The Debt-Equity Distinction PDF

The Debt-Equity Distinction
Robert Flannigan*
The distinction between debt and equity often is crucially important. Yet some
doubt that there is a distinction of kind, or that the distinction is certain. My objec-
tive is to illuminate the conventional view of the difference — the imparity between
fixed and contingent participation — and address the main challenges it has en-
countered. I first describe the common law and statutory developments that crystal-
lized the distinction. I then review the entangled criticisms: that debt and equity are
functionally equivalent or that the difference between them is fatally uncertain. Fi-
nally, I briefly consider the utility of the distinction in specific contexts.
La distinction entre les notions de titre de créance et titre de participation

revêt souvent une importance cruciale. Toutefois, certains doutent de l’importance
de cette distinction ou, même, de son existence. L’auteur présente l’analyse tradi-
tionnelle de la distinction entre les deux notions ainsi que les caractéristiques dist-
inguant les titres de participation fixe des titres de participation éventuelle. Il
décrit d’abord l’évolution de la common law puis l’évolution législative qui ont
cristallisé cette distinction. Il passe en revue les deux écoles de pensée qui mettent
en doute cette approche traditionnelle, l’une soutenant que les notions de créance
et de participation s’équivalent d’un point de vue fonctionnel, l’autre, que la différ-
ence entre ces deux notions est fatalement incertaine. Enfin, il examine brièvement
l’utilité de la distinction dans des contextes particuliers.
1. THE CONVENTIONAL DISTINCTION

The rudimentary distinction between debt and equity is apparent.1 Classic or
prototypical equity investment involves contributing “permanent” capital that is at
risk of loss in exchange for rights to participate in the control and residual gain of
an undertaking.2 Classic debt, in contrast, is term capital that is advanced for a
* University of Saskatchewan. My thanks to Tim Edgar for his comments.

1 The distinction frequently is engaged for financial purposes (debt-equity ratio, cove-
nant compliance) and regularly is an issue for taxation and bankruptcy matters.
2 The fact that capital is contributed on a “permanent” basis might seem on its face to be
of independent relevance. See, however, David Hariton, “Distinguishing Between Eq-
uity and Debt in the New Financial Environment” (1994) 49 Tax L. Rev. 499 at
504–508. Appreciate that where there are secondary markets for securities, the only
effect of formal permanence is to externalize to those markets the recovery of the capi-
tal contribution, with the result that the contribution is not actually permanent at all.
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452 BANKING & FINANCE LAW REVIEW [26 B.F.L.R.]
fixed return without rights to participate in the control of the undertaking. The ele-
mental difference between these prototypes is that only the equity investment is
linked contingently to the performance risk of the venture once past the floor risk
of viability. Three main forms of risk participation are involved. First, those who
advance equity assume the risk that their capital will appreciate or be wholly or
partially lost as a result of the quality of performance. Those who advance debt
retain the right to recover their original principal notwithstanding the vagaries of
performance or situational stresses affecting the issuer. Secondly, equity contribu-
tors assume the risk of contingent returns. Their returns (dividends) vary with per-
formance. For classic debt, interest payments are not contingent on performance.
Debt providers assume the risk of firm failure, but not the risk of inferior perform-
ance. Thirdly, equity contributors assume some power or ability (through rights of
control) to participate in defining the risk associated with the undertaking. Debt
providers do not possess positive control powers. These risk differences between
classic equity and debt all reflect a difference in kind. Equity has skin in the game
in a way that debt does not. Equity embraces the contingency of performance. Debt
declines contingency. Query, however, whether that difference is erased or dis-
solved as arrangements depart from the prototype positions and begin to approach
each other. Where is the border between debt and equity? Is there a border?
The definitive approach to the issue is to focus on solvent competitive rela-
tions, rather than on conditions of firm distress. The essence of the distinction must
be found in its ordinary-course application. Accordingly, one dimension of risk
must at the outset notionally be removed from the calculation: the risk that a firm
will fail because it lacks sufficient value or value-generation capacity to meet its
fixed commitments. That viability risk — a component of performance risk — is
not a distinguishing consideration.3 All debt and equity claims, conditioned by
whatever default or negotiated priorities apply, are diminished or defeated by the
failure of a firm to reach or maintain viability.4 Neither dividend nor interest pay-
Contributors may also have negotiated rights to sell or “put” their securities to the firm
or to others.
3 Viability risk is the threshold component of performance risk in that performance de-
termines whether viability can be achieved or sustained. Viability is the baseline objec-
tive of performance. Thereafter the objective is the maximization of overall gain. Via-
bility risk, as I employ the term, is different from what might be labelled default or
insolvency risk if those terms imply temporary failures that potentially can be rectified.
Viability risk is the risk of the effective termination of competitive operations with no
prospect of recovery, leaving only liquidation procedures to eventually resolve out-
standing claims. Viability risk is roughly equivalent to bankruptcy risk, in the sense
that the firm is defunct notwithstanding that formal bankruptcy proceedings have not
commenced.
4 Firm viability risk registers differently or uniquely with different stakeholders. Contrib-
utors of financial capital perceive viability risk in terms of their own respective circum-
stances, including the effects of default and negotiated priorities that apply inter se,
their inside information, their security and their risk sensitivity. A contributor with se-
curity, for example, might regard a firm as viable where an unsecured contributor
might not. The converse perception is also possible where, for example, a secured con-
tributor obtains negative information from covenant discipline.
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THE DEBT-EQUITY DISTINCTION 453
ments, nor the recovery of capital, can escape the effects of the demise of the un-
dertaking. The capacity to meet the terms of continuing obligations is ended. Some
contributors with higher priority may recover their capital, but they will not enjoy
the returns scheduled to be paid (at rates no longer available elsewhere) for the
remainder of the original term.5 While both equity and debt claims may have exter-
nal protection (puts, guarantees), those are separate devices that operate indepen-
dently of the economic performance of the capital.
Setting viability risk to one side because it is a commonality clears the concep-
tual terrain. It then becomes apparent that there is a sharp border between forgoing
and embracing contingency. Contributions exchanged for a specific return and the
full recovery of the principal amount avoid the contingency of performance.
Neither return nor recovery is tied to relative success in capricious markets. It is
fundamentally different where a contributor embraces or assumes the contingency
of performance. Whenever or however the rate of return or the recovery of capital
is made dependent on the idiosyncratic risk of an undertaking, a community of
enterprise or fortune is introduced.6 The prospects of the contributor beyond the
threshold of viability are no longer independent of the prospects of the firm. It is a
qualitative difference. Accepting (negotiating) contingency for either return or cap-
ital recovery (income or capital variation) brings a contributor inside a firm. There
is a realignment of incentives.7 Profitability, or the dilation of value, replaces via-
bility as the primary concern of the contributor. From the firm perspective, the ac-
ceptance of contingency by the contributor provides cushioning or flexibility to the
firm to accommodate internal and external fluctuations affecting its operations.
That ex ante grant of cushioning reserve to the firm (to be managed unilaterally by
the firm) is fundamentally different from the ad hoc payment concessions or waiv-
ers that a firm might be able to extract after the fact from contributors with defined
claims. The contribution of capital on contingency (where either return or capital
recovery is contingent on performance) is the kind of participation we convention-
ally distinguish as equity.
The border between fixed and contingent participation always exists. It is the
5 Relative priority or subordination invariably is contractual in character (as express

terms or as unaltered (accepted) default terms) and may affect either debt or equity in
either direction. Priority/subordination is not associated exclusively with one kind of
risk exposure; it merely alters the degree of each kind of risk.
6 Linking return to external indices, it should be apparent, is not idiosyncratic contin-
gency. The return is variable but not contingent on the idiosyncratic performance of the
issuing firm.
7 Debt provides leverage that equity interests seek to exploit, potentially very aggres-
sively. Debt contributors understand that and consequently price and condition their
contributions (in rate and covenant terms) according to the risk profiles of their bor-
rowers. They collectively are primarily concerned with debt-servicing capacity (viabil-
ity risk), not the ultimate magnitude of borrower profit. Equity contributors share the
viability risk, but have distinct incentives both internally (managers versus sharehold-
ers) and externally in the employment of the contributed capital.
only difference in kind, in terms of risk exposure, between debt and equity.8 It
cannot be erased by the “blending” of debt and equity characteristics. It is a real
border, a real distinction that conventionally reflects our sense of the difference
between market (debt) and firm (equity). It is a separate question whether it is a
border or distinction that we might wish to enlist for any given purpose.
2. CRYSTALLIZATION OF THE DISTINCTION

