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Corporate Finance SUMMARY
December 2004
PART I – INTRODUCTION ......................................................................................................................................2
PART II – DEBT FINANCING .................................................................................................................................9
COMFORT LETTERS .................................................................................................................................................. 10
LOAN AND CREDIT AGREEMENTS ............................................................................................................................ 12
1. Standard Form Personal Line of Credit ........................................................................................................ 12
2. Short-form Commercial Credit Agreement .................................................................................................... 14
DEBT INSTRUMENTS ................................................................................................................................................ 27
1. Trust Indenture and Related Matters ............................................................................................................. 27
2. Creditor Protection ........................................................................................................................................ 33
3. Convertible Securities and Warrants ............................................................................................................. 44
PART III - EQUITY FINANCING AND PROTECTION .................................................................................... 53
GENERAL CONSIDERATIONS .................................................................................................................................... 53
How do you create a CBCA corporation? ........................................................................................................................ 53
Share Capital .................................................................................................................................................................... 53
Microcell’s Post-Restructuring Share Capital .................................................................................................................. 55
Pre-emptive Rights of Existing SHs ................................................................................................................................. 55
How does the corporation actually issue a share? ............................................................................................................ 55
Declaring and paying dividends ....................................................................................................................................... 57
Redemption, Retraction and Acquisition .......................................................................................................................... 59
PREFERRED SHARES ................................................................................................................................................. 61
1. Nature of Relationship between Preferred SHs and Corporation.................................................................. 61
2. Preferred Shareholders’ Rights ..................................................................................................................... 63
DIVIDENDS, RETAINED EARNINGS AND LEGAL CAPITAL RULES .............................................................................. 68
1. Declaring Dividends ...................................................................................................................................... 68
2. Capital Protection Rules: Acquisition or Redemption of Corporation’s Own Shares, etc. .......................... 70
PART V – MERGERS AND ACQUISITIONS ...................................................................................................... 72
FIDUCIARY DUTIES OF DIRECTORS AND OTHERS ..................................................................................................... 77
LOCK-UP AGREEMENTS AND TERMINATION FEES ................................................................................................... 83
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Part I – Introduction
Introduction to Fundamental Concepts – Debt and Equity
Debt and Equity  these two components comprise balance sheet
A. Debt
 Indebtedness for money borrowed (this is a subset of debt, and the only thing we will be studying).
Debt created when borrower receives money lent to it.
 Examples of indebtedness for money borrowed:
o Long-term debt:
 Bonds,
 Debentures,
 Notes,
 Bank loan (lots of non-banks will make bank loans) – usually precise arrangements
(3-5 years generally).
 **Note that bonds are a security and can be traded; bank loans are not securities and
generally cannot be traded
o Short-term debt:
 Credit overdraft (borrowing from your bank pursuant to agreement with bank that
allows you to do that, e.g. overdraft protection in checking account, very short-term
debt),
 Operating lines of credit (also very short term)
 Loan vs. promise to lend:
o Note that a loan is an actual advance of funds
o An operating line of credit is promise to lend
o (see this distinction in CCQ)
 Note that debt can be secured or unsecured (mortgage is a form of security)
 Secured Debt
o Can be ranking of secured debt (senior and junior?)
o May be ranking on one specific project (e.g. you have first ranking on this project which you
are financing but not the rest of my business)
o Secured rank senior to unsecured
 Unsecured Debt
o Can there be ranking of unsecured debt? 3 ways to effectively rank unsecured debt
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1) Debtor promises (in covenant) to pay one creditor (A) before another (B)
PROBLEM: If debtor breaches, i.e. pays B before A, only remedy available to A is contractual
damages (cannot sue to get priority). A would only bother suing, however, if debtor didn’t have
money to pay A after having paid B, therefore suing in contractual damages probably wouldn’t be
very fruitful (debtor doesn’t have any money!)
SH: Can debtor and A agree that A will be paid ahead of B if B doesn’t agree to the same?
2) Debtor promises not to incur additional indebtedness
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Debtor agrees (in covenant) that, if debtor takes on certain amt of additional debt (or increases D:E
ratio), is in default of loan and creditor can accelerate loan and put debtor into b-ruptcy.
3) Subordination – creditor agrees to be subordinate to other creditors
Promise made by the lender rather than the debtor; agreement to rank after other unsecured lenders
Why would a lender agree to be subordinate? Increased risk = increased rate of return (in form of
higher rate of interest and/or convertibility into shares). Rate of return increases as go down the
priority chain
Venture capital firms lending to start-ups often lend on a subordinated convertible basis – if things go
well, want to be shareholders; if things go poorly want to be debtors. [Note that in such contexts, may
even see secured convertible indebtedness]
In event of b-ruptcy, TIB will usually give effect to subordination. Issues will arise, however, wrt
exact character of subordinated debt. Sub debtors don’t usually agree to subordinate themselves to all
unsecured debt, only some types (e.g. publicly issued debt instruments, bank lenders). Creates
interpretation issues – how wide to construe types of debt to which subordinated.
 Asset based lender: only make loans that are secured by certain types of assets
 Sinking fund: promise to pay regularly – e.g. promise to pay certain proportion of principal every
year. One way to deal with a prepayment stream. Again, is only a promise; if fail to repay after a
year, suing doesn’t give creditor priority [SH: I’m not sure why it would give creditor priority
anyway?].
o SH: money accumulated on a regular basis in a separate custodial account that is used to redeem
debt securities or preferred stock issues. A bond indenture or preferred stock charter may specify
that payments be made to a sinking fund, thus assuring investors that the issues are safer than
bonds (or preferred stocks) for which the issuer must make payment all at once, w/o the benefit of
a sinking fund.
B. Equity
 Share capital (again a subset of equity) – authorized shares in capital structure; issued from time to
time by corporation. By def’n, share capital is issued by a corporation. That said, can find
equivalents to share capital in other types of organizations (e.g. partner capital in partnerships)
 Preferred Shares – usually take some kind of priority on liquidation (any money paid after all
debtors paid goes to pay [fixed amounts owed to] preferred shareholders)
 Vs. Common shares
C. Debt vs. Equity  Characterization
Different Disciples Characterize Differently
- A given instrument may be characterized in different ways by different disciplines/for different
purposes  legal, accounting, tax
- Law:
o Preferred redeemable shares are equity; they are not debt, even in situation of
bankruptcy/insolvency (Central Capital). For a lawyer, there is a clean line
separating debt instruments and shares. This line is particularly important for bruptcy/insolvency purposes
o Debt instrument convertible at option of issuer (i.e. can repay in shares or cash) is
debt until conversion occurs. If company went b-rupt, debt would be due
- Accounting:
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Preferred redeemable shares will appear on the balance sheet as debt, not equity.
WHY? B/c preferred shares have a fixed dividend and have to be repaid at a certain
point in time; irrespective of whether co. goes b-rupt, redeemable shares will have to
be re-financed and co. will have to find replacement source of funds w/in the
specified time. From a practical perspective, it is debt that is/will be due.
Debt instrument convertible at option of issuer is equity b/c company has option of
paying in shares
Tax:
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Tax people will look at whether or not the dividend/interest is deductible to
determine whether instruments are debt/equity. If periodic payment is deductible –
debt. If not deductible – equity.
Corps will often try to structure an instrument that will be characterized differently by tax lawyers
and accountants. E.g. debt for tax purposes (such that interest deductible) but equity for accounting
purposes (good for co. b/c shows that SH capital is greater than debt of co.)
What about ‘hybrid instruments’?
- From lawyer’s point of view, “hybrid” instruments don’t exist. An instrument is either debt or equity.
There is such thing as convertible instruments (but at one time debt and another time equity, not both
simultaneously)
Question: subordinated convertible debt seems just like preferred shares? Sure, but from lawyer’s point
of view, big difference is that holder of debt has legal right to be paid interest and can enforce it in court.
Shareholder doesn’t have legal right to enforce claim to dividends. Debt = legal contractual right to be
repaid.
What U.S. tax courts look at to decide if something is debt (page 6 CB)
- Why is this impt? B/c tax authorities get very suspicious of certain types of debt
- Incentive to say that all of capital structure is debt (b/c can deduct interest payments).
1. Is the instrument labeled a debt instrument?
2. Is there a fixed maturity date? Debt by def’n is due at some point in the future; contrast to
traditional common shares – no period at which time shares get repaid; preferred shares usually
have redemption date, are retired; there are perpetual preferred shares as well.
3. Does the holder enjoy the typical creditors’ remedies? If all creditors’ remedies are waived,
doesn’t look much like debt.
4. Is the payment subordinated to other indebtedness? Subordinated date starts to look like
something in the nature of an ownership interest
5. Is the interest rate competitive? wWhy would anyone in their right mind would lend at nominal
rate of interest; usually because owner will lend to own company at such a nominal rate (like
parents lend to kids). This looks more like equity; it looks like something an owner and not a
third party would do).
 Note that there are debts with no interest  An e.g. is zero coupon bonds – buy them for
less than the face value. Promise to pay $100 in five years has value of $65 today –
issued at discounted price. Generally get same yield as if bought for $100 and received
interest.
6. Is the interest fixed or contingent (i.e. payable out of earnings)? Possible to have conditional
loans (earn additional interest when co. does well) – this starts looking like shares.
7. Does the holder have the right to participate in the venture (e.g. a board seat)?
8. Is the putative debt secured? If secured, less likely to be in nature of ownership interest.
9. Have payments, in fact, been made on the debt? Has the note gone into default w/o any
attempts to enforce the rights of the creditors? (if nobody has behaved as though it is debt, will
be equity)
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10. What is the ratio of debt to equity, or of “thin capitalization”? (Thin capitalization = lots of
debt and not much equity; tax authorities will expect about 5:1 debt:equity. If tax authorities see
greater ratio, this is thin capitalization. High ratio looks like scheme to increase deductions
[interest].
11. Are there any sinking fund or serial payment provisions? Provisions re. periodical payment –
looks like debt.
12. Have the creditors and the debtors adopted consistent filing positions? Debtor may say debt
for tax purposes; if creditor takes a different position – tax authorities will be suspicious.
13. Is the debtor “bankable” in the conventional sense? i.e. would the bank give them money?
14. Are any outside creditors loaning on comparable terms? If there are other parties in capital
structure lending on same (possibly ridiculous) basis, then more like debt.
15. Are the proceeds used to acquire “capital” assets? This is not too relevant; money is fungible
– LT debt doesn’t necessarily finance LT capital; there could, however, be use of proceeds
provisions in lending instruments.
D. Why borrow? (i.e. finance via debt instead of equity)
Example:
Business opp costs $100
Rate of return = $10/year
If E = 100, D = 0. Return on equity = 10/100 = 10%
If D = 50 at 5% interest per annum, E = 50. Interest payment = 2.50. (10-2.50)/50 = 15%
If D = 90 at 5% interest per annum. Interest = 4.50. Made $5.50 (10-4.50) on equity. 5.50/10 = 55%
return in one year.
What is the problem with this very thin capitalization?
- Cost of borrowing might go up (as you take on more debt)
- Liquidity and cash flow problems as result of high interest payments
- Assumption that rate of return = $10. What if one year it is $3  then interest>return and go into
default (debtholder can then sue to accelerate the loan and put you into bankruptcy)
- Tax problems (tax authorities will be suspicious if debt to equity ratio gets too high)
Leverage: debt in relation to equity in a firm’s capital structure. Measured by debt:equity ratio. More
long-term debt there is, the greater the financial leverage. SHs benefit from financial leverage to the
extent that return on the borrowed money exceeds the interest costs and the market value of their shares
rises. For this reason, financial leverage is popularly called trading on the equity. Because leverage also
means required interest and principal payments and thus ultimately the risk of default, how much leverage
is desirable is largely a Q of stability of earnings (e.g. electric utilities have stable earnings).
Leverage is great (that’s how hedge funds work – lots of leverage) but too much is very risky! Most
public companies will be at ~1:1. If do an acquisition, might go to ~ 2:1 (borrow to finance acquisition
then have agreement with bank to pay down debt quickly). Increase leverage = increase risk.
You always want some debt in your capital structure, but not too much.
Debt
- Secured
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o Ranked – 1st, 2nd, 3rd, etc.
Unsecured
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Subordinated (perhaps convertible)
Equity
- Preferred shares
- Common shares
READING: Debt, Equity and Structured Finance, page 7 CB
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Basic sources of cash for business  internal sources and external sources
Internal cash sources
- money or credit produced through the running of the business itself
- Three basic sources of internal financing: trade credit, accruals, revenue from operations (i.e.
retained earnings)
- > 50% of total capital needs are financed by internally generated income
- Trade Credit
o Financial benefit conferred upon a corporation by suppliers of goods and services to corp
where suppliers do not require payment in advance or immediately upon delivery.
o Attractive form of financing b/c usually credit free; businesses try to get max possible
benefit by stretching out payables
o To prevent this, suppliers often give early-payment discount. Law may consider this to
constitute interest. Characterization can be important wrt Interest Act or Criminal Code
- Accruals
o E.g. wages and salaries which are paid in arrears (after the labour has been performed).
Frequency of payment has effect on magnitude of salary (less frequent = co. saving
money). Most employees don’t take this into account when choosing a job.
o Two impt legal considerations
 Most statutes provide that corp. directors liable to employees of the corporation
for up to six months wages
 Income tax liability
- Retained Earnings
o Single most important source of corporations’ financing
External Sources of Cash
Two fundamental types of corporate capital  Debt and Equity (modern financial instruments = line
btwn them is becoming blurred)
Debt
- claim on corp’s assets that is created when corp borrows money
- Creates contractual obligations on part of borrower to repay borrowed monies + interest, as well as
contractual rights on part of lenders
Equity
- claim on corp’s assets that is created when corporation issues shares of capital stock in exchange for
subscription proceeds
- equity is the residual economic interest in the corporation’s assets, after all outstanding debts have
been satisfied (sort of like “equity in a home” – what’s leftover after pay off mortgage)
Distinction btwn debt and equity is linked with concepts of risk and proprietorship
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In any given financing transaction, the financial interest created could have elements of both debt and
equity – i.e. debt and equity blended together in the creation of actual financial instruments.
Characteristics of Debt and Equity
Form of instruments
Form of distributions by
corporation
Debt
- Loans (secured/unsecured)
- Bonds, debentures, notes
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Common “features” of
instruments:
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Interest paid at regular
interval (stipulated in
instrument)
Interest may be fixed or
floating rate or linked to
something (e.g. profits)
Can be
convertible/exchangeable
(allows holder to convert into
shares of corp or related
corp)
Prepayment/callability: May
be provisions allowing
corporate borrower to repay
debt before maturity date
(callable). Would call if mkt
interest rates fell below
interest owing on outstanding
debt)
PIK (payments in kind):
interest payable in form other
than cash (e.g. securities of
issuer)
Security: payment may be
secured by real or personal
property
Covenants: Loan agreement
Equity
- Shares (common, preferred,
other)
- Preferred shares usually have
some preferential right over
common shares (e.g receive
dividends at stated rate
before paid on common
shares; receive fixed return
of capital when corp wound
up)
- Dividends, declared by BOD
- Preferred shares – usually
provide for stated dividend %
rate based on share’s
redemption value
- Cumulative dividends: if not
declared in any year,
accumulate (only preferred
shares with stated annual
dividend would have such a
feature)
- Non-cumulative: if not
declared in a given year, then
do not accumulate – lost.
- Convertible: preferred
shares might be convertible
into common shares
- Redeemable: issuer, upon
payment of specified price,
may repurchase and cancel
shares
- Retractable: shareholder
may require issuer to
repurchase at price specified
in share conditions
- Voting or non-voting
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Ranking of instruments upon a
winding-up of the corporation
December 2004
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(negotiated loan) or trust
indenture (bonds, notes,
debentures) often has lots of
covenants to protect the
borrower (re. liquidity and
asset mix, solvency,
restrictions on incurring
indebtedness)
Debt vs. equity: debtholders
entitled to all unpaid interest
and principal before any
return of capital to SHs
Types of debt: Senior before
Junior before Subordinated.
Purchaser of any junior
ranking debt must agree to it
(thus, where silent, presumed
equal with most senior debt)
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Equity always ranks below
debt
Certain classes may rank
above others
Important Differences between Debt and Equity
1. Priority: Debt ranks ahead of equity if corporation is wound up, liquidated or dissolved
- Thus, debt issued by a firm is a less risky investment than equity issued by that same firm
2. Debtholders earn interest and have a legal right to receive interest payments; equityholders
may receive dividends unless and until they are “declared” by a corporation
- payment of interest is a contractual obligation (once interest is due, it is a debt)
- dividends do not constitute a debt of the corporation until they are declared. Thus, shareholders have
no right to sue for recovery of dividends until they are declared (even in the case of preferred shares
with a stated, cumulative dividend rate). Once declared – dividends are debt which SHs can enforce
3. Tax Treatment: Interest paid on debt is tax deductible. Dividends paid on shares are not
- Tax system treats debt and equity differently and this treatment is the single most important
distinction between the two
- Difference: reasonable interest paid by a corp on its outstanding debt is deductible in calculating
taxable income. Dividends are not deductible.
- Result of difference – corps try to design hybrid instruments which are debt for purposes of tax law
but appear as equity on balance sheet
4. Upside Potential: Debt Offers a Maximum, Fixed Return; Equity May Offer the Possibility of
Unlimited Upside
- Lender gets fixed rate of return; success of company doesn’t make much difference. Unlimited
upside and potentially significant loss = lenders will be wary of borrowers’ engaging in excessively
risky business
- Equity investors are more likely to favour risk-taking
- This explains restrictive convenants found in loan agreements and trust indentures (under which
public debt securities are issued)
5. Voting control: equityholders have greater power and influence over corporate management
6. Debtholders enjoy contractual rights. Equityholders are protected by the fiduciary obligations
imposed upon a corporation’s directors.
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Part II – Debt Financing
Corporate Authority to Borrow
Borrowing powers – Unless the articles or by-laws of or a unanimous shareholder
agreement relating to a corporation otherwise provide, the directors of a corporation may,
without authorization of the shareholders,
(a) borrow money on the credit of the corporation
…
etc.
Delegation of borrowing powers – Unless articles or by-laws of or a unanimous SH
189(2)
agreement relating to a corporation otherwise provide, the directors may, by resolution,
CBCA
delegate the powers referred to in (1) to a director, a committee of directors or an officer
Extraordinary sale, lease or exchange – A sale, lease or exchange of all or substantially
189(3)
all the property of a corporation requires the approval of the shareholders in accordance
with subs (4) to (8)
- Board can authorize corporation to borrow and/or delegate power to so authorize to officers
- Some jurisdictions – power to borrow (i.e. to set general authorized level of indebtedness) is held by
SHs [SH: but power is held by SHs under CBCA too – could exercise power by unanimous SH
agreement; difference is that don’t need SH approval under CBCA?]
- While CBCA imposes no statutory or SH-determined limits on borrowing, Articles of Incorporation
could impose limits
189(1)
CBCA
When loan instrument being issued, always ask: Who has the authority to bind the company?
- Ostensible authority/indoor management rule: lender dealing with board member or officer may
presume that he/she has authority to bind the company and need not investigate whether he/she
actually does have the authority to so bind. Must, however, rely in good faith.
- Few lending institutions will actually rely on the indoor management rule. Most will ask their lawyer
to determine if signing officer/board member has authority to sign the instrument. Must determine:
1. Whether officer/director duly appointed
2. Whether officer/director acting pursuant to a resolution or bylaw adopted by the Board
o General bylaws often give certain officers power to sign certain instruments
o Major transaction – unlikely will rely on general bylaws. Usually pass specific resolution
giving signing officer authority to enter into agreement/transaction
3. Whether anything in Articles (or CBCA) requires Board to get SH approval
- MB: need to do diligence all the way back to incorporation, issuance of shares [SH: really? Why
need to check that shares properly issued?]
What is a loan?
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2312 CCQ: two kinds of loans – loans for use and simple loan
Loan for use (2313 CCQ): gratuitous K by which lender hands over property to borrower for his
use, under obligation to return it to lender after certain time
Simple Loan (2314 CCQ): K by which lender hands over a certain quantity of money or other
property that is consumed by the use made of it, to the borrower, who binds himself to return a like
quantity of the same kind and quality to the lender after a certain time.
Loan of money presumed to be made by onerous title (2315 CCQ): simple loan is presumed to be
made by gratuitous title unless otherwise stipulated or unless it is a loan of money, in which case it is
presumed to be made by onerous title. [MB: presumption that onerous = presumption that interest
will be owed on loan]
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Promise to lend = right to claim damages (only) (2316 CCQ): A promise to lend (e.g. an operating
line of credit) confers on the ben of the promise, failing fulfillment of the promise by the promisor,
only the right to claim damages from the promisor.
o What would damages be? E.g. Bank breaks promise to loan and I go to another bank and
get loan at higher rate – can claim damages amounting to difference in interest rate.
Consideration for loan = interest
Consideration for promise to loan  depends upon whether promise is committed (cannot be
w/drawn) or uncommitted (can be w/drawn by promisor at any time)
o Uncommitted: no compensation necessary b/c no opp cost from lender’s perspective
o Committed: lender will usually charge a stand-by fee (b/c opportunity cost when cannot
use the money for some other purpose)
Borrower is owner and bears risks of loss (2327 CCQ)
Borrower must return nominal value of money borrowed (2329 CCQ): i.e. borrow $6 million
US = must return $6 million, regardless of whether price of US dollars has increased, decreased or
stayed the same
Loan bears interest from date money is handed over to borrower (2330 CCQ)
Lesion (2332 CCQ)
A term is for the benefit of the debtor unless it is apparent from the law, the intent of the parties or
the circumstances that it has been stipulated for the benefit of the creditor or both parties (1511 CCQ)
o General rule: creditor cannot accelerate term of loan (but debtor can)
o Parties may stipulate that term is for benefit of both, i.e. that neither can accelerate.
WHY? B/c creditor wants benefit of interest. This is particularly common in fixed rate
loans (don’t want debtor to be able to accelerate if mkt interest rate drops).
Comfort Letters
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Agreements create legal obligations between parties
Comfort letters create situations which are not as legally crisp and clear
TD v. Leigh Instruments, [1998] O.C.J.; [1999] Ont. C.A.
Facts:
- Parent (Plessy) refused to guarantee a credit facility (operating line of credit) granted by TD to
subsidiary Leigh
- Instead, parent agreed to sign a comfort letter which provided that it is Plessey’s policy that Leigh be
managed in such a way as to be always in a position to meet its financial obligations…this
letter…does not constitute a legally binding commitment.
- When loan not repaid, Bank sued Plessey, Leigh, GEC Siemens and GEC (latter acquired Plessey in
hostile takeover) for breach of K, negligent misrep and fraud.
Issue: Breach of K? Negligent misrepresentation?
Held: no and no
Ratio:
Breach of K
- Final line of letter (i.e. this does not constitute a legally binding commitment) is the full and complete
answer to ptf’s claim in K
- Absent this line – what would be effect of statement of corporate policy contained in third para of
comfort letter? Court followed Kleinwort. This statement is a representation and not a contractual
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promise or warranty. Para does not use promissory language or language of undertaking. It simply
contains a statement or rep as to Plessey policy at the time the letter was executed, and does not coin a
contractual promise that it will cause Leigh to be so managed or a promise that the bank will be paid.
[SH: contrast to Bankque Brussels Lambert, an Australian case in which the court held similar
language to be promissory in nature, entailing a continuous commitment to ensure that the sub would
be in a position to repay the loan. According to court however, statement was not tantamount to a
guarantee, i.e. parent did not thereby assume secondary liability for the debts of the principal debtor.
Rather, a failure to adhere to the statements would give rise merely to a claim for damages.]
Negligent Misrepresentation
- In order for a statement to constitute a negligent misrep, it must be materially misleading. Statement
of policy was not materially misleading b/c it was a correct statement of the policy which existed at
the time the comfort letter was signed, i.e. Plessey actively supervised the mgmt of Leigh and
attempted to solve its problems. Had the letter been issued a few months later (i.e. when parent
realized that b-ruptcy of Leigh was only option), the statement might have been misleading.
- [SH: C.A. suggested that the rep was a ‘continuing’ one – how do we reconcile this w/ holding of trial
judge (i.e. above)? Trial J. indicated that he might have found neg misrep if bank had not called loan
upon receiving notice of change to policy, i.e. ‘by the time the decision was made to abandon Leigh,
the bank had already frozen the loan, no further funds had been advanced, and no damages incurred
by the bank.’] [Also, in C.A., ptfs argued that, while rep was not misleading when made, it became
untrue or misleading when Plessey realized that L’s financial viability was uncertain. Court held that
‘there is nothing inconsistent with the continued existence of a policy that Leigh should manage its
affairs so as to be able to meet its financial obligations and the existence of circumstances which
imperiled Leigh’s ability to conduct its affairs in accordance with that policy. The policy may remain
extant even if circumstances make compliance difficult or doubtful.’ C.A. also referred to the trial J’s
finding that the policy remained in place up until bankruptcy.
- Even if statement had been materially misleading, there was no reasonable reliance by ptf. First,
unreasonable to place reliance on comfort letter which includes language ‘not legally binding.’
Second, once Plessey was acquired by GEC, the commercial considerations (i.e. reputation, etc.) for
honouring the debt were no longer operative.
POINT: Statements made in a comfort letter given by a parent co. in support of borrowings by its
subsidiary are not tantamount to a guarantee.
What is the value of a comfort letter? (i.e. given that it may not be legally binding)
- Comfort letter creates a moral obligation. When parent signs such a comfort letter, will likely stand
behind it (i.e. pay debts) for reasons of reputation, fear of adverse publicity, higher future borrowing
costs, etc.
- Note also that a comfort letter is part of a calculated risk – Bank continued to make unsecured,
unguaranteed loans to Leigh b/c wanted to establish a good working relationship with Plessey, a
major multinational. In other cases, a Bank may charge higher interest rate for loan that is merely
supported by a comfort letter and not a full guarantee.
- Note finally that not all provisions in a comfort letter are non-binding statements of policy.
“Provisions prohibiting a change of control of the subsidiary or requiring prior notice of same are
clearly undertakings and are binding as such.”
Barbeau:
- Can drive a truck through the statement ‘it is our policy.’  policy today? In the future? What
happens if policy is not implemented? If policy is implemented but result is not achieved?
- Last para is key – if there is no express indication that letter is non-binding, may be enforceable
- How might we redraft para 3 to create an obligation to repay the loan?
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o
o
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Full guarantee
‘Support agreement’ or ‘funding agreement’: i.e. we agree to inject into the co. such
funds as are required to repay its obligations.
o ‘We will cause our subsidiary to be operated in such a way that it generates cash (i.e. a
cash positive way)’ [not clear that this would make them
2 questions to ask re. comfort letters:
o Enforceable  YES or NO? (may well be enforceable absent words ‘this is not a legally
binding commitment’)
o Even if enforceable  What kinds of legal obligation do the words create? (obligation of
means vs. obligation of result)
Clarke, Enforceable Obligations in Comfort Letters in Australia
…
Minimizing Risks from Comfort Letters
- Avoid promissory language
- Make relevant reps and undertakings contingent to subsequent approvals of issuer’s board,
shareholders
- Express representations as a matter of current policy, rather than in a way that could be interpreted as
pertaining to future conduct
- Include an explicit statement that the letter does not constitute a promise or create a contract or any
other binding obligations
- Consistently disabuse, both expressly through the terms of the letter as well as by conduct, any
perception that the recipient of the letter may have that the letter is intended to create legal obligations
or is promissory.
SH: Even if court finds a comfort letter binding (e.g. the Leigh letter absent the words ‘this is not legally
binding’), what would be the remedy? Parent wouldn’t be obliged to repay the debt owed to the bank,
would it? Court in the Australian case suggests that would merely give rise to damages. But what would
damages be? Even if statement in Leigh letter had been legally binding, couldn’t they have argued that
they didn’t breach it? I.e. that Leigh continued to manage its affairs in accordance with the policy (until
b-ruptcy, by which time the bank had already called the loan).
Loan and Credit Agreements
1. Standard Form Personal Line of Credit
A personal line of credit or corporate operating line of credit is a promise to lend, not a loan.
Bank Discretion
- Termination [s. 10]: Bank can terminate right to use PLC w/o notice at any time (constrained by GF
– bank must exercise discretion in GF)
- Amendment [s. 11(d)]: Bank may amend agreement without notice (including to change credit limit
or manner in which interest calculated) (again, constrained by GF)
- Service Charges and Penalties [s. 8]: must pay service charges as those are changed from time to
time
- Payment on demand [s. 4]: You will pay the Indebtedness to the Bank on demand
- All these discretionary powers are consequence of the fact that the line of credit is uncommitted.
Borrower not paying any consideration for Bank commitment (i.e. stand-by fee). Uncommitted loan
= bank can terminate at any time BUT also that can amend w/o agreement of borrower. Provisions
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effectively saying – we are terminating this facility unless you agree to xyz amendments. Sounds
nicer to say ‘we will amend from time-to-time.’
Note that s. 11(d) which provides that Bank may amend w/o notice may be overreaching. MB
doesn’t think Bank could make any significant changes w/o notice. Perhaps the ‘without notice’ is
referring specifically to amendment of the Prime Rate. Bank will not provide notice of change to
prime rate; b/c prime rate is announced publicly, borrower is presumed to take notice of changes to it.
[SH: in that case, why does s. 3(a) provide that the interest rate will change automatically, without
notice, whenever Prime changes?]
Interest
- Interest is due on monthly basis. What interest? Total of all amounts calculated daily. Interest is
calculated daily based on amount outstanding and the interest rate on that day.
- Interest doesn’t normally accrue/compound (i.e. don’t pay interest on interest). BUT, under 3(b)
unpaid interest will compound.
Daily interest = rate today/365 * (outstanding principal + unpaid interest from previous months)
Interest due at month’s end = ∑(daily interest)
Use of Proceeds Clause (s. 2 – Restricted Use)
- Use of proceeds clauses are common in commercial credit agreements. I.e. can use monies borrowed
only to buy x company, build y building, refinance debt, etc. This is part of risk assessment that
bankers do (interest rate may depend on use of proceeds)
- Operating line of credit will generally not have use of proceeds clause. Agreement will usually
provide that monies can be used for general corporate purposes but not, under any circumstances, for
launching a hostile takeover bid. (WHY? Bank could be drawn into any future litigation b/c
effectively funding the bid. Bid could be illegal.)
Drawdown
- Drawdown = the actual act of taking the $
- Mechanics of drawdown = allowable means of taking the $. See mechanics of drawdown at s. 2:
You may draw on your PLC Account in any manner that the Bank may permit from time to time,
including by cheque, ATM, etc.
Waterfall Clause
- re. how payments are applied
- S. 4 (shorthand waterfall clause): The Bank applies payments first to any past due amount, then to
your current due amount, then to any Overlimit due amount and then to your remaining debit balance.
- Such a clause may stipulate that payments applied first to fees/expenses/charges due to bank, second
to interest accrued and finally to reduction of capital.
Set-off
- S. 11(a): The Bank may debit any other account you have with the Bank for the amount of any
payment or any other liability you owe to the Bank under this Agreement. The Bank may credit the
amount to your PLC account.**
- S. 5(c): The Bank may debit any of the lines of credit (if multiple lines) for any amount that the Bank
may, under this Agreement, charge to your PLC Account.
- Set-off permits party who is owed money by and owes money to the same person to set off these
debts against each other (e.g. bank deposit vs. line of credit).
- Bankruptcy and Insolvency Act allows principles of set-off to operate (i.e. legal set-off) when an
individual is bankrupt (even though stay of proceedings).
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Example:
Line of credit = $500; Balance in checking account = $100; Bankrupt’s debt = 20,000
If no set-off  Bank gets $500/$20,000 * bankrupt’s estate
With set-off  Bank gets $100 + ($400/$20,000 * bankrupt’s estate)
-
Can any type of account be set-off? (e.g. mutual fund, treasury bills held by bank’s subsidiary)
o Only debts can be set-off against each other. If bankrupt owns bonds, bank could not set
them off against line. BUT, if bank is debtor for amt of bonds, could set-off.
o Subs – could only set-off debts of bank’s sub against debts owed to bank if agreement
provided for it. Legal set-off doesn’t include affiliates; must provide for it by K.
**Note that if this agreement had been negotiable, counsel would probably negotiate such that set-off
would only operate in situation of default.
[SH: B and I Act allows set-off to operate…but only if parties provide for it by K? If no set-off
provision in K, then no set-off? If so, then what is the difference btwn contractual and legal set-off? If
provided for by Act on the other hand, i.e. that set-off operates automatically to cancel all reciprocal
debts, then what would be good of negotiating set-off vs. no set-off clause]
Covenants
- S. 2: You may use your PLC Account to pay off other debts, but not simply to move your debts
around (?)
- S. 6(b): If you sell or transfer the Property (on which Bank is given mortgage), or give another
Mortgage on the Property to someone else, you must pay the Bank immediately the full balance of the
Indebtedness [sell the property = prepayment obligation. Why? b/c risk changes!]
- S. 6(c): You will insure the Property for the amount and against the risks that the Bank reasonably
requests.
Multi-Party Facilities
- e.g. Parent and Sub may be party to the same line of credit (as opposed to Parent borrowing and
deploying money internally to sub)
- 11(b) provides that for individual and collective liability in such multi-party situations.
2. Short-form Commercial Credit Agreement
Stages of a Lending Relationship
Non-syndicated, need money now
1. Exchange a term sheet
- Prepared by Bank’s counsel
- Will say ‘this is not a binding agreement/commitment to lend’
- Makes initial negotiations easier (relative to using massive agreement as basis for negotiation)
- Sets out key terms – principal, interest rate, currencies, basic covenants
2. Negotiate and sign credit agreement based on term sheet
- Depending on size of co., longer version of the term sheet might be sufficient for agreement
Syndicated, need money for takeover bid at day 0
Note: Under securities laws, cannot have make takeover bid that is conditional on financing. Thus, need
to get committed financing before make bid. Also, do not want to make intention to bid public before bid
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December 2004
date. Thus, wouldn’t want to syndicate before that date (syndication effectively makes bid public).
Bottom line  need commitment to lend from lead bank willing to take risk of syndication.
1. Exchange a term sheet (non-binding) (as per above)
2. Attach commitment letter to term sheet (= now binding promise to lend on these terms)
- Lead bank will commit to lending full amount by attaching commitment letter to negotiated term
sheet. Commitment usually subject to conditions such as:
o Market out: bank need not lend if material adverse change in financial markets affects
ability to fund [Lower standard than frustration. Lending need not be impossible, merely
impractical or inadvisable]
o Note that market out condition will translate into terms of takeover bid (i.e. bid is
w/drawn if Bank uses market-out clause). This is not tantamount to making bid
conditional on financing. (sketchy but common practice)
- Consideration for commitment to lend? Stand-by fee (b/c setting aside money is costly for Bank)
- At this time, bank is taking syndication risk, i.e. always possible that won’t be able to syndicate or
that will only be able to syndicate on disadvantageous terms.
3. Bid becomes public
4. Syndication
5. Sign credit agreement
What if bank doesn’t honour commitment to lend? Art. 2316 CCQ provides that breach of promise to
lend gives rise to damages only (i.e. Bank won’t be forced to lend). Note that, in case of takeover bid,
bank also exposes itself to SHs of target (can sue Bank).
Syndicated Loans
Saibil, “Relations between Co-Lenders” p. 52
SYNDICATED LOANS
A. Competition
- syndicated loan = group of lenders join together to provide credit facilities to the same borrower or
group of borrowers
- WHY syndicate? Share risk of borrower’s default AND satisfy needs of borrower which could not be
satisfied by single bank on its own. [MB: note also that syndication lowers the cost to the borrower
b/c allows a Bank to diversify its lending portfolio. A more diversified loan portfolio (i.e. not 100%
of funds in widget industry) is less risky and thus allows the lender to charge a lower cost for
borrowing].
- One of the lenders acts as agent (negotiates term sheet, handles day-to-day administration) – usually
fierce competition for this spot.
- Can have two lead banks (often one Cdn and one American)
B. Co-operation
- Once arrangers/lead agents chosen, all banks cooperate (rather than being secretive and competitive)
C.
-
The Syndicate
Choice of members controlled by agent but borrower has input
Borrower may want/not want certain lenders in the syndicate (based on past relationships)
For lead bank, impt to have credit-worthy lenders b/c agent often advances funds to borrower and
only receives funds from syndicate member later the same day or next day
D. Swing-line Loans
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When borrower needs only small amount from syndicated facility (e.g. $50,000), doesn’t make sense
for all members of syndicate to advance proportion of that small amount
A swing-line facility is a small facility embedded in larger facility, and made available by agent
alone. Agent will advance funds as need arises.
Since part of larger syndicated facility, other syndication members will have to buy a participation in
the swing-line facility in the event of a default by borrower.
E. Letters of Credit
- Syndicated facilities often provide for the issuance of letters of credit. Certain lenders designated as
issuing banks for letters of credit (take extra risk therefore will be concerned about credit-worthiness
of other syndicate members)
- What is letter of credit? Seller selling to buyer in another jurisdiction may not want to extend credit
to buyer (risk that will have to sue in that jurisdiction). Buyer will ask its bank to issue a letter of
credit such that bank will pay seller in event that buyer does not pay (i.e. defaults under buyer-seller
agreement).
- Only issuing bank (and not other syndicate members) participates upfront (i.e. issues letter).
Syndicate members will be called upon to reimburse issuer (based on their pro-rata share of the
facility) in the event that the issuer of the letter was called upon to honour it and make payment
thereunder.
F. Assignment
- Facility usually provides that members of syndicate can assign their participation in the loan subject
to certain restrictions/conditions, such as:
o Agreement of borrower (not to be unreasonably withheld) – borrower may not approve,
for example, of assignment to Bank which realized on family member.
o Agreement of agent (and other members?) – since agent has risk as swing-line lender or
issuing bank for letters of credit, it will want to be sure that new members are
creditworthy.
o Must assign to financial institution
o Cannot assign to competitor of borrower
o Minimum amount for assignment (don’t want 200 banks each holding very minor
position)
o Restrictions on assignment lessened or eliminated in situation of default (probably won’t
need consent of borrower for example)
G. Majority
-
-
Syndicate needs to make decisions, e.g. when to call default, amendments to loan agreement, waiver
of default
Default (i.e. if no clause) is unanimity; most agreements provide for 50%+1 or 66 2/3%
Fundamental amendments (RATS) will usually require unanimity
o Rate
o Amount and Amortization – how much being paid and how frequently; increasing
commitments; changing pro-rata sharing of payments; requiring loans in additional
currencies
o Term
o Security
o [And changing the amending formula]
SH: of course, borrower has to agree to any amendments
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H. Pari-Passu Treatment
-
-
Agreement will usually provide that any payment or prepayment received after the occurrence of an
event of default is distributed pari passu amongst the lenders in accordance with the proportionate
share of each
Agreement will often also provide for pari passu treatment when a lender exercises a right of set-off
and thereby obtains a reduction in the amount owing to it that exceeds the portion of the outstanding
loan that it otherwise would be entitled to under the loan agreement.
I. Cash Collateralization
-
Syndicated loan agreements often provide that if an event of default occurs, the borrower must
deposit cash collateral in a blocked account with the agent in certain circumstances. E.g. of such
circumstances – if there are letters of credit outstanding but not yet due or if a currency fluctuation
causes the outstanding amount of the credit to exceed the lenders’ commitments.
PARTICIPATIONS
-
-
an assignment that is not an assignment
Syndicated lender grants participations or sub-participations to other lenders. This is done
independently of the syndicate and the borrower, and their consent is not necessary. Borrower not
party to participation agreement. In many cases, borrower doesn’t even know that lender has ‘sold
down’ his commitment (which is important if lender has very important relationship with borrower).
If participant fails to advance funds, lead lender will still be liable to the borrower (and this fact will
be reflected in pricing negotiated btwn lead lender and participant)
This is efficient way for lead lender to deal with economic risk involved with being a lender (sell
down commitment w/o negotiating with agent, borrower, etc.)
Control issue arises – participant cannot vote re. changes, etc. so lender must figure out how to
represent him. This could be detrimental for borrower – it may be at the mercy of participants it
doesn’t know and cannot negotiate with.
THE AGENT
A. Mandate
-
-
role of lender as agent for a syndicate starts with a mandate which the agent received from a
borrower, i.e. agent agrees to syndicate the credit (best efforts or firm commitment basis) structure the
credit terms, ID potential lenders, assist the borrower in preparing an information memo, work with
counsel in preparing the credit agreement, etc.
Role of agent may be divided amongst various lenders (e.g. arranger, administrative agent,
syndication agent, bookrunner, etc.)
B. Duties of Agent
-
Primary responsibility – act or refrain from acting in accordance with the terms of the credit facility
Credit documentation will usually contain a bunch of disclaimers, i.e. absolving agent of
responsibility in certain circumstances. These will be enforced unless contrary to public order.
Article gives examples of situations where extensive exculpatory provisions might not be enough to
absolve agent of responsibility to syndicate of lenders. E.g. agent fails to disclose material
information to other lenders, misleads other lenders, engages in conduct designed to prevent other
lenders from discovering relevant information
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Implied covenant of good faith and fair dealing (1375 CCQ) will apply to agent
C. Conflicting Duties
- While agent should have undivided loyalty to members of the syndicate, conflicting duties or loyalties
may exist or develop (gives examples)
- Conflicts may lead to claims by members of syndicate for placing them in disadvantageous position.
But, major financial institutions don’t like to sue each other b/c have ongoing or potential business
relationships.
- [Author also discusses what agent should do if it receives unfavourable information about the
borrower]
When does a credit agreement “speak of”?
- Most commercial agreements speak of today and of some date in the future, i.e. are ongoing
agreements to do, not do or warrant/represent certain things
- Reps and warranties: e.g. we have x liabilities, we own these assets, etc. “I represent that some state
of facts exists.” These will have to remain true for the entire term
- Covenants: agree to do (positive) or to refrain from doing (negative) certain things; these obligations
stick with borrower for life of agreement
- Conditions of drawdown: i.e. conditions precedent to drawing upon facility
- [MB also gives example of buying/selling a business – see page 16]
Terms of Credit Agreement
S. 2: Credit Commitment
 Subject to the conditions hereinafter contained and so long as no Event of Default has occurred
hereunder or is continuing, Bank hereby agrees to make available to the Borrower a credit facility
which the Borrower may utilize and repay from time to time in accordance with the provisions herof
or as otherwise permitted by the Bank
 [Only have access to the money subject to conditions and as long as no event of default has occurred]
 Tranches = subsets of the credit facility (e.g. Tranche B = 1 million USD, Tranche A = 1 million
CDN). Contrast tranche to form of availability (prime, fixed, BA, credit letter, LIBOR)
S. 3: Conditions Precedent
 Usually two kinds of conditions precedent
1. Conditions precedent to agreement becoming effective (“initial conditions precedent”). E.g.
a. Provide financial statements
b. Show that have money from other sources (equity subscription or subordinated loans)
c. Register security
d. Title examination of security property
e. Insurance policies/riders evidencing the addition of bank as beneficiary
2. Conditions of draw-down – must meet as of date of draw-down, not signing
S. 12: Representations of the Borrower
 Must be true at time of signing but also throughout life of agreement
 12.1 – Corp duly incorporated and in good standing
 12.2 – Corp has necessary corporate powers and authority to enter into this Agreement. Execution of
and compliance with this Agreement will not result in any violation of or be in conflict with or
constitute a default under any term or condition of any other agreement or instrument evidencing
outstanding indebtedness of the Borrower
o Why include this?
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

