Chapter 34
FINANCIAL STRUCTURE
I. Debt Securities
A. Authority to Issue Debt Securities
B. Types of Debt Securities
1. Unsecured Bonds
2. Secured Bonds
3. Income Bonds
4. Convertible Bonds
5. Callable Bonds
II. Equity Securities
A. Issuance of Shares
1. Authority to Issue Shares
2. Preemptive Rights
3. Amount of Consideration for Shares
a. Par Value Stock
b. No Par Value Stock
c. Treasury Stock
4. Payment for Shares
a. Type of Consideration
b. Valuation of Consideration
3. Stock Options
III. Dividends and Other Distributions
A. Types of Dividends and Other Distributions
1. Cash Dividends
2. Property Dividends
3. Stock Dividends
4. Stock Splits
5. Liquidating Dividends
6. Redemption of Shares
7. Acquisition of Shares
B. Legal Restrictions on Dividends and Other
Distributions
1. Definitions
2. Legal Restrictions on Cash Dividends
a. Earned Surplus Test
b. Surplus Test
c. Net Assets Test
3. Legal Restrictions on Liquidating
Distributions
Cases in This Chapter
Metropolitan Life Insurance Company v.
RJR Nabisco, Inc.
Cox Enterprises, Inc v. Pension Benefit Guaranty
Corporation.
Dodge v. Ford Motor Co.
Chapter Outcomes
After reading and studying this chapter, the student should be able to:
Distinguish between equity and debt securities.
Identify and describe the principal kinds of debt securities.
Identify and describe the principal kinds of equity securities.
Explain what type and amount of consideration a corporation may
TEACHING NOTES
I. DEBT SECURITIES
A debtor-creditor relationship is established by sale of a debt security (or
bond). The corporation is the debtor and the creditor is the bondholder. Debt
securities require payment of a #xed interest rate by the company. Some
states, but not the Revised Act, permit articles of incorporation to confer
voting rights on debt security holders; a few states allow other rights to be
conferred on bondholders. Sale of debt securities is regulated by state law
and the federal Securities Act of 1933. Exemption from regulation under
these laws is possible.
A. AUTHORITY TO ISSUE DEBT SECURITIES
The board of directors retains the power to issue bonds without the
authorization of shareholders.
B. TYPES OF DEBT SECURITIES
Bonds are generally issued pursuant to an agreement, called an indenture,
which provides the details.
Unsecured Bonds
Referred to as debentures, and are backed by only the promise of the
corporation. As a result, debenture holders are unsecured and will recover
their claims on an equal footing with other general creditors.
Secured Bonds
Convertible Bonds
Typically, debentures that may be exchanged for corporate equity securities.
This exchange is made at the bondholder’s option and will be at a specified
ratio.
Callable Bonds
A redemption provision allows these bonds to be called in for redemption by
the issuing corporation and paid prior to the date of maturity at a certain
interest rate.
CASE 34-1
METROPOLITAN LIFE INSURANCE COMPANY v. RJR
NABISCO, INC.
United States District Court, S.D. New York, 1989
716 F.Supp. 1504
http://scholar.google.com/scholar_case?case=2457879042014277410&q=716+F.Supp.
+1504&hl=en&as_sdt=2,34
Walter, J.