A common perception is that the debt-equity distinction is a finance issue. Its
legal character, however, has roots in liability questions. We find this in certain
nineteenth-century developments that clarified various matters of personal respon-
sibility. One important issue arose in partnership law. Where was the dividing line
between a debtor-creditor relationship and a partnership relationship?9 The early
jurisprudence on the issue has been rehearsed at length elsewhere.10 Only a sum-
mary is necessary here. There were cases in the nineteenth century that suggested
that taking a share of profit established conclusively that a person advancing capital
was a partner. The contributor was regarded as having common cause with the for-
mal partners — sharing the risk of the venture. The contrast was between those
engaged in the business (equity) and those engaged in an independent undertaking
of lending to the business (debt). While that contrast was appropriate, the supposed
absolute quality of the profit-sharing criterion was not, and it was denied by the
House of Lords in Cox v. Hickman.11 Sharing in profit was prima facie, not conclu-
sive, evidence of partnership. Those who contributed capital in exchange for a
share of the profit were entitled to rebut the presumption of partnership by proving,
inter alia, that the relation was one of debtor and creditor. There is some dissonance
in the case law, but certain aspects are clear. The formal question is whether one
carries on business in common with others. Sharing in profit indicates partnership
because the recipients share the contingency of performance. Sharing in control of
the undertaking also indicates that actors are carrying on business in common be-
cause they jointly define the risk associated with performance of the undertaking.
In Cox, the attempt to establish a partnership relation failed because the court con-
8 Sharing in control (risk definition) is a separate potential boundary that, if exclusive,

would exclude from equity status all those with contingent interests who do not possess
control powers.
9 Where the rights of third parties were concerned, the determination of whether suppli-
ers of capital to partnerships were creditors or partners did not depend on the character-
ization that the parties themselves assigned to an arrangement. The courts were not
bound to defer to contractual assertions that capital contributors were creditors only.
Nor did it matter that contributors contracted to receive “interest” on their advances, or
otherwise cosmetically formulated their arrangement to have the appearance of a
debtor-creditor relation. Courts sought to identify the substance of the arrangement. If
suppliers essentially had joined in the contingency of the venture, through either a con-
tingent return or recovery, or the ability to shape risk by the exercise of control, they
were principals for liability purposes. See generally Robert Flannigan, “The Limits of
Status Assertion” (1999) 21 Advocates’ Q. 397.
10 See Robert Flannigan, “The Control Test of Principal Status Applied to Business
Trusts” (1986) 8 E.T.Q. 37 at 76–95.
11 (1860), 8 H.L.C. 268, 11 E.R. 431.
cluded that the arrangement involved only the repayment of fixed debt. There was
no agreement to link the quantum of the return or the recovery of the capital to firm
performance. Moreover, while the creditors potentially could have taken control of
the business, they had not put themselves in a position to do so.12 They had not
purported to either assume or define the risk of contingent gain.13
Sharing in profit beyond a fixed return is to embrace performance risk. The
cases indicate that, unless there are strong counter factors, sharing in profit is alone
a sufficient basis for a partner or “equity” characterization. Similarly, sharing in
control — participating in the projection of risk — strongly indicates an equity par-
ticipation.14 That remains the case today, and it has been augmented by the creditor
control jurisprudence that generally imposes responsibility on creditors who control
debtors.15 Overall it appears that it is the linkage to performance risk (exposure to,
definition of) that determines whether a person carries on business with others, or
whether, for present purposes, there is an equity participation.
The same conclusion is apparent in the structure of the other organizational
forms that were utilized for business purposes in the nineteenth century.16 Both the
limited partnership17 and the business trust18 were employed as structures to facili-
tate passive equity investment. Passivity in fact was required if the investors were
to enjoy limited liability. Investors were allowed to exercise certain rights, but not
12 See Flannigan, supra, n. 10 at 76–88.