Don’t want to lend into default
Don’t want to be sued by other lenders for intentional interference with K-ual
relations
o Execution of this agreement might = default under another agreement if that agreement puts
ceiling on subsequent indebtedness or prohibits encumbrances (security)
 12.3 – Borrower not in default under any existing agreement evidencing indebtedness for borrowed
money or securing the same. [i.e. not necessarily this credit agreement that puts into default]
 Two things to consider:
1. These reps don’t leave much room for borrower to move – try to limit 12.3 to material default or
default on agreement over $5 million b/c borrowers are in immaterial default all the time
2. True that if default under other agreement is immaterial, lender will not likely accelerate loan.
However, may not advance money unless default is cured. Want client to be able to access facility
when he needs it.
S. 13: Affirmative Covenants of the Borrower
 Three types of affirmative covenants – informational, operational and financial

Informational: deliver annual and quarterly financial statements (13.1, 13.2), notify Bank of any
change in any material fact or condition represented or warranted in this Agreement, etc. (13.5).

Operational: operate business and subs’ business in compliance with applicable environmental
protection laws (13.6), conduct biz in orderly and regular manner, keep assets in working condition
and maintain insurance (13.3), pay Bank’s expenses (13.4, see below)
Expenses of the Bank: promptly pay to the bank all reasonable out-of-pocket costs, fees and
expenses paid by or invoiced to the Bank (including the reasonable fees and expenses of counsel to
the Bank) in connection with the negotiation prep of agreement, enforcing obs of Borrower,
exercising rights, remedies, or security.
Why must pay expenses of Bank? Would be too complicated to factor it into margin (i.e. cost of
loan) b/c expenses unpredictable; if tried to predict expenses in advance, some Borrowers would end
up subsidizing the cost of other Borrowers’ loans.
MB: reasonableness requirement will likely not apply when it comes to taking action against the
Borrower.
MB: dispute expenses = default. Bank likely won’t accelerate loan but may refuse draw-down
-
-

-
Financial (13.7): from lender’s point of view, the most important affirmative covenants b/c deal with
indicators of Borrower’s financial health.
Must maintain at all times (continuous) certain: working capital ratio, level of working capital, debt
to equity ratio, level of tangible net worth, interest coverage ratio
For purpose of calculating these ratios, principal amount of subordinated loans shall be considered
‘equity’ rather than ‘debt’ (K-ual arrangements modeling themselves on accounting rules)
Presents a monitoring problem b/c must maintain ratios at all times but such ratios usually determined
only quarterly. Might be better to say: “maintain at all times but tested quarterly.”
S. 14: Negative Covenants of the Borrower
 More specific than affirmative covenants
 Not usually curable, i.e. once you’ve done it you’re in default and often cannot undo what has been
done
 Under this agreement, cannot do any of the following without prior written consent of the Bank
(which consent shall not be unreasonably withheld). But, while can always ask for consent of Bank,
Bank may ask for something in return, e.g. a higher margin.
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14.1







December 2004
Mergers and Sale of Assets
Merge, amalgamate or consolidate itself with any other corporation, or sell, transfer or
otherwise dispose of all or any substantial part of its fixed assets out of the ordinary course of
business.
Outside ordinary course of business can be very helpful for borrower, but is a difficult line to walk,
i.e. not always clear whether some sale, transfer, etc. is outside ordinary course of business.
Any substantial part [SH: see debt cases for how interpreted]
Merge or amalgamate: these words don’t have a precise meaning; can mean just about anything.
Buy co., sell co., merge with another co. = come w/in this clause
E.g. Joint venture – would this be allowed under this agreement? Ask: what is the economic effect
of the joint venture agreement at issue? What is borrower contributing to it? If borrower is
contributing substantial part of its assets, could be argued that tantamount to a sale of a substantial
part. If joint venture partner is taking 50% of borrower’s revenue stream, could be argued that
company has been ‘otherwise disposed of.’
This provision is very, very broad and clearly stipulated for lender’s benefit? How can we fix it?
o Anticipate what activities client might want to engage in and list them as exceptions
o Ask for a ‘basket,’ e.g. can sell $x worth of assets in the year
o Permit purchase of co. provided that borrower doesn’t take on co’s debt (i.e. don’t merge
with financially sick co.)
o These provisions are most dangerous when they are short, absolute prohibitions
Look at every word and ask: what will happen to this company during term of agreement and might
it need a waiver?
NB: Might Bank have action against acquirer? If acquirer knew about the credit agreement, might be
action in tort. If no security, unless there is fraudulent preference, buyer not bound by seller’s
contractual obligations. [SH: if security, Bank has real right in asset and can follow it into hands of
buyer].
14.2
Further Encumbrances
Create, assume or have outstanding any Encumbrance upon any of the present and future assets
of the Borrower except Permitted Encumbrances (see def’n).
Permitted encumbrance means (a) any legal cause of preference securing payment of taxes, etc
payable to the State if such payment is not past due or the legality thereof is contested in good
faith by the Borrower; (b) servitude existing now or granted in future for public utility purposes;
(c) a mortgage to finance purchases of property made after this agreement OR any extension,
renewal or refinancing of an existing mortgage if outstanding principal amt of the indebtedness
secured thereby is not increased; (d) any Encumbrance held by the Bank itself or which the Bank
has specifically permitted in writing.





Most common negative pledge
Even borrowers with very high credit rating will be subject to it
Provides that no security shall be created on assets of corporation except…
Effect of such a provision – all lenders, upon bankruptcy, will be pari passu, i.e. all will be unsecured
and equal
This clause is very broad; a more flexible clause would restrict borrower from securing only certain
types of obligations, indebtedness for money borrowed for instance. Such a clause would not catch
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

involuntary encumbrances (e.g. wages with legal preference, tax liens, or security for other
contractual obligations)
The words ‘have outstanding’ catch involuntary encumbrances (e.g. a judgment lien – under
provision, would have to pay judgment so that encumbrance no longer outstanding). Words also
catch encumbrances which were assumed before agreement was signed; borrower would be in default
as soon as agreement became effective. To avoid this, negotiate for exception at outset.
o Example: when negotiating loan, borrower anticipates that will be purchasing co. with
secured debenture. Borrower should ask for clause that allows for this purchase; clause may
put conditions on assumption of debt (e.g. security will be restricted to assets of company
acquired).
Permitted encumbrances clause may also prohibit subsidiaries from charging their assets.
14.3




December 2004
Reduction of Capital, Dividends, etc.
Make any redemption of shares or other reduction of capital OR
Pay any dividend OR
Make any reduction in the principal amount of loans or advances (except short term advances
made in the ordinary course of business) now or hereafter owing to Related Persons
IF the Borrower is in default of any of the provisions hereof or if the making of any of the
foregoing can reasonably be expected to render the Borrower in default of any of the provisions
hereof
Effect of provision is to draw box around borrower and control money coming out of the box.
Stock-dividend probably wouldn’t fall w/in this clause (?)
Another type of capital reduction – asset stripping. Note that K-ual promises, unless backed up by
security, do not give K-ing party right to follow asset. So if director/shareholder strips assets and
leaves corporation as a shell, Bank cannot follow assets into cash form unless there is security which
can realize on.
[SH: reduction of capital = paying out funds which have been subscribed for shares]
14.4
Loans, Guarantees, Investments, Borrowings, etc.
Make any loans to, investments in or guarantees on behalf of others outside of the ordinary
course of business OR borrow money from or give security to any person except the Bank or as
permitted herein.
S. 15: Events of Default
Default vs. event of default vs. acceleration
- Default, in and of itself, is of no consequence
- Once default turns into event of default, borrower has right to accelerate loan and demand repayment
(though might not exercise this right)
Importance of cure period
- If default or event-of-default has occurred, can file for CCAA creditor protection. Once loan is
accelerated, however cannot get creditor protection
- Therefore very important to have cure periods, i.e. time btwn default and acceleration. Longer the
cure period = longer the time available to reorganize.
Waivers
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December 2004
in practice, will see many more waivers of covenants than events-of-default
I.e. lender will waive a default and parties will go back to the bargaining table to renegotiate terms
The occurrence of any one or more of the following events shall constitute an “Event of Default” under
this agreement.
15.1:





Failure to pay = default
Can cure within 10 days
If don’t cure w/in 10 days – event of default
*10 days is very long; most agreements provide that failure to pay principal is an immediate event of
default and not curable
*Always the first event-of-default listed in a credit agreement
15.2




Termination of Business, Insolvency, etc.
Loses corporate or legal existences, ceases to carry on biz, winding up, liquidation or
dissolution, assignment or proposal for benefit of creditors, petition in bankruptcy presented
against it, becomes subject to any other insolvency legislation.
No cure period; immediate event of default
15.3

Payment of principal or interest
If Borrower defaults in the payment to the Bank, within 10 days of its due date, of any installment
of principal or interest required herein to be made, with or without notice on the part of the Bank.
Default in other indebtedness
If the Borrower defaults under the terms of any other writing or agreement evidencing
indebtedness for borrowed money and the creditor thereof exercises a right of acceleration and
demands the immediate payment by the Borrower of such indebtedness prior to its maturity.
Cross-acceleration clause: if another lender accelerates  event of default and we are entitled to
accelerate.
Lender wants this clause so that if another party is entitled to take proceedings, this lender is also so
entitled. Don’t want to be left out of the bankruptcy table.
Other versions of such a clause: cross-default and cross-event-of-default
o Cross-default: entitles lender to accelerate this loan upon simple default of another one
o Cross-event-of-default: entitles lender to accelerate this loan if there is event-of-default
under another loan (i.e. other lender must be entitled to accelerate but need not actually do so
for the clause to operate)
o Cross-default clause is draconian
Can make such a clause more flexible by providing for event-of-default only where event-of-default
under other agreement is material, e.g. stipulate minimum for amt of indebtedness
15.5:
Misrepresentations or Material Adverse Changes
If Bank discovers that any statement, representation or warranty herein or in any document
delivered to the Bank pursuant hereto is false or misleading in any material respect
if there is any material adverse change in the financial condition or business operations and
activities of the Borrower, its subsidiaries or controlling affiliates which constitutes in the
reasonable opinion of the Bank, a serious and substantial deterioration in the financial
condition of the or prospects of the Borrower which impairs or is likely to impair the ability of
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the Borrower to satisfy his liabilities and obligations hereunder on a timely basis – event of
default unless situation has been remedied, or adequate remedial action commenced to the
reasonable satisfaction of the Bank within 15 days after written notice thereof by the Bank to the
borrower.

