Residual/Equity Interests v.

Fixed Interests

 Residual claim/interest holder– gets whatever is leftover after the fixed claim/interest
holder recovers its fixed interest
 Equity / residual interest – what the owner (who is the borrower) has
o Owner has a residual claim in cash flow generated
o Owner has control over business, limited by agreements with creditors, investors, etc.
o “Idea-type owner” = full residual claim and full control (in reality, is on a spectrum)

 Fixed interest – what an salaried employee or creditor (the lender) has

o “ideal-type employee” = a fixed claim, to a salary, and is obligated to follow all the
owners’ directions (in reality, is on a spectrum)

 Common mixture: Employee’s compensation package = baseline salary (fixed claim)+

bonus based on profits (residual claim)
o such an employee may bargain for some degree of control (ex. discretion to hire/fire
underlings)
 note: Even if owner contracts this control to employee, in practice, the law
will not grant specific performance relating to control. (24)

 Note:
o In corporations: equity investors = shareholders; collectively own the residual/equity
interest in the corporation

4 Fundamental Bargain Elements (or “deal points”):

1) Risk of Loss – allocation among participants of losses from the investment in or operation of
the business
a. CORP: shareholders’ have collective residual claim; they bear risk of loss only up to
the amount of their investment

2) Return – salaries, interest, and other fixed claims; and shares of the residual (profit)
a. Division of the residual has many possibilities:
i. May grant lender an option to convert its fixed claim into some share of
the residual

3) Allocation of Control – determines who has the right to make the carious decisions affecting
the business
a. General goes with the residual claim
b. CORP: management authority is vested in BOD, not in the shareholders
i. Shareholders elect a BOD, who then select the officers who run the business

4) Duration
a. how long the relationships will last
b. which relationships can be terminated
c. terms on which a claim may be transferred
d. ASK: What happens if an owner wants to withdraw?
 5) Note:
a. Greater risk of loss = greater control
b. Allocations of return and loss are major incentives
c. The attributes: risk, control, returns → associated with ownership

Constraints on Business Arrangements (3):

1) Conflict of Interest
a. Self-serving behavior may be hard to detect or control
b. Devices that may help control:
i. structure of compensation package
ii. protective rules (ex. limitations on certain transactions between corporations
and their officers and directors)
2) Government Regulation
a. May limit freedom of participants to adopt rules they would otherwise have chosen
i. Ex) bankruptcy laws limit ability of a borrower to agree to an expeditious
foreclosure in the event of default on a loan
3) Level of specificity
a. Complete specificity is not possible or even worth the cost
b. Vague general rules leave room for potential litigation

3 Basic sets of Legal rules, doctrines, and devices

used in creating business arrangements:

1) Employment relationships
2) Partnerships
3) Corporations

CONCEPTUAL:
 Legal rules and devices are tools by which people entering business relationships seek to
resolve issues re: bargaining elements (allocation of loss, returns, and control; duration)

 Derivative suit (205)

o If a corporate official violates any duties owed to the corporation + BOD fails to take
appropriate action → shareholder has a right to sue in the corporation’s behalf
o The shareholder derives the right to sue from the corporation (hence: derivative suit)
o Parties:
 Plaintiff = shareholder(s)
 Defendant = nominally, the corporation; actually, the individuals who
wronged the corporation’s officers and/or directors
o Damages:
 Recovery accrues to the corporation
  In a successful derivative suit: the corporation must pay for the π
shareholder’s legal expenses
 Solves the “free rider” problem – this in effect taxes all shareholders
(including the wrongdoer) and thus equitably apportions the costs of
monitoring Δ’s conduct

Derivative suit –

TYPES OF SECURITIES: BONDS, DEBENTURES, AND NOTES (248)

 Basic elements
o Terms used
o relationships between investors with different claims in the firm (between lenders and
equity investors)
 Focus on: traditional obligations –
o Fixed claims to interest and principal; and
o Fixed duration

General:
 Short-term
o Notes – shorter-term obligations

 Long-term (5+ years, seldom more than 30-40 years):

o Bonds – long-term obligation secured by a mortgage on some property of the issuer
o Debenture – long-term unsecured obligation
o NOTE: Bonds and debentures tend to be referred to interchangeably as “bonds”
o Essentially:
 Commitments of funds to a firm for a relatively long, but limited period
 Maturity date – a fixed date at which the firm must pay the principal sum

 A corporation “selling or issuing bonds to the public” means that:

o The corporation is borrowing money from people
o Those people/lenders may receive a fancy certificate as tangible evidence of the
corporation’s obligation to:
 Pay interest
 Repay the principal
 Abide by certain terms and conditions

 Bond holders can sell the bond to anyone for any price

Bond calculations:
 Bonds/debentures are usually issued in denominations of $1,000
o Price quotes in financial pages:
 Price per $100 face value
 Price of bond is 98 ½ → denomination is $1,000 and price is $985
 Denomination = face value = par value of a bond
o the amount that must be paid on maturity (at the end of the term of the loan)

 A bond manifests the borrower/corporation’s obligation to pay:

o A fixed amount of interest at regular intervals (usually 6 mos.)
 Expressed as the nominal interest rate or coupon rate
o Face amount at maturity

 Nominal interest rate = coupon rate:

o The total annual interest payment expressed as a % of the face value
o Reveals the annual $ amount that the borrower is required to pay
o (AOT the true interest rate or yield which is different if bond is not bought and sold
at par)
o Example:
 If a bond obligates a company to pay $85/year and $1,000 at maturity →
coupon rate is at 8.5%
o Note:
 Original sale price and current market price → NO effect on coupon rate

 Yield/true interest rate considers:

o Coupon rate,
o current price of bond, and
o length of time to maturity