Capital Structure and Corporate

Governance
 International Banking and Finance Law Series

VOLUME 2 1

Series Editors
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SMU Dedman School of Law, Dallas
Ross P. Buckley Professor of Law, University of New South Wales, Sydney
Douglas W. Arner
Asian Institute of International Financial Law, University of Hong Kong

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Itzikowitz, Edward Nathan Sonnerbergs and University of the Witwatersrand,
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Executive Editors
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Guiliani, Dallas
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The titles published in this series are listed at the end of this volume.
Capital Structure and Corporate
Governance

The Role of Hybrid Financial Instruments

Lorenzo Sasso

�. Wolters Kluwer
Law & Business
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To my Mum and Dad
 Table of Contents

Acknowledgements Xl

Introduction 1

Part I : Regulatory Issues of Hybrid Financial Instruments :

The Classification Approach 7

CHAPTER 1
A Historical Perspective 9

§1.01 The Birth and Evolution of Preference Shares in the British Legal
System 9
[A] Particular Features of the Preference Shares : The Preferential
Dividend 18
[B] Priority to the Repayment of Capital in Event of Liquidation 22
[ C] Conversion and Redemption of Preference Shares 27
[1] Failure to Redeem 31
§1.02 Nature of a Debenture 33
[A] The Origin and Evolution of the Subordinated Irredeemable
Debentures 37
[B] Elements of Convertible Obligations 40
[ C] Debt Holding Restrictive Covenants and Veto Rights 43

CHAPTER 2
Distinguishing between Equity and Debt 47

§2.01 Does Capital Structure Matter? 48

§2.02 Definition of Equity and Share Capital so
§2.03 Why Distinguish between Equity and Debt: The Role of
Accounting as Control over Regulations 52

. .

vu
 Table o f C o n tents

§ 5 . 03 Shareholder-Convertible Bondholder Agency Problems 1 24

[A] The Protection of Convertible Bondholders in Mergers and
Acquisitions 125
[B] The Protection of Convertible Bondholders in Assets Disposal 1 29
[C] Other Situations of Potential Dilution : The Distribution of
Dividends 131
§ 5 . 04 An Evaluation of the Rationale and Protection for Hybrids 135

CHAPTER 6
Financing through Hybrid Instruments : Risks Opportunism and Legal
Strategies for Mitigation 137

§6.01 The Use o f Convertible Bonds to Reorganize and Restructure a

Firm 137
§ 6 . 02 The Manager-Convertible Bondholder Conflict 1 39
[A] The Timing of the Conversion and the Issuer' s Call Option 141
[B] Value Dilution of the Conversion Option 1 43
[1] Price-Based Methods of Anti-dilution 145
[2] Full Ratchet and Weighted Average Ratchet Anti-dilution
Provisions 1 47
§ 6 . 03 The Majority-Minority Conflict in Venture Capital Financing:
The Investor' s Claim Dilution 1 50
[A] Existing Legal Remedies in the UK and US 151
[B] Loan Covenants , Veto Rights and Pay-to-Play Clauses 1 53
§ 6 . 04 An Evaluation of the Rationale and Protections for Hybrids 1 56

CHAPTER 7
Control Transactions 1 59

§7.01 The Agency Conflict i n Control Transactions 1 60

[A] The Exit Event in Venture Capital Start-Up Firms 1 62
[B] The Use of Convertible Instruments as a Device to Allocate
Control 1 64
§ 7 . 02 Existing Legal Strategies for Preference Shareholders Protection 1 67
[A] The UK Takeover Panel and the City Code on Takeovers and
Mergers 1 67
[B] The Standard Strategy: The Duty of Loyalty in a UK-US
Comparative Perspective 1 70
[ 1] Do Directors Owe Fiduciary Duties to Preference
Shareholders? 1 73
§ 7 . 03 Financial Contract Design for Controlling the Board' s Power in
Exit Events : Veto Rights, Drag-Along and Tag-Along Clauses 1 76
§ 7 . 04 An Evaluation of Hybrid Financial Instruments ' Use and Protection
in the UK and US Jurisdictions 1 79

IX
Table of Contents

[A] The Accounting Standards for Classifying Hybrid Financial

Instruments 54
[B] Classifying Hybrid Financial Instruments for Tax Purposes 63
[ C] Re-characterization of Financial Claims in Liquidation 68
§2 . 04 Classification of Financial Instruments in Different Regulatory Areas 70
§2 . 05 Hybrid Financial Instruments ' Implications for Corporate Law 73

CHAPTER 3
Setting the Theoretical Framework 75

§3 . 0 1 Transaction Costs and Company Law 76

§3 . 02 The Company as a 'Nexus of Contracts' and the Theory of
Agency Costs 77
§3 . 03 Contract Incompleteness and Ex Post Conflicts 81
§3 . 04 The Modern Theory of Property Rights 82
§3 .05 Summary of the Analysis 86

Part II: Governance Regulation of Hybrid Financial Instruments:

The Functional Approach 89

CHAPTER4
From the Classification to the Functional Approach 91

§4 . 0 1 Governance Implications o f Issuing Hybrid Instruments 92

[A] Large Publicly Traded Companies 94
[B] Small Closely Held Start-Up Firms 96
§4 . 02 The Structure of Part II 98

CHAPTER 5
Significant Corporate Decisions 101

§5.01 Contracting for Governance Rights at a Company's Start-Up 101

[A] Limits to the Control Power of a Lender 1 OS
[B] The Use of Hybrid Instruments to Align the 'Ex Ante'
Incentives of Managers : Stage Financing and Contingent
Convertible Debt 1 07
[1] Preference Shares as Incentive Contracts 1 10
[C] The Use of Hybrid Instruments to Reduce the ' Ex Post'
Hold-Up Problems 111
§ 5 . 02 The Manager-Shareholder Conflict in Charter Amendments :
Variation of Class Rights 1 13
[A] The Position of Preference Shareholders and their Protections :
A UK-US Comparative Analysis 115
[B] What Constitutes a Variation of Class Rights? 1 19
[ C] Legal Strategies for Preference Shareholders 121

. . .

Vlll
Table of Contents

Conclusion 181

CHAPTER 8
Conclusive Considerations 1 83

§8.01 The Rationale for Hybrids and Implications for Corporate Governance 1 84
§ 8 . 02 Legal Strategies for Protection: The Need for Regulation or More
Flexibility? 1 86

Bibliography 1 93

Table of Cases 217

Table of Legislation 225

Index 22 7

x
 Acknowledgements

This book is the result of my years of research conducted as PhD candidate at the law
department of the London School of Economics and Political Science. Those years
spent in Britain, mostly between London and Oxford, were extremely stimulating for
my research . I had the chance to know many people - colleagues and friends - who
have challenged and helped me in many different ways to become who I am.
I would like to reiterate my gratitude to my supervisor - Professor Paul L. Davies -
for encouraging me to not surrender to develop my ideas and follow my instincts . This
book would not have been possible without his help . His sense of perspective and
unparalleled in-depth analysis has been a source of admiration and motivation for me.
Special thanks go to the j ury members of my PhD defence - Professors Eva Lomnicka
from King' s College and David Kershaw from LSE - for their insightful and though­
provoking comments on my work. I am also very grateful to all the participants to the
' Law and Finance' Seminars in Oxford organised by Professor John Armour from
University of Oxford . I have learned much from discussions at these events on corporate
finance law and so many other topics .
Indeed, I am very thankful to my Italian supervisor - Professor Marco Lamandini
- for our challenging exchanges of ideas, for his availability and continuous support;
and to the law department at the University of Bologna, Faculty of Economics - in
general, for allowing me to continue my research in a highly stimulating environment.
I am also very grateful to Professor Luca Enriques for his support.
Lastly, I would like to thank my partner Zeynep for all her love, unfailing support
and encouragement in all my pursuits, my brother Stefano and his dog Ruben for
cheering me on in moments of frustration and my parents Annamaria and Cosimo, to
whom the book is dedicated, for having given me the world to play with .

.
XI
Introduction

This book consists of a study of English and US corporate finance law and, in particular,
the law in relation to hybrid financial instruments . Generally, all research or work on
corporate finance law begins by underlining a basic distinction regarding how capital
is raised. This concerns the two different channels of investment in a company: equit:y
and debt. Equity represents the totality of the claims characterized by governance
entitlements, while debt is regarded as the part of the capital structure that benefits
from financial entitlements . Given that equity is the last of bankruptcy priorities, it is
often defined as risky capital compared to debt, which is distinguished by its contrac­
tually specified financial claims . In particular, I refer to ordinary shares as the equity
stock held by the members of the company because this is the classic class of shares
clearly distinguished from debentures both in law and fact. The rights of an ordinary
share are considered to be essentially residual, and a shareholder only expects to
benefit from the surplus, both for any given period and as accumulated over a period,
i . e . , retained earnings . For this reason, ordinary shareholders are also called the
residual claimants in the corporation and usually hold all or most of the voting power,
the right to contribute to the organization of the company' s business and the right to
control its affairs, appointing and removing its directors , through attendance at
meetings or voting. Conversely, the full rights of a debt-holder contrast well with the
expectations of a shareholder. I refer to bond as a debt security held by a creditor of a
company. This contract is the legal relationship between a company and its bond­
holder, based on a pecuniary cause, where the investor loans a certain amount of
money to the company and the latter engages itself in repaying this amount by a certain
date or on a fixed date with corresponding periodical interest. The bondholder is in law
not a member of the company with rights in it, but a creditor with rights against it. This
can result, if the company defaults, in the bondholder petitioning the Court on behalf
of its rights and asking for the repayment of its credit. 1

1. See among the others : P . L. Davies & S . Worthington, Gower and Davies ' Principles of Modem
Company Law 1 2 0 1 et seq. (9th ed. , Sweet & Maxwell 20 1 2) ; D . Kershaw, Company Law in
Context: Text and Materials 649 and 797 (Oxford New York, 2nd ed. Oxford U. Press 20 1 2) ; L.
Cullifer & J. Payne, Corporate Finance Law: Principles and Policy Ch. 3 (Oxford and Portland,
Hart Publg. 2 0 1 1 ) .

1
 Introduction

Despite a clear distinction in law between equity and debt, this has become
increasingly blurred over the years , and sorting reality into clear-cut categories has
become extremely difficult. Some of the financial instruments issued by companies,
so-called hybrid instruments, fall into a grey area between debt and equity, forcing
regulators to look beyond the legal form of an instrument to its practical substance . In
the context of this book, I adopt a broad definition of the financial category 'hybrid
financial instruments ' . In particular, I consider hybrid (or of hybrid nature) any
financial instrument that presents a mix of equity and debt characteristics . Therefore,
this book excludes from examination all the derivative instruments that are debt whose
value is derived from the performance of assets, interest rates, currency exchange rates
or other external indexes, but not from the issuer' s own shares. Instead, there are two
main types of hybrid security that will recur in my analysis, in relation to their
relevance to the situation studied: preference shares and convertible bonds . Although
a third type of hybrid is included in this definition, the book does not devote as much
attention to it as the others due limitations of space . This is the debenture-holding
covenants or veto rights . While it is common practice to consider preference shares and
convertible bonds as hybrid, it is less intuitive to include bonds with covenants or veto
rights in this group, especially considering that in the British experience these
covenants or appraisal rights are not commonly used, and the few that are have
become standard clauses in commercial contracts . However, these securities, which
are financial obligations - being generally deeply subordinated debt - retain a power of
control, typical of controlling shareholders, that limits the directors ' discretion in the
management of the company through the use of positive and negative covenants .
The aim of the book is twofold: to assess the role of hybrid instruments in the
modern company unveiling the costs and benefits of issuing these securities . It
achieves it by recognizing and categorizing the different problem fields in which
hybrids play an important role and by identifying the interrelationship between legal
and contracting solutions to governance and finance problems . Overall, the book
provides an account of the complex regulatory problems created by hybrid financial
instruments and of the different ways in which regulatory regimes (UK and US) have
responded to related problems . At the same time, the book also gives a comprehensive
account of the relevant legal and contractual strategies employed in order to resolve
contracting and governance problems arising from hybrids . The analysis compares the
UK law dealing with hybrid instruments with the corresponding law of the US - in
particular the laws of New York and Delaware - which are the most relevant
jurisdictions in relation to company law. The comparative analysis with the US
experience on this matter is extremely important to fully understand the origins and the
growth of these securities over the years since they have a similar history of develop­
ment. Comparing the US and UK approaches shows how different legal standards are
often used in these two legal systems to reach the same results . Furthermore, although
the legal jurisdiction of relevance is the UK and the issues are discussed in a UK context,

E. Ferran, Principles of Corporate Finance Law 49-54 and 3 1 3 (Oxford New York, Oxford U .
Press 2008) ; R. Pennington, Pennington 's Company Law 234-235 (London, Butterworth 200 1 ) .

2
Introduction

many of the general principles discussed in the book apply to all common law
jurisdictions . Therefore, in relation to hybrid instruments, the US market is too
important to be disregarded.
A central aspect of this work is the importance of economic theory for the
understanding and meaningful analysis of the relevant problems . Most of the research
conducted on hybrid instruments has taken its first steps from the Modigliani and
Miller (M&M) theorem, focusing on the profile of optimal leverage, namely the optimal
ratio of debt-to-equity capital . Economic theory shows very little justification for a strict
equity/debt distinction and it became quite clear to me that the law - by applying this
distinction - creates a strong incentive for regulatory capital arbitrage. Finance theory
explains this phenomenon mainly by pointing towards the differing tax and regulatory
treatment of debt and equity as well as information asymmetries between the creditors,
shareholders and managers . The differences in tax, accounting and regulatory treat­
ment give rise to distortions and this can be costly for the society. Rather than focussing
on the real advantages a certain capital structure offers, companies mainly try to
optimize their capital structure with a view to these two areas . Much of the increase in
the use of hybrids throughout the past two decades can be explained by tax and
regulatory factors . Therefore, most of the empirical and theoretical research in this area
has focused on the tax advantages of issuing hybrids as a way of reducing the cost of
capital from a company' s point of view, or on their capacity to be subordinated to all
the creditors and to be unable to trigger the liquidation of the firm in case of default on
its payouts . However, very little contribution has been made to the analysis of these
securities with regard to their implications for corporate governance. A large part of
this manuscript is dedicated to this original approach. In this sense, I propose a
functional approach for analysing and discussing the governance regulation of hybrid
financial instruments .
Currently, our approach is based on the traditional understanding of debt and
equity as fundamentally different, opposing methods for financing a corporation' s
business . Starting from there, tax and accounting regulation try to define every hybrid
financial instrument as merely a mix of the two opposing ends of the capital spectrum
- pure debt or pure equity. I argue that this simplified view of hybrid financial
instruments fails to properly grasp the complexity of modern corporate finance. In my
view, more emphasis should be put on the agency relations and the property law claims
embedded in such unconventional financial instruments . Economic theories on the
nature of the firm have generally explored two areas of intervention in order to reduce
managerial opportunism and conflicts of interest. The stream of doctrine who studied
the agency costs as the main cause of inefficiency, has focused on the principal-agent
relationships in the company trying to align managers ' and shareholders ' incentives in
order to maximize the company' s wealth. Other part of the doctrine instead - focusing
on property rights - emphasizes the importance of ownership when it comes to
allocating control powers and residual claims . As a matter of fact, companies deal with
uncertainty and risk in their businesses . Changing economic conditions also compa­
nies' choices change. What has been agreed between the parties before may not work
anymore and (financial) contracts are incomplete by nature . Transaction cost econom­
ics maintains that bargaining is pervasive during a business life because it is extremely

3
 Introduction

difficult to anticipate all of the relevant bargaining action at the initial contracting stage.
Thus, governance mechanisms for ex post regulation or measurement are needed to
avoid expensive disputes or opportunistic behaviours during the life of the firm. In this
sense, contractual design is essential . A more flexible contract going beyond pure
equity or debt such as a hybrid security could effectively work as a very efficient
compensation contract, aligning the ex ante incentives of managers and investors while
allowing a perfect economic integration between the investors in the firm. In fact,
peculiar features of hybrids are their vague terms and conditions - always observable
if not verifiable by a Court - that allow the parties to re-negotiate their rights when a
significant change occurs .
A functional approach also means putting more emphasis on the corporate
governance implications of hybrid financial instruments . While some scholars ques­
tion the case for mandatory company law, as a matter of fact there are no jurisdictions
leaving all questions of corporate law and governance to the incorporators ' freedom.
Assuming that there is a case for mandatory corporate law, we also need to ask whether
holders of financial instruments who are not shareholders in the traditional sense, but
whose contribution fulfil much of the same function as traditional equity financing,
should also be offered the same level of (mandatory) protection we deem necessary for
the typical member of a company.
As emerges from the historical analysis of these financial contracts, the status of
preference shares has often given rise to a number of grounds for dissatisfaction.
Historically, companies in need of finance have often raised funds in the form of
preference shares, promising investors a higher return and priority for capital repay­
ment at liquidation to compensate for their lack of voting rights . However, once these
companies became profitable again, they often excluded preference shareholders from
sharing in the profits beyond a certain fixed percentage stipulated in the terms of the
contract. Preference shareholders support a risk similar to ordinary shareholders when
they contribute funds in a time of financial difficulty for a company because they are,
like ordinary shareholders, subordinate to all the creditors in liquidation. However,
they do not enjoy the same rewards if the company is successful. It seems therefore that
preference shares have become more similar in nature to debentures than to shares,
without having the same advantages . The assessment of the value of these shares ,
compared to ordinary bonds, while the company is a going concern, is difficult because
it must take into account the contingency of whether or not the ordinary shareholders
will act to appropriate the company' s profits for themselves before a winding up . With
regard to the nature of the preference share, it is arguable that many of its inconsis­
tencies could be eliminated if it were fully equated, with respect to capital entitlements,
with debenture or other fixed income securities . However, the essential nature of the
preference share has never been clarified by the courts or in law, apart from their
rights, which are stated to be contractual in nature. This poses the main problem for
hybrid instruments .
It is often debatable how far their protection is a matter of contract and how far
it is a mandatory matter of company law. Although nowadays the UK courts seem to
have reached some definitive canons of construction, some recent US cases take a
different direction, opening up again the discussion of directors ' fiduciary duties

4
Introduction

towards shareholders as a whole, including preferred shareholders . The analysis

shows that a lot of scope is left to the parties involved to bargain for their financial
rights and rights of voice. Mandatory rules for public companies , which are few, are
generally optional for private companies . This provides the investors with a strong
incentive to contract for their rights .
The remainder of the book i s organized a s follows . Chapter I initially defines the
hybrid instruments under examination, giving the reader an understanding of the
peculiarities of these securities and of their evolution over the years . Chapter 2
discusses the economic and legal rationale for distinguishing between various claim­
ants in the firm. The law is dedicated to a classification approach. In particular, this
chapter examines some regulatory issues in relation to hybrids following classic legal
analysis, which includes the legal classification of these securities according to
different legal disciplines . The study highlights the limits and the inconsistencies of this
approach and provides the basis for a new taxonomy: a functional approach . This
approach is applied in the remaining chapters of the book. Chapter 3 concludes Part I
by setting out the theoretical framework with a reassessment of the main theories of
corporate finance and governance . In Part II, the hybrid instruments as referred above
are observed in several critical situations depending on their relevancy to the situation.
Therefore the governance regulation of hybrid instruments is analysed in significant
corporate decisions such as firm ' s constitution, variation of class rights, assets disposal
and distribution of dividends (Chapter 5) , in corporate financing decisions under
uncertainty when the risks of opportunism of the parties is very high (Chapter 6) and
in corporate control transactions (Chapter 7) . Statutory law, legal standards and
strategies for protection are discussed, compared and evaluated. Chapter 8 concludes
with some considerations .
The legal distinction between equity and debt can be meaningless and the results
of that categorization misleading. As observable in practice, the increase in financial
innovation reflects the necessity of the parties to allocate control and cash flow rights
in a way that diverges from the classic allocation resulting from equity and debt.
Companies and capital structures evolve continuously in conditions of uncertainty and
the incentives of the parties may diverge during the years . Thus, the parties may
disagree on something they agreed on before. In such situations, the law is intended to
protect the weak party from any possible abuse, while at the same time facilitating the
business in the best interest of the firm. The functional approach unveils an important
rationale for issuing hybrids . Both the US and UK have legal systems characterized by
transactional flexibility that places these two countries among the most business­
friendly legal systems . Both the US and UK legal systems rely on ex post standards
strategies to protect preference shareholders and on the judiciary to evaluate the
fairness of a transaction. The choice of the regulator not to burden the market with
excessive mandatory company law has left a lot of scope and given a strong incentive
to the parties to contract for their rights . This has favoured the business and allowed
the parties to better protect themselves with careful drafting.

5
Part I: Regulatory Issues of Hybrid Financial
Instruments: The Classification Approach
CHAPTER 1

A Historical Perspective

The purpose of this chapter is to describe these hybrid financial instruments and to
examine their origins in order to inform later analysis of the character of those
securities . In particular, the examination focuses on the evolution of these instruments
showing how certain forms of contract, as preference shares, have moved away from
standard equity peculiarities and certain others, as subordinated irredeemable deben­
tures, convertible bonds and bonds with covenants, have moved away from standard
debt characteristics . Moreover, it assesses the financial issues that such hybrid
contracts raise and how the law and the courts have coped with their use since their
first appearance in the history of corporate law .

§1. 0 1 THE BIRTH AND EVOLUTION O F PREFERENCE SHARES I N THE

BRITISH LEGAL SYSTEM

Atypical security issues, which were different from ordinary shares, can be found in the
records of British companies as long ago as the seventeenth and eighteenth centuries . 1

1. Since they appeared as an alternative to equity and evolved over the years such that preference
shareholders ' rights became ' somewhat more approximated to the role . . . of debenture­
holders' as Lord Evershed MR stated in 1 949 , Re Isle of Thanet Electricity Supply Co . [ 1 950] Ch.
1 6 1 at 1 75 . See also L.C.B. Gower, Principles of Modern Company Law 22-28 and 3 5 7-368 (3rd
ed. Stevens & sons 1 969) ; R. Pennington, Partnerships and Company Law 97- 1 03 (Butter­
worths 1 962) ; J . H . Farrar, Farrar's Company Law 226-235 at Ch. 1 8 (Butterworths 1 988) ; R.C.
Michie, The London Stock Exchange: A History 3 1 et seq. (Oxford U . Press, 1 999) ; R. Burgess,
Corporate Finance Law 3 1 9-323 (London: Sweet & Maxwell 1 992) ; A. Stiebel, Company Law
And Precedents 62- 7 1 (Sweet & Maxwell 1 929) ; W.R. Scott, The Constitution and Finance of
English, Scottish and Irish Joint-Stock Companies to 1720, I, 3 64-365 (Cambridge U. Press
1 9 1 2) ; C.R. Stiles , Alphabet of Investment, Fin . Rev . of Rev . 24-26 (May 1 9 1 8) . In this treatise,
the author refers to the bonds issued in 1 698 by the Mine Adventurers' company as 'in effect,
preference shares' . For a historical analysis of preference shares in USA, see also A. Stone
Dewing, The Financial Policy of Corporations 1 1 3- 1 36 (3d ed . , Ronald Press Co . 1 92 1 ) ; A. Stone
Dewing, A Study of Corporation Securities: Their Nature and Uses in Finance 1 34, n. (b) (Ronald
Press Co . 1 934) ; A. Stone Dewing, Corporate Promotions and Reorganizations Ch . 2 at 1 9

9
§ 1 .01 Lorenzo Sasso

In 1 702 , the stock of the East India Company was divided into two classes , one of
which, since it was entitled to a dividend of 8 % to be paid by the government, can be
considered analogous to preference shares. 2 Among an increasing number of British
companies in the later eighteenth and the early nineteenth centuries, there was also a
rise in the number of companies issuing securities which are best described as
preference shares . 3 Although these companies were the first to use these privileged
securities in Great Britain, it was with the railroad corporations that this new
instrument of finance developed and became popular. 4
The financial distress of the early transportation companies was one of the main
reasons for the growth of the preference shares . The projects carried on by these
companies were almost habitually started without an adequate understanding of the
engineering difficulties to be overcome and in many cases, the initial capital was
exhausted before the work was completed . Proprietors often faced with the prospects
of a bankruptcy with the consequent loss of their enterprise, or the choice to entice new
funds into their business in the hope that the proj ect could eventually be made to pay
a reasonable return. At that time, many barriers created difficulties for a company
intending to raise money. First of all, the small size of markets and limitations on the
circulation of a currency (along with related risks) meant that the resources required
for each proj ect had to be obtained mainly in the region in which the project was
located. Second, the raised money could not be immediately productive because the
time required for construction was at least several years. Furthermore, the parliament

(Ronald Press Co. 1 9 1 4) ; A. Berle, Case and Materials on Corporation Finance 438 , 44 1 , 459
(Chicago : Callaghan and Company 1 930) ; F.F. Burtchett, Corporation Finance 79 et seq.
(Harper & brothers 1 934) ; W. Cook, A Treatise on the Law of the Corporations having a Capital
Stock I, 884-935 (Baker, Voorhis & Co . 1 923) ; R.L. Masson, New Shares for Old 22-46 (Harvard
U . Press 1 958) ; G . H . Evans, Early Industrial Preferred Stocks in the United States, J. Pol . Econ.
40, 227-243 ( 1 932) ; W.J . Schultz & M . R . Caine, Financial Development of the United States
52-56 and 96- 1 03 (Prentice-Hall 1 93 7) ; J . B . Baskin & P .J. Miranti Jr. , A History of Corporate
Finance 1 52 (Cambridge U . Press 1 997) ; J . D . Lawson, Preferred Stock, The Am. L. Register,
New Series XX, 633 -649 ( 1 88 1 ) ; R.M. Buxbaum, Preferred Stock-Law and Draftsmanship, Cal.
L. Rev. 42 , 243 ( 1 954) ; W . H . Stevens, Stockholders ' Voting Rights and the Centralisation of
Voting Control, The Q . J. Econ. 40, 3 5 7 , 367 et seq. ( 1 926) .
2. W . R . Scott, The Constitution and Finance of English, Scottish and Irish Joint-stock Companies to
1720, I 1 86 (Cambridge U. Press 1 9 1 2) .
3. For example, this is the case of Aberdeenshire Canal in 1 80 1 , the Commercial Docks Company
in 1 8 1 1 and again in 1 8 1 7, the Edinburgh Joint Stock Water Company in 1 8 1 9 , the Gloucester
and Berkeley Canal Company in 1 822 , the Southwark Bridge Company in 1 823 and 1 824, the
Edinburgh and Glasgow Union Canal and the Leominster Canal companies in 1 826 and the
Portsmouth and Arundel Canal and the Thames Tunnel companies in 1 82 8 . For more details of
these canal companies in 1 826 and the Portsmouth and Arundel Canal and the Thames Tunnel
companies in 1 828. For more details of these cases and an accurate bibliography of the
publication written at that time see G . H . Evans, British Corporation Finance 1775-1850, at
74-8 1 (Johns Hopkins Press 1 936) ; H . C . Bishop, The Joint-Stock Company in England,
1800-1825, J . Political Econ. XLIII, 1 -33 ( 1 935) ; H . C . Bishop, The Joint-Stock Company in
England, 1830-1844, J . Political Econ. XLill, 3 3 1 -364 ( 1 935) .
4. R . W . Kostal, Law and English Railway Capitalism 1825-1875, a t 28-48 (Clarendon Press 1 994) ;
G . H . Evans, British Corporation Finance 1775-1850, at 82- 1 06 (Johns Hopkins Press 1 93 6) , and
R.C. Michie, The London Stock Exchange: A History 3 1 et seq. (Oxford U. Press 1 999) .

10
Chapter 1 : A Historical Perspective § 1 .01

introduced a limitation o n corporate borrowing powers t o one-third o f the paid up

share capital. 5
In such a situation, since mortgages, annuities and promissory notes were not
always well accepted because offering higher interest rates could often mean to face a
high-risk of bankruptcy, the sale of shares was the only device left. 6 However, in order
to finalize a sale of shares in such a desperate condition, they had to make the shares
more attractive to the existing propriety or the public. Two methods for doing this were
developed: the first was to sell shares at a discount and the second was to attach a
preferential dividend to the new shares . The former had a number of drawbacks mainly
due to the fact that the capital raised did not equal the par value of the shares issued.
Given that a company, in order to increase its debt, had to comply with the limitation
imposed by law on the equity-debt ratio , there were two clear disadvantages in issuing
shares issued at a discount. These were not only that they lowered the proceeds of the
sale but also that they reduced the possibility of the company to raise new funds in the
future. Moreover, registered companies were prohibited from issuing shares at a
discount . 7 If the new share and loan capital actually raised were not sufficient to enable
the company to complete its works, Parliament had to be petitioned for the privilege of
issuing more shares and the procurement of a supplementary act was costly. The
preference share, which could be sold at par or at a smaller discount than an ordinary
share, minimized this disadvantage. It is in such a confused context, in which the need
for financing new businesses was strong and the regulation for corporate finance was
in continuous change that, the new instrument - preference share - was born and
during its life, it acquired an important economic status before its clear legal definition
was developed. 8
Another important consideration that has to be taken into account, concerns the
significant role of the statutory companies in the evolution of the preference shares . As
it emerges from the empirical data of that time, most of the companies adopting these
new kinds of securities were utility companies such as railway, gas, water and
electricity undertakings . In the past, when these public utilities were left to private
enterprise, statutory incorporations by private Acts were comparatively common since
the undertakings would require power and monopolistic rights which needed a special
legislative grant. Subsequently, as a result of the post war nationalization measures,
most of these statutory companies have been taken over by public boards and
corporations set up by public Acts . An evidence of the changing conditions of those
years is the history of the Oxford Canal. Under its act of incorporation, passed in 1 769,
the company was supposed to pay 5 % interest on all sums paid in upon its shares but

5. P . G . Dickson, The Financial Revolution in England: A Study in the Development of Public Credit,
1688-1756, Modem Revivals in History Ch. 1 4 (Gregg Revivals 1 967 edn) .
6. G.H. Evans, British Corporation Finance 1775-1850, at 76-77 and 85 (Johns Hopkins Press
1 936) ; V.E. Morgan & W.A. Thomas , The Stock Exchange. Its History and Functions 44 (Elek
Books 1 962) ; R . C . Michie, The London Stock Exchange: A History 26-28 (Oxford U. Press 1 999) .
7. Ooregum Gold Mining Co. of India v. Roper [ 1 892] A.C. 1 2 5 .
8. G . H . Evans, British Corporation Finance 1775-1850 96 (Johns Hopkins Press 1 936) ; R . C .
Mitchie, The London Stock Exchange: A History 3 1 -3 6 (Oxford U . Press 1 999) ; V.E. Morgan &
W.A. Thomas, The Stock Exchange, Its History and Functions 68-69 (Elek Books 1 962) ; J . B .
Baskin & P . J . Miranti Jr. , A History o f Corporate Finance 1 22 (Cambridge U. Press 1 997) .

11
§ 1 .01 Lorenzo Sasso

given that this payment was proved to be ' disadvantageous and inconvenient ' to the
company, its rate was reduced to 4% by a second parliamentary act in 1 775 . Later,
when the proprietors, to assure the payment of the dividends that were in arrears ,
decided to transform these accrued amounts into capital stock, Parliament sanctioned
this agreement and removed the obligation to pay 4 % interest on the shares . Dividends
were henceforth to be determined by the company, although certain limits were placed
upon the rate until the borrowed money had been repaid. However, the inconvenience
and humiliation, which beset companies which were financially unable to comply with
the terms of their agreements requiring the payment of a fixed dividend on all shares,
led to the introduction of more cautious provisions into parliamentary acts. 9
Forty years later, as the railway industry developed, some important newspapers
of that time strongly supported the payment of about 4 % fixed dividend on the deposits
and calls paid upon shares, arguing that this would create the right conditions for
raising new money, inj ect new funds to finance future proj ects as well as lend stability
to the stock market. 10 The idea of a fixed return for the investor did not involve any
preferential treatment for a particular class of shares, but the idea might have
strengthened the inclination to offer a preference whenever the condition of a company
made impossible the payment of dividends to all shareholders . Furthermore, some
differentiation in shareholders that had gradually been introduced also made the use of
preference shares a logical step for a company in dire financial straits . On 4 June 1 829,
the Edinburgh and Dalkeith Railway was authorized by Parliament to issue shares with
a 'Right to Preference or Priority' over the existing shares to the extent of a 5 %
non-cumulative dividend but with a further participation in profits . Following this
example, between 1 829 and 1 850 more than one hundred railway preferred stock
issues were either authorized by Parliament or made by companies. 11
Since their first appearance, preference shares were characterized by a hybrid
nature . Being a privileged class of shares with the right to receive a fixed dividend,
preference shares were sometimes made to rank with or ahead of the debt in the
payment of their financial entitlements, 1 2 the only exception being the payment of the
annual interest and principal due on the government loans. 1 3 Moreover, the preference

9. L.C . B . Gower, Principles of Modem Company Law 6 and 438-439 ( 3 d ed. , Stevens & sons 1 969) .
10. R.W. Kostal, Law and English Railway Capitalism 1825- 1875 28-48 (Clarendon Press 1 994) ;
see also Herapath' s Railway Magazine, May 1 839, at 209-2 1 5 .
11. L. C . B . Gower, Principles of Modem Company Law 3 5 1 -353 (3d ed. Stevens & sons 1 969) ; R.C.
Mitchie, The London Stock Exchange: A History 58-59 (Oxford U. Press 1 999) ; J.B. Baskin & P.J.
Miranti Jr. , A History of Corporate Finance 1 52 (Cambridge U . Press 1 997) . For a historical
empirical data on preference shares issued in those years , see G . H . Evans, British Corporation
Finance 1775-1850 1 63 (Appendix) (Johns Hopkins Press 1 936) .
12. As in 1 822 when the Gloucester and Berkeley Canal was authorized to issue preference shares
which were entitled to pay dividends in preference to any existing ordinary shareholder but
also in preference to any interest or payment in respect of any mortgage, bond, note, debenture,
annuity or other security due to any creditor.
13. In the Whitby and Pickering Railway Act of 1 83 7, the statute fixed that the preferred dividend
was payable after the interest on the existing debts, but in preference to the interest on debts
incurred subsequent to the issue of the new shares . The Edinburgh and Glasgow Union Canal
Act of 1 826 not only ranked the preferred shareholders pari passu with the creditors, but it
made the dividends cumulative; in other words, the part of the dividend outstanding was
deferred and accrued to the future dividend payable. Finally, the London and South western

12
Chapter 1 : A Historical Perspective § 1 .01

shares were issued with a guarantee o f either property o r revenue from a particular
source and allowed the conversion into ordinary shares when all calls were paid. 1 4 In
addition to the promise of a preferred dividend, sometimes reinforced by provisions
designed to assure the fulfilment of the company' s obligations, the preference share­
holder often possessed many of the rights of the ordinary shareholder. These included
unlimited participation in profits, the privilege of voting and the right to subscribe to
new issues . Sometimes when profits were negligible or non-existent, the dividend
promised on preferential shares was to be paid out of capital. Although Parliament did
not pursue a uniform course at first, when the speculation in shares increased and it
was thought desirable to take adequate measures, Parliament decreed in the Compa­
nies Clauses Consolidation Act that no company should declare a dividend which
would hinder its capital maintenance unless the mortgagees and bondholders gave
their consent. 1 5 This concept was strengthened few years later when the House of
Commons took an even stronger attitude stating that it would not grant any railway the
right to pay interest on calls out of capital . The Courts did not consider the Companies
Clauses Consolidation Act a document legitimating the preference shares and narrowly
interpreted this statute so that preference share issues not specifically authorized by
Parliament were illegal even as late as 1 863 , the date in which the fist general act
dealing with preference shares was created. 1 6
Preference shares became very popular and the proceeds of their sale were used
to retire loans . However, their peculiarities were about to change with their growing
success . Preference shares were introduced in the market as a temporary device, their
privileges being guaranteed for only a short period at the end of which the financial
distress of the issuing company would presumably have disappeared. Parliamentary
provisions usually protected the rights of the preference shareholder as long as he
retained his preferential position, but gradually, the preference shares became a perfect
replacement for debt while being shares . As a consequence, they started to lose the
right to rank ahead of or on a par with debt and their preferential dividend became
payable, only out of distributable profits and if approved by the general meeting. They
only maintained the priority to be paid before the ordinary shares received anything
and otherwise accumulated in a subsequent year. However, even this protection was
disappearing since some issues were being made non-cumulative . Furthermore, voting
rights and participation in new issues of securities were increasingly reserved for the
ordinary shareholder and the right to convert preference into ordinary shares was
restricted . 1 7 While until 1 847, preference shares were assumed to have voting rights

Railway Act, dated 1 839, contained a provision which allowed the payment of a dividend to a
preferred shareholder 'subject and without prejudice to all mortgages and bonds made and
issued and to be made and issued' .
14. See the cases o f the Sunderland and Durham Railway in 1 840 and o f the Preston and Wyre
Railway Harbour and Dock Company in 1 843 in Herapath' s Railway Magazine, 7 Nov. 1 840 at
858 and Ibid. , 2 1 Jan. 1 843 , at 7 1 .
15. '. .. the interest of the money borrowed upon any such mortgage or bond shall be paid in
preference to any dividends payable to the shareholders of the Company', Companies Clauses
Consolidation Act, 1 845 .
16. The Companies Clauses Act, 1 863 , 2 6 & 2 7 Viet. c. 1 1 8, s s 1 3 - 1 5 .
1 7. G . H . Evans, British Corporation Finance 1 775- 1 850 92 (John Hopkins Press) .

13
§ 1 .01 Lorenzo Sasso

unless they had been issued specifically as non-voting shares, in the second half of the
nineteenth century, the participation privilege was relatively less frequently given and
the non-participation feature was often linked with the right of conversion and
sometimes a prohibition on voting. 1 8 Another group of express provisions , which were
attached to preference shares , included those, which provided for the termination of
the dividend priority through conversion and redemption. Whenever the dividend was
not promised in perpetuity, preference shares automatically became ordinary shares
upon the expiration of the preferential dividend period. 1 9
Between the end of the nineteenth and the first half of the twentieth century, the
use of preference shares decreased and many outstanding preferred issues were
redeemed by companies and replaced with other sources of financing. 2 0 Despite the
scepticism showed by some commentators of that time, 2 1 interest in preference shares
revived in the UK and US markets between the 1 950s and 1 980s. 22 The phenomenon,
which allowed the reintroduction of the preference shares in the market, was the rather
substantial growth of the companies ' receivables during the 1 950s. This was financed
mainly with short-term debt and by the end of the 1 958, the ratio debt-to-equity had
reached a critical point and new form of equity finance was necessary. 2 3
The main obstacle they had to overcome was the introduction of a UK corpora­
tion tax in 1 965 . Since preferential dividends were paid out of taxed profits, it was
argued that preferred stock financing did not compare favourably with debt financing
which benefited from the tax deductibility of interest. However, it was also argued that
the comparison between debt and preference shares tended to mislead and confuse the
issue. If preference shares had to be compared, a more significant comparison would
have been with common stock, such as ordinary shares . 24
Many advantages characterized preference shares over the common ordinary
shares . First, preference shares, being equity, could improve the capacity of the firm to

18. As in the cases o f the Monklands Railway in 1 848 and London, Brighton and South Coast
Railway in 1 847, see Herapath' s Railway Magazine, February 1 847 and September 1 848 at 282
and at 665 respectively.
19. Few doubts rose regarding the advisability o f creating shares, which would permanently bear
a high dividend rate. Fixed income bearing security could be dangerous in view of the
possibility of periods of price inflation or unfair and unsuitable. See this point in G . H . Evans,
British Corporation Finance 1775-1850 1 3 5 -148 (Johns Hopkins Press 1 93 6) .
20. W. Ashworth, An Economic History of England, 1870- 1939 2 7 1 -2 72 (Cambridge U . Press 1 9 6 1 ) .
21 . A. Stone Dewing, The Financial Policy of Corporations 1 66 (5th ed . Ronald Press Co. , 1 953) ; L.J.
Santow, Ultimate Demise of Preferred Stock as a Source of Corporate Capital, Fin. Analyst J . ,
XVIII (3) 47-54 (May-June 1 962) .
22 . For some cases compare among others D.A. Fergusson, Recent Development in Preferred Stock
Financing, The J . Fin. 7, 461 -462 ( 1 9 52) ; G . Donaldson, In Defense of Preferred Stock, Harv.
Bus . Rev. 44 , 1 3 6 ( 1 962) ; D . E . Fisher & G.A. Wilt Jr. , Non-Convertible Preferred Stock as a
Financing Instrument, 1950-1965, The J . Fin. 23 , 624 (September 1 968) ; H . H . Elsaid, The
Function of Preferred Stock in the Corporate Financial Plan, Fin . Analyst J. 1 1 2 - 1 1 6 ( 1 969) . To
see the cursus that brought to the introduction of preference shares in Continental Europe and
in particular, in Italy, see M. Lamandini, Struttura finanziaria e govemo nelle societa di capitali
(Bologna: ii Mulino ed. 2002) , 2 1 -34.
23 . See J . R . Lindsay & A. W. Sametz, Financial Management: An Analytical Approach 400 (Richard
D. Irwin, Inc. 1 963) .
24. L.C . B . Gower, Principles of Modem Company Law 353 (3d ed . , Stevens & sons 1 969) ; G.
Donaldson, In Defense of Preferred Stock, Harv. Bus . Rev. 44, 1 2 5 (1 962) .

14
Chapter 1 : A Historical Perspective § 1 .01

take o n additional debt financing and create a better ratio equity/ debt. This fact could
represent a possibility to pay a lower interest on new bond issues . Second, the
liquidation preferences and the preferential dividend paid to preference shareholders
were limited. Therefore, they were a cheaper source of funding, assuming that the cost
of ordinary shares is measured by the expected return on the finance supplied. Third,
in a situation of financial distress within a company, it was possible to suspend the
payment of the preferred dividends, whereas it was not possible to default on the
payment of interest without causing the winding up of the company. Thus , in case of
temporary insolvency, preference shares and their peculiarities became very crucial for
the company as they could signify continuation or cessation of the business.
Empirical research also showed that companies issued convertible and non­
convertible preferred shares simply to exploit the market conditions and meet the
various demands of different types of investors . 25 At that time, many investors were
particularly inflation-conscious but still desired the protection of a fixed income
security. The prevailing sentiment was that if the earnings of a corporation rose along
with inflation (which is by no means certain) , common shares would rise in price and
therefore the preference shares, especially the convertible ones, would have also risen
in market value. 26
From the 1 960s to the 1 980s, preference shares have significantly financed the
increasing merger and acquisition activities in the UK and US markets . 27 Empirical
studies reported a large use of convertible preference shares . Many were the reasons
behind the use of these securities . Convertible preference shares offered common
shareholders of the target company a double opportunity: equity in potential higher
earnings as well as in assets . If the firm' s cash flow proved to be successful, they could
convert and reap the benefit of higher earnings, whereas if the expected increase in
earnings did not materialize, they could enj oy whatever protection the bonds might
provide. 28
During the 1 980s, significant changes occurred in the market for preference stock
in terms of large number of new types of preference shares issued . Moreover, in sharp
contrast to previous periods, 2 9 the results showed that industrial firms rather than
utilities issued the majority of preference shares . 3 0 This phenomenon was facilitated by

25. A . L . & C . O . Houston, Houston, Financing with Preferred Stock, Fin. Mgt. 3 , 5 2 et seq. ( 1 990) .
26. H.H. Elsaid, The Function of Preferred Stock in the Corporate Financial Plan, Fin. Analyst J .
( 1 969) : 1 1 2 - 1 14.
27. H . E . Phillips & J . C . Ritchie, Investment Analysis and Portfolio Selection 32 (2d ed . , S . W. Pubg.
Co. 1 983) ; N. W. Huckins, An Examination of Mandatorily Convertible Preferred Stock, The Fin .
Rev. 34, 89- 1 08 ( 1 999) .
28. H . H . Elsaid, 'The Function of Preferred Stock in the Corporate Financial Plan ' , Fin. Analyst J .
1 1 2 - 1 1 5 ( 1 969) . However, convertible preference shares were not used primarily to finance
mergers, see A . L. & C . O . Houston, 'Financing with Preferred Stock' Financial Management 3 ,
53-54 ( 1 990) .
29. See H . E. Phillips & J . C. Ritchie, Investment Analysis and Portfolio Selection 3 2-3 5 and 597-598
(2d ed. , S. W. Pubg. Co. 1 983) ; for US situation see G . H . Evans, The Early History of Preferred
Stock in the United States, The Am. Econ. Rev. XIX, 43-58 ( 1 929) .
30. See S . Laurent, Securities that Do the Deal: The Decision to Issue Preference Shares by UK Firms,
23 (Bristol Bus . Sch. , Working paper, 200 1 ) available on SSRN online; A.L. & C . 0 . Houston,
Preferred Stock Financing: A Survey of Trends in the 1980s, J. Applied Bus. Res . 7 , 1 -8 ( 1 99 1 ) .

15
§ 1 .01 Lorenzo Sasso

the downturn in capital expenditures by the utility industry and changes in the tax laws
that made preference shares a tax-advantaged investment for corporate investors . 3 1
The advantage was conferred by a tax exemption accorded to the recipient for 85 % of
the amount of dividend paid . 3 2
In contrast with the US market, the UK market has experienced less - at least for
large public companies - the use of preference shares, which has been more popular for
private companies . 33 It can be argued that the strong British favour for the principle of
proportionality between capital and control has acted as a break to the development of
preference shares while in the US , where the regulation of one share - one vote was
broken in the 1 980s and companies started issuing a greater variety of shares including
multiple voting shares and non-voting preference shares, that did not happen . 34
Nevertheless, the British Companies Act has always left a lot of scope for shareholders
to regulate the terms of preference shares, the only constraint imposed on the
companies being the existence of at least one class of shares with unlimited voting
rights and one class of shares entitled to receive the net assets of the corporation upon
dissolution. 35 An enormous variety of different rights , related to dividends, return of
capital, voting, conversion into ordinary shares, redemption and other matters , might

31. Fooladi I . & G . Roberts, On Preferred Stock, J . Fin . Res . 3 1 9-324 (Winter 1 986) . They integrated
preferred shares into Miller' s 'Debt and Taxes' framework.
32. I n the US market, the rise o f preference shares was due t o some important regulatory changes
in the financial service industry that produced significant implications for capital structure
choice. For example, a change made to Federal Home Loan Bank Board regulations in 1 984
permitted thrifts to transfer up to 30 % of their assets to wholly owned financial subsidiaries for
the purpose of obtaining a separation from the assets of the parent firm and collateralising the
issuance of securities, typically preferred stock. See, S . K . Cooper & D.R. Fraser, The Boom in
Bank Preferred. Stock Issues, The Bankers Mag. 73-77 (November/December 1 983) ; J . D .
Finnerty, An Overview of Corporate Securities Innovation, J. Corp . Fin. 4, 23-39 ( 1 992) ; J . D .
Finnerty, Financial Engineering i n Corporate Finance: A n Overview, Fin. Mgt. 1 7, 1 4-33 ( 1 988) .
33. For statistics on numbers o f preference shares see The Shearman and Sterling Report, Report on
the Proportionality Principle in the European Union, available at http: //ec. europa.eu/
internal_market/company/docs/shareholders/study/final_report_en. pdf at para. 20070,
78-79 .
34. See, L. Enriques, ' Quartum non datur: appunti in tema di " strumenti finanziari partecipativi"
in Inghilterra, negli Stati Uniti e in Italia ' , Banca, borsa e titoli di credito II (2005 ) : 1 66- 1 83 ; R.
Costi & D' Alessandro, ' Aumento di capitale, categorie di azioni e assemblee speciali' , Giuris­
prudenza commerciale, 1 ( 1 990) : 5 8 1 et seq. ; M. Lamandini, Struttura finanziaria e govemo
nelle societa di capitali (Bologna: il Mulino ed. 2002) , 5 7 et seq. ; G . B. Portale, 'Uguaglianza e
contratto: ii caso dell' aumento del capitale sociale in presenza di piu categorie di azioni ' ,
Rivista del diritto commerciale 88 (9) ( 1 990) : 730 et seq. ; M. Bigelli, Le azioni d i risparmio
(Bologna: ii Mulino ed. 2003) , 67; In Italy these preferential shares for public companies must
be issued only as a small percentage of the equity capital. For some authors, the ratio of this
limit lies under the need of the market to rely on 'plain vanilla' financial instruments to reduce
the so-called transaction costs see V. Santoro, 'Commmento all' art. 2346' , in La riforma delle
societa. Commentario al d. lgs 1 7 gennaio 2003, ed. Sandulli & Santoro (Torino: Giappichelli ed. ,
n . 6 , 2003) 1 48 . I n France, Y . Guyon, Traite des contrats, Les societes: amenagements statutaires
et conventions entre associes, 3rd edn (Paris: LGDJ, 1 997) , 1 76.
35. I n UK, s s 638 and 5 5 6 o f the CA 2006 (before s. 1 28 o f the CA 1 985 and originally s . 3 3 o f the
1 980 Act) allows the registration of particulars of special rights, normally included in the
company ' s memorandum or articles, see among the many handbooks P . L. Davies, Gower and
Davies ' Principles of Modem Company Law 663 , 820 (8th ed. , London: Sweet & Maxwell 2008) ;
G . Stedman & J . Jones, Shareholders ' Agreement 7 et seq. (London: Sweet & Maxwell 1 990) .

16
Chapter 1 : A Historical Perspective § 1 .01

b e attached t o classes o f shares described as preference shares . 3 6 Furthermore,

different series of preference shares can be created, namely categories of preferred
shares within the same class that differ according to the financial entitlements
attached. Their only commonality is the privilege of a higher dividend to be paid in
preference to all the other ordinary shareholders . 37
A class of preference shares may have mandatory and fully cumulative dividends
included in its rights or may not, reflecting a payment stream of highly contingent and
speculative quality . Moreover, after creditors have been paid in full upon liquidation,
preference shareholders may have a priority pay-out over the common capped at the
amount paid in per share at original issue. The preference shares may have the feature
of being convertible and redeemable at a certain time and at the option of the issuer or
of the investor. As such, depending on a company' s requirements , it is very easy to let
such securities take on the characteristics of debt or equity, or virtually transform
preference shareholders into creditors or residual claimants . In the event they are made
redeemable at the option of the company, carrying a fixed cumulative dividend without
any voting rights and with priority in repayment of capital in liquidation, they represent
the extreme borderline in the equity-debt continuum of the corporate financial
structure. 3 8

36. Whether shares are ordinary or preference shares may be a question of construction: Alliance
Perpetual Building Society v. Clifion [ 1 962] 1 W.L.R. 1 2 70; [ 1 962] All E.R. 828 .
37. I n U K under Ch. 9 s . 629 Companies Act 2006 (previous s s 1 28- 1 2 9 CA 1 985) ; i n USA, the
Revised Model Business Corporation Act, s . 6. 0 1 , in particular replicated in the Delaware
General Corporation Law (DGCL) s. 1 5 1 (Classes and Series of Stock; Rights etc. ) and in the New
York Business Corporation Law (NYBCL) s. 5 0 1 (A uthorized shares) . In Canada, s . 229 of the
Business Corporation Act.
38. See s . 684 o f the Company Act 2006 (previous s . 1 59 o f the C A 1 985) and s o o n . The ' freedom
of bargaining' approach adopted by the American and British legislators has been then
replicated (to a lesser extent though) in several other European countries . For a quick excursus
see T.E. Stocks, Corporate Finance: Law and Practice 1 7 (London: Sweet & Maxwell 1 992) ; R.
McCormick R. & H . Creamer, Hybrid Corporate Securities: International Legal Aspects 1 6
(London: Sweet & Maxwell 1 987) . In Italy, see among the others M . Lamandini, Struttura
finanziaria e govemo nelle societa di capitali. Le prospettive di rifonna (Bologna: il Mulino ed.
2002) , 3 5-50; M. Lamandini, 'Autonomia negoziale e vincoli di sistema nella emissione di
strumenti finanziari da parte delle societa per azioni e delle cooperative per azioni ' , Banca
Borsa e tit. credito I (2003) : 520; C.F. Giampaolino, Le azioni speciali (Milano : Giuffre, 2004) ,
1 4 1 et seq. ; M . S . Spolidoro, ' Conferimenti e strumenti partecipativi nella riforma delle societa
di capitali' , Diritto della banca e del mercato finanziario 1 7 (2) (2003 ) : 205-2 1 8 ; M. Notari,
'Azioni e strumenti finanziari : confini delle fattispecie e profili di disciplina' , Banca Borsa e tit.
di credito I (2003) : 542 ; G . B . Portale, 'Tra " deregulation " e crisi del diritto azionario comuni­
tario' , in La rifonna delle societa quotate, ed. AAVV (Milano : Giuffre, 1 998) , 3 76; U. Tombari,
Azioni di rispannio e strumenti ibridi partecipativi (Torino : Giappichelli, 200 1 ) , 5 1 . In France,
see among the others P . H . Conac, The New French Preferred Shares: Moving towards a More
Liberal Approach, European Co . & Fin. L. Rev . 2 , 487 (2005) ; M. Germain, ' Les actions de
preference' , Revue des Societes 8 (3) (2004) : 600; A. Viandier, ' Les actions de preference' , JCP 40
(2004) : 1 529; R. Mortier, ' Rachat d' actions et actions rachetables' , Rev. Soc. 34 (3) (2004) : 652 .

17
§ 1 . 0 1 [A] Lorenzo Sasso

[A ] Particular Features of the Preference Shares: The Preferential

Dividend

One of the main features of preference shares is represented by the qualified right to
receive a preferential dividend on the distribution of profits, before any dividend is paid
on the company' s ordinary shares for a financial year or any shorter period prescribed
by its memorandum or articles . 39 As preference shares are part of the company' s share
capital, any distribution of dividends has to be done only out of existing and sufficient
profits according to section 83 0 ( 1 ) and (2) of the CA (CA) 2006, 4 0 because otherwise
the payment of the dividend would be an illegal return of capital to the preference
shareholders . 4 1 In addition to the General Meeting' s approval of the final accounts, in
which a positive result or distributable funds must emerge, preferential dividends (like
ordinary dividends) are payable only if declared. 42 Therefore, the resulting resolution
that decides the amount of dividends directors propose to distribute is the source of the
company' s obligation to pay. 43 Once that dividend is declared, it becomes a credit for
the shareholders and no ordinary shareholder can be paid unless all the preference
shareholders are satisfied according to their privileges. 44 In truth, the directors'
discretion may be limited and the preferential dividend may become a credit of the
preference shareholder even after the first resolution that approves the annual financial
statements, assuming profits are available . It is sufficient to expressly include in the
memorandum of the company the profits in each year to be applicable first in payment
of a preferential dividend on the preference shares 45 or to be due on certain defined
dates . 4 6

39. P . L. Davies, Gower and Davies ' Prindples of Modem Company Law 820-828 (8th ed . , Sweet
& Maxwell 2008) ; R. Pennington, Partnerships and Company Law 9 7-99 (Butterworths 1 962) ;
J . H . Farrar & B . M . Hanningan, Farrar's Company Law 230 (4th ed. , Butterworths 1 998) ; G.
Morse, Palmer 's Company Law vol. l , 6039-6052 (London: Stevens & Sons 1 959) ; W.W.
Bratton, Corporate Finance, Cases and Materials 353-385 (5th ed. New York: Foundation Press
2003 ) ; J. Hill, Preference Shares, in The Law of Public Company Finance Ch. 6, 1 3 9- 1 68 (Austin
& Vann eds . , L. Book Co. 1 986) .
40 . Previous s . 263 ( 1 ) and (2) of the CA 1 98 5 .
41 . Trevor v. Whitworth ( 1 887) 1 2 App Cas 409 .
42 . Arrears even of cumulative dividend are prima facie not payable in a winding-up unless
previously declared. See Crichton 's Oil Co, Re [ 1 902] 2 Ch. 86 CA; Roberts & Cooper, Re [ 1 929]
2 Ch . 383 ; Wood, Skinner & Co . Ltd, Re [ 1 944] Ch. 323 .
43 . Bond v. Barrow Haematite Steel Co. [ 1 902] 1 Ch. 3 5 3 ; Re Accrington Corporation Steam
Tramways Co. 2 Ch . 40 [ 1 909] 2 Ch. 40 . It makes no difference if the articles provide that the
preference dividend shall become payable without any declaration; this merely dispenses with
a declaration by the shareholders in general meeting and it is still necessary for the dividend to
be declared by the directors see Re Buenos Ayres Great Southern Railway Co. Ltd [ 1 947] Ch. 3 84,
[ 1 947] I All ER 729 . See also Burland v. Earle [ 1 902] A.C. 83 , PC; Godfrey Phillips Ltd v.
Investment Trust Ltd [ 1 95 3 ] 1 W.L.R. 4 1 .
44 . Wood v. Odessa Waterworks Co. [ 1 889] 42 Ch. D 636.
45 . Like in Evling v. Israel & Oppenheimer Ltd, [ 1 9 1 8] 1 Ch. 1 0 1 , where clause 6 of the
memorandum of association provided that 'the profits of the company' in each year should be
applied in an order of priorities, in which the placing of sums to reserve was expressed to be
subsequent to the payment of preference dividend. Here, the dividends paid out reduces the
total profit distributable to the ordinary shareholders.
46. See Bradford Investments (No . 1 ) , Re [ 1 99 1 ] B . C.L.C. 224.

18
Chapter 1: A Historical Perspective §1.01 [A]

The dividend attached to a preference share may be cumulative or non­

cumulative. It may also be fixed or limited to a percentage of the nominal amount of the
shares per year. It is a cumulative preferential dividend when is payable out of the
profits in priority to the subordinate class or classes of shares so that if the profits of one
year are not sufficient to pay the dividend for that period, the deficiency accumulates
against subsequent profits . 47 Thus, no dividend can be paid in respect on ordinary
shares or junior classes of preference shares until the preference dividends for all past
financial years have been paid in full. The accumulation of unpaid preference
dividends may continue over any number of years, because it is not a debt, which
becomes statute-barred after the expiration of a limitation period. The accumulation
will cease only once every preference shareholder has been paid for all the past
complete financial years. If preference shares of the same class have been issued at
different times and the dividend is unpaid in respect of some shares for more years than
it is in respect of others, the total arrears have to be satisfied rateably when a dividend
is paid in order to comply with the entitlements of each preferred category. 4 8
It is generally presumed by courts that, when one class of shares carries a fixed
dividend in preference to another class, the dividend is cumulative, even though the
terms of issue do not in any way indicate that they ought to be, 49 unless the
construction of the regulations can be applied to deny it . so Earlier, the doctrine has
argued whether a preferential dividend had to be paid out of undistributed profits
carried forward from prior financial years, or only out of profits realized in the current
year. The problem is now definitively resolved by the law: profits available for
distribution are defined under section 83 1 of the CA 2006 (section 263 (3) of the CA
1 985) as the company' s accumulated realized profits from the time of its incorporation
less the company' s accumulated realized losses from the time of its incorporation. s 1 It
then seems unnecessary for the terms of issue to contain any formulas explaining how
it has to be defined the distributable profit for preference shares, because in the absence
of a contrary provision, s i the dividends are payable out of profits and revenue reserves

47. Re Wakley, Wakley v. Vachell [ 1 920] 2 Ch. SOS ; Godfrey Phillips Ltd v. Investment Trust
Corporation Ltd [ 1 9S3] Ch. 449 , [ 1 9S3] 1 All ER 7 .
48 . Webb v. Earle ( 1 87S) L.R. 20 Eq. S S6; First Garden City Ltd v. Bonham-Carter [ 1 928] Ch. S 3 ,
where Tomlin J . held that payment should b e proportionate t o the total arrears o f each class.
See also before Weymouth Waterworks v. Coode & Hasell [ 1 9 1 1 ) 2 Ch. S20, where Parker J . held
that payment should be proportionate to the rate of dividend.
49 . See Webb v. Earle [ 1 87S] LR 20 Eq. SS6; Henry v. Great Northern Railway Co. [ 1 8S7] 1 de G &
J 606; Stevens v. South Devon Railway Co. [ 1 8S l ] 9 Hare 3 1 3 ; Sturge v. Eastern Union Railway
Co. [ 1 8SS] 7 de GM & G 1 S8; Crawford v. North Eastern Railway Co. [ 1 8S6] 3 K & J 723 ; Corry
v. Londonderry and Enniskillen Railway Co. [ 1 860] 29 Beav. 263 ; Foster v. Coles and N. B. Foster
& Sons Ltd [ 1 906] W.N. 1 07.
SO. Staples v. Eastman Photographic Materials Co. [ 1 896] 2 Ch. 303 , CA.
S1 . On this matter before the introduction of the s . 263 see Long Acre Press Ltd v. Odhams Press Ltd
[ 1 930] 2 Ch. 1 96, [ 1 930) All ER Rep 2 3 7 .
S2 . Re Bridgewater Navigation Co. [ 1 89 1 ) 1 Ch. l S S at 1 69 where the company' s articles direct the
payment of the whole of the residual profits to the ordinary shareholders . In US, see the
American case Gallagher v. New York Dock Co. 1 9 NYS (2d) 789 [ 1 940) ; affd 32 NYS (2d) 348
[ 1 94 1 ) where it was expressed in the terms of issue that the preference dividend for each
financial year was payable out of profits of that year alone.

19
§ 1 . 0 1 [A] Lorenzo Sasso

already in hand. 53 Of course, this can only be done if profits or reserves still exist when
the payment is proposed . Otherwise if this surplus has been eroded or eliminated by
previous losses suffered by the company since they were earned or created, or if it has
been capitalized and bonus shares has been issued and paid up by the capitalization,
a preference dividend cannot afterwards be paid out of them, given that no longer
exist. 54
When a preferential dividend is stated to be non-cumulative, if dividends for that
year are insufficient or inexistent, a preferential dividend does not cumulate upon
omission of payment and the deficiency is extinguished instead of being carried
forward against subsequent profits. 55 Thus, the difference between cumulative and
non-cumulative preference shares is very substantial . While the preferential dividend
accumulates over the years in the former case, it expires in the latter if it cannot be paid
out of the yearly distributable profits available for the company. It appears that the
interests of the ordinary and preferred shareholders may not always be aligned, as in
the case of the non-cumulative preference shareholders, and opportunistic behaviour
of ordinary shareholders may concretize at the expenses of the preferred sharehold­
ers . 5 6 In fact, in case of corporate retention of annual earnings, the market share value
appreciates correspondingly and the ordinary shareholders theoretically may always
realize their capital appreciation by selling some of their shares at enhanced market
prices . Different is the case of the cumulative and non-cumulative preferred sharehold­
ers . The cumulative preferred shareholders are entitled to an annual fixed percentage
of return on investment regardless of corporate earnings and at least exert some
pressure toward distribution of dividends to common shareholders, since arrearages

53 . Crawford v. North Eastern Railway Co. [ 1 856] 3 K & J 723 .

54 . Re John Fulton & Co. Ltd [ 1 932] NI 3 5 . See also the American case Lich v. United States Rubber
Co. 1 2 3 F 2d 1 45 [ 1 94 1 ] .
55. For a n assessment o f the types o f non-cumulative preference shares i n U S see W . H . S . Stevens,
' Rights of Non-Cumulative Preferred Stockholders' , Colum. L. Rev. 34 ( 1 934) : 1439, where the
Author identifies 'three principal kinds of non-cumulative preferred share, including a)
discretionary dividend type; b) cumulative-if-earned or mandatory dividend type; c) dividend
credit type' . Recently in Australia, see Trojan Equity Limited v. CMI Limited [2009] QSC 1 1 4; in
UK Coulson v. A ustin Motor Company Limited ( 1 927) 43 TLR 493 . In US Sanders v. Cuba
Railroad Co. , 2 1 N.J. 78, 8 5, 1 20 A.2d 849, 852 ( 1 956) ; Guttmann v. Illinois Central R. Co. , 1 89
F.2d 927 (2nd Cir.) , cert. denied, 342 U . S . 867 ( 1 95 1 ) , Dohme v. Pacific Coast Co. , 5 N.J. Super.
477, 68 A.2d 490 ( 1 949) .
56. See L.E. Mitchell, The Puzzling Paradox of Preferred Stock (And Why We Should Care About It) ,
Bus . Law . 5 1 , 443 ( 1 996) ; N.M. Holladay, The Limited Fiduciary Duties Owed by Corporate
Managers to Preferred Stockholders: A Need for Change, Ky. L.J . , 88, 87 (2000) ; W . H . Stevens,
The Discretion of Directors in the Distribution of Non-cumulative Preferred Dividends, Geo . L. J.
24, 3 7 1 ( 1 936) . For an analysis of some of these problems see the discussion paper of the UK
Law Commission, Shareholders ' Remedies (Cm 3 769, London, 1 997) . For some US cases Rosan
v. Chicago Milwaukee R.R. Corp. , 1 990 WL 1 3482 7-8 (Del . Ch. 1 990) ; Eisenberg v. Milwaukee
Railroad Corp. , 5 3 7 A.2d 1 05 1 (Del . Ch. 1 98 7) ; Dalton v. American Investment Co. , 490 A.2d
5 74 (Del. Ch. 1 985) ; Dart v. Kohlberg, Kravis, Roberts & Co. , 1 985 WL 2 1 1 45 (Del. Ch. 1 985) ,
reh ' d denied, 1 985 WL 1 1 566 (Del. Ch. 1 985) ; Security National Bank v. Peters, Writer &
Christensen, Inc. , 569 P . 2d 875, 8 8 1 (Colo. Ct. App . 1 977) .

20
Chapter 1 : A Historical Perspective § 1 . 0 1 [A]

block any other payment of dividends, even if accruals are often threatened with
elimination by corporate action and thus might not bloat market quotations . 57
However, the situation is even worse for the non-cumulative preference share­
holders who do not receive accrual rights when annual earnings are retained. Some­
times, when it is expressly stated in the terms of issue that a preference shareholders '
class right to receive a non-cumulative preferential dividend is confined to the annual
profits, it would appear to be possible for directors to utilize the reserves and retained
earnings, if available, to pay dividends on the ordinary shares through a buyback of
these shares, in an year in which the company reported a loss, while paying no
dividends on the non-cumulative preference shares . Furthermore, another source of
conflict is represented by the directors ' discretion to propose a dividend at the annual
general meeting. Theoretically, the board of directors is at liberty to recommend
carrying as much profit as they see fit to reserves . Therefore, they could carry the
totality of the profits and extinguish the entire preferential dividend for that year if they
are aware a payment of dividends could jeopardize the company' s going concern. 5 8
The key problems which have arisen with particular reference to dividends on
preference shares have been those concerned with the precise amount of which is
entitled normally, and upon winding up . Since a dividend cannot be distributed if not
declared, it has been uncertain whether preference shareholders are entitled to their
dividends after winding up procedures have already commenced, if these dividends
have not been declared and no express provision for their payment has been made in
the company' s regulations . The courts have shown a substantial evolution on this
matter. An early decision of the Court of Appeal laid down the basic principle that,
prima facie, arrears of a cumulative preferential dividend were not payable on

57. J . F . Meck, Accrued Dividends on Cumulative Preferred Stocks: The Legal Doctrine, Harv. L. Rev.
5 5 , 8 1 et seq. ( 1 94 1 ) ; A. Stiebel, Company law and Precedents 147- 1 48 (London: Sweet &
Maxwell 1 929) .
58. Theoretically, the holders o f preference shares cannot prevent the company setting aside
profits earned in any year to make good the losses sustained in previous years or to build up
reserve if good faith is observed, even if their preferential dividend is cumulative. See Bond v.
Barrow Haematite Steel Co. [ 1 902] 1 Ch. 3 5 3 ; Fisher v. Black and White Publishing Co. [ 1 90 1 ]
1 Ch. l 74; Re Buenos Ayres Great Southem Railway Co. Ltd [ 1 947] Ch. 3 84, [ 1 9 74] 1 All ER 729 .
This seems t o b e the approach i n U S a s well where non-cumulative preferred dividends could
be reasonably retained as long as the directors could show an appropriate corporate purpose for
doing it, see Lich v. U.S. Rubber Co. , 39 F. Supp. 675 (D . N.J. 1 94 1 ) in contrast with the previous
approach called the Wabash rule see Wabash Railway v. Barclay, 280 U . S . 1 97 ( 1 930) . This rule
was expanded later by the judgment in Guttmann v. Illinois Central R.R. Co. , 1 89 F. 2d 927 (2d
Cir. 1 95 1 ) , cert. denied, 342 U . S . 867 ( 1 9 5 1 ) and more recently Sunstates Corp. Shareholder
Litigation, 788 A.2d 530 (Del . Ch. 200 1 ) . Sometimes it may be stated that dividends are paid to
preference shareholders only if the realised profits reach a certain pre-defined amount . In Italy,
azioni di risparmio (saving shares for public companies) paid a higher dividend to preferential
shareholders to compensate their lack of voting (see L. Zingales, The Value of the Voting Right:
A Study of the Milan Stock Exchange Experience, Rev . Fin. Stud. 7, 1 2 5 et seq. ( 1 994) . However,
the unpopularity of these securities was not surprising considering that their privilege was
capped at 5 % of their nominal value (Art. 1 45 of Testo Unico della Finanza) . For an analysis of
the reasons of the failure of saving shares see G. Visentini, La societa per azioni nella
prospettiva della corporate governance (Roma: CERADI Luiss / Giuffre, 1 997) , 1 36.

21
§ 1.01 [B] Lorenzo Sasso

liquidation. 59 The only exceptions to this were when the articles entitled the share­
holders to their dividend once profits had been earned irrespective of a declaration, in
which event they would be entitled to payment if the company had accumulated profits
in its hands, 60 or when the dividends had actually been declared, though not paid,
before the liquidation. Subsequently, the courts in several instances have avoided the
application of this principle and reached the opposite conclusion instead . 6 1
Generally, in order to satisfy its cumulative preference shareholders, a company
will have to provide in its articles of association or the memorandum with the
entitlement to receive a dividend in a winding up , even if not declared while the
company was a going concern . 62 If the preference shareholders are merely entitled to
'unpaid preference dividends ' or ' arrears of dividends ' , the dividends are calculated
only up to the commencing of the winding up . 63

[B ] Priority to the Repayment of Capital in Event of Liquidation

Preference shares usually have priority to the return of capital in event of liquidation of
a company, if funds are still available after that all the creditors have been paid.
However, while preference shares are prima facie assumed to have a cumulative
dividend, it cannot be presumed that just because a class of shares carries a preference
with respect to dividends, it likewise carries a right to preferential treatment for capital
in a winding up . 64 However, any capital priority is conditioned on express clauses
stated in the articles, in the memorandum or in the terms of issue of the company. The
preference shareholder' s priority to the repayment of capital generates a further
discussion regarding the entitlement of a preference shareholder to participate in the
surplus assets of the company after that all the creditors have been satisfied. The
interest of this debate is due to the fact that capital assets, to which the preference
shareholders may or may not have a claim, include accumulated profits of previous

59. R e Crichton 's Oil Co. [ 1 902] 2 C h . 8 6 , C . A . This presumption was applied i n R e Roberts and
Cooper, Ltd [ 1 929] 2 Ch. 383 and Re Wood, Skinner & Co. , Ltd [ 1 944] Ch. 323 .
60 . Re Bridgewater Navigation Co. [ 1 89 1 ] 2 Ch. 3 1 7 C.A.
61 . Re Walter Symons, Ltd [ 1 934] Ch. 30 8; Re F. de long & Co. [ 1 946] Ch. 2 1 1 , C.A. ; Re E. W. Savory,
Ltd [ 1 95 1 ] 2 All E. R. 1 036; Re Wharfedale Brewery Co. [ 1 952] Ch. 9 1 3 .
62 . Re New Chinese Antimony Co. Ltd [ 1 9 1 6] 2 Ch. l l 5 ; Re Springbok Agricultural Estate Ltd [ 1 920]
1 Ch. 563 ; Re Wharfedale Brewery Co. [ 1 952] Ch. 9 1 3 , [ 1 952] 2 All ER 63 5 .
63 . Griffith v. Paget [ 1 877] 6 ChD 5 1 1 ; Re E W Savory Ltd [ 1 95 1 ] 2 All ER 1 036. In US, certain legal
systems - as for instance New York - provide preferred shareholders with the right to appoint
' a minimum of two directors upon default of the equivalent of six quarterly dividends' see
NYSE Listed Company Manual, § 3 1 3 . 00 (e) (C) . Alternatively the American Stock Exchange
AMEX has a similar provision to protect the class 'no later than two years after an incurred
default in the payment of fixed dividends' see AMEX Listing Standards, Policies and Require­
ments, § 1 24.
64 . Re London lndia Rubber Co. ( 1 868) L.R. 5 Eq. 5 l 9 ; Re Accrington Corp. Steam Tramways [ 1 909]
2 Ch . 40. Nor will an exclusion of participation in dividends beyond a fixed preferential rate
necessary imply an exclusion of participation in capital although it will apparently be some
indication of it, see Scottish Insurance Corporation v. Wilsons and Clyde Coal Co. [ 1 949] AC 462 ,
[ 1 949] 1 All ER 1 068; Dimbula Valley (Ceylon) Tea Co. , Ltd [ 1 96 1 ] Ch. 353 .

22
Chapter 1 : A Historical Perspective § 1 . 0 1 [B]

years which could have been distributed by way of dividend to the ordinary share­
holders prior to the commencement of the winding up . 6 5 However after winding up has
been commenced and company' s debts and liabilities have been satisfied, the same
accumulated reserves become part of the company' s residual capital assets in which
the preference shareholders are entitled to share equally with the ordinary sharehold­
ers . Therefore, the question that was presented was whether or not the preference
shareholders were entitled to participate rateably with the other shareholders in the
surplus assets of the company on winding up . 66
The courts' reasoning on this matter has substantially changed over the years .
Earlier, it was held at first instance that, in the absence of an express exclusion of
participation in surplus assets, preference shareholders were entitled to participate -

pari passu - with the other ordinary shareholders in addition to any preferential
rights . 6 7 In 1 9 1 4, the House of Lords decided that where the preference shareholders
were given a preferential dividend , that was all they were entitled to by way of
dividend. 68 For the purpose of defining preference shareholders' rights on return of
assets in liquidation, the courts were uncertain as to what was meant by surplus assets .
It was held in the Court of Appeal that reserves of undistributed profits, which could
have been distributed, by the way of dividend, before the commencement of a winding
up to the ordinary shareholders, were not included in the surplus assets . 69 In fact, the
company cannot declare a dividend after it commences winding up, 70 and the
preference shareholders cannot acquire a title to the assets by anything done in the
winding up proceeding, unless the dividend was not declared . 71 Thus, a preference as
regards both dividends and return of capital were presumed to be non-participating in
dividends but participating as regards a return of capital . 72 After a period of consider­
able fluctuations of judicial opinion, 73 in 1 949, this distinction was removed by the
House of Lords; preference shareholders with preferential or express rights to divi­
dends or to a repayment of capital were presumed not to be participating as regards
further dividends or capital repayments . 74 It was said that a preferential right, if

65 . Re Bridgewater Navigation Co. [ 1 89 1 ] 2 Ch. 3 1 7, where the Court of Appeal decided that the
surplus had to be regarded as belonging to the ordinary shareholders and therefore distribut­
able to them alone.
66. See Dimbula Valley (Ceylon) Tea Co. , Ltd v. Laurie [ 1 96 1 ] Ch. 3 5 3 .
67. Re Espuela Land and Cattle Co. [ 1 909] 2 Ch. 1 87.
68. Will v. United Lankat Plantations Co. [ 1 9 1 4] AC 1 1 , H . L .
69 . Re William Metcalfe Ltd [ 1 93 3 ] Ch. 1 42 , C.A.
70. Re Catalinas Warehouses and Mole Co. Ltd [ 1 94 7] 1 All ER 5 1 ; Re Artisans ' Land and Mortgage
Corpn [ 1 904] 1 Ch. 796. Re W Foster & Son Ltd [ 1 942] 1 All ER 3 1 4; Re Severn and Wye and
Severn Bridge Railway Co. [ 1 896] 1 Ch. 559.
71 . Re Odessa Waterworks Co. [ 1 90 1 ] 2 Ch . l 90n; Re Crichton 's Oil Co. [ 1 902] 2 Ch. 86; Re Madame
Tussaud & Sons Ltd [ 1 92 7] 1 Ch . 657; Bishop v. Smyrna and Cassaba Railway Co. [ 1 895] 2 Ch .
265 ; Re Bridgewater Navigation Co. [ 1 89 1 ] 2 Ch. 3 1 7 ; Scottish Insurance Corporation v. Wilsons
and Clyde Coal Co. [ 1 949] AC 462, [ 1 949] 1 All ER 1 068.
72 . In Re William Metcalfe Ltd [ 1 933] Ch. 1 42 , C.A.
73 . Cf. Re Fraser & Ch. aimers Ltd [ 1 9 1 9] 2 Ch. 1 1 4; Anglo-French Music Co. v. Nicoll [ 1 92 1 ] 1 Ch.
3 86; Re John Dry Steam Tugs [ 1 932] 1 Ch. 594 (in favour of preference shareholders) contra: Re
National Telephone Co. [ 1 9 1 4] 1 Ch. 755; Collaroy Co. Ltd v. Giffard [ 1 928] Ch. 1 44.
74 . Scottish Insurance Corporation v. Wilsons and Clyde Coal Co. [ 1 949] AC 462 , [ 1 949] 1 All ER
1 068; later confirmed by the case Re Isle of Thanet Electricity Supply Co . [ 1 950] Ch. 1 6 1 .