13 That jurisprudence necessarily informed lending practice. Lenders who were intent on
avoiding partner liability advanced funds for fixed returns and did not seek operational
control over debtor affairs. They relied instead on security or often only on the promise
to pay. Lenders who were more aggressive would go further and add elements of
profit-sharing or control, while hoping to remain on the creditor side of the distinction.
14 It is de jure control, or the right to control, that is relevant. Few shareholders in public
corporations have de facto control. Through the coordination of their de jure rights,
however, they have the potential to assume de facto control.
15 Consider Margaret Douglas-Hamilton, “Creditor Liabilities Resulting From Improper
Interference With the Management of a Financially Troubled Debtor” (1975) 31 Bus.
Law. 343; K. Thor Lundgren, “Liability of a Creditor in a Control Relationship With
Its Debtor” (1984) 67 Marq. L. Rev. 523; J. Dennis Hynes, “Lender Liability: The
Dilemma of the Controlling Creditor” (1991) 58 Tenn. L. Rev. 635; Adam Feibelman,
“Debt as a Lever of Control: Commercial Lending and the Separation of Banking and
Commerce” (2007) 75 U. Cin. L. Rev. 943.
16 The unincorporated joint stock company, the partnership antecedent of the modern re-
gistration corporation, is of collateral interest. The “joint stock company” phrase ini-
tially described larger partnerships characterized by centralized management and freely
transferable shares. See Playfair Development Corp. Pty. Ltd. v. Ryan, 1969 WL 89147
(NSWSC)[1969] 2 NSWR 661, 90 WN (Pt1) (NSW) 504 (NSWSC 1969).
17 The limited partnership is a statutory creation in common law jurisdictions. Its struc-
ture replicated the medieval commenda. Consider Kenneth Setton (ed.), A History of
the Crusades, vol. 5 (Madison: University of Wisconsin Press, 1985) at 402–405; Ron
Harris, “The Institutional Dynamics of Early Modern Eurasian Trade: The Commenda
and the Corporation” (2009) 71 J. Econ. Behav. Org. 606.
18 Robert Flannigan, “The Nature and Duration of the Business Trust” (1983) 6 E.T.Q.
181 and “Business Trusts — Past and Present” (1984) 6 E.T.Q. 375.
rights which gave them more than nominal (or possibly defensive) control over the
undertaking.19 The legal structure of the two vehicles indicated that advancing cap-
ital that was exposed to performance risk in terms of either income or capital was
an “equity” investment, notwithstanding that the investors were not entitled to
freely define the risk of the enterprise. Participation in the definition of risk
(through control) was not essential, though separately it was also sufficient.
The development of the modern registration corporation in England in the
nineteenth century is of parallel significance in a number of respects. The mid-
century decision of Parliament to make corporate status generally available was
implemented by requiring existing joint stock companies to register with the state.
Joint stock companies were partnerships at law. The shareholders (partners) in
those companies were the “owners” or principals of the business. Incorporation
fundamentally altered that status.20 The new corporate entity became the
owner/principal of the business. The shareholders ceased to be “owners” relative to
the business operation.21 Instead they assumed the novel statutory status dictated
by the legislation. Shareholder became a defined status different from the partner
status it represented prior to incorporation. That status initially was defined only in
limited general respects by the statute. It was otherwise defined by the terms of the
constitution of each individual joint stock company. Subsequently a comprehensive
set of primarily default terms developed as incorporation statutes evolved. Corpo-
rate actors could displace the default terms, but commonly they did not make ex-
tensive revisions to the basic character of the standard form.22
This fundamental transformation from owner to shareholder produced certain
effects. It negated any analytical appeal to “owner” status to buttress arguments
supporting automatic shareholder dominance in corporate affairs. It was soon con-
cluded, for example, that shareholders did not possess residual power to overrule
decisions of the board of directors.23 Also, once properly understood, the transfor-
mation necessarily checks the modern argument of “shareholder primacy.”24 Share-
19 On the limited partnership, see Robert Flannigan, “Limited Partner Liability — A Re-
sponse” (1992) 71 Can. Bar Rev. 552. On the business trust, see Robert Flannigan,
“Trust or Agency: Beneficiary Liability and the Wise Old Birds,” in Stephen Goldstein
(ed.), Equity and Contemporary Legal Developments (Jerusalem: Maccabi Press, 1990)
275.
20 Robert Flannigan, “The Personal Tort Liability of Directors” (2002) 81 Can. Bar Rev.
247 at 250–61.
21 The continuing use today of the term “owner” to describe shareholders only clouds
their status. Shareholders do not own corporations. They own shares, or claims, issued
by corporations. Nor do shareholders have a special or privileged default access to rev-
enues or retained earnings. Consider Daniel Greenwood, “The Dividend Puzzle: Are
Shares Entitled to the Residual?” (2006) 32 J. Corp. L. 103 at 111 (fn 21).
22 Because the statutory standard form essentially incorporated the experience/norms of
the private-order economic form, it usually was the efficient choice. Appreciate, how-
ever, that the main default of limited liability is the one element of the corporate stan-
dard form that frequently is modified (at the insistence of creditors).
23 See Automatic Self Cleansing Filter Syndicate Co. v. Cunninghame, [1906] 2 Ch. 34.
24 Robert Flannigan, “The Political Imposture of Passive Capital” (2009) 9 J.C.L.S. 139
at 157–63.
holder status represents but one kind of claim relative to the undertaking. Share-
holders and creditors, in like manner, negotiate with the corporation to define their
respective positions. Neither class of interest is privileged over the other on an
“ownership” basis. The two classes contract for different sets of terms against back-
grounds of different default rules, but neither class can insist on primacy over the
principal status of the corporation itself.
The transformation from partner to shareholder did not nullify or cancel the
debt-equity distinction. The need to distinguish between partner and creditor was
replaced by the need to distinguish between shareholder and creditor. It was still
necessary as a financial matter to differentiate between equity and debt. And the
risk analysis had not changed. It was confirmed, in particular, that passivity in the
management of the business did not imply that a contribution was debt. Many part-
ners in joint stock companies were passive investors.25 One effect of the incorpora-
tion of such companies was the transfer of the vicarious liability of the former part-
ners to the new corporate entity. That conceptual move occurred without any
coincident requirement to change or redesign the physical arrangement or structure
of the joint stock company. All of the shareholders, whether active or passive, were
granted limited liability.26 Corporate law thus from the outset of its modern incar-
nation accepted passive at-risk investment as equity investment. There was no ex-
pectation that shareholders needed to participate in defining performance risk
(share in control) in order to justify their statutory shareholder status. Like passive
partners, they exposed their contributions to performance risk (as to either income
or capital), and that established the equity nature of their participation.
The same conception of equity character is evident in the contemporaneous
development of the preference share.27 Shares with preferences originally were de-
25 Passive investment had been facilitated by the exit option. Secondary markets in equi-
ties developed as partnership (joint stock company) shares became freely transferable.
Markets solved the equity lock-in “problem” and thereby expanded the range of poten-
tial investors and the relative size of enterprises. On the development of markets, con-
sider C.F. Smith, “The Early History of the London Stock Exchange” (1929) 19 Am.
Econ. Rev. 206; S.R. Cope, “The Stock Exchange Revisited: A New Look at the Mar-
ket in Securities in London in the Eighteenth Century” (1978) 45 Economica 1;
Jonathan Baskin, “The Development of Corporate Financial Markets in Britain and the
United States, 1600–1914: Overcoming Asymmetric Information” (1988) 62 Bus. Hist.
Rev. 199; Douglass North & Barry Weingast, “Constitutions and Commitment: The
Evolution of Institutions Governing Public Choice in Seventeenth-Century England”
(1989) 49 J. Econ. Hist. 803; Edward Stringham, “The Extralegal Development of Se-
curities Trading in Seventeenth Century Amsterdam” (2002) 43 Q. Rev. Econ. & Fin.
321; Oscar Gelderblom & Joost Jonker, “Completing a Financial Revolution: The Fi-
nance of the Dutch East India Trade and the Rise of the Amsterdam Capital Market,
1595–1612” (2004) 64 J. Econ. Hist. 641. It is of incidental interest that increased num-
bers of partners added a measure of liability protection in the form of the dispersion of
loss amongst a larger group of contributors.
26 The passive investor actually had the stronger justification for limited liability (no di-
rect influence on risk projection). On the political significance of the passive investor
for the original limited liability debate, see Flannigan, supra, n. 24.
27 George Evans, British Corporation Finance 1775–1850: A Study of Preference Shares
(Baltimore: John Hopkins Press, 1936).
signed to raise capital when a corporation was in exigent circumstances. They ini-
tially were fully participating shares (participating in voting, profit and on winding-
up) with the added feature of a preferential dividend and/or capital recovery. Be-
cause the corporation was in distress, the preference was necessary to induce the
new investment. However, when preference shares later came to be issued for more
ordinary-course financings, there simultaneously occurred a process whereby the
array of rights offered to preference shareholders were cropped or diminished. Pref-
erences were continued, but over time fewer or lesser other rights were conveyed.
Essentially corporate proprietors were seeking to ascertain the minimum set of
rights or terms that would induce at-risk capital investment.28 They did this to pla-
cate the holders of ordinary common shares (by creating a different tradeoff, rather
than a starkly superior claim) and to see whether they could access capital that (as
in limited partnerships and business trusts) would have little power to interfere in
management. Eventually corporations found they were able to issue shares with
preferences for fixed dividends that were otherwise denuded of rights, particularly
voting rights. Retail shareholders in public markets accepted the shares with equa-
nimity. Their formal passivity conveniently matched their de facto desire to be pas-
sive. They were content to take their return ahead of other shareholders and to have
the option to exit the investment at will. Again we see that “equity” status did not
require participation in defining the risk of the undertaking (control). It was enough
that either the return or recovery of the contribution was linked to the performance
of the business. Equity status was maintained even though, like debt, contributors
bargained for distribution preferences over ordinary or common shareholders. It
was the contingent exposure to performance risk, not the preference per se, that
distinguished preference shares.
It usefully may be added at this point that the debt-equity distinction generally
tracks legal form mechanically or in rote fashion in the corporate context. That is,
the legal form assigned by the corporation itself to its securities is treated as con-
clusive by stakeholders and courts (even in some instances where third party inter-
ests are engaged).29 If a corporation assigns share status to a particular security, the
holders of that security have that status throughout the operation of the statute even
though the actual terms of the security indicate debt character. That status will de-
termine, for example, who must be included in a unanimous shareholder agreement
or who is entitled to spontaneous voting rights in the event of a fundamental
change. Rote characterization may also distort the operation of the financial provi-
sions of many statutes. Solvency tests that regulate dividend payments, share
purchases, redemptions and other matters appear to depend on the self-labeling of
debt and equity. The rote tracking of form, it will be appreciated, provides firms
with an opportunity to engineer a single set of terms that will receive formal treat-
ment as equity for one purpose (corporate law) and de facto treatment as debt for
28 Ibid., at c. 8–10.
29 The rote tracking of form might be viewed as an under-appreciated “advantage” of the
corporate form. It reduces the risk, at least for many corporate law purposes, of the ex
post recharacterization of the asserted status.
another (tax law).30

