Capital Structure, Preferences, And Classes Of Securities

• Author: James D. Cox/Thomas Lee Hazen
• Profession: Professor of Law at Duke University/Professor of Law at the University of North Carolina, Chapel Hill
• Pages: 424-442

§ 18.1 Choices in Debt and Equity Financing

The “capitalization,” financial str ucture, or permanent fina ncing of a cor-

poration is based on the issuance of capital securities. Permanent fina nc-

ing includes not only common stock but also senior secu rities, which can

be (1) an equity interest by way of preferred stock or (2) bonds and deben-

tures, which are the long-term or funded debts. Debt obligations are

issued against t he corporation’s actual or prospect ive earning power even

more than against its assets. The power to issue bonds and other debt

obligations is not dependent, as stock issues a re, on express authorization

by the corporate charter. Debt financing thus provides more flexibility

because there generally is no need for prior shareholder approval.

A sound and well-balanced capital structure must be carefully

planned. The choice between stocks and bonds of different varieties

depends on many considerations, including whether the business has

an established earnings record, the ratio of property to its obligations,

the rate of return that must be paid, probable marketability and attrac-

tiveness to investors, advantages under federal and state tax laws, and

the effect on the future credit and ability of the corporation to survive

business cycles.

The tax laws encourage debt financing by treating interest pay-

ments, but not dividends on stock, as deductible from corporate gross

income.1 In order to safeguard against abuse due to thin equity financ-

ing, payments on the debt instruments may be treated for tax purposes

as disguised dividends.2 Similarly, too high a debt-to-equity ratio may

lead a bankruptc y court to classi fy debt as stock for the purposes of sub-

ordinating claims of shareholder/creditors to those of other creditors.3

Attorneys are frequently asked to assist in evaluating the financial

soundness of a firm’s capital structure. The choice among different

kinds of securities should be determined by the organizer and manag-

ers, considering the inducements needed to attract different types of

investors and the control of management. They must f urther adequately

anticipate the corporation’s future fi nancial needs. Questions that inevi-

tably arise include: (1) How can the company raise money at the lowest

cost? (2) What are the tax advantages of different forms of securities?

(3) How can control be reserved to the organizers without requiring

them to invest too large an amount in the corporation? (4) To what

extent can the company meet fixed financial charges when its income is

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fluctuating? (5) How can the company best ensure its credit for future

financing to meet expansion and growth?

Preferred shares, which are frequently viewed as a hybrid of debt

and equity, may be advisable as an alternative to pure debt because pay-

ment of dividends is not a mandatory fixed charge and non-payment

will not entail foreclosure or receivership. In addition to the ability to

pass on payments without being in default, there is usually no maturity

date for retirement of preferred shares, and t he redemption provision, if

any, is normally an option in favor of the corporation. In the absence of

a prohibitory covenant, the corporation has t he power to borrow money

by issuing notes or bonds that take priority over the preferred shares.

Preferred shares may be desirable because they tend to attract a type

of investor different from those who invest in pure debt instruments.

Special features, such as the right of conversion into a different type of

security, further expand the alternative vehicles for raising capital.

The issuance of senior secur ities such as bonds a nd preferred shares

may be attractive to the issuer for various reasons. First, senior securi-

ties create “leverage” for the common shares—that is, a greater chance

of possible gain to the common on the tota l capital investment. Second,

senior securities represent money invested for a limited return on the

basis of a stable income to the investor; therefore, they have no claim

on capital appreciation or increased corporate income. Third, preferred

shares facilitate retention of voting cont rol by the initial or current inves-

tors, as all senior securities usually have at most only contingent voting

rights. This reduces the amount of investment necessary to obtain vot-

ing cont rol by way of e ither init ial inves tment or subs equent acquis ition.

Fourth, preferred shares and bonds can be used to tap the reservoir of

savings of those who seek to avoid the risk s of common stocks.

§ 18.2 Bonds and Debt Financing

Bonds or debentures are essentially promissory notes with more elab-

orate provisions than ordinary commercial loans. They are generally

long-term, but in times of f luctuating interest rates shorter-term instr u-

ments are not uncommon. Despite its existence as a corporate debt, the

longer-term instrument has led to the view of bondholders as “joint

heirs in the corporate fortunes—participants in the success or failure

who have been given preferential rights in t he common hazard.”

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