Financing the Corporation

• Pages: 37-67
• Author: Stephen M. Bainbridge

37

Chapter 3

FINANCING THE CORPORATION

§ 3.1 Introduction

The numerous technological changes wrought by the Industrial

Revolution, especially the development of modern mass production

techniques in the nineteenth century, gave great advantages to firms

large enough to achieve economies of scale. In turn, those advantages

gave rise to giant industrial corporations. These firms required

enormous amounts of capital, far exceeding the resources of any

single individual or family. They could be financed only by

aggregating many small investments, which was accomplished by

selling stock or bonds to many investors—each of whom held only a

tiny fraction of the firm’s total capital.

Capital markets facilitated this process in at least two respects.

First, the primary market gave issuers access to a large and ever-

growing pool of potential investors. Second, the secondary markets

for corporate stocks and bonds gave investors essential liquidity and,

accordingly, encouraged investment. In a liquid market, investors

can freely sell their securities without involving the firm. Liquidity,

in turn, makes it easier and cheaper for the company subsequently

to raise capital in the primary market, because investors generally

prefer (and will be willing to pay more for) liquid securities.

A. Corporate Capital Structure

A corporation’s capital structure consists of the permanent and

long-term contingent claims on the corporation’s assets and future

earnings issued pursuant to formal contractual instruments called

securities. There are two basic types of securities: debt and equity. In

most cases, of course, the funds needed to finance the corporation will

largely come from bank loans or retained earnings, not through

selling debt or equity securities. Bank loans and retained earnings

are not regarded as being part of the c orporation’s capital structure,

however, because neither involves a securitized investment in the

firm.

Equity securities are issued in the form of shares, which

represent “the units into which the proprietary interests in a

corporation are divided.”

1

As this statutory definition suggests, the

law traditionally regards a corporation as being owned by the holders

of its equity securities. Holders of debt securities are not in any sense

1

MBCA § 1.40(22).

38

FINANCING THE CORPORATION

Ch. 3

owners of the corporation; rather, they are creditors of the

corporation.

The law’s conception of equity security holders as the

corporation’s owners has the important consequence that corporate

officers and directors owe fiduciary duties to the equity security

holders. In contrast, the relationship between the corporation and its

debt security holders is essentially contractual. Directors and officers

normally owe no fiduciary duties to debt security holders.

2

Another important distinction between debt and equity

securities is their respective risk exposure. All else being equal,

equity securities are riskier than debt securities issued by the same

corporation. Equity securities represent the “residual claim,” which

means their holders are entitled to whatever funds are left after all

other claims on the corporation’s assets and earnings have been

satisfied. In contrast, debt securities represent a fixed claim on the

corporation’s assets and earnings superior to that of the equity.

Because debt securityholders are entitled to be paid before the equity

securityholders, they are less likely to be hurt by sub-par corporate

performance.

A third important difference between debt and equity is their

respective duration. Although equity securities often change hands,

the securities themselves represent permanent claims on the

corporation. In contrast, debt securities usually are limited in

duration. At some contractually specified date, the debt security will

mature and the corporation will pay off the principal.

B. Equity Securities

Many corporations divide their equity securities into multiple

classes of stock, of which common and preferred stock are the basic

forms. As with other corporation statutes, the MBCA requires the

articles of incorporation to authorize one or more classes o f stock

together having unlimited voting rights and one or more classes that

together are entitled to receive the assets of the corporation upon

dissolution.

3

They need not be the same class, however, which gives

transaction planners considerable flexibility.

1. Common Stock

Common stock carries two basic rights, voting and economic,

both of which are subject to being unbundled and sold separately. As

to voting rights, holders of common stock have a limited right to

2

See, e.g., Metropolitan Life Ins. Co. v. RJR Nabisco, Inc., 716 F.Supp. 1504

(S.D.N.Y.1989); Simons v. Cogan, 549 A.2d 300 (Del.1988); Katz v. Oak Indus., 508

A.2d 873 (Del.Ch.1986).

3

MBCA § 6.01(b).