It is also convenient here to clarify another aspect of the debt-equity distinc-
tion in the corporate context. In investment relations outside the corporate context,
the debt-equity distinction generally corresponds with the imposition of fiduciary
accountability. Conventional equity interests (e.g., partnership and business trust
interests) attract status fiduciary duties — debt interests do not. Incorporation radi-
cally repositions the fiduciary accountability of corporate actors.31 Consider again
the historical transformation from partner to shareholder. In joint stock companies
the partners carried on business for their joint benefit. Their access to partnership
assets was limited to their collective ends. They therefore were status fiduciaries to
each other. They were not entitled to entertain unauthorized conflicts or benefits.
Incorporation changed the nature of their access. The new interposed entity now
owned the business operation. The former partners (the former “owners”) assumed
the novel statutory status of shareholder. Their equity subscriptions were recast in
terms of the access that was granted to the corporation. Unlike partners, their con-
tributions were not advanced for their own benefit. Rather, their funds were con-
veyed to the corporation for its benefit. The corporation received the funds on an
open access basis (to use in its own self-interest). The directors and employees who
deployed the corporate capital still had status fiduciary duties, but now those duties
were owed to the corporation. None of that, however, altered the contingency of
return or recovery. While shareholders lost the benefit of status fiduciary accounta-
bility owed to them directly, they retained their status as equity investors. That was
because, again, the risk analysis had not changed. Their income or capital claims
were still tied to the performance risk of the business.
The last major crystallizing development was the adoption of the debt-equity
distinction for taxation purposes.32 The most significant application of the distinc-
30 Corporate law has a variety of distorting effects on relative levels of debt and equity.
Limited liability is one example. The limited liability rule partially reverses the stan-
dard default position of open liability for the adverse consequences of risk-taking. It
caps downside risk and thereby alters the equilibrium debt-equity ratio. The oppression
remedy is another example. Concern that current debt or equity contributors might
challenge a new issue of securities on the basis that it would unfairly disregard their
interests (e.g., dilute value or control) could drive the decision to issue debt or equity.
Rules other than corporate law rules may also interfere with a purely financial determi-
nation of capital structure. Regulatory rules concerned with economic stability or for-
eign ownership, for example, may (and are often intended to) influence capital
structure.
31 Robert Flannigan, “Fiduciary Duties of Shareholders and Directors” [2005] J.B.L. 277
at 279-80. See also Flannigan, supra, n. 24.
32 Consider generally William Plumb, “The Federal Income Tax Significance of Corpo-
rate Debt: A Critical Analysis and a Proposal” (1971) 26 Tax L. Rev. 369; Alvin War-
ren, “The Corporate Interest Deduction: A Policy Evaluation” (1974) 83 Yale L.J.
1585; Adam Emmerich, “Hybrid Instruments and the Debt-Equity Distinction in Cor-
porate Taxation” (1985) 52 U. Chi. L. Rev. 118; David Hariton, “The Taxation of
Complex Financial Instruments” (1988) 43 Tax L. Rev. 731; Hideki Kanda,
“Debtholders and Equity Holders” (1992) 21 J. Leg. Stud. 431; Michael Knoll, “Taxing
Prometheus: How the Corporate Interest Deduction Discourages Innovation and Risk-
tion was its use to determine whether distributions to capital contributors could be
deducted from firm income (interest payments, but not dividend payments, were
deductible). A commonly-cited description of the distinction framed the difference
in terms of risk exposure:
The essential difference between a stockholder and a creditor is that the
stockholder’s intention is to embark upon the corporate adventure, taking
the risks of loss attendant upon it, so that he may enjoy the chances of
profit. The creditor, on the other hand, does not intend to take such risks so
far as they may be avoided, but merely to lend his capital to others who do
intend to take them.33
As time progressed, however, judicial efforts to refine the risk analysis appeared to
lose focus. American judges, in particular, accumulated numerous factors that they
thought were relevant to determining whether a contribution was debt or equity,
albeit with disagreement over the relevance and weight of various factors. That
ultimately resulted in a seemingly indefinite tax case law that was both frustrating
and conducive to exploitation. There were government efforts to clarify the distinc-
tion, but those efforts largely failed.34 Judges were left with the clutter of their
taking” (1993) 38 Vill. L. Rev. 1461; Hariton, supra, n. 2; Robert Santangelo, “To-
wards Reshaping the Debt-Equity Distinction” (1997) 23 J. Corp. Tax’n. 312; Richard
Wood, “The Taxation of Debt, Equity, and Hybrid Arrangements” (1999) 47 Can. Tax
J. 49; Anthony Polito, “A Modest Proposal Regarding Debt-Like Preferred Stock”
(2000) 20 Va. Tax Rev. 291; Katherine Pratt, “The Debt-Equity Distinction in a Sec-
ond-Best World” (2000) 53 Vand. L. Rev. 1055; Tim Edgar, The Income Tax Treat-
ment of Financial Instruments: Theory and Practice, Canadian Tax Foundation Paper
No. 105 (Toronto: Canadian Tax Foundation, 2000); Herwig Schlunk, “Little Boxes:
Can Commodity Tax Methodology Save the Debt-Equity Distinction” (2002) 80 Tex.
L. Rev. 859; Garry Bourke, “Drawing a Sharp Line in the Sand of the Debt/Equity
Desert — Division 974 — Oasis or Mirage?” (2004) 33 Aust. Tax Rev. 24; Ilan Ben-
shalom, “How to Live with a Tax Code with which You Disagree: Doctrine, Optimal
Tax, Common Sense, and the Debt-Equity Distinction” (2010) 88 N. C. L. Rev 1217;
Wayne Gazur, “An Arm’s Length Solution to the Shareholder Loan Tax Puzzle”
(2010) 40 Seton Hall L. Rev. 407.
33 U.S. v. Title Guarantee & Trust Co., 133 F.2d 990, 43-1 U.S. Tax Cas. (CCH) P 9293,
30 A.F.T.R. (P-H) P 1008 (C.C.A. 6th Cir. 1943) at 993 [F.2d]. The language replicates
that in Helvering v. Richmond, F. & P.R. Co., 90 F.2d 971, 37-2 U.S. Tax Cas. (CCH)
P 9353, 19 A.F.T.R. (P-H) P 984 (C.C.A. 4th Cir. 1937) at 974 [F.2d], which in turn
tracks that in Commissioner of Internal Revenue v. O.P.P. Holding Corporation, 76
F.2d 11, 35-1 U.S. Tax Cas. (CCH) P 9179, 15 A.F.T.R. (P-H) P 379 (C.C.A. 2d Cir.
1935) at 12 [F.2d] (“[Contingency of payment] marks the vital difference between the
shareholder and the creditor. The shareholder is an adventurer in the corporate busi-
ness; he takes the risk, and profits from success. The creditor, in compensation for not
sharing the profits, is to be paid independently of the risk of success, and gets a right to
dip into the capital when the payment date arrives.”).
34 The history of ostensible uncertainty and failed government definition is summarized
frequently in the literature. See Hariton, supra, n. 32 at 768–80; Pratt, supra, n. 32 at
1065–72. See also Tim Edgar, “The Classification of Corporate Securities for Income
Tax Purposes” (1990) 38 Can. T.J. 1141. Benshalom, supra, n. 32 at 1237, claims that
the uncertainty “was not the problem of the debt-equity distinction — it was the solu-
multiple factors.
It nevertheless appears that the aggregated factors broadly replicated the risk
exposure analysis. In one pithy 1969 enumeration, Holzman described thirty-eight
criteria he had culled from the tax jurisprudence.35 When assessed, most of the
criteria are significant only because they indicate that either the return from, or the
recovery of, a contribution is exposed to performance risk. With respect to return,
for example, a contribution likely is equity if payments on principal are not en-
forced by the contributor, are not certain, do not cumulate when not paid, are sub-
ject to unilateral modification by the issuer, or depend on affirmative action by the
issuer. Each of those criteria indicates directly or indirectly that the parties contem-
plate a contingent income stream. It is the same for the recovery of a contribution.
According to Holzman, equity is indicated if recovery depends on issuer success,
recovery is systematically or frequently postponed, there are no clear or effective
enforcement powers, contributors do not pursue enforcement, the “loan” is ad-
vanced and repaid in serial fashion or the issuer has the option to convert the debt
into equity. Those criteria manifest an explicit, implicit or tacit exposure to the
performance risk of the undertaking. Overall the criteria coalesce in a singular cri-
terion of contingent participation.36 They are not otherwise grounded in discernible
policy.37 Still, that risk exposure construction of the multiple factor approach is not
widely understood and that leaves the approach seemingly vulnerable to the com-
plaint that it is obsolete in the face of the financial innovation that has occurred
over the past number of decades.38
3. THE FUNCTIONAL EQUIVALENCE ARGUMENT

