Creditor Protection -- Overview

1. Creditor Protection -- Overview • 1. Mandatory Disclosure • 2. Capital Regulation • Distribution Constraints • Minimum Capital Requirements • Capital Maintenance Requirements • 3. Fiduciary Duty Constraints • Director Liability • Creditor Liability: Fraudulent Conveyance • Shareholder Liability: Equitable Subordination & • Piercing the Corporate Veil

2. BALANCE SHEET Liab. Generally not available for distributions Assets Shldrs’ Equity “surplus” Shareholder Equity Accounts Stated capital Capital surplus Retained earnings “Net Assets” = Assets - Liabilities

3. Par Value “Par value” was the sales price Promoter Subscriber Subscription Agreement

4. Par Value Corporation Stockholder $

5. Par Value Par value is a “trust fund” for creditors Corporation Stockholder $ Creditor

6. “Legal Capital” Distributions to stockholders? Corporation Stockholder Creditor

7. “Legal Capital” Cannot impair “legal capital” Corporation Stockholder Creditor

8. “Legal Capital” Capital = outstanding shares x par value Corporation Stockholder Creditor

9. Disconnecting Par Value and Price No law required par value to equal issue price Promoters were reluctant to lower par values because they didn’t want their corporations to appear as “penny stocks” Once that inhibition was overcome, par values and issue prices began to separate Today par values are set at a trivial amount (usually $.01 or less) In the absence of par value, the board of directors specifies a “stated capital”

10. Distribution Constraints New York Bus Corp. Law § 510 (capital surplus test): may only pay distributions out of surplus (§510(b)), and distributions cannot render the company insolvent. AND: NYBCL § 516(a)(4) allows board to transfer out of stated capital into surplus if authorized by shareholders. DGCL § 170(a) (“nimble dividend” test): may pay dividends out of capital surplus + retained earnings, or net profits in current or preceding fiscal year (whichever is greater). AND: DGCL § 244(a)(4) allows board to transfer out of stated capital into surplus for no par stock. Cal. Corp. Code § 500 (“modified retained earnings test”): may pay dividends either out of its retained earnings (§ 500(a)) or out of its assets (§500(b)(1)), as long as ratio of assets to liabilitiesremains at least 1.25, and CA>=CL (§500(b)(2)). RMBCA § 6.40(c): may not pay dividends if you can’t pay debts as they come due (§ 6.40(c)(1)); or assets would be less than liabilities plus the preferential claims of preferred shareholders (§ 6.40(c)(2)). BUT: board may meet the asset test using a “fair valuation or other method that is reasonable in the circumstances” (§ 6.40(d)).

11. Example: Alpha’s Inc. (p.139) Current assets Liabilities Cash 1,000 Current liabilities 9,650 Securities 650 Long-term liabilities 5,000 Accounts receivable 6,000 Total liabilities 14,650 Inventory 5,000 Property, plant and equipment 3,000Shareholder equity Total assets 15,650 Stated capital 200 Capital surplus 300 Retained earnings 500 Total shareholder equity 1,000

12. “Nimble” Dividends – Typical Application (DGCL § 170(a)) OR: make distribution to shareholders Apply to deficit in retained earnings Income Statement: Net Sales $500 COGS $300 Fixed Costs $100 Net Profit $100 Balance Sheet: Current Assets $200 Current Liabilities $200 PP&E $200 Long-Term Debt $300 Stated Capital $100 Retained Earnings -$200 Total Assets $400Liab + Equity $400

13. “Nimble” Dividends – Double Dipping? When various procedural maneuvers are taken into account, therefore, the insolvency test appears to be the only real, ultimate limit on management’s ability to make distributions to shareholders legally – even when the governing statute seems to impose a tougher, “earned surplus” test. Clark, Corporate Law at 616. 1 2 +$200 -$100 $200 $100 $0 -$200 Period => Net Profits Distribution End-of-Period Retained Earnings

14. Expected value of judgment = $15.55 Settlement offer @ $17.5 Settlement offer @ $12.5 equityholders bondholders Credit Lyonnaise (pp. 141-2) Diagram Payoff to class ($MM) $12 $12 Value of firm ($MM)

15. Credit Lyonnaise Payoffs Scenario Prob. Total Payoff Payoff to Bondholders Payoff to Equityholders . Affirm 25% $51.0 $12.0 $39.0 Modification 70% $4.0 $4.0 $0.0 Reversal 5% $0.0 $0 $0 Expected Value of Trial $15.55 $5.8 $9.75 $12.5 million settlement $12.5 $12.0 $0.5 $17.5 million settlement $17.5 $12.0 $5.5

16. Fraudulent Conveyance & UFTA §4 (a) A transfer made . . . by a debtor is fraudulent as to a creditor, whether the creditor’s claim arose before or after the transfer was made . . . if the debtor made the transfer . . . (1) with actual intent to hinder, delay, or defraudany creditor of the debtor; or (2) without receiving a reasonably equivalent value in exchange for the transfer. . . and the debtor: (i) was engaged or about to engage in a business transaction for which the remaining assets of the debtor were unreasonably small. . . or (ii) intended to incur. . . or reasonably should have believed that he [or she] would incur debts beyond his [or her] ability to pay as they came due. . .

