ANSWERS TO PROBLEMS
1. Olympic National Agencies was organized with an authorized capitalization of preferred
stock and common stock. The articles of incorporation provided for a 7 percent annual
dividend for the preferred stock. The articles further stated that the preferred stock would
be given priority interests in the corporation’s assets up to the par value of the stock.
After some years, the shareholders voted to dissolve Olympic. Olympic’s assets greatly
exceeded its liabilities. The liquidating trustee petitioned the court for instructions on the
respective rights of the shareholders in the assets of the corporation upon dissolution.
The court ordered the trustee to distribute the corporate assets remaining after the
preference of the preferred stock is satisfied to the common and preferred stockholders on
a pro rata basis. Was the court correct in rendering this decision? Explain.
Answer: Preferred Stock. No. The preferred stockholders should be paid only the par value
of their stock before any liquidation dividends are paid to the common stockholders.
2. The XYZ Corporation was duly organized on July 10. Its certificate of incorporation
provides for total authorized capital of $1 million, consisting of 10,000 shares of common
stock with a par value of $100 per share. The corporation issues for cash a total of 500
certificates, numbered 1 to 500 inclusive, representing various amounts of shares in the
names of various individuals. The shares were all paid for in advance, so the certificates
are all dated and mailed on the same day. The 500 certificates of stock represent a total
of 10,500 shares. Certificate 499 for 300 shares was issued to Jane Smith. Certificate 500
for 250 shares was issued to William Jones. Is the validity of the stock thus issued in any
way questionable? What are the rights of Smith and Jones?
Answer: Issuance of Shares. The XYZ Corporation may not validly issue more than 10,000
shares of its common stock, as that number of shares is all that it is authorized by its
3. Doris subscribed for 200 shares of 12 percent cumulative, participating, redeemable,
convertible, preferred shares of the Ritz Hotel Company with a par value of $100 per
share. The subscription agreement provided that she was to receive a bonus of one share
of common stock of $100 par value for each share of preferred stock. Doris fully paid her
subscription agreement of $20,000 and received the 200 shares of preferred stock and the
bonus stock of 200 shares of the par value common. The Ritz Hotel Company later
becomes insolvent. Ronald, the receiver of the corporation, brings suit for $20,000, the
par value of the common stock. What judgment?
Answer: Amount of Consideration for Shares. Ronald is entitled to recover $20,000 from
Doris. Par value shares may be issued for any amount, not less than par, set by the board
4. Hyperion Company has an authorized capital stock of 1,000 shares with a par value of
$100 per share, of which 900 shares, all fully paid, were outstanding. Having an ample
surplus, Hyperion Company purchased from its shareholders 100 shares at par.
Subsequently, Hyperion, needing additional working capital, issued the 200 shares in
question to Alexander at $80 per share. Two years later, Hyperion Company was forced
into bankruptcy. How much, if any, may the trustee in bankruptcy recover from
Alexander?
Answer: Treasury Stock. The trustee in bankruptcy may not recover with respect to the sale
of the 100 treasury shares, but may recover $2,000 from Alexander with respect to the
100 previously unissued shares. The outstanding 900 shares of capital stock were all
5. For five years, Henry and James had been engaged as partners in building houses. They
owned the equipment necessary to conduct the business and had an excellent reputation.
In March, Joyce, who previously had been in the same kind of business, proposed that
Henry, James, and Joyce form a corporation for the purpose of constructing
medium-priced houses. They engaged attorney Portia, who did all the work required and
caused the business to be incorporated under the name of Libra Corp.
The certificate of incorporation authorized one thousand shares of $100 par value stock. At
the organizational meeting of the incorporators, Henry, James, and Joyce were elected
directors, and Libra Corp. issued a total of 650 shares of its stock. Henry and James each
received 200 shares in consideration for transferring to Libra Corp. the equipment and
goodwill of their partnership, which had a combined value of more than $40,000. Joyce
received 200 shares as an inducement to work for Libra Corp. in the future, and Portia
received 50 shares as compensation for the legal services she rendered in forming Libra
Corp.
Later that year, Libra Corp. had a number of financial setbacks and in December ceased
operations. What rights, if any, does Libra Corp. have against Henry, James, Joyce, and
Portia in connection with the original issuance of its shares?
Answer: Liability for Shares. The answer differs depending upon the statutory provision
that has been adopted in the state of incorporation. In general, consideration for the
issuance of capital stock is defined in a more limited fashion than under contract law. In
6. Paul Bunyan is the owner of noncumulative 8 percent preferred stock in the Broadview
Corporation, which had no earnings or profits in 2012. In 2013, the corporation had
large profits and a surplus from which it might properly have declared dividends.
However, the directors refused to do so, using the surplus instead to purchase goods
necessary for the corporation’s expanding business. The corporation earned a small
profit in 2014. The directors at the end of 2014 declared a 10 percent dividend on the
common stock and an 8 percent dividend on the preferred stock without paying preferred
dividends for 2013.
a. Is Bunyan entitled to dividends for 2012? For 2013?
b. Is Bunyan entitled to a dividend of 10 percent rather than 8 percent in 2014?
