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Chapter Five Common Stock Chapter Five Common Stock

Limited Liability Issues • • • Partnership – joint & several liability The risk Limited Liability Issues • • • Partnership – joint & several liability The risk for wealthy investors Discouragement of passive investments Inability to accumulate large amounts of capital The Scottish bank exception Externalizing Losses – the Contract Case – Protection by contract: – Personal shareholder guarantees in close corporations – Negative covenants from debtor corporations – Security interests in debtor’s assets – Higher interest rates to compensate for risk The Tort Case (1) Firms may take excessive risks (2) Corporations may underinsure (3) Product costs may not reflect social costs of production (accidents) Large size of many corporations formerly solved the problem Mass torts mean some tort creditors don’t recover 5 -2

The History of Limited Liability 5 -3 • Joint & several liability existed in The History of Limited Liability 5 -3 • Joint & several liability existed in Rome, but so did some limited liability. • 12 th & 13 th century – Italian shipping ventures gave limited Liability to passive investors. • The spread of the Limited Partnership form on the Continent. • Corporations, except royally chartered ones, remained like partnerships. • 1855 – England granted limited liability to companies. • 1816 -1850 – states adopted limited liability with adoption of general incorporation acts.

Issuing New Shares 5 -4 • A decision of the Board of Directors • Issuing New Shares 5 -4 • A decision of the Board of Directors • Can be limited by: – Par value protected against economic dilution but with low or no par value it does not any more. – Charter (authorized number of shares) – Charter (pre-emption rights) – Shareholder Agreement (restrictions) – Provisions of Corporate Law and Directors Duties

DGCL 152 5 -5 The consideration. . . for subscriptions to, or the purchase DGCL 152 5 -5 The consideration. . . for subscriptions to, or the purchase of, the capital stock to be issued by a corporation shall be paid in such form and in such manner as the board of directors shall determine. . In the absence of actual fraud in the transaction, the judgment of the directors as to the value of such consideration shall be conclusive. The capital stock so issued shall be deemed to be fully paid and nonassessable stock upon receipt by the corporation of such consideration. .

Voting But Not Economic Dilution • Value of A’s outstanding common stock: 100 shares Voting But Not Economic Dilution • Value of A’s outstanding common stock: 100 shares @ $10 = $1, 000 • New issue of common stock: 100 shares @ $10 + $1, 000 • New value of A’s stock: 200 shares @ $10 = $2, 000 5 -6

Extreme Economic Dilution 5 -7 • Value of A’s common stock: 100 shares @ Extreme Economic Dilution 5 -7 • Value of A’s common stock: 100 shares @ $10 = $1, 000 • New issue of common stock: 100 shares @ $0 + • New value of A’s stock: 200 shares @ $5 = $1, 000 0

Penalty Dilution - Option (i) 5 -8 • Assume, for example, a $1, 000 Penalty Dilution - Option (i) 5 -8 • Assume, for example, a $1, 000 investment that has gone bad, so that creditors will get one-half of the firm’s assets if no new funds are put in. But if an additional $1, 000 is invested, the investment will be worth $1, 750, 000. If 100 original units were sold at $10, 000 each, consider the options: • (i) Another 100 units are sold at $10, 000 each. At the end, 200 units will share a net worth of $1, 750, 000, or $8, 750 per unit. A rational investor who owns one unit, looking out exclusively for his own interest, will decline to invest a fresh $10, 000, hoping that others will do so. His loss on one unit: $1, 250; Loss on two: $2, 500

Penalty Dilution - Option (ii) 5 -9 • Assume, for example, a $1, 000 Penalty Dilution - Option (ii) 5 -9 • Assume, for example, a $1, 000 investment that has gone bad, so that creditors will one-half of the firm’s assets if no new funds are put in. But if an additional $1, 000 is invested, the investment will be worth $1, 750, 000. If 100 original units were sold at $10, 000 each, consider the options: • (ii) 133. 33 new units are offered at $7, 500 each. At the end of the day, 233. 33 units will share a value of $1, 750, 000, or $7, 500 per unit (we have ignored rounding, where there is a 7¢ difference. The investor is now indifferent: he can invest another $10, 000, and own 2. 333 units worth a total of $17, 500. He has lost $2, 500. If he fails to invest, his original unit is worth $7, 500, and his loss is $2, 500.

Penalty Dilution - Option (iii) 5 -10 • Assume, for example, a $1, 000 Penalty Dilution - Option (iii) 5 -10 • Assume, for example, a $1, 000 investment that has gone bad, so that creditors will one-half of the firm’s assets if no new funds are put in. But if an additional $1, 000 is invested, the investment will be worth $1, 750, 000. If 100 original units were sold at $10, 000 each, consider the options: • (iii) 200 new units are offered at $5, 000 each. At the end of the day, 300 units will share a value of $1, 750, 000, or $5, 833 per unit. The investor who buys two new units has invested $20, 000 for a total of three units worth $17, 500. He has lost $2, 500. If he fails to invest, his original unit is worth $5, 833, and his loss is $4, 167.

