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Securities Regulation
University of Mississippi School of Law
Bullard, Mercer E.

Mercer Bullard

Securities Regulation

Spring 2011

Capital Structure:

The combination of a firm’s capital raising arrangements is known as its “capital structure.”

DEBT

1. Debtholders generally do not have any say in the management of the corporation. The terms under which firms borrow money often limit their activities to some extent, but usually only in a very limited way. Raising capital by issuing debt allows the owners to retain complete control over the firm and to retain all of the profits in excess of interest payments. This factor is considered an advantage of raising capital by borrowing money.

2. The firm must pay interest regularly, at six-month intervals for a typical bond. This obligation is fixed. There is no deferral of interest payments when the firm is unprofitable, but there is also no obligation to pay more when the firm is profitable. Management flexibility is limited by debt because cash must be used first to pay interest, even if there may be better uses for it inside the business.

3. Debt increases risk for the owners of the firm. If the firm is unprofitable, interest on the debt will still have to be paid, which may increase the likelihood of failure. Even if the firm is profitable, debt can cause its collapse if the firm has insufficient cash flow. Insufficient cash flow might occur, for example, if a firm experienced a temporary delay in collecting payments from customers (“accounts receivable”) and the company could not generate the cash to meet its interest obligations. This might lead to a default on a loan. A default can trigger an obligation to repay the full amount of the debt immediately. This can force a company into bankruptcy.

In bankruptcy, debtholders have priority over stockholders. Debtholders are entitled to recover accrued interest and repayment of principal before stockholders receive anything. In the event of bankruptcy, there may be nothing left for the owners after the debtholders have been made whole.

EQUITY

Equity (ownership) is a kind of mirror image of debt.

1. Stockholders have a say in firm management. They actually own the firm. They are generally entitled to vote on the directors of the firm and on major firm policies.

2. The firm has no fixed obligation to make payments to stockholders. The firm’s decision whether to pay dividends to stockholders is generally within the discretion of the board of directors. The firm therefore has greater flexibility in managing its distributions as profits rise and fall. This flexibility may reduce the risk of bankruptcy by enabling the firm to conserve its cash in difficult times. It also permits larger payments to stockholders when the firm is extremely profitable, whereas the payments to debtholders are contractually limited.

A major downside of equity is that stockholders generally will not have priority over debtholders in the event of bankruptcy. This means that stockholders have a greater risk of losing the entire value of their investment. With the greater upside potential offered by unlimited distributions comes the greater downside risk of a total loss of principal. This reflects a fundamental principal of finance. The promise of greater rewards generally entails taking greater risks.

Valuation:

Risk

The value of a business is a function of the amount of risk that it presents, as opposed to merely the reward that it promises. Examine the opportunity cost of the investment. Get an expected value. What is the “quality” of the risk?

Cost of the Financing

When valuing a business that we are thinking of purchasing (or issuing debt to), we are really asking ourselves what we would charge the business for our money. This question is reversed for the business.

Dilution

Fundamental question: at what price should the firm (underwriter) issue additional shares? NOT: at what price should an existing shareholder sell his shares of the firm?

This is a crucial difference because, when a corporation issues a share, the corporation

receives the proceeds of the sale and increases in size by that amount. The assets of the corporation increase by the amount it receives in return for the additional share.

If the shareholder sells a share to someone else, the corporation itself is essentially unaffected. The value of the corporation’s net assets does not change. The proceeds of the purchase go to the selling shareholder, and the share comes from the selling shareholder. This type of transaction is often referred to as occurring in the “secondary market.” Issuance occurs on the “primary market.”

Equation for Proper Valuation:

1/(aggregate old shares) * $(aggregate total worth of all pre-existing shares) =

1/(new amount of aggregate shares) * X

X= the value of the corporation after the proceeds of the sale of the new shares have been added to the corporation’s assets.

[Get the amount of the firm’s total assets that each share owned and ensure that the new shares, with their proceeds added to the firm’s assets, equal that per/share value.]

“Watered stock”: Overpriced shares of stock based on inflated valuations of the firm’s worth. The purchase of watered stock enriches existing shareholders at the expense of new shareholders.

The purchase of newly-issued shares at a discount harms existing shareholders by reducing the per/share value of the existing shares.

Control

Debt Interests and Control

Holders of a firm’s debt do not have any control over a firm beyond that which is expressly provided in the contract setting forth the terms of the loan. Those terms generally will not include the ability to vote on any corporate matters, although they typically will include the right to demand immediate repayment in the event of a default, for example. A debtholder’s contracts may include many default triggers. When a firm is in trouble and a default-event occurs, the debtholders may be in a position of de facto control. The debtholders also may be able to assume control if the firm files for bankruptcy. Situations in which debtholders assume such legal or de facto control are the exceptions, however. In the ordinary course of business, using debt to raise

capital avoids control issues.

Equity Interests and Control

When a firm raises capital by issuing equity interests, control issues become critical.

As a general matter, however, a 50% interest will almost always give the owner effective control over a firm.

In fact, a stake of less than 50% can confer control. An investor does not necessarily

need to own interests sufficient to outvote all other investors combined. If one investor owns 10% of the interests i

hat no security is involved.

· Promissory Notes: IS THERE AN EVIDENCE OF INDEBTEDNESS? IF SO, WHAT IS ITS SUBSTANCE? Like stock, notes are specifically listed as “securities” in Section 2(a)(1) of the 1933 Act, but “the context otherwise requires” exception presents unique challenges.

a) The “Family Resemblance” Test: To determine whether the note is a security, courts apply the “family resemblance” test. The test includes a presumption and exceptions to the presumption. The test:

I. Presumption that the note is a security: Since notes are specifically mentioned in the 1933 Act, there is a presumption that they are securities.

II. Exceptions: (Reves) The following notes, and notes bearing a “family resemblance” to them are deemed not to be securities under the 1933 Act:

· Consumer financing

· Home mortgages

· Short-term secured financing of business.

· Commercial bank loans for current operations.

III. Four Factors for Interpretation:

· The motivations of the buyer and seller of the note (financing vs. investment?).

· The plan of distribution (will the instrument be openly traded?).

· The reasonable expectations of the investing public (does the public have a reasonable expectation that the 1933 Act protections would apply to this instrument?).

· The existence of a comparable scheme of regulation (the existence diminishes the likelihood of SEC involvement).

2. Investment Contracts

1. Traditional “Howey test”: An investment contract is any contract or profit-making scheme whereby a person: (Modern courts have relaxed some of these requirements)

· Invests his money;

· In a Common Enterprise;

· And Expects to Make a Profit;

· Solely from the Efforts of Others.

Investment of Money:

Factors determining whether the “investment/participation” is an “investment contract”:

· Does the investor have an expectation of profit?

· Is there a common enterprise?

· Does the success of the enterprise depend mainly on the efforts of persons other than the investors?

· Do the investors need the protection of the 1933 Act?

Common Enterprise:

Horizontal test – there must be a sharing or pooling of funds or other assets by several investors and profits derived from these combined funds. This standard has been relaxed. Interests of investor must “rise and fall” with the performance of the combined funds.

Vertical commonality – a common enterprise will be found if the investor is relying on the efforts of the promoters to make a profit. Investors’ fortunes must be “interwoven with and dependent upon the efforts and success of those seeking the investment.”