Misrep clause – might negotiate such that only applies to misreps in this document
Material Adverse Change Clauses
 These are increasingly common, not just in credit agreements but in underwriting agreements, merger
agreements, and commitment letters
 Some MAC clauses, including the one above, apply where material adverse changes in the business
of one party. Others apply where material adverse changes in the market/world economy.
 Underwriting and financing agreements often contain market-out or disaster-out clauses: relives
parties of obligations if something occurs which is outside of their control (e.g. terrorist attack, war,
serious deterioration of lending markets)
 Commitment letters often contain syndication-out or market-flex clauses:
o Syndication out = if I am unable to syndicate, I don’t have to lend
o Market out = if I try to market portions of the credit and find that I mispriced the transaction,
I can change the terms (though I am still committed to lend)
o Such clauses are necessary b/c lead bank is pricing the loan blindly; it cannot test the market
because the deal is confidential.
o *NB: even if no such clause (i.e. lead bank as no out), lender who is having trouble
syndicating can always sell to lenders at discount (but risk of bad pricing entirely borne by
lender, rather than by lender and borrower in case of market-flex)



Borrowers don’t much like MAC clauses because they are very open-ended; effectively provide that
if something happens that is not otherwise provided for in this agreement, Bank can call loan.
MB suggests that borrower should think very hard before accepting a MAC clause; certain events-ofdefault are standard (e.g. payment default), and borrower can’t hope to have them excluded. This
clause is definitely negotiable however.
Could make above clause more flexible by providing for an objective test of material adverse change
(i.e. go to a judge), rather than “in reasonable opinion of Bank.” Can also play with effects of MAC,
i.e. this clause speaks of MAC which affect ability to pay; this seems more reasonable than MAC
which affects share price (share price shouldn’t matter to bank).
15.8:


Defaults
If the Borrower defaults in the observance or performance of any other covenant or condition
contained in this Agreement and such default has not been remedied to the reasonable
satisfaction of the Bank within 15 days after written notice specifying such default has been given
to the Borrower by the Bank…
Longer cure period than for payment default
While cure period exists, some defaults (particularly of negative and financial covenants) are
impossible to cure. E.g. merger – difficult to unscramble the eggs. E.g. not at x:y ratio on certain
date – very difficult to cure. Waivers thus very important – CFO, if anticipates that will be close on
financial ratio, will want to line up waiver well in advance.
Forms of Availabilities
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Borrower may utilize available commitment in five ways: prime rate loan, base rate loan, fixed rate
loan, LIBOR loan, bankers’ acceptances.
S. 5: Interest
5.1
Prime Rate Loan
Unpaid balance shall bear interest in respect of each day, both before and after maturity or
default, at a rate per annum = PRIME RATE + 2% (i.e. the ‘margin’). Calc and payable monthly
5.2
Base Rate Loan
Unpaid balance shall bear interest in respect of each day, both before and after maturity or
default, at rate per annum = BASE RATE + 2%; payable by borrower in US dollars. Calculated
and payable monthly.
5.3
Fixed Rate Loans
Borrower and Bank set this up; stipulate mutually agreeable amount and term period; Bank
quotes interest rate. No Fixed Rate Loan may be prepaid prior to maturity. Upon maturity,
unpaid balance of Fixed Rate loan will be automatically converted into Prime Rate Loan.




Commercial lenders usually lend at variable, not fixed rates, of interest b/c do not want to take risk of
interest rates rising/falling; borrower pays cost of funds and bank is just there to make funds
available.
Rate usually = prime (CDN dollar loans) or base (US dollar loans) + ‘margin’ which reflects risk of
borrower. Here margin is 2%, but many agreements provide for ‘applicable margin,’ i.e. margin may
fluctuate with credit rating of the borrower.
‘before and after default’ included to override procedural rules which set interest rates at default
Default interest rate = provision stipulating that margin goes up if default. [this agreement doesn’t
have one] NB: Interest Act provides that cannot have default interest rate on loans secured by
mortgage.
S. 6: Bankers’ Acceptances
6.1
Issue of Bankers’ Acceptances
The borrower may utilize part of Available Commitment by issuing Bankers’ Acceptances
denominated in Cdn dollars, provided that such utilization is in an aggregate principal amount of
at least $100,000 and over that amount, in increments of $100,000, and provided that not more
than 50% of the unpaid balance of the Loan may at any time be represented by outstanding
Bankers’ Acceptances. Shall be issued for term of not less than 30 days and not more than 180
days.

Bankers’ Acceptances are the most popular availability in Canada to borrow Cdn dollars. Extremely
liquid and efficient market.
How do they work?
 $100,000 Bankers’ Acceptance: bank stamps promise to pay (in x days). “Pay holder $100K”
 Bank sells BA, on borrower’s behalf, for discounted amt (discounted at BA rate [~ 2.44%] annually
for x days). Bank charges stamping fee which replicates margin, i.e. reflects risk of borrower. This
fee is not interest b/c no borrowing but is a charge for using the bank’s credit (i.e. when holder of
promise goes to bank to get money, bank will have to pay)
 Bank gives proceeds to borrower
 X days later, money-market investor comes back to the bank and demands $100K.
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
Bank pays and either (1) borrowers roll over into another bankers’ acceptance or (2) amount paid is
added to Prime Rate loan [NB: (2) is provided for by this particular agreement; not general rule]
 Effect of all this – borrower uses bank’s credit to get money from money-market at fixed rate of
2.44% plus margin.
Why does bank/third party do this?
 Bank has guaranteed use of money for x days; can invest and do what it wants with it
 For third party, is a good short-term investment
 Note that if borrower was senior issuer (i.e. very good credit), could do this on its own, i.e. access
money-markets directly by issuing ‘commercial paper.’
 *Note that b/c this is a fixed rate loan, borrower is always taking risk that prime will fall below fixed
rate
S. 7: Libor Loans Option
The Borrower may utilize part of Available Commitment by way of Libor based loans denominated in US
Dollars.
7.1
Notice of Utilization/Rollover
Must give 3-days notice if propose to utilize or rollover a Libor loan
Each interest period for Libor loan shall be btwn one and six months
Must be for min amt of $100,000 US
If Borrower doesn’t give notice to Bank to rollover outstanding Libor and does not repay Libor
loan on last day of its interest period, it shall be automatically converted into Base Rate Loan.
7.2
Timing of Interest Periods
No Libor loan may be prepaid or converted by the Borrower into a Base Rate Loan prior to the
last day of the Interest period
7.3
Interest on Libor Loans
Rate = Libor + 2% (margin)

Use BA to borrow Cdn dollars and Libor to borrow US dollars. Mechanics different than those of
BAs, i.e. functions like a loan
 Libor = London Interbank offering rate. It is locked in for a certain period of time, so if prepared to
borrow at locked in rate, will get better rate if borrower at Libor than at US base rate. E.g. on October
8, 3-month Libor = 2.06%, 1-year Libor = 1.54%, US prime = 4.75%
Mechanics
 If want to borrow US dollars, ask Bank what Libor rates will be in 3 days. If sound good, tell Bank to
go out and borrow in Libor market.
 When Libor loan due, can rollover into new Libor (i.e. ask bank to go back into interbank mkt and
borrow) OR can repay loan



Most borrowers will stay in BAs and Libors until need to get out of them.
Will need to get out of them if must pay off (b/c facility ending), or have ability to pay off loans at
given point in time, and that given point in time is w/in the term of the Libor or BA
Could conceivably prepay Libor or BA, but would incur breakage fees. See relevant portion of S. 16
(Remedies): Should the Bank incur breakage costs in connection with the early termination of any
outstanding Locked-in Loan, such costs will be added to the indebtedness of the Borrower to the Bank
hereunder. Any facility with BA and/or Libor availability will have this clause.
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S. 10: Changes in Circumstance
10.1



This is a yield-protection clause. Banks have to comply with all sorts of capital rules, and if these
rules change, might effect yield or cost of loan
Such changes could affect all borrowers or only a sub-set of borrowers (e.g. some industry)
Easy for bank to get away with such a clause b/c any regulatory/legal changes would affect all banks
in the same way, so borrower could go to another bank but cost of loan would be similarly affected
10.2



Illegality
If loan or some aspect of it becomes unlawful or prohibited due to change in law, regulatory
requirement, official directive, etc. the Bank may, by written notice to Borrower, terminate its
obligations under this Agreement or to maintain such commitment, whereupon Borrower may:
(1) pay to the Bank the Loan or portion thereof that has been determined to be unlawful or (2)
arrange with Bank for termination or conversion into other facilities and indemnify Bank for any
out-of-pocket expenses incurred as result of termination/conversion.
E.g. law which provided that could no longer lend to any lenders in country X.
For a time, was thought that Libor loans might become illegal
10.3

Increased Costs
If there is change in any applicable law, directive, regulatory requirement, etc. (whether or not
having force of law), or in interpretation or application of any law, etc. and this change creates a
liability or increases cost of loan, or reduces net income receivable by Bank under the loan by an
amount which the Bank considers material in its reasonable discretion, Borrower shall either, at
its option: (1) compensate bank for additional cost or liability or reduction in income or return
on capital OR (2) terminate or convert the facilities and indemnify Bank for any out-of-pocket
expenses.
Substitute Basis of Borrowing
If Libor loans become impracticable, inefficient and inappropriate (for any of a number of listed
reasons), Bank shall terminate its obligations to make Libor loans available to the Borrower
hereunder. Each outstanding Libor Loan, if any, will be automatically reconverted into a Base
Rate loan.
Remnant of beginning of Libor market (people worried that the whole thing could be illegal or, if not
illegal, just dry up)
These clauses are starting to disappear b/c has been 40 years since Libor market was introduced and
concerns are dissipating.
S. 20: Judgment Currency
When Bank receives payment in Cdn dollars pursuant to court judgment, the Bank may purchase United
States Dollars with those Canadian Dollars. If the US Dollars so purchased are less than the sum
originally due to the Bank in US Dollars [i.e. at date of judgment], the Borrower agrees as a separate
obligation and notwithstanding any such judgment, to indemnify the Bank against such loss and if the US
Dollars purchased exceed the sum originally due to the Bank in US Dollars, the Bank agrees to remit
such excess to the Borrower or its assigns.

While Ks in other currencies will be enforced in Cdn courts, Currency Act provides that judgments by
Cdn courts must be rendered in Cdn dollars.
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Problem arises if Cdn dollar is worth more on date of judgment than date of payment – Judgment
currency clause addresses the deficit (and conversely any excess). Judgment currency clause may
create new obligation to pay on a given date, so exact same problem may arise, i.e. amt of Cdn paid
on date of payment doesn’t equal amount owed in USDs
Example:
Judgment of $502,000 CDN (for US 340,000)
Pay 502,000 CDN which on date of payment is only worth 330,000 USD, thus owe 10,000 USD payable
on payment date.
Pay 15,000 CDN on payment date which on that date only wroth 9999 USD
Lender may go back and demand the $1 – no payment = default and get another judgment. If the
situation is this bad, likely a TIB is involved…in which case a deal will usually be cut.
Debt Instruments
1. Trust Indenture and Related Matters
Why incur LT debt?
- Credit agreements are necessary for special projects (e.g. building plant or financing acquisition), but
too much bank debt exposes borrower to interest rate risk. Bank debt is usually a floating rate
arrangement and if interest rates skyrocket, so does cost of borrowing. [Can get fixed-rate loan from
bank but will pay higher cost, i.e. to reflect risk that rates will rise].
- Makes sense from management point of view to have long-term fixed rate debt.
- Access debt market via public fixed-rate debt instruments, i.e. debentures, bonds and notes. [NB:
there are some floating rate notes, but most debt instruments are fixed-rate arrangements].
How do you issue LT debt?
- Most issuers approach underwriter and indicate desire to sell x dollars worth of notes
- It is to issuer’s advantage to offer all notes at once – creates market for notes and thus gives buyer of
note confidence that he will be able to sell it if necessary.
- Offering all notes at once creates problem re. registration of security. Must register name of
person/entity to whom security is granted. If there are many notes and they are being regularly
transferred, registration of security beneficiaries would be complicated.
- Solution – trust indenture. Notes are issued under the trust indenture; all notes are governed by one
instrument signed by the trustee on behalf of all current and future note holders.
- Trustee model is convenient for two reasons: (1) reg’n of security (can register w/o knowing who the
initial note holders are); (2) can sue on behalf of all holders or represent them in insolvency
Types of trust indentures
- Single-purpose: governs specific issuance of notes
- Multi-purpose: governs all issuances of notes; may be supplemental indentures for specific issuances
Statutory rules governing trust indentures
- US: Trust Indenture Act
- Canada: CBCA
Pricing of bonds, notes, debentures
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Initial price reflects (1) demand, (2) risk of issuing company, (3) risk-free value of money in x years,
x being term. Risk-free value of money = cost of gov’t borrowing; sovereign borrowers are risk free.
Price is fixed for term of x years BUT risk of issuing company and risk-free value of money will
probably fluctuate. As result, price of bond on secondary market might go up or down, i.e. bond will
be worth more or less than face value.
E.g. 7% $50 million bond due in 5 years
Holder 1 sells to Holder 2 2-years into term by which point interest rates have risen considerably.
Holder 2 will pay less than $50 million. If interest rates have fallen, holder 2 will pay more than $50
million.
If risk of borrower changes, value of bond will change. If issuer goes bankrupt, $50 million bond
might be worth $1 million. At that point, cost of risk-free borrowing is irrelevant; all that matters is
what assets are in the company and how long liquidation will take.
Mechanics of debt holding and issuing
- Issuer  Trustee (Registrar and Transfer Agent)  Brokers  Bondholders
- At closing of offering, issuer issues $100 million note to trustee. While issuer has obligation to keep
records of bondholders, can delegate to registrar/transfer agent/trustee. So trustee holds the note
registered in its name and issues certificates to brokers/bondholders as well as registers transfers
when bonds are bought and sold.
- Issuer has no idea who bondholders are but may want to gauge their opinion at certain points (e.g. if
looking for waiver or thinking of restructuring). There are companies which exist merely to
communication information about holders to issuing company.
Payment of interest
- usually annually or semi-annually (contrast to credit agreement – payable monthly)
- Value of interest is greater the more frequently it is paid
Individual and Collective Rights
Marcel Kahan, Rethinking Corporate Bonds: The Tradeoff between Individual and Collective
Rights
-
Article summarizes bondholder rights, identifies whether amendment or enforcement of those rights
is usually collective or individual, sets out advantages and disadvantages of vesting rights
individually and collectively and the institutional features which bear on the practical significance of
these advantages and disadvantages, and argues that the structure of individual and collective BH
rights established by a typical bond indenture is flawed.
Overview of Substantive BH Rights:
Financial Terms
- right to receive payment of interest at stated intervals and principal when bonds mature
- Optional redemption rights (company’s rights to call before maturity)
- Sinking fund (mandatory redemption) rights – obligate company to repay specified portion of a bond
issue prior to final maturity of all bonds in issue
- Put rights – obligate co. to repay bonds of BHs who elect to exercise rights
- Conversion rights – permit BHs to exchange bonds for other securities of issuing co.
- Subordination clauses – agreement by BHs to subordinate right to receive payments from co. to rights
of other specified creditors
Protective Covenants
- Limitations on co’s conduct of business designed to protect BHs’ entitlement to receive payments
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from the co.
include debt restrictions, dividend restrictions, asset sale restrictions, investment restrictions,
restrictions on mergers, restrictions on liens and sale/leasebacks, restrictions on transactions w/
affiliates
Other miscellaneous contractual rights
- right to receive replacement bond certificate should one’s certificate get lost or stolen
- right to receive notice of a redemption of bonds or of the fact that a put right has become exercisable
- right to have conversion price adjusted in certain events
- right of holders of subordinated bonds to be subrogated to the rights of holders of senior debt once all
senior debt is paid in full
Rights created by statute or CML i.e. rights as creditors or securityholders)
- rights under fraudulent conveyance law
- rights under provisions of corp law designed to protect creditors
- rights under securities laws
- rights under federal b-ruptcy law
- rights under common law of fraud
Individual vs. Collective Rights
- Two dimensions along which one can structure right as individual or collective  ENFORCEMENT
and AMENDMENT
- Rights may be collective on both dimensions, individual on both or individual on one and collective
on the other.
Amendments/Waivers of default
- Usually three types of amendments, with separate approval requirements
o Trustee alone: Non-substantive amendments which can be amended by trustee alone
(note that trustee alone cannot waive defaults). [*MB’s comments see below]
o Unanimity: usually required to reduce or postpone payment of principal or interest,
reduce redemption premium or make the bonds payable other than in cash. Where
unanimous consent required, modifications can sometimes be effected via exchange offer
(BHs who consent exchange bond for new securities with different terms; BHs who don’t
consent keep existing bonds). Exchange offer mechanism not possible for modification
of protective covenant (b/c cannot just be binding wrt some BHs)
o Majority or 2/3 consent: applies to most covenant amendments, amendments to sinking
funds, conversion rights, guarantees, subordination and BH put rights.
Enforcement
- Default vs. event of default:
o Default = any breach of indenture provision.
o Payment default automatically = event of default.
o Other defaults become events of default only if either the trustee or holders of 25% of
the bonds give a ‘notice of default’ to the company and co. fails to cure default w/in
specified time
- Upon event of default, indenture usually provides for two categories of remedies
o Acceleration (principal and accrued interest become immediately due)
o Other remedy to collect payment of principal and interest or enforce performance of any
provision in the indenture
- Mechanisms for enforcing BHs rights:
o Subject to powers of holders of a majority of bonds, trustee has power to accelerate bonds
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or pursue any other remedy [MB: would take very dramatic event of default for trustee to
act w/o clear instructions from significant proportion of holders]
o Individual BH has right to sue following non-payment of principal or interest
o Holders of 25% of the bonds have the right to accelerate
o BHs have right to pursue any other remedy provided they comply with no-action clause
which requires that:
1. holder notifies the trustee of a continuing Event of Default
2. holders of at least 25% of the bonds request trustee to pursue a remedy and offer
indemnity, satisfactory to the trustee, against any loss, liability and expense; and
3. the trustee fails to take any action for 60 days
o [MB: Effect of no-action clause – cannot sue alone, either under indenture or for
oppression]
o Holders of a majority of outstanding bonds typically have the right to rescind any
acceleration, to block holders of 25% of the bonds from pursuing any remedy even if
complied with no-action clause, and to give directions to trustee as to the manner of
enforcement
Summary: rights to receive payment and interest when due – individual for amendment and
enforcement. Other financial terms (e.g. redemption rights, conversion rights) may be collective or
individual for amendment purposes but are collective for enforcement purposes. Other K-ual rights
are collective for amendment and enforcement purposes
Problems with individual rights
- Conflict of interest problem – e.g. some BHs might be SHs of co. or have biz relations with it;
making right individual allows minority to prevail over majority
- Collective action problem wrt amendments – obtaining consent of all the BHs is costly!
- [Note that these above two problems don’t arise if rights can be severed by exchanging bonds of those
who consent. Some rights, such as protective covenants, are not severable]
- Holdout problem – arises when some BHs benefit from the agreement by other BHs to modify their
rights. BH may refuse to participate in restructuring for e.g., anticipating that his/her holdout will not
doom it; if many BHs reason this way, the restructuring will fail.
- Frivolous suit problem
Problems with collective rights
- Collective action problem wrt to enforcement – costly to get everyone together, coordinate and
communicate
- Coercion – co. may offer to pay BHs for consenting to an amendment that is not in their interest
- Incentive problem – an infringement may affect only a subset of all BHs; other BHs thus have no
incentive to take action.
- Loss of control problem - flip-side of conflict of interest problem; majority controls minority
Bondholder Reps and Collective Rights
- Presence of BH rep (trustee) ameliorates some problems and generates others
- Reduces collective action, incentive and coercion problems BUT rep may suffer from conflicts of
interest (e.g. owns stock in or is creditor of co.) and lack of incentives.
The Institutional Setting
- significance of problems and effect of trustees depends on institutional setting of the bond market and
institutional arrangements affecting the indenture trustee.
- ID of BHs: Bond market dominated by institutional investors (few individual investors) – reduces
frivolous suit problem, coercion problem (sophistication of investor) and collective action problem.
May increase conflict of interest (institutional investors more likely to also hold stock or have biz
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dealings with debtor) problem and loss of control problem
Dispersion of BH Ownership: bond ownership very concentrated (compared to stock ownership).
Reduces collective action problem re. enforcement and coercion problem
Indenture Trustee: structure of trusteeship creates few incentives for trustees to act as effective reps
of the BH
o No pre-Event of default fiduciary duties
o No direct monetary stake in preserving bond value
o Not extremely well compensated
o Heightened post-event of default duties = incentive to refrain from action that could
trigger Event of Default (e.g. investigating suspicions of default)
BH Enforcement Actions: for various reasons (which he outlines at 73)the fear of frivolous
bondholder lawsuits is not warranted
B-ruptcy law: ability of financially distressed companies to circumvent the K-ual amendment
provisions through a Ch. 11 filing significantly reduces the practical significance of the holdout
problem in distressed corporate restructurings
Reputation: Reputational incentives can ameliorate imperfections in enforcement regimes to the
extent that cos, for reputational reasons don’t violate rights in the first place. (admits incentives
somewhat weak)
Flaws in the Present Structure of Individual and Collective Rights
- Given the above analysis, author identifies flaws in present structure of individual and collective
rights
1. Inconsistent: certain substantive rights are vested in the individual bondholder wrt to
amendment (i.e. they cannot be modified by majority vote) but they vest collectively with respect
to enforcement. If anything BH powers wrt to enforcement should be same as or stronger than
powers with respect to amendment
2. Unworkable: broad interpretation courts have given to no-action clause makes enforcement
system for some claims unworkable – e.g. vindicating noncontractual rights requires compliance
with no-action clause under which must notify trustee of continuing Event of default…but there is
no Event of Default outside of the indenture context!
3. Illogical: indentures subject claims to collective enforcement even if they are held only by a few
BHs and other BHs lack incentives to join in the pursuit of these claims.
4. Imprudent: excessive reliance on trustee (even though has no incentive to act as effective rep)
and excessive limits on enforcement by bondholders.
Author then discusses the need for contractual reform and proposes a reform which involves (1) judicial
re-interpretation of no-action clauses; and (2) modifications to the indenture
NB: No fiduciary duties between holders. If 60% of holders want to amend or pursue some remedy, they
can amend/pursue remedy; do not have to take into consideration the interests of the 40%.
Amendments by Trustee Alone
*see Stone Consolidated indenture – Modification and waiver
Company and Trustee may, at any time and from time to time, without notice to or consent of any
Holder, enter into supplemental indentures or amend security documents…[list of circumstances
when trustee/co. can amend alone. Includes (1) to evidence the succession of antoher Person to
the Company and the assumption by such successor of the covenants of the Company under the
Indenture and Notes; (2) to add to the covenants of the Company, for the benefit of the Holders,
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or to surrender any right or power under the indenture; (3) to add any additional Events of
Default or to secure the Notes or Bond with additional collateral…etc.]


