Tài liệu The_law_of_corporate_finance_general_principles_and_eu_law_volume_iii

The Law of Corporate Finance: General Principles and EU Law Petri Mäntysaari The Law of Corporate Finance: General Principles and EU Law Volume III: Funding, Exit, Takeovers 123 Professor Petri Mäntysaari Hanken School of Economics Handelsesplanaden 2 65100 Vaasa Finland [email protected] This title is part of a three volume set with ISBN 978-3-642-03105-2 ISBN 978-3-642-03057-4 e-ISBN 978-3-642-03058-1 DOI 10.1007/978-3-642-03058-1 Springer Heidelberg Dordrecht London New York Library of Congress Control Number: 2009938577 c Springer-Verlag Berlin Heidelberg 2010  This work is subject to copyright. All rights are reserved, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilm or in any other way, and storage in data banks. Duplication of this publication or parts thereof is permitted only under the provisions of the German Copyright Law of September 9, 1965, in its current version, and permission for use must always be obtained from Springer. Violations are liable to prosecution under the German Copyright Law. The use of general descriptive names, registered names, trademarks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. Cover design: WMXDesign GmbH, Heidelberg Printed on acid-free paper Springer is part of Springer Science+Business Media (www.springer.com) Table of Contents 1 Introduction......................................................................................................1 1.1 Cash Flow, Risk, Agency, Information, Investments ..............................1 1.2 Funding, Exit, Acquisitions .....................................................................1 1.3 Financial Crisis ........................................................................................2 2 Funding: Introduction.....................................................................................3 2.1 General Remarks .....................................................................................3 2.2 Separation of Investment and Funding Decisions?..................................3 2.3 Forms of Funding, Funding Mix, Ancillary Services ..............................5 2.4 Legal Risks Inherent in Funding Transactions ......................................13 2.5 Particular Remarks on the Subprime Mortgage Crisis...........................17 2.6 Funding Transactions and Community Law..........................................19 3 Reduction of External Funding Needs .........................................................21 3.1 Introduction ...........................................................................................21 3.2 Retained Earnings..................................................................................22 3.3 Management of Capital Invested in Assets............................................22 3.3.1 Introduction ................................................................................22 3.3.2 Excursion: IFRS and Derecognition...........................................23 3.3.3 Leasing .......................................................................................25 3.3.4 Sale and Lease-back ...................................................................35 3.3.5 Repos and Securities Lending ....................................................39 3.4 Management of Working Capital ..........................................................39 3.4.1 General Remarks ........................................................................39 3.4.2 Management of Accounts Payable .............................................40 3.4.3 Management of Accounts Receivable ........................................44 3.4.4 Particular Aspects of Securitisation............................................57 3.4.5 Cash Management ......................................................................70 3.5 Excursion: Basel II ................................................................................81 4 Debt .................................................................................................................83 4.1 Introduction ...........................................................................................83 4.2 Management of Risk: General Remarks ................................................87 4.3 Particular Clauses in Loan Facility Agreements....................................98 4.4 Prospectus............................................................................................111 4.5 Particular Remarks on Corporate Bonds..............................................112 VI Table of Contents 4.6 4.7 Particular Remarks on Securities in the Money Market ...................... 119 Particular Remarks on Syndicated Loans ............................................ 125 5 Equity and Shareholders’ Capital.............................................................. 131 5.1 The Equity Technique, Different Perspectives .................................... 131 5.2 Share-based Equity and Equity That Is Not Share-based .................... 138 5.3 The Legal Capital Regime ................................................................... 140 5.4 The Legal Capital Regime Under EU Company Law ......................... 145 5.5 Strategic Choices ................................................................................. 158 5.6 Legal Aspects of Equity Provided by Shareholders ............................ 163 5.6.1 General Remarks ...................................................................... 163 5.6.2 General Legal Aspects of Shares in Legal Entities .................. 163 5.6.3 Shares in Partnerships .............................................................. 171 5.6.4 Shares in Limited Partnerships................................................. 172 5.6.5 Shares in Private Limited-liability Companies......................... 173 5.7 Private Placements............................................................................... 180 5.8 Shares Admitted to Trading on a Regulated Market ........................... 183 5.9 Listing and the Information Management Regime .............................. 185 5.9.1 Introduction .............................................................................. 185 5.9.2 Listing Conditions .................................................................... 193 5.9.3 Prospectus ................................................................................ 199 5.9.4 Periodic and Ongoing Disclosure Obligations ......................... 205 5.9.5 Disclosure of Risk .................................................................... 207 5.9.6 Disclosure of Corporate Governance Matters .......................... 208 5.9.7 Prohibition of Market Abuse.................................................... 209 5.9.8 Enforcement ............................................................................. 215 5.9.9 Delisting ................................................................................... 218 5.10 Shares as a Source of Cash .................................................................. 