FIRST PART
LEGAL CAPITAL
DOCTRINE—
CONSTRUCTING THE
LABYRINTH SUBPART ONE
LEGAL CAPITAL
DOCTRINE—EXPOSITION
PREVIEW OF LEGAL CAPITAL
‘The ownership interest in a corporation is its From an
economic standpoint, the number of shares of stock of & corporation, the
par value per share and stated capital are all arbitrary concepts.
1. Number of Shares. ‘The number of shares into which the stock of a
corporation may be divided is arbitrary because, no matter how many
shares into which you slice a pie, the size of the pie remains the same,
Suppose the following opening balance sheet for the corporation formed by
you and me:
ASSETS LIABILITIES
s-0-
SHAREHOLDERS’ EQUITY
Issued and
outstanding stock 100
100 $100
It is irrelevant whether you and I own one share each (total of two shares
issued and outstanding), 50 shares each (100 shares issued and outstanding),
100,000 shares each (200,000 shares issued and outstanding) or one-half share
each (one share issued and outstanding). In each ease, you and I each own 50% of
the issued and outstanding shares of stock and thus each of us has a one-half
interest in the value of the corporation, however that value is determined (and
there are lots of ways to value a corporation or other business).
2 Par Value. ‘The par value per share is also an arbitrary number, get by the
incorporators of the corporation. Historically, par value in the United States
Tepresented the full anTount of the shareholders’ investment in the corporation.
This was because (1) early nineteenth century creditors (perhaps suspicious of the
growing use of corporations, which resulted in so-called “limited liability” for their
owners, the shareholders) insisted that the money paid in by the shareholder
remain in the corporation (at least until the creditors had been paid) and (2) par
value was a convenient way of assuring that each stockholder contributed the
same amount of capital, on a per share basis, as every other shareholder. In time,
both of these ideas evaporated: Creditors found more effective ways to protect
themselves (e.g, taking a security interest in assets, insisting on elaborate default
provisions in the loan contracts). Shareholders also realized that just because
they invest $X per share today in a corporation does not mean that (1) a new 5 Legat. CaPrTaL DocTiine—EXPOSITION
/BPART ONE
shareholder tomorrow will want to invest §X per share (e.g., if the corporation has
Jost money in the interim) or, conversely, (2) the corporation will want to sell stock
tomorrow for as little as $X per share (¢.g., if the corporation has made money in
the interim),
3. Capital. It naturally follows that if the number of shares and the
y ar value per share are arbitrary figures, their product—aggregate par value
(Stated capital)—must be. arbitrary. For example, suppose. that-tameéaved—
‘Thumbscrew, Inc. ("LTT") issues 100 shares (50 to you, 50 to me), with a par value
of $1 per share, for a price of $1 per share. (Note: Price per share is not a totally
arbitrary number. Price is an economically derived figure that is arrived at by you
and me when we calculate (a) how much money we think we need to start our
corporation, divided by (b) the (arbitrary) number of shares of stock we decide on
for the corporation's stock.) ‘The opening balance sheet will look like this:
ASSETS ‘LIABILITIES
Cash $100 $-0-
; ry
Stated capital (100
shares issued and
outstanding, $1
par value per
— share) 100
$100
Suppose, instead, we decide on a par value of only $.01 per share, The
opening balance sheet will look like this:
ASSETS LIABILITIES
Cash $100 $-0-
SHAREHOLDERS’ EQUITY
Stated eapital (100
shares issued and
outstanding, $.01 par
value per share) $1
Paid-in surplus —22
$100 $100
Note that with aggregate par value (stated capital) reduced to $1, the $99
excess of the total price paid by you and me for our stock over the $1 aggregate par
value must be accounted for in order for the balance sheet to balance. ‘That excess
is typically called something like “paid-in surplus,” “paid-in capital” or “capital
e surplus.”
From an economic viewpoint, do you think that your or my shares should be
worth any more or less depending on whether the par value per share is $1 or
is $.01—or nothing at all? Of course not. ‘The economic value of our shares in LITT is PREVIEW g Leaat, CAPITAL Docr#ine—EXPostTion
based on (a) past performance (including (i) what the shareholders have invested
(stated capital plus paid-in surplus) and (ji) What the corporation has earned but
hot_distributed to its shareholders (retained earnings), all as shown in the
"harcholders’ equity section of the balance sheet), and (b) expectations of future
performance (based in part, of course, on past performance).” Different people Witt
have differing views on “value”
So, why is it still important to understand legal capital? Because many
American states’ statutes, most notably Delaware, still focus, to one degree or
hother, on stated capital as a test for the legal power of the corporation to pay
jdends (or make other distributions, eg., redemptions of shares) to its
stockholders. The European Union still clings to this approach as well."