This sort of provision is rarely used but can be useful. Example of where useful:
Co. A buying Co. B. Both had public debt. Once purchase complete, wanted to issue new debt at
level of B. Couldn’t combine debt b/c from different jurisdictions. New debt holders wanted B debt
guaranteed by A. Problem? This would structurally subordinate original debtors of A (parent) and B
(sub) to new debtors of B. If original B debtholders enforced against B, could get access to B’s assets
but not A’s. Same would go for A debtholders (could only realize on assets of A). New debtholders,
however, would be able to realize on assets of A and B. This would make original debt holders of A
and B upset. Solution? Trustee signed supplemental indenture to indenture governing existing A and
B debt. Supp indenture made A liable on B’s bonds and B liable on A’s bonds.
Relevant CBCA Provisions
Part VIII – Trust Indentures
82(2)
This Part applies to a trust indenture if the debt obligations issued or to be issued under the
trust indenture are part of a distribution to the public.
“trust indenture” means any deed, indenture or other instrument, including any supplement
or amendment thereto, made by a corporation after its incorporation or continuance under
this Act, under which the corporation issues debt obligations and in which a person is
appointed as trustee for the holders of the debt obligations issued thereunder.
So Act doesn’t apply if no trustee appointed
82(1)

90
Notice of default
Trustee shall give holders notice of any event of default arising under indenture w/in 30
days after trustee becomes aware of it unless trustee reasonably believes that it is in the best
interests of the holders to w/hold such notice [e.g. host of immaterial defaults which
company can easily remedy]
Duty of care
A trustee in exercising their powers and discharging their duties shall
(a) act honestly and in GF with a view to the BI of the holders
(b) exercise the care, diligence and skill of a reasonably prudent trustee
Reliance on statements
92
Not w/standing s. 91, a trustee is not liable if they rely in GF on statements contained in a
statutory declaration, certificate, opinion or report that complies with this Act or the trust
indenture.
Note difference in Cdn and American positions – in US, trustee fid duties only arise upon default.
Under CBCA such duties exist pre- and post- default.
91

No exculpation
No term of a trust indenture or of any agreement between a trustee and the holders of debt
obligations issued thereunder or between the trustee and the issuer or guarantor shall
operate so as to relieve a trustee from the duties imposed on him by s. 91.
Cannot K out of the duty of care/loyalty
S. may be redundant. M&A cases which have struck down agreements which lock board into given
transaction in face of superior proposal suggest that, at common law, cannot K out of fid duty
93


Page 32 of 84
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
December 2004
As result of this s., ‘indemnity’ referred to in no-action clause cannot relieve trustee of its fid duties.
(i.e. those who request that trustee sues must indemnify trustee against any loss caused by taking such
action, BUT such indemnification will not relieve trustee of responsibility for losses resulting from
breach of fid duty or duty of care. If trustee is incompetent, indemnification will not protect him)
2. Creditor Protection
(a) Business, Financial and Other Covenants
Extract from Stone Consolidated Prospectus
Background
- SCC (US co) had Cdn sub CB (Consolidated Bathhurst)
- Times were tough in newsprint industry so CB decided to spin off its newsprint assets. Resulting
company was Stone Consolidated (a ‘pure play,’ i.e. a company that is virtually all devoted to one
line of business)
- Stone did IPO – issued shares, convertible debentures and 7-year 10.25% notes
- At time of issuance, these notes considered to be risky (b/c newsprint industry so volatile). Pattern of
covenants is therefore akin to high-yield notes (i.e. bonds that pay higher yield to compensate for
greater risk). Covenants are very restrictive.
Prospectus vs. Indenture
- former summarizes latter
- Misreps in prospectus will be caught be securities law
- Indenture will be interpreted consistently with prospectus; if inconsistent, prospectus trumps
Description of Notes
- Aggregate principal amt = $225 million
- Secured notes will rank pari passu in right of payment with all other existing and future Senior
Indebtedness of the Co, and will rank senior to all subordinated indebtedness of the Company
- Mature Dec. 15 2000
- Bear interest at rate of 10.25% per annum, payable semiannually
- Company will increase amts payable in event that Co. becomes obligated to pay additional amounts
(i.e. w/holding taxes)
Optional Redemption (at premium/penalty)
1) Co may, prior to 12/15/95 redeem up to 33 1/3% of the principal amount of the outstanding notes
with the proceeds of one (but not more than one) public equity offering by the Company after the
Issue date, total gross cash proceeds at least $100 million  redemption price = 110.25%
 Rationale: Balances interests of co and BHs. Co. – if things go well, issuer wants to be able to issue
more shares, and when issuing those shares to be able to tell potential buyers that will reduce debt.
BHs – get premium and get to keep some debt and debt probably worth more (b/c co. less risky)
2) Redemption at par of up to 100% of principal amount outstanding if co. becomes obligated to pay any
Additional amounts in respect of the notes.
 Under Tax Act, debtor that pays interest to a non-resident must withhold tax (25% of interest) and
remit to CRA. Exception for debt with term to maturity of five years or more and less than 25% of
debt payable before five years.
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
December 2004
Cdn issuers, to make themselves competitive with American issuers, promise that if law changes and
w/holding taxes are levied, issuer will gross up interest to cover w/holding tax. BUT, issuer also
protects itself by including provision which allows it to immediately redeem at par in such a situation.
High-yield covenants
Limitation on Indebtedness
Co will not, and will not permit any of its Restricted Subs to incur any indebtedness unless after giving
effect to the incurrence on a pro forma basis, the Company’s Consolidated Interest Coverage Ratio is x.
Notwithstanding the foregoing, Company may, and may permit its Restricted Subs, to incur [list of
exceptions, i.e. types of indebtedness that co. can incur even if brings it below stipulated interest coverage
ratios]
General exception at (m): indebtedness incurred which is not otherwise permitted under this covenant,
but which does not exceed US$50,000,000 in the aggregate at any one time.

Consolidated interest coverage ratio = taking into consideration company and its subs
Limitation on Restricted Subsidiary Indebtedness
Company will not permit any Restricted Sub to incur any indebtedness, other than the following [subset
of the exceptions listed under limitation on indebtedness covenant]


Why more restrictive wrt indebtedness incurred by restricted subs? Structural subordination issue
Debtors of RS could realize on assets of the sub whereas debtors of co. would be shareholders of the
sub and entitled to RS’ assets only after RS debtors’ claims were satisfied. [SH: if there was ever a
problem (b-ruptcy of both companies), creditors of SC wouldn’t have direct access to RS’ assets, i.e.
as creditors, but assets would be more liquid because subject to less debt. Once all of RS’ debtors
satisfied, TIB would sell shares of RS (an asset of SC) and used them to satisfy claims of SC’s
debtors]
Limitation on Restricted Payments
Company will not, and will not permit any of its restricted subs, to make any Restricted payment if, at the
time of such restricted payment and, after giving effect to the proposed restricted payment on a pro forma
basis, (a) event of default; (b) company would be unable to incur an additional $1.00 of debt and still
meet interest coverage ratio, etc.
“Restricted Payment”
(a) declare, pay or make dividends or distributions in respect of stock
(b) purchase, redeem, exchange or otherwise acquire or retire for value any capital stock of co. or
affiliates
OTHER THAN
(i)
stock dividends (provided not redeemable stock)
(ii)
dividends or distributions payable to company or wholly owned RS
(iii)
payments to eliminate fractional shares
(c) make any principal payment on, or redeem, repurchase, defease, etc. prior to any scheduled principal
or sinking fund payment, any indebtedness of the company or any affiliate which is subordinate in
right of payment to the senior secured notes
(d) make any investment in any person other than
(i)
permitted investments
Page 34 of 84
Corporate Finance SUMMARY
(ii)
December 2004
investments made by the co. in a wholly owned restricted sub
Limitation on ownership of capital stock
Company will not permit any Peron (other than the Company or any wholly owned RS) to own any
capital stock of any RS.

All restricted subs must be wholly owned. Minority SHs make it difficult to get to RS’ assets.
Negative Pledge
Property other than Collateral – co will not incur any liens (other than permitted liens) without at same
time causing the Senior Secured Notes to be secured equally and ratably with the Indebtedness secured by
such Lien.
Collateral (i.e. property securing these notes) – Company will not and will not permit any of its restricted
subs to, incur any lien of any kind upon any of the Collateral except for permitted collateral liens

In secured instrument, will always be two negative pledges, one dealing with liens on collateral (very
restrictive pledge) and one dealing with liens on all other assets (not collateral; much more liberal
pledge)
Limitation on sale-leaseback transactions
Company will not enter into or otherwise become liable with respect to any sale-leaseback transaction
involving any of its property, unless…
Notwithstanding the foregoing, the Company will not enter into or otherwise become liable with respect
to, any Sale-Leaseback transaction involving the collateral.
Limitation on distributions from restricted subs
The Company will not, and will not permit any of is RS to, create any consensual encumbrance or
restriction which by its terms expressly restricts the ability of any RS to (a) pay dividends in cash or
otherwise; (b) repay indebtedness to the company; (c) make loans to the company or any of its RS, etc.

How might an RS limit its ability to make distributions? By incurring debt and agreeing to include a
restricted payment clause
Limitation on Transactions with Affiliates
Company will not, and will not permit any of its RS to, conduct biz or enter into any transactions with
affiliates unless (a) no less favourable than what would be obtained in arms length transaction, etc.
Limitation on Consolidations, Mergers, Conveyances, Transfers and Leases
**The successor-obligor clause
[Note: see attached description of mergers/consolidations]
Why important? To figure out whether a transaction falls w/in this clause, need to know how the
transaction is structured.
The Company will not, and will not permit any RS to, enter into any transaction or series of transactions
to consolidate or amalgamate with or merge with or into any other Person (other than the consolidation,
amalgamation or merger of a wholly owned RS with another wholly owned RS or into the company) OR
sell, convey, assign, transfer, lease or otherwise dispose of all or substantially all of its Property
Page 35 of 84
Corporate Finance SUMMARY
December 2004
(determined on a consolidated basis for the Company and its RSubs taken as a whole) UNLESS
(a)
 The co. is the continuing person in the case of a merger OR
 If the surviving entity is other than the company, the surviving entity is a US or Cdn corp, AND
assumes all obligations under the indenture
(b)
 Immediately before and after giving effect to such transaction or series of transactions on a pro forma
basis, no Default or Event of Default shall have occurred and be continuing
(c)
 After transaction, must be able to incur $1.00 of additional debt in compliance with basic limitation
on indebtedness (i.e. the ratio). [MB: sets bar higher than under the covenants; must not only meet
ratio but be able to meet it if incurred $1.00 of additional debt]
(d)
 After merger, must have a consolidated net worth (value of co. less debt) equal to or greater than the
consolidated net worth going in.
(e)
 Must deliver certificate which says that merger is in compliance with all terms of indenture.
*Under these terms, merger/amalg must not just not make the company worse-off, but must keep
company stable or make it better
*Note that this SO clause is only triggered if there is an actual merger, consolidation, amalgamation or
asset purchase. Mere share purchase (not followed by short-form amalgamation), i.e. a change of control
wouldn’t trigger the SO clause. It would, however, trigger the change of control clause
Change of Control
Following any change of control triggering event, each holder will have the right to require the
Company to repurchase such Holder’s notes (a “Change of Control Offer”) at a purchase price in cash
equal to 101% of the aggregate principal amount, plus accrued and unpaid interest to the date of purchase.
A change of control triggering event requires both the occurrence of a change of control and a rating
event (downgrading by a credit agency).


As result of RJR Nabisco, all indentures will now have change of control provision.
Why necessary? B/c value of debt can deteriorate depending on who buys the company
Limitation on Asset Sales
Company will not consummate or permit any Asset sale. Sale of asset = event of default unless (a)
consideration = FMV; (b) 75% of consideration is in cash or cash equivalents; and (c) proceeds are
applied to purchase additional assets, repay senior indebtedness other than these Senior Secured Notes, or
make a Senior Secured note offer.
Sharon Steel Corp. v. Chase Manhattan Bank, N.A., [1982] 2nd Cir.
Facts:
- UV Industries had $155 MM of long-term debt outstanding pursuant to 5 different indentures.
- Each indenture allowed for redemption at a premium prior to maturity and contained a successor
obligor clause which allowed UV to assign its debt to a corporate successor that purchased “all or
substantially all” of UV’s assets.
- UV operated three separate lines of business:
- Federal Electric Co.: generated 60% of UV’s operating revenue and 81% of operating profits. It
constituted 44% of the book value of UV’s assets and 53% of operating assets.
Page 36 of 84
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December 2004
- Oil and Gas Properties: produced 2% of operating revenue and 6% of operating profits. These were
5% of book value assets and 6% of operating value assets.
- Mueller Brass: produced 13% of profits, 38% of revenues and constituted 34% of book value assets
and 41% of operating assets.
- Cash: in addition, it had cash or other liquid assets amounting to 17% of book value assets.
- In 1979, UV’s shareholders approved a plan to sell Federal Electric and within 12-months to liquidate
and sell the remaining assets. Also, sold most of its oil and gas properties.
- Later in 1979, Sharon Steel proposed to buy UV’s remaining assets (Mueller Brass and cash). It entered
into an agreement for purchase of assets (Mueller Brass) and an instrument of assumption of liabilities
(assumed UV’s debt).
- Sale to Sharon included agreement that Sharon assume all of UV’s debt obligations. UV and Sharon
thought that Sharon was purchasing “all or substantially all” of UV’s assets within the meaning of the
successor obligor clauses. Therefore, they believed that they could transfer debt.
- Trustees disagreed. Sharon, in an attempt to formalize its position as successor obligor, delivered to the
trustee supplemental indentures executed by Sharon and UV. Indenture trustees refused to sign them.
- Trustee issued notices of default (as result of UV’s purported assignment of its obligations to Sharon)
and brought actions for redemption of the debentures.
Issue:
Did UV transfer all or substantially all of its assets to Sharon within the meaning of the successor obligor
clause? How are successor obligor clauses to be interpreted?
Held:
No
Ratio:
Interpretation of Indentures
- S.O. clauses are ‘boilerplate’ clauses and must be given a consistent, uniform interpretation
- They do not depend on particularized intention of parties to the indenture and therefore are a matter of
law and not fact
- Uniformity in interpretation of indenture language is important to the efficiency of capital markets b/c it
makes it easy for buyers to compare one debt issue with another. Uncertainty as to meaning of
boilerplate provisions would decrease the value of debenture issues and increase risk and cost of
borrowing. [MB: interpret provisions by looking to expectations of parties in the market]
Meaning of successor obligor clause
- Were all or substantially all of UV’s assets transferred to Sharon?
- Must look at purpose underlying S.O. clause. Sharon argues that S.O clause protect only borrowers
[SH: enable them to undertake transaction that wouldn’t otherwise be permitted to undertake provided
that assign debt]
- Court disagrees. S.O. clauses protect borrowers and lenders. Borrowers are enabled to sell entire
businesses and liquidate, to consolidate or merge with another corporation, or to liquidate their
operating assets and enter a new field free of the public debt. Lenders are assured a degree of
continuity of assets, i.e. that the principal assets of a borrower will be available for the satisfaction of
the debt.
- Where K-ual language is designed to protect the interests of both parties and where conflicting
interpretations are argued, the K should be construed to sacrifice the principal interests of each party as
little as possible.
- What are the contending positions here? Indenture trustees argue that proceeds from earlier sales in
a predetermined plan of piecemeal liquidation may be counted in determining whether a later sale
involves ‘all assets.’ Sharon argues that on Nov. 26, 1979, it bought everything that UV still owned
and therefore that the transaction was a ‘sale’ of ‘all’ of UV’s ‘assets.’
Page 37 of 84
Corporate Finance SUMMARY
December 2004
- The trustees’ interpretation best accommodates the principal interests of corporate borrowers and
lenders.
- Boilerplate successor obligor clauses do not permit assignment of the public debt to another party in the
course of a liquidation unless “all or substantially all” of the assets of the company at the time the plan
of liquidation is determined upon are transferred to a single purchaser. The Sharon transaction involved
only 51% of the book value of UV’s total assets. This is not ‘all or substantially all’ of UV’s assets.
The successor obligor clauses are therefore not applicable – UV is in default on the indentures and the
debentures are due and payable.
Must UV pay redemption premiums?
- Trial judge found that UV defaulted [SH: why?] under the indenture agreement and that the default
provisions provide for acceleration rather than a redemption premium.
- This court disagrees. Acceleration provisions of the indentures are explicitly permissive and not
exclusive of other remedies. We see no bar to trustees seeking specific performance of the redemption
provisions where the debtor causes the debentures to become due and payable by its voluntary actions.
This is not a case where debtor finds itself unable to pay. Default here stemmed from plan of
voluntary liquidation. The purpose of a redemption premium is to put a price upon the voluntary
satisfaction of a debt before the date of maturity. [SH: Where default is voluntary and principal is paid
before date of maturity, debt holders are entitled to the redemption premium. Shouldn’t give benefit of
voluntary default to defaulting party.]
Barbeau:
- SH approval cases suggest that 51% might be “all or substantially all”
Morgan Stanley v. Archer Daniels Midland Co., [1983] S.D.N.Y. p. 112
Facts:
- In 1991, ADM issued $125 million in 16% sinking fund debentures
- Indenture set out table of optional redemption prices should ADM decide to redeem bonds before
maturity (2011)
- However, indenture also provided that, prior to May 15, 1991, ADM could not redeem the debentures
with funds borrowed at an interest rate lower than the debenture interest rate. [protect debt holder if
interest rates fall]
- In 1982 and 1983, subsequent to issuance of these debentures, ADM raised money through public
borrowing at interest rates less than 16%. ADM also raised money through two common stock
offerings.
- In 1983, Morgan Stanley bought some debentures for prices which exceeded ADM’s optional
redemption price for 1983. The next day, ADM announced that it was calling for the redemption of the
16% sinking fund debenture. The direct source of funds was to be two ADM common stock offerings
of Jan and June 1983.
- Morgan claimed that proposed redemption was barred by the express terms of the call provisions of the
indenture. Claimed that the two public borrowings at rates less than 16.08% were at least indirectly
funding the redemption and that the stock issuance was an irrelevant ‘juggling of funds’ used to
circumvent the protections afforded investors by the redemption provisions of the debenture.
- Morgan claimed that provision should be interpreted as barring redemption during any period when
issuer has borrowing at rate lower than 16.08%, regardless of whether the direct source of the funds is
issuance of equity, sale of assets, or merely cash on hand.
Issue:
Do these call provisions mean that there is absolute restriction on redemption of the debentures if issuer
engages in contemporaneous lower-cost borrowing?
Page 38 of 84
Corporate Finance SUMMARY
December 2004
Held:
No
Ratio:
- The source of funds is the dispositive factor in determining the availability of redemption to the issuer
- Also, language of redemption provision supports dft’s interpretation: broad language allowing
redemption at election of the company followed by restrictive phrasing of limit on redemption.
- Ptf’s fear that bondholders would be left ‘unprotected’ by adoption of the ‘source’ rule is overstated.
Issuer contemplating redemption must get money from source other than lower-cost indebtedness (i.e.
from reserves, sale of assets or proceeds of cmn stock issue). BHs thus protected against short-term
refunding of debt during times of plummeting interest rates (exactly what provision was intended to
protect against). Also, this is not a case where protections against premature redemption are absent:
indenture provides for early redemption premium.
- [NB: court prefers this ‘source’ approach to a case-by-case approach (i.e. which looks to the magnitude
of the borrowing and to the time period between borrowing and redemption). This type of approach
would result in too much uncertainty.]
RULE: Source of funds is key factor in determining availability of redemption to issuer.
Redeeming bonds while contemporaneously engaging in lower-cost borrowing doesn’t offend a provision
that prohibits redemption with proceeds of lower cost borrowing. Ask: What is the direct source of
funds for the redemption? (2) [as in Sharon] Subjective expectations of the BHs are irrelevant when
dealing with indentures, and boilerplate provisions in particular.
Barbeau:
- Case shows that bond indentures are narrowly construed. If provision doesn’t explicitly prohibit it, then
is not prohibited. There are ways to draft redemption provision such that MS would have gotten what it
wanted.
Metro Police v. Telus, [2003] Ont. S.C.J. p. 137
Facts:
- BC Tel redeemed bonds using proceeds of a securitization transaction entered into btwn Telus and
RAC (a special purpose vehicle or “SPV”)
- Plaintiff bondholders claimed that redemption breached the No Financial Advantage Covenant
(NFAC) which provided that: The Company shall not redeem bonds other than for sinking and
improvement fund purposes by the application, directly or indirectly, of funds obtained through
borrowings having an interest cost to the Company < 11.35%.
- Proceeds of securitization transaction were deposited by BC Tel in a separate bank account and
applied directly toward redemption of bonds.
- [Court describes mechanics of the receivables purchase agreement and the concept of securitization, a
corporate financing mechanism which became prevalent in the late 80s early 90s]
- Both BC Tel and RAC intended the securitization transaction to be a sale of the Purchased
Receivables; both parties would obtain all benefits of the transaction only if it was a sale
Issues:
1. Were bonds redeemed by indirect application of borrowed funds having interest cost to BC Tel of
less than 11.35%?
2. Direct application?
3. Did redemption effect result that unfairly disregarded interests of Bond holders?
Page 39 of 84
Corporate Finance SUMMARY
December 2004
Held: No, no and no
Ratio:
Indirect Application of Funds
- Court cites Shenandoah Life Insurance: inclusion of ‘indirect’ language is intended to reach
situations in which underlying economic reality of completed transaction is the functional equivalent
of a direct loan for purposes of effectuating a redemption [see e.g. at 141 CB]
- Ptfs claimed that such analysis applicable to case at bar. Court disagreed:
o Securitization transaction approved by Board separately from approval of redemption
o Securitization not approved strictly for purpose of using proceeds to redeem the Bonds
o Securitization transaction was beneficial in and of itself (even if not combined with
redemption)
o In order to find that transaction was indirect application of funds obtained through
borrowings, the transaction would have to have been constructed by BC Tel, specifically and
exclusively for the purpose of redeeming the Bonds and have no independent economic
function either from the perspective of BC Tel or of RAC
o [Note that court agrees with Ptf’s submission that the ‘purchase discount’ stipulated in RACBC Tel Agreement is simply a flow through to BC Tel of the interest cost payable to RAC on
borrowings made by it through the issuance of commercial paper but this fact is not
necessarily determinative of whether or not the transaction represents an indirect borrowing
by BC Tel]
Direct Application of Funds
- Were funds received by BC Tel borrowed funds? I.e. was securitization agreement a secured loan or
a sale?
- To make this determination, must look at intention of parties (evidenced by language of K), how
trans-axn transpired, conduct of parties in K performance, AND at factors which can be used to
determine whether a transaction is a true sale (ownership risk and recourse, right to surplus,
determination of purchase price, ID of assets, collection of receivables, right of redemption)
1. Intention of Parties
- wording of the agreement clearly indicates the intention of both parties that the transaction be a true
sale. Parties could only get full benefit of the transaction if it was a sale.
2. Ownership Risk and Recourse
- True sale transaction: must be transfer of ownership risk to the purchaser. Most significant factor in
determining degree of ownership risk transferred – extent of recourse the transferee (of receivables)
has against the transferor. Greater recourse = less likely to be characterized as true sale
- Ptfs argue that RAC had, under agreement, full economic recourse, i.e. which would guarantee a
return on the investment regardless of quality of assets sold. Court disagrees: recourse is clearly a
recourse as to collectibility only. [RAC assumes risk of uncollectibility in case of insolvency of BC
Tel]
3. Rights to Surplus
- surplus remains with BC Tel
- Inability of purchaser to retain surplus is not fatal to characterization of a transaction as a true sale.
4. Determination of Purchase Price
- Certainty of purchase price is a fundamental element of a sale transaction. The purchase price of the
subject matter of the transaction between BC Tel and RAC on any given day can be determined.
Price is therefore not uncertain
5. Identification of Assets
- subject matter of the sale must be ascertainable. Here, the subject matter of the sale of receivables
from BC Tel to RAC was ascertainable on any particular day. Fact that Agreement contemplated that
a receivable might, under certain circumstances, be reconveyed to BC Tel, doesn’t derogate from fact
that original conveyance was a true sale
Page 40 of 84
Corporate Finance SUMMARY
December 2004
6. etc. (this is all irrelevant)
- Bottom line: none of the factors considered in determining whether true sale or secured loan
transaction negates clear wording of the Agreement and clear intention of the parties that the
transaction be a true sale of receivables
Oppression
- Did the directors, in effecting redemption through the proceeds of the securitization transaction
unfairly disregard the interests of Plaintiffs as security holders?
- Must look at the reasonable and legitimate expectation of security holders
- Reasonable legitimate expectations of the BHs were not frustrated by action of directors in approving
securitization and redemption b/c BHs were aware that Bonds could be redeemed by application of
proceeds of sale of assets. If anything, reasonable expectations of BHs were frustrated by the fact that
securitization developed as a financing mechanism after the bonds were purchased and that courts
have interpreted such transactions as being sales, not borrowing transactions.
POINTS:
1) Action under indenture (K) and in oppression (s. 241 – were reasonable and legitimate expectations,
raised in the mind of security holders by the words or deeds of the issuer, frustrated? Here no, b/c
BHs were aware that Bonds could be redeemed by proceeds of sale of assets.)
2) “Indirect application of borrowed funds”  look to whether transaction has independent value of
its own, whether it was approved strictly for purpose of redeeming bonds. Is the economic effect of
the transaction a loan?
3) Interpretation of indentures – will be very narrowly construed; if no express prohibition, not
prohibited.
(b) Fiduciary, Fairness and GF Obligations
Express contractual obligations (e.g. NFAC – no financial advantage covenant) vs. implicit K-ual
obligations (GF) vs. obligations that exist outside of the K (fiduciary). How are the latter two relevant in
trust indenture/debt instruments context?
Metropolitan Life Insurance Co. v. RJR Nabisco, [1989] S.D.N.Y p. 161
Facts:
- Met Life held bonds of RJR Nabisco, a very senior issuer
- Nabisco such a senior issuer that, over course of term, had been able to ‘strip out’ some covenants
and replace them with less restrictive ones.
- 1988 – bidding war. KKR used debt-financed acquisition vehicle to buy RJR for $109 per share (i.e.
a ‘leveraged buy-out’ or LBO). [Pressure from KKR debt-holders to merge with RJR so that not
structurally subordinated to RJR debt holders]
- 1989 – KKR holding company and RJR merged and RJR thereby [pursuant to successor obligor
clause in KKR indenture?] assumed $19 billion of new debt
- [Risk profile of co. changed b/c assumed high-yield debt = value of bonds dropped = bondholders
complained]
- Ptfs alleged that RJR’s actions drastically impaired value of bonds by, in effect, misappropriating the
value of those bonds to help finance the LBO and distribute windfall to SHs.
- Claimed that RJR violated an implied restrictive covenant of good faith and fair dealing by incurring
debt necessary to facilitate the LBO and thereby betraying the ‘fundamental basis of ptf’s bargain
with the co.’ [i.e. that securities were investment grade]
Issue:
Page 41 of 84
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December 2004
Does indenture include an implied covenant of GF and fair dealing and if so, was it breached?
Held:
No
Ratio:
- No express covenant restricted incurrence of new debt. This court will not imply a covenant to
prevent the LBO and thereby create an indenture term which, while bargained for in other contexts,
was not bargained for here.
- Implied covenant of GF is appropriate in some circumstances: Where one part has effectively
deprived the other of the express, exclusively bargained for benefits of the K, court will read an
implied covenant of GF and fair dealing into the K to assure that neither party deprives the other of
the fruits of the agreement. That is, the implied covenant of GF is only breached when one party
seeks to prevent the contract’s performance or to withhold its benefits. It ensures that the parties to a
K perform the substantive, bargained-for terms of their agreement.
- An implied covenant derives its substance directly from the language of the Indenture. E.g. BH’s
right of conversion – if borrower gives inadequate notice of redemption, and BH is not able to
exercise right of conversion before deadline, court might imply obligation of GF (i.e. must act with
GF in giving the notice) in order to protect plaintiff’s bargained-for right of conversion.
- Appropriate analysis: examine the indentures to determine ‘the fruits of the agreement’ between the
parties, and then decide whether those ‘fruits’ have been spoiled. In this case, substantive ‘fruits’
guaranteed by indenture include periodic interest payments and eventual repayment of principal.
There is no evidence that these obligations were breached or exercised in bad faith.
- Fruits of these indentures do not include an implied restrictive covenant that would prevent the
incurrence of new debt to facilitate the recent LBO. Plaintiffs do not invoke a covenant of GF to
protect a legitimate, mutually contemplated benefit of the indentures; they seek to have Court create
an additional benefit for which they did not bargain. Limitation on incurrence of additional debt [or
obligation to maintain credit rating] has been expressly bargained for in past contexts.
- Ptfs are asking the Court to make sure they have a good investment. Defendants were not under duty
to make sure that plaintiffs had made good investment but to carry out the terms of the agreement.
- Court must not ignore the expectations of the market. Market doesn’t expect courts to add new
substantive terms to indenture as they see fit. Also, market, in evaluating bonds such as these,
probably discounted for possibility that company might engage in LBO heavily financed by debt.
- Courts are reluctant to imply into an integrated agreement terms that have and remain subject to
specific, explicit provisions, where the parties are sophisticated investors, well versed in the market’s
assumptions, and do not stand in a fiduciary relationship with one another.
Fiduciary duty claim
- Corporate bond issuer does not have fiduciary duty to bondholders not to engage in leveraged by out
which reduced value of the bonds
RULE: An obligation of GF may be implied where necessary to give effect to or protect existing
obligations, but will not be implied in order to create a term, covenant, etc. which was not bargained for.
Terms of indenture limited to the four-corners of the agreement. Rationale for this rule: terms of
indenture are expressly bargained in advance; expectations of the market – certainty, etc; bargaining
power of parties – these were sophisticated investors. [SH: try to delineate the rights under the indenture
and then determine whether actions effectively denied BH these rights]
Notes:
- Court says that could have bargained for a change-of-control provision (i.e. change of control = debt
redeemed). In fact, as result of this case, change-of-control provision is now standard in trust
indentures.
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Note that Met Life internal memos suggested that ptf was very aware of possibility of LBO and fact
that there was nothing in indenture to protect them against effects of such an LBO.
Discussion of parol evidence rule
SH: consider People’s here – no fiduciary duty owed directly to corp’s creditors.
Millgate Financial Corp. v. BCED Holdings Ltd., [2003] Ont. S.C.J. p. 181
Facts:
- BCED issued $100 million in convertible, subordinated, and unsecured debentures and, 2 years later,
became insolvent and defaulted on interest payments
- As part of some post-issuance financing, BCED had transferred 16 of its properties to a subsidiary,
and provided security (in form of share-pledge and guarantee) to the company that was financing it.
- Ptfs alleged that these actions constituted breach of trust indenture, oppression (s. 241), breaches of
fid duty and fraudulent conveyance.
Issue:
1) Was conveyance a breach of the indenture?
Held:
Ratio:
(b) Securities Legislation
Deutsche Bank Canada v. Oxford Properties, [1998] Ont. Ct. J., p. 200
Facts:
- Ptf purchased $30 million in Oxford convertible debentures in reliance on reps made in prospectus
- Prospectus stipulated conversion price and provided that, if certain events occurred (including
distribution to all common shareholders of any securities or assets other than cash dividends and
equivalent stock dividends in ordinary course), conversion price would be adjusted OR convertible
debenture holders would be allowed to participate in distribution.
- As part of merger effected by plan of arrangement, Oxford distributed to its SHs 70% of the shares in
Concord Pacific, a wholly owned sub of Oxford.
- DB argued that this dividend was not a dividend in the ordinary course and, alternatively, that
Oxford’s treatment of debenture-holders amounted to oppression.
- Oxford, relying on the def’n of “Dividends Paid in the Ordinary Course” found in indenture, claimed
that the dividend was a dividend paid in ordinary course and thus did result in conversion price
adjustment or permit DB to participate in the distribution.
Issue:
Is DB entitled to conversion price adjustment or participation in distribution? [How does court deal with
inconsistent indenture and prospectus?]
Held:
Yes
Ratio:
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Language of indenture
- Under specific indenture def’n, the Concord dividend was a “dividend paid in the ordinary course.”
- More is required, however, than a telescopic reading of the indenture terms alone.
- The indenture must be considered, interpreted and given its effect in light of the reps made in the
Prospectus. It is inappropriate to ignore the documentation of the deal.
- How must this ‘documentation of the deal’ be interpreted? Give words their plain and ordinary
meaning and do not interpret clauses out of context.
- The plain meaning of dividend in ordinary course is a dividend paid to the shareholders in the normal
fashion out of profits and other amounts available for distribution as a result of the operations of the
corp.
- Absent the special def’n in the indenture, the Concord dividend is not a dividend paid in the ordinary
course as that term is generally understood. Concord dividend was an isolated transaction
unrelated to the normal day to day business of Oxford. It was not a dividend paid out of earnings
in the ordinary way. In fact, Oxford used the dividend as ‘bait’ to attract SH approval for plan of
arrangement, and in doing so called the dividend a “special dividend.”
Oppression
- Oxford’s act or omission in failing to ensure that the language of the Indenture was true to the
representations it made in the prospectus, and in failing to accord DB conversion price adjustment
under the debentures were “unfairly prejudicial to” the interests of DB, or at least they “unfairly
disregarded” those interests.
- [I.e. judge comes to some conclusion on oppression remedy basis]. Judge emphasizes that dft’s
argument that DB was sophisticated market player and should have known to check the indenture
before investing cannot carry the day. The indenture was executed after most of the debentures were
already purchased.
- What about buyers in secondary market – will they be able to make the same claim? Court suggests
yes: “The Debentures are marketable securities, and there cannot be one set of terms governing those
purchased before the closing and another set of terms for the same Debentures purchased after
closing.”
RULE: Indenture will be interpreted in light of reps made in the prospectus, i.e. the documentation of the
deal. When interpreting these documents, give words their plain meaning and do not interpret clauses out
of context. [SH: If prospectus and indenture are inconsistent, favour interpretation which accords with
plain meaning of provisions/terms/etc. and which matches the expectation of the markets].
Quebec Securities Act
3. Convertible Securities and Warrants
(a) Conversion Provisions and Other Terms of Issuance
Options
- Two kinds  put and call
- Put = option to sell object (usually stock) at specified price during specified term
- Call = option to buy object (usually stock) at specified price during specified term
-
Warrants: options that are traded in the market; ‘options’ usually held by management and warrants
usually held outside of management. Warrants often issued in combination with publicly issued
bonds and common and preferred shares. Principles/valuation/etc. the same as options.
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Price of Option
 Exercise price – price which option-holder must pay option-giver in order to obtain the
underlying object. Note that exercise price may be adjusted in certain circumstances.
 Option price – price which option-holder pays to get an option in the first place. An option has
its own intrinsic value, i.e. gives holder the option to wait and see, to decide whether want to
buy or not, and in the meantime to hold onto (and presumably invest) the money that might
have been used to buy shares. This value disappears upon expiry of option (after term, value =
0).
Option Term
 American style options – can exercise at any point during term of option
 European style options – can exercise only at end of option (i.e. in window before expiry)
 Asian style options – can exercise option at specific points during term
 NB: Most options get exercised at the last minute, i.e. on expiry date, if Pmkt > Pex  exercise
option, sell shares and make a gain. If Pmkt < Pex, walk away having lost only the option
value. Why exercise at last minute? Can use capital elsewhere while waiting to see if value in
underlying security.
 NB: Even if market price increases significantly mid-term, would probably sell option rather
than exercise (i.e. if you just wanted to take advantage of the increase in price). If really
wanted the shares, then might exercise [SH: but if you had really wanted the shares, you could
have bought them in first place rather than buying an option]
Object (i.e. subject matter of the option)
 Usually common shares, but could be something else (e.g. a gov’t bond)
Value of an option
 If share price rises above exercise price, value of option will rise. Value will probably be
greater than (share price – exercise price) in order to account for the option value.
 If share price falls below exercise price, value of option will fall. Value will still be positive,
however, b/c of intrinsic option value.
o E.g. At given time, Microcell share price = $16. Exercise price of warrants (traded
options) = $20. Market value of warrants = $2.05!
Two types of share options – granted by co. vs. by third party
 Corp grants option – in case of warrants, convertible debentures and mgmt stock-options
o Each time one of these options is exercised, the company must issue a new share (i.e.
increase amt of shares outstanding).
 Third party grants option – i.e. existing SH of company finds 3rd party and grants him option to
buy. If option is exercised, no new share is issued; existing share merely changes hands.
o An arbitrager might enter into such an option agreement ‘short’ – i.e. grant option to buy
something which he doesn’t own. If option is exercised, must go out and buy it.
Arbitrager hopes that value of the underlying object will fall (and option will thus not be
exercised?)
Physical vs. cash settlement
 Physical settlement: pay exercise price and get share
 Cash settlement: option-giver pays option-holder the difference between the share price and the
option price.
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
December 2004
Options granted by corporations rarely settled in cash. WHY? Physical settlement much more
attractive to co. and its creditors b/c it increases capital of corp by exercise price. Cash
settlement depletes cash resources, i.e. takes cash from working capital.
Cashless exercise: closest that issuer will get to cash settlement. Corp cancels option and gives
option-holder amt of shares corresponding to difference btwn share price and exercise price
[i.e. Number of shares = (share price – exercise price)/share price]
Option-holders are not shareholders
 Option-holders are not shareholder b/c shares are not fully paid, i.e. no such thing as shares not
fully paid for.
 Option-holders don’t have right to vote (Molson example), though in case of
merger/acquisition, they participate in decision-making process to the extent that tendering of
options, warrants, etc. contributes to 66 2/3% condition (i.e. condition of most deals).
Futures/Forwards
- While option creates right to buy at a certain price by a certain date, futures/forwards are K-ual
obligations to buy at given price on given date, i.e. effectively a contract of sale at future date
- Forward contracts are private contracts negotiated between private parties, i.e. ‘over-the-counter’
derivatives.
- Futures contracts are market-traded. They are standardized contracts that may be bought and sold on
an organized exchange. When one purchases a futures contract, the other party to the contract is the
exchange itself, not a dealer.
- Options, futures and forwards all trade as a function of future value.
Trading value of future/forward vs. option
 Future/forward vs. option with same underlying object, term and exercise price – option will
trade at higher price. WHY? B/c can choose not to buy or to buy. Loss suffered if mkt price
falls below exercise price is greater in case of forward/future than in case of option.
Rights Offering
- co. issues to existing shareholders an option to buy company stock at specified price w/in a specified
time. (usually offered at discount off of market price)
- Rational SH will only subscribe to the rights offering if subscription price is below the market price
of the stock on the expiration of the offer date.
Convertible Bond/Debenture
- Debt obligation PLUS option to buy shares. The two are inseparable, i.e. the debt must be converted
into shares; debt holder cannot keep debt and buy shares at conversion price
- Indenture will stipulate conversion price
- Note that conversion price will be adjusted in certain circumstances (always check debenture)
- Convertible bonds are often unsecured and subordinate (i.e. greater risk BUT potential reward if
underlying shares gain in value). Will likely also have lower interest rate than non-convertible debt
- Value of convertible debt: behave like debt as long as market price is lower than conversion rate. If
market price rises above exercise price, value of convertible debt will rise also.
Call vs. Put
 Call: option (of holder) to convert debt into stock
 Put: option (of issuer) to repay debt in stock (i.e. issue # of shares that, at market value, equals
principal owed to debt holder).
 Indenture usually has exception such that co. cannot put if insolvent
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Priority of call over put
 Typical convertible debenture indenture will give overriding option to the debt holder
(assuming it has both a put and a call feature)
 $300 debt. Conv price = $30. Mkt price = $10. Debt holder will wait for co. to repay in cash
or ‘put’ (i.e. repay in shares) unless market price rises above $30.
 $300 debt. Conv price = $30. Mkt price = $60. If debt holder exercises his option (i.e. buy
10 shares), co. cannot put 5 shares (?)
Adjustment clauses in warrant or conv-deb indentures
What happens to convertibility feature if shares into which debt is convertible are redeemed, converted
(into different kind of share or into cash), split, consolidated or transformed by a fundamental transaction
such as a merger/acquisition? Look to indenture  adjustment clause.
S. 4.9: Adjustments
Sub (2) - Distributions
Current share rate = 1 share per warrant. This rate may be adjusted from time to time,
(a) where corporation (1) splits shares; (2) consolidates shares; (3) issues shares to all or substantially
all of the holders of shares by way of stock dividend or other distribution (other than an ordinary
course dividend)
(b) if at any time the corporation issues rights, options or warrants to all or substantially all of the
holders entitling them to subscribe for or purchase shares at a price per share less than 95% of the
current market price. Share rate will be readjusted to extent that rights, warrants or options are not
issued or not exercised.
(c) If at any time corporation makes a distribution to all or substantially all the holders of shares of (1)
shares of any class other than shares which warrant gives option to buy, whether shares of the issuer
or another corp; (2) rights, options or warrants other than those in (b); (3) evidence of indebtedness;
(4) cash, securities or other property or assets (other than an Ordinary course dividend)