Dilution Equation 5 -11 • L = ma - (mx + p) (a) • Dilution Equation 5 -11 • L = ma - (mx + p) (a) • x+d • where: L = existing shareholders’ loss through dilution; • m = market price of a share before issuance; • a = a shareholder’s share ownership at the time new shares are issued; • x = shares outstanding before dilutive issuance; • d = number of shares issued in dilutive distribution; • p = proceeds from sale of new shares.

Pre-emption 5 -12 • The right to buy shares in a new issue pro Pre-emption 5 -12 • The right to buy shares in a new issue pro rata to existing holdings. • Created by Courts in the US • Created by Charter in the UK

Stokes Case 5 -13 • Shareholders authorized issue of new shares (doubling shares), par Stokes Case 5 -13 • Shareholders authorized issue of new shares (doubling shares), par value $100, and then sale to Blair at $450 per share. • Stokes voted for first resolution but not second. • He claimed a pre-emptive right to buy a pro rata portion for par value. • Court held he had the eright.

Stokes Case 5 -14 1. What business reasons motivated the increase in authorized stock Stokes Case 5 -14 1. What business reasons motivated the increase in authorized stock and the sale to Blair & Co. ? •

Stokes Case 5 -15 1. What business reasons motivated the increase in authorized stock Stokes Case 5 -15 1. What business reasons motivated the increase in authorized stock and the sale to Blair & Co. ? • Enlarge the size of the business; • Bring Marshall Field and other merchants into management; • Obtain their banking business.

Stokes Case 5 -16 2. Do you have any reason to believe that $450 Stokes Case 5 -16 2. Do you have any reason to believe that $450 per share was an unfairly low price for the sale of new shares in Continental Trust Company?

Stokes Case 5 -17 2. Do you have any reason to believe that $450 Stokes Case 5 -17 2. Do you have any reason to believe that $450 per share was an unfairly low price for the sale of new shares in Continental Trust Company? • Not a self-dealing transaction, at least as reported. • The shareholders approved the sale, presumably by a majority vote. • The Dissent notes stock had never sold for a price this high before.

Stokes Case 5 -18 3. Would it have been fair to other shareholders to Stokes Case 5 -18 3. Would it have been fair to other shareholders to allow Stokes to purchase newly issued shares at their par value of $100?

Stokes Case 5 -19 3. Would it have been fair to other shareholders to Stokes Case 5 -19 3. Would it have been fair to other shareholders to allow Stokes to purchase newly issued shares at their par value of $100? • The Dissent points out it would have denied the Company $350 per share. • Second, it defeats purpose of bringing Marshall Field and others into management and getting their banking business. • Note that it would deny Blair effective control, with a 50% block.

Stokes Case 5 -20 4. Assuming the shares of Continental had a fair market Stokes Case 5 -20 4. Assuming the shares of Continental had a fair market value of $450, and could have been sold for that price to Blair, how much of a loss would the other Continental shareholders have suffered if Stokes were allowed to purchase 221 new shares at their par value of $100? (See the dilution formula that precedes this opinion. Note that you can’t simply use Stokes’ bargain purchase ($450 - $100) for his 221 shares, because the dilution reduces the value of all shares below $450. )

Dilution Equation 5 -21 • L = ma - (mx + p) (a) • Dilution Equation 5 -21 • L = ma - (mx + p) (a) • x+d • where: L = existing shareholders’ loss through dilution; • m = market price of a share before issuance; • a = a shareholder’s share ownership at the time new shares are issued; • x = shares outstanding before dilutive issuance; • d = number of shares issued in dilutive distribution; • p = proceeds from sale of new shares.

Stokes Case • • 5 -22 Note that there were 5, 000 original shares, Stokes Case • • 5 -22 Note that there were 5, 000 original shares, and the company proposed to issue another 5, 000, so 10, 000 shares would be outstanding. Assume that the purchase price of $450 represented the market value of each share. And assume that 5, 000 - 221 shares were sold to Blair & Co. , (before Stoke’s exercise), so that 9, 779 shares were outstanding. At this point Stokes is allowed to buy 221 shares @ $100.