Many states, for example, say that corporations incorporated under their
Jaws may not pay a dividend if, after payment of the dividend, the corporation's
stated capital would be “impaired,” i.e. (as explained below at p. 80), “one deducts
the liabilities shown on the right side of the balance sheet from the assets shown.
bn the left side of the balance sheet and then deducts from that difference the
‘amount of the stated capital.” If this result does not produce a negative dollar
figure. then distributions of up to the positive balance (‘surplus’) may be legally
made to shareholders.
‘Thus, in the $1 par value example above, the corporation could not pay any
dividends because, if it paid even $1 in dividends, the assets left after the $1
dividend (899 in cash), less the sum of liabilities ($0), less stated capital ($100),
produces a negative number, -81. However, in the $.01 par value example above,
the corporation could pay as much as $99 in dividends because, if it did so, the
faasets left after the $99 dividend (81 in cash), less the sum of liabilities ($0), less
stated capital ($1), produces $0, which is not a negative dollar figure, and thus
stated capital is not “impaired.”
New York and Delaware still have this type of archaic statute, but both
provide some relief by allowing dividends to be paid out of “net profits” (whatever
that means) for the current or preceding fiscal year if the corporation has no
surplus? For some of the problems that can arise under the Delaware statute, see
p_B4, n.47, below. Does it make any sense to you that the legal power of a
Corporation to do something as economically significant as paying dividends or
Other distributions should turn on an arbitrary number such as stated capital?
‘There are other types of statutes which in some degree depend upon stated
capital and which are described and discussed later. (Note the transaction
Csamples beginning at p. 113.) The point here is not to catalogue the statutes but
to emphasize that (1) you must know the applicable statutes on distributions for
the jurisdiction in which the corporation in question is incorporated and (2) to the
taint that these statutes are based on stated capital (number of issuéd and
Outstanding shares times par value per share), they are based on totally arbitrary
Concepts. Nevertheless, as noted above, they continue to be an important part of
Corporation law in many states and in the European Union, Now, having
previewed the story, it is time to begin.
pp 212
= DBL. GEN, ConP. Law § 170(a); N.Y. BUS. CORP. LAW § 510(b). CHAPTER 1
THE PROBLEM—CORPORATE
CREDITOR AND CORPORATE
SHAREHOLDER
‘Legal capital” is the body of rules developed by common law and statutes
governing (@) the investment (sometimes called “contribution”) of cash or other
Sesets by shareholders for or on account of their shares and (b) the payment by the
corporation of cash or other assets to shareholders in co ideration Tor their
shares.
‘The typical corporation raises the cash necessary to operate by selling shares
of its stock or by borrowing. In addition, the corporation may contract for the
provision of goods (like raw materials or computers) or services (like office space
Piternet avcess or labor) by agreeing, if the supplier also agrees, to pay for the
goods or services sometime in the future. Buyers of shares of stock are known as
Shareholders’ (or, synonymously, “stockholders”) and lenders of money and
providers of goods and services who agree to be paid in the future are known as
‘creditors:” ‘The shareholders’ investment (generally in the form of cash) and any
earnings retained in the corporation are known as its “equity,” the obligations of
the corporation to pay for goods and services are known as the “liabilities” (or
debt) of the corporation. ‘There are some refinements on the foregoing for
fecounting and other purposes but generally this nomenclature works for the
purposes of this book. As well, these general principles apply to forms of doing
Business other than just corporations but, as we shall see, the doctrine of legal
capital has evolved primarily in corporation law (which raises the question why, if
Tonal capital makes any sense, hasn't it been adopted for other forms of doing
business?)
‘The interests of the creditors and the shareholders of a corporation are
adverse whenever cash or other assets are to be invested in the corporation by the
SharshoWers-and-whenever_cash or other assets are to be distribuved by tre
corporation fo the sharehol is SHUTCHOMETS like to minimize the former and”
-wttnize the latter; creditors like the opposite. ‘The legal apparatus built by
tommon law and statute around the concept of “legal capital” is fundamentally
fimed at striking ‘@ partial accommodation of the inevitable and continuing
conflict of interests between creditors and shareholders.