Introduction
The corporate parties to this action are among the country’s most sophisticated financial
institutions, as familiar with the Wall Street investment community and the securities market
as American consumers are with j the Oreo cookies and Winston cigarettes made by
defendant RJR Nabisco, Inc. (sometimes “the company” or “RJRNabisco”). The present
action traces its origins to October 20, 1988, when F. Ross Johnson, then the Chief
Executive Officer of RJR Nabisco, proposed a $17 billion leveraged buy-out (“LBO”) of the
company’s shareholders, at $75 per share. (Court’s footnote: “A leveraged buy-out occurs
when a group of investors, usually including members of a company’s management team,
buy the company under financial arrangements that include little equity and significant new
debt. The necessary debt financing typically includes mortgages or high risk/high yield
bonds, popularly known as “junk bonds.” Additionally, a portion of this debt is generally
* * *
Plaintiffs * * * allege, in short, that RJR Nabisco’s actions have drastically impaired the
value of bonds previously issued to plaintiffs by, in effect, misappropriating the value of
those bonds to help finance the LBO and to distribute an enormous windfall to the
* * *
Although the numbers involved in this case are large, and the financing necessary to
complete the LBO unprecedented, the legal principles nonetheless remain discrete and
familiar. Yet while the instant motions thus primarily require the Court to evaluate and apply
traditional rules of equity and contract interpretation, plaintiffs do raise issues of first
impression in the context of an LBO. At the heart of the present motions lies plaintiffs’ claim
that RJR Nabisco violated a restrictive covenant—not an explicit covenant found within the
four corners of the relevant bond indentures, but rather an implied covenant of good faith
and fair dealing—not to incur the debt necessary to facilitate the LBO and thereby betray
what plaintiffs claim was the fundamental basis of their bargain with the company. The
company, plaintiffs assert, consistently reassured its bondholders that it had a “mandate”
from its Board of Directors to maintain RJR Nabisco’s preferred credit rating. Plaintiffs ask
this Court first to imply a covenant of good faith and fair dealing that would prevent the
recent transaction, then to hold that this covenant has been breached, and finally to require
RJR Nabisco to redeem their bonds.
RJR Nabisco defends the LBO by pointing to express provisions in the bond indentures
that * * * permit mergers and the assumption of additional debt. These provisions, as well as
others that could have been included but were not, were known to the market and to
plaintiffs, sophisticated investors who freely bought the bonds and were equally free to sell
them at any time. Any attempt by this Court to create contractual terms post hoc, defendants
Background
* * *
The Parties
Metropolitan Life Insurance Co. (“MetLife”), incorporated in New York, is a life insurance
company that provides pension benefits for 42 million individuals. According to its most
recent annual report, MetLife’s assets exceed $88 billion and its debt securities holdings
exceed $49 billion. [Citation.] MetLife alleges that it owns $340,542,000 in principal
amount of six separate RJR Nabisco debt issues, bonds allegedly purchased between July
Jefferson—Pilot Life Insurance Co. (“Jefferson—Pilot”) is a North Carolina company
that has more than $3 billion in total assets, $1.5 billion of which are invested in debt
securities. Jefferson-Pilot alleges that it owns $9.34 million in principal amount of three
separate RJR Nabisco debt issues, allegedly purchased between June 1978 and June Those
bonds, bearing interest rates of anywhere from 8.45 to 10.75 percent, become due in 1993
and 1998. [Citation.]
RJR Nabisco, a Delaware corporation, is a consumer products holding company that
owns some of the country’s best known product lines, including LifeSavers candy, Oreo
cookies, and Winston cigarettes. The company was formed in 1985, when R.J. Reynolds
The Indentures
The bonds implicated by this suit are governed by long, detailed indentures, which in turn
are governed by New York contract law. No one disputes that the holders of public bond
issues, like plaintiffs here, often enter the market after the indentures have been negotiated
and memorialized. Thus, those indentures are often not the product of face-to-face
negotiations between the ultimate holders and the issuing company. What remains equally
true, however, is that underwriters ordinarily negotiate the terms of the indentures with the
issuers. Since the underwriters must then sell or place the bonds, they necessarily negotiate
* * *
Further, as plaintiffs themselves note, the contracts at issue “[do] not impose debt limits,
since debt is assumed to be used for productive purposes.” [Citation.]