Stokes’ Gain on Shares @ $100 Purchase Price 5 -23 • Stokes’ gain: $350 Stokes’ Gain on Shares @ $100 Purchase Price 5 -23 • Stokes’ gain: $350 gain per share x 221 = $77, 350 • All shareholders’ losses on Stoke’s purchase: • L = ($450)(9779) - (($450) (9779) + (($100)(221)) (9779) • 9779 + 221 • L = $4, 400, 550 - ($4, 400, 550 + $22, 100) (9779) • 10, 000 • L = $4, 400, 550 - ($4, 422, 650) (9779) • 10, 000 • L = $4, 400, 550 - ($442. 265) (9779) • L = $4, 400, 550 - $4, 324, 909 = $75, 640 • Stokes’ outcome: gain on purchase $77, 350 • Less 221/9779 share of dilution ($75, 640) 1, 709 • Stokes’ net gain: $75, 641

Stokes Case 5 -24 5. Why would the other shareholders vote to dilute their Stokes Case 5 -24 5. Why would the other shareholders vote to dilute their own share of ownership by selling new shares to Blair at $450?

Stokes Case 5 -25 5. Why would the other shareholders vote to dilute their Stokes Case 5 -25 5. Why would the other shareholders vote to dilute their own share of ownership by selling new shares to Blair at $450? • They would not, as a general rule. • But this looks like voting dilution, not economic dilution. • That’s the best assurance this is a fair price - a sale to a third party.

Stokes Case 5 -26 6 What effect would honoring Stokes’ preemptive rights be likely Stokes Case 5 -26 6 What effect would honoring Stokes’ preemptive rights be likely to have on Blair’s interest in acquiring one-half of the total shares of Continental?

Stokes Case 5 -27 6 What effect would honoring Stokes’ preemptive rights be likely Stokes Case 5 -27 6 What effect would honoring Stokes’ preemptive rights be likely to have on Blair’s interest in acquiring one-half of the total shares of Continental? • Destroy it. Stokes’ free riding attempt could destroy the deal for everyone. • Presumably Blair wants control.

Stokes Case 5 -28 7. Does the majority opinion suggest any limits on the Stokes Case 5 -28 7. Does the majority opinion suggest any limits on the preemptive rights doctrine that might provide a way for Blair and the other shareholders to avoid Stokes’ claims? If so, how would you suggest restructuring the transaction if you represented Blair or the majority of the shareholders?

Stokes Case 5 -29 7. If the sale is other than for cash. The Stokes Case 5 -29 7. If the sale is other than for cash. The court stated at page 293: – “As the right to increase the stock belonged to them, the stock when increased belonged to them also, as it was issued for money and not for property or for some purpose other than the sale thereof for money. ” • Have Blair buy property the Company wanted and then sell it to Copmany for stock.

Stokes Case 5 -30 7. Or if the sale is at a public auction, Stokes Case 5 -30 7. Or if the sale is at a public auction, as the court stated at page 293: – “The new stock belonged to the stockholders as an inherent right by virtue of their being stockholders, to be shared in proportion upon paying its par value or the value per share fixed by vote of a majority of the stockholders, or ascertained by a sale at public auction. ” • Have the vote authorizing the sale of shares fix the price at $450.

Quick Check Question 5. 1 5 -31 How do RMBCA and DGCL deal with Quick Check Question 5. 1 5 -31 How do RMBCA and DGCL deal with this issue of pre-emption?

Quick Check Question 5. 1 5 -32 In the early 20 th century some Quick Check Question 5. 1 5 -32 In the early 20 th century some statutes required preemptive rights unless the corporation opted out of them in its articles.

RMBCA § 6. 30: Shareholders’ Preemptive Rights • • 5 -33 – (a) The RMBCA § 6. 30: Shareholders’ Preemptive Rights • • 5 -33 – (a) The shareholders of a corporation do not have a preemptive right to acquire the corporation's unissued shares except to the extent the articles of incorporation so provide. – (b) A statement included in the articles of incorporation that “the corporation elects to have preemptive rights” (or words of similar import) means that the following principles apply except to the extent the articles of incorporation expressly provide otherwise. – (1) The shareholders of the corporation have a preemptive right, granted on uniform terms and conditions prescribed by the board of directors to provide a fair and reasonable opportunity to exercise the right, to acquire proportional amounts of the corporation's unissued shares upon the decision of the board of directors to issue them. – * * * – (3) There is no preemptive right with respect to: (i) Shares issued as compensation to directors, officers, agents, or employees of the corporation, its subsidiaries, or affiliates; (ii) Shares issued to satisfy conversion or option rights created to provide compensation to directors, officers, agents, or employees of the corporation, its subsidiaries, or affiliates; (iii) Shares authorized in articles of incorporation that are issued within six months from the effective date of incorporation; (iv) Shares sold otherwise than for money.