23
§ 1 . 0 1 [B] Lorenzo Sasso

expressly specified in the memorandum, is presumed to be exhaustive 75 and the

burden of proving the contrary is upon the preference shareholders if they claim further
or better entitlements . 76
Subsequently, it was reasonably said that to analyse nature and origin of surplus
assets would have led to insuperable difficulties and seemed to be quite illogical, 7 7
since under our dividend rules any part of the surplus could have been distributed to
the shareholders by way of dividend. Therefore, the preference shareholders were
granted with the right to participate to the surplus profits in liquidation but only when
the articles provided that undistributed profits should be divisible among such
shareholders . 7 8 Nowadays, it is common to see preference shares carrying a priority to
return of capital, whereas the liquidation preference is often fixed at a specified price
per share and no rights to surplus assets in winding up are allowed. 79
Similarly, some uncertainty, arising from the case of a company distributing a
dividend to its shareholders through a reduction of capital, pushed the court to take an
opinion. 80 The court held that their position was the same it would apply in a winding
up and that accordingly the first-class of capital to be repaid was the class comprising

75 . Will v. United Lankat Plantations Co. [ 1 9 1 4] AC 1 1 , H.L. In USA, see, Waggo ner v. Laster, 5 8 1
A . 2 d 1 1 2 7 (Del . 1 990) and Shintom Co. , Ltd v. A udiovox Corporation, 8 8 8 A.2d 2 2 5 (Del . Supr.
2005) where the preferential right was limited to distribution of the surplus in liquidation. In
Canada International Power Co. v. McMaster University & Montreal Trust, [ 1 946] S . C . R . 1 78
followed the Will v. United Lankat Plantations Co, making that the law; also recently Re
Canadian Pacific Ltd ( 1 990) , 68 D . L.R. (4th) 48 (Alta. C.A.) .
76 . Scottish Insurance Corporation v. Wilsons & Clyde Coal Co. [ 1 949] A.C. 462; Re Isle of Thanet
Electricity Supply Co . [ 1 950] Ch. 1 6 1 . Previously in Re William Metcalfe & Sons, Ltd [ 1 93 3 ] Ch.
1 42, as in some earlier cases, the view had prevailed that a preferential right in this category
was not exhaustive but operated to confer an additional privilege over those otherwise enjoyed
by the preference shareholders as a member of the company. For a discussion of these points,
see G. Morse, Palmer's Company Law vol. l , 303 (London: Stevens & Sons 1 959) ; R.
Pennington, Preference Shares Again, S . J . 1 05 , 45 1 ( 1 96 1 ) where the Author explains when the
provision precluding participation in surplus assets is absent, the court construes the right of
preference shareholders in respect of capital to be the same as if the provision were expressed,
but this is because the court treats the priority given for repayment of preference capital as
exhaustively defining the preference shareholders' rights and not because the court implies a
provision precluding participation in surplus assets in the terms of issue. See also M.A.
Pickering, The Problem of Preference Shares, MLR 503-505 (September 1 963) .
77. It is also inconsistent with the well established principle that on a winding up all assets are
distributed as a fund of capital see Staffordshire Coal & Iron Co. v. Brogan [ 1 963] 1 W.L.R. 905 ,
H.L. and with the line of cases culminating in Re Wharfedale Brewery Co. [ 1 952] Ch. 9 1 3 see
these cases in L. C. B. Gower, Principles of Modem Company Law 362-363 (3d ed. , Stevens &
sons 1 969) .
78 . Dimbula Valley (Ceylon) Tea Co. , Ltd [ 1 96 1 ] Ch. 353 . See also Re Bridgewater Navigation Co.
[ 1 89 1 ] 2 Ch. 3 1 7, where actually under the original articles there was only one class of
shareholder.
79. In the US States, the majority of the Courts implied - in the absence of any precise clause in the
memorandum - a provision precluding participation in surplus assets in the terms of issue. In
this sense Squires v. Balbach Co. , 1 77 Neb . 465, 1 29 N . W.2d 462 ( 1 964) ; St. Louis Southwestern
Ry. Co. v. Loeb, 3 1 8 S . W.2d 246 (Mo . 1 958) ; Englander v. Osborne, 1 04 A. 6 1 4 (Pa . 1 9 1 8) .
Contra Niles v. Ludlow Valve Mfg. Co. , 202 F. 1 4 1 (2nd Cir. 1 9 1 3) .
80 . For an interesting and doctrinal opinion see L.C.B. Gower, Company 's Reduction of Capital:
Note, MLR 1 4 , 330-333 ( 1 95 1 ) .

24
Chapter 1 : A Historical Perspective § 1 . 0 1 [B]

the preference shares . 8 1 Therefore, as long as the statutory requirements are complied
with and the preference shareholders receive their rights on a winding up, 82 the
reduction has to be approved. 8 3 This decision was later approved by the House of
Lords , although in that situation, the articles expressly provided that the rights attached
to the preference shares on a return of capital other than on winding up were the same
as the rights which they enj oyed on a winding up . 84
When preference shares are drafted to receive a share of surplus profits in the
company, all combinations accepted by the parties are possible. They can rank pari
passu with the subordinate shares after those shares have received a specified
dividend, receive an aliquot portion of the surplus profits, or their dividend can rise
automatically in proportion to the dividend on the ordinary shares rises beyond the
specified figure. For example, the market of preference shares has known a standard of
preference shares commonly called preferred ordinary shares . 8 5 These securities have
the rights to participate in surplus profits but they are not entitled to priority for
repayment of the capital in respect of their shares in the company' s winding up . Their
participation dividend cannot be cumulative because it is related to and bound up with
a dividend on common stock. Therefore, both classes of ordinary shares participating
or not, share the fortune or the misfortune. Directors likewise have discretion to
propose at the general meeting, or refuse to propose, even though earned, participation
dividends on preferred or ordinary dividends on common stock. For this reason,
preference ordinary shareholders have a position with respect to participation divi­
dends analogous to that of a holder of non-cumulative preferred stock. 8 6
Other variations can consist of issuing different series or categories of preference
shares . Normally, if a class of preference shares is issued with an attached right to a
fixed preferential dividend, it means a preferential dividend in priority to all other
shares . However, where the preferential rights are defined only in the articles of
association or by resolution, the company could, as a rule, create preference shares
ranking pari passu with the original preference shares simply by inserting an article
that states whether a new class of preference share shall modify the rights of already
existing preference shareholders . In addition, preference shares may hold the right, in
a winding up or on a reduction of capital, to a premium. The terms on which an issued

81. This arrangement seems nonsensical, because the preferred shares participating as regards
income but non participating as regards capital, on a reduction of capital they are paid off on
the latter basis, thus losing any share in the accumulated reserves, for L.C.B. Gower, Principles
of Modem Company Law 362 , footnote 93a (3d ed . , Stevens & sons 1 969) .
82 . Re Saltdean Estate Co. Ltd [ 1 968] 3 All ER 829 .
83 . This approach has been confirmed in more recent judgments, see Re Ransomes plc [ 1 999] 2
BCLC 59 1 ; Re Ratners Group plc [ 1 988] BCLC 685 ; Re Holders Investment Trust Ltd [ 1 9 7 1 ] 2 All
ER 289.
84 . See House of Fraser plc v. ACGE Investments Ltd [ 1 987] AC 387, HL.
85 . See J . Birds & A.J. Boyle, Boyle and Birds ' Company Law 2 1 3 (6th ed. Jordan Publishing 2007) .
86. See A. Berle & G . Means, The Modem Corporation and Private Property 307-3 1 2 (Harcourt
Brace & World 1 926) , revised edn, 1 968, where the Authors wrote that the doctrine of the
non-cumulative stock cases, that merely deferring dividends does not alter rights, should be
applied also in the cases of participating preferred or ordinary dividends paid on common
stock, otherwise the participation right of the preferred stock ceases to be a right in contract and
becomes a mere gamble on the manner in which a board of directors will exercise its discretion.

25
§ 1 . 0 1 [B] Lorenzo Sasso

share may provide for the payment of this premium is known as a 'Spens Formula' and
is commonly attached to preference shares . This formula is used in cases in which the
value of the shares of a company is represented in a stock market. According to the
Spens Formula, holders of the share capital concerned are expressly entitled to a
premium, if during a defined period prior to the repayment, the shares have been
standing in the market at a figure in excess of par. The premium is usually calculated
with reference to the average stock exchange price for the relevant period before the
payment subj ect to adjustments to take account of any accrued arrears of dividend,
which is reflected in the market price of shares . 8 7
Unfortunately, because of the variety in the drafting of these documents through­
out history, the courts have had to evolve different canons of construction of the
documents, thus overruling earlier decisions and defeating the legitimate expectations
of the investors who purchased preference shares relying the construction adopted
earlier. At the moment, reasonable and uniform canons of construction as well as a
modus operandi to determine their entitlements appear to have been adopted. Thus,
the nature and the extent of a class rights is, first, determined primarily as a question
of the construction of the relevant regulations of the company. 88 Second, where specific
provision in the nature of preferential rights is made, such provision will normally be
construed as definitive of the whole of the rights of the class in respect of that
provision. 89 Third, in the absence of specific provisions the rights of all shareholders
are deemed to be the same. 9 0
The fundamental legal concept of the inclusion of these securities to equity
capital has never been qualified by the courts or by the statute. Better still, some past
judgments have shown a reversal in trend on the nature of preference shares,
recognizing that the position of a preference shareholder has again become more
approximated to that of a debenture-holder than was the case some eight years ago . 9 1
For instance at law, unless it is explicitly conferred by the company' s regulations,
preference shareholders do not have any right to participate in surplus profits . 9 2 The
package of rights of the preference shares usually vary greatly depending on the result
a company want to achieve issuing these securities . 93

87. It could be argued whether the inclusion of the Spens Formula makes preference shares
relevant shares for the statutory pre-emptive rights contained in Companies Act 2006, s. 560.
88. See Scottish Insurance Corp. v. Wilson & Clyde Coal Co. [ 1 949] A.C. 462 ; 1 949 S.C. (H .L.) 90;
1 949 S . L.T. 230.
89. This proposition was stated in Re Isle of Thanet Electricity Supply Co. [ 1 950] Ch . 1 6 1 , CA.
90. Birch v. Copper [ 1 889] 1 4 App Cas 52 5 .
91 . See Lord Simonds in Scottish Insurance Corp. v. Wilson & Clyde Coal Co. [ 1 949] A. C. 462 ; 1 949
S . C . (H .L.) 90; 1 949 S . L.T. 230; and Sir Raymond Evershed in Re Isle of Thanet Electricity Supply
Co. [ 1 950] Ch. 1 6 1 , CA.
92 . See the case Will v. United Lankat Plantations Co. , Ltd [ 1 9 1 4] A.C. 1 1 .
93 . P M.A. Pickering, 'The Problem of Preference Shares' , MLR (Blackwell Publishing
September 1 963) : 499-5 1 9 . For US doctrine see for all J . D . Cox & T.L. Hazen, Business
Organizations Law, 548 (3d ed. West, St. Paul 201 1 ) , where the Author states ' [I ] t has
generally been held that a liquidation preference including accrued dividends is valid, whether
or not there are accumulated earnings or surplus available for dividends. The formerly
prevalent rule that dividends cannot be paid out of capital is applicable only to a going
concern, not on final liquidation and winding up after payment of the corporation' s debts ' .

26
Chapter 1: A Historical Perspective § 1.01 [C]

[C] Conversion and Redemption of Preference Shares

There are two common features that are generally included in the terms of a preference
share: the conversion and the redemption clauses . I will discuss the conversion first.
Preference shares may be made convertible at the option of the holder into common
shares or at a fixed ratio specified in the memorandum of association. Where the
conversion option is exercised, the company must notify the Registrar of Companies
within one month of the alteration in the rights attached to the converted shares and
their redefinition as ordinary shares . 94
The apparently simple matter of converting preference shares into ordinary
shares can become one of considerable complexity, at least where the nominal value
and the number of the ordinary shares into which the preference shares are to be
converted differ from those of the preference shares to be converted, so that there is a
danger that the transaction will involve an unauthorized return of capital, on the one
hand, or the issue of shares at a discount, on the other. If the nominal or paid up value
of the preference shares is changed on their conversion into ordinary shares, whether
on the exercise of preference shareholders' conversion options or as a result of
agreement at the time of conversion, the conversion may be effected in five alternative
ways : by the company consolidating or subdividing the original shares into ordinary
shares with a higher or lower nominal value each, the paid up capital in respect of the
original shares being allocated proportionately to the new shares; 95 by the preference
shareholders surrendering their original shares in exchange for new ordinary shares
with a total paid up value not exceeding that of the surrendered shares and the amount
remaining to be paid up on the new shares , being not less than the amount unpaid (if
any) on the original ones; 9 6 by the company reducing its issued share capital by a
special resolution approved by the court so as to repay the capital paid up on the
preference shares, issuing new ordinary shares to the former preference shareholders
in their place and appropriating the amount of the reduction of capital to pay up the
nominal value of the new shares; 97 by the company purchasing the preference shares
for cash under its statutory power to effect off market purchases and the preference
shareholders subscribing for new ordinary shares and paying for them with the
purchase price; 9 8 or by a scheme of arrangement approved by meetings of all interested
classes of shareholders and by the court. 99
If the paid up capital in respect of the ordinary shares resulting from the exercise
of conversion is to be greater than the capital paid up on their original shares, the
difference may be provided by capitalizing the company' s undistributed profits or
revenue reserves, but this may be done only if the company' s articles expressly so
provide. This option for the preference shares can be attractive when common shares
are publicly traded, so that an active market exists for the conversion securities .

94 . Companies Act 2006, s . 636.

95 . Companies Act 2006, s . 6 1 7 .
96. Re County Palatine Loan and Discount Co, Teasdale 's Case [ 1 873] 9 Ch. App 54.
97. Companies Act 2006, s . 641 (3) (4) (5) . Re St James' Court Estate Ltd [ 1 944] Ch. 6.
98. Companies Act 2006, s. 690 and s. 694.
99. Companies Act 2006, s. 895 (2) .

27
§ 1 . 0 1 [C] Lorenzo Sasso

The company can also make the preference shares redeemable at a future date.
This type of shares appeared in England granted to companies under section 46 of the
CA 1 929, a provision introduced following the recommendations of the Greene
Committee. 1 00 The use of redeemable preference shares increased due to their advan­
tages. First, they allow a company to raise short-term capital while enj oying the
benefits of a relational contract. Second, they ensure that any loss of control resulting
from an issue of shares to outsiders is only temporary. However, since their existence
these peculiar shares have sparked many doctrinal debates on the nature of the
obligation to redeem them at a fixed time and on the coordination of these securities
with the set of guidelines of maintenance of capital and with the prohibition against a
company to purchase its own shares . 1 01 Despite of the distrust at that time on the utility
of this tool, in 1 948, the power to issue redeemable preference shares was given to
companies by section 58 of the CA, which reproduced with certain amendments the
section of the previous Act. 1 °2 Later, section 1 59 in the 1 98 1 Act extended this
possibility for both private and public companies to all the categories of shares . 10 3
Thus, all the shares are now potentially redeemable either by initial agreement on issue
or by subsequent agreement to purchase. This new authority has to be seen in the
context of sections 658-676 (sections 1 62- 1 69 before in CA 1 985) which allow
companies, subject to certain procedures, to purchase their own shares and sometimes
to hold those shares as treasury shares . Generally, the preference shares are issued as
redeemable shares either at a set date or event, or at the option either of the company
or the shareholder. The date or dates for redemption of the shares will commonly
equate with the investors usual requirements for the payment of a commercial loan. 104
The redeemed shares must be fully paid and the terms in the articles must provide for
payment on redemption . These requirements apply equally for companies purchasing
their own shares . 1 05
The power of a company to issue redeemable shares, provided it is authorized to
do so by its articles, is now contained in section 684 of the CA 2006 . No redeemable
shares may be issued at a time when there are no issued share of the company which
are not redeemable, 1 06 obviously in order to avoid the result of a company being left
with no share capital following the redemption of the shares . The modalities of

1 00 . 1 926 Cmnd 265 7, para. 28 where the Greene Committee commented redeemable preference
shares 'would prove useful in certain cases' and should be given, 'provided that proper
safeguards are adopted' . Basic rules on the redemption or withdrawal of shares are contained
in Arts 35-40 (in particular 39) of Directive 77 /9 1 /EEC (Second Company Law Directive) .
1 0 1 . Trevor v. Whitworth ( 1 887) 1 2 App . Cas . 409 . For a discussion see Gower L.C . B . , Principles of
Modem Company Law 4 1 3 (4th ed. , Stevens & sons 1 979) .
1 02 . 1 945 Cmnd 6659 where the Cohen Committee that concluded proper safeguards were
particularly necessary to protect creditors from the potential harm arising from the erosion of
the doctrine of capital maintenance.
1 03 . For a quick comparative excursus see T.E. Stocks, Corporate Finance: Law and Practice 1 7 et
seq. (London: Sweet & Maxwell 1 992) .
1 04 . G . Stedman & J . Jones, Shareholders ' Agreement 1 8 (Sweet & Maxwell 1 990) .
1 0 5 . Article 42 of Directive 77 /9 1 /EEC (Second Company Law Directive) as modified by the
Companies (Acquisition of Own shares) (Treasury Shares) Regulation 2003 , SI 2003/ 1 1 1 6, reg.
2 ( 1 ) , (3) as from December 2003 .
1 06 . Section 684 (4) of the CA 2006.

28
Chapter 1 : A Historical Perspective § 1 . 0 1 [C]

redemption have been, since their introduction, a matter of some dispute among the
doctrine because it was unclear whether the company' s articles could give a measure
of discretion to the directors with regards to the detailed aspects of the redemption,
such as the redemption price and the date of redemption or whether it requires those
details to be set out specifically in the articles . 1 0 7
The debate seemed to subside when the British Parliament introduced section
1 3 3 in CA 1 989, delegating to the directors the power to fix the redemption date and
allowing the redemption price to be determined in accordance with a formula specified
in the company' s articles as an alternative to specifying a firm redemption price in the
articles . However, the requirements of including a redemption date or a period in the
articles created some difficulties and critics , because it precluded shares being issued
on terms that they were redeemable at the option of the company and / or the holder
as contemplated by the CA 1 985 or as being redeemable as a result of specified events .
Furthermore, these requirements had adverse capital adequacy implications for banks
and for private companies whose shares were not actively traded because it could be
difficult to devise a viable formula that did not require a measure of discretionary
judgment from its auditors or other valuers as to the value of the shares . The Company
Act 2006 clarifies the position in favour of a flexible approach. 108 Therefore, section 685
permits the directors to ' determine the terms, conditions and manner of redemption of
shares if they are authorised to do so by the company' s articles or by a resolution of a
company' . 1 09 The current approach can then be summarized as the requirement to
provide the terms and manner of redemption in the articles with a cautious approach
for what concerns the level of details to include according to Article 39 of the Second
Directive. 1 1 0 However, such provision can also be inserted at a later date from the time
when the shares are issued . It is not essential to specify a redemption date or period,
and it seems possible to include in the articles the possibility to redeem the shares at
any time at the option of the company and / or the holder or after the occurrence of
specified events. 1 1 1

1 07 . This idea was also strengthened by some analogy in Australian law, where a provision similar
to the English one has been interpreted as permitting the articles to provide for delegation to the
directors : TNT A ustralia Pty v. Normandy Resources NL [ 1 990] 1 ACSR 1 , SA SC; see this and
other cases in J. Hill, Preference Shares in The Law of Public Company Finance 1 43- 1 53 (Austin
& Vann eds. , L. Book Co . 1 986) . In the US, in order to avoid expensive amendments to the
articles of incorporation, a number of states authorised the creation of 'blank shares'
(authorised by § 6 . 02 of the RMBCA) namely shares containing no financial terms at all but
delegating the board of directors to designate them, see R. T. McDermott, Legal Aspects of
Corporate Finance 3 0 1 (4th ed. Lexis Nexis, 2006) . For a recent case Siegman v. Palomar
Medical Technologies. [ 1 998] WL 1 1 82 0 1 Del . Ch.
1 08 . In 1 993 , the Company Law Review (CLR) proposed to remove the requirement and instead to
require companies, after the event to include this information in the return which companies
are required to make to the Registrar. See, Company Law Review: Terms and Manner of
Redemption of Redeemable Shares. Sections 1 59A and 1 60 (3) of the Companies Act 1 985. DTI
Consultative Document .
1 09 . Company Act 2006, s. 685 ( 1 ) .
1 1 0 . Second Council Directive 77 /9 1 /EEC of 1 3 Dec. 1 9 76.
1 1 1 . E. Ferran, Principles of Corporate Finance Law 1 5 7- 1 58 and 227 (Oxford U . Press 2008) ; R.
Burgess , Corporate Finance Law 323 (London: Sweet & Maxwell 1 992) .

29
§ 1 . 0 1 [C] Lorenzo Sasso

Detailed rules apply to the financing of redemption. Apart for private companies
for which an exception applies, 1 1 2 redeemable shares can be redeemed only out of
distributable profits or out of the proceeds of a fresh issue of shares made for the
purpose. 1 1 3 It is also usual to expect the company to pay a premium on redemption and
this premium sometimes varies with the date of redemption, decreasing in value with
the passing of time. The financial terms of redeemable shares may include a provision
for the payment of a redemption premium, that is, an amount greater than the par value
of the shares . Redemption premiums must be paid out of distributable profits, 1 1 4 except
that in respect of redeemable shares which were issued at a premium, where any
premium payable on redemption may be paid out of the proceeds of a fresh issue of
shares, but in this case a redemption premium may not exceed the lesser of the
aggregate amount of share premiums received by the company on the issue of the
redeemable shares and the amount credited to the company' s share premium account
at the date of the redemption (including share premiums paid as part of the proceeds
of the fresh issue of shares) . 1 1 5
Normally, on redemption the preference shares are cancelled and the issued
share capital reduced by their nominal amount, or when redeemed out of the proceeds
of a fresh issue the capital yardstick will be maintained as a result of the issue . 1 1 6 In any
case, they cannot be held as treasury shares . 1 1 7 Sometimes, where no fresh issue of
shares for the purposes of redemption is contemplated, the requirement that capital be
repaid from profits may be inhibiting for an issuing company. It may be difficult for the
company to find sufficient profits for both payment of dividends and redemption.
Issuing preference shares at a premium can solve this problem. However, in order to
avoid unlawful repayments of the company' s assets to the shareholders 1 1 8 and to
protect creditors , a provision in section 733 of the CA 2006 provides that when
redeemable shares are redeemed out of assets representing a company' s distributable
profits, the amount by which the company' s issued share capital is thereby diminished
must be transferred from profits or revenue reserves to a special capital reserve called
' the capital redemption reserve' . 1 1 9 This reserve can be reduced only in the same way
as paid up share capital. 1 20 The amount credited in this special reserve replaces the
aggregate nominal values of the redeemed shares and the transfer from profits or
revenue reserves makes the amount transferred unavailable for distribution of divi­
dends . 1 2 1 However, it is possible for this amount credited to capital redemption reserve

1 12. Companies Act 2006 s. 709 ch 5 .

1 13. Ibid. , s . 687 (2) . See Quayle Munro Ltd, Petitioners, [ 1 99 1 ] S . L.T. 723 , l . H .
1 14. Ibid. , s . 6 8 7 (3) .
1 15. Ibid. , s . 687 (4) .
1 16. Ibid. , s . 687 (5) .
1 1 7. Ibid. , s . 688 CA 2006.
1 18. See, for instance. Dimbula Valley (Ceylon) Tea Co. v. Laurie [ 1 96 1 ] Ch. 3 5 3 ; Re New Zealand
Flock & Textile Ltd [ 1 9 76] 1 N.Z.L.R. 1 92 ; Blackbum v. Industrial Equity [ 1 977] 2 A.C.L.R. 42 1 ;
[ 1 977] 3 A.C.L.R. 89 .
1 1 9 . CA 2006, s. 733 ss 1 -4.
1 20 . CA 2006, s. 733 ss 5-6.
1 2 1 . CA 2006, s . 734.

30
Chapter 1 : A Historical Perspective § 1 . 0 1 [C]

to be converted into share capital by the company using it to pay up the nominal value
of the new fully paid shares to be issued as bonus share . 1 22

[1] Failure to Redeem

It is section 735 of the CA 2006 that deals with the consequences of failure to redeem
preference shares by the due date. However, prior to the 1 98 1 Act, which introduced
that provision, the question of failing to redeem had been surprisingly uncertain. There
were basically two main perspectives. On the one hand, the agreement to redeem
between the parties was considered as not being compulsory because it is not a
contractual obligation arising from a debtor-creditor relationship but is simply a
shareholders ' expectation as others . Therefore, the shareholder could not sue the
company for the redemption moneys as a debt owing. At an extreme point, what has
sometimes even been put forward is that upon the passing of the date for redemption
the shares cease to be redeemable and the shareholder has no right whatever to insist
on redemption. On the other hand, it was said that shareholders had a contractual right
to redemption and although redeemable preference shareholders could not enforce it
by a mandatory injunction, the failure to redeem might surely j ustify winding up of the
company or the granting of an injunction to prevent payment of dividends to ordinary
shareholders until redemption of preference shares had taken place . 1 23 That argument
had to be viewed in light of the rules governing the method of redemption in the CA. 1 24
Thus, if no funds specified under this section were available to redeem the shares there
would be no default by the company in failing to redeem and no contractual rights
which the shareholder could enforce. Moreover, although a winding up order in favour
of the preference shareholders might in certain circumstances be appropriate, it could
not be based on any breach of contract, but simply on the general principles under the
'just and equitable' ground. In this direction a further possible source of relief for the
shareholder, whether or not the nature of the redemption clause was contractual,
would have been an action under section 994 on the basis that the failure to redeem
was ' unfairly prejudicial to the interests' of the preference shareholders . The court
would have had sufficiently broad powers to make an order requiring the company to
redeem the shares . 1 2 5
The uncertainty regarding what the remedies of a shareholder are if the company
fail to redeem or purchase his shares and what happens if the company goes into
liquidation before the shares have been redeemed or purchased was clarified by section
73 5 . Accordingly, the company is not liable for damages in respect of any failure on its

1 22 . At general law the prohibition not to allot shares at a discount s . 580 and the exceptions at ss
586, 587, 593 of the CA 2006 see Ooregum Gold Mining Co. of India v. Roper [ 1 892] A.C. 1 2 5 .
For a n analysis o f the main debate regarding the s o called ' nimble dividends' see for all, J . Hill,
Preference Shares, in The Law of Public Company Finance 1 5 5 (Austin & Vann eds . , L. Book Co.
1 986) .
1 2 3 . G . Morse, Palmer's Company Law, vol . l , para. 6.02 7 (London: Stevens & Sons 2004) .
1 24 . Now s. 684 CA 2006 (before s. 1 59 CA 1 985) .
1 2 5 . See Re Holders Investment Trust, [ 1 97 1 ] 1 W.L. R . 583, 2 All E.R. 289 .

31
§ 1.01 [C] Lorenzo Sasso

part to redeem or purchase. 1 26 However, the shareholder shall retain any other right to
sue the company but the court shall not grant an order for specific performance ' if the
company shows that it is unable to meet the costs of redeeming or purchasing the
shares in question out of distributable profits ' . 1 2 7 In the case of liquidation of the
company, when ' at the commencement of the winding up any of the shares have not
been redeemed or purchased, the terms of redemption or purchase may then be
enforced against the company and when the shares are accordingly redeemed or
purchased, they are cancelled' . 1 28 The investor seller will change his position in the
company from member to creditor. However, this does not apply if the terms of
redemption or purchase provided for performance to take place at a date later than that
of the commencement of the winding up or if during the period beginning with the date
when redemption or purchase was to take place and ending with the commencement
of the winding up , the company did not have distributable profits equal in value to the
redemption or purchase price . 1 29 Of course, the shareholder will gain little or nothing
by enforcing the contract if the winding up is an insolvent liquidation because his claim
in respect of the purchase price is postponed to the claims of all the creditors and all the
other shareholders whose shares carry rights to capital or dividend which are preferred
to the rights as to capital of the shares to be redeemed or purchased . 1 3 0
The vulnerability of the redeemable preference shareholders, particularly regard­
ing receipt of dividends and redemption of shares, has been reduced by the introduc­
tion of ancillary safeguards . A typical redeemable preference share issue includes a
so-called put option. According to it, the parent company of the issuer enters into an
agreement to purchase the shares from the investor in certain specified circumstances,
the most important being default by the issuer in dividend payments or in repayment
upon redemption. Many other occurrences may threaten the security of the preference
shareholder and thus the list of triggering events in the purchase agreement may be
long, covering matters such as reduction of capital by the issuer, allotment of equal or
prior ranking shares, and changes to income tax law . As the name implies, the
requirement to purchase the shares does not automatically arise; it will depend on an
election by the investor to enforce it. This will usually be done by requiring that the
investor make a purchase request within a certain period of becoming aware of the
occurrence of the triggering event. 1 3 1 The consideration for the parent company' s

1 26 . Companies Act 2006 s. 735 (2) .

1 2 7 . Ibid. , s . 73 5 (3) . The provision does not protect the company against paying damages in all
cases as a result of its failure to redeem, see British & Commonwealth Holdings Plc u. Barclays
Bank Plc [ 1 996] 1 W.L.R.J. , CA .
1 28 . Companies Act 2006 s. 735 (4) .
1 2 9 . Ibid . , s . 73 5 (5) .
1 3 0 . Ibid., s . 73 5 (6) .
1 3 1 . See J. Hill, Preference Shares, in The Law of Public Company Finance 1 44 (Austin & Vann eds . ,
L. Book Co . 1 986) , where she says that the correct analysis o f this arrangement should b e seen
in the decision United Dominions Trust (Commercial) Ltd u. Eagle Aircraft Services Ltd, [ 1 968] ,
l , W.L.R. at 74, where it would appear to be that a unilateral contract exists whereby the parent
makes an irrevocable offer to the investor which will become enforceable upon the fulfilment
of the conditions precedent of triggering event and notification . On this analysis, the investor
has no right to call on the parent to purchase the shares unless there is strict compliance with
the notification requirement.

32
Chapter 1 : A Historical Perspective § 1 . 02

promise to purchase is the investor' s promise to take up shares in the issuing company,
obviously, the put option agreement must therefore be entered into before or at the
same time as the contract of allotment. Otherwise the consideration would be past
consideration and the promise in the put option would not be binding. 1 32
A further clause is commonly included in the terms of a redeemable preference
share issue whereby, if the company fails or is unable to redeem on the redemption
date, a specified percentage of the holders of the preference shares may elect to have
the company apply, from time to time, any money permissible towards redemption
until full repayment has occurred. Only at this time will the shares be redeemed.
Moreover, in order to avoid any doubt on whether the preference shareholders, acting
in this way, preclude themselves from relying on failure to redeem to bring into
operation the put option, 1 33 they may explicitly write this clause to be 'without
prejudice' to the company' s obligation to redeem on the redemption date. This wise
precaution can be very useful for a preference shareholder, because assuming that the
failure to redeem were construed as a continuing default, it would therefore seem that
the shareholder could activate the put option at any later time. Finally, the position of
the shareholder can be further fortified by the issue of a letter of credit by a bank that
secures the performance by the parent of its obligations under the purchase agreement.
The bank, in granting this facility, will usually require that security be given, often in
the form of charges over the property of the parent company. There are many possible
permutations of this basic structure. The terms of issue of the shares can contain
various indemnities protecting the shareholders from, for example, detrimental
changes to income tax law and other problems arisen by the hybrid characterization of
such a transaction. 1 34

§ 1 .02 NATURE OF A DEBENTURE

Standing in contrast to common shares are debentures . Although, the term ' debenture'
is frequently used in statutes, 1 35 unfortunately, the Company Act was not possible to
provide a comprehensive definition of this term. However, in practice, the absence of
a precise definition has given rise to surprisingly few problems and to even fewer
reported cases . Section 73 8 of the Companies Act 2006 defines a debenture by saying:

1 32 . A.J. Triantis & G . G . Triantis, Conversion Rights and the Design of Financial Contracts, Wash. U .
L. Q. 72 , 1 240 et seq. ( 1 994) .
1 3 3 . See J. Hill, Preference Shares in The Law of Public Company Finance, 1 64 (Austin & Vann eds . ,
L . Book Co . 1 986) . It i s not clear whether the preference shareholders merely waive a right to
redemption on a particular date, which can be reinstated by the giving of reasonable notice or
rather impose a new obligation on the issuer precluding themselves from relying on the failure
to redeem to activate the put option.
1 34 . See K. Dawson, Option agreements, Comp . Law. 72 , 1 52 ( 1 997) ; E. Ferran, Company Law and
Corporate Finance 3 9 1 (Oxford U. Press 1 999) .
1 3 5 . Companies Act 2006 contains, in Pt. 1 9 ' Debentures' , eight sections under the heading
Debentures as well as frequent references throughout the Act to debentures and debentures
holders .

33
§ 1 . 02 Lorenzo Sasso

In the Companies Acts, debenture includes debenture stock, bonds and other
securities of a company, whether or not constituting a charge on the assets of the
1 36
company .

This definition is also adopted for the purposes of section 29 (2) of the Insolvency Act
1 986. The j udges have long attempted to formulate definitions of this term, often
lamenting the complexity of doing it. 1 37 A first attempt was to identify a debenture with
the ' document which either creates a debt or acknowledges it' . 1 3 8 Again a debenture
was described as a statement that 'generally imports a payment obligation with, in
most cases, a security' 1 39 and as a receipt or a certificate for a deposit made with a
company (other than a bank) when the deposit was repayable at a fixed period after it
was made. 1 4 0 This instrument may also be issued to one person such as a bank. 1 4 1
However, a bank facility has been held not to be a debenture where the terms of the
customer' s letter acknowledging it failed to contain any undertaking to draw down the
facility. 1 42 Some kinds of instruments are referred to as debentures, by considering a
debenture to be simply:

a statement by two directors that the company will pay a certain sum of money on
a given day, and will also pay interest half-yearly at certain times and at a certain
1 43
place, upon production of certain coupons [ . . . ] .

A secured debenture is normally the first in seniority in a corporate capital structure.

However, whether they are secured and unsecured securities, according to the
definition included in the Companies Act, they will in law be debentures . 1 44
Thus, the legal relationship between a company and his debenture-holders is a
contractual relationship of debtor and creditor, coupled, if the debt is secured on some
or all of the company' s assets, with that of mortgagor and mortgagee. The debenture­
holder is not a member of the company having rights in it, but a creditor having rights

1 36 . Former s . 744 of the Companies Act 1 985 with minor drafting differences , this definition was
first introduced into company law by the reforms of 1 928- 1 929 . Downsview Nominees Ltd v.
First City Corp. Ltd (No. 1) [ 1 993] B . C . C . 46 (PC) . If there is no charge it will normally be
described as a 'bond' or a ' loan note' see Gardner v. London Chatham & Dover Railway Co. (No.
1) ( 1 867) L.R. 2 Ch. App. 2 0 1 .
1 3 7 . See Chitty J . in Levy v. Abercorris Slate & Slab Co. ( 1 887) 3 7 Ch. 260 at 264, where he lamented
over a century ago: ' I cannot find any precise definition of the term, it is not either in law or
commerce a strictly technical term, or what is called a term of art ' .
1 38 . See Chitty J . i n Levy v . Abercorris Slate & Slab Co. ( 1 887) 3 7 C h . 260
1 39 . Edmonds v. Blaina Co. ( 1 887) 36 Ch. D . 2 1 5 , 2 1 9 .
1 40 . United Dominions Trust Ltd v. Kirkwood [ 1 966] 2 QB 43 1 at 468, [ 1 966] 1 All ER 968 at 988, per
Diplock U.
1 4 1 . Re Woodroffes (Musical Instruments) Ltd [ 1 986] Ch. 366. Deposit receipts issued by a finance
house for short-term loans have also been characterised as debentures see in British India
Steam Navigation Co. v. IRC ( 1 8 8 1 ) 7 Q . B . D . ; Speyer Bros. v. I. R. C. [ 1 907] 1 K.B. 246; [ 1 908]
A.C. 92 and Lemon v. A ustin Friars Investment Trust Ltd ( 1 926) Ch. 1 .
1 42 . Queensland Cement Ltd v. Commissioners of Stamp Duties [ 1 996] 1 Qd.R. 508, applying Knights
Deep Ltd v. Inland Revenue Commissioners [ 1 900] 1 Q . B . 2 1 7 .
1 43 . See Lindley J . in British India Steam Navigation Co. v. I.R. C. ( 1 88 1 ) 7 Q . B . D . at 1 72 . See also
Warrington L.J . in Lemon v. Austin Friars Investment Trust Ltd ( 1 926) Ch. 1 at 1 7, CA.
1 44 . See the House of Lords in Knightsbridge Estates Trust Ltd v. Byrne ( 1 940) A.C. 6 1 3 a mortgage
was considered a ' debenture' for the purposes of s. 1 93 of the Companies Act 1 985 (now s . 739
of the Companies Act 2006) . See a description of the case in Davies [2003 , 808) .

34
Chapter 1 : A Historical Perspective § 1 . 02

against it . In contrast with shareholders, debenture-holders are entitled to receive a

fixed rate of interest, whether the company is doing well or poorly, whereas the
declaration of a dividend on ordinary shares is usually a matter for the discretion of the
directors . Debenture-holders are also entitled to have their principal repaid by a
company at a certain date and their rights are actionable if the due date for repayment
has passed, whereas shareholders (unless the shares are issued as redeemable) are
considered as residual claimants that means that normally their money is returnable
only on winding up and only after that all the outside creditors have been paid in full
(starting from the ones who hold a secured loan) . 1 4 5 The position of a debenture-holder
is strengthened by the remedies available to him to obtain payment of the sums due to
him whether they are principal or interest. 1 4 6 A company may purchase or redeem its
own debentures without condition as well as pay interest on a debenture out of capital.
Moreover, interest payable on a debenture is paid out of pre-tax assets whilst dividend
on a share can only be paid out of post-tax profits. 1 47
Hence, the debenture is potentially the most secure of the company' s securities .
It appeals to the investor who wants a relatively small certain return without risk of
losing his money. On the face of it, the debenture-holder stands entirely detached from
the company governance. 1 4 8 However, it has to be said that this is something of an
over-simplification. An ordinary share in a first-class company may in economic reality
be less risky than its debenture, because in inflationary conditions all prior charges are
highly vulnerable . In fact when the true purchasing power of money is depreciating,
the nominal value of a company' s assets generally appreciate so that the nominal
amount of the annual yield and capital return will rise proportionally and provide an
hedge against inflation. However, a debenture, which only entitles the holder to the
future return of the nominal value of the money advanced, may be a very inadequate
security for the repayment of the true worth of the money invested. 1 49
While the difficulty in the case of shares is to fit them into any normal legal
category, one is unlikely to be left in doubt whether something is or is not a share . The
converse is the case in relation to debenture. Thus, although the characteristics of
equity and debt securities clearly diverge in reality, the history of company law
demonstrates that a debenture-holder has often performed the role of the investor with

1 4 5 . Creditors may petition for a winding-up order where the company is unable to pay its debts (IA
1 986, s. 1 22 ( l ) (f) ) . whereas shareholders have more freedom to wind up the company
including on the 'just and equitable' ground (IA 1 986, s. 1 22 ( 1 ) (g) ) .
1 46 . The main remedy (usually included in the debenture document) is the right to appoint a
receiver. Even where the debenture is silent on this matter, the court has power to appoint a
receiver in certain circumstances . A debenture holder may also take the unusual step of asking
a court to foreclose on the security, i . e . , request the court to take possession of the security and
realise it for the satisfaction of the creditors' debts.
1 4 7 . P . L. Davies , Gower and Davies ' Principles of Modern Company Law Ch. 3 1 (9th ed . , Sweet &
Maxwell 20 1 2) ; R. Pennington, Pennington 's Company Law 234 et seq. (Butterworths 200 1 ) ;
J . H . Farrar Farrar's Company Law 256 et seq. (Butterworths 1 988) .
1 48 . According to s . 9 of the Company Act 1 985 ordinary shareholders may attend and vote at
general meetings and certain actions cannot be taken by the company unless and until the
shareholders have made a decision by resolution in a general meeting. For example, the articles
of association can only be altered if a special resolution of the members is passed .
1 49 . L.C . B . Gower, Principles of Modem Company Law 352 (3 d ed . , Stevens & sons 1 969) .

35
§ 1 . 02 Lorenzo Sasso

an interest in a company different in degree but not in kind from that of a shareholder.
Eventually, the practice of markets has proved that covenants in the loan instruments
may also give the debenture-holders considerable influence over the way in which the
company is managed. 1 5 0
The typical debenture is one of a series, each of which confers like rights, thus
creating a 'class' similar to a class of shareholders . 1 5 1 Consequently, debenture­
holders ' rights can substantially differ from class to class according to the character­
istics included in their contracts . Some types of debentures blur the distinction between
equity and debt. For example, where the debenture is secured by a floating charge on
all the undertaking and assets of the company, the interests of the debenture-holder are
tied up with the prosperity of the company almost to the same extent as those of a
shareholder, for if the company trades unprofitably, the debenture-holder' s security
will be placed in jeopardy, whereas if it flourishes, his security will normally be
enhanced, although the creditor' s interest in the up-side is of course limited by the fact
that its return is limited to the restoration of the sum advance. Indeed such a
debenture-holder is aced very much in the legal position that a shareholder was
formerly thought to assume, that of having an equitable interest in the fluctuating
property of the company. 1 52 Like the shareholders, it is unlikely that the debenture­
holders individually or collectively will be able, if they are not mortgagees with a
secured credit, to demand their money whenever they want it. In all probability the
money will be repayable only after a date many years in the future, or only repayable
at the option of the company and in some cases it may not be repayable at all, of course,
except on a winding up, when the debentures are made irredeemable or perpetual. 1 53
Both in law and in commerce, the fact that the debentures are a type of transferable
security is regarded as their essential feature for most purposes . They resemble shares
in being either registered with the company and transferable by the same simple
transfer or by being in bearer form, in which case there is a judicially recognized
custom that they are negotiable instruments . A debenture-holder' s rights are embodied
in his contract with the company . In this contract he may be granted special rights such
as entitlement to a share of profit whether or not available for dividend, to attend and
vote at the general meetings, 1 54 and even to convert his debentures into equity share.
A debenture may be issued at a discount, although a company may not issue a
debenture at a discount with an immediate right to convert it into a share . To permit
this would effectively sanction an issue of shares at a discount. 1 55

1 50 . L.C . B . Gower, Principles of Modem Company Law, 3 5 5 et seq. (3d ed. Stevens & sons 1 969) .
1 5 1 . Levy v. Abercorris Slate & Slab Co. ( 1 887) 3 7 Ch. 260, 264.
1 52 . S o much so that on a scheme of arrangement the debenture-holders normally give u p some o f
their rights like the shareholders (obtaining, it is true, some quid pro quo) , whereas the
unsecured creditors (over whom they theoretically have priority) are paid in full. See L.C.B.
Gower, Principles of Modem Company Law Ch. 26 (3d ed. , Stevens & sons 1 969) .
1 53 . The normal rule of equity that a mortgage may not be made wholly irredeemable does not apply
to registered companies : Companies Act 2006, s. 739 . That a debenture may be something more
than a mere loan is also recognised by the fact that a contract to take up debentures may be
specifically enforced; Companies Act 2006, s. 740 .
1 54 . See s . 990 of the Companies Act 2006.
1 5 5 . See Moseley v. Koffyfontein Mines Ltd 1 9 1 1 1 Ch. 73 .

36
Chapter 1 : A Historical Perspective § l . 02 [A]

[A] The Origin and Evolution of the Subordinated Irredeemable

Debentures

Since its introduction in the Company Clauses Act of 1 863 in Britain, the redeemable
debenture has been considered a ' security of an anomalous character' . 1 5 6 Although it
was issued as a debenture, it included more peculiarities of equity than of debt. This
security was irredeemable unless Parliament enacted otherwise for particular cases.
The interest was a payable part with a fixed rate, with another part payable out of
profits . Although debenture-holders could obtain the appointment of a receiver if the
interest payments went into arrears, they could take only the fruit of the tree . In other
words, they could not realize their security by foreclosure or sale . Nevertheless they
ranked before all ordinary creditors as against the undertaking and the income
thereof. 1 57
From the standpoint of the issuing company, a security which creates no
obligation to the repayment of capital while the company is a going concern, whose
servicing costs are finite and constitute a deduction in the computation of profits for tax
purposes (as opposed to giving rise to a charge) and which does not confer a stake in
(as opposed to a charge on) the company' s assets must be attractive. From the
standpoint of the investor, the right to receive a contractually stipulated income in
perpetuity, irrespective of the company' s profitability, coupled with priority in the
event of a winding up also has its attractions, although these have proved to be
insufficient to outweigh the demand for a guaranteed maturity. In fact, although a
stated principle of law related to irredeemable debentures existed, after an initial
enthusiasm for these hybrid securities, 1 5 8 for many years only a few issuances of
perpetual debentures have been registered in the London Stock Market. 1 59
For its perpetual duration, such a security was made payable only in the event of
winding up, or after six months' default in payment of interest . Sometimes , this
security issued in the form of debenture or of debenture stock, where not made
irredeemable, was made payable at a very remote period, such as SO or I 00 years after
issue. It is in cases like these that some commentators of that time denied classifying

1 56 . F . B . Palmer, A.F. Topham & R. Buchanan-Dunlop , Debenture, in Palmer's Company-precedents

vol. 3 , 3 0 (Stevens & Sons 1 952) ; L . C . B . Gower, Principles of Modem Company Law 4 1 3 (4th
ed. , Stevens & Sons 1 979) .
1 5 7 . F. B . Palmer, A.F. Topham & R. Buchanan-Dunlop, Debenture, in Palmer's Company­
Precedents, vol. 3 , 3 1 (Stevens 1 952) ; G. Fuller, Corporate Borrowing: Law and Practice
3 1 5-3 1 9 (4th ed. , Jordan Publg. 2009) ; R. Cranston, Principles of Banking Law 229-23 1 (2d ed. ,
Oxford U . Press 2002) ; E . Ferran, Company Law and Corporate finance 545-564 (Oxford U.
Press 1 999) ; R. Goode, Principles of Corporate Insolvency 1 80- 1 8 1 (3d ed. , Sweet & Maxwell
2005) .
1 58 . Not only in England but also in the United States and in Europe issuances of irredeemable
debentures were common practice. See the Swiss Federal Railroad issue in 1 890 of perpetual
debentures in R. McCormick & H. Creamer, Hybrid Corporate Securities: International Legal
Aspects 56 (Sweet & Maxwell 1 987) . For the American cases see A. Stone Dewing, The
Financial Policy of Corporations 97 (5th ed. , Ronald Press Co . 1 953) ; C.J. Johnson & J .
McLaughling, Corporate Finance and the Securities Laws 697 et seq. (Aspen Law & Business
1 997) ; Investor Liability: Financial Innovation in the Regulatory State and the Coming Revolu­
tion in Corporate Law, Harv . L. Rev . 1 07, 1 94 1 ( 1 994) .
1 59 . R. Burgess, Corporate Finance Law 3 1 6 (London: Sweet & Maxwell 1 992) .

37
§ 1 . 02 [A] Lorenzo Sasso

this instrument as debt, considering that the indefinite or prolonged postponement of

the right of redemption was in effect a 'clog on equity redemption' . 1 60 To remove these
doubts and to bring the law into accord with what it has commonly been taken to be,
the British regulator introduced in section 14 of the Companies Act 1 907 some rules
which are substantially still enforced and represented in section 73 9 of the Companies
Act 2006. 1 6 1 Further, notwithstanding any rule of equity to the contrary, 'a condition
contained in debentures or in a deed for securing debentures, is not invalid by reason
only that the debentures are thereby made irredeemable or redeemable only on the
happening of a contingency (however remote) or on the expiration of a period
(however long) ' . 1 62 This applies to debentures whenever issued and to deeds whenever
executed . In this line of reasoning, a mortgage of land by a company to a single
mortgagee is a debenture within this section, and is not invalid by reason of the date of
redemption being postponed to a remote period . Section 739 does not, of course,
validate the debenture if terms other than those relating to the date of its maturity
constitute a clogging of the equity of redemption. 1 6 3
The introduction of the ' wait and see' rule under section 3 of the Perpetuities and
Accumulations Act (PAA) 1 964 has lessened the risk of a contract being held void for
remoteness. This provides that a disposition not void for remoteness until such time (if
any) as it becomes established that the interest disposed of, cannot vest in the
perpetuity period. In the meantime, the contract is treated as if it were not subj ect to the
perpetuity rule. To avoid uncertainty, the eighty-year limitation period should be
specified whenever the draftsman has reason to believe that rule against perpetuities
may become relevant. 1 64 For some scholars , the regulation of these debentures in the
Companies Act brought to the logical effect that such securities, which were expressed
to be perpetual or irredeemable, were still to be considered loans if, on their true
construction, they nevertheless became repayable on the winding up of the com­
pany. 1 6s

1 60 . Although a provision that the debt is redeemable only in the company' s winding up or at the
company' s option will probably not be, in light of the Court of Appeal' s decision in Knights­
bridge Estates Trust Ltd v. Byrne, [ 1 939) Ch. 44 1 , affd on other grounds [ 1 940) AC 6 1 3 .
1 6 1 . Previous s . 1 93 Companies Act 1 985 and s. 8 9 Companies Act 1 948 . See a comment o f it in S . W.
Magnus & M . Estrin, Companies Law and Practice 1 0 1 (Butterworths 1 978) 1 0 1 .
1 62 . CA 2006, s. 739 ( 1 ) .
1 63 . The introduction of that section in the CA was also needed in the English law in order to
coordinate these issued securities with a provision existing since the primordial law in England
that is the rule against perpetuities . The rule relating to perpetuities stipulates that every
executory limitation (any contingent interest) must vest within the perpetuity period. The rule
does not apply to vested interests but those which are contingent upon a future event. The
perpetuity period allowed by the rule is a life or lives in being at the date of the instrument
taking effect, provided they are ascertainable and twenty-one years afterwards . However,
under s. 1 of the PAA 1 964, an optional period not exceeding eighty years may be specified in
the instrument creating the contingent interest, subject to s. 9 (2) of the PAA. See G. Stedman
& J. Jones, Shareholders ' Agreement 275 (Sweet & Maxwell 1 990) .
1 64. J . Cadman, Shareholders ' Agreements 277-278 (4th ed. , Sweet & Maxwell 2004) .
1 65 . G . Fuller, Corporate Borrowing: Law and Practice 43-44 (4th ed. , Jordan Publg. 2009) . As some
commentators underlined these securities have some similarities with the project finance,
which is financing of long-term infrastructure and industrial projects based upon a complex
financial structure where project debt and equity are used to finance the proj ect, and debt is

38
Chapter 1 : A Historical Perspective § l . 02 [A]

The use of irredeemable debentures was fuelled by banks' internal and interna­
tional practice of raising capital through perpetual deeply subordinated debt . 166 This
hybrid instrument has the twofold peculiarity of being deeply subordinated to all the
rest of the ordinary bondholders and being perpetual in its duration or of a very long
maturity. 1 6 7 The main reason for their growth was their official inclusion as supple­
mentary capital in the capital adequacy requirements of the Bank of England. 1 68
Bankers and insurers could raise fresh funds without any dilution of the shareholders '
ownership interest which would have occurred if additional shares were immediately
issued. At the same time, the perpetual subordinated debt provided an important
protection for the senior creditors while broadening the borrowing base of the issuer
company. 1 69 Perpetual subordinated debt represented a further safety for creditors and
especially senior debt-holders, which might be availed of at the time it was most
needed, as for instance, at the time the debtor' s assets were being divided among its
creditors . 1 70 In fact, in winding up, the payment to the senior creditors will be
composed of their share of money plus the one paid on the subordinated debt that by
reason of the subordination provisions required that they be turned over to the holders

repaid using the cash flow generated by operation of the project, rather than the general assets
or creditworthiness of the proj ect sponsors.
1 66 . The paper is Bank of England, Subordinated Loan Capital Issued by Recognised Banks and
Licensed Deposit-Takers, 28 Nov. 1 984 at para. 1 7 (a) with some anticipations in Bank of
England , The Measurement of Capital, September 1 980. This phenomenon was worldwide, for
US see P . Tufano, Financial Innovation, in Handbook of the Economics of Finance I (A) 307-33 5
(Elsevier 2003 ) ; F . Allen & D . M . Gale, Financial Innovation: An Overview, Fin . Innovation &
Risk Sharing 36-40 (MIT 1 994) . In Italy, see for all M . Lamandini, Struttura finanziaria e
governo nelle societa di capitali (Bologna: Mulino 2002) , 84-90; G . B . Portale, "'Prestiti
subordinati" e "prestiti irredirnibili " (Appunti) ' , Banca, borsa, tit. cred. I (Giuffre 1 996) : 1 -20;
M. Lamandini, ' Perpetual notes e titoli obbligazionari a lunga o lunghissima scadenza' , Banca
Borsa tit. cred. II (Giuffre 1 99 1 ) : 606.
1 67 . If the debtor had outstanding more than one class of subordinated debt, a distinction should
have been made between the various classes or tiers . In such cases, the top class or tier of
subordinated debt was called ' subordinated debt' or 'senior subordinated debt' while the lower
tiers were referred to as 'junior subordinated debt' or sometimes ' capital debt' . Each descend­
ing class of subordinated debt was subordinated to senior debt and all higher classes of
subordinated debt in descending order.
1 68 . Introduced in Europe with the implementation of the EU Directive 89/299/CEE concerning the
own funds of credit institutions as a direct consequence of the International ' Basel Accords' of
1 988. The Swiss and Canadian regulators also expressed their considerations at this regard. See
for Switzerland Art. 1 1 (g) Ordinance Supplementing the Federal Law Relating to Banks and
Saving Banks, 1 7 May 1 972 and for Canada, Inspector General of Banks, Definition of Capital
for Purposes of Measuring Capital Adequacy of Canadian Banks, Ottawa, 3 Mar. 1 983 . For more
details see R. McCormick & H. Creamer, Hybrid Corporate Securities: International Legal
Aspects 55 (Sweet & Maxwell 1 98 7) .
1 69 . Institutional lenders , in analysing the financial statements of corporations, place subordinated
debt 'below the line' from whence it follows that, subject to practical limitations, the more the
subordinated debt, the larger the equity base, the greater the borrowing capacity of the
corporation. See A. Stone Dewing, The Financial Policy of Corporations 268 (5th ed. , Ronald
Press Co . 1 953) .
1 70 . Some American commentators of that time defined the proceed paid out of the subordinated
debt as a ' double dividend' out of the bankruptcy for the senior creditors, see D. M . Calligar,
Subordination Agreements, Yale L. J . , 70, 3 76 and 293 et seq. ( 1 96 1 ) .

39
§ 1 . 02 [B] Lorenzo Sasso

of the senior debt. 1 7 1 The great success of these hybrids of debt was also favoured by
a ratings-based regulation (Basel Accords I and II) , which assigned a crucial regulatory
role to the evaluation report issued by rating agencies for risk assessment. 1 72

[BJ Elements of Convertible Obligations

The vacuum between ordinary shares and ordinary debentures was further reduced by
the issuance of convertible debt providing the bondholder with a right to convert its
debt into ordinary shares of the company. The history of convertible bonds goes back
to the beginning of the nineteenth century. At that time transport routes with railway
lines were financing their investment needs . In England, as a consequence of the South
Sea Company and other fraudulent issues, a strict legislation was introduced that
severely limited stock promotions . However, the need for fresh finance to build the
canals and railroads in the nineteenth century eventually restored public acceptance of
business corporations and trading in market securities became the primary activity.
This resulted in the establishment of the London Stock Exchange in 1 802 and the repeal
of the legislation in 1 825 . 1 73 So important did the London market become to the railroad
promoters of the Middle Atlantic and Southern states that they, following the example
of the states governments, began to issue their bonds in sterling denominations with
the interest and principal payable in London. 1 74
While in densely populated England and New England, local resources were
sufficient to enable the early railroads to use mostly equity financing, the railroads
constructed in the western United States raising funds in the British financial market
were largely debt-financed. 1 75 US railroads tended to raise debt finance for two main
reasons . In primis, because the importance of American railroad finance involved huge

1 7 1 . If we assume that a bankrupt debtor has GBP 600,000 of assets and has outstanding GBP
500,000 of senior debt, GBP 500,000 of subordinated debt, and GBP 500,000 of other debt
claims of general creditors. Each of these are proved on parity with one another in accordance
with the provisions of the pari passu rule. Thus each of the creditors must receive a pro rata
share of the bankruptcy proceeds . However, on a distribution of such assets, the senior debt
would receive GBP 400,000 : the GBP 200,000 dividend paid on the senior debt, plus the GBP
200,000 dividend paid on the subordinated debt which by virtue of the subordination
provision, has been turned over to the senior creditor. Of course if the company in winding up,
by virtue of collection of claims, receives another GBP 300,000, on pro-rata distribution on all
the claims, GBP 1 00,000 being paid on the senior debt, GBP 1 00,000 on the subordinated debt
and GBP 1 00,000 on the other debts, given that the senior debt has now been paid in full, the
subordinated debt holder may retain this GBP 1 00,000 distribution. It is important to point out
here that if it were issued equity shares instead of subordinated debentures in the case above,
in distributing the GBP 600,000, only GBP 300,000 would have been paid on the senior debt and
GBP 3 00,000 on the other debt.
1 72 . R . H . Weber & A. Darbellay, The Regulatory Use of Credit Ratings i n Bank Capital Requirement
Regulations, 1 . Banking Reg. 1 0, 1 (2008) .
1 73 . V.E. Morgan & W.A. Thomas , The Stock Exchange, Its History and Functions 1 6 (Elek Books
1 962) .
1 74 . A. Chandler, Patterns of American Railroad Finance, Bus . History Rev . 28, 248-263 ( 1 9 54) .
1 75 . F.A. Cleveland & F.W. Powell , Railroad Promotion and Capitalization in the United States
50-5 1 (Ayer Publg. 1 909) ; A. Stone Dewing, The Financial Policy of Corporations 64 (2d ed . ,
Ronald Press Co . 1 9 1 9) and W.Z. Ripley, Railroads: Finance & Organizations 1 05 (Longmans,
Green and Co . 1 9 1 5 [reprinted 2000 by Beard Books] ) .

40
Chapter 1: A Historical Perspe ctive § l .02 [B]

sums and only equity was not sufficient. Second, since these proj ects needed to seek
funds from distant regions, in which the investors were poorly informed about the
project' s duration and its related developments, debt securities , being the safest
channel to invest in a corporation' s business, were considered the best mean to obtain
finance . 1 7 6
However, at that time, the greater asymmetry of information between the
investors and the companies made even debt finance problematical. Financial institu­
tions had to be invented to make 'trading on equity' feasible . Generally, as long as the
payment of interests and principal are guaranteed, a corporate debt security can be
priced accurately. However, the evaluation of debt finance was complicated by the
uncertainty and high-risk perceived by the investors . In order to reduce it, in 1 836, an
order of English Parliament introduced a capital ratio equity-debt of one-third for
companies and conditioned borrowing to the full payment of at least one-half of share
capital . 1 77 This policy of limiting leverage may have made corporate debt securities
more marketable, but also restricted possible benefits . The most prevalent technique of
reducing perceived risk was therefore through liens . 1 78 When the debt security was
issued as a debenture, but not only, it was most likely made convertible into a share of
the company. The equity option was considered an acceptable compensation for the
increased risk due to the absence of liens . 1 79 Two of the three largest privately financed
roads, the Reading and the Camden and Amboy, shortly after they began construction,
floated twenty-year and thirty-year sterling bond issues secured by mortgages on the
road' s property and convertible to stock at the holder' s option. The long-term
convertible mortgage bond initiated here was to remain throughout the nineteenth
century the standard type of American railroad bond. 1 80
A convertible obligation may be defined as a corporate obligation to pay money
that includes a stipulation granting to the holder at his election the privilege of
requiring the debtor corporation to deliver shares of stock in place of payment of the
debt . The privilege granted to the holder of a convertible obligation is an option
separate from the corporate obligation to pay the money and its invalidity will not
affect it. 1 8 1 For investors, this future claim gives convertible bonds the advantage of

1 76 . J . B . Baskin, The Development of Corporate. Financial Markets in Britain and the United States,
1600- 19 14: Overcoming Asymmetric. Information, Bus . History Rev. 62 , 1 99-23 7 ( 1 988) .
1 77 . W.Z. Ripley, Railroads: Finance & Organizations 1 1 6 (Longmans, Green & Co. 1 9 1 5 [reprinted
2000 by Beard Books] ) .
1 78 . As of 1 9 1 3 , 90 % of the funded railroad debt in the US (USD 1 1 .2 billion) was backed by some
type of mortgage and only 1 0 % consisted of debentures, see W .Z. Ripley, Railroads: Finance &
Organizations 1 3 9 (Longmans, Green & Co. 1 9 1 5 [reprinted 2000 by Beard Books] ) .
1 79 . See also F .A. Cleveland & F. W. Powell, Railroad Promotion and Capitalization in the United
States 1 56- 1 64 (Ayer Publg. 1 909) .
1 80 . A. Chandler, Patterns of American Railroad Finance, Bus . History Rev. 28, 248-263 ( 1 9 54) .
1 8 1 . A. Stone Dewing, A Study of Corporation Securities: Their Nature and Uses in Finance 62 1
(Ronald Press Co. 1 934) where the Author speaking of convertible bonds states ' [ . . . ] But these
partake largely of the nature of stocks, since they are issued with the hope that the holder will
become a partner and not a creditor, if the enterprise can in the future be made to appear
sufficiently attractive. They stand for an indirect method of increasing the stock or of creating
an artificial market for the bonds by attaching to them a speculative element which is foreign
to the fundamental conception of funded debt ' . C.J. Johnson & J . Mc Laughling, Corporate
Finance and the Securities Laws (Aspen Law & Business 1 997) , 697 et seq . ; L.C.B. Gower,

41
§ 1 . 02 [B] Lorenzo Sasso

combining desirable features of straight bonds, such as fixed income payments and
principal repayment, with the up-side potential of common stock. 1 82
In consideration of the conversion privilege, which gives bondholder the right to
convert the bond into the issuer' s (or guarantor' s) equity, an investor is prepared to
accept a lower interest rate. Thus, a convertible bond is usually issued with a lower
coupon than that payable on a comparable straight bond of the same issuer in the same
currency. The coupon or interest rate payable on the bond is, however, fixed at a
premium over the current dividend yield of the underlying shares so as to make the
convertible an attractive investment when compared with purchasing the underlying
equity. In exchange for the future equity claim, bondholders customarily also accept a
subordinated status in the priority list of claims of the firm and not to impose restrictive
covenants to the firm. To issuers, these concessions give convertibles advantages over
straight debt, such as cost savings, increased future capacity to incur senior debt and
greater flexibility to advance the interests of the common stockholders . 1 83
In order to measure the conversion privilege included in a convertible bond, it
becomes essential to break it down into its elements : its debt value, its conversion
value and its conversion premium. Its ' debt value' is the value of an equivalent straight
bond with the same coupon rate. This value is sensitive to the variables dominant in
straight bond valuation, such as interest rate levels and the issuer' s equity cushion. The
price at which the convertible bondholder may subscribe to shares in the issuer or
guarantor is its 'conversion price' . This price is usually higher than the prevailing
market price for the shares at the date of the bond issue. If the conversion price is a
constant, conversion value, which the amount is resulting by multiplying the conver­
sion price by the number of shares the bondholder receives upon conversion (conver­
sion ratio) , varies with any change in price of the underlying common stock. The terms
and conditions of the bonds will prescribe the mechanics of conversion and provide
that the number of shares into which the bond converts will be equal to the
denomination of the bond divided by the conversion price . For example, if a bond of
GBP 1 ,000 denomination is convertible into shares with a conversion price of GBP 2 per
share, 500 shares will be issued to the bondholder on conversion . Effectively, the debt
1
represented by the bond will be released through the issue of such shares . 84
The bondholder' s investment in a fixed rate convertible bond is also protected
against an upward movement in interest rates, which would usually depress bond
value, due to the equity cushion in the form of the conversion privilege. Even if interest
rates rise well above the rate payable on the convertible, the value of a convertible may
not fall or fall as much as ordinary bonds, because investors would regard the
convertible feature as adequate compensation for lower interest rates . In such events,
arbitrage possibilities would prevent the bond from selling below the lower of debt or

Principles of Modem Company Law 4 1 3 (4th ed. , Stevens & sons 1 979) ; S.W. Magnus & M .
Estrin, Companies Law and Practice 1 0 1 (Butterworths 1 9 78) ; A. Berle, Studies i n the Law of
Corporate Finance 1 30 (Callaghan & Co. 1 928) .
1 82 . W.W. Bratton, The Economics and Jurisprudence of Convertible Bonds, Wis . L. Rev. 673 ( 1 984) .
1 83 . W.A. Klein, The Convertible Bond: A Peculiar Package, U. Pa. L. Rev. 1 2 3 , 547-573 ( 1 975) .
1 84. W.W. Bratton, Corporate Finance, Cases and Materials 420 (5th ed. Foundation Press 2003) ; E.
Ferran, Principles of Corporate Finance Law 520-522 (Oxford U . Press 2008) .

42
Chapter 1: A Historical Perspective § l . 02 [C]

conversion value. The investor stands to lose only where interest rates rise well above
the convertible coupon and at the same time the stock price of the issuer does not rise
above the conversion price. Of course, the optimal gain to an investor would occur if
the issuer' s stock price rises well above the conversion price specified in the bond at a
time prior to final redemption . The amount by which market value exceeds debt or
conversion value is called 'conversion premium' . In convertible bonds issuer the
' conversion premium' is usually around 5 % -2 5 % above current share value. 1 8 5
The period during which a bondholder may exercise his conversion privilege
usually commences at the end of the forty-day period after completion of distribution
and continues until a date just prior to any date fixed for redemption of the bonds . 1 8 6
In practice, however, a bondholder would not wish to convert his bond into
equity until the shares market price has exceeded the conversion price specified in the
bond instrument, otherwise he would be subscribing shares at a price higher than their
market price. On the other hand, a call option may be conferred on the issuer in
convertible bonds, giving the company a right to redeem the bonds prior to the final
maturity date . An issuer would usually wish to redeem the convertible bonds outstand­
ing if interest rates moved significantly below the rate payable on the convertible. Such
a right of redemption is also a mechanism whereby an issuer can force the bondholder
to convert and exercise the conversion privilege, since the redemption of the bonds
results in the extinction of the conversion privilege. Ideally, the issuer would wish
bondholders to convert soon after the market price for the issuer' s ordinary shares or
conversion stock is at a level above the conversion price specified in the bond
instrument.

[C] Debt Holding Restrictive Covenants and Veto Rights

It is already known the dependence of the corporate sector on debt. Since debt
characteristics assign the creditor defined contractual rights against the company,
providers of debt are in a position to play a significant role in corporate governance by
monitoring managers and pressurizing them to fulfil their obligations . Generally, the
larger is the part financed by debt, the more control and pressure on the management
the debt-holders will exert and this will be useful for the shareholders too . 1 8 7 The extent
to which bondholders can perform or would choose to perform the function of
monitoring or controlling management will depend on the size of the loan, its intended
duration, whether or not it is secured and above all which kind of covenants are

1 85 . See J . S . Katzin, Financial and Legal Problems in the Use of Convertible Securities, Bus . Law . I ,
359-3 6 1 ( 1 969) says that i n the U S domestic market the premium was around 1 0 % t o 20 % ; R.
McCormick & H . Creamer, Hybrid Corporate Securities: International Legal Aspects 4 (Sweet &
Maxwell 1 987) place the premium between 5 % and 25 % in the international markets in
London.
1 86 . See P . Wood, International Convertible Bond Issues, Journal of International Banking and
Financial Law 1 2 , 69 (Butterworths 1 986) .
1 87 . In general, see G.G. Triantis & R.J. Daniels, The Role of Debt in Interactive Corporate
Governance, Cal . L. Rev. 83 , 1 073 ( 1 995) ; B . Cheffins, Company Law: Theory, Structure and
Operation 75-79 (Clarendon Press 1 997) ; E. Ferran, Company Law and Corporate finance 480
et seq. (Oxford U. Press , 1 999) .

43
§ 1 . 02 [C] Lorenzo Sasso

included in the terms of issue of their securities . The practice of financial contract
design has a long tradition in UK. Loan covenants were commonly used by early UK
and US commercial banks, which were usually structured as joint-stock companies . At
that time, banks operated in markets characterized by a high information asymmetry.
In order to reduce the risk of default, lenders must create information about the
borrowers . Early banks created information by probing the applicant' s credit history
and current financial condition, by evaluating the flow of funds through the borrower' s
checking account and by negotiating restrictive covenants specifying the users to
which a particular loan would be put. Therefore, covenants allow financial institutions
and financiers a say in the way that borrowing companies conduct their affairs and
provide them with the leverage to re-negotiate for yet more stringent control of
borrowers in financial difficulties . The spirit of covenants is to prevent the managers
from taking actions that benefit stockholders at the expense of bondholders . This aim
is pursued by dealing with three main areas of concern for banks and investors :
liquidity, the long-term risk of a borrower getting into financial difficulty and manage­
ment. 1 88
These obligations are usually more frequent and stringent when the lender is
taking a large exposure. A lender, which is advancing a relatively small amount, may
attach less importance to covenants . 1 8 9 When the counterpart is composed of a pool of
creditors, a large syndicate generally reduces the incentive for each investor to monitor
decisions and increases haggling and coordination costs . 1 9 0 The negotiating strength of
the borrowing company and the nature of its business are also relevant considerations .
A small company, which has limited access to other sources of finance, may have no
commercial alternative but to accept short-term finance or funds which are subj ect to
detailed restrictive covenants, while a large and well-established company with a good
credit rating and many available borrowing options may contract better and more
flexible conditions in their loans. 1 9 1
However, even if a borrower would be willing to accept severe restrictions or,
perhaps more accurately, lack the negotiating strength to resist them, a lender might
hesitate to impose them. In fact, if a covenant is unduly onerous so that management
is required to retain more of the company' s profits than it can prudently invest, this
could result in investments being made in risky ventures with potentially adverse
consequences for both lenders and shareholders . 1 92 This issue has generated concern

1 88 . P. Wood, International Loans, Bonds and Securities Regulation 32 (Sweet & Maxwell 1 995) .
1 89 . J . Day & P . Taylor, Evidence on the Practice of UK Bankers in Contracting for Medium-Term
Debt, JIBL 9 , 394 ( 1 995) ; J . Day & P . Taylor, Bankers ' Perspectives on the Role of Covenants in
Debt Contracts, J. Intl. Banking L. 5, 20 1 et seq. ( 1 996) .
1 90 . R.G. Rajan & A. Winton, Covenants and Collateral as Incentives to Monitor, J. Fin. SO,
1 1 1 3 - 1 1 46 ( 1 995) .
1 9 1 . Normally, 'bank power tends to be inversely related to borrower size, because the latter is
closely correlated with credit rating and available borrowing options' see E.S. Herman,
Corporate Control, Corporate Power 1 22 (New York, Cambridge U. Press 1 98 1 ) ; see also D .
Lomax, The Role o f Banks, in Capital Markets and Corporate Governance, 1 6 1 , 1 73 - 1 77
(N . Dimsdale & M. Prevezer eds . , Oxford and New York, Oxford U. Press 1 994) outlining
differences in a clearing bank' s relationships with small and larger businesses.
1 92 . R. Lister, Debenture Covenants and Corporate Value, Co. L. 6, 209 and 2 1 3 ( 1 985) ; R.
Sappideen, Fiduciary Obligations to Corporate Creditors, JBL 365 and 3 78 ( 1 99 1 ) .

44
Chapter 1 : A Historical Perspective § l . 02 [C]

between both academics and practitioners, especially in relation to the drafting of

terms attached to publicly issued debt securities . 1 93 The potential difficulties arise most
sharply in that context because, if the terms originally drafted prove to be too
restrictive, the process of obtaining a relaxation may be particularly cumbersome,
time-consuming and expensive as it may require the convening of a special meeting of
the holders of the securities for that purpose. 1 94 Furthermore, managers are especially
likely to resist restriction of discretion to make investments . Accordingly, these
covenants are likely to appear only in private placements and institutional investors '
venture capital and private equity transactions in which the lender has substantial
contracting power as, for instance, in venture capital . 1 95
In the common practice of business covenants, a formal distinction can be made
between affirmative and negative promises or between borrower' s promises to do and
borrower' s promises to refrain from doing. Positive covenants concern the promise of
the borrower to make periodic informational reports, to comply with law, maintain its
franchises, insure and maintain its properties, and pay all properly assessed taxes .
These covenants are useful because allow bondholders to monitor their investment.
However, they do not change the debt nature of the security, because none of them
materially constrains management' s discretion to operate the business, which is still
prerogative of the controlling shareholders . In contrast, negative covenants oblige the
borrower not to do certain operations, in order not to put its financial position at risk
and in this way, they can significantly drive the business decisions-making by
managers . In other words, whereas positive covenants are about information, negative
covenants are about control. The longer is the list of prohibited outcomes, the stronger
the control. At some point, the magnitude of control may become as great as to give the
lender effective control of the firm. 1 9 6

1 93 . In the United States the work of the American Bar Foundation in sponsoring the development
of standardised forms of debenture indentures (an indenture being the contract entered into
between the issuing company and the holders of securities) has provided a focus for this
debate: see V. Brudney & W.W. Bratton, Brudney and Chirelstein 's Corporate Finance 1 8 7- 1 93
(4th ed. Found . Press 1 993) . For an economic analysis of covenants see C.W. Smith & J . B .
Warner, O n Financial Contracting: An Analysis o f Bond Covenants, J. Fin . Econ. 7, 1 1 7 ( 1 979) .
1 94 . Accordingly, covenants in bank loans are traditionally more restrictive than in bond issue, see
P. Wood, Intemational Loans, Bonds, Guarantees, Legal Opinions 1 3 7 (Sweet & Maxwell 2007)
where he says that the relaxation process , either by way of the banks consenting to occasional
transactions or by way of a formal variation to the contractual terms, may be relatively
straightforward. However, it has to be remembered, in order not to oversimplify, that a
syndicated loan involving a number of lending banks could give rise to administrative
difficulties similar to, if not as severe as, those which could be encountered in the context of
debt securities .
1 95 . W.W. Bratton, Bond Covenants and Creditor Protection: Economics and Law, Theory and
Practice, Substance and Process, European Bus. & Organizational L. Rev. 7, 48 (2006) . For
empirical data, see S . N . Kaplan & P . Stromberg, Financial Contracting Meets the Real World: An
Empirical Analysis of Venture Capital Contracts, Rev. Econ. Stud. 70, 28 1 -3 1 6 (2003 ) .
1 96 . W.W. Bratton, Bond Covenants and Creditor Protection: Economics and Law, Theory and
Practice, Substance and Process, EBOR 7, 49 (2006) ; Y. Amihud, K. Garbade & M. Kahan, A New
Corporate Structure for Corporate Bonds, Stan. L. Rev. 5 1 , 462 et seq. ( 1 998) ; W.W. Bratton,
Bond Covenants and Creditor Protection: Economics and Law, Theory and Practice, Substance
and Process, EBOR 7, 5 1 et seq. (2006) ; C . W . Smith & J . B . Warner, On Financial Contracting:
An Analysis of Bond Covenants, J . Fin . Econ. 7, 1 24 (1 979) ; M. McDaniel, Bondholders and

45
§ 1 . 02 [C] Lorenzo Sasso

Negative covenants can further be divided into occurrence-based versus

maintenance-based covenants. Covenants for high-yield loans will typically be
occurrence-based that means the issuer can only undertake certain actions, such as
raising additional debt or selling assets, if the action contemplated will not result in it
breaching certain financial ratio tests at that time. These may include leverage ratio
tests as, for instance, the debt/total capitalization ratio or the debt/EBITDA ratio and
coverage tests as, for instance, the EBITDA/interest ratio . Conversely, bank credit and
private placement note purchase agreements usually contain restrictive maintenance­
based covenants that are tested quarterly or semi-annually. Non-compliance with such
tests would typically constitute an event of default even if the issuer had not borrowed
another penny since the original debt issuance. 1 97
An extreme application of negative restrictive covenants comes from the use of
veto rights as a protective provision often attached to preference shares in venture
capital financing. These clauses give the investors a right to oppose unfair company' s
actions carried on against their interests . However, the scope of these provisions differs
from company to company. Veto rights are generally employed by venture capital
investors in order to avoid claim dilution in situations in which the risk supported by
them is disproportionate vis-a-vis their return. Accordingly, they allow the investors to
oppose the completion of a firm' s recapitalization through the issuance of new
securities involving the entry of a new investor, if the subscription price is considered
to be too low compared to the real share price or the presumed share price. 1 9 8 These
covenants are also frequently used in the context of an exit event, a sale of all or
substantially all of the company' s assets, a merger or other important corporate
transactions . For instance, in Initial Public Offerings (IPOs) , if the financier considers
unacceptably low the price per share proposed for the listing, he or she may benefit
from a right to veto and block the transaction by refusing to convert the preference
shares into common shares . 1 99

Corporate Governance, Bus . L. 4 1 , 423 (1 986) ; J. Day & P. Taylor, Bankers ' Perspectives on the
Role of Covenants in Debt Contracts, J. Intl. Banking L. 5 , 2 0 1 et seq. (1 996) .
1 97 . These covenants can also be used as early warning signs of a financial deterioration of the
business .
1 98 . See R.A. Mann et al . , Starting From Scratch: A Lawyer's Guide to Representing a Start-Up
Company, Ark. L. Rev. 56, 86 1 -862 (2004) .
1 99 . The preferred stock purchased by financiers will generally have a provision requiring the
automatic conversion of preferred stock upon either an IPO at a pre-specified price per share or
the requisite vote of preferred stockholders.

46
CHAPTER 2

Distinguishing between Equity and Debt

The starting point for any research in capital structure is the Modigliani & Miller
(M & M) theorem. It suggests that - under very strict and unrealistic assumptions - a
company' s capital structure does not matter. However, without doubt, a lot of energy
is invested in finding the optimal capital structure for a given company in the real
world. Theory explains this mainly by pointing towards the differing tax and regulatory
treatment of debt and equity, respectively, as well as information asymmetries
between creditors, shareholders and managers. However, once the conditions that
underpin the M&M study on the optimal capital structure are relaxed, 1 the choice
between financing assets with debt or equity becomes material, and mutatis mutandis,
the classification of a financial instrument as either debt or equity. As far as classifi­
cations are concerned, accounting rules play an important role in the framework of
corporate law. They are targeted to measure and classify the financial instruments
issued by a company in order to reflect the desire for transparency between company
and investors . Furthermore, regulatory bodies heavily rely on accounting numbers as
control over regulations .
Accountants and tax authorities are dedicated to a dichotomous classification
that has been considered the most suitable way to identify and then interpret certain
results as the annual income and taxable results . Although in principle, a twofold
distinction between equity and debt can appear quite straightforward because of their
contrasting characteristics, it is in reality blurred by the existence of hybrid financial
instruments, which consist in securities with a mix of both equity and debt features .
Therefore, hybrids complicate the task o f the regulators because they provide the users
with an optimal tool of regulatory arbitrage.

1. It means that markets are not perfect and efficient so taxes and bankruptcy costs exist as well
as asymmetric information and borrowing costs .

47
§2 . 0 1 Lorenzo Sasso

§2 .01 DOES CAPITAL STRUCTURE MATIER?