Discussion
* * *
The indentures at issue clearly address the eventuality of a merger. They impose certain
related restrictions not at issue in this suit, but no restriction that would prevent the recent
RJR Nabisco merger transaction. * * *
* * *
In contracts like bond indentures, “an implied covenant * * * derives its substance
directly from the language of the Indenture, and ‘cannot give the holders of Debentures any
rights inconsistent with those set out in the Indenture.’ [Where]plaintiffs’ contractual rights
[have not been] violated, there can have been no breach of an implied covenant.’ [Citation.]
(emphasis added).
* * *
It is not necessary to decide that indentures like those at issue could never support a
finding of additional benefits, under different circumstances with different parties. Rather,
* * *
The sort of unbounded and one-sided elasticity urged by plaintiffs would interfere with
and destabilize the market. * * * The Court has no reason to believe that the market, in
evaluating bonds such as those at issue here, did not discount for the possibility that any
company, even one the size of RJR Nabisco, might engage in an LBO heavily financed by
* * *
[Judgment for defendant on count of breach of implied covenant.]
*** Chapter Outcomes ***
Distinguish between equity and debt securities.
Identify and describe the principal kinds of equity securities and debt securities.
II. EQUITY SECURITIES
Includes common and preferred stock each of which evidences ownership
rights in the corporation. These ownership rights may include the right to: 1)
participate in control,
2) participate in earnings, or 3) participate in residual corporate assets upon
dissolution.
A. ISSUANCE OF SHARES
Ownership of shares of stock is the method for determining proportionate
ownership of the corporation. The issuance of equity securities is regulated
by state law (blue sky laws) and the federal Securities Act of 1933, although
exemptions may be available.
Authority to Issue Shares
The articles of incorporation will specify the number and types of shares
authorized to be issued.
Preemptive Rights
Amount of Consideration for Shares
Board of Directors usually determine the price for which shares will be
issued.
Par Value Stock — Par value stock may be issued at a price set by the
board or shareholders so long as it is at least par value. This can be an
arbitrary value selected by the corporation and may or may not reflect the
actual value of the share or the price paid to the corporation. It indicates
only the minimum price that the corporation must receive for the share. The
RMBCA has eliminated the concept of par value.
No Par Value Stock — No par value stock has no minimum stated price
and may be sold for any amount set by the board or shareholders.
Treasury Stock — Treasury stock is stock that was once issued and
outstanding, i.e., the corporation repurchases this stock after issuance.
These shares have no voting or preemptive rights and receive no dividends.
The RMBCA has eliminated the concept of treasury stock.
NOTE: See Figure 34-1: Issuance of Shares
*** Chapter Outcome***
Explain what type and amount of consideration a corporation
may validly receive for the shares it issues.
Payment for Shares
Type of Consideration — Consideration for issuance of capital stock is
defined in a more limited fashion than under contract law. In about 30 states
cash, property and services actually rendered are valid consideration, but
Liability for Shares
A shareholder is responsible for unpaid consideration for shares that are
issued prior to full payment.
B. CLASSES OF SHARES
Common Stock
This type of stock has no unique contract rights and common stock-holders
generally bear a more signiticant risk of loss should the corporation fail.
Common stockholders share more in the upside if the corporation should
prosper. These contract rights must appear in the charter.
Preferred Stock
Although the rights of preferred shareholders are secondary to the creditors
of the corporation, they do have dividend and/or liquidation rights superior to
those of common stockholders.
Dividend Preferences — The board of directors determines whether
dividends will be paid. If preferred stock has a dividend preference, holders
of this stock will receive full dividends prior to any payment to common
shareholders. Cumulative preferred stock requires that any failure to pay a
dividend during a certain period will result in the unpaid portion
Liquidation Preferences — Upon liquidation all stockholders will share pro
rata in the assets of the corporation after payment of corporate debt. If a
class of stock has a liquidation preference, then the preferred stock holders
will be accorded a preference in this distribution process.
Additional Rights and Limitations—Preferred stock may have additional
rights and/or limitations such as limited voting rights or special convertibility.
Stock Options