Note that split/consolidation requires SH approval therefore stock dividend (i.e. board takes retained
earnings and transforms them into capital) is more popular way to increase # of outstanding shares
Note that (b) only applies where discount off market price is > 5%. Why? 5% not really a discount.
Get 5% off b/c company is issuing shares directly and doesn’t have to pay commission to underwriter.
Any discount > 5% is effectively a distribution of value to existing SHs (see Sabex).
Note that share rate not adjusted if co. issues ordinary course dividend (see def’n of this in Deutsche
Bank). Warrant holders must agree to allow co. to issue dividends in ordinary course.
If warrant holder didn’t have protection in form of adjustment clause, could always exercise, i.e.
become a SH and get the distribution of rights or the benefit of the stock split. BUT, warrant-holder
doesn’t want to be forced to exercise; warrant-holders pay for the opportunity to ‘wait and see.’
Sub (3) – Fundamental Transactions
(a) If there is (1) any reclassification of the shares or any change of the shares into other shares,
securities or property of the Corporation; (2) any amalgamation, arrangement, merger or other form
of business combination with or into any other corp resulting in any reclassification of the shares or
a change of the shares into other shares, securities or property of the corporation; or (3) any sale,
lease, exchange or transfer of all or substantially all of the undertaking or assets of the corporation
to another corporation [(1), (2) and (3) = Fundamental Transactions] THEN
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Any holder of warrant which is thereafter exercised will get what he would have been entitled to
receive if he had been the registered holder of the number of shares to which he was entitled upon
such exercise.
(b) IF there is fundamental transaction which provides for holders of outstanding shares to receive
consideration solely in the form of cash: (1) where cash consideration > exercise price, WH will
receive the cash consideration which he would have been entitled to receive had exercise taken place
immediately prior to the fundamental transaction [less the exercise price]; (2) where cash
consideration < exercise price, WH will be deemed to surrender its warrants, w/o payment of
consideration. Following such deemed exercise, all Warrants shall be cancelled and of no further
value or effect.