During the years, the equity-debt trade-off has animated many doctrinal discussions in
relation to dividend policies, the optimal financial structure on investment choices,
conflicts of interests arising between different claimants of future streams of returns
and the management of the company, as well problems associated with the separation
between ownership and control in a company. 2
One strong argument against writing a book on the Debt-Equity distinction is the
M & M theorem, which demonstrates how the division between the two is irrelevant to
the value of the firm and the doctrine on corporate finance should not concern itself
with figuring out the perfect debt-equity ratio to maximize the shareholders' value . The
theorem was published in 1 95 8 and since then has been considered by many as the
foundation of the modern corporate finance. 3
In the study, Modigliani and Miller assumed several strict conditions . First, in
their fictitious economy they assumed the absence of any costs of insolvency (bank­
ruptcy costs) as well as the absence of any taxation imposed either at the firm level or
at the individual level. Second, markets are efficient and perfect. The efficient markets
assumption means that there is no asymmetric information between the managers and
all market participants . Therefore, the prices on traded stocks, bonds or property
already reflect all known information, and instantly change to reflect new information.
The perfect markets assumption means that transaction costs do not exist and there are
no barriers to exit or enter in the markets. Thus, all investors share homogeneous
expectations about the future prices of securities and individuals can borrow at the
same interest rate as corporations. Third, in this fictitious world there is no division of
the stream between cash dividends and retained earnings in any period, because the
management is presumed to be acting in the best interests of the stockholders . The
issued shares are divided into ' equivalent return' classes that means that all the shares
issued by any firm in the same class have the same return and the various shares within
the same class differ, at most, by a ' scale factor' . In this way it is possible to classify
firms into groups within which the shares of different firms are 'homogeneous' or

2. See P . L . Davies, Gower and Davies ' Principles o f Modem Company Law 859-864 and
1 1 79- 1 1 99 (9 th ed. , Sweet & Maxwell 20 1 2) ; D. Kershaw, Company Law in Context: Text and
Materials 1 63 et seq. (Oxford U. Press 2009) ; J . H . Farrar & B.M. Hanningan, Farrar's Company
Law (4 th ed . , Butterworths 1 998) 1 58- 1 60; R. Burgess, Corporate Finance Law 5-6 (2d ed . ,
Sweet & Maxwell 1 992) ( ; T .E. Stocks, Corporate Finance: Law and Practice 6 (Sweet & Maxwell
1 992) ; R. W. Hamilton, Corporations, Including Partnership and Limited Liability Companies,
Cases and Materials 299 (West Group 1 998) ( ; J . D . Cox & T.L. Hazen , Business Organizations
Law 540 (3d ed . , West 2 0 1 1 ) ; W.A. Klein & J . C . Jr. Coffee, Business Organization and Finance:
Legal and Economic Principles 7- 1 1 ( 9 th ed. , Foundaton Pr 2004) ; R. McCormick & H . Creamer,
Hybrid Corporate Securities: International Legal Aspects 2 (Sweet & Maxwell 1 987) ; but this
opinion is supported since long time A. Stone Dewing, The Financial Policy of Corporations 34
and 78 (2d ed. , Ronald Press Co . 1 9 1 9) .
3. See F. Modigliani & M . Miller, The Cost of Capital, Corporate Finance and Theory of Investment,
Am. Econ. Rev . XLVIll, 26 1 -2 75 ( 1 958) . The essay was modified in part later by F. Modigliani
& M. Miller, Corporate Income Taxes and the Cost of Capital: A Correction, Am. Econ. Rev . Lill,
43 3-443 (1 963) , and reconsidered more recently by M.H. Miller, Debt and Taxes, J . Fin . 3 2 ,
26 1 -275 ( 1 977) and M . H . Miller, The Modigliani Miller Propositions After Thirty Years, J . Econ.
Perspective 4, 99 ( 1 988) .

48
Chapter 2 : Distinguishing between Equity and Debt §2 . 0 1

perfect substitutes for one another. At the same time, all bonds are assumed t o yield a
constant income per unit of time, are traded in a perfect market and are perfect
substitutes for each other up to a ' scale factor' . 4
Given those assumptions, the first and most famous proposition establishes a
company capital structure does not matter because it is completely independent from
the investment choices. 5 To support its thesis, the M&M theorem showed that as long
as the relations between 'market value' and ' average cost of capital' did not hold
between any pair of firms in a class, arbitrage could take place and restore the stated
equalities simply because if an investor were to exploit an arbitrage opportunity and to
acquire shares at a lower price, the value of the overpriced securities would fall and the
under priced shares value would rise, eventually eliminating the discrepancy.
From the first proposition derives the second proposition that concerns the 'rate
of return' on ordinary shares in companies capitalized by debt. The second proposition
establishes that gearing the firm does not increase the shareholders' return or reduce
the cost of capital, because the cost of equity capital is a linear function of the
debt-equity ratio . 6 Obviously, M&M theorem does not deny that a different composi­
tion of the financial structure could affect the expected rate of return of a company, but
it shows that increasing the rate of return of the ordinary shares increases the amount
of debt and consequently the financial risk, generating in a long-term investment a
zero-sum game.
A conclusion for an optimal investment policy of the firm that summarizes the
M&M theorem is reported in their third proposition where they state that the optimum
ratio equityI debt is completely unaffected by the type of security used to finance the
investment. 7 For the authors, firm value is determined by the size and riskiness of the
cash flows arising from the investments in risky proj ects . The underlying investment
and operating decisions that determine corporate cash flows are independent of
financing decisions i . e . , are unaffected, and therefore capital structure decisions will
merely result in changing the distribution of these cash flows between the different
claimants . Capital structure decisions will, of course, alter shareholder' s anticipated
risk and returns but this will not have any impact on total firm value because in a
perfect and complete capital market, investors can profit without cost from any market
mispricing via the application of 'home-made leverage' , namely the arbitrage effect.
Subsequently in a following study, Miller and Modigliani - first, and Miller -
then, observed the same scenario relaxing the no taxation assumption. Due to the
preferential treatment of debt relative to equity in tax law, the optimal capital structure

4. However, Stiglitz demonstrated that this third assumption is not essential, see J.E . Stiglitz, A
Re- Examination of the Modigliani-Miller Theorem, Am . Econ. Rev . LIX, 784-793 ( 1 969) .
5. See F . Modigliani & M. Miller, The Cost of Capital, Corporate Finance and Theory of Investment,
Am . Econ . Rev. XLVIII, 268 (1 958) .
6. See F. Modigliani & M. Miller, The Cost o f Capital, Corporate Finance and Theory o f Investment,
Am. Econ. Rev. XLVIII, 2 7 1 ( 1 958) where the authors say ' the expected yield of a share of stock
is equal to the appropriate capitalization rate p (k) for a pure equity stream in the class, plus a
premium related to financial risk equal to the debt-to-equity ratio times the spread between p (k)
and r'.
7. See F. Modigliani & M. Miller, The Cost of Capital, Corporate Finance and Theory of Investment,
Am . Econ. Rev. XLVIll, 288 (1 958) .

49
§2 . 02 Lorenzo Sasso

can be complete debt finance. However, although a firm could generate higher after-tax
income by increasing the debt-equity ratio and thus higher pay-out to stockholders and
bondholders, the value of the firm need not increase. The explanation for it is that
while debt lowers the firm' s cost of capital because passive interests are tax deductible,
it rises the level of taxation to individual investors, because for an investor taxes are
higher on interest payments than on equity returns . The disproportion in taxation
resulting from a cheaper tax rate on dividends and capital gains than on interest at the
investor level, eliminates or partly offset the tax advantage of debt finance to the firm. 8
Company will persuade the market investors to hold debt instead of shares as long as
the corporate tax saving is greater than their personal tax loss . 9
The fundamental contribution of the M&M theorem is that it structures the debate
on why irrelevance of the financial structure fails around the theorem' s assumptions,
i . e . , neutral taxes, no transaction costs, asset trade restrictions or bankruptcy costs ;
symmetric access to credit markets, symmetric information and firm financial policy.
So doing, the theorem identifies exactly where to look for determinants of optimal
capital structure and how those factors might affect capital structure. 1 0 With regard to
firm capital structure, the Theorem opened a host of literature on the fundamental
nature of debt versus equity. The doctrine has been debating whether and in which
ways the distinctions between debt and equity, as two distinct forms of capital, are
really substantial in economic terms . 1 1 Therefore the main questions driving this
chapter are : does a clear distinction between equity and debt, as two different opposing
methods to contribute finance in a corporation' s business exist in law and how hybrid
financial instruments fit in this dichotomy? And if yes, since economic theory finds no
justification for it, why the law needs to classify investors' claims and why companies
issue hybrid instruments?

§2 .02 DEFINITION OF EQUITY AND SHARE CAPITAL

The section 548 of the Company Act 2006 defines equity share capital as:

its issued share capital excluding any part of that capital which, neither a s respects
dividends nor as respects capital, carries any right to participate beyond a specific
12
amount in a distribution.

8. M. H . Miller, Debt and Taxes, J . Fin. 3 2 , 269 and 2 70 (1 977) , where the author says the value
of the firm in equilibrium will be independent of its capital structure but 'there would be no
optimum debt-equity ratio for any individual firm' .
9. D . Farrar & L. Selwyn, Taxes, Corporate Financial Policy and Retum to investors, Natl . Tax J. 20,
444-454 (1 967) ; S.C. Myers , Taxes, Corporate Policy and Returns to Investors: Comment, Natl.
Tax J. 20, 455-462 ( 1 967) ; S . C . Myers , Capital Structure, J . Econ. Perspectives 1 5 , 87-88
(200 1 ) ; R.C. Stapleton, Taxes, the Cost of Capital and the Theory of Investment, Econ. J. 82 ,
1 2 73 - 1 292 ( 1 9 72) ; J.E. Stiglitz, Taxation, Corporate Financial Policy and the Cost of Capital, J.
Public Econ. 2 , 1 -34 ( 1 9 73) .
10. P . H . Huang & M . S . Knoll, Articles and Essays: Corporate Finance, Corporate Law and Finance
Theory, S . Cal . L. Rev. 74, 1 79 (November 2000) .
11. A . P . Villamil, Modigliani-Miller Theorem, in The New Palgrave Dictionary of Economics (Steven
N. Durlauf & Lawrence E. Blume eds . , 2d ed . , Palgrave Macmillan 2008) .
12. Section 548 (ex s. 744 o f the CA 1 985) .

so
Chapter 2 : Distinguishing between Equity and Debt §2 . 02

Preference shares are normally, although not always, entitled only to a fixed return by
way of both dividends and capital. They do not therefore constitute equity share capital
although they may do so if the return on dividend or capital is not fixed or deferrable.
In accountancy, a broader notion is the generally accepted definition as reflected in the
international accounting standards documents where equity is defined as the residual
interest in the assets of an enterprise after deducting its liabilities . 1 3 The European
accounting rules makers have chosen not to make the definition of equity conceptually
based, but simply based on an arithmetic calculation : that is, knowing assets and
liabilities , equity can be inferred. The purpose of this choice is the desire to include the
totality of classes of shares without entering in difficult legal definitions . In fact, some
items included in the equity of the balance sheet are merely ' accounting figures' given
that they are not based on contracts as the other capital instruments. Instead, these are
items sometimes based on statutory requirements, such as retained earnings and
sometimes neither based on contracts nor statute such as currency translation adj ust­
ments or gains and losses that have been recognized directly 'in equity' . Under current
International Financial Reporting Standards (IFRS) , these items are not recognized in
the income statement (revaluation reserve, cash flow hedging reserve) . They are
simply figures that exist as a result of certain accounting conventions. Nevertheless,
since shareholders may claim them, at least upon liquidation, they still do form capital
interests that are attached to a capital instrument . Therefore, it can be argued that the
capital side of the balance sheet comprises 'claims' that only differ on their intensity.
The claims to the company' s assets generally feature a combination of certain criteria
such as term, type of return and existence of voting rights and their corresponding
attributes : fixed term v. perpetual life, fixed v. variable return, existence of positive or
negative covenants etc. 1 4 Shares and bonds strongly differ in the intensity of their
claims . However, in between these two distinct categories, there is a myriad of hybrid
financial instruments that mix characteristics, which are generally associated with
straight equity and straight debt, making their classification into a dichotomous
structure of capital very difficult. 1 5 Difficulties in distinguishing between equity and
liabilities arise especially when the single characteristics of a security point into
different directions . For example, a security may assign to its subscribers a right to
participate in the company' s gains and losses, which is a characteristic generally
associated with ordinary shares, but at the same time be repayable at a fixed date, as
a plain vanilla bond. As Table 2 . 1 below shows, it is possible to replicate any typical
characteristic of equity or debt with hybrid financial instruments while obtaining a
different classification. Therefore, if ambiguity in the accounting constructs is to be
accepted as an important conceptual and practical issue, it is necessary to understand
how these constructs are utilized by financial statement users and how they potentially

13. IASB, F. 49 (c) .

14. Pro-active accounting activities i n Europe (PAAinE) , Discussion Paper Distinguishing between
liability and equity, January 2008 , available at http : //www .iasplus. com/efrag/080 1 liab
equitydp .pdf (accessed March 2 0 1 2) .
15. F . Allen, The Changing Nature of Debt and Equity: A Financial Perspective, in Financial
Innovation and Risk Sharing 347 et seq. (Franklin Allen & Douglas M. Gale eds . , Massachusetts
Institute of Technology (MIT) Press 1 994) .

51
§2 . 03 Lorenzo Sasso

influence real decisions made by companies and individuals and perhaps, potentially,
affect wider interests .
Table 2. 1

Classification as:
Characteristic features
EQUITY HYBRID SECURITIES DEBT

Participation in ongoing profit or

x Participating preference shares
losses

Subordination to all the creditors in

x Subordinated/perpetual debentures
liquidation

Fixed payment on the instrument Cumulative preference shares x

Variable claim in repayment / Profit participating loans /

x
redemption redeemable preference shares

Possibility to agree on no redempt ion x Redeemable shares

Cumulative redeemable preference

Fixed term / maturity x
shares / convertibles

Veto rights preference shares /

Control / voting rights x
voting bonds

§2 .03 WHY DISTINGUISH BETWEEN EQUITY AND DEBT: THE ROLE

OF ACCOUNTING AS CONTROL OVER REGULATIONS

The importance of distinguishing equity from liabilities or equity instruments from

debt instruments respectively has to be considered in relation to the fundamental role
that accounting numbers have acquired within the framework of company law.
Nowadays, accounting numbers are perceived to have sufficient credibility to act as a
basis for economic contracting between corporate entities and related interest groups .
Disclosure and transparency rules, which are mandatory for public companies,
strongly rely on accounting numbers . Public companies generally need to publish their
accounts according to certain defined international standards and have them certified
by an authorized audit company. Financial accounting provides investors with the
primary source of independently verified information about the company' s economic
situation and the performance of managers . 16 For instance, widespread use is made of
accounting-based performance measures in managerial compensation contracts 1 7 and

16. For a analysis o f the role o f accounting information i n financial contracting see C. Villiers
Corporate Reporting and Company Law 1 3-34 (Cambridge U . Press 2006) . See also S. Gilson &
J. Warner, Private versus Public Debt: Evidence from Finns That Replace Bank Loans with Junk
Bonds passim (Harv . Bus. Sch . , Working Paper, 1 998) available at SSRN : http ://ssrn. com/
abstract = 14009 3 ; S . N . Kaplan & P . Stromberg, Financial Contracting Meets the Real World: An
Empirical Analysis of Venture Capital Contracts, Rev. Econ . Stud . 70, 286-295 (2003) .
1 7. R.M. Bushman & A.J. Smith , Financial Accounting Information and Corporate Governance, J .
Acctg. & Econ. 32, 23 7-3 33 (December 200 1 ) .

52
Chapter 2 : Distinguishing between Equity and Debt §2 . 03

in collective wage negotiations or of accounting-based covenants in public debt

contracts . 1 8
The level o f gearing that measures the proportion o f debt financing i n the
financial structure in comparison to equity financing is a strong instant indicator of the
potential financial risk associated with a company. The rationale for this measure is
based on the fact that debt is issued under contractual terms requiring the repayment
of principal and interest on specified dates, whereas equity capital carries no such
contractual obligations. As a matter of fact, the risk of default on debt repayments will
increase as the proportion of debt finance in the capital structure increases. Decisions,
which are based on risk assessments such as bankers' lending decisions and investors'
decisions to buy or sell securities in the secondary markets , will depend on such
analysis . Furthermore, the fundamental approach to define income implicit in conven­
tional accounting procedures is to measure the change in equity between two points in
time, adjusting for any new subscriptions of equity capital or withdrawals of capital in
the period . Although profit or loss is calculated from flow variables such as revenues
and expenses, the accounting model on which financial statements are based, linked
by the process of double entry bookkeeping, ensures that revenues or other recognized
gains are also reflected as increases in assets or decreases in liabilities, whereas
expenses will coincide with decreases in assets or increases in liabilities . In both cases,
changes in the values of assets and liabilities arising from investments by or distribu­
tions to the owners of an enterprise would be excluded from the definition of income.
If the above definition of income is accepted, then it is clear that the ability to
distinguish between equity and liabilities is crucial to the income measurement
process. In fact, the determination of the final result of the period together with the
retained profits or other distributable reserves is usually the primary test for determin­
ing the maximum distribution to shareholders, whether the EU Second Directive 1 9
applies or whether a solvency test is taken into account, as for instance, in the case of
'whitewash procedure' . 20 Moreover, as a matter of fact, extensive evidence shows that
equity prices for public companies listed in the secondary market are associated with
reported income. 2 1
Regulatory bodies heavily rely o n accounting numbers a s controls over regula­
tions, for example, in the case of banks and insurances' compliance with capital
adequacy requirements, in the assessment of a company' s obligation to file its annual
tax returns or when preparing the list of priorities in a company' s winding up . Other
special authorities or market controllers rely on accounting numbers . The UK Stock
Exchange, for example, imposes various constraints on listed companies, such as

18. E.G. Press & J . B . Weintrop, Accounting-Based Constraints i n Public and Private Debt Agree­
ments: Their Association with Leverage and Impact on Accounting Choice, J. Acctg. & Econ . 1 2 ,
65-95 ( 1 990) ; A . P . Sweeney, Debt-Covenant Violations and Managers ' Accounting Responses,
1 . Acctg. & Econ. 1 7, 2 8 1 -308 ( 1 994) ; D .A. Peel & P . Pope, Corporate Accounting Data, Capital
Market Information and Wage Increases of the Firm, J . Bus. Fin . & Acctg. 1 77- 1 88 ( 1 984) .
19. Second Council Directive 77 /9 1 /EEC o f 1 3 Dec. 1 976 .
20. P . F . Pope & A.G. Puxty, What is Equity New Financial Instruments in the Interstices between
-

the Law, Accounting and Economics, MLR 54, 889 and 895 ( 1 99 1 ) .
21. B . Lev, On the Usefulness of Earnings and Earnings Research: Lessons and Directions from Two
Decades of Empirical Research, J. Acctg. Res . : Supp . 1 53- 1 92 ( 1 989) .

53
§2 . 03 [A] Lorenzo Sasso

requiring the disclosure of contracts of significance (Class 3 transactions) in the

directors ' report, defined as contracts which represent 1 % or more in value of a
company' s net assets for a capital transaction . Again accounting numbers, in this case
the total assets minus total liabilities or net worth (the equity of the firm) , assume a
pivotal role. The reclassification for banks and insurers solvency requirements as well
as the financial analysis for credit rating is strictly based on the accounting statements .
Furthermore, the income measurement process is essential in the calculation of
corporate tax liabilities . Finally, the law of insolvency hinges crucially on accounting
numbers to define the insolvency event and hence, the situations under which
directors face penal sanctions or are imposed creditor-regarding duties . 22 It is clear that
the measurement of the magnitude of liabilities in relation to the total assets is crucial
in the first instance in defining insolvency. Formally, one of the criteria the court will
take into account when determining whether a company is unable to pay its debts is
whether the value of the company' s assets is less than the value of its liabilities, taking
into account its contingent and prospective liabilities . 2 3

[A ] The Accounting Standards for Classifying Hybrid Financial

Instruments

Entities have long struggled with the question of whether financial instruments they
issue to raise capital should be reported as liabilities or equity when those instruments
possess characteristics of both debt and equity . The current accounting requirements
governing the classification of financial instruments as liabilities or equity under both
IFRS and US GAAP (Generally Accepted Accounting Principles) have been criticized for
lacking a clear and consistently applied set of principles and for not distinguishing
between equity and non-equity in a manner that best reflects the economics of the
transactions involving those instruments . 24 Responding to these concerns, in February
2006, as part of their Memorandum of Understanding, 2 5 the IASB and F ASB Boards
agreed to undertake a joint proj ect on financial instruments with characteristics of
equity to improve and simplify the financial reporting. The project includes classifica­
tion and measurement of financial instruments, impairment of financial assets and
hedging. However, the boards have not converged on each element, so there are

22 . P .L. Davies, Directors ' Creditor-Regarding Duties in the Vicinity of Insolvency EBOR 7, 336-33 7
(2006) .
23 . Insolvency Act 1 986, s . 1 2 3 .
24. See FASB, Preliminary Views, Financial Instruments with Characteristics o f Equity, file
reference no. 1 550- 1 00, www . fasb . org. According to the FASB, US-GAAP currently contains
sixty pieces of related literature, and the FASB itself views those as 'inconsistent, subject to
structuring, difficult to understand and apply' and acknowledges that ' the complexity has
caused many questions and numerous restatements over the past few years' . See IAS 32 on
' Financial Instruments Puttable at Fair Value and Obligations Arising on Liquidation' , paras SO
(b) and 51 of the Basis for Conclusions to IAS 32 (rev . 2008) , which refer to ' counterintuitive
accounting' and a ' lack of relevance and understandability' .
25 . Also called 'The Norwalk Agreement ' , after the joint meeting in Norwalk, Connecticut, USA on
1 8 Sep . 2002 , where IASB and FASB acknowledged their commitment to the development of
high-quality, compatible accounting standards that could be used for both domestic and
cross-border financial reporting.

54
Chapter 2 : Distinguishing between Equity and Debt §2 . 03 [A]

expected to be differences in the final standards . Regarding what matters most for our
purposes - the classification and measurement of financial instruments - the boards
decided to defer further work on this project in 20 1 1 in order to give priority to IFRS 9
(IAS 3 9) and ASC 8 1 5 (Derivatives and Hedge Accounting) and only very recently
reactivated it . 2 6
According to the international accounting standards, it is IFRS 7 (previous IAS 32)
that deals with whether an instrument or security issued by a company should be
classified as debt or equity in the liabilities sector of its balance sheet. 27 Its fundamental
principle is that on initial recognition, a financial instrument is classified either as a
financial liability or as an equity instrument according to the substance of the contract
and not its legal form. 2 8 In order to achieve this aim, IAS 32 has shifted the view from
equity interests to equity instruments defining, at paragraph 1 1 , equity instrument as :

any contract that evidences a residual interest in the assets of an entity after
deducting all of its liabilities .

In contrast, a financial liability is defined as :

any liability that is:

a) a contractual obligation:

a. to deliver cash or another financial asset to another entity; or

b . to exchange financial assets or financial liabilities with another entity under
conditions that are potentially unfavourable to the entity; or
b) a contract that will or may be settled in the entity' s own equity instruments and
is :

a . a non-derivative for which the entity is or may be obliged to deliver a variable

number of the entity ' s own equity instruments; or
b . derivative that will or may be settled other than by the exchange of a fixed amount
of cash or another financial asset for a fixed number of the entity' s own equity
instruments . [ . . . ]

The above-cited definition of financial liability excludes the economic compulsion that
is the circumstance in which the terms and conditions of an instrument oblige an entity
to act in a certain way even in absence of any contractual obligation. For instance, an
entity may be economically compelled to exercise a right to repay a liability that is
legally a perpetual instrument - if the terms of the contract contain a clause that the

26. Several papers have been issued in the years, see the Pro-active Accounting Activities in Europe
Initiative (PAAinE) of EFRAG and the European National Standard Setters, Discussion Paper,
April 2007; IASB Discussion Paper, Financial Instruments Puttable at Fair Value and Obliga­
tions Arising on Liquidation, February 2008; IASB Discussion Paper, Financial Instruments
with Characteristics of Equity, February 2008 . IASB Exposure Draft, Classification of Rights
Issues proposing to amend IAS 32 on August 2009; IASB Amendments, Offsetting Financial
Assets and Financial Liabilities (Amendments to IAS 32) on December 201 1 . For the more
detailed agenda look at http ://www.iasplus. com/agenda/liabequity. htm.
27. Reg. (CE) n . 223 7 /2004, i n OJ 3 1 Dec . 2004.
28. In U K , the international standard IAS 32 was first implemented b y FRS 25 and then b y FRS 2 9
which has the effect o f implementing the amended disclosure requirements o f IFRS 7 ' Financial
Instruments : Disclosures ' , issued by the IASB in August 2005 . FRS 29 is applicable for
accounting periods beginning on or after 1 Jan. 2007.

SS
§2 . 03 [A] Lorenzo Sasso

interest rate payable on this instrument will quintuple at a certain point in time.
However, since IAS 32 covers only contractual obligations, the financial instrument
would be classified as equity. 2 9
There are some exceptions to this principle represented by the so-called fixed test
for non-derivative and 'fixed for fixed ' test for derivative financial instruments as well
as the recent amendment on puttable financial instruments . Where a non-derivative
financial instrument may be settled by issuing shares, classification will depend on
whether the number of shares to be issued is fixed or variable . If the entity is obliged
to issue a fixed number of own equity instruments in exchange for a fixed amount of
cash, the obligation is not recognized as a financial liability, but as equity. Conversely,
if a variable number of equity instruments is delivered or if delivery is against reception
of a variable amount of cash, the instrument is a financial liability. 3 0 Similarly, in order
to avoid classification as a financial liability, a derivative financial instrument must be
settled by an entity issuing a fixed number of shares or a fixed amount of cash of its
own equity instruments. The derivative instruments that meet the ' fixed for fixed ' test,
fall outside the scope of IAS 39 and are treated as equity. 3 1 The reasoning underlying
this exception is that the financial position of the contract holder is, due to the
exchange relation being fixed, somewhat similar to that of a present holder of equity
instrument . Assuming that the entity is a going concern and is still in business when the
contract is settled, the accounting reflects the outcome, as if the contract had already
been settled . 3 2
The other exception concerns puttable financial instruments . Although they are
generally classified as financial liabilities, because the right to put an instrument back
to the issuer gives rise to an obligation on the side of the entity, the IASB amended IAS
32 with respect to the balance sheet classification of puttable financial instruments and
obligations that arise only on liquidation. 33 The rationale of this amendment was to
improve financial reporting of particular types of financial instruments that meet the
definition of a financial liability but represent the residual interest in the net assets of
the entity. These financial instruments entitle their holders with the right to either put
the instrument back to the issuer at the fair value of a pro rata share of the net assets
of the entity or receive a pro rata share of the net assets of the entity upon liquidation.
As a result of the amendments, subj ect to specified criteria being met, these instru­
ments would be classified as equity, whereas under the previous requirements they

29. IAS 32 para . 20.

30. IAS 32 paras 1 6 (a) and 1 6 (b) .
31. In addition, rights, options or warrants to acquire a fixed number of the entity' s own equity
instruments for a fixed amount of any currency are equity instruments if the entity offers the
rights, options or warrants pro rata to all existing owners of the same class of its own
non-derivative equity instruments .
32. In other words, b y fixing upfront the number o f shares t o b e received o r delivered o n settlement
of the instrument in concern, the holder is exposed to the upside and downside risk of
movements in the entity' s share price. A contractual right or obligation to receive or deliver
anything other than a fixed number of the entity' s own shares will result in liability
classification of the instrument in concern.
33. See IASB Paper, Amendments t o puttable financial instruments and obligations arising only on
liquidation, February 2009 . The amendments are effective for annual periods beginning on or
after I Jan. 2009 .

56
Chapter 2 : Distinguishing between Equity and Debt §2 . 03 [A]

were classified as financial liabilities . The most critical conditions are that the
instruments are in the most subordinated class of instruments with a claim to the
entity' s net assets . All instruments in this class have equal terms and conditions and
apart from the holder' s put right, there are no other obligations . 34
In contrast with the IASB ' s principles stated in IAS 32, the FASB Accounting
Standard Codification (ASC) 480 'Distinguishing Liabilities from Equities' (previous
FAS 1 50) restricts the definition of equity, leaving the liability category as a default
basket for most of the hybrid financial instruments . FASB employed two perspectives
from which hybrid instruments are differentiated: the solvency perspective and the
valuation perspective . Both perspectives provide an excellent basis for discussing the
accounting for complex instruments . The solvency perspective reflects the existence or
absence of contractually specified claims on assets . Therefore, debt-holders can file for
a company to be put in liquidation in order to access the assets and satisfy their debt,
whereas shareholders cannot. The valuation perspective reflects the existence or
absence of an ownership relationship or residual claim. Following this reasoning,
common shareholders have a residual claim, which means they are paid only after
everyone else, while debt-holders have a fixed claim that give them a priority in case of
liquidation of the company. In other words, the two main bases for sequencing and
disaggregating claims, so as to enable financial statement users to distinguish obliga­
tions from non-obligations and residual claims from non-residual claims, are the
contractual specificity of their pay-off, that is almost completely unspecified in the
common stock, whereas it is specified in detail in the debt and their order of priority in
the event of bankruptcy. According to the first criterion, common equity is the ultimate
residual claim and all other claims reduce the value of common equity and increase the
mean and the variance of the return on common equity. According to the latter
criterion, which follows the insolvency risk assessment, since a firm can become
insolvent only as a result of its obligations , those are liabilities while non-obligatory
claims are equity.
This twofold approach has generated several criticisms mainly based on the fact
that although the two perspectives are very effective in classifying simple or separable
compound financial instruments, they appear inadequate and poor when they had to
classify hybrid instruments . 35 First, it was lamented that there is a lack of coordination
in the cross-section analysis of company' s different financial statements . Second,
restricting the classification of instruments as equity and effectively using the liability
category as a default balance sheet classification for complex financing instruments
could severely impair financial analysis . The problem was created by the primacy of

34. IAS 32 para. 1 6. The greatest impact of this amendment has been in the fund management
industry and those jurisdictions where local law permits or requires entities to have a limited
life. Open-ended mutual funds, unit trusts , partnerships and other entities that allow investors
to withdraw their interest at a pro rata share of net assets, previously recognised liabilities
equal to the assets in the fund.
35. American Accounting Association' s Financial Accounting Standards Committee, Evaluation of
the FASB 's Proposed Accounting for Financial Instruments with Characteristics of Liabilities,
Equity, or Both: AAA Financial Accounting Standards Committee, Acctg. Horizons 1 5 , 3 87-400
(200 1 ) .

57
§2 . 03 [A] Lorenzo Sasso

the solvency perspective over the valuation perspective, which was carried out in such
a subordinated and narrow manner that made it relatively difficult for a financing
component to qualify as equity. 3 6 Third, the American Accounting Association judged
that the classification methodology focused too much on contractual provisions and
essentially ignored economic substance. 3 7
Generally speaking, three types of obligations may require liability treatment
under ASC 480- 1 0-2 5 :

Mandatorily redeemable financial instruments .

Obligations to repurchase the issuer' s equity shares by transferring assets.
Obligations to issue a variable number of shares .

Regardless of how certain features are labelled (for instance an agreement may or may
not use the word mandatorily redeemable or puttable) , the financial contracts should
be reviewed carefully for obligations of the issuer to redeem instruments for cash or
other assets; or the rights of the holder to return certain instruments to the issuer for
cash or other assets (preferred stock and warrants respectively) . Under ASC 480- 1 0-20,
mandatorily redeemable financial instruments are defined as :

Any of various financial instruments issued in the form of shares that embody an
unconditional obligation requiring the issuer to redeem the instrument by trans­
ferring its assets at a specified or determinable date (or dates) or upon an event that
is certain to occur.

In considering this definition, it must be pointed out that term extension options or
similar provisions that defer redemption until a specified liquidity level is reached do
not affect the classification of a mandatorily redeemable financial instrument as a
liability. 3 8 As long as the obligation of the issuer to redeem the instrument is
unconditional, the instrument will be classified as a liability. This means that there may

36. See American Accounting Association' s Financial Accounting Standards Committee, Evalua­
tion of the FASB 's Proposed Accounting for Financial Instruments with Characteristics of
Liabilities, Equity, or Both: AAA Financial Accounting Standards Committee, Acctg. Horizons
1 5 , 1 59- 1 86 (200 1 ) ; C.A. Botosan, et al. , Accounting for Liabilities: Conceptual lssues, Standard
Setting, and Evidence from Academic Research, Rev. Acctg. Horizons 1 9 , 1 59- 1 86 (2005) ; Q .
Cheng, P . Frischmann & T. Warfield, The Market Perception o f Corporate Claims, Res . Acctg.
Reg. 1 6, 3-28 (2003) where ' . . . financial theory suggests that a primary characteristic of debt
is that creditors have the option to force a delinquent debtor into bankruptcy. '
37. Research demonstrated that investors tend to treat hybrid securities like preferred stock
differently according to the financial health of the firm and therefore, as equity if the company
is in financial distress and as debt if the company is going well, see T. Linsmeier, C.
Shakespeare & T. Sougiannis, Liability/Equity Classification Decisions and Shareholder Valua­
tion, 1 et seq. (U . Ill . , Working paper, 2008) ; P . Kimmel & T. Warfield, The Usefulness of Hybrid
Security Classifications: Evidence from Redeemable Preferred Stock, The Acctg. Rev. 70, 1 5 1 - 1 6 7
( 1 995) ; A. Patel, D . Emery & Y. Lee, Firm Performance and Security Type in Seasoned Offerings:
An Empirical Examination of Alternative Signalling Models, J . Fin. Res . 1 6, 1 8 1 - 1 92 ( 1 993) ; C.
Lewis, R. Rogalski & J . Seward, Is Convertible Debt a Substitute for Straight Debt or Common
Equity, Fin. Mgt. 28, 5-27 ( 1 999) . These studies showed that the classification of a convertible
preferred stock was influenced by the company' s economic performance and economic
intuition. Thus, it was seen as equity for companies in financial distress and as debt for
companies performing well .
38. ASC 480- 1 0-25-6.

58
Chapter 2 : Distinguishing between Equity and Debt §2 . 03 [A]

be a continuous need for reassessment as instruments that are conditionally redeem­

able if the event occurs, the condition is resolved, or the event becomes certain to
occur. 39 If a conditionally redeemable instrument becomes mandatorily redeemable,
the instrument is adjusted to fair value, reclassified as a liability, with equity reduced,
recognizing no gain or loss on the reclassification. 40
There are several exceptions to ASC 480- 1 0-2 5 . For instance, if the redemption is
required to occur only upon the liquidation or termination of the reported entity or
death or termination of the holder, the instrument is classified as equity because its life
do not have a specified limit that either cannot be required to be redeemed or can be
required to be redeemed only if the entity decides or is forced to liquidate its assets and
settle claims against the entity or if the holder dies . 41 Similarly, redeemable instruments
that are convertible into ordinary shares of the issuer are generally not considered to be
mandatorily redeemable during the conversion period since redemption is conditional
upon the holder not electing to convert. For this purpose, non-substantive or minimal
features - such as a very high conversion price in relation to the current share price -
are disregarded. 4 2
The second type of obligations is represented by the obligations to repurchase the
issuer' s equity shares by transferring assets . When the instrument under consideration
is a freestanding financial instrument such as a warrant, which means is not inter­
twined with preferred or other shares, this financial instrument is accounted for as a
liability - whether it embodies a conditional or unconditional obligation to repurchase
the issuer' s equity shares and whether it requires or not the issuer to settle the
obligation by transferring assets . 43 Under existing US GAAP, no specified-for-specified
criterion is associated with the assessment of whether contracts over an entity' s own
equity should be accounted for in equity. Therefore, a derivative to issue a mandatorily
or puttable equity instrument would be classified as a liability. 44
The third type of obligations , which is classified as a liability, is the financial
instrument that embodies an unconditional obligation or other warrant or right that
embodies a conditional obligation, that the issuer must or may settle by issuing a
variable number of its own shares, if - at the inception - the monetary value of the
obligation is based solely or predominantly on:

• ' A fixed monetary amount known at inception;

• Variation in something other than the fair value of the issuer ' s equity shares ;
• Variation inversely related to changes in the fair value of the issuer' s equity
shares . ' 45
The ratio behind these criteria is that to be considered - and therefore classified - as
equity an obligation should expose its holder to the essentially same risks and benefits

39. ASC 480- 1 0-25-5 and 7 .

40 . ASC 480- 1 0-30-2 .
41 . ASC 480- 1 0-25-4.
42 . ASC 480- 1 0-55- 1 2 .
43 . ASC 480- 1 0-25-8.
44. See ASC 480- 1 0-55-3 3 .
45 . ASC 480- 1 0-25- 1 4 .

59
§2 . 03 [A] Lorenzo Sasso

of a shareholder. That means that any risks or benefits of changes in the obligation
must stem directly from changes in the fair value of the issuer' s equity shares . For
instance, if a warrant or preferred stock requires settlement by issuance of shares for a
certain amount on the settlement date, the number of shares to be issued varies based
on the fair value of those shares at settlement. Conversely, if the preferred stock is
convertible into shares at the holder' s option it does not fall within the scope of ASC
480 . If an equity-linked instrument does not fall within the scope of ASC 480,
consideration would next generally be given to ASC 8 1 5 'Derivatives and Hedging' to
determine if the instrument or any embedded features should be accounted for as a
derivative at fair value with changes in fair value recognized through income. 4 6
Finally, the Securities and Exchange Commission (SEC) has issued a special
section for its registrants (public companies) that is ASC 480- 1 0-S9 9 . Of course, its
application is recommended also for non-public entity' s instruments that meet the
same criteria. ASC 480- 1 0-S99 provides guidance on when temporary versus perma­
nent classification is appropriate. The section is also relevant for determining the
classification of amounts associated with convertible debt that are otherwise classified
as equity, if any. According to ASC 480- 1 O-S99, ownership instruments - such as
common shares or preferred stock - which are redeemable at a fixed or determinable
price on a fixed or determinable date; at the option of the holder; or upon the
occurrence of an event which is not solely within the control of the issuer (i. e. , puttable
shares) , are classified as temporary equity or mezzanine equity and otherwise as
permanent equity.
Regarding the measurement of financial instruments, the accounting rules
generally distinguish between compound financial instruments and hybrid instru­
ments . A compound financial instrument consists of multiple components of which at
least one is a liability and another is equity, while hybrid instruments present
inseparable equity and debt components . IAS 32 deals with compound instruments by
the ' decomposition method' . It requires the component parts to be accounted for and
presented separately as financial liabilities, financial assets or equity instruments in
accordance with the substance of the contractual arrangements. The split between the
liability and equity components of a compound financial instrument is made at
issuance and is not subsequently revised, even when exercise of the conversion option
becomes more likely. 47 The company must, on initial recognition, measure the fair
value of the compound instrument as a whole, measure the fair value of the liability
component and assign a value to the equity component by deducting from the fair
value of the whole instrument the amount separately determined for the liability
component. 4 8 On conversion of a convertible, the company derecognizes the liability
component and recognizes it as equity. The original equity component remains as

46 . ASC 8 1 5- 1 0- 1 5-83 .
47. IAS 32 para. 28.
48 . Thereafter, the fair value of the compound instrument as a whole is its nominal value. The
liability component is recognized at fair value calculated by discounting at a market rate for a
non-convertible debt the cash flows receivable (interests received during the years) plus the
repayment of the bond at the end .

60
Chapter 2 : Distinguishing between Equity and Debt §2 . 03 [A]

equity, although it may be transferred from one line item within equity to another.
There is no gain or loss arising on conversion at maturity. 49
Compound financial instruments separation is required in all cases in the balance
sheet of a company, while for hybrid financial instruments, it is only required where
certain conditions are met. In fact, a hybrid financial instrument has characteristics of
a liability and equity but does not have distinct components that are straight debt or
common equity. Preference shares provide a perfect example of hybrid financial
instrument following the distinction between financial liabilities and equity made by
IAS 32 . When a hybrid security is mixed with a detachable feature as in the case of a
redeemable preference share convertible at a fixed price, the instrument has to be
accounted for as a liability (preference share) and as equity for its equity put option
element . Where separation is required, an embedded derivative is accounted for at fair
value, unless it is functioning as a hedge. s o
Under existing US GAAP, some convertible debt instruments are classified as
liabilities in their entirety and others are bifurcated into liability and equity components
(in particular, convertible debt with a beneficial conversion feature and convertible
debt that the issuer may elect to settle in cash upon conversion. 5 1 Similarly to IASB,
existing US GAAP ASC 480- 1 0 does not include the concept of economic compulsion in
distinguishing between liabilities and equity. However, the IASB' s and FASB' s boards
have decided that debt instruments that are convertible, at the holder' s option, into a
specified number of instruments that will be classified as equity in their entirety upon
issuance should be separated into a liability component and an equity component.
Other debt instruments that are convertible into a variable number of shares should be
classified as liabilities in their entirety. 5 2
Even if globally accepted, the approach of breaking compound financing instru­
ments into components that are classified separately at issuance has generated
disagreement among the scholars of accounting and law. 53 The worries come from the
lack of reliability of some compound instrument valuations , especially when a
financing instrument includes two or more interacting options . For inseparable com­
pound financing instruments, both the probability that the instruments will pay-off in
a given form and its other valuation parameters change over time, causing the relative

49 . See IASB - IFRS Handbook, IAS 32, AG3 2 .

50. The same requirement applies according to the American financial accounting standards .
Compare with M. Barth , W. Landsman & R . Rendleman , Option Pricing-Based Bond Value
Estimates and a Fundamental Components Approach to Account for Corporate Debt, The Acctg.
Rev. 73 , 73- 1 02 (January 1 998) ; M. Barth, W. Landsman & R. Rendleman, Implementation of
an Option Pricing, Based Bond Valuation Model for Corporate Debt and Its Components, Acctg.
Horizons 455-479 (December 2000) .
51. Depending on whether the criteria in ASC 4 1 5-40- 1 5 are met.
52 . See ASC 470-20 - ASC 8 1 5 and IAS 32 - IAS 39 for the US and EU accounting standards
respectively .
53 . C. Lewis, R. Rogalski & J. Seward, Is Convertible Debt a Substitute for Straight Debt or Common
Equity, Fin. Mgt . 28, 5-2 7 ( 1 999) .

61
§2 . 03 [A] Lorenzo Sasso

values of components to change, often in a negatively correlated fashion. 54 Further­

more, although the maj ority of this instrument' s value is usually classified as a liability
under both systems, empirical studies have underscored the fact that both firms and
investors view convertible debt primarily as equity in certain circumstances (see Table
2 . 2) . 5 5

Table 2.2

Instrument Current US Accounting Current IASB Accounting

Standards Standards
Perpetual preferred share Equity Equity
Mandatorily redeemable preferred Liability (depending on Equity (depending on
shares whether the criteria in whether the
ASC 480- 1 0-25 are met) . fixed-for-fixed test is
met)
Redeemable preferred shares on Equity Equity
the occurrence of an event
(contingent redemption) ; Puttable
stock
Redeemable convertible preferred Equity Equity
shares
Ownership instrument that is Liability Liability (fair value of
redeemable at the option of the put option)
holder (puttable shares) , other
than upon retirement or death
Equity (mezzanine equity for
public companies)
Options, rights issues, and Liability or Equity Equity
warrants settled by delivering a (depending on whether
specified number (fixed number the criteria in ASC
under IAS 3 2 ) of shares for 8 1 5-40- 1 5 (formerly EITF
a specified price (fixed price Issues 07-58 and 00- 1 99)
under IAS 32) are met)

Perpetual preferred share Equity Equity

convertible into a specified
number (fixed number under IAS
32) of ordinary shares

54. S.G. Ryan et al. , Evaluation of the FASB 's Proposed Accounting for Financial Instruments with
Characteristics of Liabilities, Equity, or Both: AAA Financial Accounting Standards Committee,
Acctg. Horizons 1 5 , 1 (200 1 ) .
55. A. Patel, D . Emery & Y. Lee, Firm Performance and Security Type i n Seasoned Offerings: A n
Empirical Examination of Alternative Signalling Models, J. Fin . Res. 1 6, 1 8 1 - 1 92 ( 1 993) .

62
Chapter 2 : Distinguishing between Equity and Debt § 2 . 03 [B]

Instrument Current US Accounting Current IASB Accounting

Standards Standards
Debt convertible into a Specified Typically liability Liability and
number (fixed number under IAS Equity
32) of shares
Debt that is convertible, but not Typically liability Liability
into a specified number (fixed (depending on whether
number under IAS 32) of shares the criteria in ASC
8 1 5-40- 1 5 are met)

[B] Classifying Hybrid Financial Instruments for Tax Purposes

Significant legal distinction between equity and debt arises also in tax law. A common
thread, though, between the bodies of law run in the linkage between the obligations
of the firms and the rights of the investor. From a tax point of view, the debt-equity
classification assumes a particular importance for two reasons. First, the issuer can
treat interest paid on debt as tax deductible in most cases, 5 6 and second, for the
investor, the classification determines whether the payments received from the
respective instrument is treated as a dividend or as interest. 5 7 The distinction between
interest and dividend in taxation is based on the distinction between debt and equity or
on the distinction between a debtor-creditor relationship and a shareholder-company
relationship . 5 8
Concentrating on the economic substance of an instrument rather than its legal
form is in line with the principle of tax neutrality. In order for a tax system to be neutral,
economically equivalent instruments must be taxed the same way. Therefore, the more
equity characteristics are included in a debt instrument, the more reason there is to tax
the debt as equity. The vice versa applies . The problem, however, is to determine what
level of equivalency is required between two instruments before they must be taxed
similarly. The classification of hybrid instruments for tax purposes is a source of
important opportunities and risks in the area of international tax management,
especially in international groups, where these securities can be used efficiently as
flexible, tailor-made forms of finance . In certain cases, the characterization of a hybrid

56. The only exceptions being: the interests paid as hidden profit distribution, the reclassification
as equity of the security on which the interests are paid on and the non-deductibility of the
interests paid in contrast with some anti-tax avoidance regulations .
57. E. Eberhartinger & M. Six, National Tax Policy, the Directives and Hybrid Finance, Discussion
paper no . 1 6, 1 22 (2005) ; M. Helminen, Classification of Cross-Border Payments on Hybrid
Instruments, International Bulletin of Fiscal Documentation 5 6 (2004) ; J.A. Duncan, General
Report: Tax Treatment of Hybrid Financial Instruments in Cross-Border Transactions, IFA
Cahiers de droit fiscal international 85a (2000) : 24-34; J . Wittendorff & E. Banner-Voigt,
Taxation of Hybrid Instruments, IBFD Derivatives and Financial Instruments 3 (Kluwer 2000) .
58. P.J. Connors & G . H .J . Woll, Hybrid Instruments, Current Issues PLI/TAX 553 , 1 83 (2002) . See
also K. Pratt, The Debt-Equity Distinction in a Second-Best World, Vand. L. Rev . 5 3 , 1 05 5 and
1 056- 1 05 7 (2000) .

63
§2 . 03 [B] Lorenzo Sasso

instrument as debt under one regime while treated as equity in another can lead to
double non-taxation of the profits, since the payment would then be deductible as
interest in the source state and might be exempt as a dividend in the state of residence
of the parent company. The opposite case, where the hybrid instrument is treated as
equity in the source state and as debt in the state of residence of the parent company,
might lead to double taxation, when the payment is subj ect to withholding tax in the
source state and to income tax in the state of residence of the parent company. 59
According to Article 1 0 of the OECD Model Tax Convention on Income and on
Capital, only income from corporate rights that is subj ect to the same taxation
treatment as income in the source state constitutes dividends. 60 The relevant criterion
for qualification as a corporate right in terms of Article 1 0 of the OECD Tax Convention
is twofold: one, participation in the current profits of the issuer, and two, potential
benefits from a future increase in the value of the company' s assets as remuneration for
sharing the risk run by the enterprise. However, the wording of Article 1 0 does not
explicitly list any criteria in detail. The wide scope of possible characteristics of hybrid
instruments as, for instance, conversion rights, fixed repayment by a definite date,
fixed minimum interest rates consequently makes it difficult to decide, whether the two
criteria mentioned above are fulfilled. Whether or not the combined extent of profit
participation and participation in the liquidation proceeds impart enough participation
in the entrepreneurial risk to allow for qualification of the financial instrument as a
corporate right, must therefore be evaluated in each individual case in light of all the
characteristics of the financial instrument in question. In addition, many international
tax treaties differ from the OECD Model in that the third part of the dividend definition
referring to the source state classification does not use the term 'corporate rights' at all.
Thus, a hybrid financial instrument, which is not profit participating or which does not
share the same risk of common shares, may qualify as a dividend-generating invest­
ment under these treaties if the source state treats the income from it as a dividend . 61
EC law does not affect the domestic tax law treatment of interest as dividends or
dividends as interests as long as the domestic law treatment does not constitute a
forbidden discrimination or restriction under the EC Treaty. The benefits of the

59. M. Six, Hybrid Finance and Double Taxation Treaties, Bull. Intl. Taxn . 63 , 22 (2009) .
60. Article 1 0 (3) OECD Model Tax Convention on Income and on Capital defines the term
dividends as follows : ' [ ] 1 ) income from shares, "jouissance " shares or "jouissance " rights ,
. . .

mining shares, founders' shares ; or 2) other rights not being debt-claims, participating in
profits; 3) as well as income from other corporate rights, which is subjected to the same
taxation treatment as income from shares by the laws of the State of which the company
making the distribution is a resident' .
61 . E. Eberhartinger & M.A. Six, Taxation of Cross-Border Hybrid Finance - A Legal Analysis,
Intertax 8 (2009) ; M. Helminen, The Dividend Concept in International Tax Law 83 and 2 7 1
(Kluwer 1 999) ; M. Helminen, Classification of Cross-Border Payments o n Hybrid Instruments,
International Bulletin of Fiscal Documentation 58 (2004) ; K. Vogel, Klaus Vogel on Double
Taxation Conventions 5 73-574 (Kluwer 1 99 1 ) ; F.M. Giuliani, Article 1 0(3) of the OECD Model
and Borderline Cases of Corporate Distributions, International Bulletin of Fiscal Documentation
1 1 - 1 4 (2002) ; M. Lang, Off-Track Interpretation of Double Taxation Treaties as Exemplified by
the Taxation of Lecturers, Steuer und Wirtschaft International 5 1 1 (1 998) .

64
Chapter 2 : Distinguishing between Equity and Debt § 2 . 03 [B]

Parent-Subsidiary Directive 62 in eliminating any withholding tax on transfers under

certain conditions - apply to distributions of profits by a subsidiary to a parent
company by virtue of an association between the companies . The term ' profit
distribution' is somewhat broader than the term 'dividend' and should cover any
payment by the subsidiary to the parent company based on the shareholder-company
relationship or the association between the companies . There is no reason why the
term ' association' cannot cover constructive equity capital . Income from a hybrid debt
that, in its true nature, is equity should qualify as a profit distribution under the
Parent-Subsidiary Directive. Interpretative aid with respect to the term ' distribution of
profits ' in the Parent-Subsidiary Directive may also be derived from the Directive on
the taxation of intra-group interest and royalty payments that explicitly excludes the
profit distributions and certain payments from debt-claims assimilated to dividends. 6 3
From a tax perspective, the issuer of a hybrid security wants a tax deduction for
the associated dividends or coupon payments . Therefore in assessing hybrid financial
instruments for tax purposes, three sets of rules should be considered : the corporate
debt rules, the rules on distribution of profit and the arbitrage rules . In the UK, the tax
rules relating to corporate debt (loan relationships) include an anti-avoidance rule that
prevents a tax deduction for interest to the extent that, broadly, the company is party
to a loan relationship for an 'unallowable purpose' . 64 An unallowable purpose is a
purpose that is not among the business or other commercial purposes of the company.
Securing a tax advantage, such as a deduction for interest paid, is not a business or
other commercial purpose if it is the main purpose or one of the main purposes for
which the company is party to the loan relationship . A purpose test could be used by
the tax administration to deny the issuer a tax deduction if its main purpose in issuing
a hybrid was to secure a tax deduction by paying interest on debt rather than dividends
on equity. The purpose test could also be used to deny the issuer part of a tax deduction
if its main purpose in issuing a hybrid was to secure a tax deduction for the higher
interest payments on hybrid debt as compared to conventional debt. 6 5 These principles
apply to both financial institutions and companies outside the regulatory capital
sector. 66

62 . See Arts 1 and 4 of the Council Directive 90/43 5 1 EEC of 23 Jul. 1 990 on the common system of
taxation applicable in the case of parent companies and subsidiaries of different Member
States .
63 . See Art. 4 ( 1 ) the Council Directive 5926/03 1 EC of 3 Mar. 2003 active for all the Member States
starting from 1 Jan . 2004 . The list includes: ' ( . . . ) (b) payments from debt-claims which entitle
the creditor to that carry the right to participate in the debtor' s profits, (c) payments from debt
claims which entitle the creditor to convert the right to interest to the right to participate in the
debtor' s profits and (d) payments from debt-claims with no provision for the repayment of the
principal amount or where the repayment is due more than SO years after the date of issue . '
64 . See ss 44 1 -443 of the Corporation Tax Act 2009 (before para. 1 3 , Schedule 9 , Finance Act
1 996) .
65 . See SS 442-443 of the CTA 2009 .
66. However, as a practical matter, financial institutions will often be able to show that they have
a clear non-tax purpose for issuing hybrid debt, namely the need to satisfy regulatory capital
requirements . Unlike a financial institution, an ordinary corporate issuer will not be able to
point to regulatory capital requirements to establish that they have a non-tax purpose for
issuing hybrid debt .

65
§2 . 03 [B] Lorenzo Sasso

Distributions of dividends as well as a number of corporate transactions other

than the p ayment of a dividend that can be treated as distributions for tax purposes are
not tax deductible . This includes certain types of interest, such as : interest that is
dependent 'to any extent' on the results of the borrowing company's business and is
paid to a lender that is not a UK company; 6 7 interest paid on 'equity notes ' issued by the
borrowing company and held by certain kinds of associated company as, for instance,
perpetual or very long dated debts . 6 8 The distribution rules are widely drafted and the
UK tax administration takes a wide approach to their interpretation. Unless care is
taken as to how certain equity-like features of hybrids, such as ' optional' interest, are
achieved in the UK, interest on them could be classified as a distribution, and therefore
rendered non-deductible, under the distribution rules . 6 9
One of the main advantages of hybrid financial instruments is the regulatory and
tax arbitrage, that is, the ability to evolve their characteristics in order to exploit the
differences of the various legal systems and tax regimes existing among states . The thin
covering sufficient to fill instruments with an equity-like character under the current
regulatory regime appears unlikely to suffice in a changed reporting environment.
Some commentators have argued that the dynamic nature of regulatory arbitrage
seems to be a consequence of the inappropriate approach of the regulators drafting the
rules, whereby a highly technical and detail-based bent would encourage the creativity
of many hybrid securities' issuers . 70 The resulting diversity in tax treatment unsurpris­
ingly provides numerous opportunities for tax arbitrage . 71 Thus, international tax
arbitrage results from the intrinsic inconsistencies in the tax rules of the different
countries and their exploitation by the sophisticated taxpayers . 72

67. This, in practice, includes non-cumulative interest.

68 . See s . 209 in Income Corporation Taxes Act 1 988.
69 . However, it is possible to achieve similar practical commercial effects in relation to UK hybrids
without giving rise to interest that is classed as a distribution in the UK. For example, by using
an offshore partnership structure providing for deferred interest to cumulate but be paid only
on redemption, or providing that interest will be paid from the proceeds of a specific issue of
shares or satisfied by all issue of shares.
70. T.M. Carlin, G . Ford & N . Finch, Magic Pudding or Regulatory Arbitrageur's Friend ? The Use of
Hybrid Debt Equity Securities by Australian Listed Corporations, J . Applied Res . Acctg. & Fin. 1 ,
70 et seq. (2006) ; M . Williams, Sun Sets on Re-Set Shares, CFO Magazine, 7 1 -75 (October 2005) .
71 . For a discussion in the UK, see M. Penney, United Kingdom, in Tax Treatment of Hybrid
Financial Instruments in Cross-Border Transactions vol. 85a, 645 (J .A. Duncan ed. , Kluwer L.
Intl . Cahiers de droit fiscal international 2000) . In USA, their use increased significantly when
the Treasury released the check-the-box regulations (Treas . Reg. §§ 3 0 1 . 770 1 -3 in 2004) , which
allowed a taxpayer to choose to be treated as a corporation or as a transparent entity for tax
purposes . Some commentators point out that check-the-box regulations, promulgated to
improve the compliance of entity classification, reach too far by including foreign entities in
their regulatory reach, thus creating additional opportunities for tax arbitrage. See K. Mat­
thews, IRS Official Discusses Check-the-Box Proposal for Foreign Entities, Tax Notes Intl. 1 2 ,
54 1 -542 ( 1 996) ; K. Matthews, NYSBA Tax Section Strongly Endorses Check-the-Box Entity
Classification Proposal, Tax Notes Intl. 1 1 , 7 1 8-7 1 9 ( 1 995) ; E. Fleischer, 'If it Looks Like a
Duck ': Corporate Resemblance and Check-the-Box Elective Tax Classification, Colum. L. Rev . 96,
5 1 8, 54 1 -542, 547-549 and 553 -554 ( 1 996) ; E. Fleischer & G.K. Yin, The Taxation of Private
Business Enterprises: Some Policy Questions Stimulated by the 'Check-the- Box ' Regulations,
Southern Methodist University (SMU) L. Rev. 5 1 , 1 2 5 and 1 29- 1 33 (1 997) .
72 . A. Krahmal, International Hybrid Instruments: Jurisdiction Dependent Characterization, Hous­
ton Bus . & Tax L. J. 1 1 7 (2005) .

66
Chapter 2 : Distinguishing between Equity and Debt § 2 . 03 [B]

The opportunities for tax arbitrage generate not only from the diversity among
the tax jurisdictions, but also when the tax and economic distinctions do not match, or
when the tax law provides a distinction but the economics of the transaction do not
warrant one, thus allowing the taxpayer to elect the tax result without varying his
underlying economic position. 73 The difficulty and the resulting legal complexity that
arise in characterizing the hybrid instruments for tax purposes is a direct consequence
of trying to strike a delicate balance. On one hand lies the need to encourage the use
and development of innovative financial instruments to ensure access to capital at a
competitive rate and to attract inbound investments . On the other lies the competing
and often incompatible need to protect the tax base from the abusive transactions,
advance policy goals of encouraging savings and investment and discouraging a pure
tax optimization activity, while simultaneously 'preserve an equitable sharing of the
tax base between countries . ' 74
Tax courts dealing with tax arbitrage and characterization of capital contribution
have not established any bright line guidance but they have endeavoured to charac­
terize instruments according to their substance rather than their form. 75 Accordingly,
an obj ective test of economic reality is generally used to determine the nature of the
contribution. 7 6 In UK, complex new rules intended to combat tax avoidance through
arbitrage were introduced in the Finance (No 2) Act 2005 (FA 2005) . 77 Unusually for
UK tax legislation, the arbitrage rules apply to a company in relation to a particular
transaction only if the tax administration issues a notice to the company to that effect .
Among other things , the arbitrage rules can operate to deny some or all of a tax
deduction in relation to certain schemes using hybrid instruments that have obtained
a tax advantage as their main purpose. The arbitrage rules may apply where a hybrid
instrument is used to create either a double tax deduction for the same expense or a tax
deduction for a payment that is not taxed in the hands of the recipient . In this context,
the term 'hybrid instrument' that is used by tax practitioners and by the tax authorities
in its guidance has a technical meaning based on the legislation and refers to specific
types of instruments used in arbitrage schemes 'with hybrid effect' . 78 It does not
include all hybrid securities in the wider commercial sense. Importantly, however, it
does include debt instruments that are treated as equity for accounting purposes .
The arbitrage rules affect some UK hybrid issues . For example, the rules
potentially apply where a hybrid is treated as equity in another tax jurisdiction so that

73 . C.T. Plambeck & D . M . Crowe, Overview of the Taxation of Financial Instruments, Tax Notes
Intl. 95, 1 2 5 ( 1 995) ; J . E . Stiglitz, The General Theory of Tax Avoidance, Natl. Tax J . , XXXVIII,
325-33 7 ( 1 985) .
74 . C.T. Plambeck & D . M . Crowe, Overview of the Taxation of Financial Instruments, Tax Notes
Intl. 95, 1 25 ( 1 995) ; J. Neighbour, Innovative Financial Instruments Challenge the Global Tax
System, Tax Notes Intl. 14, 93 1 (1 997) .
75 . M . P . Haskins , Can the IRS Maintain the Debt-Equity Distinction in the Face of Structured Notes
Recent Developments, Harv. J. on Legis . 3 2 , 525 ( 1 995) .
76. G.C. Poindexter, Dequity - The Blurring of Debt and Equity in Securitized Real Estate Financing,
Berkeley Bus. L. J . 2 , 254 (2005) .
77. See ss 24-3 1 and Schedule 3 to the Finance (No 2) Act 2005 with minor amendments recently
passed in the Finance Act 20 1 3 (FA 20 1 3) .
78 . See part 3 of Schedule 3 to FA (N02) 2005 .

67
§2 . 03 [C] Lorenzo Sasso

payments on it are treated as non-taxable dividends rather than taxable interest in the
hands of a recipient resident there. However, the arbitrage rules can only apply if the
issuer has a main purpose of obtaining a tax advantage. The purpose test that operates
in this context is similar to the purpose test that operates in relation to the loan
relationship and gives rise to similar issues . The key distinction is that, while sections
44 1 -443 of the Corporate Tax Act 2009 looks only at the issuer' s purpose in being party
to the loan relationship, the arbitrage rules look to the purpose of the entire arrange­
ments . Therefore, the mere fact that a hybrid instrument has some equity-like features
or is even accounted for as equity as well as the existence of a UK tax deduction is not
fatal if an issuer has good commercial reasons apart from tax, for raising hybrid capital.
A tax advantage main purpose implies that in the absence of the issue of hybrid
instruments, tax deductions arising from those securities would not have arisen at all,
or would have been of a lesser amount. 7 9
There are therefore two key tax challenges the would-be corporate hybrid issuer
has to overcome - the complexity and purpose tests . Regarding the first former,
ordinary corporate issuers, like financial institutions, will need to consider the impact
of the distribution rules on the terms and structure of their hybrids . For the latter,
however, ordinary corporate issuers unlike financial institutions are not subj ect to
regulatory requirements that give them a clear, non-tax reason for issuing hybrids, so
they need some other good commercial reasons . UK tax administration has issued and
has recently been updating some guidance available on tax avoidance involving tax
arbitrage. In particular, they provided a list of examples of schemes that are considered
not allowed by the tax administration because of their illicit purpose. 80

[C J Re-characterization of Financial Claims in Liquidation

Similar measures of re-characterization are introduced in some European insolvency

regulations 8 1 or used by some courts of US law to deal with the (hybrid) financial
instrument known as ' shareholder loan' . 8 2 In liquidation, the list of priorities is
practically based on the grade of subordination of the different claims in the corporate
financial structure. The split would logically result in all capital in one class being
subordinated to all capital in the other class . Insolvency courts are adept at dealing with

79. http ://www .hmrc.gov. uk/international/ arbitage.htm

80. http ://www . hmrc.gov.uk/internationaljarbitrage-examples .pdf
81 . UK, France or the Netherlands do not provide for specific rules and regulations on loans
granted by shareholders to their companies in distress, while their treatment varies signifi­
cantly among countries using such a concept as for example Germany, Austria, Italy, Spain.
82 . In the United States the courts developed the doctrine of equitable subordination, primarily
directed at loans by a parent company to a greatly undercapitalised subsidiary. The doctrine is
now incorporated by reference in s. 5 1 0 (c) of the federal Bankruptcy Code ( 1 1 U . S . C . ) of 1 994.
However, it does not appear to have been applied so far in common law jurisdictions outside
the United States . See Bank of Marin v. England, 385 U . S . 99, 1 03 ( 1 966) (stating that 'there is
an overriding consideration that equitable principles govern the exercise of bankruptcy
jurisdiction ') ; A. DeNatale & P . B . Abram, The Doctrine of Equitable Subordination as Applied
to Non-management Creditors, Bus. Law. 4 0 42 1 ( 1 985) (discussing origins of doctrine of
,

equitable subordination) .

68
Chapter 2 : Distinguishing between Equity and Debt §2 . 03 [C]

classifications of either debt or equity . Where it becomes difficult is classifying a claim

that has attributes of both debt and equity, for example, subordinated debt that is
nonetheless nominally secured. Alternatively, some securities may appear as straight
debt but need to be considered as hybrids due to the modalities and circumstances
under which they have been issued . For example, ' shareholder loans' demonstrate a
hybrid nature because while the contract is a normal debt loan, the investor lending
money is a member of the company thus a shareholder. 8 3 This peculiarity leaves room
for elusive and opportunistic behaviour. If the shareholder-manager, for example,
knowing the company is traversing a period of insolvency, decides to invest through
secured debt while the company' s circumstances were such that he should have
inj ected equity and then, when the company goes into a winding up procedure, decides
to repay the shareholder loan, a court can order for a mandatory subordination of
shareholder loans . B4 The same result would be if the company distributed dividends or
profits to its members in various ways, while being in financial distress, even if those
sums were due. Bs The problem is that a shareholder' s ambiguous loan may create an
obligation that other creditors do not even know exists . Thus, a potential investor who
assesses the company' s overall debt situation may not see any reference to the
shareholder' s purported loan . The misleading picture of the company' s finances could
cause, among other things, the supplier to provide credit it otherwise would have
withheld. B6
It is important to point out that the re-characterization of debt as equity is in this
case quite different from the tax law jurisprudence. B 7 Even if taxation and insolvency
law share the same struggle in classifying hybrid instruments, their classification points
at different purposes . The tax cases are most worried about low priority obligations that
function like a class of stock but are treated like debt in order to give a shareholder the
tax benefits of debt. For this reason, the convertibility feature is worrisome from a tax
perspective, since debt that can be converted into voting stock enables the company to
treat the interest payments on the debt as a (deductible) business expense, while giving
the security holder the option of converting to stock for the purposes of voting
control . BB However, convertibility has not been at issue in the re-characterization cases

83 . J .A. Brighton, Capital Contribution or a Loan? A Practical Guide to A nalyzing Re­

characterization Claims (or, When Is Equitable Subordination the Appropriate Analysis ?) , Am.
Bankr. Inst. J. 2 1 , 42 (2002) .
84. See M . Gelter & J . Roth, Subordination of Shareholder Loans from a Legal and Economic
Perspective, J . Institutional Comparisons 5 , 40-47 (2007) ; D . Skeel & G. Krause-Vilmar,
Re-characterization and the Non-hindrance of Creditors, European Bus. Org. L. Rev . 7, 268-269
(2006) .
85 . P . Wood , Set-off and Netting, Derivatives, Clearing Systems para. 2-033 (2d ed. , (London, Sweet
& Maxwell 2007) .
86. See R. Clark, The Duties of Corporate Debtor to Its Creditors, Harv . L. Rev. 90, 505 ( 1 977) .
87. The classic analysis of Internal Revenue Service doctrine on whether a security should be
treated as debt or equity for tax purposes is found in W.T. Plumb , The Federal Income Tax
Significance of Corporate Debt: A Critical Analysis and a Proposal, Tax L. Rev . 26 3 69 ( 1 9 7 1 ) .
For an overview of tax re-characterization doctrine, see D . Skeel, Markets, Courts and the Brave
New World of Bankruptcy Theory, Wisconsin L. Rev . 465 and 5 0 1 (1 993) .
88. D . Skeel & G. Krause-Vilmar, Re-characterization and the Non-hindrance of Creditors, EBOR 7,
259-285 (2006) .

69
§2 . 04 Lorenzo Sasso

in liquidation, since the existence of a right to convert would tell very little about
whether the initial characterization as debt should be honoured. In the insolvency
context, it is essential to understand how the contributions to the company are
structured, whether as a traditional secured loan or subordinated . Thus, from this
perspective, secured shareholder loans are quite worrisome for creditors and where the
status of a loan is ambiguous, courts would do well to focus directly on the real
problem with this ambiguity. 8 9
English law appears not to have evolved any doctrine of equitable subordina­
tion . 9 0 This may be because the rules on 'wrongful trading' imbue the court with all the
necessary powers to subordinate claims of creditor-directors found guilty of fraudulent
behaviour. 9 1 When a UK company runs into insolvency, its directors are expected to
accede to insolvency proceedings rather than continue business as usual in the hope of
digging out of the company' s hole. Directors who violate this expectation may be liable
of wrongful trading. 9 2 The wrongful trading rule reflects an assumption that directors
who carry on with ordinary trading after the company begins to haemorrhage cash are
hindering their shareholders and creditors . 93

§2 .04 CLASSIFICATION OF FINANCIAL INSTRUMENTS IN DIFFERENT

REGULATORY AREAS

Most concepts of accounting for hybrid financial instruments, for instance, in tax and
accounting law, share a preliminary principle for keeping the binary structure on the
balance sheet. The rationale for keeping a simple structure lies in the regulatory need

89. In general, three conditions have to be satisfied in order for the court to apply the doctrine of
equitable subordination: an inequitable conduct of the subordinated creditor, which resulted in
injury to other creditors or conferred him an unfair advantage and equitable subordination
must not be inconsistent with the provisions of the Bankruptcy Act . See Pepper v. Litton, 308
U . S . 295 , 307-08 (1 939) ; Taylor v. Standard Gas & Elec. Co. , 306 U . S . 307, 323 ( 1 939) ; Benjamin
v. Diamond in Re Mobil Steel Co. 563 F.2d 692 (5th Cir. 1 977) ; Unsecured Creditors ' Comms. of
Pac. Express, Inc. v. Pioneer Commercial Funding Corp. (In re Pacific Express, Inc . ) , 69 B . R . 1 1 2 ,
1 1 5 (B .A. P . 9th Cir. 1 986) ; Diasonics, Inc. v. Ingalls, 1 2 1 B . R . 626, 632 (Bankr. N . D . Fla 1 990) .
90. However, there is the subordination of creditors who have lent money at a rate of interest
varying with profits see s. 3 of the English Partnership Act 1 890, which does not apply only to
partnerships and is paralleled elsewhere (e.g. , Canada) ; and the subordination of sums due to
company members in the nature of dividends or profits .
91 . Insolvency Act 1 986, s . 2 1 5 (4) .
92 . The wrongful trading rule is described by J . Armour, B. Cheffins & D .A. Skeel, Corporate
Ownership Structure and the Evolution of Bankruptcy Law: Lessons from the UK, Vanderbilt L.
Rev. 55, 1 699 and 1 746- 1 747 (2002) ; R . Goode, Principles of Corporate Insolvency 1 99 et eq. (3d
ed. , Sweet & Maxwell 2005) .
93 . Different is the approach of US corporate law. For an analysis, see A.M. Dickerson, A
Behavioral Approach to Analyzing Corporate Failures, Wake Forest L. Rev . 3 8, 1 0 1 (2003 ) .
Germany has recently passed a reform on mandatory subordination of shareholder loans
converging towards the English system. Under the new rules , payments on shareholder loans
outside insolvency proceedings of the company are generally permitted but the managing
directors of the company may become obliged to reimburse the company for any payments
made to a shareholder, if said payments necessarily led to the illiquidity of the company unless
such an outcome was not conceivable for managing director exercising due care, see A. Cahn,
Equitable Subordination of Shareholder Loans ? European Bus . Org. L. Rev. 7, 292 et seq. (2006) .

70
Chapter 2 : Distinguishing between Equity and Debt §2 . 04

to provide investors with clear and easily accessible balance sheets . Therefore,
accounting and tax law attempts to fit hybrid financial instruments into the two
traditional baskets - equity and debt. While this leads to a binary classification of the
entire instrument as either debt or equity in tax law, an intermediate approach is taken
in accounting. Here, using the traditional baskets, an instrument can be classified as a
combination of these two ends of financing spectrum . It can easily be seen, however,
that debt and equity still remain the reference points in accounting, and hence are
treated as the building blocks (or ingredients) of any financial position.
Capital adequacy regulation in banking (and likewise in insurance regulation) as
well as assessment of financial instruments by credit rating agencies (CRAs) on the
other hand, partly abandons the traditional binary model . Banking regulation acknowl­
edges multiple categories or different ' qualities ' of capital, which are represented by
the various tiers and sub-tiers of capital . 94 Unlike in accounting regulation, not all of
these baskets can simply be regarded as a mix of a plain vanilla debt position with
common share-like equity. Mainly because of the particular risks associated with the
inherently fragile financial sector and the resulting regulatory goals, factors that do not
fit in well with the traditional divide - such as remaining time until maturity, pay-out
restrictions, redemption (i .e. , pre-payment) restrictions, etc. - are increasingly taken
into account in bank capital regulation. This effectively goes some way towards
acknowledging a multi-dimensional approach to the classification of hybrid financial
instruments . Going even further, the approach of CRAs in assessing hybrids almost
completely abandons the traditional divide . The aim of CRAs is to rate the quality of a
claim from the creditor' s (or beneficiary' s) perspective. This aim necessarily implies a
more commercial - or functional - approach to this exercise.
It is worth noting that all of these approaches are interconnected. For instance,
the approach taken by CRAs has an important impact on banking regulation. While a
banking-specific regulatory framework applies to the right-hand side of a bank' s
balance sheet, the regulatory use of CRA-assessments 95 in relation to a bank' s assets
import their approach to hybrid classification into the banking regulation sphere. To a
certain extent, such links also exist between accounting and tax law.
None of the aforementioned approaches is able to consistently deliver the
'correct' results, even within the narrow boundaries of the respective discipline or
regulatory aim. Hence, they often create incentives for regulatory arbitrage. In fact,

94 . The Capital Requirements Directives of the European Community (CRD) EC Directive 2006/
48/EC and 2006/49/EC, OJ L1 77/20 1 30/6/2006; amended by the Capital Requirement
Directive of the European Community (CRD II) EC Directive 2009/ 1 1 1 /EC and subsequently
amended by the Capital Requirement Directive of the European Community (CRD III) EC
Directive 201 0/76/EU. In the overhaul of banking capital regulation, the previous regime has
been simplified according to the last proposals leading to the approval of Basel III Accords. In
particular, upper and lower Tiers two capital will be removed and replaced by a single set of
criteria that resemble those currently applicable to lower Tier two capital only and Tier three
will be eliminated as announced in BCBS, 'Strengthening the resilience of the banking sector'
(Consultative Document, December 2009) . See also the proposals of the CEBS, 'Guidelines on
Hybrid Capital Instruments' (December 2009) and the FSA, Strengthening Capital standards 3
(CP 9 Dec. 2009) .
95 . See R. Weber, The Regulatory Use of Credit Ratings in Bank Capital Requirement Regulations,
J. Banking Reg. 1 0 , 1 (2008) .

71
§2 . 04 Lorenzo Sasso

hybrids show a capacity to evolve and change their characteristics during their life in
order to exploit the differences of different tax systems or simply the inconsistencies in
the same regulation. For this reason, they are widely used as tools for intra-group
financing, driven by both tax and accounting regulation. Research has shown that with
a simple equity-debt split the reporting companies are almost encouraged to take
advantage of this somewhat limited view by structuring their instruments' terms and
conditions in order to achieve a desired accounting classification. 9 6
Moreover, issuers can raise funds without fully having reflected their true
financial positions in headline financial metrics such as the debt-to-equity ratio . Hence,
the heavy reliance by institutional investors and analysts on key financial figures in
itself creates scope and incentives for arbitrage, which is independent of the regulatory
system. Just as firms sometimes buy back shares in order to ' adj ust' (i . e . , manipulate)
financial figures such as earnings per share (EPS) , which then incidentally result in
increased incentive pay, 9 7 managers can also use hybrid forms of financing to
' optimise' their firm' s capital structure - or at least its perception in the market. 9 8
How can the problems created by inconsistent and imperfect classification of
hybrids be addressed? It has been argued that a more faithful representation of a
company' s financial position would require adding a third category - 'mezzanine
capital' - to the traditional dichotomy of equity and debt. 99 However, a threefold
capital structure would not only require a costly revision of the entire accounting and
tax system. It is submitted that it would also be an inadequate response to the problems
identified in this chapter. If the main finding is multi-dimensionality, it is unclear how
introducing a new 'in-between' category would do more than complicating things even
more. In fact, the proposed ' mezzanine' category seems very similar in result to the
already practised accounting rules applicable to certain hybrid instruments, whereby
the capital raised is bifurcated (i. e . , accounted for partially as equity and partially as
debt) . 1 00

96. E. Engel, M. Erickson & E. Maydew, Debt-Equity Hybrid Securities, J. Acctg. Res . 3 7 , 262 et seq.
(Autumn 1 999) . The evidence found demonstrated how important is for managers the
classification of some financial instruments and that firms often are able to pay a 'premium' to
achieve certain classification status .
9 7 . For an empirical study of this effect in the context of accelerated share repurchases see e.g. ,
C.A. Marquardt , C . E . Tan & S . M . Young, Accelerated Share Repurchases, Bonus Compensation,
and CEO Horizons (2009) . Available at http ://ssrn.com/abstract 1 346624 (accessed 1 8 Jan.
=

20 1 1 ) .
98. Empirical evidence on this is provided by P . Hribar, N . Jenkins & W . Johnson, Stock
Repurchases as an Earnings Management Device, J . Acctg. & Econ. 41 , 3 (2006) . Hribar et al.
find that share buy-backs are significantly more likely to be implemented where they lead to the
issuer meeting analysts' EPS forecasts, which otherwise they would have fallen short of.
99. P. Hopkins , The Effect of Financial Statement Classification of Hybrid Financial Instruments on
Financial A nalysts ' Stock Price Judgments, J. Acctg. Res . 34, 45-46 ( 1 996) where the author
shows how analysts examined more carefully the attributes of hybrid securities as the
mandatorily redeemable preference shares when they were classified in the mezzanine instead
of either debt or equity. This idea was already proposed long time ago, see W .A. Paton,
Accounting Theory: With Special Reference to the Corporate Enterprise passim (New York,
Ronald Press 1 922) .
1 00 . See IAS 3 2 .

72
Chapter 2 : Distinguishing between Equity and Debt §2 . 05

The analysis also shows that the different aims of classifying hybrid instruments
in accounting, tax and corporate law render it impossible to find a single consistent
approach for this exercise. This divergence cannot, in the opinion of this author, be
bridged by introducing a third classification category. Nor will it be possible - or indeed
desirable - to create a common methodology for assessing hybrid financial positions
across different disciplines . 1 01

§2 .05 HYBRID FINANCIAL INSTRUMENTS' IMPLICATIONS FOR

CORPORATE LAW

For a long time, international regulatory bodies and courts have struggled with the
classification of hybrid instruments . Over time, hybrid financial instruments and
capital structures have grown to such complexity that their consistent classification
across different regulatory spheres has become virtually impossible . The analysis in
this Part highlights some of the most important regulatory issues raised by hybrid
financial instruments and points to the influence the law has on the way companies
raise their financing. We have considered several regulatory areas, all of which take
different approaches to classifying hybrids .
One area that has received significantly less attention in the literature than the
classical regulatory issues is corporate law . While deeply interwoven with accounting
and insolvency law, corporate law also uses the distinction between debt and equity as
a reference point when assigning roles within the organizational governance structure.
While economic models typically regard shareholders ' governance rights as a natural
counterweight to their 'residual claimant' -nature and their lack of fixed entitlements to
the firm' s assets , 1 0 2 company law typically takes a very formalistic approach towards
assigning such control rights . As we have explored in other areas, hybrids can often
closely resemble or even perfectly replicate an equity holder' s financial position
without using traditional, pre-packaged bundles of rights (i. e . , ordinary or preference
shares) . Moreover, legal capital rules used in Europe likewise use a formal approach
towards classifying financial instruments, thereby also leaving room for regulatory
arbitrage .
Thus, hybrids can, to some extent, call into question basic propositions like
' equity holders will only receive distributions out of profits (or in the course of a capital
reduction) ' or ' debt-holders will not be allowed to vote in the shareholder' s meeting' .
If, for instance, an issuer is able to create an equity-like financial position, which, from
a corporate law perspective, does not make the holder of the instrument a shareholder,
redemptions of such instruments are not formally restricted by the rules on share
buy-backs . Moreover, fundamental shareholder rights like pre-emptive rights and

1 0 1 . Creating a third category of capital or abolishing any categorization between equity and debt
would necessitate addressing questions that reach beyond a stand-alone revision of the current
standards . Compare the report of S . G . Ryan et al. , Evaluation of the FASB 's Proposed
Accounting for Financial Instruments with Characteristics of Liabilities, Equity, or Both: AAA
Financial Accounting Standards Committee, Acctg. Horizons 1 5 , 38 7-400 (200 1 ) .
1 02 . See e.g. , 0 . Williamson, The Mechanisms of Governance 1 85 (Oxford U. Press 1 996) .