222 5.10.1 General Remarks ...................................................................... 222 5.10.2 Management of Risk ................................................................ 224 5.10.3 Internal Corporate Action......................................................... 234 5.11 Shares as a Means of Payment............................................................. 236 5.11.1 Introduction .............................................................................. 236 5.11.2 Community Law: General Remarks......................................... 237 5.11.3 Mergers and Share Exchanges ................................................. 239 5.11.4 Mergers and Company Law ..................................................... 244 5.11.5 Share Exchanges and Company Law ....................................... 256 5.11.6 Share Exchanges and Securities Markets Law ......................... 260 5.11.7 Fairness, Price, Existence of a Market ..................................... 268 5.12 Shares as a Means to Purchase Other Goods....................................... 278 5.13 Share-based Executive Incentive Programmes.................................... 281 6 Mezzanine..................................................................................................... 283 6.1 Introduction ......................................................................................... 283 6.2 Example: Venture Capital Transactions .............................................. 289 6.3 Loan-based Mezzanine Instruments .................................................... 292 Table of Contents 6.4 6.5 VII 6.3.1 General Remarks ......................................................................292 6.3.2 Structural Subordination of Debts ............................................293 6.3.3 Repayment Schedules as a Form of Subordination ..................293 6.3.4 Statutory Subordination............................................................294 6.3.5 Contractual Subordination of Debts .........................................294 6.3.6 Contractual Subordination of Collateral...................................298 6.3.7 Structural Subordination of Collateral......................................300 6.3.8 Participation in Profits..............................................................300 Share-based Mezzanine Instruments....................................................302 Profit-sharing Arrangements................................................................306 7 Chain Structures and Control ....................................................................309 7.1 General Remarks .................................................................................309 7.2 Examples of Cases...............................................................................309 7.3 Legal Risks ..........................................................................................311 7.3.1 Parent........................................................................................311 7.3.2 Companies Lower Down in the Chain .....................................312 8 Exit: Introduction ........................................................................................315 8.1 General Remarks .................................................................................315 8.2 Exit from the Perspective of the Investor ............................................316 8.3 General Remarks on the Management of Risk ....................................318 8.3.1 Introduction ..............................................................................318 8.3.2 Replacement Risk and Refinancing Risk .................................318 8.3.3 Risks Relating to Ownership Structure and Control.................320 8.3.4 Counterparty Risks (Agency) in General .................................321 8.3.5 Information and Reputational Risk...........................................321 9 Exit of Different Classes of Investors .........................................................325 9.1 General Remarks .................................................................................325 9.2 Exit of Asset Investors.........................................................................325 9.3 Exit of Debt Investors..........................................................................327 9.4 Exit of Shareholders ............................................................................328 10 Exit of Shareholders ....................................................................................329 10.1 Introduction .........................................................................................329 10.2 Cash Payments by the Company .........................................................329 10.2.1 General Remarks ......................................................................329 10.2.2 Dividends and Other Distributions ...........................................331 10.2.3 Redemption of the Subscribed Capital .....................................334 10.2.4 Share Buy-backs.......................................................................335 10.2.5 Redeemable Shares...................................................................340 10.2.6 Withdrawal of Shares Otherwise..............................................342 10.3 Third Party as a Source of Remuneration ............................................342 10.3.1 Introduction ..............................................................................342 10.3.2 Clean Exit, Private Sale, Auction, IPO, Bids ...........................343 VIII Table of Contents 10.4 10.5 10.6 10.7 10.3.3 Termination of a Joint-Venture ................................................ 362 10.3.4 Privatisation.............................................................................. 365 Mergers and Divisions......................................................................... 370 10.4.1 General Remarks ...................................................................... 370 10.4.2 Mergers .................................................................................... 370 10.4.3 Formation of a Holding SE ...................................................... 377 10.4.4 Divisions .................................................................................. 378 Private Equity and Refinancing ........................................................... 383 Walking Away..................................................................................... 388 Liquidation .......................................................................................... 389 11 Takeovers: Introduction ............................................................................. 391 11.1 General Remarks, Parties .................................................................... 391 11.2 Structures............................................................................................. 392 11.3 Consideration and Funding.................................................................. 398 11.4 Process................................................................................................. 