1 / 80

Chapter Five Common Stock

Chapter Five Common Stock. Limited Liability Issues 5- 2. Partnership – joint & several liability The risk for wealthy investors Discouragement of passive investments Inability to accumulate large amounts of capital

astra-santos
Download Presentation

Chapter Five Common Stock

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Chapter Five Common Stock

  2. Limited Liability Issues 5-2 • Partnership – joint & several liability • The risk for wealthy investors • Discouragement of passive investments • Inability to accumulate large amounts of capital • The Scottish bank exception • Externalizing Losses – the Contract Case • Protection by contract: • Personal shareholder guarantees in close corporations • Negative covenants from debtor corporations • Security interests in debtor’s assets • Higher interest rates to compensate for risk • The Tort Case • (1) Firms may take excessive risks • (2) Corporations may underinsure • (3) Product costs may not reflect social costs of production (accidents) • Large size of many corporations formerly solved the problem • Mass torts mean some tort creditors don’t recover

  3. The History of Limited Liability 5-3 • Joint & several liability existed in Rome, but so did some limited liability. • 12th & 13th century – Italian shipping ventures gave limited Liability to passive investors. • The spread of the Limited Partnership form on the Continent. • Corporations, except royally chartered ones, remained like partnerships. • 1855 – England granted limited liability to companies. • 1816-1850 – states adopted limited liability with adoption of general incorporation acts.

  4. Issuing New Shares 5-4 • A decision of the Board of Directors • Can be limited by: • Par value protected against economic dilution but with low or no par value it does not any more. • Charter (authorized number of shares) • Charter (pre-emption rights) • Shareholder Agreement (restrictions) • Provisions of Corporate Law and Directors Duties

  5. DGCL 152 5-5 The consideration. . . for subscriptions to, or the purchase of, the capital stock to be issued by a corporation shall be paid in such form and in such manner as the board of directors shall determine. . . . In the absence of actual fraud in the transaction, the judgment of the directors as to the value of such consideration shall be conclusive. The capital stock so issued shall be deemed to be fully paid and nonassessable stock upon receipt by the corporation of such consideration. . . .

  6. Voting But Not Economic Dilution 5-6 • Value of A’s outstanding common stock: 100 shares @ $10 = $1,000 • New issue of common stock: 100 shares @ $10 + $1,000 • New value of A’s stock: 200 shares @ $10 = $2,000

  7. Extreme Economic Dilution 5-7 • Value of A’s common stock: 100 shares @ $10 = $1,000 • New issue of common stock: 100 shares @ $0 + 0 • New value of A’s stock: 200 shares @ $5 = $1,000

  8. Penalty Dilution- Option (i) 5-8 • Assume, for example, a $1,000,000 investment that has gone bad, so that creditors will get one-half of the firm’s assets if no new funds are put in. But if an additional $1,000,000 is invested, the investment will be worth $1,750,000. If 100 original units were sold at $10,000 each, consider the options: • (i) Another 100 units are sold at $10,000 each. At the end, 200 units will share a net worth of $1,750,000, or $8,750 per unit. A rational investor who owns one unit, looking out exclusively for his own interest, will decline to invest a fresh $10,000, hoping that others will do so. His loss on one unit: $1,250; Loss on two: $2,500

  9. Penalty Dilution- Option (ii) 5-9 • Assume, for example, a $1,000,000 investment that has gone bad, so that creditors will one-half of the firm’s assets if no new funds are put in. But if an additional $1,000,000 is invested, the investment will be worth $1,750,000. If 100 original units were sold at $10,000 each, consider the options: • (ii) 133.33 new units are offered at $7,500 each. At the end of the day, 233.33 units will share a value of $1,750,000, or $7,500 per unit (we have ignored rounding, where there is a 7¢ difference. The investor is now indifferent: he can invest another $10,000, and own 2.333 units worth a total of $17,500. He has lost $2,500. If he fails to invest, his original unit is worth $7,500, and his loss is $2,500.

  10. Penalty Dilution- Option (iii) 5-10 • Assume, for example, a $1,000,000 investment that has gone bad, so that creditors will one-half of the firm’s assets if no new funds are put in. But if an additional $1,000,000 is invested, the investment will be worth $1,750,000. If 100 original units were sold at $10,000 each, consider the options: • (iii) 200 new units are offered at $5,000 each. At the end of the day, 300 units will share a value of $1,750,000, or $5,833 per unit. The investor who buys two new units has invested $20,000 for a total of three units worth $17,500. He has lost $2,500. If he fails to invest, his original unit is worth $5,833, and his loss is $4,167.