If no such clause (e.g. Empire), then even if all of company’s shares are acquired and de-listed,
convertible debentures will continue to exist. [Buyers don’t like this (?)]
Rationale behind these clauses: if underlying security holders approve something, accessory holders
(i.e. option holders) should follow.
Effect of this clause is that indenture relates to the transformed underlying security. In case of (a) 
warrant to buy transformed security, can exercise or not. In case of (b)  warrant to buy cash, but
holder cannot choose whether wants to exercise or not – he is deemed to have exercised and warrant
is cancelled.
Microcell example
- Bidder offered price for 2005 and 2008 warrants equal to price offered per share minus exercise price.
BOD couldn’t get fairness opinion from financial advisors, b/c this price didn’t take account of the
option value of the warrant (i.e. didn’t expire until 2005 and 2008 therefore had intrinsic value).
BOD did recommend that SHs accept the offer.
Cases
Sabex
Gardner and Florence Call Cowles Foundation v. Empire Inc., [1984] S.D.N.Y. p. 214
Facts:
- Ptfs owned 9% convertible subordinated debentures of Empire. Conversion price = $48.75 per share,
i.e. 20.51 shares per $1000 face value of debenture
- Empire merged with Exco Acquisition Corporation. Empire was surviving corp.
- Immediately prior to merger, shares were trading at $20. To effect merger, Exco issued 3 million
shares, which were purchased by dfts for $30,000 in aggregate. 96% of Empire shareholders
approved the merger, and exchanged each outstanding common share for $22 in cash and one new
debenture with market value equal to $5 (= share price + premium of $7).
- Following purchase of outstanding stock, each share of Exco common stock was converted into one
share of Empire common.
- Prior to merger, each debenture holder was given opportunity to convert at price of $48.75 and
receive the same consideration ($27) received by the Empire SHs in the merger. Alternatively, could
hold onto debentures and, following merger, their debentures would continue to be convertible to
Empire common shares. None of debenture holders converted b/c debentures were trading at greater
than $27.
- Ptfs claimed that (1) Empire breached indenture b/c did not adjust conversion price pursuant to s.
4.05(c) of Indenture and that (2) dfts breached fiduciary duty.
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Issue:
Breach of indenture? Breach of fiduciary duty?
Held:
No and no
Ratio:
Did Empire breach obligation under Indenture?
- s. 4.05(c): if company distributes to SHs debt or securities or assets (excluding cash dividends paid
out of retained earnings) or rights to subscribe therefor, conversion price shall be adjusted
- Ptfs argued – cash payment made in exchange for surrender of Empire shares constituted a massive
distribution of assets that triggered this section.
- Court rejects. Doesn’t need to decide whether this transaction constituted a massive distribution of
assets b/c this is not the type of transaction that was intended to invoke adjustment under the 4.05(c)
- What is s. 4.05(c) designed to protect against? The section is an anti-dilution provision designed to
protect debenture holders against corp’s unilateral alteration of the value of their conversion right
through transactions that dilute the value of common stock.
- This section governs where there is a change in the relative position of shareholders, debenture
holders and the company.
- [court discusses ‘record date’ language in the provision]
- Indenture contains a separate provision which governs mergers, consolidations and reorganizations.
The fact that this section doesn’t apply to this merger (b/c Empire was surviving corporation) is of no
consequence.
Breach of fiduciary duties
- Ptfs alleged that dfts’ breached fid duties b/c merger resulted in financial windfall for the common
shareholders, at a corresponding cost to ptfs who now bear the risk that Empire may not be able to
satisfy its obligations to pay debentures when due. Ptfs also alleged that dfts’ actions destroyed the
value of their conversion right b/c new Empire stock into which now entitled to convert is worth less
than old stock.
- Court rejected.
- Fiduciary duties in a debenture K do not exist in the abstract but are derived from the Indenture itself.
Since the dft fully complied with its obligations under the Indenture can have no liability for breach
of fiduciary duty.
- What ptfs experienced was a risk inherent in investment.
- Dfts were under duty to carry out the terms of the K but not to make sure that ptfs had made a good
investment.
- Fact that dft financially successful in merger is not itself proof that he breached fid duty.
- Ptfs have not provided evidence that, as result of merger, Empire won’t be able to repay debt. Also,
actions of debenture holders and shareholders at time of merger strongly indicate that the conversion
right had long been rendered valueless by the operation of the market.
RULE:
1) Fid duties in debenture K do not exist in abstract, but are derived from the indenture itself.
2) Interpretation of conversion price adjustment clause – it is an anti-dilution provision intended to
protect debenture holders against corp actions which dilute the value of common stock.
Notes:
- Note discussion of Pittsburgh Terminal case: breach of fiduciary duty b/c dfts had intentionally
failed to notify debenture holders of an upcoming dividend, thus depriving them of an opportunity to
convert and participate in that dividend.
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Casurina Limited Partnership v. Rio Algom Ltd., [2004] Ont. C.A. p. 225
Facts:
- Ptfs held convertible debentures of Rio Algom. Conversion price = $40 per common share
- Debenture indenture included the following: (1) RA covenanted that, while debentures outstanding,
corp would maintain status as reporting issuer, and that the debentures and cmn shares would be listed
at time of issue on TSE. (2) Section requiring RA to protect the rights of debenture holders in event
of merger with another company or acquisition by another company BUT protection of rights not
required in event of “any sale, lease or exchange of all or substantially all the property of the
Corporation in the ordinary course of business.” (3) Section providing that failure to perform any
covenant is event of default and where event of default, trustee may give notice to corporation
declaring principal and accrued interest due and payable. (4) No-action clause which provided that
no debenture holder shall have right to institute any action or exercise any remedy under indenture for
purpose of enforcing payment of principal or interest owing on any debenture or for the execution of
any trust or power hereunder unless…[standard conditions]
- In 2000, Billiton made successful takeover bid for shares of Rio Algom. Shares were delisted,
rendering the convertible feature of the debentures of no further value. Billiton expected that
delisting of shares would be event-of-default, and offered to redeem the convertible debentures at par
(i.e. remedy provided for in indenture). DB holders refused.
- Ptfs brought application for oppression remedy. Claimed that had reasonable expectation that, (1) so
long as debentures were outstanding, common shares would always remain listed; (2) RA was
prohibited from entering into a merger or acquisition w/o protecting the conversion rights of the
debenture holders. The takeover breached the covenant that shares would remain listed AND
unfairly disregarded the interests of the DB holders b/c it effectively removed their conversion
privilege, a key component of the original value of the DBs. Remedy sought? B/c of oppressive
conduct, not limited to K-ual remedy but entitled to be compensated for loss of conversion privilege.
Issue:
Conduct of RA/Billiton oppressive? Does no-action clause preclude ptf from taking this action?
Held:
No and yes
Ratio:
- Covenant against delisting of shares: Indenture provided that delisting of shares was event-of-default
that could be remedied by redemption at par. Because indenture provided for this, DB holders could
not have reasonably expected that delisting would not occur, and that if it did, that they would receive
any remedy other than redemption at par. Indenture could have included provision to provide special
compensation to debenture holders in case of takeover bid, but it did not. [Cannot bargain ex-post].
- Oppression remedy will not be applied where parties have provided for their own remedy.
- Section re mergers and acquisitions: protects DB holders in the event of a merger or acquisition of
the corporation but not in the event of a takeover (i.e. where sale was not voluntary), the latter being
caught by the exception for “sale, lease or exchange of all or substantially all the property of the
Corporation in the ordinary course of business.”
Re-no action clause: doesn’t apply only to actions against the issuer (i.e. applies also to actions
against third parties – in this case, Billiton). Doesn’t apply only to claims under indenture (i.e. also
applies to oppression claims). Court distinguishes this no-action clause from that in Millgate.
RULE: Oppression remedy not available where parties have provided for their own remedy in the
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indenture.
Notes:
- Trust indenture is not a contract of adhesion; its terms are negotiated as part of the underwriting
process and the holders make a decision to purchase/not purchase based on these terms
Amaranth LLC v. Counsel Corp., [2003] Ont. S.C.J. p. 236
Issue: Does no-action clause preclude debenture-holders form taking oppression proceedings against
third parties?
Held: Yes
Ratio:
- Language of the clause, i.e. “all powers and trusts hereunder shall be exercised and all proceedings of
law shall be instituted by the trustee” includes the power given to the trustee to take all proceedings
necessary to protect or enforce the interests of the debenture holders and that would include
proceedings by way of oppression against the issuer of debentures and third parties.
- This makes good commercial sense – legal proceeding which affects the rights and remedies of the
holders of a class of securities should be brought by a trustee on behalf of all the holders, and thereby
avoid a multiplicity of proceedings and the possibility of conflicting results.
RULE: Interpretation of no-action clause – precludes DB holders from taking oppression proceedings
against 3rd parties.
Insight Venture Associates LLC v. SLMSOFT Inc., [2003] Ont. S.C.J. p. 237
(b) Implied Obligations
Harff v. Kerkorian, [1974] Del. Ch. Ct. p. 243
Facts:
- Ptfs held 5% convertible subordinated debentures of MGM
- During debenture-term, MGM declared cash dividend of $1.75 per share of common stock.
- Ptfs alleged that dividend declaration damaged MGM by depleting its capital thereby endangering its
future prospects, and that it damaged the DB holders by impairing the value of the conversion feature
and causing decline in mkt value of the debentures themselves.
- Ptfs brought derivative action against corporation and class action against directors (breach of fid
duty)
Issues:
Standing to bring derivative action? NO
Breach of fiduciary duty? NO
Ratio:
Standing to maintain derivative actions
- Under Delaware law, stockholder may use the derivative action to sue in the corporation’s name
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where those in control of the corporation refuse to assert a claim belonging to the corporation.
The plaintiffs are creditors, not stockholders. That a bond is convertible into stock should no more
affect its essential quality of being a bond than the fact that cash is convertible into stock affect the
nature of cash. All property is convertible into something else! A convertible debenture is a bond
and not an equity security until conversion occurs.
Class action, breach of fid duty
- Ptfs concede that directors didn’t breach indenture provision dealing with restrictions on payment of
dividends, but assert that they have K-ual rights which exist independently of the indenture. Assert
that dfts breached their fid duty to refrain from acting in their own self interest. Unless there are
special circumstances (fraud or insolvency or violation of statute) which affect the rights of the
debenture holders as creditors of the corporation, the rights of debenture holders are confined to the
terms of the indenture pursuant to which debentures were issued.
- Fact that market value of stock into which debt convertible is not sufficiently attractive to make
conversion profitable at a particular time doesn’t give rise to a cause of action against management.
The legal payment of large cash dividends is a valid means by which a corp can discourage
convertible debenture holders from exercising their right to convert their debentures into common
stock
-
RULE: Except in special circumstances, directors don’t owe fiduciary duty to convertible debenture
holders. Rights of convertible debenture holders are confined to the terms of the indenture agreement.
Pittsburgh Terminal Corp. v. Baltimore & O.R. Co., [1982] 3d Cir. p. 249
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Part III - Equity Financing and Protection
General Considerations
(10-29-04)
(11-05-04)
Debt  Convertible Debt  Equity
-
Debtholders’ Rights are (primarily) contractual
SHs Rights are primarily derived from corp Charter and corp law (CBCA) (e.g. duty of directors to
act in BIC and oppression remedies)
How do you create a CBCA corporation?
A. Apply for Certificate of Incorporation
1. Articles of Incorporation which include
a. Name of corporation
b. Province or Territory of Reg’d Office
c. Shares – set out classes of shares (etc.)
d. Restrictions on share transfers – transfers (of shares of closely held co.) must normally be
approved by directors and/or shareholders
e. Number of directors
f. Restrictions on business (if any) – CBCA corps have powers of natural persons BUT can
voluntarily restrict their powers by setting out restrictions in articles
g. Other provisions – e.g. borrowing powers of corp, private co. restrictions (e.g. max # of
SHs)
h. Incorporators – the incorporator signs the articles, notice of directors and notice of
registered office and sends them in
2. List of directors
3. Notice of registered office
B. Organizational Meeting (s. 104 CBCA)
S. 104 (1)
CBCA
After issue of the certificate of incorporation, a meeting of the directors of the corporation
shall be held at which the directors may
(a) make by-laws;
(b) adopt forms of security certificates and corporate records;
(c) authorize the issue of securities;
(d) appoint officers
(e) appoint an auditor
(f) make banking arrangements; and
(g) transact any other business
Share Capital
S. 6 CBCA
Articles shall contain the following:
…
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(c) The classes and any maximum number of shares that the corporation is authorized to
issue, and
i. If there will be two or more classes, of shares, the rights, privileges, restrictions
and conditions attaching to each class of shares, and
ii. If a class of shares may be issued in series, the authority given to the directors
to fix the number of shares in, and to determine the designation of, and the
rights, privileges, restrictions and conditions attaching to, the shares of each
series
Max Number of Shares
- Old corp law provided for max number of shares, i.e. a ceiling which could only be raised with SH
approval
- Under CBCA, articles can stipulate a maximum but need not; corp can authorize unlimited # of shares
- Quid pro quo for ability of directors to issue unlimited no. of shares  directors must not dilute value
of existing shares; must issue new shares at same value as existing shares (otherwise liability).
- [Note that when a co. does a public offering, will typically offer shares at slight discount off trading
price. This is permitted b/c fair value does not necessarily = trading value. Price slightly below
trading value is still fair value.]
- Typical Cdn co. will not have max number of common shares BUT will usually have restricted # of
preferred shares of any class or series. WHY? B/c preferred shares are quasi-debt instruments. You
issue preferred shares with no intention to issue more in same series. If you want to issue more,
move on to new series/class.
SH Rights; Classes vs. Series
- Can only issue shares in multiple ‘classes’ (e.g. Common, Preferred, Class A, Class B) if these
classes are set out in articles. Classes of shares may be issued in series provided that articles either
fix the series [27(1)(a)] or give the directors authority to fix the # of shares and rights, etc. attaching
to the shares of a new series [27(1)(b)]
- Under CBCA, the rights, privileges, restrictions and conditions attaching to the shares of each class
are the same [24(3)]. If want to create shares with different rights, must either (1) create multiple
classes and stipulate rights, etc. attaching to shares of these classes; or (2) create series or possibility
for creation of series within classes and stipulate rights, etc. attaching to shares of those series.
o Unless articles stipulate that shares of a given class are issuable in series, and they are so
issued, the rights of all shares of one class will be the same (cannot have some voting shares
and some non-voting shares in the same class)
o If no distinction is made btwn classes or series w/in classes (i.e. Articles silent), default is that
SHs are equal [presumption created by 24(3)]
- Can only add or remove class by amending Articles pursuant to s. 173 (requires special resolution
[need SHs])
- *What is justification for giving directors authority under 27(1)(b) to create new series? Economics.
Preferred shares behave like debt instruments (fixed redemption price and rate of return). Rights,
privileges, etc. attached to preferred shares depend upon economic conditions when issued (e.g. rate
of interest). Issuing new preferred shares (and stipulating rights that attach to them) would be very
impractical if Board had to get SH approval – by the time SHs meeting held, economic conditions
will have changed.
S. 24(3)
Rights attached to shares – Where a corporation has only one class of shares, the rights
of the holders thereof are equal in all respects and include the rights
(a) to vote at any meeting of the SHs of the corporation;
(b) to receive any dividend declared by the corporation; and
(c) to receive the remaining property of the corporation on dissolution
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S. 24(4)
S. 27(1)
December 2004
Rights to classes of shares – The articles may provide for more than one class of shares
and, if they so provide,
(a) the rights, privileges, restrictions and conditions attaching to the shares of each class
shall be set out therein; and
(b) the rights set out in sub (3) shall be attached to at least one class of shares but all such
rights are not required to be attached to one class
Shares in series - The articles may authorize, subject to any limitations set out in them,
the issue of any class of shares in one or more series and may do either or both of the
following:
(a) fix the number of shares in, and determine the designation, rights, privileges,
restrictions and conditions attaching to the shares of, each series; or
(b) authorize the directors to fix the number of shares in, and determine the designation,
rights, privileges, restrictions and conditions attaching to the shares of, each series.
Redeemable vs. Retractable Shares
S. 2(1)
CBCA
Redeemable share means any share issued by a corporation
(a) that the corporation may purchase or redeem on the demand of the corporation
[REDEEMABLE]
(b) that the corporation is required by its articles to purchase or redeem at a specified
time or on the demand of a SH [RETRACTABLE]
Microcell’s Post-Restructuring Share Capital
Pre-emptive Rights of Existing SHs
-
SHs have pre-emptive rights if articles so provide (s. 28 CBCA)
Most Cdn companies don’t provide for this in Articles – can issue to anyone
Absence of pre-emptive rights creates trouble (from SHs point of view) in M&A context: corp can
defeat hostile bid by offering shares to one person who can block the hostile bid.
28(1)
28(2)
If the articles so provide, no shares of a class shall be issued unless the shares have first
been offered to the SHs holding shares of that class, and those SHs have a pre-emptive
right to acquire the offered shares in proportion to their holdings of the shares of that
class, at such price and on such terms as those shares are to be offered to others
Notw/standing that the articles provide the pre-emptive right referred to in sub (1), SHs
have no pre-emptive right in respect of shares issued
(e) for a consideration other than money;
(f) as a share dividend; or
(g) pursuant to the exercise of conversion privileges, options or rights previously granted
by the corporation.
How does the corporation actually issue a share?
Consideration for Shares:
25(1)
Issue of shares – subject to the articles, the by-laws and any unanimous SH agreement
and to s. 28 [pre-emptive rights], shares may be issued at such times and to such persons
and for such consideration as the directors may determine.
[MB: very broad discretion]
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Corporate Finance SUMMARY
December 2004
Consideration – A share shall not be issued until the consideration for the share is fully
paid in money or in property or past services that are not less than the fair equivalent of
the money that the corporation would have received if the share had been issued for
money.
[Consideration must be fully paid in money or property (e.g. corporate shares; bricks and
mortar]
[MB: funny rule b/c doesn’t actually tell us how much shares must be issued for]
Definition of “property” – For the purposes of this section, “property” does not include
25(5)
a promissory note, or a promise to pay, that is made by a person to whom a share is
issued, or a person who does not deal at arm’s length with a person to whom a share is
issued.
**Under 25(5), promissory note made by person to whom share issued (subscriber) is not good
consideration. Would allow corp to get around fully paid requirement. Subscriber can, however, pay for
shares with promissory note made by third party, e.g. Gov’t of Canada or another public company.
**Example of property given as consideration for shares (sort of example): CP had a division called
Marathon and wanted to spin it off. Dropped down Marathon’s assets into a new corporation. Shares in
new corp were issued in exchange for property (i.e. assets of Marathon).
25(3)
Stated Capital Account:
-
Corp, upon issuing shares, must set up (or add to existing) notional account, i.e. the stated capital
account (s. 26 CBCA). Separate account for each class and series.
Like the ‘equity’ account for accounting purposes
26(1)
26(2)
Stated capital account – A corporation shall maintain a separate stated capital account
for each class and series of shares it issues.
Entries in stated capital account – A corporation shall add to the appropriate stated
capital account the full amount of any consideration it receives for any shares it issues.
[see exception in 26(3) – rollover transactions]
Example:
Shares issued
Day 1
Day 2
Day 3
100
100
100
Consideration
$100
$100 worth of prop
$150
SCA
$100
$200
$350
Participation in SCA
$1
$1
350/300
**Note that each share’s participation in the stated capital is proportionate. Doesn’t matter how much
share was actually issued for (e.g. $1 on Day 1 or $1.50 on Day 3)
-
If doing corporate audit, look at register of share issues. It should show the amount added to the
stated capital account each time. If don’t find this, look to board resolutions (e.g. that establish f.m.v.
of property provided as consideration)
**Rollover transactions
Generally speaking, stated capital should reflect the f.m. value of property or money received by the
company in exchange for shares. Exception:
Exception for non-arm’s length transactions – Despite sub (2), a corporation may,
26(3)
subject to sub (4), add to the stated capital accounts maintained for the shares of classes
or series the whole or any part of the amount of the consideration that it receives in an
exchange if the corporation issues shares
(d) in exchange for
i. property of a person who immediately before the exchange did not deal with the
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Corporate Finance SUMMARY
-
-
December 2004
corporation at arm’s length
ii. shares of, or another interest in, a body corporate that immediately before the
exchange, or that because of the exchange, did not deal with the corporation at
arm’s length
iii. property of a person who, immediately before the exchange, dealt with the
corporation at arm’s length if the person, the corporation and all the holders of
shares in the class or series of shares so issued consent to the exchange.
Non-arm’s length transactions (e.g. company buys shares of its sub using its own property or shares):
may add to SCA something less than fair market value in order to avoid some capital gains tax. Will
(always?) add amount equal to adjusted cost base (i.e. purchase price of asset) rather than fmv of that
asset.
As a result, tax people will always be interested in the legal stated capital. Stated capital for
accounting purposes won’t be good enough for legal purposes.
**Convert class A share to class B share  Effect on capital account?
- Take stated capital attributable to share being converted and move it into stated capital for class B
shares [MB said that s. 26 provides for this, but I don’t see how]
- In example above  (350/300) would be moved to class B stated capital
Declaring and paying dividends
-
-
2 basic claims that SHs have to corporation’s cash and assets:
1) claim to dividends (equivalent to interest in debt context)
2) claim to capital (equivalent to repayment in debt context)
CBCA imposes limits on ability of corporation to make distributions of dividends and capital to its
SHs (s. 26 ff)
Dividends – A corporation shall not declare or pay a dividend if there are reasonable
grounds for believing that
(a) the corporation is, or would after the payment be, unable to pay its liabilities as they
become due; or
(b) the realizable value of the corporation’s assets would thereby be less than the
aggregate of its liabilities and stated capital of all classes
**This rule is a legal manifestation of the priority of debtholders. Can hand out cash/assets to share
holders but must comply with priority. Shareholders are at bottom of the pile
**This applies to dividends issued to both common and preferred shareholders.
42
**Important elements of s. 42 test
1. Sub (a) - Unable to pay liabilities as come due
- Companies in good financial health – no real difficulty
- Struggling companies – interpretive difficulties arise. Do you look at what is owed now or what is
owed in future? If future, how far out do we look?
o 42(a) definitely talks to present but is also slightly forward looking. Thus, director would
look at current financial statements but also at forward looking information
o Most boards will get a solvency certificate from an officer, such as CFO, who is very
familiar with the financial health of the corp.
2. Sub (b) – basic balance sheet test
[Realizable value of assets] must be equal to or greater than [liabilities + stated capital]
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Corporate Finance SUMMARY
-
-
-
-
December 2004
Looks like balance sheet (i.e. liabilities on one side and assets/share capital on the other but some
differences
o Stated capital is less than full equity in co. (equity for accounting purposes includes
retained earnings)
o Realizable value of assets (as opposed to historical value used for balance sheet
purposes). What could you sell the asset for today? (If price of asset has fallen, may not
be in position to pay dividend…despite what balance sheet says)
Rationale for this rule: decision of corporation to give some money to SHs should not impair
company’s ability to pay liabilities and return stated capital. Protect creditors and amount invested to
date by SHs. Note: why does test take SHs into account given that SHs are getting benefit of
dividend? B/c a dividend may (likely will) only be distributed to holders of some classes. Test
protects holders of classes not receiving dividend (b/c equation includes all stated capital)
What is?
o Realizable value: what corp could realize on assets if sold today; some discretion and
judgment permissible (realization value if sold quickly vs. value if can wait for good
offer)
o Stated capital: of all classes/series
o Liabilities: includes current liabilities and contingent liabilities. Corp may have
contingent liabilities if has signed guarantee or is involved in ongoing litigation. What is
value of contingent liability? Guarantee – depends on how likely it is you will be called
upon under guarantee (guarantee gov’t of Canada – not likely will be called upon)
Note that for most corporations, realizable value of assets is so great that, even if include all
contingent liabilities, will still meet test
3. Will not declare OR pay
- Declaration (by Board) and actual payment (cheque by officers) will occur on different days (perhaps
20 days apart). Wording of s. 42 suggests that solvency test must be met on both days.
- If test met on declaration date but not payment date, must withdraw declaration. MB doesn’t think
this has ever happened.
- B/c CBC provides that test must be met at payment date, declaration of dividend does not create a
debt of the corporation. Dividend becomes debt of corporation only on payment day (if test met). Be
careful b/c old case law is to the effect that declaration = debt.
- **See application of s. 36 in Central Capital
Relates to Central Capital case: redemption/retraction of shares. Very similar test to that in s. 42. (s. 36)
Held: redemption proceeds payable to SHs on redemption/retraction was not a debt; amt not payable b/c
test had not yet been met. If test had been met, debt for legal purposes, would be created. S. 36 + S. 40
gives mid-level priority (?).
4. Negative test (lower threshold than similarly worded positive test)
- Note ‘reasonable grounds for believing’ language at s. 185 (amalgamations)
- S. 185 creates much higher threshold however b/c is positively worded – can only amalgamate if test
met. S. 42 is negatively worded – cannot declare dividends if tests not met
- MB admits that while, from legal point of view, positive language creates higher threshold, for
practical purposes directors will act the same way under 185 and 42.
**Director liability
- Director who approves dividend contrary to s. 42 must restore amounts distributed (s. 118)
- Diligence Defense at s. 123(4)
Further directors’ liabilities – Directors of a corporation who vote for or consent to a
118(2)
resolution authorizing any of the following are jointly and severally, or solidarily, liable
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Corporate Finance SUMMARY
123(4)
December 2004
to restore to the corporation any amounts so distributed or paid and not otherwise
recovered by the corporation
(a) purchase, redemption or other acquisition of shares contrary to s. 34, 35 or 36
(b) commission contrary to s. 41
(c) payment of a dividend contrary to s. 42
etc.
Defense – reasonable diligence – A director is not liable under s. 118 if the director
exercised the care, diligence and skill that a reasonably prudent person would have
exercised in comparable circumstances, including reliance in GF on
(a) financial statements of the corporation represented to the director by an officer of the
corp or in a written report of the auditor of the corporation fairly to reflect the
financial condition of the corporation; or
(b) a report of a person whose profession lends credibility to a statement made by the
professional person.
**Form of dividend – share, property, money
Form of dividend – A corporation may pay a dividend by issuing fully paid shares of the
43
corporation and, subject to s. 42, a corporation may pay a dividend in money or property
**Need not meet s. 42 test if issue share dividends (b/c not taking money out of the corporation) [SH:
What about the dilution issue?]
Redemption, Retraction and Acquisition
**Redemption and Retraction
Redeemable share means any share issued by a corporation
S. 2(1)
(c) that the corporation may purchase or redeem on the demand of the corporation
CBCA
[REDEEMABLE]
(d) that the corporation is required by its articles to purchase or redeem at a specified
time or on the demand of a SH [RETRACTABLE]
Redemption of shares – Notwithstanding 34(2) or 35(3), but subject to sub (2) and its
36(1)
articles, a corporation may purchase or redeem any redeemable shares issued by it at
prices not exceeding the redemption price thereof stated in the articles or calculated
according to a formula stated in the articles
Limitation – A corporation shall not make any payment to purchase or redeem any
36(2)
redeemable shares issued by it if there are reasonable grounds for believing that
(a) the corporation is, or would after the payment be, unable to pay its liabilities as they
come due; or
(b) the realizable value of the corporation’s assets would after the payment be less than
the aggregate of its
I. its liabilities, and
II. the amount that would be required to pay the holders of shares that have a right
to be paid, on a redemption or in a liquidation, rateably with or before the
holders of the shares to be purchased or redeemed, to the extent that the amount
has not been included in its liabilities. [MB: stated capital of shares which
rank above or equally]
- 36(2) creates test similar to that in s. 42. Main difference – realizable value of assets must exceed
liabilities plus subset of stated capital. Assume class A shares rank ahead of class B shares and
redeeming A shares only – test would take into account liabilities plus stated capital of A. If
redeeming A and B shares or B shares only – take into account stated capital of A and B (plus
liabilities).
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Corporate Finance SUMMARY
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December 2004
Result – easier to meet 36(2) test than 42 test. If dealing with higher-ranking shares, don’t have to be
concerned with stated capital of lower ranking shares.
**Purchase/acquisition of shares by corporation
Acquisition of corporation’s own shares – Subject to sub (2) and to its articles, a
34(1)
corporation may purchase or otherwise acquire shares issued by it
Limitation – A corporation shall not make any payment to purchase or otherwise acquire
34(2)
shares issued by it if there are reasonable grounds for believing that
(a) the corporation is, or would after the payment be, unable to pay is liabilities as they
become due;
(b) the realizable value of the corporation’s assets would after the payment be less than
the aggregate of its liabilities and stated capital of all classes.
- “Normal course issuer bid”: Corporation purchases its own shares on the market so that it can cancel
them. Why would buy own shares? (1) if think shares are undervalued, i.e. market price is discount
off of fair value (= good financial sense to buy shares); (2) want to grant options but also to maintain
share capital at certain size (=buy back and cancel shares, then grant equivalent # of options)
- Is this ‘redemption’? Not really. Companies generally buy common shares which, by def’n, are not
redeemable. S. 36, on the other hand, is directed at redeemable shares, usually standard preferred
shares.
**Gift of corporate shares
Donated shares – A corporation may accept from any shareholder or share of a
37
corporation surrendered to it as a gift, but may not extinguish or reduce a liability in
respect of an amount unpaid on any such share except in accordance with s. 38
- Corporation can accept gift of donated shares. No test need be met. [SH: why would there be a test?
Significance of this gift thing?]
**Purchase/Redemption of Shares  effect on stated capital
Adjustment of stated capital account – on a purchase, redemption or other acquisition
39(1)
by a corporation of shares, the corporation shall deduct from the SCA maintained for the
class or series of shares of which the shares purchased, redeemed or otherwise acquired
form a part an amount equal to the result obtained by multiplying the stated capital of the
shares of that class or series by the number of shares of that class or series purchased,
redeemed or otherwise acquired, divided by the number of issued shares of that class or
series immediately before the purchase, redemption or other acquisition.
- Redeem 10 shares in above example = take 350/300 - $10 out of stated capital
- As shares issued, stated capital goes up. As shares redeemed, stated capital goes down
**Enforcement of K to buy shares
Enforcement of K to buy shares – A corporation shall fulfill its obligations under a
40(1)
contract to buy shares of the corporation, except if the corporation can prove that
enforcement of the K would put it in breach of any of ss. 34 to 36.
- Effect of this provision – cannot contract out of ss. 34-36. A company may create a separate K (i.e.
separate from articles) with shareholder which provides that shares are absolutely redeemable
regardless of solvency. 40(1) provides that such contract not enforceable if enforcement would put
corp in breach of ss. 34-36.