73
§2 . 05 Lorenzo Sasso

more generally control rights in connection with share issues could potentially be
diluted to the extent that shareholder-like positions disguised as debt instruments can
be issued by managers without approval of shareholders. Likewise, shares can also be
structured in a way that closely resembles debt instruments, conferring control rights
on parties with no (real) residual claim .
Of course, the ability of a company to assign control rights to some, but not all
equity holders, is recognized by UK company law, 10 3 and only little restrictions apply
to such structures . But even in the UK, certain shareholder rights mandatorily (also)
apply to holders of non-voting preference shares . 104 By using hybrid financial instru­
ments, parts of the mandatory corporate law can effectively be side-stepped, leading to
a more flexible framework within which a company can reach a bargain with its
investors than envisaged by the legislator.
A company can, for instance, issue a profit participating loan, which gives the
creditor the right to share in the (pre-P&L) profits of the company, achieving a result
economically similar to an issue of redeemable shares . 1 05 The redemption (repayment)
of such a loan, however, would not be subj ect to strict capital maintenance rules .
Moreover, as mentioned above, control of 'real' (legal) shareholders is at least diluted
with respect to the decision to issue such instruments .
From this reasoning it follows that in order to achieve meaningful results the
assessment of hybrid financial instruments must have regard to economic realities . In
other words, an inflexible classification approach will never be able to deal with all
forms of hybrids and adequately address the issues they may raise.
Accordingly, the debt-equity examination needs to take a further analytical step
and adopt a superior taxonomy that refers directly to the various financial and
governance features embodied in any given hybrid instrument . Therefore, the analysis
in the next part will consider the function of hybrids and the legal strategies available
for their investors to address the opportunism that can accompany fundamental
changes in the life of a firm. The list is illustrative rather than exhaustive and is written
with the understanding that some suggestions may be more practical than others and
some more controversial than others .

1 03 . Many other countries, however, take a more restrictive approach on the issuance of non-voting
shares . Restrictions as to the proportion of a company' s capital issued in the form of non-voting
preference shares exist, inter alia, in Austria, Belgium, France, Germany, Greece, Italy, Japan,
Luxembourg and Spain; see Shearman & Sterling LLP , Proportionality between Ownership and
Control in EU Listed Companies, 2007, 1 3 , available at http ://ec. europa. eu/internal_market/
company/docs/shareholders/study/study_report_en.pdf (accessed 1 0 Jan. 201 1 ) . Restrictions
generally range from 2 5 % to 50 % ; ibid.
1 04 . See e.g. , s. 633 CA 2006 .
1 0 5 . Certain company regulations imply a consequent accounting classification that may render the
related accounting rule inapplicable in that particular case. For example, in the loss absorption
approach, redeemable shares at a certain expected event are considered liability, although in
Europe the Second Directive of capital maintenance expressly allows the redemption of the
shares only out of distributable dividends.

74
CHAPTER 3

Setting the Theoretical Framework

This chapter, which concludes Part I, aims to define the theoretical framework in
which I operate and that will be useful for the following analysis in this book. It is
centred around the economic analysis of corporate law and finance. The task of it is to
found the basis of a new methodology for assessing hybrid financial instruments and
the implications for the corporate governance. For this purpose, the chapter will
re-examine some main corporate governance theories . In particular, transaction costs,
agency costs and property rights literature is discussed at the aim of developing a
functional approach. The stream of literature, which followed the M&M Theorem, has
focused on the nature of capital, examining financial contracts such as debt and equity
as two alternatives for the investors to respond to particular market frictions, in
conditions of uncertainty and asymmetric information. Therefore, the company is not
seen as a 'black box' but as ' simply one form of legal fiction which serves as a nexus
for contracting relationships and which is also characterised by the existence of
divisible residual claims on the assets and cash flows of the organisation' . 1 The study
on the nature of the firm, which started with Ronald Coase' s seminal work, 2 has been
essential in understanding the dynamics of power relations among corporate constitu­
ents . 3

1. M. Jensen & W. Meckling, Agency Problems and Residual Claims, J . L. & Econ. 26, 327 ( 1 983) .
2. R . Coase, The Nature of the Firm, Economica 4 ( 1 93 7 [reprinted 1 988] , 3 3 and 43-47) : 2 0 ff.
3. See G . G . Triantis, Financial Contract Design i n the World of Venture Capital, U . Chi. L . Rev. 68 ,
305-322 (200 1 ) ; J. Armour & M.J. Whincop, The Proprietary Foundations of Corporate Law,
Oxford J . Leg. Stud. 2 7, 440-457 (2007) ; R. Kraakman et al. , The Anatomy of Corporate Law: A
Comparative and Functional Approach passim (2d ed. , Oxford U. Press, 2009) ; S . Worthington,
Shares and Shareholders: Property, Power and Entitlements (Part 1 and 2) , Co . Law . 22, 264 et
seq. (200 1 ) ; P . L. Davies, Introduction to Company Law passim (Oxford U. Press 2002) ; M.M.
Blair, A Contractarian Defence of Corporate Philanthropy, Stetson L. Rev. 28 26 ( 1 998) ; J.R.
Macey, Fiduciary Duties as Residual Claims: Obligations to Nonshareholder Constituencies from
a Theory of the Firm Perspective, Cornell L. Rev. 84, 1 2 69- 1 2 73 (1 999) ; F. Denozza, Norme
efficienti. L' analisi economica delle regole giuridiche (Milano : Giuffre, 2002) , passim;

75
§3 . 0 1 Lorenzo Sasso

Often in the past, hybrid instruments have been analysed in relation to one or
some of their characteristics but never in context. Since the economic theories have
evolved with the development of the corporation, the analysis of the corporate
structure and in particular of the financial instruments must also be adjusted. The
originality of the methodology lies under the fact that the legal strategies concerning
hybrid forms of securities will be analysed against the background of these theories .

§3 .01 TRANSACTION COSTS AND COMPANY LAW

Much of finance literature has analysed the firm ' s choice of capital structure as
separate from the firm' s real decisions, for example, what to produce and how to
organize production. However, for a complete analysis, capital structure should be
subsumed under a more general theory of the firm. Property rights literature and
agency traditions share a view of institutional design as determined by a desire to
economize on agency costs . While agency literature has been the main alternative
approach in the capital structure literature, this literature does not explicitly consider
the allocation of control rights, which is at the base of the property rights theory.
Therefore, the two theories have to be considered complementarily. 4
The first incisive work on the study of the firm was Ronald Coase' s article on the
nature of the firm, dated 1 93 7, whose implications were long overlooked . 5 This study
broke with the traditional perfect competition model, adopted in the neoclassical
economics theory where transaction costs were considered nil, to develop a new
justification for the firm to exist. The managers of firms did intentionally what a market
did spontaneously, i . e . , to allocate resources to different uses . The economic reason for
why the firm exists as a viable alternative to the price mechanism, of course, is because
the price mechanism does not function flawlessly and costlessly. The process of
internalization of the business in the firm is explained as a means of economizing on
the transaction costs of using markets . However, internalization is costly, because as
firms increase in size, the managers become less efficient . Thus, in a world of positive
transaction costs, governance structures matter for efficiency outcomes . 6
The scope of Coase' s paper was limited by its study of the classical firm, namely
a company in which the shareholders and the managers were always coinciding. The
difference between the classical firm and the modern corporation were studied by
Adolf Berle and Gardiner Means in their famous work. 7 The authors indicated that

4. W . W . Bratton, Corporate Debt Relationships: Legal Theory i n a Time of Restructuring, Duke L .

J. 1 , 1 478- 1 50 1 ( 1 989) .
5. R . Coase, The Nature of the Firm, Economica 4 , 22 ( 1 93 7 reprinted in 1 988) .
6. The Coase' s analysis of transaction costs shares strong parallels with his later study on property
rights and externalities see R. Coase, The Problem of Social Cost, J . L. & Econ. 3 , 42 ( 1 960) .
7. A. Berle & G . Means, The Modem Corporation and Private Property 244 & 3 1 2 (New York,
Macmillan 1 933) . For a recent survey on the ownership structure of the modern corporations
see R. La Porta et al . , Investor Protection and Corporate Valuation, 5 1 1 -5 1 3 (NBER Working
Paper 7403 , Natl. Bureau Econ. Res . 1 999) . See also, R. La Porta et al. , Legal Determinants of
External Finance, J. Fin . 52, 1 1 3 1 - 1 1 50 (1 997) and R. La Porta et al . , Law and Finance, J .
Political Econ . 1 06, 1 1 1 3- 1 1 5 5 ( 1 998) ; F. Barca & M. Becht, The Control o f Corporate Europe
266-2 8 1 (Oxford 200 1 ) .

76
Chapter 3 : Setting the Theoretical Framework §3 . 02

shareholdings in many American public corporations were so diffuse that shareholders

were unable to control those who managed the firm. They argued that this separation
of ownership and control caused a divergence between the maximizing behaviour
expected of the classical firm and that these public corporations were controlled de
facto by managers . The problems associated with the separation of ownership and
control provided an enduring basis for corporate regulation. 8

§3 .02 THE COMPANY AS A 'NEXUS OF CONTRACTS' AND THE

THEORY OF AGENCY COSTS

In 1 976, Jensen and Meckling defined the firm in terms not dissimilar to Coase' s
' system of relationships ' as ' a nexus of contracts' . 9 The ' nexus of contracts' definition
disregards, as far as corporations are concerned, the distinction between a corporate
contract, which is of an ' originating' nature and that which is merely ' operational' . 1 0
The first type, which is of special interest to lawyers, may not arise for consideration in
a micro economic analysis of production theory. This explains why a ' nexus of
contracts ' definition will apply in economic analysis whether we are concerned with
the classical capitalist firm or the modern firm. 1 1
The rich literature in this field emphasized that the corporation was simply a
nexus for contracting between investors, factor suppliers and those responsible for
managing the firm. 1 2 Every single contractual relationship in the corporation generates

8. See E. Fama, Agency Problems and the Theory of the Firm, J . Political Econ. 88, 290-292 ( 1 980)
where the author considers that a corporation does not have owners in any meaningful sense
and the two functions of management and risk bearing have to be treated as naturally separate
factors within the set of contracts called the firm. A possible solution is to make the
management the ultimate beneficiary of the firm' s success (or a 'residual claimant') see this in
B. Cheffins, Company Law: Theory, Structure and Operation 3 5 (Oxford, Clarendon Press
1 99 7) ; for the management incentives see P . L. Davies, Introduction to Company Law 1 98-2 1 4
(Oxford U . Press 2002) .
9. M. Jensen & W. Meckling, Theory o f the Firm: Managerial Behavior, Agency Costs and
Ownership Structure, J. Fin . Econ. 3 , 305 ( 1 9 76) ; E. Fama & M.C. Jensen, Separation between
Ownership and Control, J . L. & Econ. 26, 3 0 1 ( 1 983) ; Fama E. & M . C . Jensen, Agency Problems
and Residual Claims, J . L. & Econ. 26, 3 27 ( 1 983) .
10. Businesses are incorporated for specific purposes and those who invest i n corporations have
different expectations , rights and responsibilities depending on the legal nature of their
investments .
11. F.H. Easterbrook & D . R. Fischel, The Economic Structure of Corporate Law (Cambridge, MA,
Harv. U. Press 1 99 1 ) , 1 2 .
12. The literature o n the 'nexus o f contracts' theory and o n the classical theory o f property rights
is considerable. See O. E. Williamson, The Mechanisms of Governance (London, New York,
Oxford U. Press 1 999) ; O.E. Williamson, The Economic Institutions of Capitalism (New York,
Free Press 1 985) ; A. Alchian & H. Demsetz, Production, Information Costs and Economic
Organization, Am . Econ. Rev. LXII , 779 (1 972) ; H . Demsetz, Toward a Theory of Property
Rights, Am. Econ. Rev. LVII, 354 et seq. (May 1 967) ; E. Fama & M . C . Jensen, Agency Problems
and Residual Claims, J . L. & Econ. 26, 327 ( 1 983) ; H . N . Butler, The Contractual Theory of the
Corporation, Geo . Mason U . L. Rev . 1 1 , 99 ( 1 989) ; R. Wilson, On the Theory of Syndicates,
Econometrica 36, 1 1 9- 1 32 ( 1 968) ; M . Berhold, A Theory of Linear Profit Sharing Incentives, Q .
J. Econ. 85 , 460-482 ( 1 9 7 1 ) ; S.A. Ross, The Economic Theory of Agency: The Principals
Problems, Am. Econ. Rev. LXII 1 34- 1 3 9 ( 1 973) ; D . G . Heckermann, Motivating Managers to
Make Investment Decisions, J . Fin. Econ. 2 , 273-292 ( 1 975) .

77
§3 . 02 Lorenzo Sasso

an agency relationship . 1 3 The 'contract ' determines the rights and obligations of the
various stakeholders . However, economists, who first advanced this view, use 'con­
tract' in a much looser sense than lawyers to indicate all sort of voluntary arrangements
and their various forms of governance, whether by legislation, by judge-made rules
(e.g. , fiduciary duties) or by private agreement (e. g. , the articles) . 1 4 They eschew the
concept of corporate ownership in assessing shareholders ' rights and directors '
obligations in the corporate system. 1 5 Thus, they considered it anomalous to view the
shareholders as corporate owners and untenable to claim directors' obligations should
be driven mainly by the need to maximize profit for the shareholders . 1 6 Simply, they
perceived corporate constituents as factor providers, whose interests in the corporation
are defined and regulated by contractual negotiations with the corporation. 1 7
Thanks to the theory of agency costs, the Coasian claim that defines the firm in
terms of internalized contracts was united with the analysis of the separation of
ownership and control, which was the reason behind the asymmetric distribution of
information, and so becoming applicable to all kind of corporations . In particular, the
theory of agency costs shed light on the nature of the transaction costs affecting
particular contracts and how parties economized on these costs . Corporate governance
trades off three things . The first is the advantages to specialization in the performance
of management functions and the bearing of residual risky by shareholders. The second
is the complexity of management. The third is the transaction costs associated with
implementing optimal governance to address contracting problems . The attributes of a
firm, such as the diffuseness of its shareholder population, the separation of manage­
rial functions from oversight functions and the structure of the board of directors, are
treated by this literature as the equilibrium that the parties expect to optimize the
outcome of this trade-off. 1 8

13. M. Jensen & W. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and
Ownership Structure, J. Fin. Econ. 3 , 308 ( 1 976) : 'We define an agency relationship as a
contract under which one or more persons (the principal (s) ) engage another person (the agent)
to perform some service on their behalf which involves delegating some decision making
authority to the agent. If both parties to the relationship are utility maximizers there is good
reason to believe that the agent will not always act in the best interests of the principal. '
14. Many o f these different contractual provisions come i n a standard form, providing either
mandatory or default rules . Because the aim of the standard form is simply to reduce
transaction costs in private arrangements, it follows that mandatory rules should be kept to a
minimum, leaving the parties free to make their own bargains in accordance with prevailing
market forces, see F . H. Easterbrook & D . R . Fischel, The Economic Structure of Corporate Law
2 1 -22 (Cambridge, MA, Harvard U . Press 1 99 1 ) .
15. See E . Fama, Agency Problems and the Theory of the Firm, J . Political Econ. 88, 288 ( 1 980) .
1 6. R.E. Freeman & W.M. Evan, Corporate Governance: A Stakeholder Interpretation, J . Behav­
ioural Econ. 1 9 , 33 7-340 ( 1 990) .
1 7. See O . E. Williamson, Corporate Governance, Yale L. J . 93 , 1 1 97 ( 1 984) ; V. Brudney, Corporate
Governance, Agency Costs, and the Rhetoric of Contract, Colum. L. Rev. 85, 1 404 ( 1 985) .
1 8. See P .L. Davies, Introduction to Company Law 201 (Oxford U . Press 2002) ; B . Cheffins,
Company Law: Theory, Structure and Operation 249 (Oxford, Clarendon Press 1 997) ; M.M.
Blair, A Contractarian Defence of Corporate Philanthropy, Stetson L. Rev. 28, 26 ( 1 998) ; S .
Worthington, Shares and Shareholders: Property, Power and Entitlements (Part 1 and 2) , Co.
Law. 22, 264 et seq. (200 1 ) ; J . R . Macey, Fiduciary Duties as Residual Claims: Obligations to
Nonshareholder Constituencies from a Theory of the Firm Perspective, Cornell L. Rev. 84, 1 266
( 1 999) .

78
Chapter 3 : Setting the Theoretical Framework §3 . 02

The agency costs analysis identifies specific contracting problems in corporations

and in particular, how investors of equity and debt capital find it difficult to observe the
exercise of managerial discretion. As a result, the directors may put into practice
opportunistic behaviours such as transferring firm resources to their own, consuming
'perquisites ' , seeking higher than market salary or job security etc. For this reason,
they need to be controlled and all the monitoring and bonding costs of auditing, formal
control system, budget restriction and establishment of incentive compensation sys­
tems will be reflected in the company' s shares value. 1 9 However, the inefficiency is
reduced the larger is the fraction of the firm' s equity owned by the manager. 2 0 In public
corporations where the managers are in control, the conflicts are between the
managers and the shareholders as a whole and the agency costs are at their maximum,
while in small private firms the conflicts, which are largely reduced, are between the
maj ority and minority of the shareholders . 2 1
These agency costs of equity can be mitigated by the existence of debt . In fact, the
larger the part of the corporate finance financed by debt, the more control and pressure
on the management the debt-holders will exert and this will be useful for the
shareholders too . Since debt legally obliges the firm to pay-out cash in order to satisfy
the bondholders' contractual rights, the amount of ' free' cash available to managers to
spend on their benefits and perquisites is clearly reduced in the case of a leveraged
company. 22 Managers have a strong incentive to avoid a financial distress situation,
because, if the company is declared insolvent, they may lose all their benefits of control
and reputation. Moreover, debt allows the company to raise new funds without
diluting the shareholders ' residual claim and to attenuate the adverse selection
problem of outside equity by presenting a right to a fixed interest rather than a residual
claim whose pay-off are less sensitive to the distribution of information. 2 3
However, debt finance does not come without its own agency costs. In order to
maximize shareholders' benefit, managers may invest in a way that transfers wealth
from the bondholders to the shareholders . For example, managers may exploit the
limited liability of the company to invest in riskier proj ects with higher returns instead

19. See A . Barnea, R . Haugen & L . Senbet, Agency Problems and Financial Contracting passim
(Englewood Cliffs, NJ , Prentice Hall 1 985) ; J .A. Brander & M. Poitevin, Managerial Compen­
sation and the Agency Costs of Debt Finance, Managerial & Decision Econ. 1 3 , 5 5-64 ( 1 992) ;
S.A. Ross, The Determination of Financial Structure: The Incentive Signalling Approach, Bell J .
Econ. 8 , 23-40 ( 1 9 77) , the author evolved a n incentive-signalling model i n which the capital
structure can be considered as a mechanism that reduces the information asymmetries
between manager and shareholders, demonstrating the robustness of financial and accounting
signalling models . See also P .L . Davies, Introduction to company law 1 98 et seq. (Oxford U.
Press 2002) .
20. M . Jensen & W. Meckling, Theory of the Finn: Managerial Behavior, Agency Costs and
Ownership Structure, J . Fin. Econ. 3 , 343 (1 976) .
21 . M.J. Barclay & C.W. Smith Jr. , The Priority Structure of Corporate Liabilities, J . Fin. S O , 899
( 1 955) ; W.A. Klein & J . C . Coffee Jr, Business Organization and Finance: Legal and Economic
Principles 35 3 (6th edn, Foundation Press 1 996) .
22 . M . Jensen, Agency Cost of Free Cash Flow, Corporate Finance, and Take-Overs, Am. Econ. Rev .
72 , 323-329 ( 1 986) .
23 . R.M. Townsend, Optimal Contracts and Competitive Markets with Costly State Verification, J.
Econ. Theory 2 1 , 265 ( 1 979) ; J.M. Lacker & J.A. Weinberg, Optimal Contracts under Costly
State Falsification, J . Political Econ. 97, 1 345- 1 3 63 (1 989) .

79
§3 . 02 Lorenzo Sasso

of choosing more valuable investments with lower variance. In so doing, equity

holders gain the most if an investment yields large returns well above the face value of
the debt . Otherwise, their risk is limited . This problem is also called 'asset substitution'
by economists . Similarly, when the firm' s cash flow from existing assets does not
provide a sufficient return for the shareholders, managers have an incentive to
discriminate and eventually turn down some profitable investment opportunities . In
fact, management will choose to make an investment only if its net present value
exceeds the face value of the debt, otherwise only creditors will benefit from this new
project. This problem is called 'underinvestment' or ' debt overhang' . 2 4 If the bond­
holders perceive the peril of being appropriated by an overinvestment in high-risk
projects or by an underinvestment in low-value proj ects, they may well adjust
downward the price they are willing to offer for the bonds or demand a higher interest
rate for the credit and thus pass back the agency costs to the firm. 2 5
There are other opportunistic behaviours that may generate agency costs .
Managers may be able to transfer wealth from debt-holders to shareholders with
excessive dividend payments. Increased dividends create a decrease in the market
value of the existing debt, when the pay-out is financed through a reduction in
investments . 2 6 Similarly, new borrowings of the same or higher priority to distribute a
dividend expropriate debt value. 27 In addition, managers may conceal problems or
situations of financial distress to prevent creditors from acting to enforce immediate
bankruptcy or reorganization, expanding the effective maturity of the debt and
increasing its risk. 2 8 In all these cases, important indirect costs occur even if bank­
ruptcy itself is ultimately avoided. 2 9 According to the theory of agency costs thus, the
equilibrium in the capital structure is given by the point of intersection between the
curves of the marginal agency costs and of the demand for outside financing. 3 0 In other

24 . S . C . Myers , Detenninants of Corporate Borrowing, J . Fin . Econ. 5 , passim ( 1 977) ; S . C . Myers ,

Capital Structure, J . Econ. Perspectives 1 5 , 97 (200 1 ) .
25. M . Jensen & W. Meckling, Theory of the Finn: Managerial Behavior, Agency Costs and
Ownership Structure, J . Fin. Econ. 3 , 3 3 5 -356 ( 1 976) .
26. F. Black, The Dividend Puzzle, J. Portfolio Mgt . 2 , 5-8 ( 1 976) ; A. Kalay, Stockholder-Bondholder
Conflict and Dividend Constraints, J. Fin . Econ. 1 0, 2 1 1 -233 (1 982) .
27. F. Black & M. Scholes, The Pridng of Options and Corporate Liabilities, J . Political Econ.
637-659 (May-June 1 973) .
28. For examples of temptation at work see P . Asquith & D . W . Wizard, Event Risk, Covenants and
Bondholder Risk in Leveraged Buyouts, J. Fin. Econ. 27, 1 95-2 1 4 ( 1 990) .
29. E. Fama & M.C. Jensen, Separation between Ownership and Control, J. L. & Econ. 26, 3 01
( 1 983) ; E. Fama & M . C . Jensen, Agency Problems and Residual Claims, J . L. & Econ. 26, 3 27
( 1 983) . For a modern approach t o the agency costs and the related legal strategies to reduce
them see also J. Armour, H. Hansmann & R. Kraakman, Agency Problems and Legal Strategies,
in The Anatomy of Corporate Law: A Comparative and Functional Approach 3 5 et seq. (R.
Kraakman et al . eds. , 2d ed. , Oxford, Oxford U. Press 2009) ; P.L. Davies, Introduction to
Company Law 1 1 1 -280 (Oxford U. Press 2002) .
30. M. Jensen & W. Meckling, Theory of the Firm: Managerial Behaviour, Agency Costs and
Ownership Structure, J. Fin . Econ. 3 , 3 5 7 ( 1 976) . This equilibrium is Pareto optimal, in other
words, given a certain level of outside financing there is no way to reduce the agency costs
without making someone worse off.

80
Chapter 3 : Setting the Theoretical Framework §3 . 03

words, an optimal capital structure can be obtained by trading off the agency costs of
debt against its benefits . 3 1

§3 .03 CONTRACT INCOMPLETENESS AND EX POST CONFLICTS

Ownership is important for economic efficiency in a real world where transaction costs
are positive. This comes as a straight consequence of the relaxation of the main agency
costs theory condition that transaction costs of contracting are nil because contracts are
complete . Contractual arrangements are viewed as devices to mitigate ex post conflicts
arising from managers ' opportunism. They revolve around three things : information
privileges, control and property rights . Thus, the parties are capable of choosing
optimal governance through contracting. 3 2 However, contracts suffer from positive
transaction costs. These costs have two specific effects : they may preclude trade or they
may cause contracts to be incomplete . Contracts are incomplete either because terms
are not specified or are not differentiated for certain possible states of the world. 33 The
contract incompleteness is due not only to the cost of bargaining, but also because
language is imprecise and opens itself to interpretation, foresight is limited and
asymmetries in information between parties may discourage more specific bargaining
or more specific drafting. 34 While the law can address some of these incompleteness
problems by providing standard terms that parties might be expected to agree to (e .g. ,
incorporation statutes of a low-cost company) , some rules are impossible to emulate
contractually since they apply to persons who are not parties to the corporate contracts
(e.g. , the prohibition on the creditors of shareholders enforcing their debts against the
assets of the company) . 35
Since corporations run their business in the presence of uncertainty, contracts
may also be incomplete in the lack of contractible elements due to difficulties in
contemplating in advance all possible future contingencies and measuring perfor­
mance under each contingency. In addition, the states of the world on which the parties

31. Given a positive cash flow, high leverage can, at its equilibrium point , compensate the agency
costs of debt and equity with its benefits. For this reason, industries in which the opportunities
for asset substitution are more limited will have higher debt levels (these include tobacco
corporations , steel, chemicals , brewing groups and television and radio broadcasting compa­
nies) . See M. Harris & A. Raviv, Capital Structure and the Informational Role of Debt, 1. Fin.
Econ. 20, 55-86 ( 1 990) : M. Harris & A. Raviv, The Theory of Capital Structure, 1 . Fin. 46, 3 02
and 320 ( 1 99 1 ) . See also R. Stultz, Managerial Discretion and Optimal Financing Policies, 1 . Fin.
Econ. 26, 3-2 7 ( 1 990) .
32. The term used by O . E . Williamson, Market and Hierarchies: Analysis and Antitrust Implica­
tions 70 (New York, The Free Press 1 9 75) , to denote ex post opportunism.
33 . 1 . Tirole, Incomplete Contracts: Where Do We Stand? Econometrica 67, 74 1 ( 1 999) ; O. E .
Williamson, The Economic Institutions of Capitalism 68-84 (Free Press 1 985) ; U . Pagano ,
Public Markets, Private Orderings and Corporate Governance, Intl. Rev. L. & Econ. 20, 453
(2000) ; G. Bellantuono, I contratti incompleti nel diritto e nell 'economia (Cedam, Padova 2000) ,
9 1 et seq.
34. A. Schwartz, Relational Contracts in the Courts: An Analysis of Incomplete Agreements and
Judicial Strategies, 1 . Leg. Stud. 2 1 , 2 7 1 -3 1 8 ( 1 992) .
35. H . Hansmann & R . Kraakman, The Essential Role of Organizational Law, Yale L.1. 1 1 0, 3 8 7 and
407-408 (2000) ; V. Ayres & R. Gertner, Filling Gaps in Incomplete Contracts: An Economic
Theory of Default Rules, Yale L. 1 . 99, 87, 1 2 0 (1 989) .

81
§3 . 04 Lorenzo Sasso

would like to condition their contractual pay-off often cannot be verified by a court . An
insufficiently state-contingent contract creates an incentive to re-negotiate or to
breach . 3 6 For example, 'a promise to pay a fixed interest will mean the promisor must
bear the risk that the production process fails, for whatever reason, to produce the
expected surplus' . 3 7 After all, the firm' s actions are not perfectly controlled . Further­
more, it is common in practice for a firm to comply fully with all of the restrictions
contained in its debt agreements while still being able to undertake many changes in
corporate policy that affect the debt-holder' s wealth. 3 8 Similarly, 'a contingent promise
will mean the promisee must be able to observe and verify to a court that failure to
make the promised payments does not fall within the contractual exclusions ' . 39
Therefore, the significance of property rights depends on other properties of the
contracts and on the transaction subj ect to contracting, such as the verifiability of
important variables and opportunities for renegotiation. By definition, ceteris paribus,
a more complete contract confers less residual property rights . The parties will adopt
an organizational structure that allows information about managers to flow to other
constituencies of the firm in order to control managerial opportunism. The parties will
allocate property rights in a way that allow managers to act in the interests of investors
and to permit persons with comparative advantages in monitoring to capture benefits
from acting to remedy problems they observe. 4 0

§3 .04 THE MODERN THEORY OF PROPERTY RIGHTS

The theory of the firm literature has been enriched by the development of the theory of
property rights . This study offers a more complex picture of the firm than the nexus of
contracts paradigm. 4 1 In contrast with the neoclassical assumption that common

36. 0 . Hart , ' One-Share One-Vote and the Market for Corporate Control' , J . Fin. Econ. , 20, 1 1 9- 1 39
(1 988) ; O . E. Williamson, The Economic Institutions of Capitalism 298 et seq. (Free Press 1 985) .
where he says contracts supported by idiosyncratic investments face difficult problems of ex
post-sequential adaptation.
37. J. Armour & M.J. Whincop, The Proprietary Foundation of Corporate Law, Oxford J . Leg. Stud.
27, 447 (2007) .
38. G . Garvey & P . Swan, The Economics of Corporate Governance: Beyond the Marshallian Firm, J.
Corp . Fin. 1, 141 ( 1 994) where the authors say 'so long as such explicit promises are fulfilled,
the bondholders bear any losses and enj oy any gains that may flow from changes in corporate
policy ' . See also U. Pagano, Public Markets, Private Orderings and Corporate Governance, Int .
Rev. L. & Econ . 20, 453 (2000) ; G. Bellantuono, I contratti incompleti nel diritto e nell 'economia
(Padova: Cedam, 2000) , 344 et seq.
39. J. Armour & M . J . Whincop, The Proprietary Foundation o f Corporate Law, Oxford J. Leg. Stud.
27, 447 (2007) . Compare to G . G . Triantis & A. Choi, Completing Contracts in the Shadow of
Costly Verification, J. Leg. Stud. 3 7 , 503 (2008) .
40. 0 . Hart, Corporate governance: Some Theory and Implications, The Econ. J. 1 05 , 95 et seq.
( 1 995) .
41 . 0 . Hart, Finns, Contracts and Financial Structures (Oxford U . Press 1 995) ; R. Rajan & L.
Zingales, Power in a Theory of the Finn, Q. J . Econ. 1 1 3 (2) , 3 87-432 ( 1 998) ; R. Raj an & L.
Zingales, The Tyranny of Inequality ', J. Pub . Econ. 76, 5 50-5 5 1 (2000) . A similar point is made
by I. Welch, Why Is Bank Debt Senior? A Theory of Priority Among Creditors, Rev . Fin. Stud. 1 0 ,
1 203- 1 23 6 ( 1 997) in relation t o the seniority structure o f debt, where observes that banks being
better at fighting in court , should hold senior debt, in order to minimise the resources wasted
in legal battles ; L. De Alessi, Property Rights, Transaction Costs, and X-Inefficiency, Am. Econ.

82
Chapter 3 : Setting the Theoretical Framework §3 . 04

shareholders have control over corporate decisions because they ' own ' the corpora­
tion, 4 2 the theory of property rights reconceptualises the corporation as merely a nexus
of contracts, asserting the company is not an entity to be owned but a legal fiction
separate from the individuals involved in it, with its own interests . This legal
personality of a company is the tool to realize a bundle of relationships or a network of
explicit as well as implicit bargains . This revived the question why one should vest
voting control in only one set of contracting parties. If shareholders retain rights of
control because they represent a residual interest in a corporation' s value, it has to be
said they are not the only risk-bearing group . Other groups also bear risk and this risk
cannot be dealt with adequately by ex ante contracting. The property rights theory
evolved to a pluralistic approach considering the investors in a firm not as shareholders
or bondholders, but as stakeholders and all residual claimants although to different
extents . The approach concedes the efficiency of linking governance and control rights
to risk bearing. 43
The theory of property rights studies the firm as combinations of contracts and
productive assets, emphasizing the significance of the allocation of property rights to
those assets for the governance of the enterprise. 44 The nature in which property rights
are defined and enforced, fundamentally impacts the performance of an economy: in
primis 'by assigning ownership to valuable resources and by designating who bears the
economic rewards and costs of resource-use decisions, property rights institutions
structure incentives for economic behaviour within the society ' ; and in secundis, 'by
allocating decision-making authority, the prevailing property rights arrangement de­
termines who the key actors are in the economic system' . 45
Property rights are defined as the rights to return streams and the rights to make
strategic decisions in contingencies not explicitly contracted upon. 46 Grossman and
Hart, in their seminal work, distinguish between specific rights, which are specified in
contracts and residual rights , which cannot be directly contracted upon. Property rights
refer to residual rights . They refer to a legal definition of ownership , equivalent to

Rev. 73 , 64-8 1 ( 1 983) ; M. Harris & A. Raviv, Corporate Control Contests and Capital Structure,
J . Fin. Econ. 20 ( 1 988) : 55-86; M . D . Whinston, Assessing the Property Rights and Transaction­
Cost Theories of Firm Scope, Am. Econ. Rev . 9 1 (200 1 ) : 1 84.
42 . G. Garvey & P . Swan, The Economics of Corporate Governance: Beyond the Marshallian Firm, J.
Corp . Fin. 1, 148 (1 994) . See also J . Kay & A. Silberston, Corporate Governance, Natl. Inst. Econ.
Rev. 88 (August 1 995) .
43 . See B . Cheffins, Company Law: Theory, Structure and Operation 3 1 (Oxford, Clarendon Press
1 99 7) ; W.A. Klein & J . C . Coffee Jr, Business Organization and Finance: Legal and Economic
Principles 1 9-20 and 68 (9th ed . , New York, Foundation Press 2004) ; M. Blair & L. Stout, A
Team Production Theory of Corporate Law, Virginia L. Rev. 8 5 , 247 (1 999) ; M. Blair, Ownership
and Control: Rethinking Corporate Governance for the Twenty-First Century 3 7 1 (Washington
D . C . , The Brookings Instn. 1 995) ; A. Pacces, Rethinking Corporate Governance: The Law and
Economics of Control Powers 1 03 , 1 1 6 et seq. (London, New York, Routledge 2 0 1 2) .
44 . See generally 0 . Hart, Firms, Contracts and Financial Structures 29 et seq. (Oxford U . Press
1 995) , See also R. Rajan & L. Zingales, Power in a Theory of the Firm, Q. J. Econ. 1 08 , 387
( 1 998) ; L. Zingales, Corporate Governance, in The Palgrave Dictionary of Economics and the
Law vol. 1 , 497 (P. Newman ed. , Macmillan 1 998) .
45 . G . D . Libecap, Contracting for Property Rights 1 0 (Cambridge U . Press 1 989) .
46 . S . Grossman & 0 . Hart, The Cost and Benefits of Ownership: A Theory of Vertical and Lateral
Integration, J . Political Econ. 94, 69 1 -7 1 9 ( 1 986) .

83
§3 . 04 Lorenzo Sasso

delegation of control, as all rights to use an asset ' not voluntarily given away or that the
government or some other party has taken by force' . 47 In other studies, these rights also
refer to residual returns , i . e . , the right to spend the firm' s money, which has not been
contracted for explicitly. 4 8 Residual rights of control are preferred to residual rights to
income, since the former are not divisible and thus a stronger concept as a definition of
ownership . Property rights also confer indirectly control over human assets by
controlling non-human assets . For example, an employer can influence a worker by
threatening to deprive him of the machine at which he works . 49
Therefore, control in the property rights theory plays a central role. It refers to
strategic decisions . By strategic decisions it means decisions with maj or implications
for the cash flows generated by a firm. The exact definition of a strategic decision, and
therefore of the scope of control, differs according to the adopted assumptions . Control
may refer to the decision of whether to liquidate, to continue or to sell the firm in small
companies and venture capital vehicles . The concept of control is expanded to include
important decisions such as reorganizations of companies and decisions to hire and fire
top management in larger companies with diluted shareholders . 5 0
Throughout most of the analysis on property rights, control is assumed to be
binary, i.e. , actors either have all control or no control. Shared control in a particular
state of nature implies unconstrained ex post bargaining between the parties in control.
Obviously, this binary definition of control is a simplification of reality. Control rights
are seldom unambiguously defined; court proceedings determining these rights would
then be unnecessary. Neither are these rights, as interpreted by public courts, absolute;
legal restrictions may, for example, prevent individual decisions from being imple­
mented without prior consultations with the parties affected or other stakeholders may
be entitled to a veto on certain strategic decisions . 5 1
Furthermore, the transfer of control from one party to another is often gradual,
for example, when creditors take over control from shareholders in bankruptcy,

47. This distinction is made by Grossman & 0 . Hart, The Cost and Benefits of Ownership: A Theory
of Vertical and Lateral Integration, J. Political Econ. 94, 69 1 - 7 1 9 ( 1 986) ; S . Wiggins, Posses­
sion, Property Rights and Contractual Enforcement, Texas A & M University, 1 988 where he
distinguishes between property rights and contractual rights .
48. B . Holmstrom & J . Tirole, The Theory of the Firm, in Handbook of Industrial Organization
6 1 - 1 34 (Richard Schmalensee & Robert Willig eds . , North Holland, Amsterdam, 1 989) ; Y.
Barzel, Economic Analysis of Property Rights 55-64 (2d ed . , Cambridge, Cambridge U . Press
1 99 7) ; A. Alchian & H. Demsetz, Production, Information Costs and Economic Organization,
Am . Econ. Rev. 62 , 777 ( 1 972) .
49 . In contrast with the agency theory and the traditional property rights school, the theory of the
firm advanced by the property rights approach does not treat the employer-employee as
symmetric; unlike the employee, the employer possesses property rights to the physical assets
and can determine how these are used. The employer can fire the worker, but the worker
usually cannot dismiss his employer See, L. Putterman, On Some Recent Explanations of Why
Capital Hires Labor, Econ. Inquiry 3 3 , 1 7 1 - 1 87 (April 1 984) ; 0 . Hart, Firms, Contracts and
Financial Structures 59 (Oxford U. Press 1 99 S) ; 0 . Hart, An Economic Perspective on the Theory
of the Firm, Colum. L. Rev . 89, 1 75 7- 1 774 ( 1 989) .
SO. Compare the distinction between decision control and decision management where the former
refers to the right to hire and fire and the latter to the right to make allocative decisions , in E.
Fama & M . C . Jensen, Separation between Ownership and Control, J. L. & Econ. 26, 3 0 1 ( 1 983) .
51 . G . G . Triantis & A. Choi, Completing Contracts in the Shadow of Costly Verification, J . Leg. Stud .
3 7 , 503 (2008) .

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Chapter 3 : S etting the Theoretical Framework § 3 . 04

creditors in many cases obtain influence prior to actual transfer and equity holders
often maintain influence over certain strategic decisions for some time. Despite these
external constraints and qualifications of control rights, the party in control can in most
cases be distinguished from other stakeholders . According to the property rights
theory, there is a need to allocate the right to decide or the rights of control in the events
not specified by the initial contract . This decision right affects the distribution of the ex
post surplus created by an enterprise and, therefore, the incentives to generate this
surplus . 5 2
For delegation of control to be a viable alternative to unconstrained bargaining or
other forms of intermediate contracts, there must be some safeguards against abuse of
authority by the controlling party. The legal definition referred to by Grossman and
Hart suggest that there are definite limits to the scope of control. Laws impose such
constraints, but the parties could also come to an agreement as to the scope. 53 In fact,
such an understanding of the limits of control, whether explicit or implicit, is necessary
for the non-controlling party to accept the delegation of control in the initial contract.
As demonstrated, such legal and moral constraints have been of maj or significance in
the evolution of contractual arrangements throughout the history of modern capital­
ism. 54 Some scholars argued that the limits of control could also be left to arbitration;
an arbiter may be preferable to specifying in great detail the ex post decision itself. 55 To
conclude control is not only hard to define unambiguously, it is also hard to observe
and measure in a precise manner. Financial instruments may differ from state to state
in how they are valued, and the control component cannot be easily isolated.
Furthermore, comparisons across countries are distorted by international differences in
accounting conventions and statistical procedures . 5 6
Some legal scholars have sought to make further progress in bringing together the
economic and legal conceptions of property in relation to corporate law . It has been
suggested that company law not only provides standard terms for the parties but also
allows assets partitioning in the firm that could not be achieved by private contract. 57

52. 0 . Hart & J . Moore, Property Rights and the Nature of the Firm, J . Political Econ. 98, 1 1 1 9- 1 1 58
( 1 990) . This is also confirmed by a recent corporate governance survey see A. Shleifer & R.
Vishny, A Survey of Corporate Governance, J. Fin. 52, 73 7-783 ( 1 997) .
53 . Corporate law resolves disputes ex post either by contingent adjudication or by proprietary
solution. An example of a proprietary resolution would be for the law to hold that it is
impossible for a majority shareholder to expropriate a minority shareholder. This confers the
property right on the minority shareholder. See M.J. Whincop, An Economic and Jurispruden­
tial Genealogy of Corporate Law 2 1 et seq. (Ashgate Publg. Co . 200 1 )
54. D . C . North, Structure and Change in Economic History passim (New York, WW Norton & Co
1 98 1 ) .
55. J. Tirole, The Theory of Industrial Organization passim (MIT Press 1 988) .
56. J. Kay & A. Silberston, Corporate Governance, Natl . Inst. Econ. Rev. 84-97 (August 1 995) ; J .
Armour, S . Deakin & S . Konzelmann, Shareholder Primacy and the Trajectory of UK Corporate
Governance, British J. Indus . Rel. 4 1 , 5 3 1 -5 5 5 (2003) ; J . Armour, The Proprietary Foundation
of Corporate Law, 25 et seq. (ESRC Ctr. Bus. Res. , U . Cambridge, Working paper no. 299, March
2005) .
57. H . Hansmann & R . Kraakman, The Essential Role of Organizational Law, Yale L.J. 1 1 0, 3 8 7 and
407-408 (2000) . See also P . G . Mahoney, Contract or Concession ? An Essay on the History of
Corporate Law, Ga. L. Rev. 34, 873 (2000) ; M. Blair, Locking in Capital: What Corporate Law
Achieved for Business Organizers in the Nineteenth Century, UCLA L. Rev. 5 1 , 387 (2003) ; P.

85
§3 . 05 Lorenzo Sasso

For other scholars, while proprietary rights better protect shareholders' claims than
contracts, because they work more effectively as governance mechanisms within the
firm, they generate costs for third parties . 5 8
According to the Coase' s theorem, parties will bargain around inefficient alloca­
tions of property rights if transaction costs do not exceed the gains from trade. A similar
argument applies to legal rules that serve a governance function. However, the parties
are better placed than the lawmakers to decide whether or not the involvement of the
law adds value, having regard to contractual or market substitutes . 59 Therefore, the law
should facilitate a freedom of bargaining and partitioning of entitlements between the
parties in the firm, while at the same time minimizing costs for third parties . 60

§3 .05 SUMMARY OF THE ANALYSIS

Economic theory has inspired two different perspectives to evaluate the relevance of a
corporate financial structure and in particular of hybrid financial instruments . The first
is from a company' s point of view and concerns the optimum leverage namely the
optimal debt-to-equity ratio for a given firm. The studies regarding this area deal with
the potential advantages of the market-value approach. Accordingly, any investment
project and its concomitant financing plan depends on the fact that this can raise the
market value of the firm' s shares and realizes a return higher than the marginal cost of
capital to the firm. From this perspective, interests of directors and shareholders are
perfectly aligned towards the maximization of the company' s share value .
The second perspective tackles the problem from the investor' s point of view and
regards the economic theories on corporate governance targeted to mitigate the
internal conflicts of interest in the firm. Agency costs theory considers all the
intersections of the economic activities of a number of parties and, in particular, the
economic agency relations existing among shareholders , directors and bondholders .
According to this analysis, the optimum amount of debt and equity in a firm is the
financial structure that reduces the costs arising from those relations to a minimum.
The property rights theory relaxes the assumptions of perfect contracts and absence of
litigation costs, which were at the core of the agency costs theory, and defines the
optimal capital structure as the mix of equity and debt that reduces to a minimum the

Ireland, Property and Contract in Contemporary Corporate Theory, Leg. Stud . 2 3 , 453 (2003 ) ; H.
Hansmann, R. Kraakman & R. Squire, Law and the Rise of the Finn, Harv . L. Rev . 1 1 9, 1 33 3
(2006) .
58. J. Armour & M.J . Whincop , The Proprietary Foundations o f Corporate Law, Oxford J . Leg. Stud.
27, 429-465 (2007) .
59. Rules can be contractible o r mandatory according the fact that they can b e altered o r not.
However, some scholars regard the moral hazard problems arising from contracting out certain
legal rules as insurmountable and maintain that markets cannot adequately 'price' these terms .
Compare L. Bebchuk, The Debate on Contractual Freedom in Corporate Law, Col um. L. Rev . 89,
1 395- 1 4 1 5 ( 1 989) ; V. Brudney, Corporate Governance, Agency Costs, and the Rhetoric of
Contract, Colum. L. Rev. 8 5 , 1 402 ( 1 985) ; J . C . Coffee Jr. , No Exit?: Opting Out, The Contractual
Theory of the Corporation, and the Special Case of Remedies, Brooklyn L. Rev. 5 3 , 9 1 9 ( 1 988) .
60 . J. Armour & M.J . Whincop , The Proprietary Foundations of Corporate Law, Oxford J . Leg. Stud.
27, 457 (2007) ; G . G . Triantis & A. Choi, Strategic Vagueness in Contract Design: The Case of
Corporate Acquisitions, Yale L.J. 1 1 9, 856 and 924 (20 1 0) .

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Chapter 3 : Setting the Theoretical Framework §3 . 05

hold-up problems and disputes generated by the contract incompleteness . These

studies concern two parallel aspects of equal importance when internal corporate
conflicts of interest are taken into considerations : the incentives ' setting up and the
proper allocation of control rights and residual rights .
O n the one side, the firm i s studied a s a 'nexus o f contractual relationships' ,
which are source of potential conflicts (agency costs) , because the interests of directors
and shareholders diverge. The financial structure plays a role in reducing these costs by
creating the right incentives for all the parties involved in the firm. On the other side,
the company is seen as a 'j oint ownership of common assets ' , which are j ointly owned
by shareholders and bondholders . The parties bargain for their rights and fix their
obj ectives ex ante but may disagree on the same ex post. This creates hold-up
problems . The internal corporate mechanism of insolvency optimizes which party
should retain the property, which is expressed as the right to control and decide over
the assets.
Part I is dedicated to the first approach that is typically a classification approach.
The law needs to apply a distinction between equity and debt. Tax, accounting as well
as regulatory treatment of debt and equity are indeed important drivers behind many
of the firms' decisions regarding their capital structure. However, economic theory
shows very little justification for distinguishing between equity and debt. This is
demonstrated by the ability of hybrid instruments to blur any artificial classification
dictated by law and create opportunities of regulatory arbitrage in accounting, tax and
insolvency law as well as in corporate law.
In order to take into consideration the governance implications of hybrid
securities, the book sets out a new theoretical framework that puts more emphasis on
the agency relations and the property law claims embedded in such ' unconventional'
financial instruments . The remaining chapters in Part II are entirely dedicated to this
functional approach.

87
Part II: Governance Regulation of Hybrid Financial
Instruments: The Functional Approach
CHAPTER 4

From the Classification to the Functional

Approach

The firm ' s capital structure through its financial instruments allocates the company' s
cash flow rights among the firm' s investors, specifying the times at which each investor
is paid their allocation. An investor' s claim may be fixed, or contingent on the value of
a specified asset or a flow variable, at the discretion of the issuer as in the case of
common stock dividends . An investor' s claim may also be represented by a combina­
tion of these features as in the case of hybrid securities . In the same way, the financial
contracts between the company and its investors assign the levers by which they may
influence the firm' s decisions . This is most obvious in the case of ordinary shareholders
who have the right to vote for the appointment or displacement of directors, and who
can enforce the directors ' fiduciary obligations to the corporation. However, not all
shareholders have control rights; some investors may have contracted them out in
return for a higher pay-out, as for instance in the case of preference shareholders .
Likewise, some powers of ' voice' , which may substantially constrain the firm' s
decisions, can be assigned to debt-holders through the use of ' covenants' or so-called
appraisal rights . Sometimes these covenants may be quite broad or restrictive enough,
depending on the situation, to require the assent of the security-holders to important
decisions in the firm, as if they were the controlling shareholders . Finally, some
financial contracts allow investors to convert their security into another security,
providing them with the right to switch their position/role within in the company.
This section provides an outline of the main features of corporate law and
corporate governance in particular. It aims to identify some key characteristics of
hybrids, which are useful for understanding these securities in context. Accordingly,
the book assesses how hybrids may constrain the board' s discretion to change the
fundamental allocation of financial and control powers among the firm' s participants,
and with what conflicts . This functional approach assessing the governance regulation
of hybrids can effectively provide an integrated insight into the corporate governance
studies . The investigation of the corporate governance implications for hybrids would

91
§4 . 0 1 Lorenzo Sasso

be impossible under the classification approach, which relies on legal distinctions

between equity and debt. The analysis has shown that hybrids blur this artificial
dichotomy, facilitating the so-called regulatory arbitrage . Conversely, from the point of
view of corporate governance, a functional analysis of these financial contracts is likely
to produce more meaningful findings .

§4.01 GOVERNANCE IMPLICATIONS OF ISSUING HYBRID

INSTRUMENTS

Two ratios should generally be observed in a corporation. The first is risk: return and
concerns corporate finance, while the second is risk: control concerning corporate
governance. This assertion comes from the analysis of a company' s allocation of cash
flow rights and control power among its investors . Both these rights are relative to risk.
Therefore, from a corporate finance perspective, a higher risk should involve a higher
return on the investment, while from a corporate governance point of view, voting
rights and control power should be allocated to the group of investors with the most
residual claims in the company, that is the group supporting the highest risk of loss and
therefore having the best incentives to promote firm value maximization. 1
When a business is conducted through a company limited by shares incorporated
under the CA 2006, its ordinary shareholders are generally considered to be suppliers
of long-term finance, which by its nature is also considered as risky capital . Because the
return on their investment is almost wholly dependent on the company' s economic
success, they are regarded as residual claimants . This does not mean that they are the
only group to have residual claims on the company. 2
However, while ordinary shareholders hold mere expectations of a financial
return from the company' s business, the other groups protect themselves fully through
contractual provisions. 3 Therefore, preferred shareholders, creditors, suppliers and
even employees can use these contracts to bargain for whatever protections are
efficient for the parties while common shareholders, who are mostly vulnerable to
insider opportunism, thus need board control and fiduciary duty protection to advance
and protect their interests . The allocation of voting rights to ordinary shareholders
would also be confirmed by a practice of corporate finance. In fact, if a company needs

1. See F.H. Easterbrook & D . R . Fischel, The Economic Structure of Corporate Law 63-72 ( Harv . U .
Press 1 99 1 ) ; O.E. Williamson, The Economic Institutions of Capitalism 304-306 ( Free Press
1 985) .
2. P . Ireland, Company Law and the Myth o f Shareholder Ownership, Modern L. Rev. 62 , 32-57
( 1 999) ; P . L. Davies, Introduction to Company Law 257 (Oxford U. Press 2002) ; S. Worthington,
Shares and Shareholders: Property, Power and Entitlements (Part 1 and 2) , Co . Law . 22 258 et
seq. (200 1 ) ; E. Fama, Agency Problems and the Theory of the Firm, J. Political Econ. 88, 288-290
( 1 980) .
3. See J .R. Macey, A n Economic Analysis of the Various Rationales for Making Shareholders the
Exclusive Beneficiaries of Corporate Fidudary Duties, Stetson L. Rev. 2 1 , 23 and 25 ( 1 99 1 ) . A
different point of view comes from H . Hansmann, The Ownership of Enterprise 53 et seq. ( First
Harv . U. Press 2000) , who has suggested that ordinary shareholders are allocated governance
rights because they are in a position to discharge the governance function more efficiently than
any other non-shareholder stakeholder group.

92
Chapter 4 : From the Classification to the Functional Approach §4 . 0 1

risk capital i t will not be able t o acquire i t o n acceptable terms unless control rights are
allocated to ordinary shareholders, or at least contractual entitlements to a higher
return on investment are given to them as compensation. 4
If being the most residual claimants in the firm place ordinary shareholders in a
full control position of the company at first when the company is set up, for the same
reason, it is understandable why those control rights should be lost when the
shareholder no longer has an investment to protect. 5 The law facilitates the granting of
such control rights to ordinary shareholders but its mandatory contribution is to
deprive them of the control rights they have contracted for at the point when their
investment has disappeared. For this reason, bondholders , who normally have a
contractual entitlement to regular interest on their loan to the company and to
repayment of the principal at a fixed point in the future, do obtain control rights when
certain events put in doubt the company' s ability to pay the interest due or to repay the
loan on time .
Studies on agency theory have underlined two main obstacles to a perfect
allocation of cash flow rights and control power in a company: information asymmetry
and the resulting increased risk and opportunistic behaviour of parties, which generate
costs for the company. These problems arise from contractual incompleteness, that is
the impossibility of the parties writing a perfect contract because of the difficulty of
covering in advance and specifying ex ante all the possible conduct of the parties in
dealing with the various different situations the company could encounter. Because of
the information asymmetry, some information is observable by only one party who
cannot or does not want to communicate it to others . As a result, risk and uncertainty
are enormously increased . Because of the agency costs, the parties cannot control
post-financing behaviour by contract because either the behaviour itself or future states
of the world cannot be verified by third-party arbiters . This results in the possibility of
opportunistic behaviour. In fact, the risks and rewards of potential business opportu­
nities may be differentially distributed across the stakeholder groups, so that the
rewards, if the proj ect is successful, will accrue predominantly to some groups, whilst
the costs of failure will fall predominantly on other stakeholder groups. 6 These two
problems greatly motivate the design of financial contracts and are the main reason for
the use of hybrid financial instruments . 7
The implications of hybrids differ according to some particular features that may
be frequently found in various companies . I am going to analyse two particular
situations in which the issuance of hybrid financial instruments has different impacts .
These are large publicly traded companies and small closely held start-up firms . 8 The

4. P . L. Davies, Introduction to Company Law 267 (2nd ed. , Oxford U . Press 201 0, reprinted 2 0 1 2) .
S. This principle is firmly embedded i n the insolvency law a s the prime function o f the law. See
s. 2 1 4 of the Insolvency Act 1 986.
6. P. L . Davies, Introduction to Company Law 269 (Oxford U . Press 2002) .
7. M. Lamandini, Struttura finanziaria e govemo nelle societa d i capitali (Mulino Bologna 2002)
1 S3 - 1 64 .
8. J . S . Ang, Small Business Uniqueness and the Theory of Financial Management, J. Small Bus .
Fin . 1 , 1 - 1 3 ( 1 99 1 ) ; J . S . Ang, R.A. Cole & J.W. Lin, Agency Costs and Ownership Structure, J.
Fin . S S , 8 1 - 1 06 (2000) .

93
§4 . 0 1 [A] Lorenzo Sasso

division between large and small groups is uniquely adopted in this book for practical
purposes . Since it is sometimes not clear when a company no longer qualifies as small
and becomes large, as for instance in venture capital businesses, it does not have to be
seen has a categorical distinction. Similarly, the distinction between public and private
companies must not be seen as categorical . Although these two typologies of company
generally show contrasting features, it may be possible to find exceptions and
similarities in both. For instance, public company shareholders, who hold their shares
listed in a stock market, usually benefit from high liquidity. However, small growing
public companies traded in the Alternative Investment Market (AIM) sometimes suffer
from very low volumes of shares exchanged and low liquidity. In the same way, there
may be a small private company governed by a centralized management of experts and
not by the majority shareholders . However, it is useful to identify these contrasting
core features because it is in relation to them that the impact of a hybrid instrument
changes .

[ A] Large Publicly Traded Companies

As companies become larger, their needs for capital to carry on their business are also
likely to increase, to the point where the public needs to be invited to provide risk
capital for the company, either directly or via intermediaries such as pension funds or
insurance companies . These companies present a large shareholding body, distinct
from the management, which is centralized and entrusted to a small group of
managers . 9 The choice of centralized management in public corporations comes from
the necessity for the company to conduct its business efficiently. The independent
board helps the company to reduce the costs of organization and accelerates decision­
making when business expands . 10
From an economic perspective, the public corporation has the main advantage of
providing the firm with a low-cost source of equity capital, because of its efficiency in
spreading risk among well-diversified investors . In a way, the public corporation can
be thought of as an ingenious risk-management device, a form of organization that
allows equity investors to specialize in bearing the residual risk of the firm without
having to manage it, since they can diversify their own portfolios . 1 1 However,
managers, who invest all their skills and time in running the firm, are risk averse and
place high value on the growth, size, and diversification of the business. While for such
corporations the arguments for centralized management are the strongest, it has to be

9. A. Berle & G . Means , The Modem Corporation and Private Property 47 (New York, Harcourt
Brace & World 1 926 [revised ed. , 1 968] ) . In their analysis, Berle and Means observe a great
fragmentation of shareholdings in large companies that caused a separation between owner­
ship and control, mainly due to the development of a specialised function of managing the
company separate from that of providing risk capital and to a shareholdings dilution in the
company.
10. P . L. Davies, Introduction to Company Law 1 03 - 1 1 1 (2nd ed. Oxford, Oxford U . Press Clarendon
Law Series 201 0) .
11. K. H . Wruck, Private Equity, Corporate Governance and the Reinvention of the Market of
Corporate Control, J . Applied Corp . Fin. 20, 8 (2008) .

94
Chapter 4 : From the Classification to the Functional Approach §4 . 0 1 [A]

said that centralized management is not without danger for shareholders . Since
managers are risk averse, they prefer to keep the surplus generated by the annual cash
flow inside the firm without considering the optimal amount of risk-taking and payouts
to investors. 1 2 For this reason, the risk of opportunistic behaviour and the agency costs
in large publicly traded companies are the highest, hence the need for corporate
governance and incentive compensation to help ensure that managers serve the
interests of the residual risk-bearing investors . 1 3 Therefore, in a publicly traded
company, centralized management raises issues mainly concerned with how the
directors can be made accountable to the shareholders.
Indeed, the phenomenon of the separation between ownership and control found
fertile ground in publicly traded companies thanks to the easy mechanism of transfer­
ability of shares existing in the stock market. According to this, the entry and exit
process of an investor in a corporation is facilitated contrary to what happens in small
firms or even in medium-large companies not listed . A dissatisfied shareholder may
simply sell his stake in the stock market if his expectations are not satisfied . Therefore,
investors in public companies are generally more concerned about the liquidity of the
stock market, so they can diversify their portfolios, than they are in control power.
Furthermore, the takeover may work as a mechanism of governance for public
companies while it is of very little importance for private groups. In certain countries
such as the United Kingdom, in which the law facilitates the removal of directors in the
case of takeover, the market for corporate control may represent quite a strong
incentive for managers to strive for the company' s success, maximizing its shares
market price. However, this may not be the same in the United States of America,
where law provides directors with effective defensive tools against hostile tender offers
that make their removal without an agreement from their side extremely difficult. 1 4
Regarding the investment policies, public companies show a greater propensity
to invest in transparent assets and assets-in-place than private companies . Transparent
assets are supposed to be assets that are easier to measure. In fact, low visibility of
corporate assets brings high-risk and may constrain the market for finance. This is
probably one of the reasons why public companies often play a weak role in
innovation, at least in a direct visible way. Since managers, who are risk averse, prefer
to diversify their assets and grow according to the economies of scale, they will only
finance research and development (R&D) or growth opportunity projects if they know
the investment will not unreasonably reduce the future company' s cash flows . In fact,
growth opportunities, options and R&D projects may involve in a great amount of
finance with the result of lowering profits for some years . Shareholders would only
accept that if they had a clear understanding of the inputs and likely outputs of
innovation. Finally, given that negotiations in the stock markets are based principally

12. F.H. Easterbrook & D . R . Fischel, The Economic Structure of Corporate Law 2 1 -22 (Harv. U .
Press 1 99 1 ) .
13. M . Jensen & W . Meckling, Theory of the Firm: Managerial Behaviour, Agency Costs and
Ownership Structure, J . Fin. Econ. 3 , 349-3 50 ( 1 9 76) .
14. R. Romano, A Guide to Takeovers: Theory, Evidence and Regulation, in European Takeovers:
Law and Practice passim (K. Hopt & E. Wymeersch eds. , Butterworths 1 992) ; P .L. Davies,
Introduction to Company Law passim (Oxford U. Press 2002) .

95
§4 . 0 1 [B] Lorenzo Sasso

on the discounted value of future expectations related to companies, they are particu­
larly influenced by any kind of news or action. Thus , changes in the corporate financial
structure may be an incentive for managers who want to send a positive signal to the
market.
To summarize, large public companies represent centralized management, the
free transferability of shares and diversified and transparent (hence tangible) assets .
Therefore, the uncertainty created by the information asymmetry problem, between
managers and investors concerning the nature of the business and the strategy of the
company, is reduced by the transparency of its assets and the disclosure rules, which
are aimed at protecting the stock market' s investors and are mandatory for public
companies . In addition, the easy exit for a dissatisfied investor guarantees a lower level
of risk than in private start-up firms. Thus, investors in these cases are less concerned
about control. In contrast, the agency costs created by the separation of ownership and
control and, consequently, the potential opportunistic behaviour of managers are at a
high.

[B] Small Closely Held Start-Up Firms

Start-up firms generally have a small number of shareholders, all or most of whom
expect to be involved in the management of the company. This choice of governance
may also reflect the need to avoid all the public disclosure requirements and to
minimize the agency problems associated with a centralized management. In fact, the
opposite problem could arise, namely whether it is worthwhile to require a company to
have two separate decision-making bodies (board and shareholders' meetings) when
the same people crop up on both occasions . 1 5 While vesting the management in the
shareholders may solve one problem that is related to the shareholder-managers
relationship, it is at the potential cost of creating another, namely the risk of oppressive
conduct on the part of the maj ority of shareholders against the minority. 1 6
The peculiar flexible governance structure of small private firms has led to them
being favoured as the most suitable vehicles for investments in innovation. The bulk of
successful venture capital is invested in the high-technology sector and the value of
these start-up firms lies in their growth options rather than in their marketable assets .
For many such firms, the principal assets consist of ideas, human capital and growth
opportunities, which will be completely worthless, and thus unavailable for creditors ,

15. I n UK, the current law keeps the two-centre decision-making structure in existence, and s o still
requires those running small companies to distinguish between what they do as directors and
what they do as shareholders , while making it more convenient for them to operate the
company. A more radical approach would be to permit the company to opt for rolling the two
decision-making bodies into one, as is permitted in some US j urisdictions . Thus, s. 3 5 1 of the
Delaware General Corporation Law permits a close corporation to opt for its affairs to be run
solely by the shareholders .
16. Not surprisingly, company law has developed rules against minority oppression, most strongly
in the small company context where control of the company is most likely to be in the hands
of the majority shareholders . See P . L. Davies , Introduction to Company Law 2 1 8 ff. (2nd ed . ,
Oxford U . Press 20 1 0) .

96
Chapter 4 : From the Classification to the Functional Approach §4 . 0 1 [B]

in the case of default. 1 7 Therefore, information asymmetries are more severe in such
firms than in large public companies . Fewer factors are observable, and far less
verifiable. Indeed, in the absence of tangible assets, the opportunity for misbehaviour
is greater, and monitoring is more difficult. 1 8
High ratios of intangible to total assets with low liquidation values, as it is the
case in the R&D investments, may create uncertainty - and consequently high-risk - in
the business of the firm and this constrains the market for finance. This seems to be
confirmed by the difficulties raising debt finance showed by many private start-up
firms developing new technologies . They commonly do not generate steady cash flows
that can be used to make interest payments on debt. Venture capital investments often
face negative cash flows in the first years . Investors only come forward if they have a
clear understanding of the inputs to and the likely outputs of innovation. When the
visibility of innovation is low and there is asymmetric information, entrepreneurs and
financiers need to engage closely with the firm, to develop a firm-specific understand­
ing in order to find the key for future innovative success . 1 9 Small private start-up firms,
which are constituted ad hoc, present the perfect vehicle where investors are aware of
the risk they support and engage closely with the firm in order to develop a
firm-specific understanding. At the same time, managers can have a high degree of
autonomy because investors maintain ultimate control over the company in case
events become unfavourable.
These companies are also referred to as ' closely held' or ' close' companies
because the transferability of shares will usually be restricted by their statutes and the
identity of any new shareholder will be regarded as a matter of concern for all the
shareholders . The company' s control is firmly locked in the hands of the entrepreneur
who is generally unwilling to cede control rights to outsiders . However, when the firm
is wealth constrained or needs new finance to expand, the equilibrium financial
contract will be one that reduces the information asymmetries without surrendering
control to the financier.
In summary, small private start-up firms, commonly used in venture capital and
private equity transactions, present several clear features : an entrepreneur-manager, a
constrained market for finance and investments in illiquid or intangible assets with
growth opportunities but low visibility. While vesting the management in the share­
holders reduces some agency costs, the conflict between maj ority and minority
shareholders or between shareholders and bondholders is exacerbated. This is due to
the combination of limited liability and locked-in control that can lead to shareholders '
opportunistic behaviour. In addition, the low visibility of assets, especially when they

1 7. See, for example, J. Armour, Personal Insolvency Law and the Demand for Venture Capital,
European Bus. & Organizational L. Rev. 5, 87- 1 1 8 (2004) ; A . N . Berger & G.F. Udell, The
Economics of Small Business Finance: The Roles of Private Equity and Debt Markets in the
Financial Growth Cycle, J . Banking & Fin. 22, 6 1 3-673 ( 1 998) ; R.E. Carpenter & B . C . Petersen,
Capital Market Imperfections, High-Tech Investment, and New Equity Financing, Econ. J. 1 1 2 ,
F54-F72 (2002) .
1 8. J . S . Ang, Small Business Uniqueness and the Theory of Financial Management, J . Small Bus .
Fin. l , 1 - 1 3 ( 1 99 1 ) .
19. See examples J . Armour, Personal Insolvency Law and the Demand for Venture Capital,
European Bus . & Organizational L. Rev. 5 , 87- 1 1 8 (2004) .

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§4 . 02 Lorenzo Sasso

are represented by human capital or technical know-how, generates an even larger

information asymmetry problem and uncertainty than in the case of publicly traded
companies . Therefore, the risk in these investments is generally very high.

§4.02 THE STRUCTURE OF PART II

While in publicly traded companies, centralized management raises issues mainly

concerned with how the directors can be made accountable to the shareholders, in a
closely held start-up, there is a greater risk that some of the shareholders will
coordinate their activities so as to control the board and run the company without
regard to the interests of the non-controlling shareholders or the creditors . The analysis
of corporate relationships in the case of hybrids is complicated by the fact that such
securities do not always attribute a ' clear' status in the company to their holders . For
example, sometimes their position may be swapped for another as in the case of
convertible securities, or they may receive a fixed 'dividend' , which is automatically
deducted from the firm' s profits as a cost, or their interests may be subordinated to the
achievement of a final positive result. This complicates the task of the law to protect
their rights . It is often arguable how far their protection is a matter of contract and how
far a mandatory matter of company law . British law has traditionally permitted broad
access on the part of shareholders to the shelter of limited liability and has left creditors
to protect themselves, largely by contract, against the risk of opportunistic behaviour.
In this strategy the role of company law has been to place creditors in a position where
they can bargain effectively with companies, for example by requiring the disclosure of
relevant information. 2 0
Indeed, the quantity and quality of information contained in the accounts has
been improved over time, notably by the development largely by the accounting
professions of accounting standards, which both reduce the directors ' discretion as to
how transactions are presented in the accounts and promote comparability across
companies . Nevertheless, it can be argued that the information contained in the public
accounts is often out of date, and many large lenders no doubt require the production
of more up-to-date information as part of the pre-contractual process . In addition, as
we discussed in Part I, the growing use of hybrid instruments has further complicated
the role of accounting law with regard to the classification 'equity-debt' . The company
law effort to facilitate creditor self-help is mostly evident in the case of small private
start-up firms in venture capital looking at the flexibility of the company' s constitution.
In fact, it is at the incorporation stage that shareholders often enable financiers to
secure representation within the governance organs of the company, even in advance
of default, if that seems to them an appropriate course of action . In any case, the
shareholders by ordinary maj ority can remove a director at any time, whether that

20. In the UK by 1 948, the filing obligation was applied to the profit and loss account as well as to
the balance sheet . Both these documents had to be audited by external and professionally
qualified persons, and the obligation to produce accounts was applied in the case of corporate
groups, to the group as a whole as well as to the individual companies within it. See CA 2006
at Part 1 5 .

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Chapter 4 : From the Classification to the Functional Approach §4 . 02

director was appointed by them or not . Conversely, the nominator has no redress other
than that which it has stipulated for in the contract, which might include, of course, the
right to call for repayment of the loan and to appoint a receiver. Equally, the courts
have insisted that the nominee director owes duties to the company, in the same way
as any other director, rather than the nominator. Despite this, the greater weight of the
policy for dealing with opportunism in this strategy lies with private rather than public
ordering. 2 1
The peculiarities o f private contracting d o not have t o b e seen only a s confined to
opting out of limited liability. Contract has an equally important role in dealing with the
consequences of transacting on the basis of limited liability. The lender may seek to
control the actions of the corporate borrower by inserting provisions in the loan
contract, requiring the lender' s prior consent to certain courses of action that the lender
judges might adversely affect the prospects of the loan being repaid. Alternatively, the
lender may introduce in the terms of the contract anti-dilution clauses in order to
protect their participation and control in the company. Furthermore, a lender may
contract for governance rights . The vote attributed to shareholders may be conferred to
creditors by covenants, the breach of which results in the sanction of a default, thereby
encouraging compliance, or in the automatic appointment of some directors to the
board . The variety of protections for creditors that can be created in this way is large
and will be discussed below .
This said, keeping in mind the core features of corporate governance and finance,
I will examine preference shares, convertible bonds and bonds holding restrictive
covenants for their state-contingent combination of features and their function, each in
several significant situations arising during the life of a firm according to the instru­
ment' s relevance to the particular case studied. The study will include the rationale of
using hybrids in particular situations where the risks of opportunism are evident and so
the conflicts of interest among the parties . For each case, I will also discuss the legal
strategies available for protection in the UK and US systems, where these securities are
common, with the aim of comparing and evaluating them .
The analysis shows that hybrids of debt generally prefer to bargain for contrac­
tual protection. In fact, certain clauses included in this kind of financial contracts are
nowadays standardized in the markets. Conversely, preference shareholders, who are
often a class of the equity share capital, benefit from the protection of statutory rules or
from ex post remedies, as for instance the regime of the variation of class rights and the
petition for unfair prejudice or for breach of directors ' fiduciary duties . However, the
financial entitlements of these securities are considered by courts to be contractual in
nature . Moreover, when their privileges pose limits for the amount of dividends and the
repayment of capital in liquidation, they are considered as not being part of the equity
share capital as defined by section 548 of the Companies Act. Therefore, they may not

21 . In 1 982 , the Report of the Review Committee on Insolvency Law and Practice (Chairman: Sir
Kenneth Cork) , Cmnd. 8558, made some use of direct control of opportunistic behaviour.
However, the Government did not act to follow some recommendations of the Committee (e.g. ,
to set aside 1 0 % of the company' s assets for unsecured creditors in the event of winding up) .
See paras 1 523- 1 549 .

99
§4 . 02 Lorenzo Sasso

have the protections they relied on. At the same time, they have a weaker contractual
position compared with creditors . Since, as the analysis shows, there are situations in
which the interests of ordinary and preferred shareholders diverge, they may have a
strong incentive to contract for their protection . This is particularly true in start-up
businesses in private equity and venture capital, where the economic environment of
the firm can evolve very quickly.

1 00
CHAPTER 5

Significant Corporate Decisions

I begin my analysis in this part by discussing some significant corporate decisions that
can create fundamental changes in the relationship between the holders of hybrid
financial instruments and the other participants in the firm . These situations need
special attention because they are the main source of conflicts of interest among the
company' s constituencies . I will discuss when the use of hybrid financial contracts
reduces the opportunities for conflict and when, by contrast, it enhances them . At the
same time, I will analyse how corporate law mitigates the opportunism that can
accompany these changes or creates legal risks evaluating whether the conflicts would
be better avoided contractually by the parties or by further intervention of the
regulator.
This chapter concerns the law in the UK and compares it with the evolution of the
corresponding law of the US . The analysis shows that there is a strong rationale for
hybrids in private equity and venture capital financing, because the investors in these
businesses need to modulate the original (normal) allocation of cash flow rights and
control rights . At the same time, the simple standard protection provided by the law,
which acts efficiently for minority shareholders, may not be adequate for covering the
sophisticate necessities of the parties involved in hybrid financial contracts . The study
suggests a careful contractual design.

§5.01 CONTRACTING FOR GOVERNANCE RIGHTS AT A COMPANY'S

START-UP

A primary lesson of corporate governance is that interests of the various claimants on

a business' s cash flow inevitably come into conflicts . 1 Many of the relationships
between participants in the firm are structured by contract, including contracts with

1. For example, the interests of creditors and shareholders clash when the firm makes a decision
about how to allocate capital, see Enriques L. & J. R. Macey, Creditors Versus Capital Formation:
The Case Against the European Legal Capital Rules, Cornell L. R. 86, 1 1 66 (200 1 ) .

101
§5.01 Lorenzo Sasso

creditors and shareholder agreements, and it is through the articles of association that
company law can balance the different interests of the main participants, allowing for
flexibility, constitutional commitments and publicity. 2 The role of bargaining is clearly
observable at the time a business is incorporated in a venture capital start-up . The
contractual arrangements for venture capital are much more complex than for most
types of finance. Normally, they involve the both sides sharing the up-side potential of
the proj ect, providing for both equity-type characteristics . 3 The entrepreneur and the
venture capitalist are only concerned with the effective allocation of cash flow and
control rights between them and not the formal labels attached to these rights . Whether
they invest in a business through equity or debt is something they care about only if
something depends on it . Venture capitalists often invest in several different countries
each of which has its own legal systems . The details of these legal systems are
important only insofar as the investment contracts must consider them. 4
Start-up firms display a high degree of 'informational opacity' . 5 Investors in this
sector face severe information asymmetries . This asymmetric information generates a
great ' adverse selection' problem. Therefore entrepreneurs, who are generally better
informed than outside investors as to the true level of skills and abilities to take on a
given task, may misrepresent their abilities to them and, these misrepresentations may
go undetected . Banks, financial intermediates and investment funds lacking the
information to identify firms with the highest expected returns relative to the degree of
risk, find it difficult to use the price mechanism to distinguish between firms 6 and ask
for higher interest rates to offset the risk incurred in lending money to a company in the
absence of collateral. This problem may constrain the market for finance of technology­
based firms . 7
The adverse selection problem is enhanced in small private companies because
they are generally unable to provide collateral or adequate guarantees for the funds
they require and, unlike public companies, they are characterized by lock-in capital for

2. M. Kahan & E . Rock, Corporate Constitutionalism: Antitakeover Charter Provisions as Precom­

mitment, U . Pa. L. Rev. 1 52 , 473 (2003) .
3. See S . N . Kaplan & P . Stromberg, Financial Contracting Meets the Real World: A n Empirical
Analysis of Venture Capital Contracts, Rev . Econ. Stud. 70, 2 8 1 and 306-308 (2003) .
4. S.N. Kaplan, P .J . Stromberg & M. Frederic, How Do Legal Differences and Leaming Affect
Financial Contracts ? ( 1 6 Jun. 2004) , available at SSRN: http ://ssrn .com/abstract=5 5 7007. In
contrast to the empirical research carried out by La Porta et al. , the variable measuring law and
order is negatively related to the importance of venture capital finance. The authors found that
venture capital grows in countries with less law and order.
5. A. N . Berger & G.F. Udell, The Economics of Small Business Finance: The Roles of Private Equity
and Debt Markets in the Financial Growth Cycle, J. Banking & Fin. 22, 6 1 3 -673 (1 998) .
6. Prior to advancing funds, if the investor offers average terms these will be attractive to
low-quality entrepreneurs , and unattractive to high-quality entrepreneurs , see S . C . Myers &
N . S . Majluf, Corporate Financing and Investment Decision When Firms Have Information That
Investors Do Not Have, J. Fin. Econ. 1 3 , 1 8 7-22 1 ( 1 984) .
7. As M. Lund & J . Write of the Bank of England Domestic Finance Division stated: ' It has
frequently been argued in economics literature that such problems can lead to credit rationing
for small and medium-sized enterprises, that is, finance is not made available to all firms with
viable projects whose net present value is positive' , The Financing of Small Firms in the United
Kingdom, Q . Bull. 1 95 (May 1 999) . See also J.E . Stiglitz & A. Weiss, Credit Rationing in Markets
with Imperfect Information, Am. Econ . Rev. 7 1 (3) , 407-408 ( 1 98 1 ) .

1 02
Chapter 5 : Significant Corporate Decisions §5.01

a long period o f time . The transferability o f shares - an essential mechanism i n public

companies for imposing discipline upon managers - is strongly limited in private firms,
where the rights of exit may be non-existent. Non-management purchasers of stock in
public companies are passive investors; if they do not like the way the company is
being run, their solution is to sell their shares . However, venture capital operates on an
entirely different set of principles . The entrepreneur possesses the idea and so he has
the incentives and the know-how to develop the concept and bring it to market. For this
reason, he generally likes to maintain control of the business and is unwilling to cede
it to outsiders . 8 While an entrepreneur is strongly motivated by private benefits of
control, the venture capitalist is more concerned about future revenues . However, the
typical founder is an incomplete businessman, with gaps in experience in matters such
as financial management and marketing. These gaps are expected to be filled by the
venture capitalist or by the venture pool of funds, who are generally professional
managers and can provide access to networks and foster credibility through the signal
of their reputation. Indeed, the venture capitalist benefits from every potential efficien­
cies improvement when the firm is performing well. 9
The lock-in feature, added to the company' s limited liability, is a source of
conflict between the entrepreneur-shareholder and the venture capital fund. 1 0 This
phenomenon is also known as the 'moral hazard' problem . If the firm ' s income
realized is inadequate because the business does not succeed, the investor may not be
able to recognize whether this was due to the entrepreneur' s lack of effort or pursuit of
private benefits, or simply by bad cyclical economic conditions . 1 1 Such a scenario will
reduce the entrepreneur' s incentives to apply effort and pursue joint benefits, while it
will increase his motivation to misallocate the raised funds by spending on items that
disproportionately benefit him. 1 2 For instance, an entrepreneur-scientist may choose to
invest finance in research activities that increase the fame of the scientist, but produce
little return for the investor. 1 3
Thus, asymmetric information at the time of start-up, and moral hazard, can also
lead to costly agency conflicts between transacting parties in the form of ex ante

8. Managing the firm confers private non-verifiable benefits t o the entrepreneur that are related to
a reputation that he may use in other business situations . Of course, private benefits accrue
only in good states of nature given that an entrepreneur does not gain in reputation running a
poorly performing company.
9. B . Black & R. Gilson, Venture Capital and the Structure of Capital Markets: Bank versus Stock
Markets, J . Fin. Econ. 47, 243-2 77 ( 1 998) ; J.W. Bartlett, Equity Finance: Venture Capital,
Buyouts, Restructurings and Reorganizations 229-230 (Aspen Publishers 1 995) .
10. See O . E . Williamson, Corporate Finance and Corporate Governance, J . Fin . 4 3 567-5 9 1 ( 1 988) ;
B. Klein, R .G . Crawford & A.A. Alchian, Vertical Integration, Appropriable Rents, and the
Competitive Contracting Process, J. L. & Econ. 2 1 , 297-326 ( 1 9 78) . For a practical example see
P. Joskow, Vertical Integration and Long-Term Contracts: The Case of Coal-Burning Electric
Generating Plants, J . L. Econ. , & Organizations, Fall . 3 3 , 32-80 ( 1 985) , where the decision to
locate a coal-fired power plant next to a coal mine left the owners of the power plant vulnerable
to expropriation and ex post renegotiation.
11. M. Jensen & W. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and
Ownership Structure, J . Fin. Econ. 3 , 348 ( 1 976) .
12. R . Green, Investment Incentives Debt and Warrants, J . Fin. Econ. 1 3 , 1 1 5 -1 1 7 ( 1 984) .
13. D .J . Denis, Entrepreneurial Finance: A n Overview of the Issues and Evidence, J . Corp . Fin. 1 0,
3 0 1 -326 (2004) .