RMBA § 6. 30 – Slide 2 • • • 5 -34 (4) Holders RMBA § 6. 30 – Slide 2 • • • 5 -34 (4) Holders of shares of any class without general voting rights but with preferential rights to distributions or assets have no preemptive rights with respect to shares of any class. * * * (b ) A statement included in the articles of incorporation that “the corporation elects to have preemptive rights” (or words of similar import) means that the following principles apply except to the extent the articles of incorporation expressly provide otherwise. (5) Holders of shares of any class with general voting rights but without preferential rights to distributions or assets have no preemptive rights with respect to shares of any class with preferential rights to distributions or assets unless the shares with preferential rights are convertible into or carry a right to subscribe for or acquire shares without preferential rights. (6) Shares subject to preemptive rights that are not acquired by shareholders may be issued to any person for a period of one year after being offered to shareholders at a consideration set by the board of directors that is not lower than the consideration set for the exercise of preemptive rights. An offer at a lower consideration or after the expiration of one year is subject to the shareholders’ p reemptive rights. (d) For purposes of this section, the term "shares" includes a security convertible into or carrying a right to subscribe for or acquire shares.

Del. GCL § 102(b)(3) • (3) 5 -35 Such provisions as may be desired Del. GCL § 102(b)(3) • (3) 5 -35 Such provisions as may be desired granting to the holders of the stock of the corporation, or the holders of any class or series of a class thereof, the preemptive right to subscribe to any or all additional issues of stock of the corporation of any or all classes or series thereof, or to any securities of the corporation convertible into such stock. No stockholder shall have any preemptive right to subscribe to an additional issue of stock or to any security convertible into such stock unless, and except to the extent that, such right is expressly granted to such stockholder in the certificate of incorporation. All such rights in existence on July 3, 1967, shall remain in existence unaffected by this paragraph unless and until changed or terminated by appropriate action which expressly provides for the change or termination;

Katzowitz v. Sidler – Investments & Payouts • • • Three shareholders own corporation Katzowitz v. Sidler – Investments & Payouts • • • Three shareholders own corporation equally. Each are owed $2, 500. Two want to take shares instead of cash. Two vote to issue new shares for $100 each. Book value is $1800 Third declines and argues is diluted. 5 -36

Katzowitz v. Sidler – Investments & Payouts 5 -37 Sidler Lasker $500 2, 500 Katzowitz v. Sidler – Investments & Payouts 5 -37 Sidler Lasker $500 2, 500 3, 000 $500 0 500 $18, 885. 52 $3, 147. 59 Invested: At Start Dec. 1961 Payouts: Katzowitz

Katzowitz v. Sidler – Investments & Payouts 5 -38 • Pre-emptive Rights Might not Katzowitz v. Sidler – Investments & Payouts 5 -38 • Pre-emptive Rights Might not Protect a Shareholder. • Normally shareholders can protect themselves either by exercising their preemptive rights or selling them to others who will exercise. • But when shares are sold below fair value, existing shareholders who either don’t want to or lack the funds to invest can have their investment diluted. • The effects of stock rights are illusory in close corporations, because there’s no market for the

Katzowitz v. Sidler – Investments & Payouts 5 -39 • The corollary of the Katzowitz v. Sidler – Investments & Payouts 5 -39 • The corollary of the equal right to buy is a right not to buy, without being diluted, if no valid business justification exists for the dilution. • Here the disparity between price and value was calculated to force Katzowitz into investing more money. • The price was a tactic, designed to place Katzowitz in a compromising position.

Katzowitz v. Sidler – Investments & Payouts 5 -40 1. If you think of Katzowitz v. Sidler – Investments & Payouts 5 -40 1. If you think of this as penalty dilution, could the defendants argue that the offer wasn’t unfair to Katzowitz?

Katzowitz v. Sidler – Investments & Payouts 5 -41 1. If you think of Katzowitz v. Sidler – Investments & Payouts 5 -41 1. If you think of this as penalty dilution, could the defendants argue that the offer wasn’t unfair to Katzowitz? • Recall that penalty dilution is justified by forcing an investor to bear his share of a burden. • The business justification here was to loan the money to another corporation all of them controlled. • It’s hard to tell if this was an urgent decision, needed to salvage value for all of them, in which it was fair to ask Katzowitz to participate.

Katzowitz v. Sidler – Investments & Payouts 5 -42 2. What does it mean Katzowitz v. Sidler – Investments & Payouts 5 -42 2. What does it mean that the book value of Sulburn’s shares was $1, 800 at the time the stock was offered to the three shareholders? • Recall the meaning of book value, as historical cost of assets less precalculated depreciation.

Katzowitz v. Sidler – Investments & Payouts 5 -43 2. What does it mean Katzowitz v. Sidler – Investments & Payouts 5 -43 2. What does it mean that the book value of Sulburn’s shares was $1, 800 at the time the stock was offered to the three shareholders? • Recall the meaning of book value, as historical cost of assets less precalculated depreciation. So this historical cost less depreciation divided by 15 shares equaled $1800 per share. Thus $27, 000 BV

Katzowitz v. Sidler – Investments & Payouts 5 -44 3. Is book value the Katzowitz v. Sidler – Investments & Payouts 5 -44 3. Is book value the ultimate test of the price at which shares should be offered in a corporation? Why or why not?