‘As already glimpsed in the Preview, the balance sheet is both fundamental to
‘an understanding of legal capital and illustrative of the relationship between
Greditors and shareholders. The structure of the balance sheet is remarkably
simple. It has two sides: On the left (or sometimes the top) side are the assets of
the company, listed in descending order of liquidity from the top down, ‘Thus, cash
is always listed first. On the right (or sometimes the bottom) side are the
obligations of the company to the creditors (invariably labeled Liabilities”) and to
the shareholders (invariably labeled “Shareholders’ Equity,” or “Shareholder's,
Equity” if there is only one shareholder), listed in descending order of priority of
payment from the top down. Liabilities and Shareholders’ Equity are typically
fotaled separately. Within Liabilities, the most current liabilities, such as
(Qeounte payable and the current portion due on longer-term liabilities, are listed Lecat. CAPITAL DOCTRINE EXPOSITION Sunpanr ONE
first and then longer-term liabilities, Within Shareholders’ Equity, the
Investment of the preferred shareholders! is listed first, in descending order of
preference, and the investment of the common shareholders, who are entitled to
Whatever Gf anything) remains after the creditors and the preferred shareholders
dire paid, is listed last, This structure gives rise to the balance sheet equation:
‘Assets = Liabilities + Shareholders’ Equity.
Does the balance sheet, with one big box for assets on the left (or top) and two
smaller boxes on the right (or bottom), seem to you to be unbalanced? (Hereafter,
sve shall refer to the left and right sides of the balance sheet, recognizing that they
eler to the top and bottom, respectively, of balance sheets presented in that way.)
What word or words can you think of that would deseribe what both the creditors
and the shareholders have? How about “interests” or, better yet, “claims?” Claims
against what? The assets. “we may say that the assets are what the
and the liabilities and shareholders’ investment (equity) are what
ce
A. THE CREDITOR’S PERSPECTIVE
1. CREDITORS—GENERAL
‘The legal term “creditor” expresses a single basic proposition. A creditor has,
subject to the terms of the credit, a claim to the assets of her debtor that is higher
than and prior to the claim of the debtor as owner of the assets (leaving aside
extraordinary circumstances as when, for example, a debtor has received a
bankruptey discharge or holds a homestead exemption). When a loan or other
claim of a creditor is not paid in accordance with its terms, the creditor may, in
normal course, enlist the law to compel the debtor to pay the debt, regardless of
the consequent diminution of the debtor's assets.
‘Though the term “priority” is usually reserved in the law to. describe
relationships among claimants other than the debtor, in a basic sense it may be
said that the creditor's claim against the assets of the debtor is “prior” to.
debtor's (or the debtor's shareholders’) own claim to the debtor's
arse has no relationship to the concept of time; it relates to hierarchy (or
seniority) of claim. If the debtor has just enough assets to pay the creditor's claim,
the creditor gets them all, ie., the creditor's claim is “prior,” and the debtor is left
with nothing.
General creditors are those creditors who are not secured creditors. A secured
creditor is @ creditor who, in addition to her creditor's claim, has a mortgage or
other security interest giving the secured creditor the right to satisfy her claim, if
hot paid by the debtor, out of assets (known as “collateral”) of the debtor that are
specified in the mortgage or security agreement, which is usually recorded (or an
abbreviated form of notice of it called a financing statement is recorded) among
public records of the jurisdiction where the collateral is located or where the
Uebtor is located, depending on the type of collateral (although a security interest
Sn certain types of collateral may only be perfected by taking possession or control
of the collateral). Since all claims of all creditors to the assets of the debtor have
7 Preferred stock may be preferred in either or both of two ways—as to payment of dividende and
acto pavincnt on liguidation. in addition, preferred stock may have other fentures, including rights to
ce Raether with the common stock or only ip certain situstions (ike failure to pay the preferred
Grider), to convert into common stock, to require the corporation to redeem (oF to be subject to
aarsmtion by the corporation) and to exchange the preferred shares for notes or other instruments, ‘Tue PRoBLEM—CoRPoRATE CREDITOR
priority over the debtor's (or the debtor's shareholders’) claim, the secured creditor
does not by force of his security interest in particular assets of the debtor gain in
Tiority vis-a-vis the debtor (or the debtor's shareholders). ‘The purpose and effect
of the collateral negotiated for and obtained by the secured creditor is to achieve a
preferred position not as against the debtor or its shareholders but against other
Eroditors if at the ertical time for payment, the debtor has endgi assets to pay
“allrcreditors, the secured creditor's security interest is irrelevant since she will be
paid in any case. But if the debtor's assets are not sufficient to pay all the
creditors’ claims outstanding against the debtor, some creditors will come out
short. The creditor who has in some manner obtained a security interest
(cometimes referred to as a lien) in some or all assets of the debtor has the
‘opportunity to claim those assets for payment of the debt owing to the creditor,
even if they are the only of the corporation and the result is that the
application of the collateral to the debt means that other ereditors will receive
nothing at all. Until paid, the secured creditor is “prior” to general ereditors to the
extent of the value of the assets that are subject to the secured creditor's lien. The
general creditors have no claim against the assets under the secured creditor's
hien except to the extent that the value of the assets exceeds the secured creditor's,
claim (which may include not only the principal amount of the loan or other
extension of credit but also any unpaid interest and any late-pavment fees and the
costs of enforcing the claim) or unless, in the bankruptey context, the secured
party has failed to take the necessary steps to perfect its lien.