1 03
§5.01 Lorenzo Sasso

underinvestment and ex post opportunistic behaviour, also known as 'hold-up '

problems . Knowledge-based start-up firms on a rapid growth trajectory and in the need
of external finance face a clear trade-off. On one hand, they are often unable to issue
long-term debt on economic terms due to high financial distress costs, especially when
these are highly innovative technology-based firms supposed to generate a negative
cash flow for several years . On the other hand, if plain vanilla bonds can be very costly
in these circumstances, pure ordinary shares could also have significant costs . The
management of firms in the early stage of a potential successful and innovative
business may believe that the current stock price fairly reflects the firm ' s growth
opportunities . Therefore, the issuance of equity would be expected to cause an
excessive dilution of existing stockholders ' claims and the owner-manager may be
reluctant to carve in outside investors at today' s stock price. At the same time, the
venture capitalist invests at risk in situations where a high degree of uncertainty exists
as to how the venture will develop over time and the aptitude and intentions of the
entrepreneur cannot be gauged with accuracy. 1 4
The financing provided for start-up firms differ in risk from the funds lent to
public companies . This is due to two main factors : first, start-up firms investing in
high-technology usually hold intangible and illiquid assets; second, the investors in
this sector contribute, in proportion, most of the funds needed to run the business
without holding the related ownership interests . Therefore, even if these funds are
provided as senior debt, they generally face the same risk as shares being locked in the
company for the entire duration of the business development' s cycle and having no
collateral for satisfying their credit. The absence of collateral means the investors
cannot simply leave the entrepreneurs to their own devices . Investing in risky assets
can generate incremental distress costs for sponsoring firms, a problem which is
referred to as risk-management. When these indirect or collateral distress costs are
sufficiently large, at least in expectation, they can exceed the asset' s net present value,
thereby turning a positive proj ect into a negative investment. Not surprisingly, venture
capital funds are concerned about resolving the uncertainty of cash flows and they
prefer to retain at least residual rights of control in the business' strategy. For these
reasons, in venture capital there is a much greater involvement of the providers of
funds than is the case with other forms of lending in an attempt to avoid the problems
arising from asymmetric information and agency relationships . 1 5

14. M. Jensen & W. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and
Ownership Structure, J . Fin. Econ. 3 , 349-3 50 (1 976) .
15. The argument that financial innovation helps to complete financial markets is an uneasy case
to beat when the novel security can be priced by equating it to a combination of existing
securities . See N . H . Hakanssan, The Fantastic World of Finance: Progress and The Free Lunch,
J. Fin. & Quantitative Analysis 1 4, 7 1 7 and 722-724 ( 1 979) . It may be, however, that the firm
can combine existing claims to satisfy investor tastes at a lower cost than financial intermedi­
aries providing this service and this would suggest a transaction cost explanation for hybrid
instruments . See R.C. Merton, On the Application of the Continuous-Time Theory of Finance to
Financial Intermediation and Insurance, Geneva Paper Risk & Insurance, 1 4, 225 (July 1 989) ,
where the author sets forth a transaction cost explanation for the role of intermediaries in
financial derivatives markets . Furthermore the development by Merrill Lynch of liquid yield
option notes (LYONs) , which are puttable convertible zero coupon bonds , seems to have been
motivated by such an attempt to provide retail investors with an attractive package of debt and

1 04
Chapter 5 : Significant Corporate Decisions § 5 . 0 1 [A]

Initially, by isolating the asset in a stand-alone special purpose vehicle, the

venture capitalist reduces the possibility of risk contamination, the phenomenon where
a failing asset drags an otherwise healthy sponsoring firm into distress . It also reduces
the possibility that a risky asset will impose indirect distress costs on a sponsoring firm
even short of actual default . However, ordinary limited liability is not sufficient to solve
agency problems and the uncertainty of future cash flows . The corporate finance
literature in this area has underlined two important issues : first, incentive contracts
must be designed in a way that optimizes the sensitivity of the entrepreneur' s wealth
to some observable signals of the entrepreneur' s effort (e.g. , output or profits) ; second,
this contract has to include a decision, not only on how claims on cash flows should be
prioritized among all the participants, but also on who has to take control in the various
states of nature. 1 6

[A] Limits to the Control Power of a Lender

There are two limits on the role that lenders can be expected to play as monitors of
corporate management that, as I have already mentioned, also depend on the type of
company they are investing in. The first is their self-interest, meaning the lenders '
pursued aims . Where lenders perform the mere function of investors, they will
probably opt not to monitor but instead to employ other risk-management techniques
such as portfolio diversification principles . In fact, since shareholders rather than
creditors benefit from capital growth, a lender has no incentive to invest resources in
employing and training staff to monitor a corporate borrower beyond the extent
necessary to satisfy itself that the company' s ability to meet its obligations under the
loan is not impaired or placed under threat. However, it is a different case when a
lender invests in private equity or venture capital. In fact, in private start-up firms, the
amount of money a financier may contribute is generally the largest share of the
company' s capital and the incentive to be involved in the governance of the company
is usually great. 1 7

stock options . See J.J. McConnell & E . S . Schwartz, The Origin of LYONs: A Case Study in
Financial Innovation, J. Applied Corp. Fin. 40 and 4 1 -42 (Winter 1 992) ; A.J. Triantis & G . G.
Triantis, Conversion Rights and the Design of Financial Contracts, Wash. U . L. Q . 72 1 236 et seq.
( 1 994) ; Contra G . W . DENT, The Role of Convertible Securities in Corporate Finance, J. Corp . L.
2 1 , 250 et seq. ( 1 996) .
16. See D.J. Denis, Entrepreneurial Finance: A n Overview of the Issues and Evidence, J. Corp . Fin .
1 0, 3 1 0 (2004) ; compare with S . N . Kaplan & P . Stromberg, Financial Contracting Meets the Real
World: An Empirical Analysis of Venture Capital Contracts, Rev. Econ. Stud. 70, 286-295
(2003 ) ; P . Aghion & P . Bolton, An 'Incomplete Contract' Approach to Financial Contracting,
Rev. Econ. Stud. 59, 473 ( 1 992) ; 0 . Hart, Financial Contracting, J. Econ. Literature 39,
1 08 1 - 1 085 (200 1 ) .
1 7. In the UK, various commentators have described the British banks' role in corporate gover­
nance to be negligible as compared with the banks' involvement in other countries such as
Germany and Japan where, according to the conventional view, closer relationships tend to
exist between banks and industrial companies and banks are more willing than within the
British model to provide long-term debt and equity finance and to participate in the monitoring
of management through supervisory board structures . Compare J. Edwards & K. Fischer, Bank

1 05
§ 5 . 0 1 [A] Lorenzo Sasso

The second limit to the power of banks, financiers and institutional investors to
monitor and control firm decisions to enhance their position, is represented by the
doctrine of shadow director. When a bondholder exercises control power over the firm
and, because of this, the firm goes into financial distress and finally insolvency, the
bondholder may be at risk of being held to be a shadow director. 18 In the UK, under
various statutory provisions, shadow directors may be made liable as if they were
directors . The main concern is caused by section 2 1 4 of the Insolvency Act 1 986.
According to this provision, directors, including shadow directors, of a company that is
in insolvent liquidation, may be ordered by the court to make such contribution to the
company' s assets as the court thinks fit. 1 9 As a result, the bondholder' s contribution
when being considered a shadow director may be even larger than his credit with the
company. Applications to the court under this section may only be brought by
liquidators and it must be established that the person from whom a contribution is
sought knew, or ought to have concluded, 2 0 that there was no reasonable prospect that
the company would avoid going into insolvent liquidation and that the person was a
director at that time . 2 1 The court may not make an order against someone who it is
satisfied took every step that ought to have been taken with a view to minimizing the
potential loss to the company' s creditors (assuming this person knew that there was no
reasonable prospect that the company would avoid going into insolvent liquidation) .
A shadow director in relation to a company is a person in accordance with whose
directions or instructions the directors of the company are accustomed to act, but
someone is not deemed a shadow director only because of advice given by him in a

Finance and Investment in Gennany 1 78- 1 9 5 (Cambridge U. Press 1 996) and E. Ferran,
Company Law and Corporate Finance 3 41 (Oxford U. Press 2008) .
18. For the UK doctrine see P . Millett, Shadow Directorship: A Real or Imagined Threat to the Banks,
Insolvency Practitioner 1 4 ( 1 99 1 ) ; P . Fidler, Banks as Shadow Directors, Journal of Interna­
tional Business and Law 3, 97 ( 1 992) ; D . Turing, Tender Liability, Shadow Directors and the
Case of Re Hydrodan (Corby) Ltd, Journal of International Business and Law 6, 244 ( 1 994) ; G.
Bhattacharyy a , Shadow Directors and Wrongful Trading Revisited, Co . L. 1 6, 3 1 3 ( 1 995)
commenting on Re PFTZM Ltd, BCLC 2 ( 1 995) : 3 54. For the US doctrine see Bartlett & Lapatin,
The Status of a Creditor as a 'Controlling Person ' , Mercer L. Rev . 28, 639 ( 1 977) ; Douglas­
Hamilton, Creditor Liabilities Resulting From Improper Interference with the Management of a
Financially Troubled Debtor, Bus. Law . 3 1 , 343 ( 1 975) ; Enstam R.A. & H . P . Kamen, Control and
the Institutional Investor, Bus . Law . 2 3 , 289 ( 1 968) ; K.T. Lundgren, Liability of a Creditor in a
Control Relationship With Its Debtor, Marq. L. Rev. 67, 523 ( 1 984) .
19. Under U S corporate law, when a creditors, acting in that capacity, exercise control power over
the firm, they become control persons under the federal securities laws, and thus potentially
liable for false and misleading statements by the company at risk of losing its limited liability
status with the result of been held personally liable to other creditors or even to the
stockholders . See the Securities Act of 1 93 3 § 1 5 , 1 5 U . S . C . § 770 ( 1 982) ; Securities Exchange
Act of 1 934 § 20 (a) , 1 5 U . S . C . § 78t (a) ( 1 982) . The classic case, Martin v. Peyton, 246 N.Y. 2 1 3 ,
1 58 N.E. 7 7 ( 1 92 7) , concerns a loan to a partnership. See, also K.M. C. Co. v. Irving Trust Co. ,
757 F. 2d 752 (6th Cir. 1 985) ; State Nat 'l Bank of El Paso v. Farah Mfg. Co. , 678 Sw. 2d 66 1 (Tex.
Ct. App . 1 984) . See also Creditor Liabilities Resulting From Improper Interference with the
Management of a Financially Troubled Debtor, Bus . Law . 3 1 , 343 ( 1 975) .
20. The standard by which a director is judged is based on the general knowledge, skills and
experience that may reasonably be expected of a person carrying out these functions and also
the director' s own knowledge, skills and experience: Insolvency Act 1 986, s. 2 1 4 (2) .
21 . Insolvency Act 1 986, s . 2 1 4 (2) .

1 06
Chapter 5 : Significant Corporate Decisions § 5 . 0 1 [B]

professional capacity. 22 In fact, a bondholder, in order to qualify as shadow director,

has to control the whole board, or at the very least a governing maj ority. 2 3 The directors
must act on that person' s instructions or directions as a matter of regular practice and
not just on isolated occasions . 24 Nevertheless, a safer course for lenders may be to
express proposals for the rehabilitation of the company in the form of conditions to the
continuation of their support. In fact, although giving advice in a professional capacity
does not leave the adviser exposed as a shadow director, 2 5 the line between 'advising'
and 'instructing' or ' directing' may be difficult to draw. 2 6
It is not surprising that because of the heavy debt structure of leverage buy-out
transactions, the doctrine of equitable subordination is much discussed in that arena.
However, in venture capital start-ups, where there is a close involvement of the
financier with the entrepreneur in the management of the company, the risk of being
considered a shadow director does not represent a major limit to their monitoring and
control power. Corporate governance plays a different role in private equity and
venture capital than it does in the public equity and bond markets. 27 In fact, high -risk
and high-growth businesses at the early stage of their business development seem to be
the only users of hybrid financial instruments motivated by elements outside the world
of regulatory arbitrage. When the business grows and becomes more stable, the
venture capital fund, someone whose comparative advantage lies in monitoring young
companies, exits and is replaced by public shareholders and by public and private
bondholders . 28

[B ] The Use of Hybrid Instruments to Align the 'Ex Ante' Incentives of

Managers: Stage Financing and Contingent Convertible Debt

The venture capitalist and the entrepreneur must deal with the fact that their incentives
may not be always completely aligned. The entrepreneur receives private benefits from
retaining ownership of the company that are unrelated to the company' s value.

22 . Insolvency Act 1 986, s. 25 1 .

23 . That is why the appointment of few bondholders ' representatives on to the board of a
borrowing company should not expose a lender to shadow directorship liability. Furthermore,
in the absence of fraud or bad faith, a person appointing a director owes no duty to take care
that the director so appointed discharges their duties as a director with due diligence and
competence.
24. Re Unisoft Group Ltd (No 2) [ 1 994] BCC 766, 775 . See also Re Hydrodan (Corby) Ltd [ 1 994] BCC
1 6 1 , 1 63 , where the j udge ruled that to establish that a defendant is a shadow director it is
necessary to allege and prove: (i) who are the directors of the company, whether de facto or de
jure; (ii) that the defendant directed those directors how to act in relation to the company or
that he was one of the persons who did so; (iii) that those directors acted in accordance with
such directions; and (iv) they were accustomed so to act.
25. Insolvency Act 1 986, s . 25 1 .
26. See Re Company (No 005009 of 1 987) [ 1 989] BCLC 1 3 . The circumstances that led to the
shadow directorship allegation against the company' s bank were such that the company had
reached its overdraft limit and the bank had commissioned a report on its financial affairs ,
which included recommendations that the company then took steps to implement.
27. D . G . Baird & R. K. Rasmussen, Private Debt and the Missing Lever o f Corporate Governance, U.
Pa. L. Rev . 1 54, 1 209 (2006) .
28. A. Shleifer & R. Vishny, A Survey of Corporate Governance, J . Fin. 52, 73 7-783 ( 1 997) .

1 07
§ 5 . 0 1 [B] Lorenzo Sasso

Therefore, entrepreneurs may be ' inclined to continue and expand their ventures even
when their contraction or termination is efficient. ' 2 9 Conversely, the venture capitalist
is only interested in its financial returns, which must be adequate to the risk incurred
and in line with its investment policy. Therefore, venture capital funds may be
expected to seek exit too early because of their own liquidity or publicity needs . In such
a scenario, if one party retains unilateral decisions power, that party will be able to
extract wealth at the expense of the other. In private equity and venture capital
investments, funds are generally invested for less than ten years, with short extensions
from one to three years allowed. During this time, some important exit mechanisms,
which also represent the best means for initial investors to obtain a return, are the IPO
of the company, 3 0 although IPOs are costly in a number of ways, and the outright sale
of the start-up to a large firm . 3 1 In order to align the interests of the parties and provide
each party with the right incentives, a start-up business needs to tailor its governance
structure to fit the specific application, which means it has to create asset-specific
governance systems that allow an optimal allocation of financial and control rights in
the firm. This purpose is achievable only if hybrid financial instruments are issued . 3 2
The sophisticated contractual terms of these securities can be designed both to give the
management appropriate incentives and to give the investors a significant role in the
governance of the firm . 33
Venture capitalists generally invest incrementally in companies so as to wrest
control from entrepreneurs . Therefore, the investment involves a number of stages: if
a firm is successful, its needs for capital grow rapidly through time. At each stage, the
funds invested are expected to carry the firm through until the next stage. Investors
may provide funds for all or some of these stages, which in any case are limited in time.
For this reason, investors may be inclined to contribute just enough working capital to
provide the management with sufficient time to either seek the sale of the company or
achieve a particular business obj ective or milestone that will increase company value
so that a future 'flat' or 'up' round becomes more feasible . By staging the advance of

29. G . G . Triantis , Financial Contract Design in the World of Venture Capital, U. Chi. L. Rev. 68, 3 05
and 308 (200 1 ) .
30. B . Black & R . Gilson, , Venture Capital and the Structure of Capital Markets: Bank versus Stock
Markets J . Fin. Econ. 47, 243-277 ( 1 998) : where the authors, comparing the United States and
Germany, point out that 'the existence of an active IPO market is the most important
determinant of the importance of venture capital in a country' .
31. An important aspect of venture capital contracts is the allocation of cash flow between the
parties . Financiers typically receive a fixed fee, usually between 1 . 5 % and 3 % of the net asset
value, in addition to share of the profits . The expected return is around 20 % of the profits. See
Cumming, Contracts and Exit in Venture Capital Finance, Rev. Fin. Stud. 2 1 , no . 5 (2008) : 1 978 ;
W.A. Sahlman, The Structure and Governance of Venture Capital Organizations, J . Fin. Econ.
27, 473-52 1 ( 1 990) .
32. F. Cornelli & 0 . Yosha, Stage Financing and the Role o f Convertible Securities, Rev . Econ. Stud.
70, 1 -32 (2003) look at the combined use of convertible securities and staged infusion of
capital, which are so common in venture capital financing; E. Berglof, A Control Theory of
Venture Capital Finance, J . L. Econ. & Org. 1 0 , 261 -263 ( 1 994) .
33. P.A. Gompers & J. Lerner, The Venture Capital Revolution, J . Econ. Perspectives 1 5 , 1 45- 1 68
(200 1 ) ; G . G . Triantis & R.J. Daniels, The Role of Debt in Interactive Corporate Governance, Cal.
L. Rev. 83 , 1 076- 1 079 ( 1 995) ; O . E . Williamson, The Theory of the Firm as Governance
Structure: From Choice to Contract, J . Econ. Perspectives 1 6, 1 7 1 (2002) .

1 08
Chapter 5 : Significant Corporate Decisions § 5 . 0 1 [B]

funds , venture capital investors make sure the correct continuation decision is made.
This means that they preserve their ability to limit losses by abandoning portfolio
companies that are not making satisfactory progress or by demanding maj ority board
control in exchange for additional finance. 34 These control rights granted to the
investor are not incompatible with the entrepreneur' s preference for control. These
rights are used to ' add value' to their portfolio businesses and not simply to protect the
investment value from the entrepreneur' s diverging obj ectives. 35
Start-up firms would typically issue ordinary common shares to the entrepreneur
and hybrid capital such as preference shares or convertible subordinated debt, as profit
participating or payment in kind loans, to the venture capital investor. In so doing, the
entrepreneur retains discretion over the business through the voting rights and has a
strong incentive to maximize the company' s profits. The entrepreneur' s incentives to
maximize quickly the potential of the company come from the threat of abandonment,
coupled with the prospect of dilution from repeated outside investments, when the
venture capital converts its debt into equity to repay its interests 3 6 or takes the control
of the board. 3 7 On the other hand, the venture capitalist is able to attract, at the end of
every tranche financing, most of the company ' s cash flows, including in the contracts
its liquidation preferences in multiples of the purchase price . Depending upon each
party' s leverage during the negotiations, the deal could involve the issuance of
participating preference shares or convertible debt with senior liquidation preferences,
which investors would presumably value more if the possibility of a relatively
worthless common stock is considered likely.
In venture capital, the cash claims of every participant are prioritized in the most
efficient way, allowing the parties to re-negotiate and readjust the expected rate of
return on the investment according to the changes in the business' performance.
Therefore, important factors for venture capitalists are the conversion price, which can
be contingent on firm performance; preferred return in shareholders ' distribution of
profits , including a description of critical events that trigger liquidation; dividend or
interest rate, which is not paid on a current basis, but is usually deferred; payment
terms , which can sometimes state the dividends or the interests accrued and are not
paid in cash, but the liquidation preference entitles the holders to the face value and the
accrued payment and voting rights typically on an as-if converted basis .

34. See Table 2 in W.A. Sahlman, The Structure and Governance of Venture Capital Organizations,
J. Fin. Econ. 2 7, 479 ( 1 990) ; D . G . Smith, The Exit Structure of Venture Capital, UCLA L. Rev. 5 3 ,
3 1 5 and 3 1 6 (2005) ; P . A . Gompers, Optimal lnvestment, Monitoring and the Staging o f Venture
Capital, J. Fin. SO, 1 46 1 ( 1 995) ; G . G . Triantis, Financial Contract Design in the World of Venture
Capital, U. Chi. L. Rev. 68 , 305-323 (200 1 ) .
35. J . Armour, Personal Insolvency Law and the Demand for Venture Capital, European Bus . Org.
L. Rev . 5, 1 04 et seq. (2004) . See also B. Black & R. Gilson, Venture Capital and the Structure
of Capital Markets: Bank versus Stock Markets, J . Fin. Econ. 47, 243 -2 77 ( 1 998) .
36. F. Cornelli & 0 . Yosha, Stage Financing and the Role of Convertible Securities, Rev. Econ. Stud.
70, 4 (2003) .
37. D . G . Smith, The Exit Structure o f Venture Capital, UCLA L . Rev. 5 3 , 325-329 (2005) .

1 09
§ 5 . 0 1 [B] Lorenzo Sasso

fl] Preference Shares as Incentive Contracts

Private equity and venture capital funds often invest in businesses that strongly depend
on human capital . For example, when the activities financed are research and
development, the assets may be represented by a group of experts, scientists, doctors,
or engineers working simply on ideas or intuition. Similarly, the registration of licenses
or patent rights and their exploitation need a specific asset-management expertise. In
such cases , the human capital, meaning the entrepreneurs in technology-based start-up
firms , is often the key to the business' success . Since the business of private equity and
venture capital investors is to manage funds and investments made with those funds,
and not to run companies, the involvement of the management becomes extremely
important, which also provides it with the right incentive to make the business
succeed. These incentives may be a share stake in the business . A well-motivated
management will reduce costs to the minimum needed and invest adequately in capital
expenditure in order to maximize profits and thus enhance the value of the company' s
shares .
Preference shares can be used as incentive contracts because they allow the
setting up of a financial structure targeted to optimize corporate governance and at the
same time to allocate the cash flows generated by the business . In practice, the private
equity fund generally invests in the company mostly through the issuance of preference
shares or other hybrids of debt and only in small part in the equity share capital, while
a large stake of the company' s shares, also referred as 'sweet equity ' , is allocated to the
management. The economic price at which the management acquire their stake in the
business is lower than that paid by the private equity investor because the latter has to
subscribe to loan notes in addition to its equity. Depending on how strong an incentive
you want to give the management, the private equity fund decides to invest most or all
of its additional capital as subordinated capital so that the company has all the capital
needed and the ownership is not diluted. 3 8 In addition, the private equity fund could
include a conversion clause in their preference shares giving them the right to convert
part of their preference shares into ordinary shares under certain circumstances in
order to penalize bad management performances . For instance, the conversion right
could be triggered by insufficient amounts of profit realized for a year or whether the
company' s objectives have not been achieved. That would provide managers with
further incentives to maximize their human capital . 39
This ' sweet equity' advantage is not intended to go to anybody other than the
management. As a result, there will be a series of prohibitions on the transfer of shares
by the management to anybody else. The shares will only be transferable to some
extent to members of the management' s family in order to undertake tax planning for
capital gains tax and inheritance tax purposes . The private equity investor will also

38. See S . Beddow, The Equity Deal, in Private Equity: a Transactional Analysis 4 6 ( C . Hale ed . ,
Globe Business Publg. 2007) .
39. T.J. Harris, Modelling the Conversion Decisions of Preferred Stock, Bus . Law. 58, 587
(2002-2003) ; R.T. McDermott, Legal Aspects of Corporate Finance 344 (4th ed . , LexisNexis
2006) .

1 10
Chapter 5 : Significant Corporate Decisions § 5 . 0 1 [C]

wish to have the right to transfer its shares among its own group . It is however
important that, where permitted transfers are allowed, the ultimate owner of the shares
falls within the scope of any pre-emptive transfer procedure or compulsory transfer
procedure. 40 In addition, from the financier' s point of view, the investment is tax
deductible because the company issues loan notes or preference shares with a fixed
cumulative return . The hybrid instruments issued will be deeply subordinated to any
other bank loan and redeemable on a date in the future. Furthermore, the securities will
usually be subj ect to the same form of permitted transfer restrictions as apply to the
shares held by the private equity investors so that the loan note is not freely
transferable . Often the loan note may be ' stapled' to the ordinary shares so that any
transfer of ordinary shares must be accompanied by the transfer of a corresponding
percentage of the loan notes .

[C ] The Use of Hybrid Instruments to Reduce the 'Ex Post' Hold-Up

Problems

In theory, as far as information asymmetry between the entrepreneur and the venture
capitalist is concerned, the best option for the firm would be to issue short-term debt
that matures at the time favourable information is expected to be revealed to the
market. 4 1 At that time, the firm may refinance on better terms either by borrowing at a
lower rate or by issuing equity at a higher price. However, the informational advan­
tages of short-term debt financing must be weighed against the risk that the borrower
may be unable to refinance the debt when it matures or to meet periodic coupon
obligations during the term of the debt . 4 2 It also has to be said that no company that
wants to run a stable business could survive without long-term debt finance.
From the other point of view, the venture capitalist prefers to use long-term
contracts to avoid the ' fundamental transformation' that takes place following invest­
ment in transaction-specific assets . 43 In fact, the 'bidding situation' that exists before
the investment is made, becomes a 'bargaining situation' after it is made. 44 This
uncertainty may threaten the ability of venture capitalists to capture project cash flows,
thereby reducing expected returns as well as ex ante incentives to invest . For this

40 . Since managers may change during the life of a company and the obj ective of the sweet equity
is to incentivise them to make the business perform to enhance its capital value, if a manager
leaves the business, he or she no longer requires the incentivization. Thus a departing manager
will be obliged to sell his or her stake to an incoming manager, so that the total number of
shares in issue does not need to increase and the ownership is not diluted .
41 . See M.J. Flannery, Asymmetric Infonnation and Risky Debt Maturity Choice, J. Fin. 4 1 , 1 9
( 1 986) ; S . C . Myers & N . S . Majluf, Corporate Financing and Investment Decision When Finns
Have Infonnation that Investors Do Not Have, J. Fin. Econ/ 1 3 , 1 8 7- 1 88 and 209-2 1 0 (1 984) .
42 . J. Stein, ' Convertible Bonds as Backdoor Equity Financing' , J . Fin . Econ.32, 3 ( 1 992) ; G.M.
Constantinides & B.D. Grundy, Optimal Investment with Stock Repurchase and Financing as
Signals, Rev. Fin. Stud. 2 , 445 ( 1 989) .
43 . R. Coase, The Nature of the Finn, Economica 4, 386-405 ( 1 93 7) ; 0 . E . Williamson, Corporate
Finance and Corporate Governance, J. Fin. 43 , 567-59 1 ( 1 988) .
44. This is common when the company' s assets are represented by human capital, but it may also
happen with the related parties of the firm that supply critical inputs or buy primary outputs,
and host nations that supply the legal system and contractual enforcement . Because so many

111
§ 5 . 0 1 [C ] Lorenzo Sasso

reason, venture capitalists try to structure proj ect companies to limit managerial
discretion over future decisions as well as to free cash flow . They use financial
contracts to constrain managerial discretion. Contracts both prescribe and proscribe
certain actions by involved parties . One of the fundamental agreements in every
venture company is the so-called cash flow waterfall, which defines what the various
claims of the participants on cash flows are and allocates cash flows accordingly.
Through the cash flow waterfall, parties agree in advance to virtually all capital
expenditures, maintenance expenditures, debt service, reserve accounts, and share­
holder distributions . However, although contracts work well as a first line of defence,
they are, inevitably, incomplete. 45
Contract incompleteness exists whenever the contracting parties are unable ex
ante to specify fully the actions to be taken in every possible future ' state of nature' . On
the one hand, some information is observable by only one party, as in the case of the
entrepreneur who has information about the technological and economic prospects of
a potential business, but a portion of that is too soft to be communicated to investors
in a credible manner. This asymmetric information increases the cost of capital for the
entrepreneur. On the other hand, the parties cannot control post-financing behaviour
by contract because either the behaviour itself or future states of the world cannot be
verified by third-party arbiters and this generates the well-known agency problems .
Hence, from an incomplete contracting perspective, residual risk bearing is inescapable
in an ex post sense for all parties contracting with the firm . Thus, the incompleteness
of contracts means that although only shareholders are entitled to the residual profits
after all other legally binding claims to other parties have been met, in terms of
economic consequences any differences in the residual claimant status of the various
contracting parties is simply a matter of degree.
The problems of information asymmetry and agency costs in an environment of
uncertainty and high-risk may be resolved by the use of convertibles, these securities
being the best substitutes for equity or debt finance. The explanation of why convert­
ibles are so commonly used in venture financing has to be sought in the exercise of the
conversion feature. In fact, convertible securities address these problems by endog­
enously allocating residual cash flow rights to both the entrepreneur and the venture
capitalist as a function of the realized value of the company. 4 6
First of all, there are some evident advantages for an investor stemming from the
fact that convertible bonds enable their subscribers to change their status in the
company. As long as they do not convert their securities into equity hold a pure debt
obligation and as such are entitled to receive a fixed interest and be repaid at maturity.

projects involve bargaining situations between bilateral monopolists, there is a need to

discourage opportunistic behaviour before making a large, durable, indivisible capital invest­
ment.
45 . 0 . Hart, Corporate Governance: Some Theory and Implications, The Econ. J. 1 05 , 84-97 ( 1 995) .
46 . D.J. Denis, Entrepreneurial Finance: An Overview of the Issues and Evidence, J. Corp . Fin. 1 0,
3 1 2 (2004) . See also K.M. Schmidt, Convertible Securities and Venture Capital Finance, J . Fin.
58, 1 1 39 (2003) ; S . N . Kaplan & P . Stromberg, Financial Contracting Meets the Real World: An
Empirical Analysis of Venture Capital Contracts, Rev. Econ. Stud. 70, 286-295 (2003) ; J . F.
Zender, Optimal Financial Instruments, J . Fin. , 46, 1 645- 1 662 ( 1 99 1 ) .

1 12
Chapter 5 : Significant Corporate Decisions § 5 . 02

The conversion option included in the debt security presents an important opportunity
for the investor to evaluate the convenience of converting into equity or not. In this
way, the investor will be able to consider whether to convert into equity during the
different phases of the company ' s life, knowing that if the company is not performing
well and its share market value is not increasing they can enj oy the benefits of a bond . 47
Second, the financier subscribing to convertibles may adjust the conversion price
according to the achievement or non-achievement of the targets for the period, which
are set up in the terms of the contract. In so doing they are able to transfer part of their
risk (but also opportunities because the company will be better priced) to the
entrepreneur. 48 In fact, the use of convertible securities may defer the sale of equity or
the repayment of debt until private information is revealed to the market, for instance,
providing funding in tranches against established milestones . 49 The parties may also
agree on a variable conversion price defining, for example, periods within which the
holder may convert and the issuer may force conversion by exercising its call privilege.
Therefore the conversion can always be state-contingent. 5 0 To summarize, convert­
ibles provide the parties with the optimal trade-off between the need to make efficient
exit decisions and allocate cash flow rights to the venture capitalist. 5 1

§5.02 THE MANAGER-SHAREHOLDER CONFLICT IN CHARTER

AMENDMENTS: VARIATION OF CLASS RIGHTS

Corporate charters serve the function of establishing a basic governance structure,

making it public and accessible to any interested investor. Corporate charters deal with
the company' s share capital in a significant way by stating the number of share classes ,
their par value and the powers, rights qualifications and restrictions on these shares. 5 2
Furthermore, corporate charters allow the entrenchment of terms, typically through a

47. R. Green, Investment Incentives Debt and Warrants, 1. Fin. Econ. 13, 1 24- 1 2 5 ( 1 984) .
48 . For example, in practice it is a common clause the reset mechanism (reset convertibles) .
According to this , the conversion price is initially fixed but adjusts or resets to the share price,
not on a continuous basis but at defined intervals based on the then existing market price of the
issuer' s common stock or in case of the (non) occurrence of predetermined events, if the
company is for example not listed on a stock market.
49 . The use of convertible debt may be simpler from a compliance point of view, and cheaper in
terms of legal fees than an issue of convertible cumulative preference shares . However, venture
capitalists subscribing to convertible debt may request aggressive terms as for instance
personal guarantees from the founders or drastic measures upon an event of default, while
there seem to be more standardised contracts for convertible preference shares (or Series A
financing) .
50. A . 1 . Triantis & G . G . Triantis, Conversion Rights and the Design of Financial Contracts, Wash. U .
L. Q . 7 2 , 1 238 ( 1 994) ; P . A . Gompers, Optimal Investment, Monitoring and the Staging of
Venture Capital, 1 . Fin. SO, 1 46 1 - 1 489 ( 1 995) ; W.A. Sahlman, The Structure and Governance of
Venture Capital Organizations, 1 . Fin. Econ. 2 7 , 473-52 1 ( 1 990) .
51. Kaplan & Stromberg, Financial Contracting Meets the Real World: An Empirical Analysis of
Venture Capital Contracts, Rev . Econ. Stud. 70, 289 (2003) ; Cumming, Contracts and Exit in
Venture Capital Finance, Rev . Fin. Stud. 2 1 , 1 947- 1 982 (2008) ; T. Hellmann, IPO's, Acquisi­
tions and the Use of Convertible Securities in Venture Capital, Stanford Working Paper, 1 4- 1 5
(2002) .
52. C A 2006, s . 1 0 .

1 13
§ 5 . 02 Lorenzo Sasso

special amendment process. 53 However, unlike ordinary contracts, the parties to the
charter can amend them with less than unanimous approval. Thus, the extent to which
charter provisions entrench governance rules may be a matter of the management' s
opportunistic behaviour towards the totality o f the shareholders, where shareholdings
are dispersed, or the minority shareholders, in companies with concentrated hold­
ings . 54
To amend a charter, UK rules require a supermaj ority shareholder vote, without
board initiative. 55 This allows large minority shareholders to veto proposed charter
amendments, but gives no formal say in the matter. By contrast, the US rules create a
bilateral veto to charter amendments and neither the board nor the shareholders can
amend it alone . 5 6 By means of charter provisions, shareholders can make credible
pre-commitments, as is the case under the Delaware approach where shareholders can
approve an anti-takeover provision in the charter, such as a classified board, which
maximizes the bargaining role of the board in an attempted takeover by reducing the
likelihood that they would accept or that an acquirer would make a takeover offer with
the approval of the board. 57 This would not be possible in UK where the law requires
the unanimity of all the members to make a provision for entrenchment . 5 8
Although, a charter amendment that adversely affects a class of shareholders
must be approved by a majority of that class voting together, the statutory law has
sometimes failed to protect minorities in the same way as the preferred shareholders
who often lack voting rights and who rely in consequence on the charter and the rules
governing its amendment to protect their interests . The special entitlements reserved
for the preferred shares have had the consequence of creating a divergence of interests
among preferred and ordinary shareholders . Therefore, additional contractual protec­
tions have been attached to these securities . However, such protections must be
carefully drafted to protect the preference shareholders and to not be simply illusory.
Historically, the British courts have drawn a sharp distinction between variations of the
formal rights of a class of shareholders, which requires separate approval and changes
in the charter that reduce the value of those rights without changing them formally. 59

S3. CA 2006, S S 2 1 -22.

S4. E. Rock et al. , Fundamental Changes, in The Anatomy of Corporate Law: A Comparative and
Functional Approach 1 83 et seq. (R. Kraakman et al . eds . , 2d ed. Oxford U. Press, 2009) .
SS. U K Companies Act 2006, s . 2 1 . Although i n practice most proposals for charter amendments
originate from the board.
S6. Delaware General Corporation Law (DGCL) at s . 242 .
S7. M . Kahan & E. Rock, Corporate Constitutionalism: Antitakeover Charter Provisions as Precom­
mitment, U . Pa. L. Rev. 1 S2 , 473 (2003) .
58. Section 22 o f the U K C A 2006.
S9. P . L. Davies, Gower and Davies ' Prindples of Modem Company Law paras 1 9-24 et seq. (9th ed . ,
Sweet & Maxwell 2 0 1 2) ; D . Kershaw, Company Law in Context: Text and Materials 668 (Oxford
U . Press, 2009) . Similar approach has been taken in the US States, see W.W. Bratton, Venture
Capital on the Downside: Preferred Stock and Corporate Control, Mich . L. Rev. 1 00, 89 1 ,
922-939 (2002) .

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C h ap t e r 5 : Significant Corporate Decisions § 5 . 02 [A]

[A ] The Position of Preference Shareholders and their Protections: A

UK-US Comparative Analysis

Since the 1 920s at the time of the Great Depression in the USA, variations of class rights
carried out by ordinary shareholders on preference shares have become very common.
After a period of depressed earnings due to the crisis, many companies were becoming
profitable again but the management could not declare common stock dividends before
it paid the often-sizeable preferred stock arrearages that had accrued . Since directors
often owned common stock, generally the only class of stock entitled to elect directors,
they were inevitably more responsive to the common shareholders ' interests than to
those of the preferred shareholders . In order to pay dividends on the common stock,
they devised ways to eliminate preferred arrearages so that they could immediately
declare common stock dividends . This was carried out through certificate amendments
such as the cancellation or reclassification of certain categories of shareholders,
mergers with shell corporations or the voluntary exchange of new preferred stock
without arrearages for old preference shares . 60
Although statutes and certificate provisions often empowered the preference
shareholders to block these proposals by class vote, many factors prevented them from
doing so . 6 1 In fact, the class of preference shares was frequently induced to cast the
necessary votes for what appear to be detrimental and sometimes disastrous conse­
quences . For instance, directors were used to create new prior preferred stock or
increase existing prior preferred stock and offer it in exchange for outstanding
preference shares . The prior preferred stock was not entitled to arrearages owed on the
outstanding preference shares and thus, when outstanding preference shareholders
exchanged their shares, their arrearages were eliminated. However, preference share­
holders were widely dispersed and lacked control over the proxy mechanisms by which
they were informed of the terms of the proposed arrearage elimination. Thus, managers
could obscure essential information concerning these proposals in proxy statements .
Directors normally controlled the manner in which a plan was presented to the
shareholders , and even if they were subj ect to some limitations imposed by the usual
proxy rules, they could emphasize any real advantages that the plan conferred on the
preference shareholders, while at the same time minimizing its disadvantages . 62
Furthermore, dividend arrearages were usually so large that statutorily they could not
be paid without a formal reduction of capital and such a reduction often required the

60 . A. Stone Dewing, The Financial Policy of Corporations 1 1 95 (5th ed . , Ronald Press Co. 1 953) ;
W.L. Cary & M. Eisenberg, Cases and Materials on Corporations 1 605 (5th ed. ,Foundation Press
1 980) .
61 . As both the commentators of that time and the Securities and Exchange Commission (SEC)
argued, preference shareholders often lacked the power to secure their rights to dividend
arrearages . See Securities and Exchange Commission, Report on the Study and Investigation of
the Work, Activities, Personnel and Functions of Protective and Reorganization Committees,
pt. VII, 1 938, at 1 09 ; V. Brudney, Standards of Fairness and the Limits of Preferred Stock
Modifications, Rutgers L. Rev. 26, 445 , 446 and 450 ( 1 973) .
62 . E.M. Dodd, Fair and Equitable Recapitalizations, Harv. L. Rev. 5 5 , 780 and 792 ( 1 942) .

1 15
§ 5 . 02 [A] Lorenzo Sasso

common shareholders' consent. For this reason, common shareholders often had the
opportunity to demand unfair concessions from preferred shareholders . 6 3
In the US, the courts chose not to intercede on behalf of the preference
shareholders , permitting the elimination of arrearages by certificate amendment or
merger in accordance with the theory that preference shareholders purchased their
stock knowing that their rights were statutorily variable by amendment or merger.
Similarly, they upheld offers of prior preferred stock without provision for payment of
past arrearages in exchange for the existing preferred stock on the grounds that any
exchange was purely voluntary. 64 However, in truth, the exchange was often more
coercive than voluntary: any preference shareholder who refused the exchange was left
with shares subordinated to the new class of prior preference and, therefore, with little
hope of ever receiving any payment of the arrearages . 65
To avoid this unfair treatment and to impose equitable limits on the bargaining
away of arrearages by the preference shareholders, some standards of fairness have
been developed, although unsuccessfully, by legal scholars . The funding theory, the
liquidation standard, the investment value doctrine and the surplus test standard were
supposed to evaluate the fairness of the consideration given in exchange. 66 Unfortu­
nately, these efforts proved to be useless and inappropriate, so that the courts almost
never adopted them. Instead, the law in this area became practically mechanical and all
the arrearage eliminations that were minimally consistent with statutory and certificate
provisions were permitted . 67 In merger transactions, when ' constructive fraud' , 'bad
faith' or 'gross unfairness' of the management could not be demonstrated, courts did
not void arrearage eliminations . 6 8 The sole source of protection for preference share­
holders against questionable arrearage elimination was the preference share contract,

63 . L.C . B . Gower, Principles of Modem Company Law 3 64 (4th ed. , Stevens & Sons 1 9 79) , points
out the need for protection for the preference shareholders because 'though they share the
disadvantages of debenture-holders they lack their advantages' .
64 . Johnson v. Fuller (3d Cir. 1 94 1 ) , 1 2 1 F. (2d) 6 1 8; Kreicker v. Naylor Pipe Co. , 3 74 Ill . 3 64, 29 N.E.
2 d 502 ( 1 940) .
65 . W.L. Cary & M. Eisenberg, Cases and Materials on Corporations 1 620 (Sth ed. , New York:
Foundation Press 1 980) .
66 . See V. Brudney, Standards of Fairness and the Limits of Preferred Stock Modifications, Rutgers
L. Rev. 26, 469 , n. 56 ( 1 973) where he says 'the funding theory measures the arrearage claim
by the discounted present value of its anticipated payment over a period of years. See Note: The
Doctrine of Strict Priority in Corporate Recapitalization, Yale L. J . 54, 840 ( 1 945 ) where it is
explained the liquidation standard would entitle preference shareholders to their liquidation
preference upon approval of a proposal to eliminate arrearages. Arrearages elimination would
be treated as triggering the maturation of the preference shareholders ' liquidation priority. See
E.M. Dodd, Fair and Equitable Recapitalizations, Harv. L. Rev. 5 5 , 8 1 2 and 8 1 6 ( 1 942) where
he says the investment value doctrine would reduce arrearages as well as a stock' s projected
dividend stream to present values . These values would then be added together and the sum
would constitute the consideration the preference shareholders must receive in exchange for
their arrearages .
67. Johnson v. Fuller (3d Cir. 1 94 1 ) , 1 2 1 F. (2d) 6 1 8 ; Barrett v. Denver Tramway Corp. , 53 F. Supp.
198 (D . Del . 1 944) ; Western Foundry Co. v. Wicker, 403 Ill . 260, 85 N . E .2d 722 ( 1 949) ; O 'Brien
v. Socony Mobil Oil Co. , 207 Va . 707, 1 52 S . E. 2d 278, cert. denied, 389 U . S . 825 ( 1 967) .
68 . Porges v. Vadsco Sales Corp. , 2 7 Del Ch. 1 2 7 , 32 A.2d 1 48 ( 1 943) ; Hottenstein v. York Ice Mach.
Corp. , 136 F.2d 944 (C. C. A. 3d 1943) ; Bove v. Community Hotel Corp. of Newport, R. I . , 1 05 R . I .
36, 249 A . 2 d 89 ( 1 969) . See R.M. Buxbaum, Preferred Stock-Law and Draftsmanship, Cal . L .

1 16
Chapter 5 : Significant Corporate Decisions § 5 . 02 [A]

namely the applicable statutory provisions and the company' s certificate of incorpo­
ration. 69
Despite the fact that some commentators argued that the market price of
preference shares already reflected the arrearage elimination risk inherent in owning
preferred stock and thus the prospective investors were fully informed of these risks, 70
in many cases , recapitalization was only a remote possibility at the time that preference
shares were issued and artificial structure built up by the ordinary shareholders in
order to avoid the dividend payments to the preferred shares was an even more remote
expectation. 71 The law cannot or at least need not assume that market-pricing
processes make arrearage elimination fair. Every case has to be analysed separately to
understand where a real abuse of the maj ority has occurred. Arrearage elimination
alters a fundamental characteristic of a preferred stock, that is the right to receive a
preferential dividend . 72
The Revised Model Business Corporation Act (RMBCA) entitles the preferred
stockholders a vote on amendments that may prejudice their interests . 7 3 In addition,
the law has always facilitated a fair bargaining between the company and the preferred
stockholders, leaving the parties free to include extra provisions in their contract. Most
preferred issues stipulated that the preferred stockholders could elect directors,
normally two , if the preferred dividends were in arrears for a period of six quarters . 74
In order to protect minorities in relation to their class rights, British regulators
introduced the provisions contained in sections 1 25 - 1 2 7 of the CA 1 985 and now
sections 630-633 of the CA 2006 . These provisions applied only to companies 'whose
share capital is divided into shares of different classes' , but the new legislation at
section 63 1 (CA 2006) extended to all companies following a recommendation of the

Rev. 42, 3 0 1 ( 1 954) : ' Lack of fairness of a particular plan independently of the admitted power
to promulgate it is no longer an independent criterion of validity in most jurisdictions ' .
69 . R.M. Buxbaum, Preferred Stock-Law and Dra�smanship, Cal . L. Rev. 42 , 243 ( 1 954)
70. This view follows from the efficient-market hypothesis under which stock prices reflect all
securities information in the public domain. See R. Posner, Economic Analysis of Law para .
1 5 .4 (Boston: Little, Brown 1 986) .
71 . For empirical evidence showing ' no statistically significant market reaction to any of . . . seven
major decisions ' of the Delaware courts studied see E.J. Weiss & L.J . White, Of Econometrics
and Indeterminacy: A Study of Investors ' Reactions to 'Changes ' in Corporate Law, Cal. L. Rev.
75, 5 5 1 and 553 ( 1 98 7) .
72 . In fact, non-cumulative preference shares are very rare, considering that they cannot be easily
sold to the public since they do not guarantee any fixed dividend to their shareholders and they
subordinate the payment of a dividend, first to the existence of the profits in the final accounts
of a firm and then to the discretion of the board of directors . See W.L. Cary & M. Eisenberg,
Cases and Materials on Corporations 1 1 1 8 (5th ed. , Foundation Press 1 980) .
73 . Revised Model Business Corporation Act (RMBCA) § § 1 0. 03 (e) , 1 0 . 04, 1 1 . 04, 1 2 . 02 , 1 4 . 02 ; in
Delaware DGCL § § 242 (b) , 25 1 , 2 7 1 , 275; in New York NYBCL § § 803-804 , 903 , 909 ,
1 00 1 - 1 002 . For US cases see Dalton v. American Investment Co. , 490 A.2d 5 74 (Del . Ch. 1 985) ;
Bove v. Community Hotel Corp. , 1 05 R.I. 36, 249 A.2d 89 ( 1 969) .
74 . See NYSE Listed Company Manual, § 3 1 3 .00 (e) (C) (previous New York Stock Exchange
Company Manual, 1 984, A-282) ; American Stock Exchange AMEX Listing Standards, Policies
and Requirements, § 1 24. See Baron v. Allied Artist Pictures Corporation, 3 3 7 A.2d 653 (Del. Ch .
1 975) . Exceptions to this listing policy are frequent .

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§ 5 . 02 [A ] Lorenzo Sasso

CLR. 75 Unlike the CA 1 985, under the new Act it is no longer possible for class rights to
be set out in the memorandum, 7 6 and where class rights attaching to shares in an
existing company are specified in the memorandum, these will be deemed, by virtue of
section 28, to be a provision in the company's articles . Class rights can be attached to
the shares by the articles, the terms of issue, an agreement or a resolution. Under the
previous CA, while it was clear that when the articles contained a procedure for the
variation of class rights, that procedure had to be followed, it was uncertain whether in
the absence of such a procedure class rights were not variable at all without the consent
of each individual shareholder affected or whether they could be varied simply by
using the normal variation procedure set out in section 2 1 of the CA 2006 (previous
section 9 CA 1 985) , which would give the minority members of the class very little
protection. 77
If the company' s articles do not provide a variation procedure, section 630
subsections (2) and (4) provide that class rights may be varied either where holders of
at least three-quarters in nominal value of the issued shares of that class consent in
writing, or if a special resolution passed by the holders of that class sanctions the
variation. This means that the articles may specify a less demanding procedure for a
variation of class rights than the statutory scheme or a more onerous regime. However,
the provisions of section 630 are expressed to be 'without prejudice to any other
restriction on the variation of rights ' . 78 Therefore, if and to the extent that the company
has adopted a more onerous regime in its articles for the variation of class rights, for
example by requiring a higher percentage than the statutory minimum, the company
must comply with it. In addition, if and to the extent that the company has protected
class rights by making provision for the entrenchment of those rights in its articles, 79
that protection cannot be circumvented by changing the rights attached to a class of
shares under this section. 80

75 . Final Report, para . 7.28. Eventually these recommendations have been introduced in the new
Company Act 2006 where the new s . 1 2 5A extends the statutory provisions on variation of class
rights to companies without a share capital, as for instance the companies limited by guarantee
that, since December 1 980, cannot be formed with a share capital. These companies may, for
example, have different classes of members with different voting rights. Before, the question of
how members' rights could be varied depended to a large extent on whether provision had
been made, either in the memorandum or articles, for their variation. This clause inserts a new
provision, comparable to those for companies with a share capital. Thus there is a minimum
requirement that class rights may be varied if three-quarters of that class consent in writing or
a special resolution of those members sanctions the variation. Again, where there is a higher
requirement in the articles or elsewhere, this would apply. This protection goes towards the
direction of Cumbrian Newspapers Group Ltd v. Cumberland & Westmorland Herald Ltd [ 1 98 7)
Ch. 1 . See P.L. Davies, Gower and Davies ' Principles of Modem Company Law 502 (7th ed. ,
Sweet & Maxwell 2003) ; D . Kershaw, Company Law in Context: Text and Materials 670 (Oxford
U. Press 2009) .
76. See the Companies Act 2006, s. 8.
77. Ref Cumbrian Newspapers Group Ltd v. Cumberland & Westmorland Herald Ltd [ 1 987] Ch. 1 .
78 . See CA s . 630 (3) .
79. See CA 2006 s. 22 .
80. See CA 2006 s . 630 (5) . In the previous CA, the function of the memorandum was to provide a
way of entrenching class rights, and the level of protection for the preference shareholders
depended on it. If there was no variation of rights clause in the company' s constitution
applicable to those rights, then the rights were variable only with the unanimous consent of the

1 18
C h ap t e r 5 : Significant Corporate Decisions § 5 . 02 [B]

This procedure contained in section 630 of the CA 2006 does not apply to
corporate actions that may affect the rights of a particular class of shareholders without
varying those rights . The courts has generally drawn a distinction between the rights
themselves and the mere enj oyment of those rights , namely between rights affected as
a 'matter of law' and as a 'matter of business' . 8 1 Whether the rights are affected as a
matter of law, the remedy included in section 633 of the CA 2006 confers a right on
dissenting preferred shareholders holding not less than an aggregate of 1 S % of the
issued shares of the class in question to object to a variation of class rights applying to
the court, within twenty-one days after the consent was given, for the variation to be
cancelled. The appeal to the court freezes the effects of the variation made . The court
on hearing the application may disallow the variation or confirm it and the 'decision of
the court is final' . 82

[B] What Constitutes a Variation of Class Rights?

There has been much controversy and confusion as to what constitutes a variation of
class rights, especially in relation to the negative effect that a 'variation' could generate.
Generally no problems have ever arisen when a majority decided a variation of class
rights by adding new rights or enhancing some existing rights without reducing any
other powers to that class of shareholders . However, a distinction is made between the
rights themselves and the mere enj oyment of those rights, namely between rights
affected as a ' matter of law' and as a ' matter of business' . 8 3
An act of the company, which impinges only on the enjoyment of rights as for
instance a subdivision or increase of one class of shares, will not amount to a variation
of the rights, even if the result can be the alteration of the voting equilibrium of the
classes . 84 In the same way, mere economic disadvantage to preference shareholders is

members (s. 1 2 5 n. 5) or under a scheme of arrangement (s . 1 2 6 and s . 425 of the CA 1 985) . If

the rights were attached by the memorandum and their variation was expressly prohibited,
only a scheme of arrangement would have been effective to vary the rights . Even if there was
a variation procedure applicable to the rights attached by the memorandum, it would have
provided the operative procedure only if the variation clause was part of the articles at the time
of the company' s incorporation and the variation was not concerned with the giving authority
for the allotment of shares or with a reduction of capital (s . 1 2 5 n. 4) . If one of these conditions
was not satisfied, the statutory procedure was required (s. 1 2 5 n. 3) .
81 . The words are those of M.R. Greene in Greenhalgh v. A rdeme Cinemas [ 1 946] 1 All E.R. 5 1 8 .
See also in White v. Bristol Aeroplane Co. Limited [ 1 95 3 ] 1 All E R 5 1 8 ; Dimbula Valley (Ceylon)
Tea Co. Ltd v. Laurie [ 1 96 1 ] Ch 3 5 3 .
82 . See CA 2006 s . 633 (5) . However, according to ss 459-46 1 ' a member of a company may apply
to court by petition for an order under this Part on the ground that the company' s affairs are
being or have been conducted in a manner which is unfairly prejudicial to the interests of its
members . . . ' (s. 459) . See Re Suburban and Provincial Stores Ltd [ 1 943] Ch. 1 56, CA. See also
Re Sound City (Films) Ltd [ 1 947] Ch. 1 69 , which seems to be the only officially reported case
on s. 1 2 7 and its predecessors . Cases in which it might have been invoked (Rights & Issues
Investment Trust v. Stylo Shoes Ltd [ 1 965] Ch. 250) have been taken instead under ss 459-46 1 .
83 . M . R . Greene in Greenhalgh v. Ardeme Cinemas [ 1 946] 1 All E.R. 5 1 8.
84. Greenhalgh v. Ardeme Cinemas [ 1 946] 1 All E.R. 5 1 2 , CA, where the result of the subdivision
was to deprive the holder of one class of his power to block a special resolution. See also White

1 19
§ 5 . 02 [B] Lorenzo Sasso

not sufficient to amount to a variation. 8 5 When preference shares are non-participating

with respect to dividend, but participating with respect to capital on a winding up or
reduction of capital, a capitalization of undistributed profits in the form of a bonus
issue to the ordinary shareholders is not a variation of the preference shareholders '
rights, notwithstanding that the effect is to deny them their future participation in those
profits . 8 6
The restrictive approach taken by the courts is also clear in other cases regarding
operations on the equity capital. For instance, a reduction of capital by repayment of
irredeemable preference shares in accordance with their rights on a winding up was not
regarded as a variation or abrogation of their rights; 8 7 nor was an issue of further shares
ranking pari passu with the existing shares of a class . 88 And where there were
preference and ordinary shares, an issue of preferred ordinary shares ranking ahead of
the ordinary but behind the preference was not a variation of the rights of either
existing class. 8 9 Because the approach of the courts was more targeted at guaranteeing
a company' s flexibility in its going concern than a full protection of the minority, it has
become common to introduce special provisions into a company' s articles to protect
preference shareholders and it is possible to construct a variation of rights clause
covering actions affecting the value of the shares as a matter of business . 9 0 In such
cases, very careful drafting will have to be used if such a provision is to be construed
as affording any greater safeguards . 9 1 In a famous case of variation of class rights, 9 2 the

v. Bristol Aeroplane Co. [ 1 95 3 ] Ch. 65, CA, Re John Smith 's Tadcaster Brewery Co. [ 1 953] Ch.
308, CA. See recently, Citco Banking Corporation NV v. Passer 's Ltd [2007] UKPC 1 3 .
85 . See for example Adelaide Electric Co. v. Prudential Assurance [ 1 934] A.C. 1 22 , HL, where the
alteration in the place of payment of a preferential dividend from England to Australia did not
vary the rights of the preference shareholders, notwithstanding that the Australian pound was
worth less than the English one.
86. Dimbula Valley (Ceylon) Tea Co. v. Laurie [ 1 96 1 ] Ch. 3 5 3 . Also see Re Mackenzie & Co. Ltd
[ 1 9 1 6] 2 Ch . 450 in P . L. Davies , Gower and Davies ' Principles of Modern Company Law 500 and
n. 89 (7th ed . , Sweet & Maxwell 2003 ) ; D . Kershaw, Company Law in Context: Text and
Materials 67 1 (Oxford U. Press, 2009) .
87. Scottish Insurance Corp. v . Wilson & Clyde Coal Co. [ 1 949] A. C. 462 , HL; Prudential Assurance
Co. v. ChatteRailway Whitfield Collieries [ 1 949] A.C. 5 1 2 , HL, and this is so even if they are
participating as regards dividends: Re Saltdean Estate Co. Ltd [ 1 968] 3 All ER 829; House of
Fraser v. AGCE Investments Ltd [ 1 987] A.C. 387, HL (Sc.) (this of course does not apply if they
are expressly given special rights on a reduction of capital) . But contrast with Re Old Silkstone
Collieries [ 1 954] Ch. 1 69, CA where confirmation of the repayment was refused because it
would have deprived the preference shareholders of a contingent right to apply for an
adjustment of capital under the coal nationalisation legislation .
88. This is expressly provided in Table A 1 948 , Art. 5 , but the position seems to be the same in the
absence of express provision: see the case cited above, but contrast with Re Schweppes Ltd
[ 1 9 1 4] 1 Ch. 322, CA, which, however, concerned s . 45 of the 1 908 Act, which forbade
' interference' with the 'preference or special privilege' of a class .
89. Hodge v. James Howell & Co. [ 1 958] C.L.Y. 446, CA, The Times (13 Dec. 1 958) . See also
Underwood v. London Musical Hall Ltd [ 1 90 1 ] 2 Ch. 309, where an issue of preference shares
ranking pari passu with existing preference shares was not a variation of class rights.
90. Re Northern Engineering Industries Plc [ 1 994] 2 B .C.L.C. 704, CA, where a clause in the articles
deeming a reduction of capital to be a variation of rights was upheld and enforced when the
company proposed to cancel its preference shares .
91 . See White v. Bristol Aeroplane Co. [ 1 95 3 ] Ch. 65 , CA, Re John Smith 's Tadcaster Brewery Co.
[ 1 953] Ch. 308, CA.
92 . White v. Bristol Aeroplane Co. [ 1 953] Ch. 65 , CA.

1 20
Chapter 5 : Significant Corporate Decisions § 5 . 02 [C]

relevant clauses referred to class rights being ' affected, modified, dealt with or
abrogated' . Even if, in the first instance, the judge considered their rights to be affected
by the decision of the ordinary shareholders, the Court of Appeal reversed the decision
because it believed only the holders' enj oyment of those rights was affected. 93

[C ] Legal Strategies for Preference Shareholders

In fundamental changes and especially in mergers, preference shareholders can

potentially be victims of the management' s opportunistic behaviour favouring their
self-interest or the majority shareholders . The law provides certain requirements that
give shareholders - included preferred shareholders - the means to challenge a merger
driven by managerialism. In the EU rules contain a requirement for an expert' s
report. 94 In addition UK company law provides two valuable tools to deal with
corporate restructuring and mergers. 95 These are the possibility to use a scheme of
arrangement under section 895 of the Companies Act 2006 or, especially for small
companies, a solvent winding up under section 1 1 0 of the Insolvency Act 1 986 to
transfer or sell the whole or part of a company' s business or property to another
company.
A scheme of arrangement involves several stages . When an arrangement is
proposed, the main concern is whether the members and creditors should be split into
different classes for the purposes of voting on the scheme. Following the issue of the
Practice Statement in 2002 , any potential problems must be drawn to the court ' s
attention by the applicant company at the initial stage. 9 6 Then meetings o f those parties
impacted by the scheme are held. If an issue of identifying classes is brought to the
court' s attention, the court will then decide whether to postpone the meeting in order
to resolve the issue and evaluate how those particular parties would be affected by a
scheme. The dissenting parties could argue that the maj ority did not fairly represent the
class . The court has full discretion whether to sanction the scheme even if meetings
have approved it. However the approach of the court to date has always been to reduce
the chances of success of the dissenting parties opposing the scheme on this ground. 97

93 . In Australia, the result of White v. Bristol Aeroplane Co. has been reversed by s . 1 97 n. 8 of the
Corporations Law, which deems the allotment of preference shares ranking equally with
existing preference shares to be a variation of the rights attached to existing preference shares
unless it was expressly authorised when the existing preference shares were allotted.
94 . If the requisite of the substantial approval is not obtained or the meetings have not been
properly conducted the court approval of the scheme can be made mandatory. See P . L. Davies,
Gower and Davies ' Prindples of Modem Company Law para . 29-9 (9th ed. , Sweet & Maxwell
20 1 2) . See the requirement in Council Directives 78/85 5/EEC and 82/89 1 /EEC later amended
by Directive 2007 /63/EC where in Art. 1 0 it is stated: ' Neither an examination of the draft terms
of merger nor an expert report shall be required if all the shareholders and the holders of other
securities conferring the right to vote of each of the companies involved in the merger have so
agreed. '
95 . P .L. Davies, Gower and Davies ' Prindples of Modem Company Law 1 1 1 7- 1 1 23 (9th ed. , Sweet
& Maxwell 20 1 2) .
96. Practice Statement (Ch D: Scheme of Arrangement with Creditors) [2002] 1 WLR 1 345 .
97. The test was set b y Bowen LJ in Sovereign Life Assurance Co. v. Dodd [ 1 892] 2 QB 5 7 3 , 583 and
then refined by Chadwick LI in Re Hawk Insurance Ltd [200 1 ] EWCA Civ 24 1 ; [2002] BCC 300.

121
§ 5 . 02 [C] Lorenzo Sasso

The rationale is that an increase of the class meetings would undermine the scheme' s
effectiveness and consequently weaken its usefulness as a statutory tool for compa­
nies . 9 8
Schemes, therefore, could raise issues of minority oppression. In fact, if a scheme
is approved it will bind all of the affected creditors and members, even if they dissent.
It is the court' s role to take into account all the reasons and exigencies of the parties and
counterbalance the minority protection with the company' s interest. In order to do it,
the court has generally drawn a line of distinction between solvent and insolvent
schemes for the purpose of finding the correct comparator to define the classes
impacted by the scheme. In fact, not all the company' s securities may be affected by a
scheme. In cases in which the company was in bad financial distress, the court
approved a scheme despite the lack of consent of the ordinary shareholders . 99 The
same principle was used to exclude a group of deferred creditors 1 00 and a group of
mezzanine lenders where the value of the assets of the company was significantly and
demonstrably less than the value of the senior debt. 1 01
Despite of all, in practice schemes are predominantly adopted as an alternative to
a takeover or to effect an arrangement between a company and its creditors where the
company is in financial distress . This is for several reasons . First because a scheme
used to effect a merger is more uncertain in its success . While in a transfer of shares by
way of a takeover, shareholders can decide on the transfer approval, in a scheme of
arrangement, each category, whether members or creditors, has an opportunity to veto
it. Moreover, in certain circumstances, mergers and divisions of public companies
share additional requirements imposed by the EU company law directives. 1 02 However,
these constraints do not apply where a scheme is used to effect a takeover because the
bidder and the target remain separate companies after the scheme has been effected.
Furthermore, for smaller companies wishing to effect a merger a more appealing
alternative may be provided by section 1 1 0 of the Insolvency Act 1 986. Accordingly, a
solvent winding up can be effected to transfer the business of the company. In contrast
with the scheme, as long as a members ' voluntary liquidation is used, no confirmation
by the court is required. However, in this case the company must be solvent. In
addition, whereas under a scheme of arrangement, once the court has sanctioned it,
dissenters are bound, under section 1 1 0 procedure the parties retain a right to exit at a
fair value. 10 3
In the US, public companies pursuing a merger customarily seek to protect
themselves from preferred shareholder suits by soliciting fairness opinions from
investment bankers, which shareholders can peruse before they vote . 1 04 This increases

98. It has not occurred to date that the court accepted not to sanction a scheme on this basis.
99. Re Tea Corporation Ltd [ 1 904] 1 Ch. 1 2 .
1 00 . R e British & Commonwealth Holdings plc (No 3) [ 1 992] BCL 323 .
101. Re Bluebrook Ltd [2009] EWHC 2 1 1 4 (Ch) ; [20 1 0] BCC 209.
1 02 . Counsel directives 78/85 5/EEC and 82/89 1 /EEC also known as Third and Sixth directives .
1 03 . Insolvency Act 1 986, s . 1 1 1 . However, reorganizations under s. 1 1 0 can be extremely expensive
if a certain number of members elect to be bough out .
1 04 . See for example, Smith v. Van Gorkom, 488 Atlantic Reporter (A.2d) 858 (Delaware Supreme
Court 1 985) where the sale of a company without a valuation report and with little deliberation
is grossly negligent despite the premium price.

1 22
Chapter 5 : Significant Corporate Decisions § 5 . 02 [C]

the efficiency of shareholder voting, although may not be always sufficient. Most US
states however, though not Delaware, 10 5 provide appraisal rights for charter amend­
ments that materially affect the rights of dissenting shareholders . 106 They allow
dissenting shareholders to have the fair value of their shares determined by a court
appointed appraiser offering them an exit option. In other words, a dissatisfied
shareholder can escape the financial effects of an organic change approved by the
maj ority, by selling his or her shares back to the corporation in certain circumstances
at a reasonable price - the fair value - determined by the appraiser. 10 7
The appraisal remedy was meant to protect shareholders as a class also by
making unpopular decisions more expensive for management to pursue . In practice,
however, cumbersome procedures, delay and uncertainty have discouraged small
shareholders from seeking appraisal rights. In addition, many US states further limit
appraisal rights by introducing a so-called stock market exception to their availability
in corporate mergers . 1 08 Accordingly, shareholders do not receive appraisal rights if the
merger consideration consists of stock in a publicly traded company rather than cash,
debt, or closely held equity. There are two reasons for this : appraisal rights ought to
protect the liquidity rather than the value of minority shares, and the valuation
provided by the market, while imperfect, is unlikely to be systematically less accurate
than that provided by a court. However, in light of this, it is unclear why appraisal
rights are available when shareholders receive cash, this hypothesis being the most
liquid merger consideration possible. 1 09 Therefore, appraisal rights are of little use to
shareholders who wish to challenge the price they receive in stock mergers between
public companies. 1 1 0 These difficulties may explain why community law does not

1 05 . See Sullivan Money Management Inc. v. FLS Holding Inc. , Del. Ch. C.A. No. 1 2 73 1 , 18 Del. J .
Corp . L. 1 1 83 , 1 1 90, [ 1 993 Del. LEXIS 25 1 ] 1 992 W L 345453 (20 Nov . 1 992) , aff' d, Del. Supr. ,
628 A.2d 84 ( 1 993) ; Warner Communications Inc. v. Chris-Craft Industries, Inc . , 583 A.2d 962
( 1 989) . More recently, Benchmark Capital Partners IV, L. P. v. Vague, 2002 WL 1 732423 (Del .
Ch. 2002) ; Glazer v. Pasternak, 693 A.2d 3 1 9 (Del. 1 997) . Not all the states have adopted the
Act' s provisions or similar provisions with regard to all the devices used by the companies to
vary preference shareholders' class rights, because they felt the appraisal rights to be too costly
to pursue or too difficult to perfect when they required severance of the dissenting sharehold­
er' s interest in the corporation. B. Manning, The Shareholder's Appraisal Remedy: An Essay for
Frank Coker, Yale L. J . 72 , 223 and 226 R ( 1 962) ; J.F. Stamler, Arrearage Elimination and the
Preferred Stock Contract: A Survey and a Proposal for Reform, Cardozo L. Rev. 9 1 3 54- 1 3 59
( 1 988) ; N . D . Lattin, Minority and Dissenting Shareholders ' Rights in Fundamental Changes, L.
& Contemp . Probs. 23, 307 and 3 1 2 ( 1 958) ; Valuation of Dissenters ' Stock under Appraisal
Remedy: An Essay for Frank Coker, Yale L.J . 72, 1 45 3 ( 1 966) ; Protection for Shareholder
Interests in Recapitalizations of Publicly Held Corporations, Colum. L. Rev. 58, 1 040, 1 05 8 and
1 068 ( 1 958) .
1 06 . The Model Business Corporation Act § § 1 3 . 0 1 - 1 3 . 3 1 (3d ed . , Supp . 1 98 7) was designed to
'motivate the parties to settle their differences in private negotiations' , see Introductory
Comment at 1 3 54. Introduced in the New York Business Corporation Law § 903 . See for the US
cases .
1 07 . H . G . Henn, Handbook of the Law of Corporations and Other Business Enterprises 997 and 1 002
(3d ed. , St. Paul, Minn. 1 983) .
1 08 . § 1 3 . 02 RM BCA; § 262 DGCL.
1 09 . § l l . 04 (f) RMBCA
1 1 0 . See P. Mahoney & M. Weinstein, The Appraisal Remedy and Merger Premiums, Am. L. & Econ.
Rev. l , 239 ( 1 999) where the authors observe 1 ,3 5 0 mergers involving public companies from

1 23
§ 5 . 03 Lorenzo Sasso

require appraisal rights as an element of the merger process , although they are offered
on a limited basis in some jurisdictions . 1 1 1
Finally in exchange offers transactions, three types of covenant were commonly
used to protect the preference shareholders : the requirement of consent to create new
prior stock, to increase existing amounts of preferred stock and to increase existing
amounts of prior preference shares . However, these covenants proved to be quite
ineffective, since it was possible and common for a company, when it issued a new
class of shares, to delegate to the directors the power of setting privileges for each series
issued without amending the articles, simply by nominating a ' series' of an already
authorized blank class. 1 1 2

§5 .03 SHAREHOLDER-CONVERTI B LE BONDHOLDER AGENCY

PRO BLEMS

There are situations in which the management has the incentive and the ability to
increase the company' s level of risk through the adoption of significant decisions or
investment policies that do not necessarily maximize the value of the firm as a whole
but simply benefit shareholders by transferring wealth away from bondholders . In so
doing, the risk of loss passes to the bondholders, since the shares are protected by the
company' s limited liability, but the potential gain mostly benefits the shareholders
because the return on bonds is limited. 1 1 3 Asset substitution or the risk-shifting
problem is opportunistic behaviour that concretizes when managers liquidate some
assets to reinvest the money in additional risky projects, increasing the grade of risk for
which the investors accepted to finance the company. 1 1 4 This manager-creditor conflict
is a typical agency cost of debt. 1 1 5
This opportunism i s common, for instance, in the sale o f assets, especially when
it reaches the level of disposal of substantially the whole of the company' s assets . This
type of occurrence is usually the result of corporate restructuring or is a prelude to a
merger or to the cessation of business . Such a transaction may jeopardize the lender
because it literally separates the assets for which the loan was contributed from the
company that contracted the debt contract, leaving the lender with no sufficient

1 975- 1 99 1 ; J. Seligman, Reappraising the Appraisal Remedy. Geo. Wash. L. Rev. 52, 829
( 1 984) . where he observed 20 mergers from 1 972- 1 98 1 .
111. Rock et al . , Fundamental Changes. in The Anatomy of Corporate Law: A Comparative and
Functional Approach 1 9 1 (R. Kraakman et al. eds . , 2d ed. , Oxford U. Press 2009) .
1 12. R.M. Buxbaum, The Internal Division of Powers in Corporate Governance, Cal . L. Rev. 73, 1 685
( 1 985) .
1 13. R. Green, Investment Incentives Debt and Warrants. J . Fin. Econ. 1 3 , 1 1 5- 1 36 ( 1 984) ; M . P .
Narayanan, O n the Resolution o f Agency Problems by Complex Financial Instruments: A
Comment. J . Fin. 42 , 1 083 ( 1 98 7) ; R.A. Haugen & LW Senbet, Resolving the Agency Problems of
External Capital Though Options. J . Fin. 36, 629 and 640 ( 1 98 1 ) .
1 14 . See C.M. Lewis, R.J. Rogalski & J . K. Seward, Agency Problems. Information Asymmetries and
Convertible Debt Security Design. J . Fin. Intermediation 7. 32-59 ( 1 998) where the authors state
'the relevant risk is not only the risk of the company' s existing operations, but also the risk of
any future operations in which the company may become involved over the life of the bond ' .
1 1 5. M. Jensen & W. Meckling, Theory o f the Firm: Managerial Behavior, Agency Costs and
Ownership Structure, J . Fin . Econ. 3 , 350 (1 976) .

1 24
Chapter 5 : Significant Corporate Decisions § 5 . 03 [A]

collateral for satisfaction. Any sale of producing assets raises questions concerning the
adequacy of the sale price and the reinvestment of the proceeds . A similar result is
obtained if managers, looking for an increased access to liquidity, actively trade
subsidiaries and divisions in a market for going concern assets, often through asset
securitization. The danger is that assets that would previously have been available to
repay the borrower' s creditors will be claimed first by the creditors of the transferee
subsidiary. 1 1 6
A lender cannot explicitly direct the use of asset sales proceeds to a particular
project viewed with favour, because of the limited liability constraint, which prevents
the dictation of positive instructions . However, the borrower company can be re­
stricted, subj ect to limited exceptions , by actions such as making acquisitions or
disposals, changing the nature of its business and by merging with other companies. 1 1 7
Mergers and consolidations, included takeovers , pool the assets and liabilities of two or
more corporations into a single corporation, which is either one of the combining
entities (the surviving company) or an entirely new company (the emerging company) .
The result is that the conversion right would be destroyed for all practical purposes,
given that after the merger or takeover becomes effective, there will be no market in the
shares of the issuer, which would have become a subsidiary of the bidder. A merger
could damage a lender even though the surviving corporation is a larger firm, because
its claim will be diluted and subordinated to other claims . In all the above-mentioned
cases, the convertible bondholders need to protect the fragile nature of the conversion
privilege . 1 1 8

[ A] The Protection of Convertible Bondholders in Mergers and

Acquisitions

European jurisdictions offer special protections to creditors when firms undergo

mergers and similar organic changes . Although creditors lack the power to stop
mergers, they are entitled to demand adequate safeguards when a merger puts their
claims at risk. 1 1 9 These safeguards often extend to a requirement that their claims be
secured by the surviving or emerging company or that their claims be discharged
before the merger, which may act as a disincentive to merger. In the US, where the
jurisdictions seem to be less creditor-friendly than in the EU, the protection of creditors
can be achieved contractually in two ways : prohibiting some types of conduct that
would dilute or destroy the conversion privilege with the use of appraisal rights, 1 20 or

1 1 6 . E. Ferran, Company Law and Corporate Finance 5 1 7-520 (Oxford U. Press 1 999) .
1 1 7 . See S . C . Myers, Determinants of Corporate Borrowing, J . Fin. Econ. 5 , 1 56- 1 58 ( 1 977) ; C . W.
Smith & J . B . Warner, On Financial Contracting: An Analysis of Bond Covenants, J. Fin. Econ.
7, 1 53 ( 1 979) .
1 1 8 . W.W. Bratton, The Economics and Jurisprudence of Convertible Bonds, Wis . L. Rev . 700 et seq.
( 1 984) .
1 1 9 . Article 1 3 Third Company Law Directive.
1 20 . Generally, voting rights are not an exclusive prerogative of shareholders . Other stakeholders
may also have the right to vote in certain determined situations . See 56 Del. Laws, c. 50, s . 22 1
( 1 967) , which states : 'every corporation may in its certificate of incorporation confer upon the

1 25
§ 5 . 03 [A] Lorenzo Sasso

requiring notice to convertible bondholders in advance of a particular event, such as

merger or reconstruction, which would enable exercise of the privilege prior to the
event taking place. While the latter is a more flexible approach, the former largely
reduces corporate management discretion and issuers often resist the imposition of
such clauses in practice. It may also be the case that under the law of the place of
incorporation a fetter on corporate power by such contractual provision is void . 12 1
Covenants dealing with prospective mergers range from very permissive to very strict.
Available modes of regulating these transactions are to subordinate the permission of
the merger to the compliance of the borrower with all covenants ex post the merger or
to a right of redemption in the lender (put option) . 1 22 Alternatively, a notice provision
clause requires the issuer to give specific notice to convertible bondholders after the
public announcement of an impending takeover, merger, consolidation or reconstruc­
tion, so that convertible bondholders may exercise their conversion option, if they so
wish. 12 3
In the case of an occurrence similar to a takeover bid, notice provisions are
usually linked to an obligation on the part of the issuer of the convertible to procure a
like offer that is extended to the holder of any ordinary shares allotted or issued to
convertible bondholders who exercise their conversion rights during the period of such
an offer. This obligation would be owed primarily to the trustee of the bond issue if
there were a trust deed and would in practice be contained in the trust deed. In the case
of mergers, consolidations and reconstructions, which result in the issuer ceasing to
exist as an entity, the notice provisions are linked to a clause that imposes on the issuer
an obligation to procure that the corporation which results or survives from the merger
executes legal instruments or documents legally necessary to ensure that each convert­
ible bondholder is not prejudiced by the mergers , consolidations or reconstructions.
This is achieved by requiring the issuer to ensure that convertible bondholders shall
have rights of convertibility into the amount of shares or other securities or property
that they would have received had they converted prior to the merger, consolidation or
reconstruction. It is important to point out that these provisions are only of benefit to
the convertible bondholder when the market price of the issuer, at the date of the
announcement of the transaction, is above the conversion price. If the market price
were below the conversion price the consequences for the convertible bondholder
would be highly disadvantageous, even with the benefit of the clauses . 1 2 4

holders of any bonds, debentures or other obligations issued or to be issued by the corporation
the power to vote in respect to the corporate affairs and management of the corporation to the
extent and in the manner provided in the certificate of incorporation [ . . ] . A similar provision
. '

is contained in the New York Business Corporations Law.