The conventional view is that the debt-equity distinction represents a differ-
ence in kind in terms of risk exposure. The main modern challenge to that view is
that debt and equity are functionally or economically equivalent and therefore are
tion chosen by courts and the IRS and endorsed by Congressional silence” to address
gaming.
35 Robert Holzman, “The Interest-Dividend Guidelines” (1969) 47 Taxes 4.
36 Consider also Nathan Christensen, “The Case for Reviewing Debt/Equity Determina-
tions for Abuse of Discretion” (2007) 74 U. Chi. L. Rev. 1309 at 1313-14, who lists
thirty criteria, which on an aggregate basis similarly reflect the risk exposure analysis.
37 Some of the other criteria described by Holzman are of doubtful relevance. Subordina-
tion to creditors, inadequate capitalization, non-standard documentation, status asser-
tions, accounting treatment (a form of status assertion) and industry practice arguably
could matter only in the most marginal circumstances. None of the thirty-eight criteria
would be determinative where (as several of the criteria indicate) substance does not
correspond with form.
38 Hariton, supra, n. 2 at 521–23 sought to refocus the analysis on the difference between
fixed and contingent participation. See also the brief risk analysis proposal of
Santangelo, supra, n. 32 at 340-41. Query Pratt, supra, n. 32 at 1083–86, who argued
that a risk-based distinction “makes less sense now” as new financial instruments “slice
and dice” risk.
not different in kind.39 According to Alchian and Demsetz: “Instead of thinking of

shareholders as joint owners, we can think of them as investors, like bondholders,
except that the stockholders are more optimistic than bondholders about the enter-
prise prospects. . . . The only difference is in the probability distribution of rewards
and the terms on which they can place their bets.”40 The functional equivalence
argument obviously is true in one sense. Firms use both debt and equity in the same
way to realize the same end — to fund operations. In that sense all contributors of
capital are investors in the success of an undertaking. That, however, misses the
mark. Both firms and contributors have risk preferences. Both make choices about
how they wish to engage or absorb risk. Their mutual objective is to marry their
risk preferences. That normally requires that a firm understand the risk preferences
of available capital contributors and target, through the design of its securities,
those contributors that can best accommodate the risk preferences of the firm. In
that process, while there are endless possibilities as to the degree of risk assumed
on either side, there will always be a dominant concern over the kind of risk expo-
sure that is mutually optimal. The point may be developed in a condensed dissec-
tion of certain capital structure concepts.
The functional equivalence argument is thought to be supported by modern
financial theory. One commentator described that view as follows:
Financial theory informs us that there exists no principled distinction be-
tween corporate debt and corporate stock — both represent contractual
claims, the value of which vary in relation to the value of the issuer’s assets.
Fundamentally, the corporate financial structure provides a mechanism
through which various investors can divide both the risks and spoils of a
corporation’s underlying assets according to their risk preferences. There
exists a spectrum of risk and return relationships that can be offered to po-
tential investors and, correspondingly, an equally vast spectrum of claims
that can be issued. Such claims differ in degree, not in kind.41
The argument seems to rest on the idea that risk is risk and varies only in how it is
bundled or packaged. That bundling variation, however, is where the substantive
difference materializes.
Modern theories of capital structure either explicitly or implicitly accept a dif-
ference of kind between debt and equity.42 Consider initially the Modigliani and
39 Consider Hariton, supra, n. 2 at 501-502; Santangelo, supra, n. 32 at 332; Edgar,

