Creditor Protection -- Overview

1. Mandatory Disclosure

2. Capital RegulationDistribution ConstraintsMinimum Capital RequirementsCapital Maintenance Requirements

3. Fiduciary Duty ConstraintsDirector LiabilityCreditor Liability: Fraudulent ConveyanceShareholder Liability: Equitable Subordination &

Piercing the Corporate Veil

Shareholder Equity Accounts

Stated capital

Capital surplus

Retained earnings

Assets

Liab.

Shldrs’Equity

BALANCE SHEET

Generallynot availablefor distributions

“surplus”

“Net Assets” = Assets - Liabilities

Par Value

Promoter Subscriber

SubscriptionAgreement

“Par value”was the sales

price

Par Value

Corporation Stockholder$$

Par Value

Creditor

Par value isa “trust fund”for creditors

$$

StockholderCorporation

“Legal Capital”

Distributionsto stockholders?

Corporation Stockholder

Creditor

“Legal Capital”

Cannot impair“legal capital”

Corporation Stockholder

Creditor

“Legal Capital”

Capital = outstanding shares x par value

Corporation Stockholder

Creditor

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”

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 liabilities remains 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)).

Example: Alpha’s Inc. (p.139)

Current assets LiabilitiesCash 1,000 Current liabilities 9,650Securities 650 Long-term liabilities 5,000Accounts receivable 6,000 Total liabilities 14,650Inventory 5,000

Property, plant and equipment 3,000 Shareholder equity

Total assets 15,650 Stated capital 200Capital surplus 300Retained earnings 500

Total shareholder equity 1,000

“Nimble” Dividends – Typical Application (DGCL § 170(a))

Income Statement:

Net Sales $500COGS $300Fixed Costs $100Net Profit $100

Balance Sheet:

Current Assets $200 Current Liabilities $200PP&E $200 Long-Term Debt $300

Stated Capital $100Retained Earnings -$200

Total Assets $400 Liab + Equity $400

Apply todeficit inretainedearnings

OR: make distributionto shareholders

“Nimble” Dividends – Double Dipping?

End-of-Period Retained Earnings

Distribution

Net Profits

-$200

$100

-$100

2

$0

$200

+$200

1Period =>

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.

Credit Lyonnaise (pp. 141-2) Diagram

Payoffto class($MM)

Value of firm($MM)

$12

bondholders

equityholders

$12

Settlementoffer @ $12.5

Expected valueof judgment = $15.55 Settlement offer @ $17.5

Credit Lyonnaise Payoffs

.

$5.5$12.0$17.5$17.5 million settlement

$0.5$12.0$12.5$12.5 million settlement

$9.75$5.8$15.55Expected Value of Trial

$0$0$0.05%Reversal

$0.0$4.0$4.070%Modification

$39.0$12.0$51.025%Affirm

Payoff to Equityholders

Payoff to Bondholders

Total Payoff

Prob.Scenario

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 defraud any 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. . .

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.”

Costello v. Fazio

Leonard Plumbing & HeatingSupply Co. (a partnership)

Fazio: $43K

Ambrose: $6K

Leonard: $2K

UnsecuredDebt

CapitalAccounts

Sept 1952

Leonard Plumbing & HeatingSupply Inc. (a corporation)

Fazio: $2KAmbrose: $2KLeonard: $2K

Secured Debt: $41K (Amer.

Trust Co.)

UnsecuredDebt

Ambrose Note $4K

Fazio Note$41K

June 1954

Higher

Lower

Priority

Secured Debt: (Amer.

Trust Co.)Some equity converted into notes and P’shipinterests then transferred into corporation

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.

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.

Sea-Land Services

Marchese

Pepper SourceTie-Net

Andre

PSCaribe

Crown, Inc.JamarCorp.

Salecaster Distributors, Inc.

MarcheseFegan Asc.

SeaLand

$87Kjudgment

50%

District Court pierces to Marchese and reverse pierces to other corps. Appeals Court reverses grant of summary judgment.

Jingle Rule vs. 1978 Act

UPA § 40(h) & (i)(a.k.a. “Jingle Rule”)

‘78 Act (§ 723(c)), RUPA § 807(a)

PartnershipAssets

IndividualAssets

PartnershipCreditors

IndividualCreditors

First Priority

Second Priority

PartnershipAssets

IndividualAssets

PartnershipCreditors

IndividualCreditors

Kinney Shoe

Polan

Polan Industries, Inc.

Industrial

Kinney

Dec. 1984sublease

April 198550% sublease

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.

Huntington, West Virginia

Walkovszky v. Carlton

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.

Othershareholders

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.

Corporate Form – Key Benefits

Benefits of Limited Liability:1. Reduces need to monitor agents (managers)2. Reduces need to monitor other shareholders3. Makes shares fungible (which also facilitates takeovers, see

below)4. Facilitates diversification (without LL, minimize exposure by

holding only one company)5. Enlists creditors in monitoring managers (because creditors

bear some downside risk)

Benefits of Transferable Shares:1. Permits takeovers => disciplines management2. Allows shareholders to exit without disrupting business3. 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)

Limited Liability in Tort? Cemex Example