121. As for example in many European jurisdictions .
1 22 . W . W . Bratton, Bond Covenants and Creditor Protection: Economics and Law, Theory and
Practice, Substance and Process, EBOR 7, 55 et seq. and 63 et seq. (2006) .
123. Notification prior to the announcement of such an event may breach provisions in applicable
insider dealing laws such as the UK' s Company Securities (Insider Dealing) Act 1 985 and the
comparable rules in the US developed under rule l Ob-5 of the US Securities Exchange Act 1 934.
1 24 . See the US case of Broad v. Rockwell International Corporation 642 F2d 929 ( 1 98 1 ) , where
Collins, a radio company incorporated in the State of Iowa, issued USO 40 million aggregate
principal amount of convertible bonds maturing in 1 987 at a low coupon rate. Collins ' stock
was trading at around USO 60 per share at the time of the issue and the conversion price of the

1 26
Chapter 5 : Significant Corporate Decisions § 5 . 03 [A]

On the other hand, according to the courts of common law, convertible bond­
holders are entitled only to such shares, cash or other property that the trust deed
provides for. It would be impossible under English law, by appropriate clauses in a
convertible bond instrument or trust deed, to impose direct obligations on a bidder in
a takeover offer for the issuer of the convertible bondholders in the company, due to
the absence of contractual privity. For this reason, the bond instrument and the trust
deed impose obligations only on the issuer and the trustee when the issuer is subject to
a takeover bid . As regards convertible securities issued by UK companies, a degree of
protection against the takeover of an issuer is provided in Rule 1 5 of the City Code on
Takeovers and Mergers . Although express consent is generally not required in convert­
1 5
ible bond issues , 2 under Rule 1 5 where an offer is made for the equity share capital
of a company, an ' appropriate offer' must also be made to the holders of convertible
securities and equality of treatment is required . 1 26
According to Rule 1 5 (a) , the adequacy of an offer or proposal is measured by its
' see-through' value, which is the value of the Rule 1 5 securities by reference to the
value of the voting equity offer. 127 In the case of 'options, warrants and other rights to
be subscribed to, these should be calculated net of any exercise price' . 128 In the case of
convertibles, which do not have an exercise price, the 'see-through value will always
be positive and an offer or proposal at no less than see-through value will be required,
even if that offer or proposal is below the market price of the convertible securities ' . 1 29
If a convertible security' s market price (if any) is higher than its see-through value,
because for example the convertible is trading as a fixed income security, a Rule 1 5
offer or proposal does not need to be at market price or above. 1 3 0 Similarly, as long as
the offer is made at no less than see-through value, a proposal addressed to holders of
Rule 1 5 securities does not need to include the same form of consideration as offered
under the voting equity offer. 1 3 1
Where the voting equity offer is a securities exchange offer and offeror securities
are also being offered to the holders of Rule 1 5 securities, the exchange ratio offered to
holders of Rule 1 5 securities shall be no less favourable than that offered under the
voting equity offer. Alternatively, if the convertible securities include an adjustment
mechanism that affects the exercise terms of the securities in the event of an offer for

bonds was fixed at USD 72 . 5 per share. In 1 97 1 , however, the share price had fallen to USD 2 1
per share and had on occasion fallen to USD 9 . 7 5 per share during that year until two years later
when the company was acquired by Rockwell International Corporation at USD 25 per share.
125. However, this consent is usually required for convertible preference shares issued in private
companies .
1 26 . See Rule 1 5 (a) of the City Code on Takeovers . The same concept is stated in the Company Act
2006 at s. 989 under Part 28 Ch. 3 where convertible securities and voting debentures (s. 990)
are treated as shares in the company for the purposes of a takeover bid.
127. Rule 1 5 , s. 2 . 1 .
1 28 . Rule 1 5 , s . 2 . 2 .
1 29 . Rule 1 5 , s . 2 . 5 .
1 30. Rule 1 5 , s . 2 . 6 .
131. Rule 1 5 , s . 2 . 7 .

127
§ 5 . 03 [A] Lorenzo Sasso

the offeree company, an ' appropriate ' offer or proposal should normally take the
adjusted exercise terms into account. 1 3 2
This protection can be formalized in the terms and conditions that may permit
bondholders to convert their bonds at an adjusted conversion price (to compensate for
early conversion) on announcement that a bid has been declared unconditional in all
respects . 1 33 Under Rule l S (b) , the board of the offeree company ' must obtain compe­
tent independent advice on a Rule 1 5 offer or proposal and the substance of such advice
must be made known to the holders of Rule 1 5 securities, together with the board ' s
views o n the offer o r proposal' . 1 34
Whenever practicable, the offer or proposal should be sent to holders of
convertible securities at the same time as the offer document is published or as soon as
possible thereafter, after the voting equity offer becomes or is declared wholly
unconditional . 135 The offer or proposal must be open for at least twenty-one days
following the date on which the relevant documentation is sent to convertibles' holders
and for no less than fourteen days after the date on which it would otherwise have
expired, if the voting equity offer has become or is declared unconditional with regard
to acceptances . 1 3 6
A company may decide to implement a takeover in the UK also by means of a
scheme of arrangement. In such a case a certain set of rules under the Company Act
2006 applies . 1 3 7 A scheme of arrangement is a statutory procedure under section 897
that permits a company to propose an arrangement to its shareholders or creditors or
any class of them. Provided that the scheme is approved by the requisite maj orities of
shareholders or creditors or any class of them and subsequently approved by the court,
it is binding on the totality of those shareholders or creditors or any class of them who
were entitled to vote, irrespective of whether or how they voted. 1 3 8 Following the
announcement of a recommended offer by an acquirer company to the shareholders of
a target company, the trustees of the bond issues have to notify the bondholders that
a document setting out the full terms of the Scheme has been sent to the shareholders

1 32 . The Takeover Panel, Appropriate offers and proposals under Rule 1 5 , amended 30 Mar. 2009,
practice statement No . 24, ss 2 . 8-2 . 1 1 .
1 3 3 . In continental j urisdictions, provision may have to be made for events such as a French fusion,
a merger mechanism where the issuer may cease to exist as a separate legal entity and holders
receive an interest in the merged entity.
1 34 . Rule 1 5 , s. 3 . 1 .
1 3 5 . Rule 1 5 (c) of the City Code on Takeovers .
1 36 . The Takeover Panel, Appropriate offers and proposals under Rule 1 5 , amended 30 Mar. 2009 ,
practice statement No . 24, at 7-8 .
1 3 7 . In the Company Act 2006, Part 26 deals with arrangements and reconstructions and Part 27
deals with mergers and divisions of public companies (previously s . 425 of the Company Act
1 985) .
1 3 8 . In UK the scheme of arrangement has become the structure of choice for implementing
takeovers and its trend is extremely positive. In 2007, 47 targets were acquired, worth in
aggregate approximately GBP 58 billion (The Times, 1 4 Jan. 2008) . In addition, of the UK public
M&A deals announced in 2007 with a value of GBP 250 million and above, 28 were announced
or subsequently structured as schemes of arrangement while just eight were structured as
contractual takeover offers . See for example, the mergers of Iberdrola SA and Scottish Power
Plc, Glaxo Wellcome and SmithKline Beecham, Halifax and Bank of Scotland , and the bid
announced for Scottish & Newcastle Plc by Heineken and Carlsberg on 25 Jan. 2008 .

1 28
Chapter 5 : Significant Corporate Decisions § 5 . 03 [B]

and that a copy of this document can obtained from the specified offices of the Paying,
Transfer, Conversion and Exchange Agents and the Registrar. Included in that docu­
ment are details of the impact of the proposed acquisition on the bonds in order to
provide that bondholders, who convert their bonds after the date in which the scheme
becomes effective, will automatically receive consideration.

[BJ The Protection of Convertible Bondholders in Assets Disposal

The law offers creditors protection, particularly in the case of corporate division, which
happens when the assets and liabilities of a single corporation are divided into two or
more surviving corporations, one of which may be the dividing corporation itself. The
risk is that creditors ' claims will be impaired because the division of assets and
liabilities, which is determined in the division contract, is not pro rata as between the
receiving companies . To this end, EC law makes companies receiving assets through a
division j ointly and severally responsible to pre-division creditors, even though the
liability of the receiving companies other than the one to which the debt was
transferred may be limited to the value of the assets transferred . 1 39
However, the law in assets disposal transactions provides little protection.
Nevertheless, it could be argued that if an investor holds a convertible bond the
above-mentioned scenario differs . The advantage of a well-drafted convertible is that
its value is not affected much by changes in company risk. In fact, while the risk
reduces the value of the bond portion of a convertible, it also increases the value of the
option included by increasing volatility of the share market price, thus providing the
investor with a hedge if the firm turns out to be riskier than expected . In other words,
it could be concluded that convertibles are relatively insensitive to the variance of the
firm' s returns because they can always participate in the firm' s profits through their
conversion privilege. 1 4 0
In truth, these types of transactions could virtually destroy the value of the
conversion privilege. In asset disposals or cessation of business, where a company
transfers all its assets but not its liabilities to another company in consideration of
shares in that company or cash, the company that issued a convertible bond is still
legally capable of effecting the conversion but the conversion privilege will be of little
value if the company is listed in a stock market. This is because the transaction would
probably cause downward pressure on the market price of the shares of that company.
The problem could be handled by introducing in the debt contract a clause that
establishes a partaking adjustment to the conversion price. In particular, this clause

1 39 . Article 12 of the Directive 82/89 1 /EEC (Sixth Company Law Directive) [ 1 982] O.J. L 3 78/47
(applicable to open companies) . For an understanding of the potential opportunistic behaviour
see L. Enriques , G. Hertig & H. Kanda, Related-Party Transactions, in The Anatomy of Corporate
Law: A Comparative and Functional Approach, 1 53- 1 79 (2d ed. , Oxford U. Press, 2009) .
1 40 . Since higher risk makes the equity component more valuable while decreasing the value of the
straight debt component of convertible debt, post-conversion equity ownership should be
higher in riskier firms or in firms in which uncertainty and risk are key-factors . See M. Brennan
& E.S. Schwartz, The Case for Convertibles, J . Applied Corp . Fin. 1 , 58 ( 1 988) ; R. Green,
Investment Incentives Debt and Warrants, J . Fin. Econ . 1 3 , 1 30 ( 1 984) .

1 29
§ 5 . 03 [B] Lorenzo Sasso

requires that, if a substantial asset transfer is effected by the issuer of convertibles , the
holder of convertibles will be given the and amount of shares and other securities and
property, including cash, as were issued upon such a sale to a holder of the number of
shares of common stock into which such convertible security might have been
converted immediately prior to the assets sale. Shareholders do not receive any
property upon the company' s sale of all, or substantially all, of its assets , though they
may receive property if the company is liquidated or dissolved following a sale.
However, in cases where stockholders are cashed out or receive debt securities, the
partaking clause is inadequate to avoid the risk dilution. In other words, if the ordinary
shareholders of the issuer are not given rights to convert their shareholdings into the
shares of the purchasing company, the convertible bondholder is without remedy. 1 4 1
Furthermore, the wording of this anti-dilution provision with respect to assets sales has
often created ambiguity. The clause is uncertain as to how the bondholder has
protection only if the sale is followed by liquidation or dissolution, or also where the
issuer who sells off assets receives a shareholding in the purchasing corporation as
consideration without completing the merger. In a seminal US case, 1 42 the issuer of
convertibles transferred 7 5 % of all its assets for cash. The trust indenture contained the
usual provision that the convertible bondholder would be entitled to common stock in
the corporation that made substantial purchases of the issuer' s assets . The court held
that the clause did not apply in the event of a cash transfer but applied only where stock
of the purchases was exchanged for assets in the seller. The court ' s reasoning was
influenced by the notion that the convertible bondholders could still convert the bonds
into the stock of the issuer. 1 43 However, this ignores the diluting effect of such a
substantial assets transfer for a cash consideration, since cash is a non-performing
asset in a company' s balance sheet and does not facilitate stock appreciation by profit
generation . 1 44
Nowadays, the practice in the ' straight' sterling bond market has also highlighted
the benefit to bondholders of the so-called Spens clause, which provides for a
termination payment that compensates the bondholders when a bond is redeemed
before its maturity or where a substantial part of the assets of the issuer or a material
subsidiary is disposed of (as an event of default) , and/or following a 'restructuring
event ' . Such an event might occur when there is a sale or cessation of the major part of
the issuer' s business typically in conjunction with a ' negative rating event' (normally
where bonds fall below the investment grade status of BBB-Baa3) .

1 4 1 . M. Kahan, A nti-dilution Provisions in Convertible Securities, Stan . J . L. Bus . & Fin. 2 , 1 59- 1 62
( 1 995) .
1 42 . BSF Co. v. Philadelphia Nationa l Bank, 42 Del Ch. 1 06, 204 A2d 746 (Sup. Court 1 964) .
1 43 . The judgment of the US Courts seems homogeneous in that direction. See more recently:
Hollinger v. Hollinger Int 'l (Del Ch. 2004) , US Bank NA v. Angeion Corp. (Ct App Minn 2000) ,
General Motors Class H Shareholders Litigation (Del Ch. 1 999) , Apple Computer Inc v.
Exponential Technology Inc (Del Ch. 1 999) , Cyri.x Corp. v. Intel Corp. v. SGS Thomson (ED Texas
1 992) , Sharon Steel Corp. v. Chase Manhattan Bank (2d Cir 1 982) , Story v. Kennecott Copper
Corp. (NY Sup C 1 9 77) .
1 44 . See L.R. Kling & E. Nugent, Negotiated Acquisitions of Companies, Subsidiaries and Divisions,
vol . l , 4 . 09 and footnotes (New York: Law Journal Press 2005) ; W.W. Bratton, The Economics
and Jurisprudence of Convertible Bonds, Wis . L. Rev. 695 ( 1 984) .

1 30
Chapter 5 : Significant Corporate Decisions § 5 . 03 [C]

Finally, especially in private firms, the practice has evolved of the use of loan
covenants . The content of these covenants may vary in their intensity. Financiers
generally protect themselves by limiting the aggregate amount of assets that a company
is allowed to sell yearly through the use of a book value or fair value cap along with a
fair value standard to govern the terms of permitted sales, or by barring sales of assets
in excess of, say, 1 0% of net worth per year. 1 45 Furthermore, a transfer from a wholly
owned subsidiary to another group company could also be problematic in that the
other shareholders in the transferee company or undertaking will acquire an interest in
the assets which ranks equally with that of the borrower. Hence, if the covenant is
qualified so as to permit intra-group transfers, this will usually exclude transfers by the
borrower itself and may also exclude or restrict transfers other than between wholly
owned subsidiaries . In the latter case, a limitation on the subsidiary indebtedness
clause is also generally included, particularly if the loan issue has been carried out at
the holding company level whereas the business is conducted through the holding
company' s operating subsidiaries . Of course, a disposals covenant must necessarily be
qualified so as to permit disposals of assets in the ordinary course of business, although
the introduction of a substance test may sow the seeds of potential future difficulties in
interpretation and application. Nevertheless, stricter clauses may forbid any sale of
assets without the consent of the creditors, preventing managers from dissipating
them. 1 4 6

[C J Other Situations of Potential Dilution: The Distribution of Dividends

Another significant corporate decision that can dilute the conversion privilege of a
convertible bondholder concerns the distribution of dividends and the ordinary
dividend policy adopted by the managers . The parties rarely contract for anti-dilution
provisions because it is often arguable whether the convertible bondholders really
suffer from dilution. It has been said that whether a distribution of dividends must be
considered an abuse of the shareholders over the creditors or simply the concretization
of a dividend policy, may be a subj ective thing to decide. A payment of dividends,
whether in cash or kind, can indeed deprive the company' s share value, because part
of the equity capital is repaid to the shareholders . If a dividend policy is such that, alter
the issue of the convertible, the rate of dividend payments is increased so that the
conversion privilege is diluted due to a much slower increase in the appreciation of the
market value of the underlying shares, the result is similar to a subdivision of shares -
a so-called stock split. Such prejudicial behaviour could result not only in a decrease of
the conversion privilege but also in the detriment of the safety capital made available
for the repayments to the ordinary bondholders . 1 47

1 4 5 . W.W. Bratton, Bond Covenants and Creditor Protection: Economics and Law, Theory and
Practice, Substance and Process, EBOR 7, 55 et seq. (2006) .
1 46 . P.A. Gompers & J . Lerner, The Use of Covenants: An Empirical Analysis of Venture Partnership
Agreements, J . L. & Econ. 3 9 , 463-498 (October 1 996) .
147. See A. Berle, Corporate Devices for Diluting Stock Partidpations, Colum. L. Rev. 3 1 , 1 239
( 1 93 1 ) ; G . S . Hills, Convertible Securities Legal Aspects and Draftsmanship, Cal . L. Rev . 1 9 ,

131
§ 5 . 03 [C] Lorenzo Sasso

The law intervenes in this sense to protect the creditors with a set of rules on
capital maintenance. In UK company law - as introduced by the implementation of the
Second EU Directive 1 4 8 - a public company can distribute a dividend only out of
profit, 1 49 provided that the distribution does not reduce the amount of net assets to an
amount less than the aggregate of its called-up share capital plus its non-distributable
reserves . 1 5 0 However, a distribution of dividends may still dilute a company' s share
value while complying with the rules on capital maintenance. A method of control
would be a clause that restricts dividend payments to a particular percentage of the net
corporate revenues or an adjustment of the conversion price on the occurrence of such
an event .
The main difficulty in connection with the adjustment of the conversion price is
to determine what is meant by capital distribution . In order to identify a ' diluting'
capital distribution, it is necessary to define what constitutes an ' ordinary' distribution
of dividends . Generally, the conversion price of a convertible bond is initially set with
the presumption that an anticipated level of dividend will be paid each year. An
adjustment to the conversion price based upon payment of that dividend would violate
the ' fixed for fixed' requirement as the relative economic rights of the convertible
bondholders and the ordinary shareholders would not be preserved - i.e. , it would
change the capital structure . 1 5 1 However an adjustment to the conversion ratio for a
dividend in excess of the anticipated level - for example a special dividend that is
effectively a return of capital that is a proportional reduction of all ordinary shares - is
unlikely to violate the ' fixed for fixed' requirement. Such an adjustment would be
viewed as preserving the relative economic rights of the convertible bondholders and
the ordinary shareholders . 1 5 2
A practice has evolved whereby a ' diluting' dividend is identified as a ' capital
distribution' and thereby affects the conversion price of the bond . Mainly, a capital
distribution usually includes any extraordinary or special dividend, distribution or
similar, in cash or in kind, which is something over certain normal thresholds . 1 53 The
board of directors, which makes the decisions with respect to these types of transac­
tions, has a fiduciary duty to common stockholders, but not necessarily to holders of
convertible securities . 1 54 Consequently, one can expect to see protection against

2 1 -22 and 36 ( 1 930) ; S . N . Kaplan, Pierdng the Corporate Boilerplate: Anti-dilution Clauses in
Convertible Securities, U. Chi . L. Rev. 3 3 , 3, n. 7 (1 965) ; S . I . Glover, Solving Dilution Problems,
Bus . Law. 5 1 , 1 269 ( 1 996) .
1 48 . Directive 77 /9 1 /EEC.
1 49 . Section 830 ( 1 ) of the UK Company Act 2006.
1 50 . Section 83 1 of the UK Company Act 2006. The position is similar in some US states . See Model
Business Corporations Act s . 40 and s. 2; Virginia Corporation Law of 1 956 s . 43 , which
prohibited the so-called ' nimble dividend' , which is the payment of dividends from current
earnings while there is no accrued revenue surplus .
151. See IAS 3 2 . 1 1 o f IFRS 7 .
1 52 . W . W . Bratton, Corporate Finance, Cases and Materials 452-453 (5th ed. , Foundation Press
2003) .
1 53 . G . Fuller, Corporate Borrowing: Law and Practice 3 1 8 (4th ed. , Jordan Publg. 2009) .
1 54 . S J . Glover, Solving Dilution Problems, Bus . Law. 5 1 , 1 248- 1 249 (1 996) . See also J.M. Irvine,
Some Comments Regarding 'Anti-Dilution ' Provisions Applicable to Convertible Securities, Bus .
Law. 1 3 , 732 ( 1 958) ; G . S . Hills, Convertible Securities Legal Aspects and Draftsmanship, Cal . L.

1 32
C h ap t e r 5 : Significant Corporate Decisions § 5 . 03 [C]

structural changes in the underlying common stock in all types of convertible securities
issued by both public and private issuers . However, since some of the anti-dilution
clauses may excessively limit the power and the discretion of the management, it is
normally easier to find covenants as the ' dividend stopper' in loans to private
companies and in high-yield securities . Provisions usually seen in practice in bond
instruments and trust deeds in the international markets do not seek to control this type
of dilution. 1 55
Courts in the US applying ordinary English common law principles have refused
to interfere with corporate dividend policy in the absence of express clauses in the bond
instrument or trust deed and in the absence of fraud. 1 5 6 A convertible bondholder is
assumed to be already protected because the convertible security is remunerated with
a fixed interest agreed by contract and its holder can always convert it into common
shares of the company if he or she likes . Therefore, a privilege holder is not entitled,
upon the conversion of a corporate obligation, to receive accrued interest thereon to the
conversion date. Likewise, the corporation cannot require the privilege holder to
reimburse it for dividends accrued or earned on the shares issued or on account of the
undivided surplus represented by such shares . In fact, immediately upon conversion
the privilege holder abandons his right to receive interest and acquires such dividend
rights as the stock issued to him may carry. A privilege holder who effects conversion
and becomes a stockholder is thereby entitled to share with other stockholders of the
same class in all subsequent cash or stock dividends . 1 5 7
Pursuant to the provisions of practically every conversion instrument, however,
an adj ustment of interest is made upon the conversion of bonds or debentures into
common or preferred stock, but in approximately half of such cases, the instrument
makes no provision for an adjustment of dividends . 1 5 8 The computation of interest

Rev. 1 9 , 2 1 -23 ( 1 930) ; S . N . Kaplan, Piercing the Corporate Boilerplate: A nti-dilution Clauses in
Convertible Securities, U. Chi. L. Rev. 3 3 , 4-5 ( 1 965) .
1 55. See P. Wood, International Loans, Bonds, Guarantees, Legal Opinions 92 (Sweet & Maxwell
2007) .
1 56 . See Harff v. Kerkorian, 324 A.2d 2 1 5 (Del. Ch. 1 974) , aff' d in part and rev ' d in part, 347 A.2d
1 3 3 (Del. Supr. 1 975) , where the court refused to interfere at the insistence of convertible
bondholders even though the cash dividend was unusually large in the context of dividend
policy in the previous years . The court' s intervention was sought based on a breach of fiduciary
duty given the absence of any fraud or any contractual provision controlling dividend policy.
However, the Harff ruling does not rule out interpreting the concept of 'fraud' as meaning a
duty of good faith towards convertible bondholders . Such an interpretation would give the
courts a power to intervene on behalf of convertible bondholders in the face of acceleration in
the site and/or frequency of dividend distributions . For an analysis of this case, see W.W.
Bratton, The Economics and Jurisprudence of Convertible Bonds, Wis .L. Rev. 695-697 ( 1 984)
and L.E. Mitchell, The Fairness Rights of Corporate Bondholders , N.Y.U. L. Rev. 65, 1 203 ( 1 990) .
157. G . S . Hills , Convertible Securities Legal Aspects and Draftsmanship, Cal . L. Rev. 1 9 , 3 7 et seq.
( 1 930) ; E. Ferran, Company Law and Corporate finance 52 1 -522 (Oxford U. Press 1 999) .
1 58 . See M . Kahan, A nti-dilution Provisions in Convertible Securities, Stan. J . L. Bus. & Fin. 2 , 1 54
( 1 995) where the author writes [ . . . ] ' About 42 % of . . . the sample offered no [anti- dilution]
protection to [convertible] bondholders for [cash] dividends . ' See also W.W. Bratton, The
Economics and Jurisprudence of Convertible Bonds, Wis. L. Rev . 695 , n . 1 14 ( 1 984) where the
author notes that of a sample of forty-six convertible bonds, thirty-five permitted cash
dividends out of surplus without adjustment and eleven permitted all cash dividends without
adjustment , while forty-four provided for adj ustments for distributions in kind.

1 33
§ 5 . 03 [C] Lorenzo Sasso

adjustments upon coupon obligations or fully registered obligations without coupons is

comparatively simple as in each case the interest is computed from the last interest
payment date to the date of conversion at the established rate. Accrued interest,
whether represented by not-yet matured coupons or not, is abandoned upon conver­
sion as the obligation itself and all not-yet matured coupons are surrendered. Gener­
ally, the conversion instrument requires no adjustments of dividends on the shares
surrendered or on the shares issued, but if adjustments are made with respect to one
class of shares, they are also made with respect to the other. It is unusual to have
adjustments of dividends on one class alone. 1 59
The adjustment of dividends on common or preferred stock is more difficult, as
several matters must be considered : dividends on preferred stock may or may not be
cumulative; common stock dividends may be regular or extraordinary, and may be
payable in cash or stock; dividends may be passed or reduced on the next dividend
payment date following the conversion date. Moreover, where distributions are made
to shareholders by way of capitalization issues or capital distributions, or where a
rights issue or securities issue by way of rights is made to existing shareholders, the
question arises whether bondholders who convert immediately prior to such events
would be given the same rights to receive such distributions .
As a matter of strict law, since they are not shareholders as of the record date of
the distribution they would not receive the benefit of the distribution. However,
provision can be included in the trust deed to permit bondholders who exercise their
conversion rights immediately after the record date for such distribution or issue to
have the same rights to the distribution or issue possessed by existing shareholders . 1 60
In such an event, while no adjustment to the conversion price is to be made, the
convertible bondholder acquires rights to the distribution or issue that will be
commensurate with the amount of shares he would have received if an adjustment had
been made to the conversion price immediately after the record date of the distribution.
The converting bondholder does not, however, get the additional benefit that would
accrue from a conversion price adjustment. 1 6 1
Thus, the issuer is usually required to give notice to convertible bondholders in
the event of rights issues, issue of shares for cash, or when the issue of any other
securities (e.g. , warrants to subscribe) to shareholders is made at a subscription price
below the current market price of the shares or where the conversion or subscription
price of securities already in issue is altered so that it is less than the market price for
the underlying shares prevailing at the time of the alteration . Two types of notice are
usually required to be given for the benefit of convertible bondholders . The first

1 59 . W.A. Klein, The Convertible Bond: A Peculiar Package, U. Pa. L. Rev. 1 2 3 , 565 ( 1 975) .
1 60 . Sometimes the period allowed for conversion after the date of decision of a dividend
distribution may be fifteen days, and sometimes it is expressly stated in the terms of the
contract that a bondholder shall not convert his bonds into shares of the company during the
period starting from the day after the date of declaration of a dividend distribution until the date
of payment of the dividends .
1 6 1 . See the Lloyds Banking Group plc ECN deed poll paragraph (b) (iii) of the GBP 7 . 5 billion
(aggregate value) Enhanced Capital Notes or contingent capital bonds (Cocos) ) issued by LBG
Capital No . 1 plc or LBG Capital No .2 plc, 3 Nov. 2009 .

1 34
Chapter 5 : Significant Corporate Decisions § 5 . 04

requires the issuer (or the guarantor as the case may be) to give notice to the trustee by
issuing a certificate stating that a particular event that gives rise to the adjustment has
occurred. In the certificate, the issuer has to specify the date on which such an
adjustment takes effect and any other information required by the trustee. The second
requires the issuer (or the guarantor) , within a specified time (usually fourteen days)
after the notice is given to the trustee, to give a second notice through a financial
newspaper to the bondholders informing them of the event and the adj ustment of the
conversion price. This covenant, however, does not protect the conversion rights of a
bondholder who may have exercised his conversion option during the fourteen-day
period prior to notice being given to bondholders. The trustee may be under a fiduciary
obligation to notify bondholders immediately so that some do not expose themselves to
incurring losses by converting their bonds prior to the adjustment date. This need for
advance notice to bondholders is dealt with in a separate clause, but only with respect
to certain adjustment events . 1 62

§5.04 AN EVALUATION OF THE RATIONALE AND PROTECTION FOR

HYB RIDS

This analysis shows that, in private equity and venture capital financing, where funds
are often contributed in businesses that strongly depend on human capital, preference
shares can be used as incentive contracts to align management and investors ' interests .
Furthermore, the research demonstrates that convertible instruments present an
optimal solution to the trade-off between the firm' s need to allocate cash flow rights to
the venture capitalists and the need to make efficient exit decisions . Regarding the
protection available for preference shareholders and convertible bondholders, the law
in the UK and US tries to facilitate bargaining between the parties without interfering
too much in business decisions . In fact, for the protection of preference shareholders,
both the legal systems prefer to adopt ex post standards strategies , although US
jurisdiction provides an exit strategy, in the form of appraisal rights for dissatisfied
shareholders while, in the UK, companies' restructuring and mergers are also dealt
with in accordance with a scheme of arrangement. For creditors' protection in public
companies, contractual rights seem to be sufficient, although British law also imple­
mented the EU directives on capital maintenance and on mergers and demergers that
provide a further safeguard for creditors . 1 63
However, the analysis also shows that the practice of the markets has developed
especially in the US but also in the UK, contractual standard clauses for convertible
bondholders to protect the conversion privilege that, in certain crucial situations,

1 62 . G . S . Hills, Convertible Securities Legal Aspects and Draftsmanship, Cal. L. Rev. 1 9 , 20 ( 1 930) ;
S . N . Kaplan, Piercing the Corporate Boilerplate: Anti-dilution Clauses in Convertible Securities,
U . Chi . L. Rev. 3 3 , 1 2 - 1 4 ( 1 965) ; W.W. Bratton, The Economics and Jurisprudence of
Convertible Bonds, Wis . L. Rev . 680-68 1 ( 1 984) .
1 63 . Respectively the Second Directive 77 /9 1 /ECC O J . L 26/ 1 , the Third Directive 78/85 5/EEC 0 .J.
L 295 and the Sixth Directive 82/89 1 /EEC 0.J. L 3 78/47.

135
§ 5 . 04 Lorenzo Sasso

would be otherwise destroyed by the shareholder-manager' s opportunism. Con­

versely, the UK statutory protection for preference shareholders regarding the variation
of the class rights regime appears inadequate to fully protect the special class of
investors in start-up businesses where particular financial and control rights are
assigned for achieving particular obj ective targets . The UK courts make a distinction
between rights affected as a ' matter of law' and as a ' matter of business' , concluding
that if an act of the company impinges only on the enj oyment of those rights, it is
unlikely to amount to their variation. However, in private equity and venture capital
transactions, a right affected even as a matter of business may completely change the
incentives of the parties and create conflicts in the firm . This study therefore highlights
the importance of careful contractual design in such cases .

1 36
CHAPTER 6

Financing through Hybrid Instruments :

Risks Opportunism and Legal Strategies for
Mitigation

The analysis continues in this chapter, where convertible preference shares, convert­
ible bonds and bonds with restrictive covenants are studied. Convertibles show a
strong rationale for their use in reorganization and restructuring transactions because
they largely reduce the agency costs of debt and the asymmetric information that can
be a critical factor in the presence of great uncertainty in the business . Instead, bonds
and preference shares holding restrictive covenants and veto rights , which are becom­
ing common in the US markets, provide the investors with strong protection against
claim dilution. However, these advantages do not come without costs . On the one hand
is the need of the founder investor (angel) not to be excessively diluted in their control
and financial rights; on the other is the danger that an excess of veto rights can hinder
a company' s capitalization. I discuss these conflicts in this chapter, highlighting some
common legal strategies to avoid these problems. These strategies show the impor­
tance of contractual design in order to avoid the economic and ownership dilution of
interests in the firm . Although this chapter concerns primary UK company law, the use
of certain contractual clauses in relation to hybrids it is adaptable to the corporate law
of other jurisdictions and especially in the Unites States where these provisions are
already common.

§6.01 THE USE OF CONVERTI B LE BONDS TO REORGANIZE AND

RESTRUCTURE A FIRM

Corporate capital structure may have a decisive signalling role in stock markets , since
a company' s grade of risk also depends on its financial obligations . Assumed managers
have insider information that outside investors do not know and, to the extent that they
aim to maximize the wealth of the company, such managers have an incentive to issue

137
§6.01 Lorenzo Sasso

new equity when they believe the company is overvalued or at least not undervalued.
Investors, who are aware of these managers ' behaviour, respond to announcements by
lowering their estimates of the issuers ' value to compensate for their informational
disadvantage. The result is a negative market reaction to new equity offerings and a
dilution of the value of the existing shareholders ' claims . 1
When directors decide to issue debt notes, however, they suggest to the market
that they have private information, which is an optimistic belief in the future business
of the company. They would not issue debt notes if they were not aware of the
company' s capacity to generate cash flows sufficient to repay the passive interests on
bonds . In light of this, the unwillingness of such companies to issue straight equity,
when viewed together with their inability to issue long-term debt, and the consequent
issue of convertible bonds instead, send a positive ' signal' to the market about the
management' s confidence in the future. The company in so doing decides to conserve
value by raising deferred equity on better terms in the future instead of issuing
undervalued equity today. 2 The issue of convertibles provides the market with a
positive signal, thus reducing the negative impact on the shares price following the
announcement. Although the negative effect will remain, economic research shows
that it is likely to be less pronounced than if the ordinary stock was issued directly. 3 At
the same time, this is an indirect way to increase equity at times when some private
information will be revealed to the market. For this reason, some authors have argued
that convertible securities are 'backdoor equity' finance. 4
Directors may have a further tool for signalling when a call provision is included
in the terms of the convertible contract. If the equity price does rise, the issuer can
typically accelerate the debt by exercising their call privilege and thereby forcing the
conversion into equity. Based on its favourable private information, the firm expects
that the debt-holder will choose to convert. The benefit from deferring the issuance of
equity through convertible debt financing is qualified by the effect of the firm' s exercise

1. P . Asquith & D . W. Mullins, Equity Issues and Offering Dilution, J . Fin. Econ. 1 5 , 6 1 and 70- 7 1
( 1 986) ; see also S . C . Myers & N . S . Majluf, Corporate Financing and Investment Decision When
Finns Have Information That Investors Do Not Have, 1. Fin. Econ. 1 3 , 1 87- 1 88 and 209-2 1 0
( 1 984) .
2. See C.M. Lewis, R . J . Rogalski& J.K. Seward, Understanding the Design o f Convertible Debt, J.
Applied Corp . Fin. 1 1 , 45-53 ( 1 998) ; S.A. Ross, The Determination of Financial Structure: The
Incentive Signalling Approach, Bell J . Econ. 8 , 23-40 ( 1 977) ; S.C. Myers & N . S . Majluf,
Corporate Financing and Investment Decision When Finns Have Information That Investors Do
Not Have, J. Fin. Econ. 1 3 , 1 87-22 1 ( 1 984) ; See M. Harris & A. Raviv, Capital Structure and the
Informational Role of Debt, J. Fin. Econ .20 55-86 (1 990) ; M. Harris & A. Raviv, The Theory of
Capital Structure, The J . Fin.46 302 and 320 ( 1 99 1 ) .
3. I n response to the announcement o f new equity issue, a company' s stock price falls b y about
3 % on average, while stock price falls from 1 % -2 % in the case of an announcement of
convertible debt. See C. W. Smith, Investment Banking and the CapitalAcquisition Process, J .
Fin. Econ. 1 5 , 8- 1 0 ( 1 986) . Some authors have shown that the issuance of callable convertible
debt may not avoid, but rather simply postpone, the negative information effect of equity
financing unless the firm refrains from calling the debt and waits for the holder to convert. See
W.H. Mikkelson, Convertible Calls and Security Returns, J . Fin. Econ. 9, 2 3 7 ( 1 98 1 ) ; P. Asquith
& D . W . Mullins , Convertible Debt: Corporate Call Policy and Voluntary Conversion, J. Finance
46, 1 2 73 and 1 2 77 ( 1 99 1 ) .
4. J. Stein, Convertible Bonds as Backdoor Equity, Financing, J . Fin . Econ. 32, 1 9-20 ( 1 992) .

1 38
Chapter 6 : Financing through Hybrid Instruments § 6 . 02

of its call privilege. A firm that calls its convertible debt in order to force conversion
communicates to the market its expectation that impending difficulties may make the
firm' s debt obligations more difficult to service or that its equity is now overvalued.
However, the delay in calling the debt has a cost: the risk of financial distress until
conversion, which the holder usually has the incentive to defer until the last possible
moment. 5
In addition, there are some evident advantages for an investor stemming from the
fact that convertible bonds enable their subscribers to change their status in the
company. Managers could invest too much in potentially negative net present value
projects in order to guarantee the continuation of the business, although this may imply
a decrease in the cash flow (also called an overinvestment problem) . Alternatively, the
company' s business may prove to be less profitable than expected. However, convert­
ible bondholders as long as they do not convert their securities into equity hold a pure
debt obligation and as such are entitled to receive a fixed interest and be repaid at
maturity. The conversion option included in the debt security presents an important
opportunity for the investor to evaluate the convenience of converting into equity or
not. Convertibles are generally issued with a conversion price that guarantees their
holders a premium over the present share market value on conversion of the securities .
I n this way, the investor will b e able t o consider whether t o convert into equity during
the different phases of the company' s life, knowing that if the company is not
performing well and its share market value is not increasing they can enj oy the benefits
of a bond.

§6.02 THE MANAGER-CONVERTIBLE BONDHOLDER CONFLICT

The use of convertible bonds to provide finance to a firm in its start-up phase or in a
time of restructuring can reduce asymmetric information problems and give parties the
right incentives . However, this is not immune from conflicts of interest (and it may be
arguable whether, in such cases, these categories of investors are adequately protected
by the law) . The motive for investors to acquire convertible bonds is the desire to
secure an opportunity to participate in the business of the issuing corporation for a
fixed price. The bargaining the investors usually think they are engaging in is based on
their perception that the value of the shares into which the bond may be converted will
rise due to the future commercial and financial performance of the corporate entity in
question, and the general upward trend of share values in the stock markets where the
shares are traded. However, the value to investors of convertibles may be difficult to

5. See C.M. Lewis, Agency Problems, Information Asymmetries and Convertible Security Design,
J . Fin. Intermediation, SO ( 1 998) where 'the intuition for the role of convertible debt as
"backdoor equity " financing rests on the trade-off between the sale of mispriced corporate
securities and the costs of financial distress' .

1 39
§ 6 . 02 Lorenzo Sasso

analyse comprehensively and any simplification of their value may be a misconcep­

tion . 6
Corporations are not static. Their capital structure changes and the share of stock
of today, while legally an identical unit to the share of yesterday, commercially, may
have become entirely different. Within the time that the corporation issues the bond
and the privilege of conversion comes into effect, the assets and the surplus already
accumulated at the beginning and forming a part of the book value of the stock can
significantly change. A company can decide to proceed with actions that may be
detrimental for the holders of a convertible bond because this opportunistic behaviour
could reduce the value of the conversion privilege. For instance, a company may have
decided to distribute its entire surplus as dividends or have paid a dividend in kind
issuing additional shares of the same class, or have created an issue of preference
shares placing the ordinary shares in a highly unattractive position with regard to both
assets and dividends . Moreover a company may have reduced the par value of its
shares, divided them into many shares of a less par value, or made them over into non
par value shares . A company may have carried out transactions that could have
influenced its shareholding, such as having merged, consolidated or even dissolved.
The entire capital structure may have been radically altered without changing the
nature or ending the existence of the shares themselves . Any such behaviour could be
fatal for the hopes of the privilege holder. 7
In the relationship between convertible bondholders and managers, the conflict
of objectives revolves around the conversion privilege. The investor' s obj ective is to
preserve and maximize the value of the conversion privilege and he has an interest in
deterring any action by the issuer that would devalue or destroy that privilege. The
issuer is not concerned with the value of the conversion privilege after the bonds have
been placed with investors, although he has an interest in the timing of the conversion.
In a rising market for the underlying shares , the investor would like to postpone
conversion as long as possible to a point just prior to the final maturity of the bond. This
would enable the investor to maximize the gain on the exchange of the bond for shares .
From the issuer' s viewpoint the sooner he can compel the bondholders to convert the
bonds into the underlying shares the more advantageous it is for him. An issuer may
also wish to redeem the convertibles to prevent a continuing equity ' overhang', namely

6. See M . Kahan, Anti-dilution Provisions in Convertible Securities, Stan. J.L. Bus . & Fin. 147- 1 48
n . 3 ( 1 995) ; M.J. Brennan & E . S . Schwartz, Analyzing Convertible Bonds, J . Fin. and Quantita­
tive Analysis 1 5 , 407 ( 1 980) ; G. Fuller, Corporate Borrowing: Law and Practice 64 et seq. (4th
ed. , JordanPublg 2009) ; W.W. Bratton, The Economics and Jurisprudence of Convertible Bonds.
Wis . L. Rev . 68 1 -689 ( 1 984) ; R.M. Buxbaum, Preferred Stock-Law and Draftsmanship, Cal . L.
Rev. 42, 243 (1 954) ; G . S . Hills, Convertible Securities Legal Aspects and Draftsmanship, Cal . L.
Rev . 1 9 , 20-39 ( 1 930) ; W.A. Klein, The Convertible Bond: A Peculiar Package, U . Pa. L.
Rev . 1 23 ,547 ( 1 975) ; A. Berle, Studies in the Law of Corporate Financel 3 l et seq. (Callaghan &
Co. 1 928) .
7. G . Fuller, Corporate Borrowing: Law and Practice 65 (4thed. , JordanPublg. 2009) ;
W.W. Bratton, Corporate Finance, Cases and Materials 420 (Sthed . , 2003) ; T.J. Harris , Model­
ling the Conversion Decisions of Preferred Stock, Bus. Law.SS, 587 et seq. (2002-2003) . For
some US cases of manipulation of the conversion right see Internet Law Library, Inc. v.
Southridge Capital Management, LLC, 223 F. Supp.2d 474, 479 (S . D . N . Y . 2002) ; Log On
America, Inc. v. Promethean Asset Management L.L. C. , 223 F. Supp . 2d 43 5 , 43 9, n. 3 (S . D . N.Y.
200 1 ) .

1 40
Chapter 6 : Financing through Hybrid Instruments § 6 . 02 [A]

the contingent obligation to issue further equity on conversion. 8 The higher the options
overhang of a company the higher the level of growth the company must generate to
compensate its investors, because the overhang may reduce the cash flow diluting the
investors' returns . 9

[A ] The Timing of the Conversion and the Issuer's Call Option

The first area of potential conflict between issuer and bond investor concerns the
timing of the conversion. The timing conflict is resolved by conferring on the issuer a
call option or early redemption option, with respect to the convertible that enables him
to redeem all or some of the bonds from time to time, prior to maturity, during a
specified period in the life of the bond . This call option in effect enables the issuer to
force the convertible bondholder to exercise his conversion option. This is because in
the exercise of the issuer' s option of redemption prior to conversion, the bond
instrument must by its terms be tendered by the holder to the issuer for payment and
cannot thereafter be converted by the bondholder. If the bondholder wishes to derive
any benefit from the conversion privilege, he must exercise the conversion option prior
to redemption of the bonds by the issuer. 1 0
Nevertheless , the conversion privilege will be o f little value t o the bondholder if
the redemption option can be exercised by the issuer prior to a time at which the market
price of the shares exceeds the conversion price for the underlying shares . Thus, in
order to enable the issuer to force conversion without harming the value of the
conversion privilege, some contractual agreements and covenants have been devel­
oped by legal practitioners . 1 1 In the international markets, an issuer is usually not
permitted to make a call until a set period after issue, often between one and three
years . Alternatively, the issuer is prohibited from calling the bond until the average
market price for the underlying shares over a given period exceeds the conversion
price, usually by about 1 5 % -30% but sometimes by up to 50% . Such a provision is
usually applicable in the three-year period immediately after the issue of the bond. In
addition, whether or not the issuer exercises his call option, he usually has to pay a ' call
premium' to the holder. This is an amount in excess of the principal or face value of the
bond. This premium is usually on a sliding scale, being at its highest in the first year

8. I n fact, stock-based compensation awarded t o executives, directors and key employees o f the
company dilutes the shareholdings of common shareholders .
9. M . J . M Brennan & E . S . Schwartz, Convertible Bonds: Valuation Operational Strategies for Call
and Conversion, J. of Fin.32, 3699 ( 1 977) , but see Klein' s response in W.A. Klein, The
Convertible Bond: A Peculiar Package, U. Pa. L. Rev. 1 2 3 , 547 and 5 5 8-559 ( 1 975) .
10. Otherwise, it would beas i f the investor lent money at a cheaper rate without having anything
in return.
11. In the US the period seems to be two years . See W.W. Bratton, The Economics and Jurispru­
dence of Convertible Bonds, Wis . L. Rev. ( 1 984) : 678; P. Wood, Law and Practice of Interna­
tional Finances . 9 . 0 7 (8) (Sweet & Maxwell 2008)

141
§ 6 . 02 [A] Lorenzo Sasso

when a call is permissible (i . e . , at the end of the three-year period) , and diminishing as
time lapses . 1 2
When an issuer decides to exercise its right to call the convertibles , it must give
notice of redemption to convertible bondholders in advance. A notice period is usually
a minimum of forty-five days and not more than sixty days but this may vary in
practice. This enables the bondholders to exercise their conversion option prior to the
actual redemption of bonds after the call has been published. 1 3 The issuer is usually
required to specify the conversion price and the current stock market price of the
shares . In the markets' practice, to ensure bondholders are not prejudiced by a failure
to exercise their conversion option, trust deeds are usually used to confer a power on
trustees (within a certain number of days after the date for redemption) to subscribe to
shares on behalf of such bondholders . This power is operative only where the trustee
is satisfied that such shares could be sold on the open market during the subscription
period at a price that would exceed the principal and interest on the bonds . The trustee
is given the discretion to effect the exercise on their behalf, normally where the
proceeds of exercise and sale of the resulting shares would be in excess of S % above the
redemption value of the bonds . If the trustee decides to exercise this power, he then has
a duty to sell the shares, which are allotted in accordance with the un-presented bonds ,
and credit the net proceeds to an account for the benefit of such bondholders . The
paying agent for the issue is then required to distribute the proceeds pro rata to all
bondholders who are entitled. 1 4
The usual rule is that bondholders will be entitled to the proceeds if they present
their bonds to the paying agent with all un-matured coupons. This clause is referred to
as the 'widows and orphans ' clause and is intended to protect the interests of those
bondholders who may not be as vigilant as others in exercising their rights of
conversion. Such a clause is also of benefit to the issuer. The company exercises its call
option with the aim of forcing bondholders to convert their bonds and not trigger the
payment obligations of the company regarding bonds, which are being redeemed or
called . It is, indeed, undesirable from the issuer' s point of view if some recalcitrant
bondholders refuse to convert and do not present bonds by the date fixed for
redemption. This is because, while a bond cannot be converted under its terms after
redemption date, the bond survives as a debt obligation of the issuer and must be
redeemed by the issuer through payment in full of the principal value . 1 5

12. See examples i n W.W. Bratton, Corporate Finance, Cases and Materials43 8 and 440-452
(5thed . , Found. Press 2003) ; V. Brudney & W.W. Bratton, Brudney and Chirelstein 's Corporate
Finance 248 et seq. (5thed. ,Found. Press 2003 ) .
13. J . S . Katzin, Financial and Legal Problems in the Use of Convertible Securities, Bus. Law. 3 66
(January 1 969) .
14. For a recent sample of convertible bond structure see the offering circular dated October 20 1 0
o f Hengdeli Holding Limited with the Trustee in London and the registrar in Luxembourg at
http ://www .hmdatalink. com/PDF_C/C0 1 700/e03389 ( 1 ) .pdf(January 201 1 ) .
15. E . Ferran, Principles of Corporate Finance Law520 et seq. (OxfordU . Press 2008) .

1 42
Chapter 6 : Financing through Hybrid Instruments § 6 . 02 [B]

[B ] Value Dilution of the Conversion Option

The conversion premium is sensible to the conversion' s privilege durability, the longer
its life, the greater its value. Conversely, the premium is reduced if the issuer retains the
power to shorten the duration of the conversion privilege . However, even if its issuer
does not redeem a convertible bond before maturity, the holders of the conversion
privilege may still worry about the protection of the conversion premium. Indeed
certain forms of corporate action may adversely affect, dilute or even completely
destroy the value of the conversion option . The conflicts in this regard arise when the
issuer tries to retain its complete freedom of corporate action and the bondholder seeks
to preserve the value of his option, limiting the issuer' s discretion instead . Typically,
convertible securities convert into a number of shares of common stock, calculated by
dividing the initial purchase price (sometimes plus accrued but unpaid interest or
dividends) by a fixed conversion price . As a consequence and without a provision to
the contrary, actions taken by an issuer that increase the number (or decrease the
value) of shares of its common stock outstanding will also decrease or ' dilute' the value
of the conversion right. 1 6 In fact, when the convertible bondholder has a right to
convert his bond at a fixed conversion price per share and the value of the underlying
shares has been halved, the bondholder' s ability to convert at a profit has been
diminished. 1 7 The date on which the necessary adjustment takes place will be the date
giving rise to the adjustment or, if earlier, the record date for determining which shares
and shareholders are to participate in the event . This is to protect bondholders, who
have converted before the event. 1 8
Another type of company behaviour that would normally depress share values
and thus prejudice the value of the conversion option is the issuance of additional
shares for less than a fixed consideration. 1 9 In this way while the number of shares in
the market increases, the value of the company' s equity decreases, diluting the future

1 6. A company incorporated under the UK Companies Act 2006 with a share capital may subdivide
its shares into shares of a smaller amount by ordinary resolution if authorised by its articles to
alter the memorandum of the company; see s. 6 1 8 of the Companies Act 2006. In the US these
are called ' stock splits' .
1 7. Let us assume, for example, that a company has a market value of GBP 1 5 per share while the
conversion price of its convertible bonds is GBP 1 0 . Thus the conversion right is ' in the money ' .
However, i f the issuer decides t o split the share capital giving five new shares t o any holder of
one old share then the market price of each share will fall to GBP 3 and so doing it will
extinguish the value of the conversion right.
1 8. Let us assume, for example, that a company carries out a share split on 1 June of each share
held by each person on the Register of Members on 1 May and the bondholder exercises their
right to convert on 2 May. Despite converting on 2 June while the record date for adjustment
was 1 May, the bondholder will receive the benefit from the adjustment to the conversion price.
19. Under the provisions o f s . 5 6 1 o f the UK Companies Act 2006 such equity securities must
usually be issued to existing shareholders . See, however, the exceptions in ss 564-566. The
position is similar under the laws of New York and most American states. See the New York
Business Corporations Law s. 622 and the comments of J. Hallows in Fuller u. Krogh1 5 Wis 2d
4 1 2 1 962 where he said: ' A pre-emptive right of a shareholder in a corporation is recognised so
universally as to have become axiomatic in corporation law . ' Although the doctrine of
pre-emptive rights was not known to English common law, it has been known to American law
at least since 1 807 after Gray u. Portland Bank 3 Mass 364 ( 1 807) . See L.C.B. Gower, Some
Contrasts between British and American Corporation Law, Harv. L. Rev . 69, 1 3 69 ( 1 956) .

1 43
§ 6 . 02 [B] Lorenzo Sasso

participation of the convertible bondholder. 2 0 Likewise, the issuance of other securi­

ties, convertible into the same class of shares at a lesser rate or price, and the issuance
of other classes of shares having a preference upon redemption, liquidation or
dissolution are also detrimental for convertible bondholders . In fact, the position of the
common stock in respect of which the privilege was granted, may become far less
valuable than was the case when the privilege holder purchased his warrant or his
convertible obligation. 2 1
In start-up business, though not exclusively, the investor usually makes their
investment by way of instalments conditional on the achievement of certain firm' s
obj ectives that, if achieved, will open the way to another tranche o f investor' s finance.
However, if, for example, because of economic downturn periods, the milestones for
the subsequent instalments are not achieved, the investor may have an option to
subscribe to the next tranche at a discounted price to the first. This stage of financing
is known as the ' down round' , a round of investing when fortunes for the start-up have
declined . The rationale underlying a down round is to provide the company with
necessary cash to survive the current difficult economic times long enough to achieve
additional business milestones, in order to increase its potential value either for the
next round of financing or an ultimate liquidity event. 22
The clear painful consequence of a down round is the dilution experienced by
existing and future shareholders including any holder of convertible securities . In order
to protect the convertible bondholders, a number of anti-dilution clauses may be
incorporated into the terms and conditions of the convertible security depending on the
particular circumstances of the issue. The anti-dilution provision is triggered each and
every time the company decides to raise new funds from its investors , offering
securities at a price below that previously paid by the company' s investors . However,
not all issuances of new shares are a cause of value dilution. For instance, when a new
investor subscribes at a price equal to, or more than, the price paid by the existing
investor, the anti-dilution provision will not operate, as the existing investor is happy
to accept dilution on this basis . This stage of capital financing is known as the 'up
round' .
Furthermore, the parties will typically accept that certain issues or grants of new
securities should not trigger the anti-dilution provision and these will be expressly
excluded from the definition of new securities . These grants and issues will usually
include, for instance, the grant of options under an employee share scheme, an
executive management incentive scheme or other incentive scheme that has been
approved by the investor, or the issue of shares to satisfy the exercise of such options .

20. For example, a company has an issued capital of GBP 200, consisting of 1 00 shares trading at
GBP 2 per share. The company has also issued a convertible bond giving the holders the right
to convert for GBP 2 . 5 0 per share. It issues 20 new shares for GBP 1 . 60 each and receives GBP
32 for them. The new conversion price will be 2 . 50x ( ( I 00+1 6) / (1 00+20) ) =GBP 2 .42 .
21 . However, see D . L . Ratner, Dilution and Anti-dilution: A Reply to Professor Kaplan, U . Chi. L.
Rev . 3 3 , 494 ( 1 966) who argues persuasively that there is no dilution effect when the new
issuance is at or above market price but below the conversion price . See also S J . Glover,
Solving Dilution Problems, Bus . Law. S I , 1 2 8 1 (1 996) .
22 . W.A. Birdthistle & M.T. Henderson, One Hat Too Many? Investment Desegregation in Private
Equity, U. Chi . L. Rev. 76, 56 et seq. (2009) .

1 44
Chapter 6 : Financing through Hybrid Instruments § 6 . 02 [B]

Venture capital investors acknowledge that some form of option pool is necessary to
give management and employees incentives , and usually agree a maximum number of
shares for allocation under such schemes . In any event, the existing investor will
already have accounted for dilution arising from the exercise of such options by
agreeing the share capitalization of the company following the investment and will
therefore agree that options or shares issued in these circumstances will not trigger the
anti-dilution provision. In addition, there may be other cases not contemplated by the
investment documents where the existing investor is ready to accept dilution as the
lesser of two evils when, for instance, the company is in financial distress and the only
alternative is liquidation. In such a situation, the articles of association should
expressly exclude such issues from the definition of new securities or provide that,
where the existing investor agrees, the firm can issue new securities at less than the
subscription price paid by the protected investor without triggering the anti-dilution
provisions . Eventually, it has become increasingly common for the anti-dilution
provision to compensate the protected investor for the dilution suffered by the issue of
new securities in a down round by issuing additional bonus shares . If the existing
investor has paid a premium for their shares, the issue of the anti-dilution bonus shares
fully paid up to nominal value will itself trigger the anti-dilution provisions . This would
not be reasonable and such issues should be expressly excluded from the definition of
new securities . Shares issued in connection with lease finance arrangements, banking
facilities and other financing up to an agreed amount may also be excluded from the
definition of new securities . 2 3

[1] Price-Based Methods of Anti-dilution

There are two methods commonly used for providing the existing investor with
anti-dilution protection: the issue of additional shares and the adjustment of the
conversion rate. The method of compensating an investor for the dilutive effect of a
down round is for the company to issue additional shares to the existing investor. The
company can compensate the investor by way of a bonus issue of shares if it fulfils all
the requirements set out in the Companies Act 2006. 24 A bonus issue to holders of
convertible securities does not differ from a bonus issue to all the existing shareholders .
In order for a company to make a bonus issue to holders of convertible securities, it
must have authority to make such an issue under its articles of association: usually this
will be expressly provided for in the articles adopted when the existing investor invests .
Depending upon the charter of the company, only certain classes of shares may be
entitled to bonus issues, or may be entitled to bonus issues in preference to other
classes. Bonus issues made under the anti-dilution provisions are usually expressly

23. See British Venture Capital Association (BVCA) drafting notes o f articles o f association at
http :/ I admin. bvca. co. uk/library/documents/Articles_of_Association_-_Drafting_Notes . pdf.
24. Let us assume that a convertible bond gives the bondholders the right to convert one bond into
one share of the company . If the company decides to carry out a stock split and allocate three
new shares for each old share, then the anti-dilution provision will provide the bondholder
converting its securities with one share plus two additional new shares to compensate its
dilution.

145
§ 6 . 02 [B] Lorenzo Sasso

excluded from any pre-emptive offers that have to be made to shareholders . 2 5 In

addition, the Company Act 2006 expressly empowers the directors of a company, if
authorized by an ordinary resolution, to capitalize certain profits or reserves in paying
up in full un-issued shares in the company. 2 6 Since there is now no 'authorised capital'
limit, a company' s changes to issued capital must be notified to the Registrar at
Companies House each time a new allotment is made. 27
Critically, the company must have sufficient distributable profits, non­
distributable reserves or other reserves such as a share premium account or capital
redemption reserve at the relevant time to capitalize and apply for paying up the
additional shares in full. The anti-dilution provision should normally state that if the
company is unable to make a bonus issue, then the protected investor could subscribe
to the additional shares at nominal value. The protected investor, therefore, will need
to ensure that the nominal value of any additional shares is low enough that they do not
have to pay a significant amount to exercise their rights . The additional shares can be
preferred shares or ordinary shares . 28
The second method of compensating an investor for the dilutive effect is the
conversion rate method, which involves the mechanism used to calculate the number
of ordinary shares into which the convertible securities convert. This amount is usually
calculated by multiplying the number of convertible bonds held by the investor by the
applicable conversion rate. The conversion rate will start at an initial rate of one for one
and every time a down round occurs triggering the anti-dilution protection, the
conversion rate is adjusted to more than one for one to account for the dilutive effect
of the down round. 2 9 Regardless of whether the conversion rate or the additional share
method is used, the anti-dilution provision often provides for adjustments to be made
to the share capital following a down round, which, in the absence of manifest error,
are normally then binding on all shareholders . This avoids any disagreement as to what
the adjustment under the anti-dilution provision should be. 3 0

25. Section 5 70 o f the CA 2006.

26. Section 5 5 1 of the CA 2006 .
27. Section 5 5 5 o f the C A 2006 .
28. The 'bonus issue' i s the most common anti-dilution mechanic i n the U K . A set out standards of
it can be found in the BVCA Model Documents at http ://www.bvca . co . uk/PEVCExplained/
StandardlndustryDocuments (January 201 1 ) .
29. Let us assume that a convertible bond gives the bondholders the right to convert into shares at
a conversion rate of one to one and each share has a nominal value of GBP 1 5 . If the company
decides to carry out a stock split replacing each share of GBP 1 5 with five new shares of GBP
3, the terms of the anti-dilution provision will normally provide to adjust the conversion rate
consequently into five shares to one bond. See other examples in D.A. Broadwin, An
Introduction to Anti-dilution Provisions (Part 1), Prac. Law. 29 (June 2004) .
30. W.W. Bratton, The Economics and Jurisprudence of Convertible Bonds, Wis . L . Rev . 68 1 -689, in
particular at 687 ( 1 984) ; See some US cases : W.W. Bratton, Corporate Finance, Cases and
Materials 42 1 -437 (5thed. , Foundation Press 2003 ) ; S . N . Kaplan, Pierdng the Corporate Boiler­
plate: Anti-dilution Clauses in Convertible Securities, U. Chi. L. Rev. 3 3 , 1 8 (1 965) ; S . N . Kaplan,
Some Further Comments on Anti-dilution Clauses, Bus . Law. 2 3 , 893 (1 968) ; D . L. Ratner,
Dilution and Anti-dilution: A Reply to Professor Kaplan, U. Chi . L. Rev. 33 494 and 496-49 7
( 1 966) .

1 46
Chapter 6 : Financing through Hybrid Instruments § 6 . 02 [B]

[2] Full Ratchet and Weighted Average Ratchet Anti-dilution Provisions

While the founders and management of a start-up firm usually accept that anti-dilution
protection is unavoidable in order to raise further finance for the company, there is
usually some debate as to the level of protection afforded to the protected investor. The
most draconian adjustment is for the protected investor to receive full anti-dilution
protection if there is an issue of new securities at less than the price paid by such
investor. A full ratchet adj ustment will compensate the protected investor reducing the
conversion price to the exact price per share paid in the dilutive issuance, in effect
allowing the holder of the convertible security to receive stock at that lower price . 3 1
Theoretically, this approach fully protects the investor against economic dilution
from the initial investment; after the adjustment, the securities receivable upon
conversion will have the same aggregate value as the initial investment. Some scholars
view full ratchet anti-dilution protection as unfair because of, among other things , the
potential for substantial dilution to common shareholders, regardless of the size of the
dilutive issuance . 3 2 Therefore, this approach is used almost exclusively in venture
capital deals, where the common stockholders tend to be founders and managers .
Because the parties in these transactions agree on a price-based on numerous assump­
tions, significant valuation gaps can exist . Venture capitalists argue that if a subsequent
round of financing is raised at a lower valuation, the assumptions underlying the
original valuation were by definition incorrect and the investor should be fully
protected. Not surprisingly, entrepreneurs often feel that, because a decrease in
valuation may be caused by many factors, for example, a fall in the general market, the
impact of a drop in valuation should be shared and therefore a different method of
adjustment is more appropriate. Not surprisingly, even in venture transactions, use of
full ratchet anti-dilution protection is rare . This type of protection is used most often in
riskier transactions or in periods of economic turmoil. 33
The amount of equity issued in the down round as anti-dilution provision should
be considered in the context of the company' s overall share structure. This is achieved
by averaging the price across the different rounds of financing, taking into account the
issued (and sometimes to be issued) share capital of the company. As the weighted
average ratchet method looks at the actual effect of the issue of new securities across
the company' s share capital, it is much more equitable to the non-investor sharehold­
ers compared to the full ratchet. For example, under the full ratchet method, if only one
down-round share is issued, the protected investor would still get an adjustment in

31. See J . S . Katzin, Financial and Legal Problems in the Use of Convertible Securities, Bus .
Law. (January 1 969) : 365 ; S . N . Kaplan , Piercing the Corporate Boilerplate: Anti-dilution Clauses
in Convertible Securities, U . Chi. L. Rev. 3 3 , 3 , n. 7 ( 1 965) .
32. M . A . Woronoff& J . A . Rosen, Understanding Anti-dilution Provisions i n Convertible Securities,
Fordham L. Rev. 1 1 8- 1 1 9 (2005) ; D . A. Broadwin, An Introduction to Anti-dilution Provisions
(Part 1 ) , Prac. Law . 3 6 (June 2004) : 3 6: ' [A] full ratchet provision can have a draconian effect
on the common stock. This effect is exacerbated by the fact that the full ratchet provision does
not take into account the number of shares issued at the low price. '
33 . See D .A. Broadwin, An Introduction to Anti-dilution Provisions (Part 1 ) , Prac . Law. 34 (June
2004) ; M.A. Woronoff& J . A. Rosen, Understanding Anti-dilution Provisions in Convertible
Securities, Fordham L. Rev. 1 1 7- 1 1 9 (2005) .

147
§ 6 . 02 [B] Lorenzo Sasso

respect of all their shares, resulting in the non-investor shareholders being severely
affected. Weighted average ratchet can be 'broad based ' , meaning that they look at the
dilutive effect of the issue of new securities on all the company' s share capital plus all
securities that would be issued on the exercise of all outstanding options, warrants and
other convertible securities . On the other hand, a ' narrow-based' ratchet only looks at
the effect of the down-round issue on the issued share capital of the company.
Therefore, with a narrow-based ratchet, the protected investor will receive a greater
adjustment than is the case with a broad- based ratchet . 34
When calculating the protected investor' s position after the operation of an
anti-dilution provision, both the method and the type of protection must be considered.
Different formulae have been devised to calculate the full ratchet and weighted average
ratchet (both broad and narrow) anti-dilution protection using both the bonus issue
method and the conversion rate method with different results for every formula. There
are advantages and disadvantages to both the (bonus issue and conversion rate)
methods . With the bonus issue method, the benefit to the protected investor can be
seen immediately. The additional shares are issued at the time of the down round,
meaning the protected investor knows exactly how many shares they have got and the
capitalization of the company is clear. With the conversion rate method, the share­
holders will not be able to see the effects of the anti-dilution provisions until the
preferred shares are converted into ordinary shares . From the investor' s perspective,
where the conversion rate method is used, the rights of the convertible securities
should be expressed to be ' on an as converted basis ' , that is, as the convertible
securities at the applicable conversion rate at the relevant time. So on a poll vote ' on an
as converted basis ' , on a return of capital, winding up or liquidation, the remaining
assets of the company would be distributed to the convertible security-holders ' on an as
converted basis ' ; dividends, if declared, would be allocated to the shareholders ' on as
converted basis ' . 35
However, the transparency of the bonus issue method is also its downfall . As the
additional shares are issued simultaneously with the down round, the entrepreneur/
shareholder can immediately see the dilutive effect of the shares being subscribed to by
the new investors in the down round, together with the additional shares issued to
compensate the protected investor, which does little for motivation levels. Under the
conversion rate method, the protected investor does not get their additional shares
until conversion into ordinary shares, so the immediate effects of the dilution caused by
the operation of the anti-dilution provisions are not so obvious (although if the rights
are adjusted 'on an as converted basis ' , then the impact is the same) . If the company
has entered into a series of down rounds, it may be difficult to keep track of the exact
adjustments to be made under the conversion rate method. With the bonus issue
method, shares are issued simultaneously with the down round.

34. D.A. Broadwin, A n Introduction to Anti-dilution Provisions (Part 1), Prac. Law . 3 5 (June 2004) ;
M.A. Woronoff& J.A. Rosen, Understanding Anti-dilution Provisions in Convertible Securities,
Fordham L. Rev. 1 1 9- 1 2 1 (2005) .
35. J . S . Katzin, Financial and Legal Problems in the Use o f Convertible Securities, Bus. Law. 366
(January 1 969) .

1 48
Chapter 6 : Financing through Hybrid Instruments § 6 . 02 [B]

The grant of any options falling within the definition of new securities exercisable
at a down-round price will trigger an adjustment under the anti-dilution provision.
However, if the options are never exercised and lapse, the non-protected shareholders
will argue that a readjustment needs to be made to ensure that the protected investor
is in the same economic position he would have been in had the options never been
granted . If the conversion rate method is used, then this is easily remedied, as the
option grant can be ignored when calculating the rate for the conversion of the
protected investor' s shares into ordinary shares . However, making such a readj ust­
ment is difficult where the bonus issue method has been used as shares have already
been issued to compensate the protected investor. One solution to this problem may be
to convert some of the additional shares into economically valueless deferred shares on
the lapse of such options . This would add to the complexity of drafting and require the
rights attaching to such deferred shares to be included in the articles of association.
For this reason, it is also quite common to use a market-price formula, which is
designed to protect the holder of a convertible security against economic dilution from
current share market value. Therefore, the market-price formula provides for adjust­
ments when additional shares of common stock are sold at a price below their current
market value . This formula assumes there is no harm to holders of convertible
securities when additional shares of common stock are issued at or above the
prevailing market price, even if below the conversion price. This is based upon a
presumption that the original conversion price was set by fully informed parties . This
presumption is most likely to be true in the public company context, and as would
therefore be expected, the market-price formula is found almost exclusively in anti­
dilution provisions of convertible securities issued by public companies . 3 6
Smaller public companies with less liquid trading markets for their common
stock raise different issues . Their trading market is less liquid and more volatile. In
addition, information barriers are more likely to exist, increasing the probability of a
disparity between the initial conversion price and the fair market value on the date the
convertible security is issued . Therefore, holders of convertible securities in small
public companies often treat these issuers like private companies and seek price
protection through a conversion-price formula. 3 7
Although there may be some anti-dilution provisions included by the parties in
their contracts, it is arguable whether convertible bondholders always need that
protection. Ideally, a proper formula should discriminate between subsequent sales
that truly dilute the convertible securities and those that merely reflect market
information about the issuer. So, sales at or above market price should never trigger
adjustments even if they fall below the original conversion price. This is the reason
why large publicly traded companies often avoid any anti-dilution provision in their
convertible issues . If the market fully values their securities, including the risk of

36. D .L. Ratner, Dilution and Anti-dilution: A Reply to Professor Kaplan, U . Chi. L. Rev . 3 3 , 498-499
( 1 966) .
37. D . A . Broadwin, An Introduction to Anti-dilution Provisions (Part 1 ) , Prac. Law.27 (June 2004) .

1 49
§ 6 . 03 Lorenzo Sasso

dilutive events, sub-market-value issuance is very rare, and investors can rely on
hedging techniques to limit the risks . 3 8

§6.03 THE MAJORITY-MINORITY CONFLICT IN VENTURE CAPITAL

FINANCING: THE INVESTOR'S CLAIM DILUTION

The reduction in the current price of a stock due to the increase in the number of shares
is not the only dilution suffered by a non-subscriber member. An issuance of new
shares decided by the maj ority shareholders may result in the shifting of fundamental
positions of the stock, like ownership percentage and voting control, other than
earnings per share and the value of individual shares. Therefore, the dilution can be
costly for two reasons : the economic loss of value of the investment and the dilution of
the investor' s ownership interest and control rights in the company. This is exactly the
case in a down-round financing in venture capital recapitalizations . A down round is a
stage of financing when fortunes for the start-up have declined because of economic
downturn periods or because the milestones for the subsequent instalments are not
achieved. 39
A new start-up business normally requires a large amount of funds to grow and
expand. During the company' s life, more than one investment fund or financier will
probably contribute finance to the business because when new finance is needed,
investors who purchased securities in earlier stages of financing may be more limited
in their ability to support the company or may prefer to wait for an acceptable exit
event . 4 0 The staging of investments in private equity and venture capital financing
ensures that a company' s investors will hold different amounts of the company' s
capital, issued at different prices at each stage of financing and with different cashflow
and liquidation rights. These differences may encourage the venture capital investors
to develop conflicting interests concerning the price at which they should sell their
participation through a company exit event, or the price at which the company should
issue new securities in the future. 4 1
Although shareholders as a category risk dilution from new equity, minority
shareholders including preference shareholders, who are holders of non-voting shares,
face the largest risk, because they are typically not protected by shareholder decision
rights. While the law facilitates creditor self-help in contracting for special anti-dilution

38. M . A . Woronoff& J . A . Rosen, Understanding Anti-dilution Provisions i n Convertible Securities,

Fordham L.Rev . 1 2 3 et seq. (2005) .
39. W . A . Birdthistle& M . T . Henderson, One Hat Too Many?Investment Desegregation i n Private
Equity, The U . Chi. L. Rev.56 et seq. (2009) .
40 . J.M. Fried & M. Ganor, Agency Costs of Venture Capitalist Control in Startups, N . Y . U . L. Rev. 8 1 ,
993 et seq. (2006) .
41 . R.P. Bartlett, The Agency Costs of Venture Capital, UCLA L. Rev . 54, 64 et seq. (2006) ; R.P.
Bartlett , Understanding Price-BasedAntidilution Protection: Five Principles to Apply When
Negotiating a Down-Round Financing, Bus. Law . 5 9 , 23 and 24-25 (2003) ; M.A. Woronoff& J.A.
Rosen, Understanding Anti-dilution Provisions in Convertible Securities, Fordham L. Rev. 1 1 2 et
seq. (2005) .

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Chapter 6 : Financing through Hybrid Instruments § 6 . 03 [A]

provisions, it protects minority shareholders with specific norms, rules and stan­
dards . 4 2

[A] Existing Legal Remedies in the UK and US

Since 1 980, UK legislation implementing the Second EC Directive has provided a

statutory pre-emption right. 43 According to this, the new issues of ' equity securities ' 44
must be offered first to ordinary shareholders on a pre-emptive basis excluding the
company itself as holder of treasury shares . However, while pre-emptive rights are a
default option for public companies in all European jurisdictions, the UK grants them
as the statutory default for closelyheld companies . If shareholders are to receive
pre-emptive rights , a company' s articles of incorporation must provide for them. In
addition, where the issuer is a company registered in England and Wales, sections
549-5 5 1 of the Company Act 200645 limits this possibility of abuse by providing as a
general rule that it is a criminal offence for directors knowingly involved46 to allot
shares or grant options to subscribe to shares or issue securities convertible into shares
(relevant securities) without the authority of the members given either in the articles or
by ordinary resolution. 47
Unfortunately, this set of rules, norms and standards does not apply to preference
shareholders but only to the ordinary shareholders , namely shareholders other than
shareholders that with respect to dividends and capital carry a right to participate only
to a specified extent in a distribution . 4 8 Therefore, preferred stockholders will have to
bargain with the company, where possible, for their protection. The decision of the law
not to intervene on behalf of the preference shareholders has to be counterbalanced
with the cost of having pre-emptive rights as a device for protection. 49 Pre-emptive
rights can hinder a company' s capacity to raise new funds, by forcing companies to
solicit their own shareholders before turning to the market and limiting the directors'
ability to issue blocks of shares with significant voting power. These constraints may
also explain why public companies in the US have practically abandoned pre-emptive

42 . P . L. Davies, Gower and Davies ' Principles of Modem Company Law 88 1 et seq. (9th ed. , Sweet
& Maxwell 20 1 2) . P . L. Davies, Introduction to Company Law 22 1 et seq. (2nd ed . , Oxford U .
Press 2 0 1 0) . D . Kershaw, Company Law in Context : Text and Materials Part II Ch . 1 6 (Oxford
U . Press 2009) .
43 . The relevant provisions are in CA 2006 ss 560-577 introduced by the Company Act 1 985
implementing the Council Directive 77 /9 1 /EEC (Art. 29) . See in the Stock Exchange: Listing
Rules, Ch. 1 3 , para. 1 3 .8 . For an overview of the operation of pre-emption rights in France,
Germany, Italy, the Netherlands and Spain, see P. Myners , The Impact of Shareholders '
Pre-Emption Rights on a Public Company 's Ability to Raise New Capitalannex B (DTI 2004) .
44 . The definition of ' equity securities' includes securities that have the right to subscribe for or
convert into a company ' s ordinary shares . See, s. 560 CA 2006 .
45 . Previously s . 80 of the 1 985 Act to which the 1 989 Act added s . BOA.
46 . Section 549 (3) and 549 (4) CA 2006 . However, such failure does not affect the validity of the
allotment. See s . 549 (6) .
47. This may help to explain in part why the 'shareholder rights plan ' or ' poison pill ' against
takeovers is rare in the UK, for the effectiveness of the plan depends heavily upon the directors
being able to adopt it without shareholder approval.
48 . Section 560 ( 1 ) CA 2006.
49 . See recently E. Ferran, Company Law and Corporate Finance 525-528 (Oxford U . Press 2008) ;
DTI, Pre-emption Rights: Final Report, February 2005 (URN 05/679) .

151
§ 6 . 03 [A] Lorenzo Sasso

rights, so while they seem more popular in closelyheld corporations . si For the same
reasons, rights issues came to the foreground of policy concern in Europe in mid 2008
because of severe difficulties encountered by several banks that found themselves
under credit-crunch-engendered pressure to shore up their balance sheets by raising
new equity. 5 2
Another remedy available in the UK for the minorities ' protection is provided by
section 994 of the CA 2006 that allows minority shareholders, including preferred
shareholders , to file a petition alleging that their minority shareholding has been
'unfairly prejudiced' by the behaviour of the maj ority and seeking a right to be bought
out at a fair price. s3 The courts will focus on the 'conduct of the company' and on the
'unfairness of the prejudice complained' and will apply an obj ective test in order to
filter the suitable cases for resolution by way of an unfair prejudice petition. Accord­
ingly, they will consider whether the conduct of the company, in its broader connota­
tion, namely any action taken by, or on behalf of the company, by any company' s
organs, but not only, 54 is prejudicial to the interests of the members of the company.
The unfair prejudice remedy addresses corporate conduct that affects the interests of a
person only as a member and in a commercial sense, not the personal interests of the
member. However, a member interests extends beyond their formal legal rights to all
its ' legitimate expectations' . s s
Only once the court has established that the conduct complained of is prejudicial
to the interests of the members, it will consider whether the prejudice complained of is
unfair. Traditionally, the courts have not interfered with how directors manage their
corporate business affairs . Therefore, they will not intervene in any technical or trivial
breach of fiduciary duty by the directors . Such conduct must be shown to be unfair for
a petition to succeed. The definition of what constitutes an 'unfairly prejudicial'
conduct has been explored and redefined in case law. 5 6

SO. In US jurisdictions , the statutory default is a rule of no pre-emptive rights for public as well as
close companies .
SL See R.C. Clark, Corporate Law7l 9 (Little, Brown & Co. 1 986) .
S2 . Under the London Stock Exchange 's Admission and Disclosure Standardsthe minimum period
for which an open offer has to remain open is l S days (Para. 3 .9 . ) , compared to the minimum
of 2 1 days that is stipulated in the Companies Act 2006, while the FSA recently reduced the
minimum rights issue offer period under the Listing Rulesfrom 2 1 days to 1 0 business days (LR
9 . S . 6) . The recent EC Directive 2007 /36/EC of the European Parliament and the Council of 1 1
Jul . 2007, [2007] OJ L1 84/ 1 7 has recently settled on 1 4 days as the minimum period for the
exercise of certain rights of shareholders in listed companies .
S3 . See s . 994 CA 2006 (re-enacting s . 459 of the CA 1 98S) .
S4. Re Phoneer Ltd [2002] 2 BCLC 24 1 ; Re Citybranch Group Ltd v. Rackind [2004] 4 All ER 73 S . See
also Nicholas v. Soundcraft Electronics Ltd [ 1 993] BCLC 360.
SS. R e Saul D Harrison & Sons Ltd [ 1 995] 1 BCLC 1 4 . For a discussion see D . Kershaw, Company
Law in Context: Text and Materials 62S-630 (Oxford U . Press, 2009) .
S6. For example, O 'Neill v. Phillips [ l 999] 1 WLR 1 092; O 'Neill v. Phillips [ l 992] 2 All ER 961 ; Re
Marchday Group [ l 998] BCC 800; Re BSB Holdings Limited (No: 2) [ 1 996] 1 BCLC l SS ; Re Saul
D Harrison & Sons plc [ 1 995] 1 BCLC 1 4 . Similarly, Hawks v. Cuddy[2007] EWHC 2999 & [2009]
EWCACiv 29 1 ; Re a Company(No: 00709 of 1 992) [ 1 997] 2 BCLC 739; Re Alchemea Ltd [ 1 998]
BCC 964 . Furthermore, where a member' s participation was diluted by a proposed or actual
decision of the company to allot further shares to other parties only to reduce the member' s
influence in the company. For selective or otherwise improper share issues , see In the matter
of Sunrise Radio Ltd[2009] EWHC 2893 ; In the matter of Gate of India (Tynemouth) Ltd[2008]

1 52
Chapter 6 : Financing through Hybrid Instruments § 6 . 03 [B]

If the court accepts that the petitioner' s interests have been unfairly prejudiced by
the conduct of the company' s affairs , the court has a wide discretion to order a variety
of reliefs . The most common remedy is the buy-out of the minority shareholder' s
shares by the other 'unfair' members o f the company or by the company itself, at a fair
price. 57 Accordingly, the court will ask for expert valuation evidence in order to
determine a ' fair price' for the shares, unless the parties can agree the price to be paid.
The courts will examine the level of involvement of the petitioner in the company' s
business at the time the petition was presented and, if of minor importance, will
discount the value of the shares to reflect the minority status of the petitioner. 5 8 Despite
its efficacy, the unfair prejudice remedy produces cases often lengthy and fact­
intensive while time is crucial for a start-up business in high-technology sector. 59

[B] Loan Covenants, Veto Rights and Pay-to-Play Clauses

When a company is in financial distress and the existing investor does not have the
capacity or the willingness to support further stages of financing, two sorts of problems
may concretize . The existing investors, who are unable to subscribe a new round of
financing, could suffer from an ' expropriation' of value if another investor shows up
and contributes new finance. Prior venture capital funds sometimes cannot even
recover the amount initially invested, to the advantage of a new venture capital
investor. At the same time, investors, who are willing to risk additional capital, expect
their co-investors to share the risk. A troublesome issue in the anti-dilution area is the
' free rider' problem, occurring when a start-up firm, facing a down round, obtains the
support of only some of the existing venture capital investors, while the others enj oy
the benefits of that support because of the automatic operation of the anti-dilution
provisions, without putting up any additional capital. Neither a price-basedanti­
dilution provision nor existing mandatory legal strategies are sometimes enough to
protect the entrepreneur and the investors from possible opportunistic behaviours such

EWHC 959; Re a Company(No: 00267 1 2 of 1 984) [ 1 985) BCLC 80; Re a Company (No : 007623
of 1 984) [ 1 986) 2 BCC 99, 1 9 1 . For unfair calls on shares, see Re a Company (No: 008 1 26 of 1 989)
[ 1 992) BCC 542 ; Re D.R. Chemicals Ltd [ 1 989] 5 BCC 39; Randall v. S & F (Quarries)
Ltd (unreported ) 1 2 Oct. 1 994; Re Regional Airports Ltd [ 1 999] 2 BCLC 30; Dalby v. Bodilly[2004]
EWCA 307. Finally, any corporate action or decision that damages the different classes of
shareholders and involves breaches of duty by directors, Re BSB Holdings Ltd (No: 2) [ 1 996] 1
BCLC 1 5 5 ; see also Re Sunrise Radio Ltd; Kohli v. Lit and others- [20 1 0] 1 BCLC 367 [20 1 0] 1
BCLC 367.
57. SudhirSethi v. (1) Patel & (2) Scitec Group Ltd [201 0] EWHC 1 830; Re Nuneaton Borough AFC
Ltd (No: 2) [ 1 99 1 ] BCC 44; Re Nuneaton Borough AFC Ltd [ l 989] 5 BCC 792 ; Re D. R. Chemicals
Ltd [ l 989) 5 BCC 3 9 .
58. R e Sunrise Radio Ltd [201 0] IBCLC 367; Fowler v . Gruber[20 1 0] IBCLC 563 ; R e McCarthy
Surfacing Ltd [2008] EWHC 2279; Re Campbell Irvine (Holdings) Ltd (No:2) [2006] EWHC 583 ;
Strahan v. Wilcock [2006] EWCACiv 1 3 ; Phoenix Office Supplies Ltd v. Larvin [2002] EWCACiv
1 740; Re Jayflex Construction Ltd [2003) EWHC 2008; CVC Opportunity Equity Partners Ltd v.
Demarco Almeida[2002] 2 BCLC 1 08 ; Re Planet Organic Ltd[2000] 1 BCLC 366; Re Elgindata
Ltd [ 1 99 1 ] BCLC 959; Howie v. Crawford [ l 990] BCC 330.
59. See Re Uniso� Ltd (No 2) [ 1 994] BCC 766 where the judge noted that 994 petitions 'have
become notorious to the judges of this court for their length, their unpredictability of
management and for the enormous and appalling costs . . . ' .

