target group: Raymond Colliery and Blue Coal (subsidiary)
BC has $6m in assets and $4m in pre-LBO liab.
RC has stock of BC, no other assets, and $1 pre-LBO liability
IIT lends $4m, all of which is paid to G+C
IIT lends $ to GA to buy RC which owns BC
Case 1: IIT lends to Great American
In liquidation of Blue Coal, BC has 6M assets
its pre-LBO creditors are paid in full 4M; and
2M is paid to its shareholder RC
In liquidation of RC, has 2M asset from BC
pre-LBO creditors are paid in full 1M; and
$1M paid to its shareholder GA
When GA is liquidated IIT receives $1M of its $4M debt from GA
Pre-LBO creditors gets 0% debt back
IIT gets 25% of debt back
Case 2: IIT lends to $4M to RC unsecured. Loan proceeds handed to GA
In liquidation of Blue Coal, BC has 6M assets
its pre-LBO creditors are paid in full 4M and
$2m is paid to its shareholder RC.
In liquidation of RC, it has 2M from BC + obligation 5M (4M to IIT and 1M pre-LBO)
IIT and RC's pre-LBO creditors get pro rate share of 2/5 = 40%
So IIT is paid 40% of 4M = $1.6 million [more than Case 1]
Pre-LBO creditors: $0.4M
6 I: Limited Liability and the Rights Of Creditors
Case 3: IIT Lends to $4M to BC unsecured. Loan proceeds handed to GA
In liquidation of Blue Coal, BC has 6M assets (4+4)
IIT and BC's pre-LBO creditors get pro rate share of 6/8= 75%
IIT gets $3m out of 4M
BC's pre-LBO creditors get $3m out of 4M
In liquidation of RC,
RC's pre-LBO creditors get $0
IIT is paid $3 million of its $4 debt.
RC gets nothing, creditor of RC gets nth
Case 4: IIT lends $4M to BC secured by its assets. Loan proceeds handed to GA
In liquidation of Blue Coal,
IIT gets $4m (as it is secured over collateral that worth 4M)
BC's pre-LBO creditors gets leftover 2M (50%).
In liquidation of RC,
its pre-LBO creditors get nothing not paid
IIT is paid in full
Difference between 3 and 4: effect of priority structure within companies (secured/ unsecured)
No need subordinate creditor's affirmative consent (unlike in contractual subordination)
Difference between case 1 and 3: structural subordination - priority in a group of company
With a holding company structure: 1) holding company, 2) intermediate holding company and 3) operating company, creditors are better off if co. hold real assets (i.e. assets other than stock of other company in the structure)
Creditor of upper tier (without real assets, only shares of subsidiaries) gets less than the lower tier (with real assets)
1) IlT got paid 25% 2) IlT got paid 75% 3) IlT got paid in full
1) Other creditors get paid in full 2) 75% 3) 0%
% of payment depends on which company are you a creditor of
Creditor of the target is better off than creditor of the buyer structurally subordinated
Typical Holding Company Structure: Holding Company owns Operating Subsidiaries, no other assets
Creditors of sub are paid from assets of sub
Creditors of parent are paid from assets of parent, i.e. equity in subsidiary
"Real" assets (i.e. excluding stock in subs) are used first to pay off sub creditors
Effects resemble those of contractual subordination
To generate obligations:
1. Lend money to RC (instead of GA)
Target vs. acquisition vehicle better off to be creditor of the target as it has assetsMethods to create priority
One company: common stock, preferred stock, debt
Within debt: different layers (e.g. senior and subordinated, usually no more than 3 layers)
Holding company structure: creditors of holding company is structurally subordination to creditors of operating sub
Through multiple layers of holding companies, one can create infinite layers of priorityQuestions
1. Why did IIT not lend the $4 million to Great American, rather than lending it to Raymond Colliery which relent it Great American?
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