Katzowitz v. Sidler – Investments & Payouts 5 -45 3. Is book value the Katzowitz v. Sidler – Investments & Payouts 5 -45 3. Is book value the ultimate test of the price at which shares should be offered in a corporation? Why or why not? • Given the fact that book value tends to diverge from market value over time for almost any asset, it’s hard to tell whether it’s fair value. • If all assets were purchased relatively recently, then it can be a pretty good proxy for market value.

Katzowitz v. Sidler – Investments & Payouts 5 -46 4. If you represented Katzowitz Katzowitz v. Sidler – Investments & Payouts 5 -46 4. If you represented Katzowitz at the time new shares were offered at $100 each, how would you advise him assuming he did not have a pressing need for the $2, 500 he had just received from Sulburn? Why?

Katzowitz v. Sidler – Investments & Payouts 5 -47 4. If you represented Katzowitz Katzowitz v. Sidler – Investments & Payouts 5 -47 4. If you represented Katzowitz at the time new shares were offered at $100 each, how would you advise him assuming he did not have a pressing need for the $2, 500 he had just received from Sulburn? Why? • He has two choices: (1) Go ahead and buy the new shares and protect himself from dilution; or (2) Sue the other directors for breach of duty in making a coercive offering at such a low price.

Katzowitz v. Sidler – Investments & Payouts 5 -48 5. The court states that Katzowitz v. Sidler – Investments & Payouts 5 -48 5. The court states that preemptive rights were created by the courts to protect two distinct rights of shareholders - their equity in the corporation and their proportionate voting control. Which is more important here?

Katzowitz v. Sidler – Investments & Payouts 5 -49 5. The court states that Katzowitz v. Sidler – Investments & Payouts 5 -49 5. The court states that preemptive rights were created by the courts to protect two distinct rights of shareholders - their equity in the corporation and their proportionate voting control. Which is more important here? • Since Katzowitz will always get outvoted unless he has a shareholders’ agreement that gives a 1/3 shareholder a veto power, it must be his economic interests.

Katzowitz v. Sidler – Investments & Payouts 5 -50 6. If shares had been Katzowitz v. Sidler – Investments & Payouts 5 -50 6. If shares had been offered to each shareholder at $1, 800 per share, would Katzowitz have any complaint?

Katzowitz v. Sidler – Investments & Payouts 5 -51 6. If shares had been Katzowitz v. Sidler – Investments & Payouts 5 -51 6. If shares had been offered to each shareholder at $1, 800 per share, would Katzowitz have any complaint? • As long as there is a plausible business purpose for the stock issue, when it’s offered pro rata to all shareholders at a presumably fair price, the business judgment rule should protect the decision.

Katzowitz v. Sidler – Investments & Payouts 5 -52 7. If the existing shares Katzowitz v. Sidler – Investments & Payouts 5 -52 7. If the existing shares of Sulburn were worth $1, 800, what is the amount of damages Katzowitz has suffered because of his failure to purchase? (Hint: see the formula preceding the Stokes case. )

Dilution in Katzowitz v. Sidler 5 -53 • At time of issue: $1, 800 Dilution in Katzowitz v. Sidler 5 -53 • At time of issue: $1, 800 book value x 15 shares = $27, 000 • Book value after issuing 50 new shares @ $100 each: • Original Equity: $27, 000 • Proceeds of issue 5, 000 • $32, 000 / 65 shares = $492. 30 book value/share • Katzowitz’s loss: • Original value: $1, 800 x 5 • Present value: $492. 30 x 5 • Loss: = $9, 000 -2, 461. 50 $6, 538. 50

Katzowitz v. Sidler – Investments & Payouts 8. Is this an offer that normally Katzowitz v. Sidler – Investments & Payouts 8. Is this an offer that normally a shareholder like Katzowitz can’t refuse? If so, can you think of any justification for allowing directors to make such an offer? 5 -54

Katzowitz v. Sidler – Investments & Payouts 5 -55 8. Is this an offer Katzowitz v. Sidler – Investments & Payouts 5 -55 8. Is this an offer that normally a shareholder like Katzowitz can’t refuse? If so, can you think of any justification for allowing directors to make such an offer? • It is a coercive offer that he can’t refuse. • Because of this, it should take an emergency to permit it, such as salvaging existing investments. (penalty dilution)

Katzowitz v. Sidler – Investments & Payouts 5 -56 9. If the right to Katzowitz v. Sidler – Investments & Payouts 5 -56 9. If the right to purchase shares for $100 that are worth $1, 800 is offered, and Katzowitz chooses not to exercise these rights, is there any other way he can obtain value from the right? If so, why didn’t he do so?