1 53
§ 6 . 03 [B] Lorenzo Sasso

as free riding and expropriation of value respectively. These kinds of abuses are better
dealt with the contractual bargain of the parties involved.
It is almost common practice for the investor in venture capital financing to
obtain special covenants to protect its investment against claim dilution. These
covenants vary in their intensity ranging from provisions that regulate the incurrence
of new debt, allowing it when justified by the firm' s financial condition to severe
control rights that in certain particular circumstances assign to the investor a real right
to veto a firm' s decision such as a debt restructuring. Standard covenants dealing with
claim dilution may achieve their finality obliging, for example, a company to seek new
equity capital for new ventures that the firm wants to pursue. 60 In fact, if the venture
were to be financed by additional borrowed funds with preferential rights or priority in
liquidation, this would dilute the value of each prior investor' s claim in the event of
failure putting the company' s solvency at risk, but investors would not reap the
benefits of success since they do not share in capital growth. 6 1 In addition, an
over-reliance on debt can result in companies rej ecting potentially profitable opportu­
nities because substantial benefits from those opportunities will accrue to lenders
rather than to shareholders . In this way, covenants restricting borrowing may reduce
the incentive to over-invest or shift risk. 62
Conversely, control rights such as appraisal rights or veto rights give the investor
a right to veto a particular company' s decisions that may j eopardize their claim
regardless of the level of control they possess as a result of their equity holdings . These
veto rights provide a way to restore their bargaining power. 63 The British reluctance to
adopt these techniqueson a widespread basis contrasts with the laws in the US, where
it is currently common to provide appraisal rights 'in connection with mergers, sales
and exchanges of substantially all assets of the corporation, and charter amendments
that materially and adversely affect the right of the dissenting shareholder' . 64 However
for public companies in the UK, just as the City Code on Takeovers and Mergers

60 . These restrictions are normally expressed in fixed debt-equity ratio, net worth minimum,
current ratio, working capital minimum and a ratio of interest:dividend payable to net profit,
which means a restriction on making payments of dividends on shares and/or payments of
interest and repayments of principal on the junior debt. See R. Nash, J. Netter & A. Poulsen,
Determinants of Contractual Relations between Shareholders and Bondholders: Investment
Opportunities and Restrictive Covenants, J . Corp. Fin. 9, 201 and 2 1 5 (2003 ) ; W.W. Bratton,
Bond Covenants and Creditor Protection: Economics and Law, Theory and Practice, Substance
and Process, European Business and Organizational Law Review 7, 39 (2006) .
61 . D . R. Fischel, The Economics of Lender Liability, Yale L. J. 99, 1 3 1 (1 989) .
62 . S . C . Myers, Detenninants of Corporate Borrowing, J . Fin. Econ. 5 , 147 ( 1 977) ; R. Sappideen,
Fiduciary Obligations to Corporate Creditors, Journal of Business Law365 ( 1 99 1 ) ; C . W . Smith &
J . B . Warner, On Financial Contracting: An Analysis of Bond Covenants, J. Fin. Econ. 7, 1 1 7 and
1 24 ( 1 9 79) .
63 . W.W. Bratton, Venture Capital on the Downside: Preferred Stock and Corporate Control, Mich .
L. Rev . 1 00, 895 (2002) ; R . P . Bartlett, The Agency Costs of Venture Capital, UCLA L. Rev . 54,
74-75 (2006) .
64 . R.C. Clark, Corporate Law 443 (Little, Brown & Co . 1 986) .

1 54
Chapter 6 : Financing through Hybrid Instruments § 6 . 03 [B]

provides affiliation rights for shareholders as a class, it also provides an exit right for
minority shareholders through its mandatory bid rule. 65
The appraisal rights or veto rights, however, do not come without disadvantages .
An analysis of the practical problems with preference shares with veto rights shows
that they cause a misalignment of the interests and objectives of different classes of
shareholders or investors in a variety of situations and this can block the company' s
ability to act in its own best interest . 66 The venture capital fund holding control rights
may have economic interests that differ from other investors owing to the capital-time
investment constraint and investment return incentives . Consequently, the possibility
exists that these veto rights may be used in a manner that adversely affects the wealth
of a particular group of investors in much the same way that a manager may use his or
her discretionary decision-making power to adversely affect the wealth of all stock­
holders . It goes without saying that it poses a constraint to the company' s capacity to
raise new funds. If the initial investor can veto any attempt to restructure with the
justification of this being against their interests, or impose stricter conditions for
potentially interested investors, it is likely that the management' s negotiation for
attracting new investors will be a harder task. 6 7
However, in the US where the investors only rely on ex postlegal remedies for
protection, the Courts seem to avail the company' s interests above everything at the
expense of the single investor. 6 8 Therefore, investors have a strong incentive in
contracting for their rights and expectations with particular care. Especially in dis­
tressed situations, the technicality in the contract can be decisive for the efficacy of the
provision. Veto rights, as well as any other preferential right and limits of preferred
stock, have to be ' expressly and clearly stated' and will not be 'presumed or implied' . 6 9
The parties who negotiate the charter are presumed to have full knowledge of the law
and to recognize that all preferred shareholder rights must be set forth explicitly. 70
In order to avoid the ' free rider' problem and encourage existing investors to
support a company, especially in down rounds, legal practitioners have designed the
so-calledpay-to-play provisions . These clauses require the investors of a company in
financial distress to make an additional investment in the company or suffer the
consequences of a dilution of their rights . In particular, if a protected investor does not

65 . City Code, rule 9 that requires a person who has acquired control over 3 0 % or more of the
voting shares in a company to offer to buy out the remaining shareholders at the highest price
paid for the shares in the controlling block.
66. R.P. Bartlett, The Agency Costs of Venture Capital, UCLA L. Rev . 54, 78 (2006) .
67 . 0 . Maynard & W. Bains, Shares Structure and Entrepreneurship in UK Biotechnology Compa­
nies: An Empirical Study, Journal of Corporate Law Studies, 8,part I, 8-9 (2008) ; J.M. Fried &
M. Ganor, Agency Costs of Venture Capitalist Control in Startups, N.Y.U. L. Rev. 8 1 , 1 003
(2006) .
68 . Re: Benchmark Capital Partners IV, L.P. v. Vague, et al. , CA. No . Civ.A. 1 97 1 9 (Del. Ch . 1 5 Jul.
2002) .
69 . See the Delaware Supreme Court ' s decision in Elliot Associates L.P. v. Avatex Corp . 7 1 5 A.2d
843 (Del. 1 998) ,see also Telecom-SN! Investors, L.L.C. v. Sorrento Networks, Inc. , No. Civ.A.
1 9038- NC, 200 1 WL 1 1 1 7505 (Del. Ch. 7 Sep. 200 1 ) .
70 . Since in the Elliot case, the parties failed to provide for the possibility of a merger in the
language of the original charter, the court applied the typical rules for a merger authorization
vote: a merger was authorized by a simple maj ority vote of all outstanding classes of stock.

1 55
§ 6 . 04 Lorenzo Sasso

take up a pre-defined percentage of their entitlement to the new securities under the
pre-emption provisions (a non-participating investor) , they lose some or all of their
anti-dilution protections . 7 1
The provision can take a variety of forms . Typically, the existing preference
shares or convertible securities of the investors failing to participate in a dilutive
financing are converted into a new series of preference shares, often referred to as the
' shadow series' . The shadow series is usually identical to the existing series of
preference shares in terms of the preferential rights to income, capital and dividends,
except it may have no pre-emption rights (pay-to-play class) . The adverse conse­
quences of non-participation may include the loss of the liquidation preference or
voting rights held by the non-participating preferred stockholders , less anti- dilution
protection such as weighted average-price instead of full ratchet protection. In more
extreme cases, the non-player' s existing securities are converted into common shares
and they lose the company board seats associated with the earlier round preferred
stock, or some combination of the foregoing advantages . 7 2
The justification for pay-to-play provisions is that when the company is in
financial distress such provisions are necessary to raise capital and, in some cases,
avoid bankruptcy . If a pay-to-play provision is incorporated into the articles of
association, advisers must ensure that, as regards class rights , the pay-to-play class and
the original preferred shares are treated as a single class . This stops a non-participating
investor, who may well be the sole shareholder of the pay-to-play class, being able to
use their class rights to veto, for example, a subsequent financing of the company.
Conversely, the holders of convertible obligations are in a different position because
they are not stockholders and have no pre-emptive right to subscribe to new stock,
although the issuance of new stock might also dilute or destroy the value of their
conversion privilege.

§6.04 AN EVALUATION OF THE RATIONALE AND PROTECTIONS FOR

HYB RIDS

Convertible bonds and convertible preference shares are indeed an optimal tool for
refinancing a firm or raising some funds for a proj ect. The study of their peculiar
features emphasizes their capacity to reduce the shareholder' s opportunism without
depriving the investors - at least in the case of convertible bonds - of the advantage of

71 . R.P. Bartlett, The Agency Costs of Venture Capital, UCLA L. Rev . 54, 5 7 (2006) ; 0 . Maynard &
W. Bains , Shares Structure and Entrepreneurship in UK Biotechnology Companies: A n Empirical
Study, Journal of Corporate Law Studies 8 ,part I, 8-9 (2008) .
72 . J. W. Bartlett, Equity Finance: Venture Capital, Buyouts, Restructurings and Reorganizations209
(Aspen Publishers 1 995) ; P.A. Gompers & J. Lerner, The Venture Capital Cycle1 7 1 et
seq. (2ded. ,MIT Press 2004) . For some judgments of the US courts see WatchMark Corp. v.
ARGO Global Capital, LLC, et al. , Del. Supr. 2004; Benchmark Capital Partners IV, L. P. v. Vague,
Del. Ch. 2002 . The courts upheld in their judgments the applicable 'pay-to-play' provisions by
focusing on procedural fairness and strict contract construction principles, rejecting equitable
arguments rooted in the notion of substantive unfairness, and rejected the notion that a
fiduciary duty was owed to the early round minority stockholders to not impair their rights .

1 56
Chapter 6 : Financing through Hybrid Instruments § 6 . 04

having a contractual right against the company. As far as convertible instruments are
concerned, the conflict of obj ectives revolves around the conversion privilege. It is
common, especially in private equity and venture capital transactions where the
finance is supplied through subsequent instalments conditional on the achievement of
certain milestones, to have new tranches of finance offered at a discounted price to the
previous rounds : the so-called down rounds. The down rounds cause dilution and give
the opportunity to the new entries to capture most of the benefits at the expense of
previous investors . Convertible bonds are an articulated and consolidated standard­
ized practice to protect investors' rights from these problems : the anti-dilution clauses .
However, not all the issuances of new shares are a cause of value dilution. For instance,
when a new investor subscribes at a price equal to, or more than, the price paid by the
existing investor, the anti-dilution provision will not operate, as the existing investor is
happy to accept dilution on this basis . Similarly, a proper formula should distinguish
between subsequent sales that truly dilute the convertible securities and those that
merely reflect market information about the issuer. For instance, sales at or above the
market price should never trigger adjustments even if they fall below the original
conversion price. This is also why large publicly traded companies often avoid any
anti-dilution clauses in their issues . If the risk of dilution is already discounted in the
market, that sub-market-value issuance is very unlikely to happen.
Nevertheless, investors may suffer from ownership dilution that is the pro rata
dilution of their voting and control powers . The UK law limits the possibility of abuse
by providing as a general rule pre-emptive rights for shareholders . However, these
norms and standards only refer to ordinary shareholders and do not apply for
preference shareholders . Moreover, pre-emption rights are optional for private com­
panies and can also be opted out of in public companies' charters . US and UK
jurisdictions rely on a standards strategy: the duty of loyalty or the fiduciary duties in
general . Therefore, a preferred shareholder may file a petition alleging that their
minority shareholding has been unfairly prejudiced by the behaviour of the maj ority.
This approach allows the courts to leave directors the discretion to manage the affairs
of the company without interfering excessively. This ex postlegal strategy seems
robust . However, in the case of private equity and venture capital, it may not be
enough, as demonstrated by the veto rights and appraisal rights attached to preference
shares in the US market. These severe control rights given to the investor can be
counterbalanced by special provisions such as pay-to-play clauses that are targeted to
avoid the opposite opportunistic behaviour namely the free rider problem . The
equilibrium must be found by the parties in the bargain, because only the parties are
able to identify their risks and contract for protection. Again, since all the preferred
rights must be explicitly stated in the contracts, the parties negotiating the charter
require a very careful drafting.
CHAPTER 7

Control Transactions

In this chapter, I discuss the legal remedies and strategies available to preference
shareholders for addressing the principal-agent problems that arise when a person -
the acquirer - attempts, through offers to the company' s shareholders, to acquire
sufficient voting shares in a company to gain control of the company. These agency
issues refer to the shareholder-board conflict in companies with dispersed sharehold­
ings and the maj ority-minority conflict in firm in which there is a controlling share­
holder or shareholding group . The difference between control transactions and merg­
ers and acquisitions is that while a merger involves corporate decisions, control
transactions are effected by private contract between the acquirer and the shareholders
individually. 1
The usefulness of hybrids in private equity and venture capital is most evident in
control transactions, where the parties must design the firm' s capital structure not only
to align ex ante the right incentives to achieve the target, but also to resolve
distributional conflicts and make use of the right to sell control in the event of a future
sale of the firm. IPO and sale of the start-up firm are two of the main exit mechanisms
adopted by private equity and venture capital investors . However, since this kind of
businesses is developed in high uncertainty, these events may occur prematurely or in
bad economic conditions, when least desired. As a result it is possible that a hostile
takeover bidder will approach the firm with the sole aim of expropriating wealth from
the parties involved. For this reason, it is essential that whoever has the power to sell
makes the decision that is most efficient for all the parties . This is possible with hybrid
instruments, because they provide an asset-specific governance system that allows an
optimal allocation of control rights and financial rights in the firm. Contractual design
through the use of hybrids also seems the most efficient way of protecting investors'

1. Of course, the acquirer often has a free choice regarding whether to structure the bid as a
contractual offer or as a merger proposal . In the UK, the rules for control shifts can be applied
to acquisitions through statutory mergers on the grounds that many of the principles are
applicable for both control shifts and statutory mergers .

1 59
§7.01 Lorenzo Sasso

rights in private equity financing and in start-up businesses, which have great
unexploited potential and very uncertain conditions . The issues discussed in this
chapter are discussed in a UK and US context, since certain particular clauses have
international application .

§7.01 THE AGENCY CONFLICT IN CONTROL TRANSACTIONS

The shareholders of the target company, both as a class and as non-controlling

shareholders , mainly suffer from agency and coordination costs . Consequently, with
respect to the acquirer, they face significant coordination problems, because the
decision to accept or reject the bid is normally made by the shareholders individually,
rather than by way of a collective decision that binds everyone . With respect to the
target management, the shareholders still face agency issues, since the board' s
recommendation to them, for or against the offer, may not be disinterested. In
particular for the preference shareholders, who are a non-voting class of shareholders,
the overwhelming problems are related to price: a preference shareholder as well as a
minority shareholder can miss the opportunity to sell shares at a high price or can be
forced to sell at too low a price. 2
The coordination problems of shareholders may be mitigated to some degree
through the board' s negotiations with the potential acquirer. The agency costs may be
reduced by the mandatory bid rule introduced by the EU Takeover Directive, 3 which
obliges the acquirer of shares to make a general offer to the other shareholders once it
has acquired sufficient shares by private contract, whether on or off market, to obtain
control of the target. 4 In fact, although the acquirer' s offer may be value-increasing for
the target company' s shareholders as a whole, the non-controlling shareholders may
not obtain their pro rata share of that value in the future. However, the mandatory bid
rule, by prohibiting partial offers for the acquisition of control over the whole of the
company' s assets, constitutes a pre-emptive strike at majority oppression of minority
shareholders . 5 By extension, the law requires comparable offers to be made for all
classes of equity shares in the target, whether those classes carry voting rights or not. 6
In closely held companies, however, the application of the mandatory bid rule is
questioned as it can result in high costs for minority shareholders . It is arguable

2. For an analysis of these costs and the related legal strategies, see P . Davies & K. Hopt, Control
Transactions, in The Anatomy of Corporate Law: A Comparative and Functional Approach
225-273 (2d ed. , R. Kraakman et al . eds . , Oxford U . Press, 2009) , .
3. EU Takeover Directive 2004/2 5/EC .
4. See Art. 5 of the Takeover Directive. The Directive leaves the triggering threshold to be decided
by the Member States, most of which, including the UK, put the triggering percentage near
30 % , while Latvia, Malta and Poland put it at 50 % or higher.
5. One argument in favour o f the mandatory bid rule i s that i t may force the buyer to end up with
a larger block of shares, producing a greater incentive alignment between the buyer and the
remaining dispersed shareholders. This would result in a smaller extraction of private benefits .
See D . Gromb, M. Burkart, & F . Panunzi, Agency Conflicts in Public and Negotiated Transfers
of Corporate Control, J. Fin . 5 5 , 647-677 (2000) .
6. The City Code contains both such rules . See Rules 1 4 (offers where more than one class of
equity share) and 36 (partial offers) .

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Chapter 7 : Control Transactions §7.01

whether this rule should b e applied to a transfer o f a controlling position, s o a s to

require the acquirer to make a public offer, where they would otherwise not wish to do
so, and on the same terms as those accepted by the controlling seller. 7 Indeed, some
privately negotiated trades may occur because the buyer expects to extract more
private benefits than the seller does in spite of the fact that the firm is expected to be
worth less under the control of the buyer. Such transactions would not occur under the
mandatory bid rule because the dispersed shareholders would have to be paid the same
as the seller, which is more than their shares were worth before the trade. However, the
rule may deter value-increasing takeovers because the takeover price fails to compen­
sate the block owner for their private benefits . 8
Since it is very difficult to establish ex ante whether the minority shareholders
will be disadvantaged by the sale of the controlling block, the regulatory choice
hesitates between reliance on general corporate law to protect the minority against
unfairness in the future and giving the minority an exit right at the time of the control
shift . 9 Nevertheless, mandatory exit rights and mandatory sharing of bid premiums for
minority shareholders are a strong disincentive for any controlling shareholder to sell
the control stake if the private benefits of control are high. In fact, the acquirer will have
to bid for the whole share capital and will generally be reluctant to offer the transferor
any premium for control if he or she does not want to overpay for the share capital
taken as a whole. Accordingly, some systems do allow variations between the price
offered to the minority and that paid for the controlling shares, or permit partial bids in
certain cases . The UK City Code is unusual in applying the mandatory bid rule to any
acquisition of voting shares by a shareholder holding between 30 % and SO % of the
voting shares . 1 0
These problems are particularly enhanced in venture capital control transactions .
When an outside competitor - the acquirer - who possesses both adequate capital and
knowledge, appears and takes over the firm, considerable maj ority/minority distribu­
tional conflicts can arise, generated by the inefficient allocation of the private benefits
of control in the firm . 1 1 Two main agency conflicts can be identified in this case: the
expropriation of managerial quasi-rents, also known as the entrepreneur' s private
benefits of control and asset stripping, which is a potential abuse by the controlling

7. The Directive leaves the Member States with scope for specific exceptions . Some, but b y no
means all, takeover regimes have responded to these concerns, either in the formulation of the
rules relating to the fixing of the price for the general offer or by extending the list of exceptions
to the rule.
8. L. Bebchuk, Efficient and Inefficient Sales of Corporate Control, Q . J. Econ. 1 09 , 95 7-993 (1 994) ;
A. Pacces, Rethinking Corporate Governance: The Law and Economics of Control Powers 332
(Routledge 20 1 2) . See also A. Dyck & L. Zingales, Private Benefits of Control: A n International
Comparison, J . Fin. 59, 53 7-599 (2004) where the Authors extricate the private benefits of
control from the increase in the share value due to the change in control , in order to perform
an empirical evaluation of the costs and benefits of the mandatory bid rule.
9. See P . Davies & K . Hopt, Control Transactions ' in The A natomy of Corporate Law: A
Comparative and Functional Approach 256-263 (Kraakman R . et al. eds. , 2d ed. Oxford U . Press
2009) .
10. See Commission o f European Communities, Report on the Implementation of the Directive on
Takeover Bids, 2007 268, 6 (SEC 2007) .
11. E. Berglof, A Control Theory of Venture Capital Finance, J. L. Econ. & Org. 1 0, 248 ( 1 994) .

1 61
§ 7 . 0 l [A] Lorenzo Sasso

parties of the non-controlling parties . For instance, the acquirer may be more efficient
in running the firm, but may also fire management without compensation and dilute
firm value by transferring assets to themselves in connection with liquidation. 1 2
Furthermore, even if the parties - investor and entrepreneur - agree ex ante to allow for
a future sale of the business, they may disagree ex post . Therefore, there is a trade-off
between, on the one hand, the wish of the initial contracting parties to benefit from
potential efficiency improvements performed by a potential future competitor who
buys the firm and, on the other hand, their desire to protect themselves against
dilution. These problems are related to two generic state-contingent conflicts in
entrepreneurial finance: one relates to private benefits in good ' state of nature' and the
other involves the value of the firm in bad states . 1 3
It seems that since the sale of the firm is a verifiable event, contracts could be
made contingent on a sale. However, because the parties ' willingness to sell may be
affected by the ' state of nature ' , that is how the company is performing and the type of
buyer, just making the contract contingent on the event of a sale is not sufficient. 1 4 This
is also why the allocation of control rights and incentives should not be separated.
When private benefits are an important part of managerial compensation schemes,
state-contingent conflicts may arise and this separation may not hold . In order to
mitigate these conflicts the decision to trade should be given to the party most
vulnerable to dilution, namely the residual claimants . 1 5

[A] The Exit Event in Venture Capital Start-Up Firms

Young growth-oriented firms, particularly in high-technology industries, frequently

require substantial capital to develop and deploy their ideas . Several factors limit their
access to capital: uncertainty, asymmetric information, the nature of firm assets and
conditions in the relevant financial and product markets . As the firm develops and
growths over time, these factors can change in rapid and anticipated ways . Thus, the
ability to change dynamically is an essential skill to remain competitive in the market,
but also a maj or problem for those contributing the finance. Careful designing of
financial contracts and firm strategies can alleviate many potential obstacles . There­
fore, the manner in which firms are financed is important; each source and type of
investor may be appropriate for a firm at different points in its life. But the form of
financing is crucial to reducing conflicts . As long as the endeavour progresses well,
entrepreneurs are well-positioned to make the decisions . Control rights remain largely

12. M . C . Jensen, The Takeover Controversy: A nalysis and Evidence, The Midland Corp. Fin. J . 1 2
( 1 986) .
13. Asset stripping is more likely when a firm' s assets are worth more in alternative uses outside
the firm.
14. P . Aghion & P . Bolton, A n 'Incomplete Contract' Approach to Financial Contracting, Rev . Econ.
Stud. 59, 476 ( 1 992) ; E. Berglof, A Control Theory of Venture Capital Finance, J. L. Econ. & Org.
1 0, 249 ( 1 994) .
15. E . Berglof, A Control Theory of Venture Capital Finance, J . L . Econ. & Org. 1 0 256 ( 1 994) ; A.
Pacces, Rethinking Corporate Governance: The Law and Economics of Control Powers 346
(Routledge 20 1 2) .

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Chapter 7 : Control Transactions § 7 . 0 l [A]

vested in them and their management teams . The venture capital fund is content with
a minority of the board. If during the stages of financing the entrepreneur faces
situations of financial distress, they can always decide to dilute their control, letting the
venture capital fund convert some of its securities to equity or to subscribe to new
rounds . 1 6
However, a control ' flip ' should be provided as and when the company gets in
trouble, meaning that the venture capital fund gains outright control of the board in
such cases, leaving the entrepreneur with a great incentive to operate for the compa­
ny' s success . For instance, control flips can occur when certain standards are not met
or because certain negative covenants in a stock purchase agreement have been
violated. The optimal allocation of control between inside and outside shareholders is
determined by the trade-off between protecting the private benefits of the entrepreneur
and the free riding of the venture capital fund. 1 7 The parties to venture capital
arrangements must design the firm' s capital structure to resolve distributional conflicts
and make use of the right to sell control, which is itself a fundamental property right
influencing compensation to the initial contracting parties in the event of a future sale
of the firm. 1 8
In economic terms, no problems arise if trading with the acquirer can improve the
situation for both initial contracting parties or, vice versa, if both parties are made
worse off by trading with the acquirer and they will not trade in that case. However,
when there are constraints on the ex post side contracting, the acquirer may collude
with one of the initial contracting parties to extract surplus from the other. For
example, an outside investor could take over a firm that is performing well and fire its
entrepreneur if he does not have the right to sell control of the firm without
compensating him for his private benefits . Alternatively, a new owner could acquire a
firm which is performing badly or is insolvent for a small price and take out assets from
the firm without paying their full market value, thus harming the interests of the
venture capital fund if its financial rights are not protected contractually or it does not
control the firm. Furthermore, in the absence of adequate investment protections when
ownership and management are transferred, venture capital funds will hardly contrib­
ute new finance or at will least demand much higher shares of revenue. 1 9
The solution would be to write a perfectly contingent contract. Such a contract
would ensure that the proper action is taken by allocating decision-making authority to
the person with the right incentives, depending on the ' state of nature' . The difficulties
involved in writing such comprehensive contracts include the verifiability of the state

16. P . Aghion & P . Bolton, A n 'Incomplete Contract' Approach to Financial Contracting, Rev. Econ.
Stud. 59, 473 -494 ( 1 992) .
1 7. S . Grossman & 0 . Hart, One-Share One-Vote and the Market for Corporate Control, J. Fin. Econ.
20, 1 75-202 (1 988) ; L. Zingales, Insider Ownership and the Decision to Go Public, Rev. Econ.
Stud. 62 , 42 5-448 ( 1 995) .
18. A . Alchian & H. Demsetz, Production, Information Costs and Economic Organization, Am.
Econ. Rev. 62 , 777-795 ( 1 9 72) .
19. See the importance o f control allocation in E . Berglof, A Control Theory of Venture Capital
Finance, J. L. Econ. & Org. 1 0, 249 ( 1 994) .

1 63
§ 7 . 0 l [B] Lorenzo Sasso

of nature, which is normally only observable and not verifiable. 2 ° Furthermore, a

company' s state of nature can be extremely difficult to describe. It really is just a
general sense of how the company is doing, and many variables encompass such an
evaluation. As a result, the contract cannot link a specified decision-maker to the
appropriate state of nature and contracting parties can only avoid costly ex post
bargaining by allocating control over strategic decisions to one of the parties . 2 1
Alternatively, the return of the parties will increase if they can make this
allocation contingent on some verifiable variables correlated with the state of nature,
designing the financial structure so as to extract more from a potential buyer. 22 For
example, the parties could agree in advance to allocate control power to the financier
or the entrepreneur depending on certain signals reflecting the company' s states of
nature . If the signals are correct, contingent control may be preferable to unilateral
control of one of the parties . 2 3 As we will discuss, hybrid financial instruments as
convertible non-voting securities can guarantee an efficient allocation of control
rights . 2 4

[B ] The Use of Convertible Instruments as a Device to Allocate Control

Different control and revenue allocations can be achieved by the parties through the
use of the standard financial contracts debt and equity. Equity ensures the entrepre­
neur compensation for his private benefits by giving him the right to sell control and
allowing the external investor to benefit as a free rider from efficiency improvements
brought about by a rival management team, but only when the firm is performing well.
Conversely, debt protects external investors in times of financial distress by transfer­
ring the right to sell control to them when debt repayments are not met or negative
covenants are missed. The basic mechanisms for control transfer associated with
equity and debt, namely takeover and insolvency, complement each other. Under the
assumption of perfect markets, takeover optimizes between outsiders and insiders

20. For a discussion of verifiability of state of nature by public court see J. Tirole, Hierarchies and
Bureaucracies: On the Role of Collusion in Organizations, J . L. , Econ . & Org. 2 , 1 8 1 -2 1 4 ( 1 986) .
See also 0 . Hart , Firms, Contracts and Financial Structures 38 and 73 (Oxford U . Press 1 995) ;
R.E. Scott & G . G . Triantis, Anticipating Litigation in Contract Design, The Yale L. J. 1 1 5 ,
8 1 4-879 (2006) ; R.E. Scott & G . G . Triantis, Incomplete Contracts and the Theory of Contract
Design (U . Va. John M. Olin Program L. & Econ. , Working Paper Series no . 23 , 2005) .
21 . S. Grossman & 0 . Hart, The Cost and Benefits of Ownership: A Theory of Vertical and Lateral
Integration, J . Political Econ. 94, 69 1 -7 1 9 ( 1 986) .
22 . P . Aghion & P . Bolton, An 'Incomplete Contract' Approach to Financial Contracting, Rev . Econ.
Stud. 59, 473-494 ( 1 992) .
23 . D . Gordon Smith, The Exit Structure of Venture Capital, UCLA L. Rev . 5 3 , 322 (2005) ; P . Aghion
& P. Bolton, An 'Incomplete Contract ' Approach to Financial Contracting, Rev . Econ. Stud . 59,
486 ( 1 992) .
24 . See S . N . Kaplan & P . Stromberg, Financial Contracting Meets the Real World: An Empirical
Analysis of Venture Capital Contracts, Rev. Econ. Stud. 70, 28 1 and 283 n. 5 (2003 ) .

1 64
Chapter 7 : Control Transactions § 7 . 0 1 [B]

while bankruptcy does so among shareholders and debt-holders . 2 5 Given that convert­
ible preference shares or bonds can be made state-contingent, they are the most
suitable to achieve the optimal allocation of control rights , and protect the initial
contracting parties as much as possible against dilution. 2 6
This is easy to demonstrate. When only equity capital is issued in a start-up firm,
the control power is allocated independently by the state of nature . One party holds or
both parties share - in case of j oint ownership - control in all states of nature. In such
a context, whether the entrepreneur issues voting or non-voting shares to the venture
capital fund, the conflicts of interest remain. If he issues non-voting equity, he will be
compensated in case of a takeover, because he enjoys his private benefits of control as
well as the venture capital fund, which will be able to enjoy the benefits of efficiency
improvement, but only if the company is performing well . By contrast, in a time of the
company' s financial distress, the private benefits of the entrepreneur are non-existent
and the venture capitalist may be subj ect to costs of asset stripping. The situation is
even worse if the entrepreneur issues voting shares to the venture capital fund. 27 In
fact, the venture capital fund, which is in control of the firm, will sell it as long as the
price is higher or equivalent to what it would get in the absence of a buyer. The
entrepreneur loses his j ob but he retains his equity holdings . Consequently, he can
share in potential value-increasing actions but his private benefits of control are
expropriated if the firm is performing well and, in addition, assets are siphoned off
when the firm is in financial distress . 28
In joint ownership , the venture capital fund can extract some of the value of the
private benefits from the entrepreneur before consenting to a sale. However, since the
entrepreneur initially has great bargaining power, the possibility to extract private
benefits in case of a sale merely leads the entrepreneur to offer the venture capital fund
a power share of verifiable revenues . In conclusion, not all equity financing may be
optimal . A possible solution has come from strategies of governance that part of the
doctrine has defined as 'shared control' . 2 9 In a shared control situation, for example,
the venture capitalist owns a maj ority of the voting stock of the portfolio company, as

25. P . L. Davies, Shareholder Value, Company Law and Security Markets Law: A British View, in
Company Law and Financial Markets 2 6 1 -288 (E. Wymeersch & K. Hopt eds . , Oxford U. Press
2002) .
26. E. Berglof, A Control Theory of Venture Capital Finance, 1 . L. Econ. & Org. 1 0, 253 ( 1 994) . The
author examines six venture capital contracts: non-voting or minority equity, equity, voting or
majority equity, joint ownership, standard debt and convertible debt or a combination of debt
and non-voting equity. See also W.A. Sahlman, The Structure and Governance of Venture
Capital Organizations, J . Fin. Econ . 27, 473-52 1 ( 1 990) ; W.W. Bratton, Venture Capital on the
Downside: Preferred Stock and Corporate Control, Mich. L. Rev . 1 00, 89 1 and 900-90 1 (2002) .
27. J.M. Fried & M. Ganor, Agency Costs o f Venture Capitalist Control i n Startups, N . Y . U . L. Rev. 8 1 ,
994 et seq. (2006) .
28. To ensure that the entrepreneur is properly compensated for his private benefits , voting equity
could be combined with a payout triggered by a sale of the firm (a golden parachute) . Such a
clause would extract more from the buyer. However, the entrepreneur should not be compen­
sated in bad states of nature, where he enjoys no private benefits. For this reason compensation
would have to be contingent on the state of nature, which is assumed not to be verifiable. See
E. Berglof, A Control Theory of Venture Capital Finance, 1. L. Econ. & Org. 1 0, 256 ( 1 994) .
29. The key feature of Bratton's interpretation of the model is the notion of ' shared control' - an
' open-ended balance of power in the boardroom [where the] venture capitalist. . . gets no

1 65
§ 7 . 0 1 [B] Lorenzo Sasso

long as he does not control a maj ority of the board of directors . Such a situation,
although unusual in the market, 3 0 would facilitate the transfer of control among the
parties in certain cases in which there is no reliable signal that could trigger the shift in
control . 3 1
Assuming it is possible to stipulate a recognizable signal, since the two agency
conflicts occur in different states of nature and between different parties, the parties
may be able to extract more from a buyer by making the allocation of control
contingent on the state of nature through debt financing. Therefore, the entrepreneur
should hold all the voting rights and the venture capital fund should participate as
debt-holder. In so doing, when the firm is performing well and a bid offer appears, the
entrepreneur, who is the person vulnerable to expropriation of private benefits, is fully
protected. Conversely, if the potential buyer shows up following the realization of a
state of insolvency, control shifts to the venture capital fund, which cares most about
firm value. The problem, however, is that while control is optimally allocated, the
allocation of rights to revenues is such that the initial contracting parties do not benefit
from efficiency improvements brought about by a buyer when the firm is growing
well. 3 2 If, for example, the buyer were less efficient than the entrepreneur, j oint
ownership would extract more from the buyer. 33
The optimum would be to combine the protection against asset stripping offered
by the contractual rights of a debt loan with the possibility of enj oying the benefits of
a bid offer through issuing equity. The solution is to assign convertible preference
shares or convertible bonds to the venture capital fund. 34 Convertible securities protect
the venture capital fund against dilution when the firm is performing poorly by

unilateral power to control the assets and terminate the entrepreneur on the downside' . See
W.W. Bratton, Venture Capital on the Downside: Preferred Stock and Corporate Control, Mich.
L. Rev . 1 00, 895 (2002) .
30. S . N. Kaplan & P . Stromberg, Financial Contracting Meets the Real World: An Empirical Analysis
of Venture Capital Contracts, Rev. Econ. Stud. 70, 287 (2003) .
31. See W.W. Bratton, Venture Capital on the Downside: Preferred Stock and Corporate Control,
Mich. L. Rev. 1 00, 893 and 9 1 2 (2002) where the author is interested in ' downside' protection,
which he says consists of two powers : ( I ) the 'power to replace the firm' s managers (or
alternatively, to force premature sale or liquidation of the firm) ' and (2) the ' power to protect
the venture [capital] contract itself from opportunistic amendment' .
32 . The venture capitalist shares with the entrepreneur expectations of equity holders indepen­
dently of the securities held, see S . N . Kaplan & P. Stromberg, Financial Contracting Meets the
Real World: An Empirical Analysis of Venture Capital Contracts, Rev . Econ. Stud. 70, 2 8 1 and
306-308 (2003) .
33. O f course there may b e considerable costs associated with unconstrained ex post bargaining, in
which case all-debt financing is more attractive.
34. See, for example, A.R. Admati & P . Pfeiderer, Robust Financial Contracting and the Role of
Venture Capitalists, J. Fin. 49, 3 7 1 ( 1 994) on the anoptimal use of ' fixed-fraction contracts' to
resolve agency problems in venture capital transactions; D. Bergemann & U. Hege, Venture
Capital Financing, Moral Hazard, and Leaming, J. Bank & Fin. 22, 703 ( 1 998) on the optimal
mix of debt and equity to address moral hazard risks posed by entrepreneurs; E. Berglof, A
Control Theory of Venture Capital Finance, J . L. Econ. & Org. 1 0, 247 ( 1 994) on the optimal
contract design to reduce conflicts of interest between the financier and the entrepreneur; T.
Hellmann, The Allocation of Control Rights in Venture Capital Contracts, Rand J. Econ. 29, 5 7
(1 998) o n the optimal use o f control rights; K . Schmidt, Convertible Securities and Venture
Capital Finance, J . Fin. 58 , 1 1 39 (2003) on the optimal use of convertibles to induce efficient
investment by entrepreneurs and investors; B. Black & R. Gilson, Venture Capital and the

1 66
Chapter 7 : Control Transactions § 7 . 02 [A]

ensuring the liquidation value of the firm under the original entrepreneur. If the firm is
performing well, asset stripping is not a problem, and debt is converted into (better if
non-voting) equity and the venture capital fund can fully benefit from efficiency
improvements as well as the entrepreneur. In addition, the conversion privilege of
convertible debt allows the parties to contract on non-verifiable but observable
information, which is the signal related to a state of nature .
The main focus of exit theory, both in legal and economic literature, has been the
trade-off between 'liquidity' and ' control' . 3 5 The right levels of liquidity and control in
each stage of a start-up firm can be adjusted through contractual rights . In designing an
optimal financial contract, investors and entrepreneurs strive to provide incentives for
efficient monitoring while allowing investors to obtain the maximum level of liquidity
consistent with such monitoring. 3 6 In fact, the allocation of voting control, decision
rights and financial rights generated by convertibles recognizes the importance of both
residual cash flow rights 3 7 as well as asset control rights 3 8 in resolving information
asymmetry and agency conflicts among deal participants .

§7.02 EXISTING LEGAL STRATEGIES FOR PREFERENCE

SHAREHOLDERS PROTECTION

[A ] The UK Takeover Panel and the City Code on Takeovers and

Mergers

In the absence of home-grown takeover remedies the Takeover Panel is the arbitrator
and referee of mergers and acquisitions in the UK. The Panel normally prohibits a target
company from taking legal action that would have the effect of frustrating an offer,
unless shareholder permission is obtained . The Takeover Panel consists of represen­
tatives from the London Stock Exchange, the Bank of England, maj or merchant banks
and institutional investors . Its task is to administer a set of rules known as the City Code
on Takeovers and Mergers (the Takeover Code) . It also operates to ensure that
takeovers are conducted in a timely and efficient manner and that target companies are

Structure of Capital Markets: Bank versus Stock Markets, J. Fin. Econ. 47, 243 and 253 ( 1 998) ;
W.A. Sahlman, The Structure and Governance of Venture Capital Organizations, J . Fin. Econ.
27, 473 ( 1 990) .
35. See, for example, J . C . JR. Coffee, Liquidity versus Control: The Institutional Investor Voice,
Colum . L. Rev . 9 1 , 1 2 77 ( 1 99 1 ) ; A. Faure-Grimaud & D . Gromb, Public Trading and Private
Incentives, Rev. Fin. Stud. 1 7, 985 (2004) ; M. Kahan & A. Winton, Ownership Structure,
Speculation, and Shareholder Intervention, J. Fin . 5 3 , 99 (1 998) ; E. Maug, Large Shareholders as
Monitors: Is There a Trade-Off between Liquidity and Control? J. Fin . 5 3 , 65 (1 998) ; M.J. Roe,
Political and Legal Restraints on Ownership and Control of Public Companies, J. Fin. Econ . 27,
7 ( 1 990) .
36. P . Aghion, P . Bolton & J. Tirole, Exit Options in Corporate Finance: Liquidity versus Incentives,
European Fin. Rev. 8 , 7 (2004) .
37. M. Jensen & W. Meckling, Theory of the Finn: Managerial Behavior, Agency Costs and
Ownership Structure, J . Fin. Econ. 3 , 307 ( 1 9 76) .
38. The Property Rights Theory see S . Grossman & 0 . Hart, The Cost and Benefits o f Ownership: A
Theory of Vertical and Lateral Integration, J. Political Econ. 94 69 1 -7 1 9 ( 1 986) .

1 67
§ 7 . 02 [A] Lorenzo Sasso

not subj ect to speculative and prolonged takeover bids . It is not, however, concerned
with the ' financial or commercial advantages [or disadvantages] of a takeover' . 39
The Takeover Panel' s supervision differs significantly from the US framework for
regulating takeovers with regards to several aspects : the time, the type and the
flexibility of the intervention. 4 0 The Panel imposes little or no delay on the takeover
effort, addressing takeover issues in real time. Furthermore, it operates a pro-active and
flexible regulatory approach, which falls outside of the courts, allowing it to adjust to
the regulatory requirements of a changing business environment. As a consequence,
lawyers play little role in the Takeover Panel, which is staffed predominately by
financial groups . The Panel is more business focused than legal and, in contrast to the
US , tactical litigation as a takeover defence is virtually ruled out of the takeover
process. Instead all obj ections and appeals are heard directly by the Panel to which
Courts has recognized full jurisdiction. 4 1
The Takeover Code also provides protection for the minority shareholders,
including preference shareholders, from possible abuses by stating:

where a company has more than one class of equity share capital , a comparable
offer must be made for each class whether such capital carries voting rights or
not . 42

A comparable offer need not necessarily be an identical offer. 43 A bid offer either via
private treaty with a small number of important shareholders or via purchases of shares
on the market, or by way of a general and public offer to all the shareholders of the
target company is clearly facilitated if the target' s shares are traded on a public market.
If this is the case and the offer concerns two or more classes of equity share capital:

the ratio of the offer values should normally be equal to the average of the ratios
of the middle market quotations over the course of the six months preceding the
commencement of the offer period. 44

Any other ratio adopted by the parties has to be fully justified . Similarly, if one or more
of the classes of equity share capital are not listed, the ratio of the offer values must be
justified to the Panel in advance. 45
When an offer for non-voting shares only is being made, comparable offers for
voting classes are not required . In addition:

an offer for non-voting equity share capital should not be made conditional on any
particular level of acceptances with respect to that class, or on the approval of that

39. The Takeover Panel, Code Committee, Consultation o n aspects o f the takeover code, 20 1 0/6.
40 . J . Armour & D . A. Skeel, Who Write the Rules for Hostile Takeovers, and Why? - The Peculiar
Divergence of U. S. and U.K. Takeover Regulation, Ga. L. J . 95, 1 744 (2007) .
41 . R v. Panel on Takeovers and Mergers ex parte Datafin [ 1 987] 2 WLR 699 . See also Regina v.
Panel on Takeovers and Mergers, ex parte Guinness Plc. [ 1 990] 1 Q . B . 1 46; Idem, [ 1 990] BCLC
255.
42 . See Rule 1 4 . 1 of the 'Blue Book' (Takeover Code) .
43 . See Rule 14.2 of the 'Blue Book' : 'where an offer is made for more than one class of share,
separate offers must be made for each class' .
44. See Rule 1 4 . 1 of the 'Blue Book' comparability of the offer.
45 . See ' Blue Book' notes on Rule 1 4. 1 .

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Chapter 7 : Control Transactions §7.02 [A]

class, unless the offer for the voting equity share capital is also conditional on the
success of the offer for the non-voting equity share capital.46

In any case, it is always better to consult the Panel in advance, because the Panel, for
the purpose of this Rule, may disregard as equity share capital certain classes of shares
recognized as such by the Companies Act 2006 but holding in practice very limited
equity rights .
The possible abuse by the acquirer in offering an undervalued price for special
categories of preferred shares may be limited to a certain extent by the market arbitrage
effect when the shares are listed on the stock market. When the undervalued class of
shares is listed in a stock market and any information regarding the firm is disclosed,
the arbitrage effect, although not without cost, will equalize the difference between the
classes of shares . Every time the price offered for a preferred class of shares, largely in
a takeover transaction, undervalues those shares in the market, qualified investors as
private equity or hedge funds, if the profits offset the costs, might always buy those
shares . They would thus acquire consistent ownership interest and control power in
the class of share to oppose the unfair transaction, taking legal action against the
company. 4 7
However, if the shares are not listed on a public market their evaluation may be
more arbitrary and difficult to oppose. In cases where preference shares are not
included in the relevant securities category and therefore do not receive an offer, their
shareholders may be left with no other remedy to avoid the wealth expropriation
conducted by the majority shareholders . A possible means of tackling this problem
could be to petition the court for relief on the grounds that the conduct of the company
has been or is prejudicial to the interests of some part of its members or an actual or
proposed act or omission of the company is or would be so prejudicial. 48 The issue of
a petition may amount to an abuse of process, even though there has been unfair
prejudice, if it is clear that the petitioner will have to sell his shares to the respondent
and the petitioner has unreasonably rej ected a reasonable offer to purchase his shares
at a fair price. 49 However, over the years not many cases have arisen, and although the

46. See Rule 1 4 . 1 of the 'Blue Book ' .

47. This i s the case o f Elliott Associates LP . They took o n Cincinnati-based P&G i n 2003 , after the
world' s biggest consumer products company bid for Wella AG, a German hair care products
company. Procter & Gamble offered the founding family and Wella management , which held
all of the voting stock, EUR 92 . 50 (USD 1 3 3 .40) a share, or USD 6.9 billion, to acquire the
company. The offer was 42 % more than the EUR 65 offered to holders of non-voting, preferred
shares .
48. See s . 994 of the CA 2006 'unfair prejudice' petition. P . L . Davies , Gower and Davies ' Principles
of Modem Company Law 7 1 8-743 (9th ed. , Sweet & Maxwell 20 1 2) .
49 . Re a Company (No : 003843 of 1 986) [ 1 987] 3 BCC 624; Re a Company (No : 003096 of 1 987)
[ 1 988] 4 BCC 80; O 'Neill v. Phillips [ 1 999] 1 WLR 1 092 ; North Holdings Ltd v. Southern Tropics
Ltd [ 1 999] BCC 746; West v. Blanchet [2000] 1 BCLC 795 ; Wyatt v. Frank Wyatt & Son Ltd
[2003 ] EWHC 520; Isaacs v. Belfield Furnishings Ltd [2006] All ER (D) 2 1 6.

1 69
§ 7 . 02 [B] Lorenzo Sasso

courts have always had jurisdiction to review the panel' s decision, 5 0 there have been
no grounds for interfering and the courts have declined to intervene. 5 1

[BJ The Standard Strategy: The Duty of Loyalty in a UK-US Comparative

Perspective

In common law countries a further protection comes from the fiduciary standards . In
the UK, for instance, a director must:

act in a way he considers, in good faith, would be most likely to promote the
success of the company for the benefit of its members as a whole. 52

The common law obligation already compels directors to behave in the best interests of
the shareholders as a whole, but section 1 72 potentially departs from that position by
requiring that, in promoting the success of the company, the director must have regard
to a number of other stakeholder interests, such as the company' s employees,
suppliers, customers and others . 5 3 Despite this, the preferable analysis of section 1 72 is
that it requires directors to have regard to the long-term interests of the shareholders .
It may happen that directors may have to take account of other stakeholder groups but
only in order to support the long-term growth of the company. 54 Thus, in a solvent
company, it is the interests of the shareholders that remain the dominant concern. In
fact, although lenders contribute significantly to corporate governance by monitoring
the directors in accordance with their own interests, they are well protected by contract
and by capital maintenance regime . 5 5
In the US, the duty of loyalty is used to monitor transfer of control in closely held
companies as well as in publicly traded ones . These duties may impose an obligation
upon the controlling seller either to compensate the remaining shareholders for
foreseeable harm caused by the transfer5 6 or to share the premium with the non­
controlling shareholders when the transfer can be identified as involving the alienation

SO. Although the Takeover Panel purports to be part of a system of self-regulation and to derive its
power solely from the consent of those whom its decisions affect, it is in fact operating as an
integral part of a governmental framework for the regulation of financial activity in the City of
London, is supported by a periphery of statutory powers and penalties, and is under a duty to
exercise what amounts to public powers to act judicially .
Sl. R v. Panel on Takeovers and Mergers ex parte Datafin [ 1 987] 2 WLR 699. See also Regina v.
Panel on Takeovers and Mergers, ex parte Guinness Plc. - [ 1 990] 1 Q . B . 1 46; Idem, [ 1 990] BCLC
2SS.
S2 . Section 1 72 of the Companies Act 2006. For a fuller discussion compare P .L. Davies , Gower and
Davies ' Principles of Modem Company Law SOS-S09 and S2S et seq. (9th ed. , Sweet & Maxwell
20 1 2) ; D. Kershaw, Company Law in Context: Text and Materials 299 et seq. (2nd ed. Oxford
U. Press 20 1 2) .
S3 . See Re Smith and Fawcett Ltd [ 1 942] Ch. 3 04, 306 per Lord M . R. Greene Directors do not owe
duties to individual shareholders . However, they may do so in specific factual circumstances:
Peskin v. Anderson [200 1 ] 1 BCC 874.
S4. D . Kershaw , Company Law in Context: Text and Materials 349-3S l (2nd ed. Oxford U . Press
20 1 2) .
SS. A. Pacces , Rethinking Corporate Governance: The Law and Economics o f Control Powers 3 S 7
(Routledge 20 1 2) .
S6. See, Gerdes v. Reynolds 28 New York Supplement Reporter 2nd Series 622 ( 1 94 1 ) .

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of something belonging to all shareholders . 5 7 However, these cases do not state the
general rule. US courts have not adopted a general equality principle, which might
have led them to generate an unqualified right for non-controlling shareholders to
share in the control premium. 5 8 A controlling shareholder can dispose of voting right
securities for a price that is not made proportionally available to other shareholders,
but is subj ect to a requirement for fair dealing. Providing self-dealing is effectively
controlled, permitting sales at a premium price gives both seller and acquirer an
appropriate regard for their extra monitoring costs . 59
As in the UK, the main US doctrine has excluded bondholders from the protection
of these duties, because no agency or trust relationship exists between them in law. 60
The contrast between the rights of debt-holders and the simple expectations of equity
holders , who are protected by fiduciary duties, has also been noted by the US courts of
Delaware in several cases, 6 1 where they declined the imposition of a fiduciary duty in
the absence of an equity interest. 62
However, in past years, especially in the US, a pluralistic approach of the
maximization of the company as a whole has been developed at least at a doctrinal
level, together with the conviction that directors' fiduciary duties are owed to the
company. 6 3 In this line of reasoning, the doctrine has tried to relax the strict legal
definition of the fiduciary relationship, adopting instead an economic concept of it.
This study extracts generally applicable concepts of the essential fiduciary obligation
from its particularized manifestation in agency and trust relationships, to replace them
with a flexible definition of the fiduciary obligation as the 'exercise of judgment on
behalf of another' . 64 This definition permits the identification of numerous interrelating

57. Perlman v. Feldman 2 l 9 Federal Reporter 2nd Series 1 73 ( 1 955) ; Brown v. Halbert, 7 6 California
Reporter 78 1 ( 1 969) .
58. See R . C . Clark, Corporate Law 478-498 (Little, Brown & Co . 1 986) .
59. R. Gilson & J . Gordon, Controlling Controlling Shareholders, U. P a . L. Rev . 1 52 , 8 1 1 -8 1 6 (2003) .
60 . For an analysis of the main case law on this matter see S . Fraidin & F. Stevelman, Duties to
Bondholders in Recapitalizations and Restructurings, Corporate Law and Practice Course
Handbook Series, 754 PLl/Corp 277, accessible at http ://www .nyls .edu/user_files/ 1 /3/4/30/
3 1 /32/PLIDuties . pdf.
61 . See Harff v. Kerkorian, 324 A.2d 2 1 5 (Del . Ch. 1 974) , aff' d in part and rev ' d in part, 347 A.2d
1 3 3 (Del. Supr. 1 975) ; In re Will Of Miguel, 71 Misc.2d 640, 336 N.Y.S.2d 3 76, 3 79 (Sup . Ct.
1 972) .
62 . Based on the decision in Harff and In re Will of Miguel, the court in Simons v. Cogan, 549 A.2d
300 (Del. Supr. 1 988) concluded: 'In sum, a convertible debenture represents a contractual
entitlement to the repayment of a debt and does not represent an equitable interest in the
issuing corporation necessary for the imposition of a trust relationship with concomitant
fiduciary duties' ; 549 A.2d at 303 .
63 . J. Parkinson, Corporate Power and Responsibility 2 1 -4 1 (Clarendon Press 1 993) ; G . Kelly & J.
Parkinson, The Conceptual Foundations of the Company: A Pluralist Approach, Co . Fin. &
Insolvency L. Rev. 2, 1 74 ( 1 998) ; L.E. Mitchell, The Fairness Rights of Corporate Bondholders,
N.Y.U. L. Rev. 65, 1 1 65 ( 1 990) ; D . Millon, Theories of the Corporation, Duke L. J. 201 ( 1 990) ;
K . N . Llewellyn, What Price Contract? An Essay in Perspective, Yale L. J. 40, 72 1 ( 1 93 1 ) . Also see
W. Leung, The Inadequacy of Shareholder Primacy: A Proposed Corporate Regime that Recog­
nizes Non-shareholder Interests, Colum. J.L. & Soc . Probs . 30, 5 89 ( 1 997) ; S . Worthington,
Shares and Shareholders: Property, Power and Entitlements (Part 1 and 2) , Co . Law . 22, 258 et
seq . (200 1 ) .
64. J . Jacobson, Capturing Fiduciary Obligation: Shepherd 's Law of Fiduciaries, Cardozo L. Rev . 3 ,
5 1 9 and 527 ( 1 982) ; T . Frankel, Fiduciary Law, Cal . L . Rev. 7 1 , 795 and 808-809 ( 1 983) .

1 71
§ 7 . 02 [B] Lorenzo Sasso

fiduciary obligations in corporate structures and consequently obligations arising from

contractual relationships as fiduciary. Furthermore, if, on the one hand, as long as the
corporate debtor remains able to repay the debt, creditors ' interests have not been
impaired sufficiently to justify legal restraints on the corporation ' s self-interested
actions, on the other, a different judgment is made regarding the insolvent corporate
debtor when the insolvency j eopardizes the repayment. In such a situation, the balance
of interests shifts to favour the creditors, giving rise to creditor protection in law. 6 5
The traditional analysis has challenged the idea of expanding the directors'
fiduciary duties towards the creditors on the basis of the assumptions underlying the
contract of corporation . Over the years there has been a weakening of the strong
distinctions equity-debt, shareholder-bondholder and, consequently, a reclassification
of their relationships into neat corporate and contract categories . 66
Corporate law used to tolerate only limited contractual alterations of the terms
governing relationships between the corporation and its stockholders , but today,
especially with respect to closely held corporations, as is suggested by the case of
hybrid instruments, contractual arrangements between the stockholders may restrict
the exercise of management discretion granted under the pure corporate model in
much the same manner as negative covenants in bond contracts or veto rights in
preference shares have done all along. 6 7
For example, the convertible bond relationship presents an area of overlap
between contract and fiduciary restraining principles . Outside the overlap, contract
and fiduciary duties go off in different directions, with fiduciary duties focusing on the
protection of the dependent party and contract duties focusing on the effectuation of
the parties' allocation of risks . Generally fiduciary duties tend to impose a higher
degree of selflessness than is imposed on contracting parties subject to the good faith
duty. The fiduciary must put the beneficiary' s interests ahead of his own even though
the costs to the fiduciary exceed the benefits to the beneficiary. In contract, under a
good faith approach the party under the duty need only give equal consideration to the
other party' s interests, placing them ahead of his own only where the balance of costs
and benefits gives primacy to the other' s interests . 68
From another point of view, however, as some attentive doctrine has pointed out,
the issuer fiduciary duty to bondholders is indistinguishable from the contract inter­
pretation informed by a good faith duty. 6 9 While the duties in theory originate in

65 . R. Clark, The Duties of Corporate Debtor to Its Creditors, Harv. L. Rev. 90, 5 1 0 ( 1 977) . See Harff
v. Kerkorian, 324 A.2d 2 1 5 (Del. Ch . 1 9 74) , aff' d in part and rev ' d in part, 347 A.2d 1 3 3 (Del.
Supr. 1 975) .
66. R. Kraakrnan & H . Hansmann, The Essential Role of Organizational Law, Yale L.J . l l 0, 3 8 7-440
(2000) .
67. F. Tung, Leverage in the Board Room: The Unsung Influence of Private Lenders in Corporate
Governance, UCLA L. Rev. l l 5 , 1 70- 1 73 (2009) ; H. Hamer Corporate Control and the Need for
Meaningful Board Accountability, Minn. L. Rev . 94, 54 1 (20 1 0) ; M . Gatti, ' Le azioni con voto
subordinato all' effettuazione di un' opa e l' "autorizzazione di conferma " ' , Giur. Comm. I
(2004) : 5 l l et seq.
68 . C.G. Goetz & R.E. Scott, Principles of Relational Contracts, Vanderbilt L. Rev. 67, l l 28 ( 1 98 1 ) .
69 . A.G. Anderson, Conflicts of Interest: Efficiency, Fairness and Corporate Structure, UCLA L. Rev .
2 5, 759-760 ( 1 9 78) .

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different places - the contract law duty in the particular contract' s bundles of promises
and conditions, and the fiduciary duty in the issuer' s exercise of judgment over the
bondholders' investment - they become functionally identical as long as the bond
contract is granted primacy over judicial fairness notions as the source of the
relationship ' s rights and duties. Both duties justify bondholder protective filling in of
contractual interstices and perhaps a generalized duty to disclose, but do nothing
more. 7 0
A court treating a contractual relationship too easily might be led to an erroneous
avoidance of an unobj ectionable contractual allocation of risk, by a rhetoric of
selflessness that originated regarding very different fiduciary relationships . 71 The strain
of bending fiduciary principles to fit the convertible bond context creates a risk of
over-protecting bondholders . Since the results of the effort only duplicate results
obtainable through contract law analysis, and since contract law provides a more
precise set of analytical tools for resolving conflicts between issuers and bondholders ,
the courts have mostly abandoned this approach in fiduciary protection. 72
Importantly, a justification key to the relative interests of stockholders and
creditors only partially applies to hybrid securities like convertibles . The conversion
privilege creates an additional bundle of bondholder interests to be thrown into the
balance. One court, recognizing this , hit upon the neat solution of extending manage­
ment fiduciary duties to convertible bondholders only in cases where the 'wrongs
alleged [impinge] upon the equity aspects [of the bond] ' . 7 3

[1] Do Directors Owe Fiduciary Duties to Preference Shareholders ?

Regarding preference shareholders, the situation may be different considering that

being part of the company' s share capital, preference shares constitute an ownership
interest in a corporation. Thus, it is certainly arguable to propose that the claim of a
preference share could be a right shared equally by the common and preferred
shareholders where fiduciary duties are owed . On the other side, as the previous
historical analysis showed, it is true that the preference shares may hold a right to
participate in the company' s fortunes or misfortunes but more likely will have a fixed
claim only subordinated to that of the creditors . To the extent that they enj oy fixed
claims their interests may not be long-term as the ordinary shareholders ' interests .
However, English courts have not adopted the approach favoured by the High Court of
Australia in Gambotto v. WCP Ltd 74 Instead, the English courts apply a subjective test 7 5
in order to understand whether the decision of the majority shareholders is bona fide

70. On good faith and duties implied in law, compare with W.W. Bratton, Corporate Finance, Cases
and Materials 438 and 440-452 (5th ed. , Foundation Press 2003) .
71 . See Zahn v. Transamerica Corp. , 1 62 F.2d 36, 46 (3d Cir. 1 947) .
72 . M.A. Chirelstein, Towards a Federal Fiduciary Standards Act, Clev. St. L. Rev. 30, 2 1 0 ( 1 98 1 ) ;
W.W. Bratton, The Economics and Jurisprudence of Convertible Bonds, Wi s . L . Rev . 730, 734
and 736-739 ( 1 984) ; J. Benj amin, Financial Law 560- 5 6 1 (Oxford U. Press 2007) .
73 . Green II, No . 76 Civ . 5433 , slip op . , at 1 7 (S . D . N .Y. 1 3 Jul. 1 9 8 1 ) .
74 . ( 1 995) 1 82 CLR 432 , 447 (HC Aust) . In this case, the majority shareholders altered the articles
of the company in order to acquire compulsorily the shares of the minority shareholders. The

1 73
§ 7 . 02 [B] Lorenzo Sasso

in the interests of the company. 76 The burden of proof is on the claimant. This will
leave a preference shareholder not many other alternatives other than a petition for
unfair prejudice, but even on that ground the courts have held that if the offer of the
maj ority to buy out the minority is fair any exclusion of the minority shareholder would
not be unfair. 7 7 The rationale underlying it is the pre-eminent position of shareholders
in a solvent company. The UK has adopted a shareholder-centred approach and the
' enlightened shareholder value' recommendations of the Company Law Steering
Group . 78
Similarly in the US , the courts have basically recognized that the rights of
preferred shareholders are ' essentially contractual and the scope of the duty is
appropriately defined by reference to the specific words evidencing that contract' . 79
Because of this, they have generally assigned no claim for breach of fiduciary duties,
when the shareholders ' rights are specifically stated and governed by the articles of the
company. In such cases, in fact, that device already protects the preference sharehold­
ers . 80 Therefore, it would seem that the contractual rights of preferred shareholders
exist alongside but independently from the duties of care, loyalty and disclosure that
are owed to all shareholders of a corporation. 8 1
Generally, in corporate restructuring transactions such as mergers or reorgani­
zations , directors cannot always overlook the fiduciary duties owed to preferred
shareholders, particularly where the transaction involves an insider or an affiliate and
benefits the common shareholders to the detriment of preferred shareholders . 8 2

High Court held the expropriation to be unlawful on the basis that it was oppressive to the
minority shareholder although the price offered was more than its market value including the
future possible cash flows .
75 . Allen Gold Reefs of West Africa Ltd [ 1 900] 1 Ch. 656.
76 . Citco Banking Corp. NV v. Pusser's Ltd [2007] UKPC 1 3 ; [2007] BCC 205 , Shuttleworth v. Cox
Brothers and Co. (Maidenhead) Ltd [ 1 92 7] 2 KB 9 , 23 .
77. O 'Neill v. Phillips, [ 1 999] 1 WLR 1 092 .
78 . See DTI, Company Law Reform (Cm 6456, 2005) , para. 3 . 3 .
79. These are the words of the court in Jedwab v. MGM Grand Hotels, Inc. , 509 A.2d 584, 594 (Del .
Ch. 1 986) at 594; Wood v. Coastal States Gas Corp. , 40 1 A.2d 932 (Del. 1 979) . In the UK, see
Lord Simonds in Scottish Insurance Corp. v. Wilson & Clyde Coal Co. [ 1 949] A.C. 462; 1 949 S . C.
(H .L.) 90; 1 949 S . L.T. 230; and Sir Raymond Evershed in Re Isle of Thanet Electricity Supply Co.
[ 1 950] Ch. 1 6 1 , CA.
80. HB Korenvaes Invs. , L.P. v. Marriott Corp. , Civ . A. No. 1 2922 , 1 993 WL 205040 * (Del. Ch. 9 Jun.
1 993) ; Harbinger Capital Partners Master Fund I, Ltd v. Granite Broadcasting Corp. , 906 A.2d
2 1 8 (Del. Ch. 2006) .
81 . According to the court in Jedwab v. MGM Grand Hotels, Inc. , 509 A.2d 5 84, 594 (Del. Ch. 1 986)
'when a right asserted is equally shared by preferred and common stockholders, the right and
scope of the correlative duty may be measured by equitable as well as legal standards' .
Similarly, in Eisenberg v. Chicago Milwaukee Corp. , 5 3 7 A.2d 1 05 1 , 1 062 (Del . Ch. 1 987)
recognized that a corporation' s directors 'are fiduciaries for the Preferred stockholders [sic] ,
whose interests they have a duty to safeguard, consistent with the fiduciary duties owed by
those directors to [the corporation' s] other shareholders and to [the corporation] itself' . See
L.E. Mitchell, The Puzzling Paradox of Preferred Stock (And Why We Should Care About It) ,
Bus . Law. 5 1 , 459 ( 1 996) ; R. B . Campbell Jr, A Positive Analysis of the Common Law of
Corporate Fiduciary Duties, Ky L.J . 84, 469 (1 996) .
82 . See Jackson Nat. l Life Ins. Co. v. Kennedy, 74 1 A.2d 377, 387 (Del. Ch. 1 999) ; Dalton v.
American Inv. Co. , 490 A.2d 5 74 (Del. Ch . ) aff' d, 5 0 1 A.2d 1 23 8 ( 1 985) ; Judah v. Delaware
Trust Co. , 3 78 A.2d 624, 628 , 63 1 (Del . 1 977) ; Zahn v. Transamerica Corp. , 1 62 F.2d 36, 42 ,
46.47 (3d Cir. 1 947) ; Dart v. Kohlberg, Kravis, Roberts & Co. , 1 1 Del . J . Corp. L. 602, 1 985 WL

1 74
Chapter 7 : Control Transactions § 7 .02 [B]

However, as it has emerged in case law, the board of directors may sometimes
encounter difficulties in owing fiduciary duties to the shareholders as a whole when the
interests of the internal shareholder classes may diverge. 8 3 Thus, it could be argued
that another key to interpreting the directors ' fiduciary duties can be proposed. It could
be assumed that preference shares are granted certain rights by statute and common
law even where the corporation' s organic documents are silent. In this way, where the
contract is silent, preference shares should get the same pro rata voting and participa­
tion rights as common shares . 84
Although in theory this scenario is possible, the approach of extending the
fiduciary duties does not really eliminate potential conflicts of interest between the
holders of preferred and common stock when those interests clash. 8 5 After all, as the
courts have made clear, the preferred shareholders are not entitled to an equal share in
the merger consideration but only to a fair share. 8 6 The difficulties arise when the board
has to decide what is fair ex ante, because although the board makes a good faith effort
to set a fair price, the indeterminacy of valuation means that reasonable people could
differ. Different is the case in which a prospective buyer that is a third person proposes
the bid for common and preferred shares . In fact, the board would likely escape
liability. 87
A possible solution would be to assimilate the preference shares to the debt
contracts . In contrast to preference shares, bond contract terms can be hundreds of
pages long and generally deal with virtually every imaginable contingency. Therefore,
the vacuum left by the preference share contract could be filled by the courts
presuming, by analogy to the bond setting, an implied covenant of good faith rather
than fiduciary duties . In the context of financial distress, where the company is unable
to satisfy the expectations of all the constituencies, such a covenant would prevent the

1 1 566 (Del . Ch . , 25 Jun. 1 985) ; Kimeldorf v. First Union Real Estate Equity and Mortgage
Investments, 309 A.2d 1 5 1 , 754 N.Y.S .2d 73 ( 1 st Dep ' t 2003 ) ; Quadrangle Offshore (Cayman)
LLC v. Kenetech Corp. , 24 Del. J . Corp . L. 748 , 1 998 WL 7783 59 (Del . Ch. , 2 1 Oct. 1 998) , appeal
refused by Kentech Corp. v. Quadrangle Offshore (Cayman) LLC, 723 A.2d 839 (Del. Supr.
1 998) .
83 . See the US court in Delaware In Re: Trados Incorporated Shareholder Litigation, No. 1 5 1 2-CC
(July 24, 2009) . See also Kohl 's v. Kenetech Corp. , 79 1 A.2d 763 (Del.Ch. 2000) and LC Capital
Master Fund, Ltd v. James, 990 A.2d 43 5 (Del. Ch. 20 1 0) .
84 . As it is the case of Jedwab v. MGM Grand Hotels, Inc. , 509 A.2d 584, 594 (Del. Ch. 1 986) .
85 . Compare, Professor Bainbridge' s Fiduciary Duties and Preferred Stockholders, J . L. , Pol . &
Culture, available at http ://www. professorbainbridge. com/professorbainbridgecom/2009/
08/fiduciary-duties-and-preferred-stockholders .html, January 201 1 ; M.M. McEllin, Note: Re­
thinking Jedwab: A Revised Approach to Preferred Shareholders Rights, Colum. Bus. L. Rev. 895
(20 1 0) ; S . Sepe, Corporate Agency Problems and Dequity Contracts, J. Corp. L. 36, 1 1 3 (20 1 0) ;
N.M. Holladay, The Limited Fiduciary Duties Owed by Corporate Managers to Preferred
Stockholders: A Need for Change, Ky. L.J. 88, 96, 1 02 ( 1 999-2000) ; L.E. Mitchell, The Puzzling
Paradox of Preferred Stock (And Why We Should Care About It) , Bus . Law. 5 1 , 448 ( 1 996) .
86. Jedwab v. MGM Grand Hotels, Inc. , 509 A.2d 5 84, 594 (Del. Ch. 1 986) .
87. In Re: Trados Incorporated Shareholder Litigation, N o . 1 5 1 2-CC (24 Jul. 2009) . The board could
defend itself on causation grounds that is, whether or not the board breached its fiduciary
duties, that breach was not the cause of plaintiff' s injuries, see, for example, Dalton v. Am. Inv.
Co. , 490 A.2d 5 74 (Del. Ch. ) , aff' d, 5 0 1 A.2d 1 23 8 (Del. 1 985) .

1 75
§ 7 . 03 Lorenzo Sasso

board from perpetrating opportunistic behaviour that deprives the preferred sharehold­
ers of the benefit of their bargain. 88 Alternatively, a special committee representing
each of the different classes of stock could be created only during certain critical
corporate transactions . 8 9
Nevertheless , it is wrong to think that protection for preference shareholders is to
be found only in the mandatory provision of company law. Provided that these
shareholders have sufficient bargaining power, they may be able to negotiate for
special private protections . Surely no court or any third party is better positioned than
the parties to design the arrangements best suited to govern their relationship . They
know what types of investment have been made and the related risks they are facing
and, therefore, only the parties, if they wish so, can design effective mechanisms to
neutralize these risks . 9 0

§7.03 FINANCIAL CONTRACT DESIGN FOR CONTROLLING THE

BOARD'S POWER IN EXIT EVENTS: VETO RIGHTS,
DRAG-ALONG AND TAG-ALONG CLAUSES

The above analysis of the court' s approach to the protection of preferred shareholders
is a strong incentive to bargain for any rights contractually in order to avoid future
surprises and misunderstandings . For this reason, to protect both the value and the
liquidity of an investment in the event of any projected transaction involving its share
capital or the composition of its shareholding, it is becoming common practice
especially in venture capital financing to confer on the participants special rights to
control, to a certain extent, how transfers of shares in the company shall occur. 9 1 These
are also called the ' drag-along' and 'tag-along' clauses . These clauses present an
alternative to the conversion feature attached to preference shares or subordinated
debt . As suggested earlier, the founders, who control sufficient stock to block a
corporate reorganization, will often prefer to hold the firm as an independent vehicle in
order to protect their employment or more frequently because their inflated expecta­
tions suggest that, in few more years, the investment may give a much higher return.
On the other hand, given the time value of money, the venture capital funds may be
impatient to realize on their investment. 9 2
Tag-along and drag-along arrangements entitle one shareholder to participate in
another' s sale to a third party. These clauses are attempt to control two types of

88. S . M . Bainbridge, Much Ado about Little? Directors ' Fiduciary Duties in the Vicinity of Insol­
vency, 26 (UCLA Sch. L. , L.-Econ . Res . paper no . 05-26, 200 5 , available at SSRN : http ://
ssrn. com/ abstract=832504) .
89. See this and several proposed solutions in M.M. McEllin, Rethinking Jedwab: A Revised
Approach To Preferred Shareholder Rights, Colum. Bus . L. Rev . 9 1 9-933 (20 1 0) .
90. See I . Saez Lacave & N . Bermej o Gutierrez, Specific Investments, Opportunism and Corporate
Contracts: A Theory of Tag-Along and Drag-Along Clauses, EBOR 1 1 , 423-458 (20 1 0) .
91 . D .T. Robinson & T.E. Stuart Robinson, Financial Contracting in Biotech Strategic Alliances,
Journal of Law and Economics 50 (3) , 5 59-596 (2007) ; D . Cumming, Contracts and Exit in
Venture Capital Finance, Rev. Fin . Stud. 2 1 , 1 9 75 (2008) ; B . Broughman & J . Fried, Renegotia­
tion of Cash Flow Rights in the Sale of VC Backed Firms, J . Fin . Econ . 9 5 , 3 84-399 (20 1 0) .
92 . P.A. Gompers & J . Lerner, The Venture Capital Cycle 345 et seq. (2d ed. , MIT Press 2004) .