supra, n. 32 at 92–96; Benshalom, supra, n. 32 at 1228-29.
40 Armen Alchian & Harold Demsetz, “Production, Information Costs, and Economic Or-
ganization” (1972) 62 Am. Econ. Rev. 777 at 789 (fn 14). See also Emmerich, supra,
n. 32 at 127 (fn 40) (“[B]oth stocks and bonds are nothing more than rights to the
future stream of income from a corporation’s assets: if the capitalization of the corpora-
tion is irrelevant from an economic and financial point of view, owners and creditors
occupy functionally indistinguishable positions as investors in the corporation.”).
41 Santangelo, supra, n. 32 at 332. It should now be evident, contra Santangelo, that the
“spectrum” of risk differs both in degree and in kind.
42 Consider parenthetically the economic distinction between firms and markets. Firms
are islands of bounded risk-sharing in a sea of risk/opportunity. Firms displace markets
where it is efficient to project singular risk (through common or delegated control). See
Robert Flannigan, “The Economic Structure of the Firm” (1995) 33 Osgoode Hall L.J.
Miller capital structure irrelevance principle.43 The principle is that the value of a
firm is independent of its capital structure.44 Subject to several critical assump-
tions, choices made as to the relative proportions of debt and equity in the financial
structure of a firm do not affect the value of the firm.45 Overall value is determined
only by investment policy, or the income stream generated by that policy, in a
given environment.46 In frictionless markets, debt and equity are substitutable
105. Those who jointly expose their capital contingently to the same performance risk
together constitute a firm. Those who do not assume performance risk on a contingent
basis remain in an exchange (or market) relation with the firm — as suppliers to the
firm. Note tangentially that most employees contribute their human capital for a fixed
return. If that were the only consideration, employees would be considered external to
their firm. They are within the firm, however, because they are controlled by it and the
recoverable value of their human capital is contingent on firm performance (training
supplied, duties assigned, reputation effects, etc.).
43 Franco Modigliani & Merton Miller, “The Cost of Capital, Corporation Finance and
the Theory of Investment” (1958) 48 Am. Econ. Rev. 261. See further Merton Miller &
Franco Modigliani, “Dividend Policy, Growth, and the Valuation of Shares” (1961) 34
J. Bus. 411.
44 See Merton Miller, Financial Innovations and Market Volatility (Cambridge:
Blackwell, 1991) at 268 (“The main point of the first, or cost of capital, article was, in
principle at least, simple enough to make. It said that in an economist’s ideal world of
complete and perfect capital markets, and with full and symmetric information among
all market participants, the total market value of all the securities issued by a firm
would be governed by the earning power and risk of its underlying real assets and
would be independent of how the mix of securities issued to finance it was divided
between debt instruments and equity capital. Some corporate treasurers might well
think that they could enhance total value by increasing the proportion of debt instru-
ments because yields on debt instruments, given their lower risk, are, by and large,
substantially below those on equity capital. But, under the ideal conditions assumed,
the added risk to the shareholders from issuing more debt will raise required yields on
the equity by just enough to offset the seeming gain from use of low cost debt.”).
45 The principle survived early years of controversy. See Merton Miller, “The Modi-
gliani-Miller Propositions After Thirty Years” (1988) 2(4) J. Econ. Persp. 99 at 99
(“Our Proposition I, holding the value of the firm to be independent of its capital struc-
ture (that is, its debt-equity ratio) is accepted as an implication of equilibrium in perfect
capital markets. The validity of our then-novel arbitrage proof of that proposition is
also no longer disputed, and essentially similar arbitrage proofs are now common
throughout finance.”).
46 The argument that investment policy is the sole determinant of firm value has been
challenged. Consider, for example, the argument that distribution (payout) policy mat-
ters. See Harry DeAngelo & Linda DeAngelo, “The Irrelevance of the MM Dividend
Irrelevance Theorem” (2006) 79 J. Fin. Econ. 293 (“[Modigliani and Miller] conclude
that the long-standing controversy over what the stock market “really” capitalizes is
essentially empty because the discounted value of cash flows from investment policy
(grouped a variety of different ways) must equal the discounted value of distributions
to currently outstanding shares. . . . With rational expectations, the stock market “re-
ally” capitalizes distributions because investors value securities only for the payouts
they are expected to provide. Earnings matter, of course, since you can’t create distri-
butions out of thin air . . ., but distribution value can fall short of investment value due,
goods that sell for the same price because arbitrage removes any differentials that
might appear.47 Price reflects risk, and the law of one price leads to the conclusion
that the equilibrium value of the firm does not depend on relative debt-equity risk
arrangements. That does not mean, however, that debt and equity are not distinct.
The irrelevance principle simply tells us that the total value (price) of the firm —
reflecting its equilibrium risk — is not altered by changing combinations of debt
and equity. Each shift in risk must necessarily produce or force neutralizing shifts
in risk elsewhere in the financial or operational structure of the firm, leaving firm
value determined only by current investment policy. But firm risk may be dispersed
amongst risk-bearers (stakeholders and others) in different ways to appeal to differ-
ent risk appetites.48 While there is one equilibrium firm risk, there are innumerable
ways to partition the bearing of that risk on the contributor side.49 Much of that
partitioning is a matter of degree (two percent one year bonds versus three percent
five year bonds), but some of it will manifest the difference in kind between fixed
and contingent participation in performance risk. Above the viability threshold,
debt engages performance risk without contingency. Equity absorbs the contin-
gency of performance risk. Modigliani and Miller accept and accommodate that
substantive difference.
Modigliani and Miller conditioned their principle on the existence of friction-
less markets. They assumed, inter alia, that there were no taxes, information asym-
metries or agency costs.50 Those assumptions subsequently have been modelled in
the so-called tradeoff, pecking order and free cash flow theories of capital structure.
The tradeoff theory, as it is commonly outlined, relaxes the assumption of no
taxes.51 It frames the decision to increase or decrease debt as a tradeoff between tax
e.g., to managerial appropriation of FCF [free cash flow] and, when it does, the stock
market value equals the capitalized value of expected payouts. And so, at the most
fundamental level, stockholder wealth is determined by payout policy, with investment
policy relevant because it determines the capacity to distribute cash. Since value is
generated for investors only to the extent that this capacity is transformed into actual
payouts, selection of an optimal payout policy is necessary to ensure that the dis-
counted value of distributions equals the discounted value of investment cash flows.”).
47 Modigliani & Miller, supra, n. 43.
48 Stakeholders other than shareholders largely bear viability risk. The general public also
bears idiosyncratic viability risk, for example, to the extent that involuntary creditors
are unable to absorb losses.
49 Firms make capital structure decisions and design securities to accommodate various
pressures. Relative face cost after tax may not be the decisive consideration. Higher-
cost equity may be required, for example, to address takeover concerns.
50 The consensus on the irrelevance principle has always been that it has little practical
application because its assumptions do not reflect the real world. Manipulation of capi-
tal structure does in fact affect firm value. On the other hand, there is no consensus on
which assumptions conceal the most value, or what changes in assumptions are re-
quired to increase predictability.
51 Modigliani and Miller did subsequently investigate the effect of taxation. See Franco
Modigliani & Merton Miller, “Corporate Income Taxes and the Cost of Capital: A
Correction” (1963) 53 Am. Econ. Rev. 433. See also Merton Miller, “Debt and Taxes”
(1977) 32 J. Fin. 261 at 262 (“Others object that the invariance proposition was derived
shielding and financial distress. The reasoning is that the increased viability risk
resulting from increased debt offsets to the margin the tax subsidy for debt. The
theory implicitly recognizes the substantive distinction between debt and equity,
albeit derivatively through adoption of the distinction in tax legislation.
The pecking order theory relaxes the assumption of symmetric information.52
The theory predicts that firms will finance where possible with internal capital, then
with debt, and finally equity. While the predictive utility of the theory is controver-
sial,53 there are distinctions from a risk perspective. Internal capital is preferred
because invariably it is the lowest cost form of finance (factoring in transaction
costs, dividend expectations, costs of submission to covenant restrictions, etc.).54
Additionally, internal financing tends not to raise large issues of information asym-
metry. When it becomes necessary to raise fresh capital externally, however, infor-
mation asymmetry becomes a significant concern because prospective contributors
cannot accurately value the firm. That problem usually is more pronounced for a
contingent participation than for a fixed participation, leading to a heavier discount-
ing of the former by contributors, and that is why it is believed that firms prefer to
issue the latter (fixed) kind of claim. In that respect, pecking order theory incorpo-
rates the difference in kind between fixed and contingent participation.
That view of pecking order dependence is supported in other risk dimensions.
If external capital is required, debt is preferred until viability risk becomes exces-
sive because debt avoids having to part with a share of the residual gain. It is the
possibility of residual gain (from performance risk) that normally motivates com-
petitive production and that inducement will be retained (and leveraged) if others
are prepared to advance capital at a tolerable fixed rate.55 Equity, accordingly, is
for a world with no taxes. In our world, they point out, the value of the firm can be
increased by the use of debt since interest payments can be deducted from taxable cor-
porate income. To reap more of these gains, however, the stockholders must incur in-
creasing risks of bankruptcy and the costs, direct and indirect, of falling into that un-
happy state. They conclude that the balancing of these bankruptcy costs against the tax
gains of debt finance gives rise to an optimal capital structure, just as the traditional
view has always maintained.”).
52 Stewart Myers & Nicholas Majluf, “Corporate Financing and Investment Decisions
When Firms Have Information That Investors Do Not Have” (1984) 13 J. Fin. Econ.
187; Stewart Myers, “The Capital Structure Puzzle” (1984) 39 J. Fin. 575; Lakshmi
Shyam-Sunder & Stewart Myers, “Testing Static Tradeoff Against Pecking Order
Models of Capital Structure” (1999) 51 J. Fin. Econ. 219.
53 Eugene Fama & Kenneth French, “Testing Trade-Off and Pecking Order Predictions
About Dividends and Debt” (2002) 15 Rev. Fin. Stud. 1; Linda Klein, Thomas O’Brien
& Stephen Peters, “Debt vs. Equity and Asymmetric Information” (2002) 37 Fin. Rev.
317; Mark Leary & Michael Roberts, “The Pecking Order, Debt Capacity, and Infor-
mation Asymmetry” (2010) 95 J. Fin. Econ. 332.
54 Both debt and equity will be preferable to internal funding if they can be sold (where
information is asymmetric) at a premium (economic rent) to the true value dictated by
the actual prospects of the firm.
55 Where the information of the parties about firm prospects is asymmetric, the preference
to issue debt is very strong. An equity issue will almost always be interpreted initially
as a risk signal of either stress or of an issuer view that its equity is over-priced.
the capital of last resort. Equity financing often also involves surrendering a mea-
sure of control over performance risk — with others becoming entitled to partici-
pate (interfere) in defining or setting the risk associated with the undertaking. Thus,
even though it is sometimes regarded as little more than a rule of thumb, the peck-
ing order theory reflects the sense that a general preference for debt over equity is
grounded in a desire to avoid having to transfer either risk exposure (potential
residual gain) or risk definition to others.
The free cash flow theory relaxes the assumption of no agency costs. Agents
do not always act in the interest of their principals.56 Specifically, they may be
inclined to utilize retained earnings to serve their personal ends. Investors under-
stand that ancient reality. It therefore may be efficient in some instances for manag-
ers to bond their conduct by assuming fixed financial obligations to substantially
reduce the free cash in the firm. They would do that to subject themselves to hard
thresholds of performance (as well as covenant compliance).57 Alternatively, bond-
ing may be installed by managers using the contingency of equity claims to regu-
larly pay out most of the free cash. That could create an even tighter margin for
managerial error and slack. Moreover, because there are less retained earnings, new
opportunities will require fresh external capital, and managers will be disciplined
by the prospect of the periodic intense assessment of their work. Accordingly, ei-
ther fixed or contingent participation may be employed to bond manager perform-
ance. Appreciate, however, that the choice between the two (unless both are in-
stalled) is guided by the difference in kind between them. They differ in their
mechanics and their incentives. In particular, fixed claims attract discipline that
largely is concerned with viability risk, while contingent claims attract discipline
that operates through the full range of performance risk. Again then, fixed and con-
tingent participations are distinctive. Relaxing the assumptions of the irrelevance
principle only confirms the substance of the distinction.
The functional equivalence argument is framed in two other ways. The con-
ceptual continuity formulation implies equivalence from the asserted absence of a
conceptual discontinuity between classic debt and equity. The notion is that debt
and equity constitute a seamless continuum. There is said to be no conceptual break
in the continuum as instruments shift in character from debt to equity. The argu-
ment simply denies or ignores the difference between fixed and contingent partici-
pation. There is a real difference, however, and the only issue in any given context
is whether it is a proper distinction for the purpose at hand.
The other formulation, the building block argument, is that all debt and equity
claims are merely selective arrangements of one set of building blocks (distribution
rights, dissolution rights, voting rights, conversion rights, redemption rights, prefer-
ences, priorities, etc.). The commonality of the architectural components suppos-
56 On agency costs generally, see Robert Flannigan, “The Economics of Fiduciary Ac-
countability” (2007) 32 Del. J. Corp. L. 393. Note (at 395-96) the necessary distinction
between exchange and production opportunism.
57 Michael Jensen, “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers”
(1986) 76 Am. Econ. Rev. 323. Appreciate that the financial cushioning provided by
retained earnings is itself of considerable value. The drawdown of that value (by distri-
bution) must be justified by the potential agency costs or the degree of shareholder
demand.
edly establishes the innate commonality of all of the final combinations. The no-
tion, however, is deficient. It can be conceded that different claims may be
constructed by the asymmetric arrangement of common or generic terms. That does
not mean, however, that the claims ultimately produced will not reflect a difference
in kind. The nature or essence of each building block matters. Many terms simply
will specify or qualify a fixed participation. Other terms will express or embody
contingency (contingent return or recovery) and specify or qualify the nature of that
contingent participation. Those various terms or building blocks may be combined
in different arrays to create arrangements where there is only a fixed participation
or arrangements where there is an element of contingency.
The building block argument has an analytical cousin in financial option the-
ory. According to Warren: “Modern financial theory suggests that the distinction
between fixed and contingent return assets is not tenable, because financial
equivalences sometimes permit one category of asset to be replicated using the
other.”58 The argument is that, because debt and equity can be substituted for each
other through the employment of puts and calls to produce equivalent value, they
do not differ in kind in economic terms.59 It should be obvious, however, why that
58 Alvin Warren, “Financial Contract Innovation and Income Tax Policy” (1993) 107
Harv. L. Rev. 460 at 465.
59 Ibid., at 465–67; Edgar, supra, n. 32 at 17–19, 94–96. The argument in the corporate
context commonly references the limited liability of shareholders. It is posited that
when a corporation borrows, the lender acquires a claim that has a value equal to the
value of a safe loan less the value of the shareholder option to default. The supposition
is that shareholders have a put option (granted by the lender) that allows them to re-
quire the lender to take the undertaking or assets of the corporation in full satisfaction
of the debt (or, alternatively, that the loan effects a conveyance of the firm to the lender
with the shareholders having a call option to reacquire it) (see Fisher Black & Myron
Scholes, “The Pricing of Options and Corporate Liabilities” (1973) 81 J. Pol. Econ.
637). That analysis, it must be understood, does not reflect the formal legal relations.
Lenders lend to the corporate entity. That entity does not have limited liability. It does,
however, have the floor liability defined by the law of insolvency. Consequently, when
a corporation borrows, the lender implicitly grants an option to it to “put” its undertak-
ing or assets to the lender in full satisfaction of the debt. That put option is available to
all insolvent debtors. As for shareholders, the statutory conferral of limited liability was
simply an adjustment to the respective default positions of shareholders and creditors.
It was seriously prejudicial only to involuntary creditors. Shareholders qua shareholder
were granted a liability floor comparable to that of debt contributors (by interposing
between them the corporate entity so as to substitute corporate assets for shareholder
assets). Both could then potentially lose their “investment” in the corporation, but they
were not otherwise liable, unless the default position was altered by agreement (e.g.,
creditor control, shareholder guarantees) or de facto shareholder domination. Share-
holders today make a one-time payment when they purchase shares (no subsequent
“calls” for capital). They acquire rights to participate in gains (and sometimes struc-
tural control) indefinitely as long as the undertaking remains viable. They do not as-
sume further positive commitments (unless by way of a unanimous shareholder agree-
ment) other than to abide by the negotiated and statutory terms of the corporate
bargain. Corporations, in contrast, do commit to continuing performance obligations to
shareholders (to paying dividends, adopting shareholder will on certain matters, etc.).
argument is misconceived even in idealized conditions. The substitutability is real-