Katzowitz v. Sidler – Investments & Payouts 5 -57 9. He could sell the Katzowitz v. Sidler – Investments & Payouts 5 -57 9. He could sell the right to someone else, who presumably would be willing to pay nearly the entire difference between the exercise price, $100, and the post-sale value of $492. 30, or $2, 461. 50. • The obvious problem is that there is no market for these rights. • The other problem is that most rational investors would not want a minority investment in a close corporation without some guarantees of control.

Rights Plans – Slide 1 5 -58 • Dividend Declaration Date – When Rights Rights Plans – Slide 1 5 -58 • Dividend Declaration Date – When Rights Plan Dividend is Declared – Right to purchase preferred stock at unrealistic price – Rights stapled to stock certificates – not separately transferable – Rights are void in the hands of an “Acquiring Person” • Rights Distribution Date - When Separate Rights Certificates Issue – Announcement of a Tender offer – “Acquisition Date” – when a Bidder Becomes an “Acquiring Person” • Acquisition Date – When Rights “flip in” to become exercisable in Common Stock – Rights are no longer redeemable by Target’s Board – Rights exercisable at 50% discount from fair market value of Common

Rights Plans – Slide 2 • Target shares outstanding: 5 -59 1, 000 • Rights Plans – Slide 2 • Target shares outstanding: 5 -59 1, 000 • Pre-bid market price per share: $10. 00 • Bidder’s per share cost for the first 15%: $15. 00 • Expected takeover bid price per share: $15. 00 • Exercise price for preferred stock rights: $40. 00 • Assumed market value per share of target shares for calculating common stock acquisition price: $15. 00 • Flip-in trigger: • Flip-in discount: • Shares issuable per right if market price is $15 ($80/15): 15% 50% 5. 3333333

How Rights Plans Dilute 5 -60 • Bidder’s initial acquisition of 150, 000 shares How Rights Plans Dilute 5 -60 • Bidder’s initial acquisition of 150, 000 shares @ $15. 00 • • • Rights flip in for 5. 33333 shares for 850, 000 rights Shares Outstanding: New shares 4, 533, 333 Original shares 1, 000 Total shares 5, 533, 333 Proceeds of exercise: (850, 000 x $40): $34, 000 Market’s estimate of value of target: $49, 000 Value per fully diluted share ($49, 000/5, 533, 333): $8. 855421 Value of bidder’s 150, 000 shares: $1, 328, 313 Bidder’s dilution losses: $921, 688 • • • Bidder’s cost for remaining shares (5, 383, 333 x $8. 855422) = Total Cost to Bidder: Less: Dividend of cash proceeds from exercise 47, 671, 688 $49, 921, 688 (34, 000) • Net Cost to Bidder: $15, 921, 688 $2, 250, 000

Del. G. C. L. Sec. 157 5 -61 • Subject to any provisions in Del. G. C. L. Sec. 157 5 -61 • Subject to any provisions in the certificate of incorporation, every corporation may create and issue, whether or not in connection with the issue and sale of any shares of stock or other securities of the corporation, rights or options entitling the holders thereof to purchase from the corporation any shares of its capital stock of any class or classes, such rights or options to be evidenced by or in such instrument or instruments as shall be approved by the board of directors.

Dilution Equation 5 -62 • L = ma - (mx + p) (a) • Dilution Equation 5 -62 • L = ma - (mx + p) (a) • x+d • where: L = existing shareholders’ loss through dilution; • m = market price of a share before issuance; • a = a shareholder’s share ownership at the time new shares are issued; • x = shares outstanding before dilutive issuance; • d = number of shares issued in dilutive distribution; • p = proceeds from sale of new shares.

Bidders’ Dominant Strategies 5 -63 Table 4 Bidder's Dilution When Shares Are Issued at Bidders’ Dominant Strategies 5 -63 Table 4 Bidder's Dilution When Shares Are Issued at Higher Levels of Bidder Ownership Bidder's % Ownership 15 20 30 40 50 85 90 95 97 98 Bidder's Dilution Losses $921, 688 1, 215, 100 1, 774, 513 2, 285, 537 2, 727, 055 2, 833, 057 2, 347, 583 1, 493, 285 1, 003, 331 708, 349 Percent of Investment Lost 41% 40. 5% 39. 4% 38% 36. 4% 22. 2% 17. 4% 10. 5% 6. 9% 4. 8%