1 76
Chapter 7 : Control Transactions § 7 . 03

opportunistic behaviour both associated with underinvestment problems . On the one

side, there is a risk of expropriation of the investment on the occasion of inefficient
sales; on the other, there is a risk of extortion in efficient or productive sales, a problem
also referred to as free riding. 93
Drag-along rights give someone the right to drag someone else along in a deal .
The provision would generally state that if a specified percentage of shareholders or
perhaps only certain categories of shareholders accept an offer to sell, then on
condition that the terms being offered to all parties are economically the same, those
maj ority shareholders can force the minority shareholders to sell even when they may
not wish to do so. 94 In particular, upon the occurrence of the triggering event, an agent
for any dissenting shareholder will be appointed as a director of the board with
authority to sign the stock transfer forms and any other necessary paperwork on their
behalf. 95
The ratio of the drag-along clauses lays in the attempt to prevent one of the
shareholders from staying in the company to appropriate the added value generated by
the third party newcomer. These clauses are commonly found in private equity
investing in various forms . It is possible to identify the percentage of the group of
investors or class of shareholders that is required to trigger the rights or to set a
condition to a transaction as for instance a minimum price that can trigger those rights .
Private equity investors often have these clauses included in a shareholders ' agreement
applicable to all shareholders who are a party to that agreement. In certain locked-in
start-ups, where the shareholders commit to a specific investment, the company agrees
not to issue additional shares of stock unless the purchaser becomes a party to the
shareholders ' agreement. The only limit remains whether this combination of defen­
sive measures and deal protection terms becomes so rigid to preclude the ability of the
directors to exercise their fiduciary duties and of the shareholders to rej ect that
transaction. 9 6 For this reason, a right to compel sale should be drafted with particular
care to set out exactly the respective obligations of the parties . 97 The practice has

93 . See P . Aghion, M. Dewatripont & P . Rey, Renegotiation Design with Unverifiable Information,
Econometrica 62 , 25 7-282 ( 1 994) and T-Y. Chung, Incomplete Contracts, Specific Investments,
and Risk Sharing, Rev. Econ. Stud. 5 8 , 1 03 1 - 1 042 ( 1 99 1 ) .
94 . I . Saez Lacave & N . Bermejo Gutierrez, Specific Investments, Opportunism and Corporate
Contracts: A Theory of Tag-Along and Drag-Along Clauses, EBOR 1 1 , 423-458 (20 1 0) ; Cum­
ming, Contracts and Exit in Venture Capital Finance, Rev. Fin. Stud. 2 1 1 947- 1 982 (2008) ; D .
Cumming, Capital Structure i n Venture Finance, J . Corp . Fin . 1 1 5 5 0-585 (2005) ; L . Zingales,
Insider Ownership and the Decision to Go Public, Rev. Econ. Stud. 62, 425-448 ( 1 995) ; D . G .
Smith, The Exit Structure of Venture Capital, UCLA L. Rev . 5 3 , 3 1 5-3 5 6 (2005) .
95 . J . W . Bartlett, Equity Finance: Venture Capital, Buyouts, Restructurings and Reorganizations
233 (Aspen Publishers 1 995) ; P. Aghion, P. Bolton & J. Tirole, Exit Options in Corporate
Finance: Liquidity versus Incentives, Rev. Fin . 8, 349 (2004) .
96. See Omnicare, Inc. v. NCS Healthcare, Inc. , 8 1 8 A. 2d 914 - Del: Supreme Court 2003 , where the
Court nullified these provisions because they included an irrevocable agreement among the
holders of 65 % of the target' s outstanding stock to vote in favour of the deal; an agreement to
put the merger to a vote of the target' s shareholders even if the board of directors withdrew its
recommendation for the deal and the lack of an effective 'fiduciary out' .
97. For Delaware corporations at least, drag-along rights prevent some issues of fraud o r duress
would be enforced, see Del . Cod . Ann. Tit . 8, 202 ( 1 983) and the case that has construed the

1 77
§ 7 . 03 Lorenzo Sasso

known some special rights to petition for dissolution that can be included in a venture
capital agreement . 9 8
Conversely, tag-along rights address the concern of minority shareholders neu­
tralizing the effects of inefficient sales . Since these exit events fail to maximize the
value of the company as a whole, they constitute expropriation. A maj ority shareholder
could sell his holding to a third party under terms that would pay for him more than his
share of the surplus due to him under the provisions of the agreement. Thanks to the
use of a tag-along clause, if the majority sell their shares , the minority will have the
right to have the offer extended at the same price. 99 In other words, the clause obliges
the shareholders with selling power to give notice to the other shareholders and
negotiate for them too . 1 00
The tag-along clauses protect the investor exposed to an expropriation risk
through a property rule designed ad hoc in the agreement. 1 0 1 Assuming a private equity
fund holds a minority share in the company but the largest stake of hybrid capital.
Therefore, it would suffer from an asset substitution problem when a third newcomer
acquires the company from the majority shareholder and starts selling the assets
piecemeal, the tag-along clause allows the investor to co-sell its stake when the
entrepreneur decides to sell . 1 02
Finally, other provisions commonly used in practice are: the demand rights or
registration rights, the piggyback rights and the catch-up clauses . Demand rights allow
the parties to force their partners to agree to take the firm public in an IPO while
piggyback rights allow the parties to demand to be included in an IPO in proportion to

sections of the Delaware statute enabling shareholders to enter agreements amongst them­
selves including an agreement respecting a forced sale: Shields v. Shields, 498 A.2d 1 6 1 , 1 68
(Del. Ch. 1 985) . In US courts other than Delaware see also in favour Gottschalk v. Avalon Realty
Co. , 23 N.W.2d 606 (Wis . 1 946) ; contra In re Bacon, 287 N.Y. 1 , 1 38 N. E.2d 1 05 ( 1 94 1 ) .
98. One of the least complicated is the ' shootout' or 'Texas auction' arrangement, whereby one
shareholder may compel a dissolution of the deadlock by fixing a price on his shares (or a
formula for fixing the price) and the other party must elect either to sell or buy at that price.
99. S . Beddow, The Equity Deal in C. HALE, Private Equity: a Transactional Analysis (Globe Bus.
Publg. 2007) : where a shareholder is selling a partial stake in the company, the other
shareholders have the right to have a corresponding percentage of their holding of shares
purchased at the same conditions.
1 00 . A similar employed device to accomplish the same aim in the US practice was to issue
redeemable preference shares at the option of the holder. The expectation of such preferred
shareholders is not necessarily that they will be able to exercise their right to put their shares
of the company at some price formula at the end of the financing cycle, but rather the threat of
such a put being exercised will be enough, when the time comes, to bring the founder into line .
See J . W. Bartlett, Equity Finance: Venture Capital, Buyouts, Restructurings and Reorganizations
23 1 (Aspen Publishers 1 995) where some cases are reported in n. 52.
101. Property rules are known to be the classic ' anti-expropriation' rules . See G . Calabresi & A . O .
Melamed, Property Rules, Liability Rules, and Inalienability: One View of the Cathedral, Harv.
L. Rev . 85, 1 092- 1 093 and 1 1 05- 1 1 06 ( 1 9 72) .
1 02 . For an economic rationale for the use of these clauses see G. Chemla , M.A. Habib & A.
Ljungqvist, An A nalysis of Shareholder Agreements, J . European Econ . Assn. 93 -94 and
1 0 1 - 1 1 3 (2007)

1 78
Chapter 7 : Control Transactions § 7 . 04

their stakes in the firm . Finally, the catch-up clauses deny the parties holding a call
option the ability to profit from exercising their call prior to a trade sale or an IPO . 103

§7.04 AN EVALUATION OF HYB RID FINANCIAL INSTRUMENTS' USE

AND PROTECTION IN THE UK AND US JURISDICTIONS

The disputes arising from the opportunism of the parties in corporate agency relations
are on the same footing as bad faith and a form of breach of contract: the breach of
contract respecting shareholder exit and cash flow rights . If the parties agreed to certain
distribution of common earnings, any ex post alteration by one of the parties to
appropriate part of the gains due to the other is contrary to good faith requirements .
The UK and US legal systems adopt ex post standards strategies to protect minorities .
US law, which is more protective of the prerogatives of management, places the
decision on the control transaction in the hands of the board and relies on fiduciary
duties, which assuming shareholders ' good faith afford protection through the judicial
review of their unfair behaviour. The UK legal system of company law has instead
always been shareholder-centred. The decision-making on control shifts is given
wholly to the shareholders, and the protection of the minorities is left to the Takeover
Panel, which acts as authority. Other ex post remedies like the petition for unfair
prejudice or for breach of fiduciary duties are also available.
The Takeover Panel offers some advantages compared to the US framework for
regulating takeovers and protecting minority shareholders . In fact, it addresses take­
over issues in real time, imposing little or no delay on the takeover effort . In the context
of an active bid, the Panel' s Executive requires participants to submit regular updates
on compliance. The Panel evaluates on a case-by-case basis whether a class of
preference shares should receive an offer according to the equity rights included in the
shares and supervises the fairness of the offer. If one of the parties to a bid protests to
the Takeover Panel, it will issue rulings as appropriate and, in contrast to the US courts,
these decisions are virtually immediate and provide real time decisions on takeovers .
Furthermore, the Takeover Panel operates a pro-active and flexible regulatory ap­
proach, which falls outside of the courts, allowing it to adjust to the regulatory
requirements of a changing business environment . Thus, in contrast to the US, tactical
litigation as a takeover defence is virtually ruled out of the takeover process . The
Takeover Panel normally prohibits a target company from taking legal action that
would have the effect of frustrating an offer, unless shareholder permission is obtained.
Instead, obj ections and appeals are heard directly by the Takeover Panel and are dealt
with outside of the courts . 104
In addition, in EU countries, the Directive on takeovers introduced the mandatory
bid rule that provides a very effective exit right for minorities . However, the use of the

1 03 . P. Aghion, P. Bolton & J. Tirole, Exit Options in Corporate Finance: Liquidity versus Incentives,
European Fin. Rev. 8 , 348 (2004) ; G . Chemla, M.A. Habib & A. Ljungqvist, An Analysis of
Shareholder Agreements, J. European Econ. Assn. 93 -94 (2007) .
1 04 . J. Armour & D.A. Skeel, Who Write the Rules for Hostile Takeovers, and Why? - The Peculiar
Divergence of U. S. and U. K. Takeover Regulation, Geo . L.J . 95, 1 744 (2007) .

1 79
§ 7 . 04 Lorenzo Sasso

mandatory bid rule is questionable, especially for closely held companies . It has been
argued that the application of this rule can cause high costs to minority shareholders
and slow down corporate restructuring, because it makes the total price of the target
firm more expensive for potential bidders. In so doing, the rule may deter value­
increasing takeovers because the price fails to compensate the block owner for their
private benefits . 1 0 5
Despite this, no rule can replace the flexibility of the venture capital agreement in
private equity control transactions . The problem is also that it is often difficult for third
parties - courts - to verify a breach, and thus ex post defenc es fail to provide
shareholders with satisfactory protection for their interests . Provided that these
shareholders have sufficient bargaining power, they may be able to negotiate for
special private protections . Surely, no court or any third party is better positioned than
the parties to design the arrangements best suited to govern their relationship . They
know what type of investments have been made and the related risks they are facing
and, therefore, only the parties, if they wish so, can design effective mechanisms to
neutralize these risks . 1 0 6

1 05 . However, the Directive leaves the countries a lot of scope for the implementation of this rule.
Some systems do allow variations between the price offered to the minority and that paid for
the controlling shares, or permit partial bids in certain cases . The UK City Code is unusual in
applying the mandatory bid rule to any acquisition of voting shares by a shareholder holding
between 3 0 % and 50 % of the voting shares .
1 06 . See I . Saez Lacave & N. Bermejo Gutierrez, Specific Investments, Opportunism and Corporate
Contracts: A Theory of Tag-Along and Drag-Along Clauses, European Bus . Org. L. Rev. 1 1 ,
423-458 (20 1 0) .

1 80
Conclusion
CHAPTER 8

Concl usive Considerations

The analysis contained in this book has shown that the dichotomous legal distinction
between equity and debt can be meaningless and the results of that categorization
misleading. The law has the necessity to classify financial and voting rights in the
equity-debt continuum because it relies on classifications as a control over regulations .
Several regulatory areas adopt different approaches to classifying hybrids driven by the
purpose they are trying to achieve . However, none of these approaches is able to
consistently deliver the 'correct' results, even within the narrow boundaries of the
respective discipline or regulatory aim . Hence, they often create incentives for regula­
tory arbitrage. The capacity of hybrids to replicate characteristics of equity or debt,
depending on the situation, makes these securities largely adopted as tools for
intra-group financing, driven by both tax and accounting regulations . Moreover,
issuers can raise finance without fully having reflected their true financial positions in
headline financial metrics such as the debt-to-equity ratio.
From a company' s perspective, opportunities for hybrid-driven arbitrage also
exist in the field of corporate law. This is an area that has so far received only scarce
attention in the legal literature. While deeply interwoven with accounting and insol­
vency law, corporate law also uses the distinction between debt and equity as a
reference point when assigning roles within the organizational governance structure.
While economic models typically regard shareholders ' governance rights as a natural
counterweight to their 'residual claimant' -nature and their lack of fixed entitlements to
the firm' s assets, company law typically takes a very formalistic approach towards
assigning such control rights . However, an issuer is always able to create an equity-like
financial position, which - from a corporate law perspective - does not make the holder
of the instrument a shareholder. This is the case of the economic owner of firm who
does not hold voting rights. This can also have important regulatory consequences
affecting third parties , since creditors ' protection rules such as the rules on share
buy-backs can effectively be disapplied by the company. Likewise, shares can also be
structured in a way that closely resembles debt instruments, conferring control rights
on parties with no (real) residual claim. In other words, by using hybrid financial

1 83
§8.01 Lorenzo Sasso

instruments, parts of the mandatory corporate law can effectively be side-stepped,

leading to a more flexible framework within which a company can reach a bargain with
its investors than envisaged by the legislator.
While it is clear that regulatory arbitrage is currently the main driver behind the
use of hybrids, the question remains whether such instruments can fulfil any useful
economic function besides granting companies additional flexibility as to the appli­
cable legal regime. As described in Part II, hybrids do indeed play an important
function in areas such as private equity and venture capital where parties rely on
complex allocation of financial rights and decision-making rights and where plain
vanilla debt and equity instruments are incapable of providing the economic exposures
the different investors want to create . In order to assess the role of hybrids the book
develops a functional approach that focuses on the economic logic of corporate law.
Often hybrids have been analysed in relation to one or some of their features but never
in context. Since economic theories have evolved with the development of the
corporation, the analysis of corporate structure and, in particular, of its financial
instruments must also be adjusted. The functional approach not only stresses the
agency problems at the core of corporate law but also integrates the theories of the firm
on transaction costs and property rights studies . Accordingly, it shows that hybrids can
be written as compensation contracts to align the ex ante incentives of managers and
investors and therefore reduce agency costs, while at the same time being stipulated as
contingent to critical strategic events and to the achievement of the firm' s obj ectives in
order to provide investors with a flexible governance mechanism of ex post regulation
or measurement during the life of the firm. The study deals with various typologies of
preference shares and convertible bonds . The definition of hybrids also includes debt
with covenants, which may constrain management discretion .

§8.01 THE RATIONALE FOR HYB RIDS AND IMPLICATIONS FOR

CORPORATE GOVERNANCE

The first conclusion derived from the analysis contained in this study highlights an
important rationale for the use of hybrid instruments, that is the firm' s need to allocate
control and cash flow rights in a way that diverges from the classic allocation resulting
from equity and debt. This need is evident in private equity and venture capital
transactions where hybrid financial instruments play an essential role in financing
innovation. In particular, these advantages are observable in situations of economic
integration, when two firms , usually an established corporation and a small research­
intensive firm or a start-up, consider an R&D alliance or develop a contract together.
The small firm has the know-how but may not have the funds or the ability to
commercialize the innovation itself. Hybrids can be stipulated as compensation
contracts to align the incentives of managers and investors . Performance can be tied to
several measures and compared to various benchmarks . It is possible to include
commitments to contract for R&D on specific topics, milestone payments contingent on
the achievement of technological and marketing obj ectives or renewal of the agree­
ment and a royalty on the eventual sales generated by the product. In addition, hybrid

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Chapter 8 : Conclusive Considerations §8.01

instruments empower compensation schemes and give investors a n incentive t o get

involved in the business and monitor the firm closely, because a specific allocation of
the cash flow is linked to certain performance records . In this way, entrepreneur and
investors ensure that appropriate decisions are taken and that suitable progress is being
made .
There is a strong rationale for convertible instruments and debt with restrictive
covenants in a firm' s reorganization and restructuring because they largely reduce the
agency costs of debt, which are caused by the incentive of the directors to engage in
transactions that lower the value of the firm but nevertheless increase shareholder
wealth by shifting wealth from bondholders to shareholders .
However, these advantages do not come without costs . The fact that funds in
private equity and venture capital are constrained with respect to time and capital
creates costs of wealth expropriation. These costs result in dilution for the investors .
On one hand stands the need of the founder investor (angel) not to be excessively
diluted in terms of control and financial rights; on the other is the danger that an excess
of veto rights could hinder the firm' s capitalization. In the case of firms raising finance
through an issue of convertibles, where information disparities exist over issuance of
these securities, it is reasonable to acknowledge the desirability of a conversion­
adjustment . Using price-based methods of anti-dilution is a common way to avoid the
outright expropriation of value from the convertible security holders to the common
stockholders . However, a commonly used market-based adj ustment may not always be
the solution because it relies on an initial conversion price set with admittedly faulty
information. In some situations conversion-adjustment formulas provide protection
that is inferior to other alternatives. For instance, in young growth-oriented high­
technology based firms, investors may suffer not only from economic dilution, but also
from the dilution of ownership interests . This dilution occurs in situations of financial
distress when an entrepreneur-manager decides to raise additional finance that the
existing investor is not able or willing to invest.
In fact, a new investor entering the firm' s capital at that point may bargain and
obtain better conditions and a discounted price. This dilution may also occur when an
entrepreneur-manager, holding control of the board, decides to sell the company or its
assets to a third party. If the entrepreneur has the power to sell the firm, they may
accept a price that rewards their efforts but which may be at a loss for the investor who
has contributed finance in several tranches . Since it is very difficult to establish ex ante
whether minority shareholders such as preference shareholders will be disadvantaged
by the sale of the controlling block, the regulatory choice hesitates between reliance on
general corporate law to protect the minority against unfairness in the future and giving
the minority an exit right at the time of the control shift through the use of the
mandatory bid rule.
The usefulness of hybrids in private equity and venture capital is most evident in
control transactions, where hybrid instruments present an optimal compromise to the
firm' s need of a bespoke capital structure able to allocate efficiently cash flow rights
and control power for exit decisions. In these situations, investors have to address the
principal-agent problems that arise when a potential bidder attempts, through offers to
the company' s shareholders, to acquire sufficient voting shares to control the

1 85
§ 8 . 02 Lorenzo Sasso

company. The acquirer may collude with one of the initial contracting parties to extract
a surplus from the other. Two main types of opportunism are discussed - the
expropriation of the entrepreneur' s private benefits of control and asset stripping at the
expense of the existing (venture capital) investors . Accordingly, an outside investor
could take over a firm, which is performing well and fire its entrepreneur if he does not
have the right to sell control of the firm without compensating him for his private
benefits. Alternatively, an outside investor could acquire a firm that is near insolvency
or performing badly for a small price and take assets out of the firm without paying
their full market value, therefore harming the interests of the existing investors, if their
financial rights are not protected contractually or they do not control the firm. The
parties have to resolve distributional conflicts and make use of the right to sell control
in the event of a future sale of the firm . It is essential that whoever has the power to sell,
takes the decision that is most efficient for all parties . This is possible with hybrid
instruments, because they provide an asset-specific governance system. In fact,
financial contracting on observable, if not verifiable, events, milestones or objectives,
allows an efficient allocation of propriety rights between the parties so that crucial
decisions are always taken by the party that has the best incentive to maximize the
firm' s value. Critical control mechanisms, such as the right to approve or oppose
important decisions for the firm, need to be effectively allocated in any relationship
between an entrepreneur and investors . Thus, contract design of hybrid instruments
anticipates the uncertainty existing in the business by preserving the flexibility to
terminate the contract if input costs rise to the point where they exceed the output
benefits. Hybrids ' contractual features, which may either set performance obligations
or define contingencies, reduce the ex post costs of litigation, facilitating the provision
of efficient incentives and the signalling of private information at the time of contract­
ing and renegotiation. Since most of the provisions included in hybrid instruments are
performance-related or contingent to observable but not verifiable events, the parties
will prefer to bargain for a solution that maximizes the common benefits instead of
supporting costs of litigation with uncertain results .
Transaction cost economics and property rights theory both focus on the role of
ownership in supporting relationship-specific investments in a world of incomplete
contracting and potential hold-up problems . The property rights approach put a strong
accent on incentives driven by ownership when investigates how control rights should
be allocated efficiently in a firm. The capital structure impacts the governance structure
of the firm and it can thus be viewed as a mechanism for dealing with incentives and
hold-up problems .

§8.02 LEGAL STRATEGIES FOR PROTECTION: THE NEED FOR

REGULATION OR MORE FLEXIBILITY?

Another important aspect of this book is its focus on the analysis of investor protection
in relation to holders of hybrid securities . Hybrids as a tool of corporate finance ought
to offer to particular investors the certainty of entitlements, while at the same time
allowing businesses a more flexible allocation of equity or debt-like cash flow rights as

1 86
Chapter 8 : Conclusive Considerations § 8 . 02

well as control rights . For example, through hybrid issues the firm can raise additional
funds without diluting the voting rights or the amount of final surplus distributable in
liquidation. At the same time, the firm does not necessarily incur the risk of insolvency
if it fails to satisfy the financial entitlements of its hybrid holders . This element features
prominently in banking regulation, where the use of hybrids often primarily tries to
achieve a more robust financial position without forcing institutions to raise traditional
equity.
Conversely, investors subscribing to convertible bonds or preference shares
accept a lesser degree of control and long-term commitment on the part of the issuer in
exchange for more extensive financial entitlements . Although the nature of a prefer­
ence share has never been declared by the courts, the rights attached to a particular
class of shares have traditionally been considered contractual in nature. In some
respects, this has made the status of a preference share more like that of a bond than
an ordinary share. However, as emerges from the historical analysis in this book, the
position of preference shareholders vis-a-vis the firm has often given rise to a number
of grounds for dissatisfaction in the past. Companies in need of finance often raised
funds in the forms of preference shares promising the investors higher returns that
never materialized, because once the economic conditions became favourable again
the law - and imperfect contracts - opened several avenues to opportunistic behaviour
on the part of the issuer. Companies sometimes were able to effectively cancel
dividends in arrears, freeze out preference shareholders when the economic outlook
became rosier, or force them to surrender their class rights .
Nowadays, the U K courts seem t o have reached a definitive canon of construction
regarding the rights attached to preference shares . Shareholders in UK firms have a
strong legal position vis-a-vis the firm regarding changes of a firm, including merger
and major restructurings . This somewhat contrasts with the situation in the US, where
preference shareholders are offered less protection as a separate class and it is still
unclear whether or not directors owe them fiduciary duties . However, US law arguably
provides stronger protection to minority shareholders in general - whether they hold
ordinary shares or preference shares - by providing exit rights in the form of appraisal
rights .
In UK law, minority shareholders - including preference shareholders - are
protected by the regulation of class rights variations and the unfair prejudice provi­
sions . In addition, the Companies Act confers a right on dissenting shareholders
holding no less than an aggregate of 1 5 % of the issued shares of the class in question
to petition the court for an annulment of changes to class rights . This remedy, however,
shows important weaknesses, given the self-restraining approach taken by the courts
when deciding what constitutes a variation of a class right . The distinction between
rights affected as a 'matter of law' and as a ' matter of business ' , and the notion that
losses of the enj oyment of rights are not the same as losses of the right itself often lead
to incomplete protection of preference shareholders' interests . This is particularly true
in the area of private equity and venture capital, where changes affecting the
enj oyment of a right as a matter of commercial reality may completely change the
original bargain and severely modify the incentives .

1 87
§ 8 . 02 Lorenzo Sasso

Likewise, the UK law allows minority shareholders including preference share­

holders, who believe their interests are being prejudiced by the behaviour of the
maj ority shareholders, to file a petition for unfair prejudice. British courts have
developed a technique for encouraging an agreed solution to unfair prejudice claims by
allowing the minority to have their shares liquidated at a fair price. This approach
allows the courts to leave directors with the discretion to manage the company' s affairs
without interfering excessively. However, this remedy has proved to be very time­
consuming, burdensome and expensive. In the fast-moving world of the high-tech
industry, where hybrid forms of financing are particularly prevalent, this remedy does
not seem to constitute an adequate solution to the problems identified here . Moreover,
determining the ' fair price' of an immature business is a difficult - and sometimes
impossible - task, which further questions the ability of the unfair prejudice remedy to
resolve conflicts between hybrid holders and the controllers of the business.
Finally, both the UK and US legal systems rely on the judiciary to oversee
transactions associated with structural changes to the corporation, particularly in
relation to mergers . Two different doctrinal paths have emerged in these two legal
systems . The US approach is more protective of the prerogatives of management and
assigns to them the decision on the control transaction but gives to the target
shareholders a veto over the transaction. Conversely, the UK scheme of arrangement
regulation is more shareholder-centred and leaves to the shareholders the decision­
making on control shifts with little use of appraisal rights and veto rights .
In relation to takeovers, the UK has effectively delegated the task of protecting
shareholders to the Takeover Panel (whose jurisdiction also includes schemes of
arrangements) . Notably, the Takeover Panel takes a less formalistic or legalistic
approach compared with the court-based protection of (preference) shareholders . It
also addresses the issues arising from control transactions in real time, imposing little
or no delay on the transaction. This standards strategy does not impede a preferred
shareholder from bargaining for additional protection in the form of contractual
clauses . However, according to the equity- or debt-like nature of the hybrid contract the
Takeover Panel retains the right to decide whether a class of preferred shares has to be
included in the group of relevant ' shares' for an offer. Doing this, the Panel adopts a far
more functional approach to the classification exercise than we examined in other legal
areas .
It is legitimate therefore to wonder whether the protection of preference share­
holders, whose contribution fulfil much of the same function as traditional equity
financing (they are subordinated to all creditors in liquidation as the ordinary share­
holders and have no certainty of a periodic interest) , should be a mandatory matter of
company law outside the takeover context, too, or whether this should simply be left
to the parties' freedom of bargaining.
This, in effect, is a question about the legislator' s trust in the efficient functioning
of the market . To the extent markets are efficient, and investors act rationally, the
answer to any such concern could simply be that hybrid securities are priced in

1 88
Chapter 8 : Conclusive Considerations § 8 . 02

anticipation of future opportunism, and hence any materialization of such anticipated

opportunism does no harm to the investor. 1
If one doubts such a smooth functioning of the market, which arguably requires
a sophisticated understanding of the intricacies of the law by (institutional) investors ,
the obvious question is whether hybrid holders are offered enough protection under
the current law .
The findings described in this book are twofold . Holders of preference shares
seem to be under-protected, creating some scope for opportunism on the part of the
issuer. Both institutional investors and the London stock exchange discourage the use
of preference shares, mainly because of this imperfect protection the law offers . 2 This
in itself seems to partly rebut the ' right price - no harm' argument made above . Where,
in addition, institutional investors shy away from non-voting preference shares, and
such instruments are primarily held by less sophisticated individual investors, the case
for increased protection is further strengthened.
Holders of convertible bonds, on the other hand, do not seem to lack relevant
protection. The underlying conflicts here are essentially the same - opportunism by the
issuer - but the problems naturally revolve around the conversion privilege. Corpora­
tions are not static . Their capital structure changes and the share of stock of today,
while legally an identical unit with the share of yesterday, may represent an investment
in an entirely different commercial entity tomorrow. Between the time of issuance of
the convertible bond and the vesting of the conversion right shareholders - and
managers - have an incentive to develop the business in a way that allocates a
larger-than-expected part of the company' s cash flows to their current shareholders . A
simple example would be a dividend payment, which essentially devalues the conver­
sion right, while benefitting the issuer' s current shareholders . While this case could
relatively easily be dealt with in the bargain, many other corporate actions with an
impact on the value of the conversion right are harder to anticipate . The problem can
thus be seen as one of incomplete contracts .
However, rather than abandoning convertible securities because of these prob­
lems, practice has developed in a direction which can be regarded as over-protective .
Lacking the ability t o anticipate the exact avenues o f future expropriation, convertible
bond holders often bargain for extensive (negative) control rights to secure their
position, arguably granting them a higher degree of influence over the issuer' s
business than would be justified based on their economic exposure. Technically, this
(over-) protection is typically achieved through the use of restrictive covenants .
This is especially relevant in the realms of private equity and venture capital,
where the business evolves in conditions of particular uncertainty . Here, the main
concern is economic dilution. Convertible bondholders use a standardized set of
anti-dilution clauses to protect their rights to address these problems . However, not all
the issuances of new shares are a cause of value dilution and restrictions on the

1. R.W. Hamilton & R.A. Booth, Corporation Finance 3 1 3 (4th ed. , Westlaw Academic Publishing
20 1 2) .
2. See M . Brennan & J . Franks, Underpricing, Ownership and Control in Initial Public Offerings of
Equity Securities in the U.K. , J . Fin. Econ. 45 , 3 9 1 and 395 (1 997) .

1 89
§ 8 . 02 Lorenzo Sasso

managers ' discretion can come at a cost . Ideally, covenants would distinguish between
truly dilutive issues and those that merely reflect market information about the issuer.
However, any assessment of the dilutive effect of subsequent rounds of financing
necessarily depend on the knowledge of (or agreement on) the company' s fair value.
As mentioned above, a consensus on the fair value will often be hard to achieve,
particularly in relation to immature businesses or financially distressed companies in
transitional phases trying to turn-around their fortunes .
The causes for disagreement between holders of ordinary and preference shares ,
as well as shareholders and convertible bondholders, do not always stem from
opportunism . Often they can simply be found in a disagreement about the firm' s
strategy. While the parties may have agreed on a business strategy ex ante, this may
change as the business develops and conditions change ex post. This adds to the
disputes arising from the opportunism of the parties in corporate agency relations . In
these situations, the protection of hybrid holders - originally developed to address
concerns about opportunistic behaviour - suddenly has wider implications . Where
certain hybrid holders are found to be over-protected, which as described is a strategy
to resolve the problems created by incomplete contracts , the protective covenants may
enable them to substantially influence the business decisions of a corporate venture,
particularly where they effectively have a veto right in relation to all possible responses
to changed economic conditions . This, in turn, may lead to opportunism on the part of
the hybrid holders , who may have an incentive to only agree to transactions that
distribute a disproportionate part of the possible gains to them. Hence, the risk of
opportunism exists on both ends of the bargain.
Surely no court or any third party is better positioned than the parties to design
the arrangements best suited to govern their relationship . This does not mean,
however, that there is no role for courts to resolve conflicts arising from unexpected
developments after the investment has been made. This is acknowledged by UK
company law, where additional discretion is vested in the courts in the form of the
unfair prejudice remedy and the procedure in section 633 CA 2006 regarding the
variation of class rights.
In the UK and especially US , the contractual design in the practice of the markets
has seen extensive use of drag-along and tag-along clause and even explicit veto rights,
giving preference shareholders or convertible bondholders wide discretion in relation
to corporate policy. Arguably, this development should be met by courts taking a more
active role, even if this means that the traditional self-restraint of judges in relation to
business decisions may suffer.
On this basis, it can also be discussed whether some common forms of hybrid
financial instruments should be standardized. In my opinion, a less flexible regulatory
framework could impede financial innovation and impose obstacles to the parties '
incentives to devise the terms that will best protect their interests, suit their circum­
stances and redesign governance mechanisms to reflect the changing economic
environment. The contractual design of hybrid financial instruments is the optimal
way to fill the vacuum voluntarily left by mandatory company law in favour of a maj or
flexibility in the market and a more business-friendly legal system.

1 90
Chapter 8 : Conclusive Considerations § 8 . 02

Standardization may also take the form of default, rather than mandatory rules .
Pure default rules would not, however, stifle innovation. I n fact, they could reduce
transaction costs and add to legal certainty by broadening the scope of application of
court decisions dealing with standardized terms . With added legal certainty and a more
balanced distribution of rights and financial entitlements , there is scope for hybrid
financial instruments to play a more important role outside the realm of regulatory
arbitrage, allowing market participants to fully realize the potential of a more flexible
allocation of financial entitlements and governance rights .

191
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215
 Table of Cases

UK Cases

a Company (No : 00267 1 2 of 1 984) [ 1 985] BCLC 80, 1 52- 1 53

a Company (No : 003 096 of 1 987) [ 1 988] 4 BCC 80, 1 69
a Company (No : 003 843 of 1 986) [ 1 987] 3BCC 624, 1 69
a Company (No : 00709 of 1 992) [ 1 997] 2 BCLC 739, 1 52
a Company (No : 007623 of 1 984) [ 1 986] 2 BCC 99 , 1 9 1 , 1 52- 1 53
a Company (No : 008 1 26 of 1 989) [ 1 992] BCC 542 , 1 52- 1 5 3
Accrington Corp. Steam Tramways Co. [ 1 909] 2 Ch. 40, 1 8 , 22
Adelaide Electric Co. v. Prudential Assurance [ 1 934] A.C. 1 22 , HL, 1 2 0
Alchemea Ltd [ 1 998] BCC 964, 1 52
Alliance Perpetual Building Society v. Cli�on [ 1 962] I W.L.R. 1 2 70; [ 1 962] All E.R.
828, 1 7
Anglo-French Music Co. v. Nicoll [ 1 92 1 ] I Ch . 3 86, 23
Artisans ' Land and Mortgage Corpn [ 1 904] I Ch 796, 23
Birch v. Copper [ 1 889] 1 4 App Cas 52 5 , 26
Bishop v. Smyrna and Cassaba Railway Co. [ 1 895] 2 Ch 265 , 23
Blackbum v. Industrial Equity [ 1 977] 2 A.C.L.R. 42 1 ; [ 1 9 7 7] 3 A.C.L.R. 89, 3 0
Bond v. Barrow Haematite Steel Co. [ 1 902] I Ch 3 5 3 , 1 8 , 2 1
Bove v. Community Hotel Corp. of Newport, R . I. , 1 05 R. I . 3 6 , 249 A.2d 8 9 ( 1 969) ,
1 1 6, 1 1 7
Bradford Investments (No . I ) , Re [ 1 99 1 ] B.C.L.C. 224, 1 8
Bridgewater Navigation Co. [ 1 89 1 ] I Ch 1 5 5 at 1 69 , 1 9
Bridgewater Navigation Co. [ 1 89 1 ] 2 Ch. 3 1 7 C.A, 22-24
British & Commonwealth Holdings Plc v. Barclays Bank Plc [ 1 996] I W.L.R.J, CA, 3 2
British India Steam Navigation Co. v . IRC ( 1 88 1 ) 7 Q . B . D, 3 4
BSB Holdings Ltd (No: 2) [ 1 996] I BCLC 1 5 5 , 1 52 , 1 53
Buenos Ayres Great Southern Railway Co. Ltd [ 1 947] Ch 3 84, [ 1 947] I All ER 729 ,
18, 2 1
Burland v. Earle [ 1 902 ] A.C. 83 , PC, 1 8
Campbell Irvine (Holdings) Ltd (No:2) [2006] EWHC 583 , 1 53
Catalinas Warehouses and Mole Co. Ltd [ 1 947] I All ER S I , 2 3
Citco Banking Corporation NV v. Passer 's Ltd [2007] UKPC 1 3 , 1 20, 1 74

217
Table of Cases

Collaroy Co. Ltd v. Giffard [ 1 928] Ch. 1 44, 2 3

Company (No 005009 of 1 98 7) [ 1 989] BCLC 1 3 , 1 07
Corry v. Londonderry and Enniskillen Railway Co. [ 1 860] 29 Beav 263 , 1 9
Coulson v. Austin Motor Company Limited ( 1 927) 43 TLR 493 , 20
County Palatine Loan and Discount Co. , Teasdale 's Case [ 1 873] 9 Ch App 54, 27
Crawford v. North Eastern Railway Co. [ 1 856] 3 K & J 723 , 1 9, 20
Crichton 's Oil Co. , Re [ 1 902] 2 Ch. 86 CA, 1 8, 22, 23
Cumbrian Newspapers Group Ltd v. Cumberland & Westmorland Herald Ltd [ 1 987]
Ch. l , 1 1 8
CVC Opportunity Equity Partners Ltd v. Demarco Almeida [2002 ] 2 BCLC 1 08 , 1 5 3
D. R. Chemicals Ltd [ 1 989] 5 BCC 39, 1 5 3
Dalby v. Bodilly [2004] EWCA 307, 1 5 3
Dimbula Valley (Ceylon) Tea Co. v. Laurie [ 1 96 1 ] Ch . 3 5 3 , 22-24, 3 0 , 1 1 9 , 1 20
Downsview Nominees Ltd v. First City Corp. Ltd (No. 1 ) [ 1 993] B . C . C . 46 (PC) , 34
E W Savory Ltd [ 1 95 1 ] 2 All ER 1 03 6, 22
Edmonds v. Blaina Co . ( 1 887) 36 Ch. D . 2 1 5 , 2 1 9 , 34
Elgindata Ltd [ 1 99 1 ] BCLC 959, 1 5 3
Espuela Land and Cattle Co. [ 1 909] 2 Ch. 1 87, 23
Evling v. Israel & Oppenheimer Ltd, [ 1 9 1 8] 1 Ch. 1 0 1 , 1 8
F. de Jong & Co. [ 1 946] Ch. 2 1 1 , C.A, 22
First Garden City Ltd v. Bonham-Carter [ 1 928] Ch 53 , 1 9
Fisher v. Black and White Publishing Co. [ 1 90 1 ] 1 Ch 1 74, 2 1
Foster v. Coles and N. B. Foster & Sons Ltd [ 1 906] W . N . 1 07, 1 9
Fowler v. Gruber [20 1 0] IBCLC 563 , 1 5 3
Fraser & Chalmers Ltd [ 1 9 1 9] 2 Ch. 1 1 4, 23
Gardner v. London Chatham & Dover Railway Co. (No. 1 ) (1 867) L.R. 2 Ch. App . 2 0 1 ,
34
Gate of India (Tynemouth) Ltd [2008] EWHC 959, 1 52- 1 53
Godfrey Phillips Ltd v. Investment Trust Corporation Ltd [ 1 95 3 ] Ch 449, [ 1 95 3 ] 1 All
ER 7, 1 8 , 1 9
Green II, No . 7 6 Civ 543 3 , slip op . , at 1 7 (S . D . N.Y. July 1 3 , 1 98 1 ) , 1 73
Greenhalgh v. Ardeme Cinemas [ 1 946] 1 All E.R. at 5 1 8 , 1 1 9
Griffith v. Paget [ 1 8 77] 6 ChD 5 1 1 , 22
Hawks v. Cuddy [2007] EWHC 2999 & [2009] EWCA Civ 2 9 1 , 1 52
Henry v. Great Northern Railway Co. [ 1 857] 1 de G & J 606, 1 9
Hodge v. James Howell & Co. [ 1 958] C.L.Y. 446, CA, 1 20
Holders Investment Trust, [ 1 9 7 1 ] 1 W.L.R. 583, 2 All E.R. 289, 2 5 , 3 1
Hottenstein v. York Ice Mach. Corp. , 136 F.2d 944 (C. C . A. 3 d 1943) , 1 1 6
House of Fraser v. AGCE Investments Ltd [ 1 987] A.C. 387, HL (Sc.) , 1 20
Howie v. Crawford [ 1 990] BCC 330, 1 53
Hydrodan (Corby) Ltd [ 1 994] BCC 1 6 1 , 1 63 , 1 06, 1 07
Isaacs v. Belfield Furnishings Ltd [2006] All ER (D) 2 1 6, 1 69
Isle of Thanet Electricity Supply Co . [ 1 950] Ch. 1 6 1 , 9 , 2 3 , 24, 26, 1 74
Jayflex Construction Ltd [2003 ] EWHC 2008, 1 53
John Dry Steam Tugs [ 1 932] 1 Ch. 5 94, 23

218
 Table of Cases

John Fulton & Co. Ltd [ 1 932] NI 3 5 , 20

John Smith 's Tadcaster Brewery Co. ( 1 95 3 ] Ch. 3 08 , CA, 1 20
Knights Deep Ltd v. Inland Revenue Commissioners ( 1 900] 1 Q . B . 2 1 7, 34
Knightsbridge Estates Trust Ltd v. Byrne, [ 1 939] Ch 44 1 , 38
Knightsbridge Estates Trust Ltd v. Byrne ( 1 940) A.C. 6 1 3 , 34
Lemon v. A ustin Friars Investment Trust Ltd ( 1 926) Ch. 1 , 34
Levy v. Abercorris Slate & Slab Co. ( 1 887) 37 Ch . 260, 34, 36
London India Rubber Co. ( 1 868) L.R. 5 Eq. 5 1 9 , 22
Long Acre Press Ltd v. Odhams Press Ltd [ 1 93 ] 2 Ch 1 96, [ 1 93 0] All ER Rep 23 7, 1 9
Mackenzie & Co. Ltd [ 1 9 1 6] 2 Ch. 450, 1 20
Madame Tussaud & Sons Ltd [ 1 927] 1 Ch 65 7, 23
Marchday Group [ 1 998] BCC 800, 1 52
McCarthy Surfacing Ltd [2008] EWHC 2279, 1 53
Moseley v. Koffyfontein Mines Ltd 1 9 1 1 1 Ch 73 , 36
National Telephone Co. [ 1 9 1 4] 1 Ch. 75 5 , 23
New Chinese Antimony Co. Ltd [ 1 9 1 6] 2 Ch 1 1 5 , 22
New Zealand Flock & Textile Ltd [ 1 9 76] 1 N.Z. L.R. 1 92 , 30
North Holdings Ltd v. Southern Tropics Ltd [ 1 999] BCC 746, 1 69
Northern Engineering Industries Plc [ 1 994] 2 B . C. L . C . 704, CA, 1 20
Nuneaton Borough AFC Ltd (No: 2) [ 1 99 1 ] BCC 44, 1 53
Nuneaton Borough AFC Ltd [ 1 989] 5 BCC 792 , 1 5 3
O 'Neill v. Phillips [ 1 992] 2 All ER 96 1 , 1 52
O 'Neill v. Phillips [ 1 999] l WLR 1 092 , 1 52 , 1 69 , 1 74
Odessa Waterworks Co. ( 1 90 1 ] 2 Ch 1 90n+D34, 23
Old Silkstone Collieries [ 1 954] Ch . 1 69 , CA, 1 20
Ooregum Gold Mining Co. of India v. Roper [ 1 892 ] A.C. 1 2 5 , 1 1 , 3 1
PFTZM Ltd, 2 BCLC, 1 995, at 3 54, 1 06
Phoenix Office Supplies Ltd v. Larvin [2002] EWCA Civ 1 740, 1 53
Planet Organic Ltd [2000] 1 BCLC 366, 1 53
Prudential Assurance Co. v. ChatteRailway Whitfield Collieries [ 1 949] A.C. 5 1 2 , HL, 1 20
Quayle Munro Ltd, Petitioners, [ 1 99 1 ] S . L.T. 723 , I . H , 30
Queensland Cement Ltd v. Commissioners of Stamp Duties [ 1 996] 1 Qd.R. 508, 34
R v. Panel on Takeovers and Mergers ex parte Datafin [ 1 987] 2 WLR 699 , 1 68, 1 70
Randall v. S & F (Quarries) Ltd (unreported) 1 2 October 1 994, 1 53
Ransomes plc [ 1 999] 2 BCLC 59 1 , 2 5
Ratners Group plc [ 1 988] BCLC 685 , 25
Regina v. Panel on Takeovers and Mergers, ex parte Guinness Plc. [ 1 990] 1 Q.B. 1 46;
-

Id. [ 1 990] BCLC 2 5 5 , 1 68, 1 70

Regional Airports Ltd [ 1 999] 2 BCLC 30, 1 53
Rights & Issues Investment Trust v. Stylo Shoes Ltd [ 1 965] Ch. 250, 1 1 9
Roberts and Cooper, Ltd [ 1 929] 2 Ch. 383, 1 8, 22
Saltdean Estate Co. Ltd ( 1 968] 3 All ER 829 , 2 5 , 1 20
Saul D Harrison & Sons plc [ 1 995] 1 BCLC 1 4, 1 52
Schweppes Ltd [ 1 9 1 4] 1 Ch. 322 , CA, 1 20

219
Table of Cases

Scottish Insurance Corporation v. Wilsons and Clyde Coal Co. [ 1 949] AC 462 , [ 1 949] 1
All ER 1 068 , 23 , 24, 26, 1 20 , 1 74
Severn and Wye and Severn Bridge Railway Co. [ 1 896] 1 Ch S S 9 , 23
Sound City (Films) Ltd [ 1 947] Ch . 1 69 , 1 1 9
Speyer Bros. v. I. R. C. [ 1 907] 1 K . B . 246; [ 1 908] A.C. 92 , 34
Springbok Agricultural Estate Ltd [ 1 920] 1 Ch S63 , 22
St James ' Court Estate Ltd [ 1 944] Ch 6, 2 7
Staffordshire Coal & Iron Co. v. Brogan [ 1 963 ] 1 W.L.R. 90S , H . L, 24
Staples v. Eastman Photographic Materials Co. [ 1 896] 2 Ch. 303, CA, 1 9
Stevens v. South Devon Railway Co. [ 1 8S l ] 9 Hare 3 1 3 , 1 9
Strahan v. Wilcock [2006] EWCA Civ 1 3 , 1 S3
Sturge v. Eastern Union Railway Co. [ 1 8SS] 7 de GM & G 1 S8 , 1 9
Suburban and Provincial Stores Ltd [ 1 943 ] Ch. 1 S6, CA, 1 1 9
Sudhir Sethi v. (1) Patel & (2) Scitec Group Ltd [20 1 0] EWHC 1 830, 1 S3
Sunrise Radio Ltd [2009] EWHC 2893 , 1 S2 , 1 S 3
Sunrise Radio Ltd, Kohli v. Lit and others [20 1 0] 1 BCLC 367, 1 S 3
Thundercrest Ltd, Re [ 1 99S] 1 B . C . L. C . 1 1 7
Trevor v. Whitworth ( 1 887) 1 2 App Cas 409, 1 8
Underwood v. London Musical Hall Ltd [ 1 90 1 ] 2 Ch 3 09, 1 2 0
Unisoft Group Ltd (No 2 ) [ 1 994] BCC 766, 77S , 1 0 7
United Dominions Trust (Commercial) Ltd v. Eagle Aircraft Services Ltd, [ 1 968] , 1 ,
W.L.R, 32
United Dominions Trust Ltd v. Kirkwood [ 1 966] 2 QB 43 1 at 468, [ 1 966] 1 All ER 968 at
988, 34
W Foster & Son Ltd [ 1 942] 1 All ER 3 1 4, 23
Wakley, Wakley v. Vachell [ 1 920] 2 Ch SOS , 1 9
Walter Symons, Ltd [ 1 934] Ch. 308, 22
Webb v. Earle ( 1 8 7S) L.R. 20 Eq. S S6, 1 9
West v. Blanchet [2000] 1 BCLC 79 S , 1 69
Weymouth Waterworks v. Coode & Hasell [ 1 9 1 1 ] 2 Ch . S20, 1 9
Wharfedale Brewery Co. [ 1 9S2] Ch 9 1 3 , [ 1 9S2] 2 All ER 63 S , 22, 24
White v. Bristol Aeroplane Co. [ 1 9S 3 ] Ch. 6S , CA, 1 20, 1 2 1
Will v. United Lankat Plantations Co. [ 1 9 1 4] AC 1 1 , H . L, 23 , 24, 26
William Metcalfe & Sons, Ltd [ 1 93 3 ] Ch . 1 42 , C.A, 24
Wood v. Coastal States Gas Corp. , 40 1 A.2d 932 (Del. 1 9 79) , 1 74
Wood v. Odessa Waterworks Co. [ 1 889] 42 Ch D 636, 1 8
Wood, Skinner & Co. Ltd, Re [ 1 944] Ch. 3 2 3 , 1 8, 22
Woodroffes (Musical Instruments) Ltd [ 1 986] Ch . 366, 34
Wyatt v. Frank Wyatt & Son Ltd [2003 ] EWHC S20, 1 69

US Cases

Apple Computer Inc v. Exponential Technology Inc (Del Ch 1 999) , 1 30

Bacon, 287 N . Y. 1 , 1 3 8 N.E.2d l OS ( 1 94 1 ) , 1 78

220
 Table of Cases

Baron v. Allied Artist Pictures Corporation, 33 7 A.2d 653 (Del . Ch. 1 9 75) , 1 1 7
Barrett v. Denver Tramway Corp. , 53 F. Supp . 198 (D . Del. 1 944) , 1 1 6
Benchmark Capital Partners IV, L.P. v. Vague, et al. , CA. No. CivA. 1 9 7 1 9 (Del. Ch. July
1 5 , 2002) , 1 23 , 1 5 5 , 1 56
Benjamin v. Diamond in Re Mobil Steel Co. 563 F .2d 692 (5th Cir. 1 9 77) , 70
Bove v. Community Hotel Corp. of Newport, R. I. , 1 05 R.I. 36, 249 A.2d 89 ( 1 969) , 1 1 6
Broad v. Rockwell International Corporation 642 F2d 929 ( 1 98 1 ) , 1 26
Brown v. Halbert, 76 California Reporter 78 1 ( 1 969) , 1 7 1
BSF Co. v. Philadelphia National Bank, 42 Del Ch 1 06, 204 A2d 746 (Sup . Court 1 964) ,
130
Cyrix Corp. v. Intel Corp. v. SGS Thomson (ED Texas 1 992) , 1 3 0
Dalton v. American Inv Co. , 490 A.2d 5 74 (Del . Ch.) aff' d, 5 0 1 A.2d 1 2 3 8 ( 1 985) , 20,
1 1 7, 1 74, 1 75
Dart v. Kohlberg, Kravis, Roberts & Co. , 1 1 Del. J . Corp . L. 602 , 1 985 WL 1 1 566 (Del.Ch .
June 2 5 , 1 985) , 2 0 , 1 74
Diasonics, Inc. v. Ingalls, 1 2 1 B . R. 626, 632 (Bankr. N . D . Fla 1 990) , 70
Dahme v. Pacific Coast Co. , 5 N.J. Super. 477, 68 A.2d 490 ( 1 949) , 20
Eisenberg v. Chicago Milwaukee Corp. , 537 A.2d 1 05 1 , 1 062 (Del . Ch. 1 98 7) , 1 74
Elliot Associates L. P. v. Avatex Corp. 7 1 5 A.2d 843 (Del. 1 998) , 1 5 5
Englander v. Osborne, 1 04 A . 6 1 4 (Pa. 1 9 1 8) , 24
Gallagher v. New York Dock Co. 1 9 NYS (2 d) 789 [ 1 940] ; affd 32 NYS (2d) 348 [ 1 94 1 ] ,
19
General Motors Class H Shareholders Litigation (Del Ch 1 999) , 1 3 0
Gerdes v. Reynolds 2 8 New York Supplement Reporter 2nd Series 622 ( 1 94 1 ) , 1 70
Glazer v. Pasternak, 693 A.2d 3 1 9 (Del. 1 997) , 1 2 3
Gottschalk v. Avalon Realty Co. , 23 N . W . 2 d 606 (Wis . 1 946) , 1 78
Gray v. Portland Bank 3 Mass 3 64 ( 1 807) , 143
Green II, No . 76 Civ 543 3 , slip op . , at 1 7 (S . D . N.Y. July 1 3 , 1 98 1 ) , 1 73
Guttmann v. Illinois Central R.R. Co. , 1 89 F. 2d 927 (2 d Cir. 1 95 1 ) , cert. denied, 342 U . S .
8 6 7 ( 1 95 1 ) , 2 0 , 2 1
Harbinger Capital Partners Master Fund I, Ltd v. Granite Broadcasting Corp . , 906 A.2d
2 1 8 (Del. Ch. 2006) , 1 74
Harff v. Kerkorian, 324 A.2d 2 1 5 (Del. Ch. 1 9 74) , aff' d in part and rev' d in part, 347
A.2d 1 33 (Del . Supr. 1 9 75) , 1 3 3 , 1 7 1 , 1 72
HB Korenvaes Invs. , L. P. v. Marriott Corp. , Civ A. No. 1 2922 , 1 993 WL 205040 * (Del.
Ch. June 9 , 1 993) , 1 74
Hollinger v. Hollinger Int 'l (Del Ch 2004) , 1 30
Hottenstein v. York Ice Mach. Corp. , 136 F.2d 944 (C. C. A. 3 d 1943) , 1 1 6
Internet Law Library, Inc. v. Southridge Capital Management, LLC, 223 F. Supp.2d 474,
479 (S . D . N .Y. 2002) , 1 40
Jackson Nat. l Life Ins. Co. v. Kennedy, 74 1 A.2d 3 7 7, 3 8 7 (Del . Ch. 1 999) , 1 74
Jedwab v. MGM Grand Hotels, Inc. , 509 A.2d 584, 594 (Del . Ch . 1 986) , 1 74, 1 75
Johnson v. Fuller, (3 d Cir. 1 94 1 ) , 1 2 1 F. (2d) 6 1 8, 1 1 6
Judah v. Delaware Trust Co. , 3 78 A.2d 624, 628, 63 1 (Del . 1 977) , 1 74
K.M. C. Co. v. Irving Trust Co. , 757 F. 2d 752 (6th Cir. 1 985) , 1 06

22 1
Table of Cases

Kentech Corp. v. Quadrangle Offshore (Cayman) LLC, 723 A.2d B39 (Del. Supr. 1 99B) ,
1 75
Kimeldorf v. First Union Real Estate Equity and Mortgage Investments, 3 09 A.2d 1 5 1 ,
754 N. Y. S.2d 73 ( 1 st Dep ' t 2003) , 1 75
Kohl 's v. Kenetech Corp. , 79 1 A. 2d 763 (Del. Ch. 2000) , 1 75
Kreicker v. Naylor Pipe Co. , 3 74 Ill. 3 64, 29 N.E. 2d 502 ( 1 940) , 1 1 6
LC Capital Master Fund, Ltd v. lames, 990 A.2d 43 5 (Del. Ch. 20 1 0) , 1 75
Lich v. U. S. Rubber Co. , 3 9 F. Supp . 675 (D . N.J. 1 94 1 ) , 2 1
Log On America, Inc. v. Promethean Asset Management L.L. C. , 223 F. Supp . 2d 43 5 ,
43 9 , n . 3 (S . D . N .Y. 200 1 ) , 1 40
Martin v. Peyton, 246 N.Y. 2 1 3 , 1 5B N.E. 77 ( 1 92 7) , 1 06
Niles v. Ludlow Valve Mfg. Co. , 202 F. 1 4 1 (2nd Cir. 1 9 1 3) , 24
O 'Brien v. Socony Mobil Oil Co. , 207 Va. 707, 1 52 S. E. 2d 2 7B, cert. denied, 3B9 U . S . B25
( 1 967) , 1 1 6
Omnicare, Inc. v. NCS Healthcare, Inc. , B l B A. 2d 9 1 4 - Del: Supreme Court 2003 , 1 77
Pepper v. Litton, 30B U . S . 295 , 307-0B ( 1 939) , 70
Perlman v. Feldman 2 1 9 Federal Reporter 2nd Series 1 73 ( 1 955) , 1 7 1
Porges v. Vadsco Sales Corp. , 2 7 Del Ch . 1 2 7, 32 A.2d 1 4B ( 1 943) , 1 1 6
Quadrangle Offshore (Cayman) LLC v. Kenetech Corp. , 24 Del. J. Corp . L. 74B , 1 99B WL
77B3 59 (Del. Ch. Oct. 2 1 , 1 99B) , 1 75
Rosan v. Chicago Milwaukee R.R. Corp. , 1 990 WL 1 34B2 7-B (Del. Ch. 1 990) , 20
Sanders v. Cuba Railroad Co. , 2 1 N .J. 7B, B 5 , 1 20 A.2d B49, B52 ( 1 956) , 20
Security National Bank v. Peters, Writer & Christensen, Inc. , 569 P . 2 d B75, BB l (Colo . Ct.
App . 1 9 77) , 20
Sharon Steel Corp. v. Chase Manhattan Bank (2d Cir 1 9B2) , 1 3 0
Shields v. Shields, 49B A.2d 1 6 1 , 1 6B (Del. Ch . 1 9B5) , 1 7B
Shintom Co. , Ltd v. A udiovox Corporation, BBB A.2d 225 (Del. Supr. 2005) , 24
Siegman v. Palomar Medical Technologies, [ l 99B] WL l 1 B2 0 1 Del . Ch. ,29
Simons v. Cogan, 549 A.2d 300 (Del . Supr. 1 9BB) , 1 7 1
Smith v. Van Gorkom, 4BB Atlantic Reporter (A.2d) B5B (Delaware Supreme Court
1 9B5) , 1 22
Squires v. Balbach Co. , 1 77 Neb . 465 , 1 29 N.W.2d 462 ( 1 964) , 24
State Nat 'l Bank of El Paso v. Farah Mfg. Co. , 67B Sw . 2d 661 (Tex. Ct. App . 1 9B4) , 1 06
St. Louis Southwestem Ry. Co. v. Loeb, 3 1 B S.W.2d 246 (Mo. 1 95B) , 24
Story v. Kennecott Copper Corp. (NY Sup C 1 9 77) , 1 3 0
Sullivan Money Management Inc. v. FLS Holding Inc. , Del . Ch. C.A. No . 1 2 73 1 , l B Del.
J. Corp . L. 1 1 B3 , 1 1 90, [ 1 993 Del. LEXIS 25 1 ] 1 992 WL 345453 (Nov. 20, 1 992) ,
aff' d, Del . Supr. , 62B A.2d B4 ( 1 993) , 1 23
Sunstates Corp . Shareholder Litigation, 7BB A.2d 5 3 0 (Del . Ch . 200 1 ) , 2 1
Taylor v. Standard Gas & Elec. Co. , 3 06 U . S . 307, 323 ( 1 93 9) , 70
Telecom-SN! Investors, L.L.C. v. Sorrento Networks, Inc. , No . CivA. 1 903 B-NC, 200 1 WL
1 1 1 7505 (Del . Ch. Sept . 7, 2001 ) , 1 5 5
TNT A ustralia Pty v. Normandy Resources NL [ 1 990] 1 ACSR 1 , SA SC, 2 9
Trados Incorporated Shareholder Litigation, No . 1 5 1 2 -CC (July 2 4 , 2009) , 1 75
Uniso� Group Ltd (No 2) [ 1 994] BCC 766, 775 , 1 07

222
 Table of Cases

Unsecured Creditors ' Comms. of Pac. Express, Inc. v. Pioneer Commercial Funding Corp.
(In re Pacific Express, Inc.) , 69 B . R. 1 1 2 , 1 1 5 (B .A.P. 9th Cir. 1 986) , 70
US Bank NA v. Angeion Corp. (Ct App Minn 2000) , 1 30
Wabash Railway v. Barclay, 280 U . S . 1 9 7 ( 1 930) , 2 1
Waggoner v. Laster, 5 8 1 A.2d 1 1 2 7 (Del . 1 990) , 24
Warner Communications Inc. v. Chris-Craft Industries, Inc . , 583 A.2d 962 ( 1 989) , 1 2 3
WatchMark Corp. v. ARGO Global Capital, LLC, et. Al, Del. Supr. 2004, 1 56
Western Foundry Co. v. Wicker, 403 Ill . 260, 85 N . E.2d 722 , ( 1 949) , 1 1 6
Will Of Miguel, 7 1 Misc .2d 640, 3 3 6 N.Y.S.2d 3 76, 3 79 (Sup . Ct. 1 9 72) , 1 7 1
Wood v. Coastal States Gas Corp. , 40 1 A.2d 932 (Del. 1 9 79) , 1 74
Zahn v. Transamerica Corp. , 1 62 F.2d 36, 42 , 46-47 (3 d Cir. 1 947) , 1 73 , 1 74
Canadian Cases
International Power Co. v. McMaster University & Montreal Trust, [ 1 946] S . C .R. 1 78
Canadian Pacific Ltd ( 1 990) , 68 D . L. R. (4th) 48 (Alta. C.A.) , 24
A ustralian Cases
TNT A ustralia Pty v. Normandy Resources NL [ 1 990] 1 ACSR l , SA SC, 29
Trojan Equity Limited v. CMI Limited [2009] QSC 1 1 4, 20

223
 Table of Legislation

EU Directives and Regulations

EU Second Council Directive 7 7 /9 1 /EEC of 1 3 December 1 9 76 (Art . 29) , 28, 2 9 , S 3 , 1 3 2 ,

lSl
EU Third Counsel directives 78/8SS/EEC (art. 1 3) , 1 22, 1 3 S
EU Directive 82/89 1 /EEC (Sixth Company Law Directive) [ 1 982 ] O .J . L 3 78/47 (art.
1 2) ' 1 22 , 1 29 , 1 3 S
EU Council Directive 90/43 S l EEC of 23 July 1 990, 6S
EU Council Directive S926/03 1 EC of 3 March 2003 , 6S
EU Directive 89/2 99/CEE (Own funds of credit institutions) , 3 9
EC Directives 2006/48/EC and 2006/49/EC, OJ Ll 77 /20 1 3 0/6/2006 (Capital Require-
ments Directive CRD I) , 7 1
EC Directive 2009/ 1 1 1 /EC (Capital Requirements Directive CRD II) , 7 1
EC Directive 20 1 0/ 76/EU (Capital Requirements Directive CRD III) , 7 1
EU Directive 2007 /3 6/EC of the European Parliament and the Council o f 1 1 July 2007,
[2007] OJ L l 84/ 1 7 (on the exercise of certain rights of shareholders in listed
companies) , 1 S2
EU Directive 2007 /36/EC of the European Parliament and the Council of 1 1 July 2007
on takeover bids (art. S) [2007] OJ L l 84/ l 7, I S2
Regulation (CE) 2003 , SI 2003/ 1 1 1 6, reg. 2 ( 1 ) , (3) as from December 2003 (Acquisition
of Own shares) (Treasury Shares) , 28
Regulation (CE) n. 223 7 /2004, in Official Journal 3 1 st of December 2004, S S

UK Legislation

Company Act 1 980 (s . 33) , 1 6

Company Act 1 98S . ss. 80, 1 26, 1 28, 1 29, 1 S9 , 1 60, 1 9 3 , 263 , 42 S , 4S 9, 744, 1 6- 1 9 , 28,
29, 3 1 , 34, 3S, 38, so, 1 1 7- 1 1 9, 1 28, I S i , I S2
Company Act 2006 S S . 8, 1 0, 2 1 , 22, 1 72 , S48, S49 , sso, S S I , S S S , SS6, S60 , S60-S 77,
S 6 1 , S64-S 66, S 70, S80, S86, S87, S93 , 6 1 7, 6 1 8 , 629 , 630, 633 , 636, 63 8, 64 1 , 684,
68S , 688 , 690, 694, 709 , 73 3 , 734, 73 S , 73 9 , 740, 83 1 , 89S, 897, 990, 994, 1 6- 1 9 ,
26-34, 3 6, 38, S0, 74, 92, 98, 1 1 3 , 1 1 4, 1 1 7- 1 1 9 , 1 2 1 , 1 2 7, 1 28, 1 32 , 1 43 , 1 46, l S l ,
1 S2 , 1 69 , 1 70, 1 90

225
Table of Legislation

Insolvency Act 1 986 ss. 1 1 0, 1 1 1 , 1 22 , 1 2 3 , 2 1 4, 2 1 5 , 2 5 1 , 34, 54, 70, 93 , 1 06, 1 07, 1 2 1 ,

1 22
The City Code on Takeovers, Rule 1 5 , 1 2 7, 1 28
Listing Rules LR 9 . 5 .6, LR 1 3 . 8 , 1 5 1 , 1 52
Company Securities (Insider Dealing) Act 1 985, 1 26
Corporation Tax Act 2009 ss. 44 1 , 442 , 443 , 65, 68
International Accounting Standards :
IAS 32 'Financial Instruments: Disclosure and Presentation' , 52, 5 5 , 56, 6 1
IAS 39 'Financial Instruments : Recognition and Measurement' , 5 5 , 5 6

US Legislation

The Model Business Corporation Act (RMBCA) : § § 6. 0 1 , 6 . 02 ; 1 0 . 03 (e) , 1 0 . 04, 1 1 . 04,

1 2 . 02 , 1 3 . 0 1 - 1 3 . 3 1 ; 1 4 . 02 , 1 7, 29, 1 1 7' 1 23 , 1 32
The Delaware General Corporation Law (DGCL) : § § 1 5 1 , 242 , 242 (b) , 25 1 , 262, 27 1 ,
2 7 5 , 1 7, 96, 1 1 4, 1 1 7, 1 2 3
The New York Business Corporation Law § § 50 1 ; 622 , 803-804, 903 , 909, 1 00 1 - 1 002 ,
1 7, 1 1 7, 1 2 3 , 1 43
American Stock Exchange AMEX Listing Standards, Policies and Requirements, § 1 24,
22, 1 1 7
Accounting Standards Codification: ASC 480 'Distinguishing Liabilities from Equities ' ,
57
ASC 8 1 5 , 'Accounting for Derivatives and Hedging' , 5 5 , 60

Other Legislation - Miscellaneous

OECD Model Tax Convention on Income and on Capital, Article 1 0 (3) , 64

226
 Index
A c
Accounting equity/debt split, 3 , 47,
5 1 -73
Accounting Standard Codification (ASC)
4 1 5 , 5 5 , 60, 62 , 63
Accounting Standard Codification (ASC)
480, 5 7-62
Adverse selection, 79, 1 02
Anti-dilution provision
full ratchet anti-dilution, 1 4 7- 1 50
price-based methods of anti-dilution,
1 45 - 1 46, 1 85
weighted average ratchet anti-dilution,
1 47- 1 5 0
Asset disposals, 1 2 9
Asset substitution, 8 0 , 1 24, 1 78
Asymmetric information, 48, 75, 97,
1 02 - 1 04, 1 1 2 , 1 3 7, 1 39 , 1 62
B Claim dilution, 46, 1 3 7, 1 50- 1 5 6
Bond. See also Debentures
convertible bonds, 2, 9, 40-43 ,
99, 1 1 2 , 1 24- 1 3 5 , 1 3 7- 1 50,
1 56- 1 5 7, 1 66, 1 72 , 1 73 , 1 84, 1 87,
1 89 , 1 90
convertible obligations (see
Convertible bonds)
deeply subordinated bond, 2, 39
irredeemable bond (see Irredeemable
debentures)
redeemable bond, 43 , 1 3 0, 1 40- 1 43
227
Capital
backdoor equity or deferred equity,
1 38
equity, 26, 49, 5 3 , 65 , 94, 1 20, 1 3 1 ,
1 54, 1 65
maintenance, 1 3 , 74, 1 32 , 1 3 5 , 1 70
mezzanine, 72
raising of capital, 3 9 , 68
redemption reserve, 30-3 1 , 1 46
return of, 1 6, 1 8 , 22-2 5 , 27, 1 32 , 1 48
share, 1 1 , 1 8, 26-28, 30-3 1 , 4 1 ,
50-52, 99, 1 1 0, 1 1 3 , 1 1 7, 1 2 7'
1 32 , 1 45 - 1 48, 1 6 1 , 1 68, 1 69 , 1 73 ,
1 76
structure, l , 3 , 5 , 34, 47-50, 5 3 , 72 ,
73 , 76, 80-8 1 , 86, 87, 9 1 , 1 32,
1 3 7, 1 40, 1 59 , 1 63 , 1 85 , 1 86, 1 89
City Code on Takeovers and Mergers,
1 2 7, 1 54- 1 5 5 , 1 67- 1 70
Classification, 5 , 3 7-38, 47, 48 , 5 1 , 52,
54-74, 87, 9 1 - 1 00, 1 14, 183, 1 88
Classification of claims, SO, 9 1 , 92
Class of shares, 1 , 1 2 , 1 6, 1 9 , 22 , 36,
1 1 4, 1 1 8, 1 1 9 , 1 24, 1 34, 1 44, 1 60,
1 69 , 1 7 7' 1 8 7
Common stock. See Ordinary shares
Companies
large publicly traded, 93 , 94-96, 1 49 ,
1 57
small closely held, 93 , 96-98
Companies Act 1 985, 29, 34, 38
Index

Companies Clauses Consolidation Act, cost of capital, 3 , 49 , SO, 86, 1 1 2

13 transaction, 3 , 48, SO, 7S-78, 8 1 , 86,
Company Act 2006, 29, SO, 1 28, 1 46, 1 84, 1 86, 1 9 1
lSl Covenant (loan covenant)
Conflicts between investors dividend stopper, 1 3 3
over an exit event, l SO, 1 62- 1 64, negative, 2 , 4 S , 46, S l , 1 63 , 1 64,
1 76- 1 79 1 72
over future financing, 1 43 positive, 2 , 4S , S 1
Conflicts of interest
maj ority versus minority shareholders,
l SO D
manager versus shareholders, 79,
1 1 3- 1 1 4 Debentures, l , 2 , 4, 26, 3 3 -46, S2, 1 3 3
shareholders versus bondholders, 1 24, Dilution
1 39 of economic value, 1 44, 147, 1 49 , l SO,
Contracts 1 89
contingent, 82 , 9 1 , 1 07- 1 1 1 , 1 62 , 1 63 , of ownership interests, 3 9 , l SO, 1 8S
1 66, 1 84, 1 86 Dividends
incomplete, 8 1 , 1 1 2 , 1 86, 1 89 , 1 90 in arrears, 1 2 , 1 9 , 2 1 , 22, 26, l l S , 1 1 7,
"nexus of contracts " , 77-83 1 87
Control in cash, 48, 1 3 1 , 1 32 , 1 34
allocation of control rights, 76, 87, diluting, 1 3 l - 1 3 S , 1 43 , 1 48, l S l ,
1 S9, 1 62 , 1 64, 1 6S 1 S6
control " flip " (see Shift of control) distribution of, S , 1 8, 20, 1 3 l - 1 3 S
power (shift oO , 3 , 9 1 -93 , 9 S , in kind, 1 32 , 1 40
l OS - 1 07, 1 S 7, 1 6 1 , 1 64- 1 66, 1 69 , stock split, 1 3 1
1 79, 1 8S , 1 88 Drag-along clauses , 1 76- 1 79, 1 90
shared, 84, 1 6S Duty of loyalty, 1 5 7 , 1 70- 1 76
transactions, S , 1 S9- 1 80, 1 8 5 , 1 88
Conversion
premium, 42 , 43 , 1 43 E
price, 42 , 43 , S9, 1 09 , 1 1 3 , 1 26, 1 28,
1 2 9, 1 32 , 1 34, 1 3 S , 1 3 9 , 1 4 1 - 143, Exit event, 46, 1 5 0, 1 62 - 1 64,
1 47, 1 49 , 1 S 7, 1 8S 1 76- 1 79
privilege, 42, 43 , 1 2S , 1 29, 1 3 1 , 1 3 S , Exit right. See Tag-along clause
1 40, 1 4 1 , 1 4 3 , 1 S6, 1 5 7, 1 67, 1 73 , Expropriation of value, 1 S 3- 1 S4, 1 8S
1 89
rate, 14S, 146, 1 48, 1 49
Convertible bonds, 2 , 9 , 40-43 , 99, 1 1 2, F
1 24- 1 3 S , 1 3 7- l SO, 1 S 6- 1 S 7, 1 66,
1 72 , 1 73 , 1 84, 1 87' 1 89 , 1 90 Fiduciary duties, 4, 78, 92 , 99, 1 32 , 1 S2 ,
Costs 1 S 7, 1 7 1 - 1 77, 1 79 , 1 87
agency cost of equity, 79 Financial distress . See Insolvency
agency costs of debt, 75 , 79-8 1 , 86, Free rider problem, 1 S 3 , l S S , 1 S 7
1 1 2 , 1 24, 1 3 7' 1 8S Functional approach, 9 1 - 1 00

228
 Index

I Overinvestment problem, 1 3 9

IAS 32, 5 5 -5 7 , 60-63

IAS 39, 5 5 , 56 p
Insolvency
re-characterization of financial claims, Payment in kind loan, 1 09
68-70 Pay-to-play provision, 1 5 5- 1 5 7
Irredeemable debentures, 3 7, 3 9 Preference share, 2 , 4 , 9-3 3 , 46, 5 1 , 52,
6 1 , 73 , 74, 99, 1 09- 1 1 1 , 1 1 5- 1 1 7,
1 20, 1 24, 1 3 5 , 1 3 7, 1 40, 1 5 5 - 1 5 7 ,
L 1 65 , 1 66, 1 69 , 1 72, 1 73 , 1 75 , 1 76,
1 79 , 1 84, 1 87, 1 89, 1 90
Liquidation preferences, 4, 1 5 , 1 7, Preferred stock. See also Preference
2 1 -26, 99, 1 09 , 1 1 6, 1 44, 1 54, share
1 56, 1 88 convertible preference share, 1 5 , 62 ,
Liquidity, 44, 58, 94, 9 5 , 1 08, 1 23 , 1 24, 147, 1 5 6, 1 66
1 44, 1 67, 1 76 cumulative preference share, 20, 2 1 ,
2 5 , 52
issue of bonus shares, 3 1 , 1 4 5 , 1 48
M non-convertible preference share, 1 5
non-cumulative preference share, 20,
Managerial quasi-rents, 1 6 1 2 1 , 25, 52
Markets shadow series of preference shares,
efficient, 48, 76, 1 1 3 , 1 64, 1 86, 1 88 1 56
perfect, 48, 49, 1 64 share premium account, 1 46
Merger & acquisitions, 1 5 , 1 25- 1 29 Profit participating loan, 52, 74
M&M Theorem . See Optimal capital
structure
Moral hazard, 1 03 R

0 Redemption
Optimal capital structure, 3 , 47, 49-5 0,
72 , 80-8 1 , 86
Option
call, 43 , 1 4 1 - 1 42 , 1 79
option to convert/ conversion option,
2 7, 60, 1 1 3 , 1 26, 1 3 5 , 1 3 9,
1 4 1 - 1 50
put option, 3 2 , 3 3 , 6 1 , 62, 126
Ordinary shares , l , 4, 9 , 1 1 , 1 3-2 1 , 2 5 ,
27, 3 5 , 40, 43 , 49 , 5 1 , 59, 62 , 73 ,
1 04, 1 09- 1 1 1 , 1 20, 1 26, 1 32 , 1 40,
1 46, 1 48, 1 49 , 1 8 7, 1 88, 1 90
Ratio equity/debt, 3 , 1 1 , 1 4- 1 5 , 4 1 , 49
failure to redeem, 3 1 -3 3
reserve, 3 0-3 1 , 1 46
Regulatory arbitrage, 3 , 47, 66, 7 1 -73 ,
87, 92, 1 07, 1 83 , 1 84, 1 9 1
Residual claimants, l , 3 , 1 7, 3 5 , 5 7,
73 -75 , 79, 83 , 92 , 9 3 , 1 1 2 , 1 62 ,
1 83
Rights
appraisal, 2 , 9 1 , 1 23 - 1 26, 1 3 5 , 1 54,
1 55 , 1 5 7, 1 8 7, 1 88
cash flow rights, 5 , 75, 9 1 -93 , 1 0 1 ,
1 02 , 1 1 2 , 1 1 3 , 1 3 5 , 1 67, 1 79,
1 84- 1 86

229
Index

class rights (variation oO , 5 , 2 1 , 26, Spens Formula, 25-26

99, 1 1 3 - 1 24, 1 3 6, 1 5 6, 1 87, 1 90 Stage financing, 1 07- 1 1 1 , 1 44, 1 50, 1 53 ,
control, 73 -74, 76, 83-8 5 , 87, 9 1 -93 , 1 63
97, 1 0 1 , 1 02 , 1 08 , 1 09 , 1 3 6, 1 5 0, Statutory companies, 1 1 , 1 22 , 1 28, 1 5 1
1 54, 1 5 5 , 1 5 7, 1 59 , 1 62- 1 65 , 1 67, Subordinated irredeemable debentures,
1 83 , 1 86- 1 87' 1 89 9 , 3 7-40
pre-emptive, 73-74, 1 5 1 , 1 56, 1 5 7 Sweet equity, 1 1 0
to preference, 1 2 , 1 1 0
property, 3 , 75, 76, 8 1 -87, 1 63 , 1 84,
1 86 T
to veto , 2 , 43-46, 52, 1 3 7, 1 5 3 - 1 57,
1 72 , 1 76- 1 79 , 1 85 , 1 88, 1 90 Tag-along clause, 1 76- 1 79 , 1 90
of voice, 5 Tax arbitrage, 66-68, 87
votin& 4, 1 3 , 1 6, 1 7, 5 1 , 52, 92 , 1 09 , Tax avoidance, 67, 68
1 14, 1 56, 1 60, 1 66, 1 68, 1 7 1 , 1 75 , Tranche of finance. See Stage financing
1 83 , 1 8 7 Transaction costs, 3 , 48, SO, 75-78, 8 1 ,
Risk 86, 1 60, 1 64, 1 65 , 1 69, 1 7 1 , 1 72 ,
of bankruptcy, 1 1 1 80, 1 84, 1 86, 1 9 1
of dilution, 1 5 0, 1 5 7 Trigger event, 32, 1 09, 1 77
opportunism, 5 , 9 3 , 9 5 , 98, 99, 1 24,
1 3 7- 1 5 7
Round u
down, 1 44- 1 5 0, 1 5 3 , 1 5 5 , 1 5 7
flat, 1 08 Uncertainty, 3 , 5 , 2 1 , 2 3 , 24, 3 1 , 38, 4 1 ,
up , 1 08 7 5 , 8 1 , 93 , 96-98, 1 04, 1 05 , 1 1 1 ,
1 1 2 , 1 1 8, 1 22 , 1 2 3 , 1 30, 1 3 7, 1 59 ,
1 60, 1 62 , 1 86, 1 89
s Underinvestment problem, 80, 1 03 - 1 04,
1 76- 1 7 7
Scheme of arrangement, 27, 1 2 1 , 1 22 , Unfair prejudice, 3 1 , 99, 1 52 , 1 53 , 1 5 7,
1 28, 1 3 5 , 1 88 1 69 , 1 74, 1 79 , 1 8 7, 1 88, 1 90
Shadow director, 1 06- 1 07
Share, 1 , 1 1 , 48 , 76, 9 1 , 1 0 1 , 1 3 8, 1 59 ,
1 83 w
Shareholder loan, 68-70
Shift of control, 1 50, 1 6 1 , 1 66, 1 72, 1 79 , "Widows and orphans " clause, 1 42
1 85 , 1 88 Wrongful trading, 70

230
 INTERNATIONAL BANKING AND FINANCE LAW SERIES

1 . Jan Job de Vries Robbe, Innovations in Securitisation. Yearbook 2006, 2006

(ISBN 90- 1 1 - 2 5 3 3 -7) .
2 . Jim Bartos, United States Securities Law: A Practical Guide, Third edition, 2006
(ISBN 90-4 1 1 -2362-8) .
3 . Hui Huang, International Securities Markets: Insider Trading Law in China, 2006
(ISBN 90-4 1 1 -255 7-4) .
4 . Barth et al. , Financial Restructuring and Reform i n Post-WTO China, 2007 (ISBN
90-4 1 1 - 25 73 -6) .
5 . Zhongfei Zhou, Banking Laws in China, 2007 (ISBN 978-90-4 1 1 -2 5 1 9-4) .
6 . Jan Job de Vries Robbe & Paul Ali, Expansion and Diversification in Securitiza­
tion Yearbook, 200 7, 2007 (ISBN 9 78-90-4 1 1 -266 1 -0) .
7 . Ross Buckley, International Financial System. Policy and Regulation, 2008 (ISBN
9 78- 90-4 1 1 -2 746-4) .
8 . Jan Job de Vries Rob be, Securitization Law and Practice: In the Face of the Credit
Crunch, 2008 (ISBN 978-90-4 1 1 -2 7 1 5 -0) .
9 . Phoebus Athanassiou, Hedge Fund Regulation in the European Union: Current
Trends and Future Prospects, 2009 (ISBN 978-90-4 1 1 -2856-0) .
1 0 . Jan Job de Vries Robbe, Structured Finance: On from the Credit Crunch: The
Road to Recovery, 2009 (ISBN 978-90-4 1 1 -2 787-7) .
1 1 . Gaetane Schaeken Willemaers , The EU Issuer-Disclosure Regime: Objectives and
Proposals for Reform, 2 0 1 1 (ISBN 9 78-90-4 1 1 -3 3 94-6) .
1 2 . Panagiotis Delimatsis & Nils Herger (eds) , Financial Regulation at the Cross­
roads: Implications for Supervision, Institutional Design and Trade, 2 0 1 1 (ISBN
978-90-4 1 1 -3 3 5 5 -7) .
1 3 . Raffaele Scalcione, The Derivatives Revolution: A Trapped Innovation and a
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1 4 . Douglas Arner & Ross Buckley, From Crisis to Crisis: The Global Financial System
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1 5 . Anton P. Trichardt, Letters of Comfort: A Trans-Systemic Analysis, 2 0 1 2 (ISBN
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1 6 . Eddy Wymeersch, Alternative Investment Fund Regulation, 20 1 2 (ISBN 9 78-90-
4 1 1 -3 690- 9) .
1 7 . Asif H . Qureshi & Xuan Gao (eds) , International Economic Organizations and
Law: The Perspective and Role of the Legal Counsel, 2 0 1 2 (ISBN 9 7890-4 1 1 -342 7-
1) .
1 8 . Rhys Bollen, The Law and Regulation of Payment Services: A Comparative Study,
20 1 2 (ISBN 978-90-4 1 1 -3 8 1 8-7) .
1 9 . Ramandeep Kaur Chhina, Standby Letters of Credit in International Trade, 2 0 1 2
(ISBN 9 78-90-4 1 1 -4560-4) .
20. Dirk A. Zetzsche (ed.) , The Alternative Investment Fund Managers Directive:
European Regulation of Alternative Investment Funds, 20 1 2 (ISBN 978-90-4 1 1 -
4044-9) .
2 1 . Lorenzo Sasso, Capital Structure and Corporate Governance: The Role of Hybrid
Financial Instruments, 20 1 3 (ISBN 978-90-4 1 1 -4843-8) .