17. Example -- Leveraged Buyouts (LBO’s) In the 1980s, unsecured creditors often attacked failed LBO’s as a fraudulent conveyance. LBO’s exchanged debt for stock. Question was whether the companies overpaid to retire stock, and whether the equity that was left was unreasonably small. Courts came out both ways. Usually not possible to recover purchase price of shares bought from public shareholders, but bankruptcy trustees successfully went after investment banker fees on the deals. BUT: should fraudulent conveyance doctrine be extended to LBO’s? Baird & Jackson (1985): “a firm that incurs obligations in the course of a buyout does not seem at all like the Elizabethan deadbeat who sells his sheep to his brother for a pittance.”

18. Leonard Plumbing & Heating Supply Inc. (a corporation) Secured Debt: $41K (Amer. Trust Co.) Some equity converted into notes and P’ship interests then transferred into corporation Unsecured Debt Fazio Note $41K Ambrose Note $4K Leonard: $2K Ambrose: $2K Fazio: $2K June 1954 Costello v. Fazio Leonard Plumbing & Heating Supply Co. (a partnership) Higher Secured Debt: (Amer. Trust Co.) Unsecured Debt Priority Leonard: $2K Ambrose: $6K Capital Accounts Fazio: $43K Lower Sept 1952

19. Veil Piercing Doctrines • Tests go under various names: “agency test;” “instrumentality of the individual”; “alter ego of the individual;” etc. • Generally consist of two components: • Evidence of “lack of separateness,” e.g., shareholder domination, thin capitalization, no formalities/co-mingling of assets (“Tinkerbell test” – to be protected, shareholder must believe in the separation) • Unfair or inequitable conduct – this is the wildcard in veil-piercing cases. • Probably no piercing: against public corporation; against passive shareholders; minority shareholders; if all formalities are observed and nothing “funny” with the accounts.

20. Formulations of the Doctrine Lowendahl test (NY): veil-piercing requires (1) complete shareholder domination of the corporation; and (2) corporate wrongdoing that proximately causes creditor injury Van Dorn test (7th Circuit – applied in Sea Land): (1) such unity of interest and ownership that the separate personalities of the corporation and the individual [or other corporation] no longer exist; and (2) circumstances must be such that adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice. Laya test (applied in Kinney Shoe): (1) unity of interest and ownership such that the separate personalities of the corporation and the individual shareholder no longer exist; and (2) would an inequitable result occur if the acts were treated as those of the corporation alone. BUT: if both prongs satisfied, there is still a potential “third prong” -- D might still prevail by showing assumption of risk.

21. Sea Land $87K judgment Sea-Land Services Andre Marchese 50% Caribe Crown, Inc. Pepper Source Jamar Corp. Tie-Net PS Salecaster Distributors, Inc. Marchese Fegan Asc. District Court pierces to Marchese and reverse pierces to other corps. Appeals Court reverses grant of summary judgment.

22. Jingle Rule vs. 1978 Act First Priority Second Priority ‘78 Act (§ 723(c)), RUPA § 807(a) UPA § 40(h) & (i) (a.k.a. “Jingle Rule”) Partnership Assets Individual Assets Partnership Assets Individual Assets Partnership Creditors Individual Creditors Partnership Creditors Individual Creditors

23. Kinney Dec. 1984 sublease April 1985 50% sublease Kinney Shoe Polan Polan Industries, Inc. Industrial Kinney obtains judgment against Industrial for $166K in unpaid rent, then sues Polan individually to collect. District Court holds for Polan, finding that Kinney had assumed the risk. 4th Court reverses, refusing to apply “third prong” of Laya.

24. Huntington, West Virginia

25. Walkovszky v. Carlton Other shareholders Carlton Seon Each corp. has two cabs, no assets, and minimum insurance. Walkovszky struck by a cab owned by Seon Corp (driven by Marchese), and seeks to hold Carlton personally liable. Court of Appeals dismisses the complaint w.r.t. Carlton for failure to state a claim, with leave to serve an amended complaint.

26. Successor Liability DGCL § 278 & § 282: shareholders remain liable pro rata on their liquidating dividend for three years. RMBCA § 14.07: same as Delaware, provided that corporation publishes notice of its dissolution. Successor Corporation Liability: Product line test in some jurisdictions may hold acquiror liable if it buys the dissolved corporation’s business intact, and continues to manufacture the same line of products => any sophisticated buyer who buys the business as a going concern will contract for indemnification for tort liability, or pay less. So only way for shareholder to escape long-term liability through dissolution is to sacrifice the going-concern value of the business and keep only the piecemeal liquidation value.

27. Corporate Form – Key Benefits • Benefits of Limited Liability: • Reduces need to monitor agents (managers) • Reduces need to monitor other shareholders • Makes shares fungible (which also facilitates takeovers, see below) • Facilitates diversification (without LL, minimize exposure by holding only one company) • Enlists creditors in monitoring managers (because creditors bear some downside risk) • Benefits of Transferable Shares: • Permits takeovers => disciplines management • Allows shareholders to exit without disrupting business • And because of LL, shares are fungible => facilitates active stock markets, increasing liquidity Derived from: Easterbrook & Fischel, The Rationale of Limited Liability, 52 U. Chi. L. Rev. 8 9(1985)

28. Limited Liability in Tort? Cemex Example