  11. Dilution Equation 5-11 • L = ma - (mx + p) (a) • x + d • where: L = existing shareholders’ loss through dilution; • m = market price of a share before issuance; • a = a shareholder’s share ownership at the time new shares are issued; • x = shares outstanding before dilutive issuance; • d = number of shares issued in dilutive distribution; • p = proceeds from sale of new shares.

  12. Pre-emption 5-12 • The right to buy shares in a new issue pro rata to existing holdings. • Created by Courts in the US • Created by Charter in the UK

  13. Stokes Case 5-13 • Shareholders authorized issue of new shares (doubling shares), par value $100, and then sale to Blair at $450 per share. • Stokes voted for first resolution but not second. • He claimed a pre-emptive right to buy a pro rata portion for par value. • Court held he had the eright.

  14. Stokes Case 5-14 • What business reasons motivated the increase in authorized stock and the sale to Blair & Co.?

  15. Stokes Case 5-15 • What business reasons motivated the increase in authorized stock and the sale to Blair & Co.? • Enlarge the size of the business; • Bring Marshall Field and other merchants into management; • Obtain their banking business.

  16. Stokes Case 5-16 2. Do you have any reason to believe that $450 per share was an unfairly low price for the sale of new shares in Continental Trust Company?

  17. Stokes Case 5-17 2. Do you have any reason to believe that $450 per share was an unfairly low price for the sale of new shares in Continental Trust Company? • Not a self-dealing transaction, at least as reported. • The shareholders approved the sale, presumably by a majority vote. • The Dissent notes stock had never sold for a price this high before.

  18. Stokes Case 5-18 3. Would it have been fair to other shareholders to allow Stokes to purchase newly issued shares at their par value of $100?

  19. Stokes Case 5-19 3. Would it have been fair to other shareholders to allow Stokes to purchase newly issued shares at their par value of $100? • The Dissent points out it would have denied the Company $350 per share. • Second, it defeats purpose of bringing Marshall Field and others into management and getting their banking business. • Note that it would deny Blair effective control, with a 50% block.

  20. Stokes Case 5-20 4. Assuming the shares of Continental had a fair market value of $450, and could have been sold for that price to Blair, how much of a loss would the other Continental shareholders have suffered if Stokes were allowed to purchase 221 new shares at their par value of $100? (See the dilution formula that precedes this opinion. Note that you can’t simply use Stokes’ bargain purchase ($450 - $100) for his 221 shares, because the dilution reduces the value of all shares below $450.)

  21. Dilution Equation 5-21 • L = ma - (mx + p) (a) • x + d • where: L = existing shareholders’ loss through dilution; • m = market price of a share before issuance; • a = a shareholder’s share ownership at the time new shares are issued; • x = shares outstanding before dilutive issuance; • d = number of shares issued in dilutive distribution; • p = proceeds from sale of new shares.

  22. Stokes Case 5-22 • Note that there were 5,000 original shares, and the company proposed to issue another 5,000, so 10,000 shares would be outstanding. • Assume that the purchase price of $450 represented the market value of each share. • And assume that 5,000 - 221 shares were sold to Blair & Co., (before Stoke’s exercise), so that 9,779 shares were outstanding. • At this point Stokes is allowed to buy 221 shares @ $100.

  23. Stokes’ Gain on Shares @ $100 Purchase Price 5-23 • Stokes’ gain: $350 gain per share x 221 = $77,350 • All shareholders’ losses on Stoke’s purchase: • L = ($450)(9779) - (($450) (9779) + (($100)(221)) (9779) • 9779 + 221 • L = $4,400,550 - ($4,400,550 + $22,100) (9779) • 10,000 • L = $4,400,550 - ($4,422,650) (9779) • 10,000 • L = $4,400,550 - ($442.265) (9779) • L = $4,400,550 - $4,324,909 = $75,640 • Stokes’ outcome: gain on purchase $77,350 • Less 221/9779 share of dilution ($75,640) 1,709 • Stokes’ net gain: $75,641

  24. Stokes Case 5-24 5. Why would the other shareholders vote to dilute their own share of ownership by selling new shares to Blair at $450?

  25. Stokes Case 5-25 5. Why would the other shareholders vote to dilute their own share of ownership by selling new shares to Blair at $450? • They would not, as a general rule. • But this looks like voting dilution, not economic dilution. • That’s the best assurance this is a fair price - a sale to a third party.