RMBCA § 6. 20 5 -64 • (a) A subscription for shares entered into RMBCA § 6. 20 5 -64 • (a) A subscription for shares entered into before incorporation is irrevocable for six months unless the subscription agreement provides a shorter or longer period or all the subscribers agree to revocation. • (b) The board of directors may determine the payment terms of subscriptions for shares that were entered into before incorporation…* * * • (d) If a subscriber defaults in payment of money or property under a subscription agreement entered into before incorporation, the corporation may collect the amount owed as any other debt. * * * • (e) A written subscription agreement entered into after incorporation is a contract between the subscriber and the corporation subject to section 6. 21. •

RMBCA § 6. 21 (b) – (d) 5 -65 • (b) The board of RMBCA § 6. 21 (b) – (d) 5 -65 • (b) The board of directors may authorize shares to be issued for consideration consisting of any tangible or intangible property or benefit to the corporation, including cash, promissory notes, services performed, contracts for services to be performed, or other securities of the corporation. • (c) Before the corporation issues shares, the board of directors must determine that the consideration received or to be received for shares to be issued is adequate. That determination by the board of directors is conclusive insofar as the adequacy of consideration for the issuance of shares relates to whether the shares are validly issued, fully paid, and nonassessable, and the authorization by the board of directors of the issuance of shares constitutes such determination. • (d) When the corporation receives the consideration for which the board of directors authorized the issuance of shares, the shares issued therefor are fully paid and nonassessable. • Official Comment • “Practitioners and legal scholars have long recognized that the statutory structure embodying “par value” and “legal capital” concepts is not only complex and confusing but also fails to serve the original puprose of protecting creditors and senior security holders from payments to junior security holders. Indeed, to the extent security holders are led to believe that it provides this protection, these provisions may be affirmatively

Delaware’s Legal Capital Rules 5 -66 § 152. Issuance of Stock, Lawful Consideration; Fully Delaware’s Legal Capital Rules 5 -66 § 152. Issuance of Stock, Lawful Consideration; Fully Paid Stock • The consideration, as determined pursuant to subsections (a) and (b) of section 153 of this title, for. . . the purchase of the capital stock to be issued by a corporation shall be paid in such form and. . . manner as the board of directors shall determine. In the absence of actual fraud in the transaction, the judgment of the directors as to the value of such consideration shall be conclusive. The capital stock so issued shall be deemed to be fully paid and nonassessable stock, if: (1) the entire amount of such consideration has been received by the corporation in the form of cash, services rendered, personal property, real property, leases of real property, or a combination thereof; or (2) not less than the amount of the consideration determined to be capital pursuant to section 154 of this title has been received by the corporation in such form and the corporation has received a binding obligation of the subscriber or purchaser to pay the balance. . . • § 153. Consideration for Stock • (a) Shares of stock with par value may be issued for such consideration, having a value not less than the par value thereof, as is determined from time to time by the board of directors, or by the stockholders if the certificate of incorporation so provides. • (b) Shares of stock without par value may be issued for such consideration as is determined from time to time by the board of directors, or by the stockholders if the certificate of incorporation so provides.

The Old Dominion Cases 5 -67 • Facts: The promoter contributed over-valued assets for The Old Dominion Cases 5 -67 • Facts: The promoter contributed over-valued assets for shares, while public investors paid a much higher price. • Old Dominion Copper Mining & Smelting Co. v. Lewisohn, 210 U. S. 206 (1908) (Holmes, J. ): • The promoter hadn’t breached any duty, because at the time of incorporation he controlled the directors, & they all knew what the mine was worth. • Thus he hadn’t breached any duty of candor to the corp. at the time of the contribution. • Old Dominion Copper Mining & Smelting Co. v. Bigelow, 203 Mass. 159, 89 N. E. 193 (1909), aff’d, 225 U. S. 111 (1911) (Rugg, C. J. ): • The promoters’ duties extend to the corporation at it will ultimately be formed, after the public investors have paid for their shares. • Thus, until they approved his shares after full disclosure, he had not fulfilled his duty of candor & loyalty.

RMBCA § 6. 22 5 -68 (a) A purchaser from a corporation of its RMBCA § 6. 22 5 -68 (a) A purchaser from a corporation of its own shares is not liable to the corporation or its creditors with respect to the shares except to pay the consideration for which the shares were authorized to be issued (section 6. 21) or specified in the subscription agreement (section 6. 20). • (b) Unless otherwise provided in the articles of incorporation, a shareholder of a corporation is not personally liable for the acts or debt of the corporation except that he may become personally liable by reason of his own acts or conduct.