ized only through the application of external instruments. One must engage the dis-
tinct risk-altering properties of puts and calls in order to engineer the sub-
stitutability. The risk-altering properties operate to bridge, not deny, the different
risk exposures of debt and equity. The need for those instruments only confirms
that debt and equity differ in kind. In the end, option theory does not dissolve or
negate the difference in kind between fixed and contingent participation. Nor do
any of the other arguments canvassed above.
4. THE UNCERTAINTY ARGUMENT

The second broad challenge to the debt-equity distinction is that it is fatally
uncertain because it lacks the analytical power to cope with either marginal differ-
ence or blended composition.60 Some versions of the challenge appeal to or repli-
cate the ideas used to support the functional equivalence claim. Because debt and
equity have a dependent risk relation, or form a seamless continuum, or are decom-
posable into common or comparable building blocks, it is argued, there is no cer-
tain distinction between them. Those arguments fail for the reasons given. Other
versions of the argument simply reference the modern surfeit of analytical criteria
and/or financial instruments, and assert that no boundary is discernible. A number
of considerations, however, indicate that the uncertainty argument is an empty one.
In the tax context in particular, the ostensible uncertainty of the American ju-
risprudence is self-inflicted. Judges understood early on the distinction between
fixed and contingent participation. They nevertheless sought the comfort of other
factors that they equated with either a debt or equity participation. Those factors
were collected together in lists and came to assume analytical independence within
those lists. The effect over time was to diminish the prior dominance of the distinc-
tion between fixed and contingent participation. The two kinds of participation es-
sentially were demoted to the status of unprivileged factors in a multi-factor test.
That made it difficult for judges in later cases to articulate or defend a general test
couched in terms of fixed or contingent participation, even though many lists sub-
stantively comprehended such a test.
A rather more important observation is that the uncertainty argument com-
monly involves an assertion of the supposed inability of the distinction to handle
the characterization of derivative securities. That argument has no traction. Deriva-
tives include futures, forwards, swaps and options. Those devices serve primarily
as risk management tools (with a consequent collateral capacity to be employed as
bare speculation instruments). They are used to manage the financial and opera-
tional risks associated with production activity. While options may be employed as
When corporations are no longer viable they need (and have) the right to end their
obligations to shareholders and other claimants by “putting” the undertaking into either
dissolution or insolvency proceedings where all claims will be settled.
60 Consider Hariton, supra, n. 32 at 768–70; Wood, supra, n. 32; Pratt, supra, n. 32; Peter
Pope & Anthony Puxty, “What is Equity? New Financial Instruments in the Interstices
Between the Law, Accounting and Economics” (1991) 54 Mod. L. Rev. 889; Georgette
Poindexter, “Dequity: The Blurring of Debt and Equity in Securitized Real Estate Fi-
nancing” (2005) 2 Berkeley Bus. L.J. 233.
bells and whistles to push an issue, derivatives generally are not used directly to
finance firms.61 They are products or inventory for firms that create and sell them
as part of their general operational activity, or they are tools that firms craft inter-
nally or with others to manage supply, price or currency fluctuations. They are
neither debt nor equity in those respects. Derivatives are not even necessarily con-
nected to or derived from the debt or equity securities of the firms that produce
them. It could be, of course, that a firm might seek to raise capital by a public or
private issue of a derivative linked to its own debt or equity, but essentially it
would be selling product (risk management or speculation instruments) to earn rev-
enue, not issuing direct claims of fixed or contingent participation in the revenues
of the undertaking. The sale of derivatives provides finance in the same way as the
creation and sale of any product. There is no discrete appeal to debt or equity con-
tributors for capital to build or maintain a production function or capacity. Markets
do exist for derivatives, but they are product markets, not capital markets.
The general substance of the uncertainty argument is that the border between
debt and equity is opaque at the margin and that consequently the distinction is an
impractical one. The argument often is illustrated by referencing securities that
combine debt and equity characteristics, or securities that have been characterized
as debt in one forum and equity in another. There are many such illustrations in the
literature and there is no need to review them here.62
Implying uncertainty from instruments that have both debt and equity features
is problematic.63 There may be unwarranted assumptions ex ante about what con-
stitutes a debt or equity characteristic. Or there may be an assumption that the dis-
tinction exercise involves “weighing” debt and equity content to determine if the
scale is tipped either way. The latter assumption would be inconsistent with the
conventional jurisprudence. The developments respecting business organizations
discussed earlier indicate that virtually any non-nominal manifestation of contin-
gent participation will produce a prima facie equity characterization. The approach
there was not to crudely weigh the supposed debt and equity features on some sort
of notional qualitative scale. Rather, it was to treat classic debt essentially as the
baseline and then determine whether the parties had introduced a significant ele-
ment of contingent participation into the arrangement. The approach was to assess
whether the contributor had passed through the threshold or ceiling of fixed partici-
61 See Edgar, supra, n. 32 at 5 (distinguishing “financial instruments” (derivatives) from

“financing transactions” (capital-raising transactions)) and 27–29 (describing the risk
management function).
62 See the materials supra, n. 32. Consider the legal treatment of retractable preference
shares. See Central Capital Corp., Re, 1996 CarswellOnt 316, 27 O.R. (3d) 494, 132
D.L.R. (4th) 223, (sub nom. Royal Bank v. Central Capital Corp.) 88 O.A.C. 161, 38
C.B.R. (3d) 1, 26 B.L.R. (2d) 88 (Ont. C.A.); Ford Credit Canada Ltd. v. R., 2007
FCA 225, 2007 CAF 225, 2007 CarswellNat 1567, 2007 CarswellNat 3206, [2007]
F.C.J. No. 826, [2007] 4 C.T.C. 157, (sub nom. Canada (Attorney General) v. Ford
Credit Canada Ltd.) 367 N.R. 37, 2007 D.T.C. 5431 (F.C.A.); Coast Capital Savings
Credit Union v. British Columbia, 2011 BCCA 20, 2011 CarswellBC 87, [2011] 3
C.T.C. 32 (B.C. C.A.).
63 According to Edgar, supra, n. 32 at 93–96, both debt and equity returns are composed
of a time value element and a “bet” element.
pation so as to shed creditor (debt) status.