  26. Stokes Case 5-26 6 What effect would honoring Stokes’ preemptive rights be likely to have on Blair’s interest in acquiring one-half of the total shares of Continental?

  27. Stokes Case 5-27 6 What effect would honoring Stokes’ preemptive rights be likely to have on Blair’s interest in acquiring one-half of the total shares of Continental? • Destroy it. Stokes’ free riding attempt could destroy the deal for everyone. • Presumably Blair wants control.

  28. Stokes Case 5-28 7. Does the majority opinion suggest any limits on the preemptive rights doctrine that might provide a way for Blair and the other shareholders to avoid Stokes’ claims? If so, how would you suggest restructuring the transaction if you represented Blair or the majority of the shareholders?

  29. Stokes Case 5-29 7. If the sale is other than for cash. The court stated at page 293: • “As the right to increase the stock belonged to them, the stock when increased belonged to them also, as it was issued for money and not for property or for some purpose other than the sale thereof for money.” • Have Blair buy property the Company wanted and then sell it to Copmany for stock.

  30. Stokes Case 5-30 7. Or if the sale is at a public auction, as the court stated at page 293: • “The new stock belonged to the stockholders as an inherent right by virtue of their being stockholders, to be shared in proportion upon paying its par value or the value per share fixed by vote of a majority of the stockholders, or ascertained by a sale at public auction.” • Have the vote authorizing the sale of shares fix the price at $450.

  31. Quick Check Question 5.1 5-31 How do RMBCA and DGCL deal with this issue of pre-emption?

  32. Quick Check Question 5.1 5-32 In the early 20th century some statutes required preemptive rights unless the corporation opted out of them in its articles.

  33. RMBCA § 6.30: Shareholders’ Preemptive Rights 5-33 • (a) The shareholders of a corporationdo not have a preemptive rightto acquire the corporation's unissued sharesexcept to the extent the articles of incorporation so provide. • (b)A statementincluded in the articles of incorporationthat “the corporation elects to have preemptive rights”(or words of similar import) means that the following principles apply except to the extent the articles of incorporation expressly provide otherwise. • (1) The shareholders of the corporation have a preemptive right, granted on uniform terms and conditions prescribed by the board of directors to providea fair and reasonable opportunity to exercise the right, to acquire proportional amounts of the corporation's unissued sharesupon the decision of the board of directors to issue them. • * * * • (3) There isno preemptive right with respect to: • (i) Shares issued as compensationto directors, officers, agents, or employees of the corporation, its subsidiaries, or affiliates; • (ii) Shares issued to satisfy conversion or option rightscreated to provide compensation to directors, officers, agents, or employees of the corporation, its subsidiaries, or affiliates; • (iii) Sharesauthorized in articles of incorporation that areissued within six months from the effective date of incorporation; • (iv)Shares sold otherwise than for money.

  34. RMBA § 6.30 – Slide 2 5-34 • Holders of shares of any class without general voting rights but with preferential rights to distributions or assets have no preemptive rights with respect to shares of any class. * * * (b ) A statement included in the articles of incorporation that “the corporation elects to have preemptive rights” (or words of similar import) means that the following principles apply except to the extent the articles of incorporation expressly provide otherwise. • (5) Holders of shares of any class with general voting rights but without preferential rights to distributions or assets have no preemptive rights with respect to shares of any class with preferential rights to distributions or assets unless the shares with preferential rights are convertible into or carry a right to subscribe for or acquire shares without preferential rights. • (6) Shares subject to preemptive rights that are not acquired by shareholders may be issued to any person for a period of one year after being offered to shareholders at a consideration set by the board of directors that is not lower than the consideration set for the exercise of preemptive rights. An offer at a lower consideration or after the expiration of one year is subject to the shareholders’ p reemptive rights. • (d) For purposes of this section, the term "shares" includes a security convertible into or carrying a right to subscribe for or acquire shares.

  35. Del. GCL §102(b)(3) 5-35 • (3) Such provisions as may be desired granting to the holders of the stock of the corporation, or the holders of any class or series of a class thereof, the preemptive right to subscribe to any or all additional issues of stock of the corporation of any or all classes or series thereof, or to any securities of the corporation convertible into such stock. No stockholder shall have any preemptive right to subscribe to an additional issue of stock or to any security convertible into such stock unless, and except to the extent that, such right is expressly granted to such stockholder in the certificate of incorporation. All such rights in existence on July 3, 1967, shall remain in existence unaffected by this paragraph unless and until changed or terminated by appropriate action which expressly provides for the change or termination;

  36. Katzowitz v. Sidler – Investments & Payouts 5-36 • Three shareholders own corporation equally. • Each are owed $2,500. • Two want to take shares instead of cash. • Two vote to issue new shares for $100 each. • Book value is $1800 • Third declines and argues is diluted.