The Advent of No-Par Shares: MBCA (1950) §§ 14, 17 & 18 5 -69 The Advent of No-Par Shares: MBCA (1950) §§ 14, 17 & 18 5 -69 • MBCA § 14 (1950): • “Each corporation shall have power to create and issue the number of shares stated in its articles of incorporation. Such shares may be divided into one or more classes, any or all of which may consist of shares with par value or shares without par value. . ” • MBCA § 17 (1950): • “… shares having a par value may be issued for such consideration expressed in dollars, not less than the par value thereof, as shall be fixed from time to time by the board of directors. ” • MBCA § 18 (1950): • “In the case of the issuance of shares without par value, the entire consideration received therefor shall constitute stated capital unless the corporation shall determine as provided in this section that only a part thereof shall be stated capital. Within a period of sixty days after the issuance of any shares without par value, the board of directors may allocate to capital surplus not more than 25 percent of the consideration received for the issuance of such shares. ”

Del. G. C. L. § 154 5 -70 • § 154. Determination of amount Del. G. C. L. § 154 5 -70 • § 154. Determination of amount of capital; capital, surplus and net assets defined • Any corporation may, by resolution of its board of directors, determine that only a part of the consideration which shall be received by the corporation for any of the shares of its capital stock which it shall issue from time to time shall be capital; but, in case any of the shares issued shall be shares having a par value, the amount of the part of such consideration so determined to be capital shall be in excess of the aggregate par value of the shares issued for such consideration having a par value, unless all the shares issued shall be shares having a par value, in which case the amount of the part of such consideration so determined to be capital need be only equal to the aggregate par value of such shares. * * * The amount of the consideration so determined to be capital in respect of any shares without par value shall be the stated capital of such shares. * * * The excess, if any, at any given time, of the net assets of the corporation over the amount so determined to be capital shall be surplus. Net assets means the amount by which total assets exceed total liabilities. Capital and surplus are not liabilities for this purpose.

RMBCA § 6. 01(b) 5 -71 • “The articles of incorporation must authorize (1) RMBCA § 6. 01(b) 5 -71 • “The articles of incorporation must authorize (1) one or more classes of shares that together have unlimited voting rights, and (2) one or more classes of shares (which may be the same class or classes as those with voting rights) that together are entitled to receive the net assets of the corporation upon dissolution. ”

US Securities Laws • • • Securities Act of 1933 Securities Exchange Act of US Securities Laws • • • Securities Act of 1933 Securities Exchange Act of 1934 Investment Company Act of 1940 Investment Advisors Act Trust Indenture Act of 1939 5 -72

US Securities Laws 5 -73 • Securities Act, Section 5: Cannot offer to sell US Securities Laws 5 -73 • Securities Act, Section 5: Cannot offer to sell a security without filing a registration statement. Cannot sell a security without registration statement becoming effective and delivering a statutory prospectus • Exemptions: – Certain Securities (commercial paper) – Exempted Transactions

US Securities Laws 5 -74 • Exempted Transactions – No issuer, underwriter or dealer US Securities Laws 5 -74 • Exempted Transactions – No issuer, underwriter or dealer • Market Trading (underwriter broadly defined) – No public offering • Regulation D Offerings (AIs) • Rule 144 A Offering (QIBs) – Intra-state – 3(a)10 Approved by Court (Bankruptcy)

US Securities Laws 5 -75 • Basic Rule: Cannot publicly sell stock which was US Securities Laws 5 -75 • Basic Rule: Cannot publicly sell stock which was not originally registered unless exemption applies – Rule 144

US Securities Laws • IPO Timetable – Working Group Formed – Draft Registration Statement US Securities Laws • IPO Timetable – Working Group Formed – Draft Registration Statement – File Registration Statement – Receive First Comments – Respond to Comments – Circulate “red” – Roadshow Ends – Price Offering – Close Offering 5 -76 Day 1 Day 30 Day 31 Day 61 Day 95 Day 106 Day 109

US Securities Laws • Shortcuts – Shelf Registration – Rule 144 A offering (A/B US Securities Laws • Shortcuts – Shelf Registration – Rule 144 A offering (A/B Exchange) 5 -77

US Securities Laws • • • Rule 144 A A/B Exchange timetable Working Group US Securities Laws • • • Rule 144 A A/B Exchange timetable Working Group Formed Draft Offering Memorandum Distribute Preliminary OM Price Offering Close Offering 5 -78 Day 1 Day 32 Day 45

US Securities Laws • • • Draft Registration Statement File Registration Statement Receive Comments US Securities Laws • • • Draft Registration Statement File Registration Statement Receive Comments Resolve Comments Begin Offer to Exchange Close Exchange Offer 5 -79 Day 55 Day 85 Day 115 Day 145

US Securities Laws 5 -80 Exchange Act • Requires Periodic Disclosure (annual, quarterly and US Securities Laws 5 -80 Exchange Act • Requires Periodic Disclosure (annual, quarterly and events) if – Listed on an exchange – More than 500 shareholders – Had a registration statement effective • Regulates markets and punishes fraud • Insider trading • Regulates Proxy Contests • Regulates Tender Offers (Williams Act)