7. Alpha Corporation has outstanding 400 shares of $100 par value common stock, which
has been issued and sold at $105 per share for a total of $42,000. Alpha is incorporated
in State X, which has adopted the earned surplus test for all distributions. At a time when
the assets of the corporation amount to $65,000 and the liabilities to creditors total
$10,000, the directors learn that Rachel, who holds 100 of the 400 shares of stock, is
planning to sell her shares on the open market for $10,500. Believing that this will not be
in the best interest of the corporation, the directors enter into an agreement with Rachel
to buy the shares for $10,500. About six months later, when the assets of the corporation
have decreased to $50,000 and its liabilities, not including its liability to Rachel, have
increased to $20,000, the directors use $10,000 to pay a dividend to all of the
shareholders. The corporation later becomes insolvent.
(a) Does Rachel have any liability to the corporation or its creditors in connection with the
corporation’s reacquisition of the 100 shares? (b) Was the payment of the $10,000
dividend proper?
8. Almega Corporation, organized under the laws of State S, has outstanding twenty
thousand shares of $100 par value nonvoting preferred stock calling for noncumulative
dividends of $5 per year; ten thousand shares of voting preferred stock with $50 par
value, calling for cumulative dividends of $2.50 per year; and ten thousand shares of no
par common stock. State S has adopted the earned surplus test for all distributions. As of
the end of 2009, the corporation had no earned surplus. In 2010, the corporation had net
earnings of $170,000; in 2011, $135,000; in 2012, $60,000; in 2013, $210,000; and in
2014, $120,000. The board of directors passed over all dividends during the four years
from 2010 through 2013, because the company needed working capital for expansion
purposes. In 2014, however, the directors declared on the noncumulative preferred shares
a dividend of $5 per share, on the cumulative preferred stock a dividend of $12.50 per
share, and on the common stock a dividend of $30 per share. The board submitted its
declaration to the voting shareholders, and they ratified it. Before the dividends were
paid, Payne, the record holder of five hundred shares of the noncumulative preferred
stock, brought an appropriate action to restrain any payment to the cumulative preferred
or common shareholders until the company paid to noncumulative preferred
shareholders a full dividend for the period from 2010 to 2013. Decision? What is the
maximum lawful dividend that may be paid to the owner of each share of common stock?
Answer: Dividend Preferences. The board had authority to exclude noncumulative shares
from any past year dividend. The cumulative preferred stock is entitled to a dividend of
$2.50 per share for each of the four years when the board of directors passed over all
dividends plus $2.50 per share for the current year if common stock is to receive any
dividend in the current year. The noncumulative preferred stock would have no right to
any accrual of dividends during the four years when no dividends were declared. The
9. Sayre learned that Adams, Boone, and Chase were planning to form a corporation for
the purpose of manufacturing and marketing a line of novelties to wholesale outlets.
Sayre had patented a self-locking gas tank cap but lacked the financial backing to market
it profitably. He negotiated with Adams, Boone, and Chase, who agreed to purchase the
patent rights for $5,000 in cash and 200 shares of $100 par value preferred stock in a
corporation to be formed.
The corporation was formed and Sayre’s stock issued to him, but the corporation has
refused to make the cash payment. It has also refused to declare dividends, although the
business has been very profitable because of Sayre’s patent and has a substantial earned
surplus with a large cash balance on hand. It is selling the remainder of the originally
authorized issue of preferred shares, ignoring Sayre’s demand to purchase a proportionate
number of these shares. What are Sayre’s rights, if any?
Answer: Dividends and Other Distributions. The corporation is obligated to pay Sayre
$5,000. Sayre will probably be unable to compel the declaration and payment of a
dividend. Sayre has no preemptive right to purchase original unissued shares of preferred
stock.
10. Wood, the receiver of Stanton Oil Company, sued Stanton’s shareholders to recover
dividends paid to them for three years, claiming that at the time these dividends were
declared, Stanton was in fact insolvent. Wood did not allege that the present creditors
were also creditors when the dividends were paid. Were the dividends wrongfully paid?
Explain.
11. International Distributing Export Company (I.D.E.) was organized as a corporation on
September 7, 2007, under the laws of New York and commenced business on November
1, 2007. I.D.E. formerly had been in existence as a sole proprietorship. On October 31,
2007, the newly organized corporation had liabilities of $64,084. Its only assets, in the
sum of $33,042, were those of the former sole proprietorship. The corporation, however,
set up an asset on its balance sheet in the amount of $32,000 for goodwill. As a result of
this entry, I.D.E. had a surplus at the end of each of its fiscal years from 2008 until 2013.
Cano, a shareholder, received $7,144 in dividends from I.D.E. during the period from
2009 to 2014. May Fried, the trustee in bankruptcy of I.D.E., recover the amount of these
dividends from Cano on the basis that they had been paid when I.D.E. was insolvent or
when its capital was impaired?