Creditors compete among themselves not only for an interest in specific
assets of the debtor but also, to the extent they are unable to achiove a fully
secured position, for priority among themselves in right of payment. The ereditor,
or a class of creditors, may be negotiated into agreeing (in advance or later) that
its claim against the debtor's assets will rank below that of some or all other
creditors or classes of creditors—though always, of course, ahead of the
shareholders’ claim to the assets, Such a creditor is said to have “subordinated”
his claim; he is referred to as a “subordinated creditor” andhis claim 1s~
"subordinated debt.” Reflecting this relative priority of claims, creditors are often
referred to as “senior” or “junior.”
‘Thus, from the perspective of any single general creditor
he is more likely to be paid, and is thus better off, the more assets the
debtor has on the payment date;
he is adversely affected by an increase in the amount of outstanding
claims of general creditors against the debtor since, in any ultimate
showdown, all the general creditors will share pro rata in the finite assets
of the debtor (recognizing, however, that if the additional claims arise as
the result of the infusion of additional cash in or other extension of credit
to the corporation, then the corporation may be healthier and better able
to pay all its debts, eventually); and
he is more adversely affected still by the creation or existence of secured
creditors, for, in the showdown, the secured creditors will, to the extent of
their security, be able to assert claims against the collateral that are prior
to those of ali general creditors, u LEGAL. CAPITAL DOCTRINE—EXPOSITION Suranr One
2. THE CREDITOR OF THE INDIVIDUAL PROPRIETORSHIP OR
PARTNERSHIP
When a creditor lends money or otherwise extends credit to an individual, the
creditor may generally look for payment of his claim to all of the debtor's assets
that have not earlier been placed under lien in favor of a secured creditor. ‘The
creditor may, of course, insist as a condition of the loan or other extension of credit
that she be empowered to pursue assets in addition to those owned by the debtor,
she may, for example, require some commitment by a third party, such as a
guaranty, letter of credit, endorsement or pledge of assets of the third party
Banks and other financial institutions provide these services for a fee; and family
and friends will sometimes provide their assistance for non-pecuniary reasons.
Occasionally, too, the law will step in to help a creditor reach assets beyond those
in the hands of the debtor; thus, a creditor may in some circumstances be able to
reach the assets of a father for an indebtedness incurred by a child or the assets of
‘one spouse for indebtedness incurred by the other or assets that an insolvent,
"Wjcccond of dhece to AMMEN Sica and 1s inevitable
than may appear. Suppose B holds net unencumbered assets worth $1,000,000:
$950,000 in real property and a $50,000 sole proprietorship interest in a small
barber shop. Suppose, further, that the barber shop needs $20,000 worth of new
fomhiligy and thot, for tala te borrow ths soney to pay
for them. L, the lender, fully understanding that the money is to be used for the
Tarber Bhop tastores, etd hadiiigMAMMMRE st th exch flow of tho barber
shag Jb suliclas to pay Sai Gag heupon lends 3 the
$20,000
Tn theoe creuinctanses, IEMUMMMMMIRIR Gin won tho time for
peyment comes, Ldhould Lote aMMMRMIEE beyoad Bre property interect
0 the barber shop. But the law is to the contrary. and all of Be unencumbered
succes "petiaia? pM nati bo okt ocuelly
£5 available to pay L. L's claim is not limit sts of the enterprise for the
eh se of which t BS assets are at jeopardy, Bis salt to
Shave united liabil
. The term “unlimited liability” is not a particularly apt one; B's liability is in
fact limited in two ways—first, by the amount of L's claim and, second, by the
1... aggregate unencumbered assets owned by B. But no matter. L, in considering
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