- Note that this section doesn’t apply to rule in s. 42 (i.e. dividends). Appears that could grant absolute
right (i.e. regardless of solvency) to receive dividends. MB: problem – might be treated as interest,
rather than as true dividend, for tax purposes. [SH: Why a problem? Both taxable? And interest
deductible!]
Page 60 of 84
Corporate Finance SUMMARY
December 2004
Status of Contracting Party – Until the corporation has fulfilled all its obligations under
a K referred to in sub (1), the other party retains the status of claimant entitled to be paid
as soon as the corporation is lawfully able to do so or, in a liquidation, to be ranked
subordinate to the rights of creditors and to the rights of holders of any class of shares
whose rights were in priority to the rights given to the holders of the class of shares being
purchased, but in priority to the rights of other shareholders.
Contractual right to absolute redemption may not be enforceable BUT, from priority point of view,
SH with this K-ual right will rank ahead of other SHs. New ranking w/in capital structure. [SH:
would rank ahead of other shareholders in same class or classes which are below in priority…but not
SHs who are above in priority or creditors?]
40(2)
-
Preferred Shares
Typical Preferred Shares
1. No voting rights
2. Fixed dividend rate
3. Fixed redemption amount
Some preferred shares are convertible (into common shares)
**SH: I believe that all this is set out in the articles of association, or in the resolution which creates a
particular series of shares.
1. Nature of Relationship between Preferred SHs and Corporation
Re Central Capital, [1996] Ont. C.A. p. 257
Facts:
- McCutcheon and SYH sold shares to Central Capital and were issued preferred shares in CC as
payment. Shares contained retraction clause entitling holder to retract shares and require corporation
to redeem them for a specified price (in 1992 and 1994)
- Aug. 1992 – CC sent notice (April 1992) of retraction privilege to holders of preferred shares; stated
that would not redeem any shares b/c such redemption would be contrary to law [s. 36(2)]
- Art. 4.3 of Series B Senior Preferred Shares provisions provided that if redemption contrary to law,
CC shall only redeem max number of preferred shares which it deems permissible (i.e. pro rata
redemption of tendered shares)
- McC and SYH tendered shares (i.e. deposited in trust account). CC did not pay redemption price
- CC filed for bankruptcy (June 15, 1992)
- McC and SYH submitted to Administrator proofs of claim as creditor. Administrator disallowed
claims on grounds that ability of CC to redeem is restricted by 36(2) CBCA
Issue: Did the retraction clauses in the aplts’ shares create a debt owed by CC as of June 15, 1992 within
the meaning of the Bankruptcy Act?
Held: No
Ratio:
- Cannot participate in reorg unless have claims provable in bankruptcy. 12(1) of Bankruptcy Act
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Corporate Finance SUMMARY
1)
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2)
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A.
B.
C.
D.
E.
December 2004
provides that ‘all debts and liabilities, present or future…shall be deemed to be claims provable in
proceedings under this Act.’ Must then determine whether relationship btwn CC and shareholders
was one of equity or one of creditor owed a debt by the company. Weiler explores three Qs.
Did agreement btwn CC and McC/SYH create a shareholder relationship?
Dissent said was not b/c McC and SYH took preferred shares in exchange for transfer of assets to CC
Weiler, J. disagreed – they sold their shares in smaller companies and took back preferred shares in
larger company as part payment; transferred part of capital investment from smaller entity to larger
entity
Risk-taking, profit-sharing, transferability of investment and the right to participate in a share of the
assets on liquidation after the creditors have been paid (all present in this case) are hallmarks of a SH
True relationship btwn parties was initially an equity transaction
Did the nature of the relationship change (after retraction date/reorganization)?
Aplts argue that while they might have been SHs initially, this relationship changed. When McC
exercised his retraction right, he ceased to be SH. Obligation to redeem SYH’s shares was triggered
when lenders of CC opted to reorganize the co. [b/c redemption date was post-reorg, i.e. 1994]
Judge rejects for several reasons:
Reduction of capital by redemption of shares is permitted by CBCA but only where requirements of s.
36 are met. S. 36 allows redemption but subject to (1) corporation’s articles and (2) a solvency
requirement. Promise to pay in articles of CC is not made independent of any ability to pay. A
finding that the aplts are creditors would defeat the purpose of s. 36(2).
Evidence of debtor-creditor relationship is lacking in the articles: no express provision that
redemption of shares is in repayment of loan, no indemnity in event that money not repaid on
retraction date, no provision that after retraction date and in event of insolvency aplts would have
right to have the co. wound up, no provision that upon winding-up or insolvency the parties are
entitled to rank pari passu with creditors. Evidence of equity relationship is abundant: Until
redemption, had right to share in profits (i.e. dividends), vote to elect directors so long as dividends
remained unpaid for period of time, participate in winding-up after creditors were paid.
Articles provide that in event of liquidation, dissolution or winding-up, aplts are only entitled to rank
after creditors but ahead of the junior ranking SHs. Suggests that aplts were not to be dealt with on
same footing as ordinary creditors. Reorganization is not winding up or liquidation but, like
liquidation is a method of dealing with insolvency.
Until the company has declared it will redeem the shares which are tendered to it, the obligation to
redeem them is not a debt or liability. The promise to pay in the articles of CC is not made
independent of any ability to pay.
S. 40 CBCA: corp shall fulfill obligations under a K to buy shares of corp, except if the corp can
prove that enforcement of K would put it in breach of any of ss. 34 to 36.
RULE: Relationship between preferred shareholders and company is equity relationship, not debtorcreditor relationship. Fact of corporate re-organization, retraction right, or exercise of retraction right by
preferred shareholder doesn’t change the nature of this relationship. Until co. has declared it will redeem
shares which are tendered to it, the ob to redeem them is not a debt or liability. The promise to pay (i.e.
the retraction clause in articles) is not made independent of any ability to pay. [SH: to determine nature
of relationship, look at the articles of incorporation and share purchase agreements – what did the parties
intend? – hallmarks of SH or debt?]
Barbeau:
- Most shares don’t have right to be retracted. Companies, if insolvent, won’t redeem shares. Right of
retraction is the crux of this case – SHs argued that retraction right was difference btwn being mere
shareholders and being creditors with a bankruptcy claim. Majority, based on language of articles,
share purchase agreements, and CBCA said NO!
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December 2004
From policy perspective, CBCA is built around creditors ranking above shareholders. Cannot through
mechanism of retraction try to change the fundamental bargain (i.e. agreement to be SH).
2. Preferred Shareholders’ Rights
(a) Claims to Dividends
Re Canadian Pacific Ltd., [1990] Ont. H.C.J. p. 285 (CP #1)
Facts:
- CP proposed arrangement (under s. 192 CBCA) to effect, with minimal tax consequences, the
distribution of 80% of the shares of a subsidiary corp, “Marathon,” to the corp’s ordinary
shareholders. [See reasons for distribution at page 296 CB]
o Note that various methods possible for distributing shares of Marathon – direct transfer of
shares, sale of shares and transfer of proceeds, transfer by way of plan of arrangement.
CP chose arrangement (a “triple butterfly”) for tax reasons – no tax payable by CP and
SHs wouldn’t have to pay tax on shares they received until they disposed of them
- CP had preference shareholders who were entitled to a 4% preferential dividend per annum, but “shall
not receive at any time a dividend at a higher rate than four per cent per annum.”
- Preference shareholders objected to the arrangement, arguing that the proposed distribution of shares
was not a dividend but a distribution of corporate assets, analogous to a distribution or winding up, in
which they were entitled to share
Issue: Was the proposed distribution of Marathon a reduction of capital (analogous to winding up) or a
dividend? If dividend, are preference SHs entitled to share in it (b/c not annual and not cash)?
Held: No and no
Ratio:
A. Nature of Distribution
- Court admits that transaction resembles distribution of capital b/c (1) nature of property being
disposed of; (2) fact that it is to be received by SHs; (3) size of transfer; (4) process chosen.
- BUT, concludes that it is a distribution of profits, in other words, a dividend.
- Reasons:
1. Distribution it is to be paid from retained earnings. No reduction of capital was considered or
authorized. Since WWII, instead of distributing major dividends to SHs, CP has diverted surplus
profits into subsidiaries such as Marathon. Profits did not lose their character upon being diverted
into Marathon. On the books of CP, Marathon constitutes profits and is available for distribution
2. Fact that the division of profits is not in cash doesn’t change its character. CBCA s. 43(1) provides
that corp may pay dividend in money or property
3. Size of distribution not relevant (except maybe for accounting purposes)
4. Fact that distribution is not, for tax and accounting purposes, called a dividend does not affect legal
characterization (though tax and accounting characterization may inform legal characterization).
What might be a dividend in one context may well not be a dividend in another context.
B. Are preference SHs allowed to participate?
- Issue is whether, in limiting the dividends of the preference shareholders (i.e. to 4% per annum and
nothing more), it was intended that the limitation extend only to annual dividends paid in cash.
- Language of resolution and prospectus expresses an intention to limit the preference SH to 4% per
more and nothing more by way of dividend. Court cites cannon of construction which provides that if
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shares are given a preferential dividend, they are presumed to be non-participating as regards
further dividends. Also cites case where held that where the article sets out the rights attached to a
class of shares to participate in profits while the company is a going concern or to share in the
property of the company in liquidation, prima facie, the rights so set out are in each case exhaustive.
RULE: A distribution is a dividend provided it is paid out of retained earnings (i.e. is not a reduction of
capital). Dividend need not be cash. If surplus earnings are channeled into subsidiaries, property, etc.,
these can be distributed to SHs, and such distribution will constitute dividend.
Barbeau:
- If court had found liquidation, preference SHs would have been entitled to get back their capital
investment and their 4% - this would have changed the economics of the entire deal
(b) Claims to Capital
Aside: plans of arrangement
-
-
Court supervised ‘plan of arrangement’ is used to effect transaction that could not otherwise be
effected per CBCA.
In non-arrangement situation, take action for injunction (as in CP #1). Argue that rights violated.
In arrangement situation, can also participate in fairness hearing – argue not that rights have been
violated but that the transaction is not fair
Process:
 Co. asks court to order SHs meeting
 Once SHs approve – go back in front of judge for fairness hearing
 Anyone who has an interest (creditors, shareholders, etc.) can show up and argue that the
arrangement is not fair and reasonable.
Advantages of arrangement:
 Can effect transactions that wouldn’t be possible under CBCA
 Safe-harbour in US, don’t have to file reg’n statement in US
Disadvantages
 Subject to fairness hearing – creates forum for parties to come and say not fair
 Fairness hearing also delays transaction b/c must wait for judge to render his judgment. Standard
transaction – once have SH approval, can proceed w/in 24 hours.
S. 192 CBCA Test for arrangement
(3) Application to court for approval of arrangement – where it is not practicable for a corporation
that is not insolvent to effect a fundamental change in the nature of an arrangement under any other
provision of this Act, the corporation may apply to a court for an order approving an arrangement
proposed by the corporation
(4) Powers of court – in connection with an application under this s., the court may make any interim or
final order it thinks fit including…(e) an order approving an arrangement as proposed by the corporation
or as amended in any manner the court may direct.
-
Court must be satisfied that:
(a) all statutory requirements have been fulfilled:
i. plan meets def’n of arrangement in 192(1)
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ii. corporate applicant is not insolvent; and
iii. must not be practicable for corporation to effect fund change in nature of the arrangement
under any other provisions of the CBCA
(b) that arrangement is put forward in good faith, and that the statutory majority who approved the
scheme was acting bona fide; and
(c) that the arrangement is fair and reasonable.
Re Canadian Pacific (No. 2), [1990] Ont. H.C.J.
Facts:
- as above
- [court now sitting as court of equity pursuant to s. 192]
Issue:
Arrangement fair and reasonable?
Held:
No
Ratio:
- The arrangement was not necessary and the applicant company did not stand to benefit from it.
Although the ordinary SHs would gain from the arrangement, the applicant company would be poorer
by 14% of its value and the preferred SHs would lose their say in the running of the company. There
would be fewer assets from which dividends would be paid and fewer assets would be available for
distribution in the event of a winding up. The preferred shares would decrease in value and the
preferred SHs stood to be prejudiced.
- Size of transaction gives court the greatest difficulty. If it were only ½ of 1% of CP’s assets, there
would be no unfairness or unreasonableness involved. If it were 90% of CP’s assets, would be
undoubtedly unfair. Have to decide where to draw the line. Because there is no necessity, because
there is detriment to the co and b/c the two classes of SHs are being treated very differently, the onus
on an applicant seeking the approval of the court should be very heavy. The applicant, for reasons set
out has not discharged the onus.
- Arrangement not fair and reasonable.
POINT: Arrangement not fair and reasonable to preference SHs even though it effected a dividend
distribution in which, legally, preference SHs were not entitled to participate (i.e. beyond their 4%).
Barbeau:
- Company doesn’t receive any consideration for spin-off of sub to shareholders. Could it thus be
argued that spin-off not in BIC of corporation? Perhaps, but could argue that if have many different
facets of business, market might be confused about what company does and what shares of that
company entail – this could affect ability to get capital
Palmer v. Carling O’Keefe Breweries of Canada Ltd.
Facts:
- Aplts were preference shareholders in COL (company that held Carling O’Keefe). Shares had par
value of $50 but were trading at much lower price [b/c interest rates had risen]. Shares redeemable at
par in event of involuntary liquidation and at premium in event of voluntary liquidation.
- IXL, a wholly-owned sub of Elders (an Australian conglomerate) borrowed lots of cash from 2
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Canadian banks and make take-over bid for common shares of COL
IXL managed to acquire 95% of the common shares and then acquired the remaining 5% under the
compulsory acquisition provisions of the OBCA. The preference shares were still owned by
independent shareholders. Elders didn’t want to cause the shares to be redeemed b/c redemption
price was so much higher than trading price. Directors of COL later offered to redeem at price btwn
market and redemption, but resolutions were defeated.
Directors of COL then passed resolution amalgamating COL with parent IXL and sub Carling (so that
interest payments would be deductible from Carling’s profits and so that lenders could get closer to
assets).1 Preference SHs thereby became SHs in co. that had taken on $400 million in debt! SHs
were angry. To protect their rights, Elders signed a support agreement in which it guaranteed the
sub’s bank debt and offered to redeem preference shares at stated redemption prices should Carling
fail to make any dividend payments.
Aplts claimed that conduct of COL directors was unfairly prejudicial and in disregard of their
interests (i.e. oppression)
Issue: Conduct of COL directors oppressive?
Held: Yes
Ratio:
- Absent the support agreement, conduct was oppressive. Preference SHs were entitled reasonably to
expect the directors to fulfill their duty to act in the interests of the corporation and to act lawfully.
- The directors did not do so. Amalgamation of IXL and COL served no legitimate corporate purpose
of COL. The marrying of the debt and the revenue was done for the exclusive benefit of Elders and
to the detriment of the financial worth of COL and the preference shareholders who had an interest in
such worth. As result of reduction of profit caused by deduction of interest charges paid on
acquisition debt, profitability of Carling may decline to point where there are no profits from which to
pay dividends on the preference shares.
- The directors’ conduct was not made legally acceptable by Elders’ support agreement. The support
agreement is only as good as Elders, an Australian company. The agreement involved a number of
risks [outlined middle of 325 CB]. The preference SHs did not invest in Elders; they invested in
Canadian brewing companies. The SHs ought not to be obliged to accept a claim against an entirely
different corporation in place of their investment in COL.
- This treatment of the preference SHs constituted conduct that was unfairly prejudicial to and unfairly
disregarded the interests of the preference SHs and involved a breach of the directors of COL of their
duty to act for the benefit of the co. as a whole. The directors treated COL as though it was a private
company, when it still had other SHs.
- Remedy: Amalgamation has been in effect for 18 months and would be difficult to unravel. Court
ordered COL to Carling to redeem preference shares at voluntary redemption price.
Barbeau:
- Oppression remedy vs. derivative action. Why did they use former and not latter?
- Probably could have made derivative claim (i.e. directors, in approving the amalgamation, harmed the
corporation) but remedy is against directors only (damages maybe). Oppression remedy – claimant
sues in his own right (i.e. not in right of corporation) and under s. 241, court can order a variety of
very powerful remedies.
- Case is Canadian equivalent of RJR Nabisco  i.e. impact of change of control on debtors and
shareholders of the target. What might result have been if creditors took oppression claim? Would
1
Note that under OBCA, used to be able to do short-form amalgamation provided that all voting shares held by one
person (i.e. not all shares as is required under CBCA).
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court have taken into account the creditors’ contractual protections? [SH: Note Wise: S.C.C. has no
difficulty in denying extension of fid duty to creditors, in part b/c creditors have recourse to the
oppression remedy. But will oppression remedy be used to give creditors the benefit of protections
that they did not bargain for? In RJR, court refused to imply the obligation of GF and fair dealing in
order to give creditors the benefit of protections they didn’t bargain for; GF and fair dealing could
only be used to give effect to creditors’ rights under the indenture, i.e. terms that were bargained for.]
Westfair Foods Ltd. v. Watt, [1991] Alta. C.A. p. 327
Facts:
- Rspdts were preferred SHs in Westfair. These SHs were entitled to annual dividend of $2 per share
and, in event of liquidation, to share equally with common shareholders (of which there was only
one) in any surplus assets.
- For many years, Westfair paid stable dividend of 20-30% of retained earnings, after had paid $2
dividend to preferred SHs. In 1985, it changed its dividend policy, and began to distribute the entire
net annual earnings as dividends to its sole common shareholder (after $2 div paid to preferred SHs).
Sole shareholder would then loan this money back to the corporation.
- Two effects of this policy: (1) capped retained surplus of company at 1984, effectively fixing value
of company in time; (2) common SHs, by lending money to Westfair, rose above preferred SHs in
corporate structure (i.e. had prior claim to monies lent) and thereby effectively overrode the right of
preferred SHs to rank pari passu with common shareholders.
Issue: Is the dividend policy oppressive?
Held: Behaviour not oppressive but reflected an unfair disregard for the preference SHs.
Ratio:
- Pref SHs argued that corp must maintain fair balance btwn common and preferred SHs, by adopting
policy of mixed retention and distribution.
- Oppression remedy: Must identify the reasonable expectations deserving protection. That is, we
regulate voluntary relationships by regard to the expectations raised in the mind of a party by the
word or deed of the other, and which the first party ordinarily would realize it was encouraging by it
words and deeds.
- Pref SHs argued that have indirect claim to retained earnings beyond $2 dividend b/c in event of
liquidation they share surplus assets equally with common shares, i.e. that their right to share in assets
on liquidation created an expectation that they would share in the ‘success or failure of the company.’
Judge rejects: any expectation that they would share in future success (as opposed to failure) of the
company in a measure beyond the dividend promised was not a reasonable expectation.
 Preferred SHs chose to purchase shares with fixed first claim on dividend pool; this gives them
advantage, i.e. will receive dividend in lean years, but also comes with price, i.e. give up any
claim to share in larger profits in years of plenty
 Right to share in assets on liquidation is a shield, not a sword. Its purpose is to offer some
assurance of capital return if the company fails, not some assurance of profit if co prospers.
 If the company had been set up with view to almost immediate liquidation or if liquidation was a
likelihood, judge might have come to different conclusion. But no prospect of this co. liquidating
in the near future! No reasonable expectation of voluntary liquidation.
- Share price (i.e. fact that share price would be lower if no expectation of future profit from a
distribution of assets) is irrelevant. The stock market is mere speculation and not enough to establish
a reasonable expectation, not a reliable guide to what is fair.
- This dispute is over how much protection the law gives the shareholders. The court can protect from
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unfair actions by the company but cannot stop action that merely impairs an unreasoned expectation
of advantage.
As between preference shares and common shares, it is fair that the common shareholders take all
unneeded earnings as dividends after the preferred dividend is paid.
After going through all this, judge says that the company regarded the preferred shareholders as a
nuisance and were insensitive to them. Also, some of their procedural complaints were well-founded.
All of this exemplified an unfair disregard for the shareholders. Forced purchase is an appropriate
remedy. Co. must buy back shares at fair value. What is fair value? Doesn’t depend on liquidation
value of company b/c must assume that co. will not be liquidated. Value of shares = present value of
income stream from $2/year dividend.
POINT: Preferred shareholders’ expectation to share in profits beyond fixed preferential dividend, and
thus that company should not pay out all of its retained earnings, was unreasonable. The right to share in
surplus assets upon liquidation is a shield and not a sword, i.e. it offers some assurance of capital if
company fails but not share in profits if company is successful. [Result might be different if there is
reasonable expectation of liquidation in the near future].
Barbeau:
- MB has problem with this case. Liquidation is not the only event that triggers realization for owner
of equity. Sale of company also triggers such realization, and there is always a prospect of sale. So
preferred SHs could have argued that they had reasonable expectation that some retained earnings
would be preserved in order to protect their claim to surplus assets upon sale of the company.
Average life of co. is only 20 years; most cos get purchased within 20 years.
- Could SHs have brought derivative action and argued that directors were stripping assets? Probably
not. But this suggests a real tension. How much latitude do directors have to make significant
distributions of dividends? [SH: CP case suggests that have a lot of latitude]
SH: You have no reasonable expectation of preservation of retained earnings b/c you will only share in
those retained earnings upon liquidation and there is no prospect of liquidation. Problem is that
shareholders also realize upon liquidation value in event of sale, and there is always a reasonable
expectation of sale. [Q: in this case, preferred SHs had claim to surplus assets equal to that of the
common shareholders? Does this mean that a buyer would pay preferred SHs a price greater than their
initial investment, i.e. the same price as is paid to common shareholders?]
Dividends, Retained Earnings and Legal Capital Rules
1. Declaring Dividends
-
-
From corporate governance point of view, strange that directors can declare dividends. They are, in
effect, corporate gifts for which SHs give no consideration (except preferred SHs – dividend part of
the bargain)
Some companies have longstanding policy of regularly paying dividends, even though nothing in
articles creates an obligation to pay dividends (e.g. BCE)
Dodge v. Ford Motor Company (1919) Mich. Sup. Ct., page 334
Facts:
- From 1908 – 1916, Ford regularly declared cash dividends and additional special dividends from time
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to time. In 1916 – Ford decided that no more special dividends would be declared and that the greater
portion of the profits would be put back into the business in order to expand it. He wanted to increase
employment and sell a larger number of cars at a lower price per car. Ford said: “my ambition is to
employ still more men to spread the benefit of this industrial system to the greatest possible number,
to help them build up their lives and their homes.”
- Two minority stockholders brought suit to compel the declaration of a dividend. They claimed that
the directors had a duty to distribute profits which were not required for legitimate business purposes.
Issue: Were the directors of Ford acting in the best interests of the corporation?
Held: NO.
Ratio:
- The expansion plan will have the immediate effect of producing a less profitable business, and will
thereby diminish the value of shares and the return to shareholders
- Ford’s testimony creates the impression that the company has made too much money and that he
wants to share it with the public by reducing the price of the output.
- Must ascertain whether the directors were acting for the best interests of the corporation. A business
corporation is organized and carried on primarily for the profit of the stockholders. The powers
of the directors are to be employed for that end. The discretion of directors is to be exercised in the
choice of means to attain that end, and does not extend to a change in the end itself, to the reduction
of profits or to the non-distribution of profits among stockholders in order to devote them to other
purposes.
- It is not w/in the BOD’s lawful powers to shape and conduct the affairs of the business for the mere
incidental benefit of shareholders and for the primary purpose of benefiting others.
- The court chooses not to interfere with the proposed expansion of Ford’s business… “the judges are
not business experts”. Court is not satisfied that the motives of the directors menace the interests of
shareholders. BUT…even accepting that these expansion plans are legitimate, Ford did not need 100
million to undertake them. They could afford to pay some of this to shareholders in dividends.
Rule:
A business corporation is organized and carried on primarily for the profit of the stockholders. The
powers of directors must be employed to that end. It is not w/in the BOD’s powers to conduct the
business for the incidental benefit of the SHs and the primary benefit of others.
Barbeau:
- one of the only cases in which co. forced to pay dividend
- no Canadian case which has forced co. to pay dividend [SH: even if corp has lots of retained earnings,
need not pay dividend; is totally at discretion of the directors]
Sinclair Oil Corporation v. Levien
Spar Aerospace
-
-
Spar Aerospace sold off a bunch of its divisions – became very cash-heavy and debt-free.
Co. had $150 million in cash reserves, but directors consistently refused to pay dividend. WHY?
Company had a massive contingent liability due to outstanding fraud lawsuit.
Group of dissident shareholders who controlled ~ 58% of Spar stock called SH meeting, and replaced
seven of Spar’s directors with five new board members representing the dissident group. SHs then
voted to give board permission to pay out as much as $123-million of Spar’s $128 million in stated
capital.
Spar directors then approved a reduction and return of capital to shareholders of $3.35 per share
(approximately $50 million in aggregate).
SHs were prepared to take the risk where directors were not. But SHs take risk and get reward
(money!).
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38. (1) Subject to sub (3), a corporation may by special resolution reduce its stated capital for any purpose
including, without limiting the generality of the foregoing, for the purpose of
(a) extinguishing or reducing a liability in respect of an amount unpaid on any share;
(b) distributing to the holder of an issued share of any class or series of shares an amt not
exceeding the stated capital of the class or series;
(c) declaring its stated capital to be reduced by an amount that is not represented by realizable
assets
(3) Limitation – a corporation shall not reduce its stated capital for any purpose other than the purpose
mentioned in paragraph (1)(c) if there are reasonable grounds for believing that
(a) the corporation is, or would after the reduction be, unable to pay its liabilities as they become
due; or
(b) the realizable value of the corporation’s assets would thereby be less than the aggregate of its
liabilities [doesn’t include stated capital as does the dividend test in s. 42; protects creditors – can
reduce stated capital as long as what is left over (i.e. the assets) are sufficient to cover liabilities]
(4) Recovery – A creditor of a corporation is entitled to apply to a court for an order compelling a
shareholder or other recipient
(a) to pay to the corporation an amount equal to any liability of the shareholder that was
extinguished or reduced contrary to this section;
(b) to pay or deliver to the corporation any money or property that was paid or distributed to the
shareholder or other recipient as a consequence of a reduction of capital made contrary to this
section
Z. Goshen, Shareholder Dividend Options, p. 358
-
-
-
Giving shareholders control over the dividend decision would reduce agency costs, facilitate optimal
earnings retention by firms and lessen the need for the indirect and expensive discipline provided by
the market for corporate control
Firm’s dividend policy reflects mgmt’s decision as to what proportion of accumulated earnings will
be distributed to shareholders and what portion will be retained for investment. Retained earnings
represent the amount of financing that the firm can utilize without having to compete with other firms
in the capital markets. In this way, reinvestment of earnings rather than payout of dividend + resort to
capital markets allows firms to avoid the direct disciplining influences of the securities market.
Managers can escape a market inspection of their performance by adopting a low-payout dividend
policy and avoiding the competitive external market for financing.
Shareholder suits to compel dividend distribution have no chance of succeeding.
Article proposes legal norm that shifts discretion over dividend policy from managers to the capital
markets, i.e. shareholders. State corporate law should adopt a rule that mandates shareholder control
over the dividend decision.
2. Capital Protection Rules: Acquisition or Redemption of Corporation’s
Own Shares, etc.
S. 30(1)
S. 30(2)
Subject to sub (2) and ss 31 to 36, a corporation
(a) shall not hold shares in itself or in its holding body corporate
(b) shall not permit any of its sub bodies corporate to acquire shares of the corp
Subject to s. 31, a corporation shall cause a sub body corporate of the corporation that holds
shares of the corporation to sell or otherwise dispose of those shares within five years from
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date.
General rule – corp cannot own its own shares (aka rule against corporate incest) – subject to all sorts
of exceptions (ss. 31-36)
S. 34: corp can acquire its own shares (for certain purposes) subject to solvency test.
S. 36: corp can redeem any redeemable shares issued by it subject to solvency test.
S. 39: if corp acquires its own shares, must adjust stated capital and cancel shares
-
What is the purpose of these rules?
o Prevent perpetuation of management (i.e. prevent management from buying shares in co.
and then voting shares as they please)
o Protect creditors: if corp issues a share to itself, it gives the illusion that it has more
stated capital than actually does (b/c corporation has used corporation’s money to buy the
share and thus merely transferred corporate capital into stated capital account). [Kwaw:
stated capital of corporation is the fund to which a creditor looks when it advances funds
to the corporation. It is a factor in determining whether the corporation has the financial
capacity to perform certain functions. Creditor is generally entitled to presume that the
stated capital will not be reduced or diminished to its detriment].
-
Former s. 44: corp cannot give financial assistance (i.e. lend money) to shareholders to do certain
things, including to buy shares of corporation. This s. created problems where corporation A wanted
to buy a holding company or, more precisely, the shares of the holding company in Corp B. Corp A
would need debt financing and lender would probably want guarantee of corporation that is held by
holding company. This gets caught by the financial assistance rule – corp is giving financial
assistance to corp A to buy its shares.
Nelson v. Rentown Enterprises Inc., [1993] Alta. Q.B. p. 376
Facts:
- Corp entered into contract to buy some of its shares in exchange for land and premises of the
corporation
- Corp met s. 34 solvency and liquidity tests on date of K-ual execution but not on date of specified by
the agreement for performance of the obligation.
Issue:
Does s. 34 prevent corp from buying its own shares if met liquidity and solvency tests on execution date
but not on performance date? [i.e. what is point in time for applying s. 34 liquidity test where corp
purchases its own shares?]
Held: Yes
Ratio:
- S. 34 solvency test should be applied not only at date that contract is entered into but also at date or
dates that contract (or part thereof if successive payments) is to be performed.
- Policy underlying s. 34 supports this interpretation: purpose of s. 34 is to protect creditors and other
SHs from share purchase agreements that may prefer one or more SHs in a situation of insolvency. If
test were only applied at execution date, corps could get around rule when co. is in shaky but solvent
state, by agreeing to purchase shares at some date far in the future.
- Language of s. 34 supports this interpretation: prohibits “any payment” and uses “after the payment”
- Language of s. 40 supports this interpretation: Under s. 40(1), a share purchase contract is
specifically enforceable against the corporation except to the extent performance of the contract
would put the corporation into a breach of s. 34. As well, s. 40(3) provides that until the contract has
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been fully performed, the other party is merely a ‘claimant’ entitled to be paid when the corporation
is able to do so, or, upon liquidation, entitled to be ranked in priority to other shareholders but
subordinate to creditors. [SH: so if don’t meet test, K not enforceable…but party to K gets some
mid-level priority in capital structure.]