12. GM Sub Corporation (“GM Sub”), a subsidiary of Grand Metropolitan Limited,
acquired all outstanding shares of Liggett Group, Inc., a Delaware corporation.
Rothschild International Corporation (“Rothschild”) was the owner of 650 shares of the
7 % cumulative preferred stock of Liggett Group, Inc. According to Liggett’s certificate of
incorporation, the holders of the 7 % preferred were to receive $100 per share “in the
event of any liquidation of the assets of the Corporation.” GM Sub had offered $70 per
share for the 7 % preferred, $158.63 for another class of preferred stock, and $69 for
each common stock share. Liggett’s board of directors approved the offer as fair and
recommended acceptance by Liggett’s shareholders. As a result, 39.8 % of the 7 %
preferred shares was sold to GM Sub. In addition, GM Sub acquired 75.9 % of the other
preferred stock and 87.4 % of the common stock. The acquisition of the overwhelming
majority of these classes of stock—coupled with the fact that the 7 % preferred
shareholders could not vote as a class on the merger proposal—gave GM Sub sufficient
voting power to approve a follow-up merger. As a result, all remaining shareholders
other than GM Sub were eliminated in return for payment of cash for their shares. These
shareholders received the same consideration ($70/share) as in the tender offer.
Rothschild brought suit against Ligge9 and Grand Metropolitan, charging each with a
breach of its duty of fair dealing owed to the 7 percent preferred shareholders. Rothschild
based both claims on the contention that the merger was a liquidation of Ligge9 insofar as
the rights of the 7 percent preferred stockholders were concerned and that those preferred
shareholders therefore were entitled to the liquidation preference of $100 per share, not
$70 per share. Are the preferred shareholders entitled to a liquidation preference? Why?
Answer: Preferred Stock. Judgment for Liggett and Grand Metropolitan. Preference rights
of preferred stock can be eliminated legally through the merger process. In addition, a
merger is a separate and distinct process from a liquidation or a sale of assets. Thus, the
7 % preferred was always subject to defeasance by merger as the merger provisions of
Delaware law are a part of Liggett’s charter. The preferential rights attaching to shares of
13. Smith’s Food & Drug Centers, Inc. (SFD) is a Delaware corporation that owns and
operates a chain of supermarkets in the Southwestern United States. Jeffrey P. Smith,
SFD’s chief executive officer, and his family hold common and preferred stock
constituting 62.1 percent voting control of SFD. On January 29, SFD entered into a
merger agreement with the Yucaipa Companies that would involve a recapitalization of
SFD and the repurchase by SFD of up to 50 percent of its common stock. SFD was also
to repurchase 3 million shares of preferred stock from Jeffrey Smith and his family. In an
April 25 proxy statement, the SFD board released a pro forma balance sheet showing
that the merger and self-tender offer would result in a deficit to surplus on SFD’s books
of more than $100 million. SFD hired the investment firm of Houlihan Lokey Howard &
Zukin (Houlihan) to examine the transactions, and it rendered a favorable solvency
opinion based on a revaluation of corporate assets. On May 17, in reliance on the
Houlihan opinion, SFD’s board of directors determined that there existed sufficient
surplus to consummate the transactions. On May 23, SFD’s stockholders voted to
approve the transactions, which closed on that day. The self-tender offer was
oversubscribed, so SFD repurchased fully 50 percent of its shares at the offering price of
$36 per share. A group of shareholders challenged the transaction alleging that the
corporation’s repurchase of shares violated the statutory prohibition against the
impairment of capital. They argued that (a) the negative net worth that appeared on
SFD’s books following the repurchase constitutes conclusive evidence of capital
impairment and (b) the SFD board was not entitled to rely on a solvency opinion based
on a revaluation of corporate assets. Explain who should prevail.
Answer: Dividends and Other Distributions. Decision for Smith’s Food & Drug Centers.
This problem is based on Klang v. Smith’s Food & Drug Centers, Inc., Supreme Court of
ANSWERS TO “TAKING SIDES” PROBLEMS
A closely held corporation sought to repurchase 25 percent of its outstanding shares
from one of its shareholders. The corporation and the shareholder agreed that the
corporation would purchase all of the shareholder’s stock at a price of $500,000, payable
$100,000 immediately in cash and the balance in four consecutive annual installments. The
state’s incorporation statute provides: “A corporation may purchase its own shares only out
of earned surplus but the corporation may make no purchase of shares when it is insolvent
or when such purchase would make it insolvent.” At the time of the repurchase of the shares,
the corporation had an earned surplus of $250,000.
(a)What are the arguments that the repurchase of shares satised the
incorporation statute?
(b)What are the arguments that the repurchase of the shares did not
satisfy the incorporation statute?
(c) Which argument should prevail?
ANSWER:
(a) At the time of repurchase there is sufficient earned surplus ($250,000) to pay the
$100,000 due. Each subsequent installment of the repurchase transaction should be