  37. Katzowitz v. Sidler – Investments & Payouts 5-37 Sidler Lasker Katzowitz Invested: At Start $500 $500 $500 Dec. 1961 2,5002,500 0 3,000 3,000 500 Payouts: $18,885.52 $18,885.52 $3,147.59

  38. Katzowitz v. Sidler – Investments & Payouts 5-38 • Pre-emptive Rights Might not Protect a Shareholder. • Normally shareholders can protect themselves either by exercising their preemptive rights or selling them to others who will exercise. • But when shares are sold below fair value, existing shareholders who either don’t want to or lack the funds to invest can have their investment diluted. • The effects of stock rights are illusory in close corporations, because there’s no market for the rights.

  39. Katzowitz v. Sidler – Investments & Payouts 5-39 • The corollary of the equal right to buy is a right not to buy, without being diluted, if no valid business justification exists for the dilution. • Here the disparity between price and value was calculated to force Katzowitz into investing more money. • The price was a tactic, designed to place Katzowitz in a compromising position.

  40. Katzowitz v. Sidler – Investments & Payouts 5-40 1. If you think of this as penalty dilution, could the defendants argue that the offer wasn’t unfair to Katzowitz?

  41. Katzowitz v. Sidler – Investments & Payouts 5-41 1. If you think of this as penalty dilution, could the defendants argue that the offer wasn’t unfair to Katzowitz? • Recall that penalty dilution is justified by forcing an investor to bear his share of a burden. • The business justification here was to loan the money to another corporation all of them controlled. • It’s hard to tell if this was an urgent decision, needed to salvage value for all of them, in which it was fair to ask Katzowitz to participate.

  42. Katzowitz v. Sidler – Investments & Payouts 5-42 2. What does it mean that the book value of Sulburn’s shares was $1,800 at the time the stock was offered to the three shareholders? • Recall the meaning of book value, as historical cost of assets less pre-calculated depreciation.

  43. Katzowitz v. Sidler – Investments & Payouts 5-43 2. What does it mean that the book value of Sulburn’s shares was $1,800 at the time the stock was offered to the three shareholders? • Recall the meaning of book value, as historical cost of assets less pre-calculated depreciation. So this historical cost less depreciation divided by 15 shares equaled $1800 per share. Thus $27,000 BV

  44. Katzowitz v. Sidler – Investments & Payouts 5-44 3. Is book value the ultimate test of the price at which shares should be offered in a corporation? Why or why not?

  45. Katzowitz v. Sidler – Investments & Payouts 5-45 3. Is book value the ultimate test of the price at which shares should be offered in a corporation? Why or why not? • Given the fact that book value tends to diverge from market value over time for almost any asset, it’s hard to tell whether it’s fair value. • If all assets were purchased relatively recently, then it can be a pretty good proxy for market value.

  46. Katzowitz v. Sidler – Investments & Payouts 5-46 4. If you represented Katzowitz at the time new shares were offered at $100 each, how would you advise him assuming he did not have a pressing need for the $2,500 he had just received from Sulburn? Why?

  47. Katzowitz v. Sidler – Investments & Payouts 5-47 4. If you represented Katzowitz at the time new shares were offered at $100 each, how would you advise him assuming he did not have a pressing need for the $2,500 he had just received from Sulburn? Why? • He has two choices: (1) Go ahead and buy the new shares and protect himself from dilution; or (2) Sue the other directors for breach of duty in making a coercive offering at such a low price.

  48. Katzowitz v. Sidler – Investments & Payouts 5-48 5. The court states that preemptive rights were created by the courts to protect two distinct rights of shareholders - their equity in the corporation and their proportionate voting control. Which is more important here?

  49. Katzowitz v. Sidler – Investments & Payouts 5-49 5. The court states that preemptive rights were created by the courts to protect two distinct rights of shareholders - their equity in the corporation and their proportionate voting control. Which is more important here? • Since Katzowitz will always get outvoted unless he has a shareholders’ agreement that gives a 1/3 shareholder a veto power, it must be his economic interests.

  50. Katzowitz v. Sidler – Investments & Payouts 5-50 6. If shares had been offered to each shareholder at $1,800 per share, would Katzowitz have any complaint?

More Related