Judge admits that requiring application of tests at execution and performance might result in business
uncertainty, but policy of business uncertainty which might underlie the CBCA is not as important as
the paramount purpose of s. 34 (i.e. protect creditors and SHs).
RULE: S. 34 solvency test must be applied (and met) not only at date of execution (of share purchase
contract) but also at date(s) of performance.
Clarke v. Technical Marketing Associates Ltd. (trustee), [1992] Ont. Ct. (Gen. Div) p. 380
Part V – Mergers and Acquisitions
Terminology, Structure and Process
-
The word merger doesn’t have a specific meaning in Canada (though it does in US). In Cda, it refers
generically and imprecisely to any method by which two or more businesses are combined.
Two ways to acquire a company
1. Asset Sale/Purchase (in general, buyers prefer)
2. Share Sale (in general, sellers prefer) – this one much more common; sell assets = capital gain
Asset Sale
DHs &
SHs
Company A
Company B
A’s Assets
B’s Assets
Company A
Company B
A’s Assets
B’s Assets
DHs &
SHs
B now in liquidation mode – must
distribute cash to shareholders by
paying dividend or doing
liquidation distribution. Sellers
don’t like this b/c process of
liquidation takes a long time.
NB: if successor obligor clause in
debt instrument, B likely had to
assign debt to A
SH Approval
Need approval of B’s SHs (b/c
sale of all or substantially all
assets)
No approval of A’s SHs b/c
directors have unltd authority to
borrow.
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Four ways to structure a friendly share acquisition:
1. Amalgamation
2. Capital reorganization
3. statutory plan of arrangement
4. take-over bid
Amalgamation
-
-
-
Two CBCA corps can amalgamate (if only one is CBCA corp, must continue other corporation under
CBCA before can amalgamate)
In an amalgamation, two or more corporations are fused into one new corporation (“AmalCo”)
Short-form amalgamation possible if one corporation is wholly-owned by the other [see 184(1)
CBCA for vertical short-form and 184(2) for horizontal short-form]
An amalgamation agreement must specify how the shares of each amalgamating corporation are to be
converted into shares or other securities of the amalgamated corporation. Often, parties choose to
eliminate all participation rights of the shareholders of one of the amalgamating corporations, by
“cashing out” their shares or issuing them redeemable preferred shares in the amalgamated
corporation (which AmalCo would redeem following the amalgamation). Latter is preferable from
tax perspective.
Amalgamation agreement must be approved by a special resolution of the shareholders (both voting
and non-voting) of both amalgamating corporations. This creates an issue for the acquiring or
‘bidding’ company b/c it would prefer not to make its bid conditional on approval of its own
shareholders. SO, bidder will generally incorporate a wholly-owned subsidiary. This sub can
amalgamate with target w/o the approval of the parent.
Bidder’s sub and target amalgamate, redeemable preferred shares of AmalCo held by target
shareholders are redeemed. Bidder and AmalCo can now be amalgamated via short-form
amalgamation. In short form amalgamation, shares of bidder stay outstanding and its shares in
AmalCo are cancelled.
-
Three-cornered amalgamation: shares of target are redeemed for shares of bidder (rather than for
preferred shares of AmalCo).
-
Merger of equals: stock-for-stock merger between two “equals.” Rather than one co. incorporating
a SPV, both boards will usually seek SH approval. SHs of each amalgamating company will get
shares of AmalCo. (could be 50-50, 60-40, etc.)
-
SH approval: 183(5) – subject to sub (4), an amalgamation agreement is adopted when SHs of each
amalgamating corporation approve it by special resolutions (66 2/3% of all shareholders  nonvoting shares will have vote, but multiple-voting shares will retain their multiple votes). Sub (4) –
shareholders of class or series specially affected by provisions of the agreement are entitled to vote
separately as a class in respect of such agreement. [Per s. 184, short form amalgamation (horizontal
or vertical) need only be approved by the Board].
Take-over bid
-
-
Def’n: an acquisition of voting or equity securities in an issuer that, together with the acquirer’s prior
holdings, represent at least 20% of a class of the target’s securities. Where target company is CBCA
corp, threshold is 10% of company’s shares.
The US concept of tender-offer is similar to the Cdn concept of a take-over bid.
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1.
2.
3.
4.
5.
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December 2004
If shareholder owns 20% of any class of shares, he will be required to comply with formal bid
requirements if acquires only one additional share.
Fundamental take-over bid requirements (pursuant to Ontario Securities law)
bid must be made to all holders of the class of securities subject to the bid; partial bids are permitted
but only if made on a pro-rata basis (i.e. if want to get only 66 2/3% and more shares are tendered,
must buy a few from each shareholder)
Bid may be all cash, all securities, or a bit of each
Offeror must offer identical consideration to all holders of shares subject to the bid [SH: will usually
have to pay control premium but, if there is controlling SH, cannot pay this premium exclusively to
the controlling SH – must pay same to all shareholders, i.e. divide control premium among them]
The bidder must accompany its bid with a detailed take-over bid circular
Once the bidder’s take-over bid circular has been delivered, the directors of the target are obliged to
consider the offer, and prepare and issue a circular of their own to shareholders – must either
recommend that holders accept or reject the offer, or, if unable to make a recommendation, must
provide reasons they have declined to make a recommendation. [must consider director’s legal
responsibilities to shareholders of target – see cases]
Bidder will aim to get 66 2/3% of shares tendered (and will likely make this a condition of its bid) –
once enough shares have been tendered, what happens?
o If greater than or equal to 90% of shares are tendered, the offeror is entitled to acquire the
shares held by the dissenting offerees (s. 206 CBCA – “compulsory acquisition”). Price
to be paid for these shares = either price paid to those who tendered their shares or, if
dissenting shareholder so elects, ‘fair value’ as determined in accordance with the Act.
[Corp must send notice to any non-tendering SHs; if they don’t respond – put $ in trust
for them].
o Note that per 206(2), can only do compulsory acquisition where have 90% of all classes
of shares (voting and non-voting) to which the bid relates. (Getting 90% of votes, or
voting shares isn’t enough).
o If less than 90% but greater than 66 2/3% of shares are tendered, can do post-bid
amalgamation squeeze, which involves long-form amalgamation between a bidding
company and a target company, effected in such a way that the participating interests of
minority shareholders (i.e. those who didn’t tender) are eliminated (i.e. get redeemable
preferred shares in AmalCo). This is known as a ‘post-bid going private transaction.’
Mechanics of the post-amalgamation squeeze
- Usually tendering of 66 2/3% will be condition of bid.
- If get to 66 2/3%, most companies will extend bid – try to get to 90%
- If don’t get to 90%, will do squeeze by voting the 66 2/3% shares in favour of a long form
amalgamation
1. Buy 66 2/3%
2. Incorporate Bsub (i.e. subsidiary of bidder)
3. Transfer shares of T down into Bsub (so that don’t get cashed out)
4. Call meeting and propose amalgamation
5. Vote the 66 2/3% in favour of the amalgamation – per the CBCA, the 66 2/3% are cancelled (CBCA
provides for this where one amalgamating company owns shares in the other) and the remainder are
converted into redeemable preferred shares (per terms of amalgamation agreement being voted on).
**Price being offered to the remaining SHs in this “second step amalgamation” must be the same as
that offered to SHs in the first step (i.e. the take-over bid).
- Note that buying 66 2/3% of the shares will be sufficient to do post-amalgamation squeeze only as
long as bidder is not doing something special to one class of shares (e.g. redeeming them for $35 even
though worth $40). Would need 66 2/3% of each class of shares being treated in a special way and 66
2/3 % of all other shares (s. 183 CBCA).
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**Takeover-bid much more common than amalgamation. Latter is popular for cross-border transactions.
Hostile acquisition
- cannot be done via amalgamation (how do you force the target company to hold a SH meeting?)
- hostile bids always done via takeover.
- Hostile bid that is rebuffed by target will usually lead to auction in which company solicits competing
bids in order to try and get best price for shareholders.
Take-over bid / amalgamation timeline
A. Company becomes “in play”
- Either b/c company decides to sell itself via auction OR b/c another company has made a ‘hostile’ or
‘unsolicited’ offer
- [Why would a company decide to sell some part of itself? When parts of company are worth more
than company itself. E.g. Sharon: newsprint asset worth more on its own than as part of the group]
- Once company is ‘in play,’ duties of BOD change. Directors go from long-term stewards of company
to maximizers of SH value. Must maximize value in way that is prudent, in BIC, and consistent with
duties owed to company. To avoid any conflicts of interest and fulfill duties  set up special
committee
- Special committee should be made up of independent directors, i.e.
o Not Officer-directors (b/c their job is on the line)
o Not Controlling SH or significant SH
o Not Any directors who are involved with a potential buyer
- MB: company only “in play” when control is for sale, or another company has bid for control (in a
“merger of equals” stock-for-stock merger between two widely held companies, neither company
would ever be “in play” (b/c control not being given up) therefore duties of Boards don’t change
B. Auction
- If company decides to sell itself, will initiate auction confidentially. Fact that co. is for sale is
destabilizing (i.e. for employees, suppliers, etc. – they will just give up) so best not to spill the beans.
- Company may, however, initiate auction in response to a public hostile bid, in which case auction will
not be confidential
- Approach potential bidders
- Set up data room and make confidential information available to those who sign non-disclosure
agreement
- Why set up data room? More information = more comfort about the company = higher bids (all part
of duty to maximize value for shareholders)
- **Note that auction process is necessary as means to fulfill fiduciary duty, i.e. maximizing value for
shareholders. Thus would not be necessary where no sale of control. Also, might not be necessary if
a bidder offers an outrageously high sum of money.
C. Non-disclosure agreement
- Potential bidders are asked to sign a non-disclosure agreement before any information is transferred.
“We will give you info about bid, possibility of sale, information about the company, etc. and if you
don’t win the bid, you will destroy everything or return it to us.”
- NDA particularly important where the bidder is a competitor. Don’t want to give competitor access
to pricing information etc. b/c could price you out of business OR you could be violating competition
laws (collusion).
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-
Confidentiality also benefits the bidder by keeping the bid price down. If secret leaks, share price
will rise and bid will become more expensive.
- Other provisions of NDA include:
1. “You will not trade in our securities”
2. Standstill provision: “you will not make offer to buy shares without the consent of the Board”
a. Allows BOD to control the process
b. Enables bidders to put their best price forward (b/c they know that if their bid wins, other
unsuccessful bidders will not be able to make another bid w/o going through BOD)
c. Protects company in event that no sale is consummated and stock price crashes – want to
prevent the potential bidders from coming in and offering low-ball price
D. Call for bids, signing of support / merger agreement
- Call for bids; choose successful bidder; enter into support/merger agreement.
- Support agreement is a commitment by target to submit the bid to SHs (amalgamation) or recommend
it to SHs (takeover bid). Board cannot promise to deliver the co. (though majority SH could)
- What provisions will be in support agreement:
1. No shop
- promise not to shop the company around anymore
2. No talk
- promise not to talk to other bidders
- EXCEPTION: fiduciary out – if another company makes a superior offer (better price and
conditions), target can enter into discussions with it. If such an ‘out’ wasn’t included, the no-talk
provision might be void as being in breach of directors’ fiduciary duty (i.e. which translates into
maximizing value for shareholders).
3. Break fee
- If superior proposal is made and completed, original winner of bid process will receive some percent
of the deal value to compensate for expenses and opportunity cost. Effect of this is that price paid by
new bidder will be higher
- See Brazen
- MB: break fee has to be high enough to compensate the original bidder but not so high as to make the
company unattractive to other potential bidders (negates effect of fiduciary out).
4. Matching right
- Right to match any superior proposal, such that directors will be bound to recommend original bidder
if that bidder merely matches (and does not exceed) a superior proposal
5. Conditions to deal – e.g. covenants re. how B will carry on business in the interim; reps and
warranties by T; material adverse change clause.
-
-
Support/Merger agreement: agreement entered into between bidder and target; will stipulate what
is required for the deal to go ahead (conditions etc.). In case of amalgamation, an amalgamation
agreement will usually be attached as a schedule.
Amalgamation agreement: in case of amalgamation, will be an amalg agreement upon which SHs
of both amalgamating corporations will vote. Will stipulate name of amalgamating co., office, what
happens to shares of each, which bylaws survive, terms of shares of amalgamated co., etc. Where B
has incorporated Bsub to amalgamate with T, the agreement will be between Bsub and T, while the
merger agreement will be between B and T.
How does this all change when there is a majority shareholder?
- The majority SH, and not the directors, will have the conversation with the bidder.
- Majority SH can commit irrevocably – doesn’t need to engage in auction process, or to include
fiduciary out in the agreement b/c majority SHs have no duty to minority SHs (at least not in Cda).
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[Buyer would like possibility of irrevocable commitment – can offer best price b/c knows that no
other bidder can come along and out-bid them].
In such a situation, not much that directors can do; best they could do
Note that even though majority SH commits irrevocably and controls the process, buyer must make
same offer to minority shareholders as it does to majority shareholders (per securities laws)
Note also that, while no duty owed to minority by majority, minority could try to take oppression
recourse in case where majority SH creates reasonable expectation (in a circular for example) that
would act in interests of minority.
How do we reconcile Wise with change of control cases?
- Wise: duty of loyalty is owed to corporation and doesn’t change on eve of insolvency
- Can we apply this same reasoning to change of control? I.e. on eve of change of control, no duty to
SHs to maximize value? Does Wise change take-over bid law in Cda?
- Interestingly, Wise cites (in support of its reasoning) several of the take-over bid cases we looked at!
Fiduciary Duties of Directors and Others
Paramount Communications v. QVC Network, [1993] S.C. Del. p. 439
Facts:
- Proposed acquisition of Paramount by Viacom to form so-called ‘strategic alliance’
- Original merger agreement contained 3 ‘defensive provisions’ designed to make it difficult for
competing bid to succeed
o No-shop provision
o Termination Fee
o Stock Option Agreement
- QVC made competing bid; Viacom and Paramount negotiated new competing bid (Amended Merger
Agreement) – defensive provisions were not removed or modified. Note: both bids would effect
change of control, b/c Viacom/QVC would get 51% of all Paramount’s stock in exchange for cash
and different kinds of Viacom/QVC stock.
- QVC made another competing bid.
- Mtg on Nov. 15, 1993 – Paramount Board determined that QVC bid not in best interests of
stockholders b/c excessively conditional, and that Viacom transaction advantageous. Did not
communicate with QVC regarding the status of its conditions b/c believed that No-shop provision
prevented such communication in absence of firm financing
Issue:
Did directors violate their fiduciary duty by rejecting QVC bid?
Held:
Yes
Ratio:
- Normal circumstances  BJ Rule, i.e. neither court nor stockholders should interfere with managerial
decisions of directors; decisions of directors entitled to deference
- In certain circumstances, however, court subjects directors’ conduct to enhanced scrutiny. Such
circumstances include: (1) approval of a transaction resulting in sale of control, and (2) adoption of
defensive measures in response to a threat to corporate control.
- Court discusses significance of a sale or change of control – minority stockholders no longer have any
voting power; cannot demand control premium. Thus, Paramount stockholders are entitled to receive
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a control premium and/or protective devices of significant value. There being no such protective
provisions in the Viacom-Paramount transaction, the Paramount directors had an obligation to take
the max advantage of the current opportunity to realize for the SHs the best value reasonably
available
Directors’ Obligations in sale of control context
- one primary objective – inform themselves of all material information reasonably available and
decide which alternative is most likely to offer the best value reasonably available to the SHs. Can
consider:
o amt of cash involved
o directors’ view of the future value of a strategic alliance
o non-cash consideration (try to quantify its value)
o Practical considerations (e.g. legality, financing, fairness, etc.)
Judicial Scrutiny of Directors’ Decision
- Board action in change of control circumstances subject to enhanced scrutiny
- WHY enhanced scrutiny?  (1) threatened diminution of current SHs voting power; (2) asset
belonging to public SHs (a control premium) being sold and may never be available again; (3)
concern of Delaware courts for actions which impede or impair SH voting rights
- 2 key features of enhanced scrutiny test: (1) adequacy of decision-making process; (2)
reasonableness of result [directors’ actions or result?]
- Caveats: courts shouldn’t ignore complexity of directors’ task. Ct must decide whether directors
made reasonable decision, not perfect decision. If board selected one of several reasonable
alternatives, court shouldn’t second guess choice.
Is ‘break-up’ required?
- Paramount argued that enhanced scrutiny test only applies where both change of control and break-up
- Court rejects this – distinguishes Time-Warner
- [Note Time-Warner: no change of control b/c was stock for stock merger, therefore shareholding
remained dispersed. Not so much an acquisition of one company by another]
Application to Facts:
- Paramount directors breached fid duty. Paramount directors’ process was not reasonable and the
result achieved for SHs was not reasonable under the circumstances.
- Court focused on (1) Board gave insufficient attn to the consequences of the defensive provisions –
Stock Option agreement had draconian features; termination fee made Paramount unattractive to
other bidders; no-shop provision inhibited board’s ability to negotiate with other potential bidders; (2)
had opp to re-negotiate the defensive measures but didn’t; (3) QVC offer exceeded Viacom offer by
over $1 billion. This big disparity cannot be justified on basis of directors’ vision of future strategy
b/c change of control would eliminate authority of Board to hold and implement their strategic vision
in any meaningful way.
Viacom’s Claim of Vested Rights:
- argued that had vested K rights wrt to no-shop provision and stock option agreement
- Ct said claim meritless. Viacom’s arg is that P directors could enter into agreement in violation of
their fid duties and then render P, and ultimately its SHs, liable for failing to carry out an agreement
in violation of those duties.
Pente Investment Management Ltd. v. Schneider Corp., [1998] Ont. C.A.
Facts:
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Schneider Corp was controlled by members of Schneider family who owned 75% of common voting
shares and 17% of Class A non-voting shares
Nov: Maple Leaf made unsolicited bid for Schneider ($19/share). In response, Board established a
Special Committee comprised of independent non-family directors in order to review ML offer and
consider alternative offers. Dodds, the CEO wasn’t on the committee, but did most of the
negotiating.
Subsequently ML made higher offer ($22), but Family rejected it. Family told committee that would
only accept the offer made by Smithfield foods ($25), which it preferred for tax and non-financial
reasons.
Family accepted Smithfield’s offer, and Smithfield thereby locked up control of Schneider.
After family had agreed to Smithfield offer, ML made further offer of $29.
ML and two shareholders of Schneider sought to have the transaction invalidated on the grounds that
the process undertaken by the special committee and the Board, which led to the Family’s agreement
with Smithfield, unfairly disregarded the interests of the non-family shareholders and unfairly
prejudiced them.
Issue:
Was transaction oppressive?
Held:
NO
Ratio:
- Trial judge found that Special Committee and directors exercised their powers and discharged their
duties honestly and in good faith with a view to the best interests of Schneider. Also found that
because Schneider was known to be controlled by the Family which could decide whether or not to
sell its shares, the company was never truly in play and no public expectation was created that an
auction would be held.
-
Duty of directors when dealing with a bid that will change control of a company: if a board of
directors has acted on the advice of a committee composed of persons having no conflict of interest,
and that committee has acted independently, in good faith, and made an informed recommendation as
to the best available transaction for the shareholders in the circumstances, the business judgment rule
applies (i.e. deference to the decision of the Board so long as decision taken is within a range of
reasonableness). [SH: the court here is conflating all duties, duty of care, duty of loyalty (fid duty)
and enhanced duty in change of control circumstances (citing Paramount for BJ rule!)
-
The real questions then are whether the Committee was independent and whether the process
undertaken by the Special Committee was in the best interests of Schneider and its shareholders in the
circumstances. While Paramount indicates that non-financial considerations have a role to play in
determining the best transaction available in the circumstances, here it was conceded that the court
should have regard to financial considerations.
-
Aplts argued that Dodds, the CEO, due to his conflict of interest (i.e. also an employee) shouldn’t
have been allowed to play central role in negotiating. Court said must balance potential for conflict
of interest against reasonable benefits to be obtained (i.e. CEO knows the business and can speak
about it). Also, court reviewed the various offers made to show that, as regarded Dodds employment,
the ML offer was in fact superior. If there was any financial bias arising out of Dodds’ self interest
in continued employment it would have been a bias in favour of Maple Leaf.
-
Was there a duty to conduct an auction? In Ontario, an auction need not be held every time there
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is a change in control of a company. Paramount: The obligation of directors when where is a bid for
a change of control is to seek the best value reasonably available to shareholders in the circumstances.
This is not law of Ontario but can offer guidance. Having undertaken a market canvass, there was no
obligation on the Special Committee to turn the canvass into an auction…i.e. no obligation to go back
to ML (before accepting the Smithfield offer) and ask it to make another offer.
-
-
Did the Family create a public expectation that an auction would be held? i.e. Q is whether the
statements made by the Family and widely reported in the press releases issued in response to ML’s
bids, created a reasonable expectation that an auction would be held. NO
o Family’s position on selling its controlling shareholding in Schneider was always conditional
to a high degree, i.e. they said they ‘might consider selling’
o ML wished there was an unrestricted auction but there never was
o Claimants didn’t have any expectations thwarted. When the gatekeeper shareholder merely
indicates that it might consider accepting a more financially attractive offer, then the SHs are
speculating that a deal on that basis may come to pass in which they could participate.
Inasmuch as there was no reasonable expectation on the part of the non-Family shareholders that an
auction would be held after receiving the last Smithfield bid, the SC was not obliged to give ML an
opportunity to make a third bid for Schneider’s shares
Brant Investments v. KeepRite, Ont. C.A. p. 467
Majority SHs owe no fiduciary duty to minority SHs. The enactment of s. 234 (oppression) has rendered
any argument for a broadening of the categories of fid relationships in the corporate context unnecessary
and inappropriate. B/c the statutory scheme of s. 234 is so broadly formulated, the evidence necessary to
establish a breach of fiduciary duty would be subsumed in the broader range of evidence which would be
appropriately adduced on application under that section.
SH: Oppression remedy – bring an action in oppression but allege that directors were not fulfilling their
duty of loyalty.
CW Shareholdings v. WIC, [1998] Ont. Ct. Justice p. 471
Facts:
- Canwest and Shaw were both significant shareholders in WIC
- CW made unsolicited takeover bid for all of W’s shares. IN response, W BOD appointed a special
committee to generate competitive bids.
- Shaw made a competitive bid, and w/in a day (and w/o informing CW), a full agreement had been
negotiated, finalized and signed.
- The pre-acquisition agreement included a “break fee” of $30 million (payable if superior bid is
successful) and an irrevocable option to acquire WIC’s radio assets for $160 million (payable even if
no superior offer).
- CW argued that the manner in which the W directors responded to the CW bid and committed to the
Shaw bid constitutes conduct which is in breach of their fiduciary duties in the take-over bid context,
and which amounts to “oppression.” [argued that entitled to oppression remedy as shareholder, not as
bidder]
Issue:
Breach of fiduciary duties? Oppression?
Held:
No
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Ratio:
Duty of directors
- In hostile take-over bid context, where the corporation is “in play” (i.e. where it is apparent that there
will be a sale of equity and/or voting control) the duty is to act in the best interests of the shareholders
as a whole and to take active and reasonable steps to maximize shareholder value by conducting an
auction. [note Pente v. Schneider however: auction not necessary]. Retaining independent legal
advice and establishing independent or special directors’ committees to assess and respond to the bid
are classic mechanisms which boards use to cope with their difficult duty.
- When evaluating whether the duty has been breached, the court uses a judicious application of the
“business judgment rule” and not the “entire fairness” or “enhanced scrutiny” tests employed in the
US. That is, where business decisions have been made honestly, prudently, in GF and on reasonable
and rational grounds, the Court will be reluctant to interfere and to usurp the board of director’s
function in managing the corporation. The Board’s decisions will not be subject to microscopic
examination. The Board must make a decision and exercise their judgment in an informed and
independent fashion after a reasonable analysis of the situation and acting on a rational basis with
reasonable grounds for believing their actions will maximize SH value.
- In this case, the court examined the process undertaken by WIC, and more specifically, (1) the special
committee (composition and role), (2) negotiations between WIC/Shaw, (3) “value” for the WIC
radio assets, (4) the inducements (break fee and radio asset option).
Break fees and asset lock up agreements
- Neither inducement/defensive tactic is illegal per se. Such inducements must be assessed on a caseby-case basis
- Break fees are appropriate where
1. they are necessary in order to induce a competing bid to come forward;
2. the bid that does come forward represents better value for the SHs
3. the fee represents a reasonable commercial balance between its potential negative effect as an auction
inhibitor and its potential positive effect as an auction stimulator.
- In examining asset lock up provisions, consider such factors as
1. whether it strikes balance btwn potential negative effect as an auction inhibitor (i.e. depressing SH
value), and its potential positive effect as an auction stimulator (i.e. enhancing SH value)
2. whether the price for the optioned asset is w/in the range of reasonable value attributed to that asset
3. whether the competing bid induced by the lock-up agreement provides enough additional value to the
SH to justify the granting of the option.
Cogeco Cable Inc. v. CFCF Inc., [1996] Qc. C.A. p. 500
Facts:
- CFCF was communications company with two classes of shares – Multiple voting (10 votes each, all
multiple voting shares held by one dude) and Subordinate voting shares (1 vote each, traded on TSE)
- CFCF entered into agreement to sell the shares of one of its subsidiaries, CF Cable, and to acquire
another television station from the buyer
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One of the subordinate share holders brought application for an order directing the company to submit
the agreement to SHs for approval, pursuant to 189(3) which provides that a sale, lease or exchange
of all or substantially all the property of a corporation other than in the ordinary course of business of
the corporation requires the approval of SHs.
Issue: Was CFCF required to submit agreement to SHs for approval? [i.e. was sale of CF cable
tantamount to sale of all or substantially all of CFCF’s property other than in the ordinary course?]
Held: No
Ratio:
- How to interpret 189(3) when there is no dispute about the fact that the proposed sale does not come
within the ‘ordinary course’ of a company’s business
1. Take into account both qualitative and quantitative criteria
2. While it is difficult to fix a percentage, when the sale involves 75% of the value of the property, it
ought to be submitted for approval
3. If the case cannot be decided by using the quantitative test (i.e. is < 75%), must proceed with a
qualitative analysis of the transaction.
4. Qualitative analysis: must determine whether the proposed transaction constitutes a fundamental
reorientation which strikes at the heart of the company’s activities. In other words, whether this is
a transaction which is out of the ordinary and which substantially affects the company’s purpose and
existence.
5. Application of qualitative test must take quantitative criteria into account. The greater the
proportion of property sold in relation to all of the company’s property, the more likely is a finding
that the transaction strikes at the heart of the company and necessitates the SHs’ approval.
- In making the determination, can take into account the market value of the property (in this case using
EBITDA)
Application to facts
- Quantitative test – comparative value of 80% for cable distribution and 20% for television
broadcasting
- Qualitative test – w/o the cable distribution sector and its generous and continuous monetary
contributions, the company could not have tolerated or even survived the serious damage suffered
since the year 1987 following deficits at the Television Quatre-Saisons network (another sub)
- Proposed transaction therefore constitutes a fundamental change which strikes at the very
heart of the company and it would substantially affect the corporate existence and purpose
What majority is required?
- Transaction must be approved by SHs pursuant to 189(3) CBCA, but what majority required?
- 189(8) provides that transaction subject to approval by special resolution of all classes together
- 189(7) provides that holders of particular class are entitled to vote separately only if such class is
particularly affected by the sale. This is not the case here therefore resolution must be adopted by 2/3
of the votes cash by shareholders in the two classes.
- Court also interprets s. 3.3.6 of the articles of incorporation - pursuant to this section, the transaction
must also be approved by a simple majority of the shareholders in each class separately.
RULE: test for whether corporation is selling all or substantially all of its property pursuant to s. 189(3)
CBCA.
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Lock-Up Agreements and Termination Fees
Brazen v. Bell Atlantic Corp, [1997] Sup. Ct. Del. p. 506
Facts:
- Merger agreement btwn Bell Atlantic and NYNEX provided that either corporation could pay up to
$550 million if it caused merger agreement to be terminated for one or more reasons. One of these
reasons was failure of stockholders to approve the transaction.
- Parties in their agreement called the fee “liquidated damages” and “not a penalty”
- Ptf, a stockholder in one of the companies, bought a class action alleging that the termination fee was
not a liquidated damages clause because it failed to reflect an estimate of actual expenses incurred in
preparation for the merger and is punitive, not compensatory. Also argued that $550 million payment
was “an unconscionably high termination or ‘lockup’ fee” employed to restrict and impair the
exercise of the board’s fiduciary duty and coerce the SHs to vote to approve the proposed merger.
Issue: Is liquidated damages clause / termination fee valid?
Held: Yes
Ratio:
- Test for validity of liquidation damages provision: where the damages are uncertain and the
amount agreed upon is reasonable, the agreement will not be disturbed.
- Both prongs of test are met in this case:
4. Damages that would result from a breach of the merger agreement must be uncertain or incapable of
accurate calculation. Yes - b/c of volatility and uncertainty in telecommunications industry, advance
calculation of actual damages approaches impossibility;
5. The fee must be a reasonable forecast of actual damages, and not a penalty intending to punish. Two
factors are relevant to determination of whether amt fixed is reasonable.
i. Anticipated loss by either party should the merger not occur
ii. Difficulty of calculating that loss: greater difficulty = easier to show that amt fixed was
reasonable. In cases where very uncertain, amount will only be unreasonable if it is
unconscionable or not rationally related to any measure of damages a party might conceivably
sustain
- $550 million in liquidated damages is reasonable. The parties determined the fee structure by
taking into account (a) the lost opportunity costs associated with a K to deal exclusively with each
other; (b) expenses incurred in negotiation, (c) the likelihood of a higher bid emerging for the
acquisition of either party; and (d) the size of termination fees in other merger transactions.
Moreover, the fee represents 2% of Bell Atlantic’s market capitalization of $28 billion. This
percentage falls well w/in the range of termination fees upheld as reasonable by other courts.
- Note that court is applying the liquidated damages rubric and not the business judgment rule (in case
of latter, court would show deference to decision taken with due care and wouldn’t apply an objective
reasonableness test). Test applied here is analogous to the heightened scrutiny process in which
courts examine the decision to assure that it is within a range of reasonableness.
-
Termination fee was not coercive. I.e. didn’t coerce SHs into voting for the merger. WHY? (1) not
egregiously large; (2) mere fact that SHs knew that voting to disapprove the merger might result in
activation of the termination fee does not by itself constitute SH coercion; (3) no authority to support
ptf’s proposition that a fee is coercive b/c it can be triggered upon SH disapproval of the merger
agreement, but not upon the occurrence of other events resulting in termination of the agreement.
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RULE: Test for validity of liquidated damages clause, i.e. a ‘break fee’ in a merger agreement.
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