There are also fundamental difficulties with implying uncertainty from com-
peting or dual characterizations of comparable instruments. Some dual characteri-
zations will result from unjustified conceptual rigidity, for example, the rote char-
acterization of corporate securities described earlier. Other dual characterizations
will be attributable to the fact that different authorities, for various reasons (includ-
ing asymmetries of all kinds), separately reach different characterization conclu-
sions. A tax court may characterize an instrument differently than a bankruptcy
court, a financial regulator, or even another tax court. That does not happen, how-
ever, because there is no substantive distinction between debt and equity. Rather, it
happens in some cases because the jurisprudence, the relevant policy matrix, or the
issue, is comprehended differently by each authority (due to asymmetric purpose,
knowledge, competence, environment, etc.). That may be because the jurisprudence
or the relevant policy is uncertain, but that means that the ostensible uncertainty is
the cause, not the effect, of dual characterization.
The uncertainty argument appears to depend largely on a preliminary rejection
of the conceptual clarity of the distinction between fixed and contingent participa-
tion. In some quarters, however, the real underlying objection may be that the con-
ventional distinction is too clear. It may not be perceived as sufficiently flexible by
financial officers. Alternatively, it may not be regarded as sufficiently generous by
creditors who would like to maintain their creditor status even while participating
in profit. But those kinds of considerations do not address clarity, they relate to
contextual suitability — and that often reduces to political perception or power.
5. THE UTILITY OF THE DISTINCTION

It is one thing to recognize that there is a sharp organic or basal difference in
kind between fixed and contingent participation. It is another matter entirely to de-
termine whether the distinction is a proper one for any particular purpose. There
can be no doubt that the distinction is an important one for ordinary operational and
financial matters. It is critical that managers, potential contributors and others un-
derstand the nature of the claims on firm resources. The burden of fixed obligations
and the cushion of contingent interests are key considerations for many decisions.
Consider also the application of the distinction to determine or assign contract, tort
and fiduciary responsibility. Those applications, with the relevant qualifications,
properly implement the underlying policies of regulating risk and opportunism. An-
other observation made earlier concerned the solvency tests that are found in many
corporate statutes. The distinction clearly is important for the operation of such
tests, but it is distorted by the rote characterization of corporate securities. By al-
lowing labelling to determine character, rote characterization leads to the early/late
triggering of solvency constraints.
The most controversial application of the debt-equity distinction arguably is in
the corporate tax context. The question is whether there is a difference in kind be-
tween debt and equity that justifies differential tax treatment for payments made to
capital contributors. The short answer is that there is a difference in kind, but it
does not justify a tax subsidy. In the absence of tax differentiation, the risk differ-
ence between fixed and contingent participation would be priced by the parties (the
market). Relative risk-bearing would be mediated by the terms of exchange. Any
shift in the capital structure equilibrium produced by the subsidy, from a pure risk
perspective, is arbitrary.
This is an issue where the functional equivalence argument is relevant. Capital
is employed in operations without reference to its sources. Debt and equity are
equivalent inputs in the production process. They fund plants, inventories and mar-
keting departments in exactly the same way. The supposed justification for the tax
difference is that debt service is a cost of production while equity payments are
distributions of profit to the proprietors of the firm. That is a flawed justification
because its characterization of debt occurs at the production stage and that of equity
at the distribution stage. Contingency does not make a contribution any less an
input, or cost of production, than a contribution exchanged for a fixed participa-
tion.64 Contingency matters, but it does not imply tax differentiation of that sort. If
both kinds of contributions are production inputs, their respective costs should be
deductible.65 Both interest and dividend payments should be deductible from firm
revenues and taxed in the hands of contributors. The use of the debt-equity distinc-
tion for that purpose would be eliminated. While that is the conceptual conclusion,
there obviously are feasibility issues in the tax context. Tax policy would require
attention.66 There would be complex technical issues in retooling a tax regime that
has incorporated the distinction from the beginning of the twentieth century. There
would be re-education costs all around. Tax planning would be disrupted. Still,
there is little room for uncertain or unjustified taxation. Liability for tax ought to
rest on sharp authentic distinctions unless ambiguity demonstrably is inherent in the
subject concept.
The matter of feasibility, it will be appreciated, is a broad concern. Not every-
one is in favour of a sharp distinction between debt and equity. Accountants and
lawyers smell fees in uncertainty. Managers may believe that a cloudy distinction is
useful in their continuing efforts to comply with covenant standards. Both firms
and regulators may find uncertainty convenient as they assert their respective posi-
tions on regulatory controls that incorporate the distinction. Whether it is techni-
cally or politically feasible to install a clear distinction, however, is not the immedi-
ate issue. Rather, the cardinal issue is whether there is a distinction of kind.
64 Nor is there analytical freight in differentiating dividends as distributions of profit to

proprietors. The corporation is the proprietor, the owner of the business, and the profit
belongs to it. Shareholders, like voluntary creditors, negotiate an exchange of terms
with the corporation. A corporation will make payments out of its profits to sharehold-
ers and creditors pursuant to those terms. Those payments are received by shareholders
and creditors as their returns from their respective investment decisions. See Flannigan,
supra, n. 24 at 158–61.
65 An alternative view is that interest payments, like dividend payments, are distributions
of profit, rather than costs of production. See Warren, supra, n. 32 at 1595-96. That
would imply no deduction for any payments to contributors. On either view, the contri-
butions are regarded as equivalent.
66 On the implications of various proposals to eliminate or address the debt-equity distinc-
tion, see Warren, supra, n. 58 at 473–82; Knoll, supra, n. 32 at 1506–15; Wood, supra,
n. 32 at 54–76; Pratt, supra, n. 32 at 1117–57. Consider Benshalom, supra, n. 32 at
1222, who believes that the difference in tax treatment between debt and equity “sub-
stantially contributed to the development of the [current financial] crisis and worsened
its outcomes.”
Thereafter the issue becomes the idiosyncratic one of whether the distinction is
appropriate for a particular purpose. Feasibility in all respects is part of that latter
calculation.
6. CONCLUSION
The debt-equity distinction is indeterminate only if we refuse to recognize the
conceptual break or discontinuity represented by the difference between fixed and
contingent participation. That difference is a sharp distinction of kind. The axial
question is whether a given contributor has assumed any significant element of the
contingency idiosyncratic to the particular firm. That normally will be a relatively
straightforward determination. Sharp distinction is also difficult to game if it is ap-
plied uniformly across contexts. The distinction between fixed and contingent par-
ticipation, it must be understood, is firmly grounded in the jurisprudence. It has lost
clarity, however, as judges have introduced multiple factors and commentators
have asserted economic or functional equivalence. I have endeavored to restore that
clarity. It is a separate matter to determine where the clear difference between fixed
and contingent participation is properly a legal distinction.

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The Debt-Equity Distinction

La distinction entre les notions de titre de créance et titre de participation

1. THE CONVENTIONAL DISTINCTION

* University of Saskatchewan. My thanks to Tim Edgar for his comments.

Electronic copy available at: http://ssrn.com/abstract=1744140

Electronic copy available at: http://ssrn.com/abstract=1744140

5 Relative priority or subordination invariably is contractual in character (as express

2. CRYSTALLIZATION OF THE DISTINCTION

8 Sharing in control (risk definition) is a separate potential boundary that, if exclusive,

12 See Flannigan, supra, n. 10 at 76–88.

another (tax law).30

3. THE FUNCTIONAL EQUIVALENCE ARGUMENT

not different in kind.39 According to Alchian and Demsetz: “Instead of thinking of

39 Consider Hariton, supra, n. 2 at 501-502; Santangelo, supra, n. 32 at 332; Edgar,

argument is misconceived even in idealized conditions. The substitutability is real-

4. THE UNCERTAINTY ARGUMENT

61 See Edgar, supra, n. 32 at 5 (distinguishing “financial instruments” (derivatives) from

pation so as to shed creditor (debt) status.

5. THE UTILITY OF THE DISTINCTION

64 Nor is there analytical freight in differentiating dividends as distributions of profit to

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