399 11.5 Contents of the Sales Contract............................................................. 401 11.6 Summary ............................................................................................. 403 12 Acquisition of Shares in a Privately-owned Company for Cash.............. 405 12.1 Introduction ......................................................................................... 405 12.2 Confidentiality..................................................................................... 407 12.3 Preliminary Understanding.................................................................. 408 12.4 Ensuring Exclusivity, Deal Protection Devices ................................... 410 12.4.1 General Remarks ...................................................................... 410 12.4.2 Exclusivity Clauses .................................................................. 411 12.4.3 Ensuring Exclusivity v Company Law..................................... 414 12.5 Signing, Conditions Precedent to Closing ........................................... 417 12.6 Employee Issues .................................................................................. 421 13 Due Diligence and Disclosures .................................................................... 427 13.1 General Remarks ................................................................................. 427 13.2 Due Diligence in Practice .................................................................... 428 13.3 Legal Requirements and Legal Constraints ......................................... 432 13.3.1 General Remarks ...................................................................... 432 13.3.2 Vendor Due Diligence, Vendor’s Perspective.......................... 433 13.3.3 Buyer Due Diligence, Vendor’s Perspective............................ 433 13.3.4 Buyer Due Diligence, Target’s Board ...................................... 436 13.3.5 Buyer Due Diligence, Buyer’s Perspective .............................. 440 13.3.6 Buyer Due Diligence, Buyer’s Board....................................... 442 13.4 Particular Remarks on External Fairness Opinions ............................. 443 14 Excursion: Merger Control ........................................................................ 447 14.1 General Remarks ................................................................................. 447 14.2 Jurisdiction .......................................................................................... 449 14.3 Complying with Community Law ....................................................... 452 14.4 National Merger Control ..................................................................... 458 Table of Contents IX 15 Excursion: Sovereign Wealth Funds ..........................................................459 15.1 General Remarks .................................................................................459 15.2 Community Law ..................................................................................460 16 Key Provisions of the Acquisition Agreement ...........................................463 16.1 General Remarks .................................................................................463 16.2 The Specifications of the Object..........................................................463 16.3 Excursion: Non-Competition Clauses..................................................470 16.4 Remedies (Indemnities) .......................................................................472 16.5 Purchase Price and the Payment Method.............................................478 16.5.1 General Remarks ......................................................................478 16.5.2 Choice of the Payment Method ................................................479 16.5.3 Adjustment of Consideration....................................................481 16.6 Buyer Due Diligence After Closing, Claims .......................................486 16.7 Excursion: Auction Sale ......................................................................487 17 Duties of the Board in the Context of Takeovers ......................................491 17.1 General Remarks .................................................................................491 17.2 In Whose Interests Shall Board Members Act? ...................................491 17.3 Duty to Obtain Advice or to Give Advice ...........................................496 17.4 Takeover Defences and the Interests of the Firm ................................498 18 Takeover Defences .......................................................................................503 18.1 General Remarks .................................................................................503 18.2 Pre-Bid Defences Well in Advance .....................................................506 18.3 Structural Takeover Defences, Control................................................506 18.4 Price-increasing Defences ...................................................................507 18.5 Keeping Assets Away from the Acquirer ............................................508 18.6 Securities Lending ...............................................................................509 18.7 The White Knight Defence..................................................................510 18.8 Poison Pills, Shareholder Rights Plans ................................................511 18.9 Greenmail and Other Targeted Repurchase Actions............................512 18.10 Tactical Litigation, Administrative Constraints...................................513 18.11 Example: Arcelor and Mittal ...............................................................514 19 A Listed Company as the Target................................................................519 19.1 General Remarks .................................................................................519 19.2 Information Management: Secrecy v Disclosure.................................521 19.3 Toehold, Creeping Takeover, Major Holdings ....................................524 19.4 Selective Disclosure Internally ............................................................531 19.5 Selective Disclosure to Lenders...........................................................533 19.6 Selective Disclosure to Outsiders by the Acquirer ..............................533 19.7 Selective Disclosure to Outsiders by the Target ..................................535 19.8 Disclosure to the Public .......................................................................539 19.9 Acting in Concert, Acting in a Certain Capacity .................................541 19.10 Public Takeover Offers........................................................................543 X Table of Contents 20 Acquisition Finance ..................................................................................... 549 20.1 Introduction ......................................................................................... 549 20.2 Funding Mix ........................................................................................ 552 20.3 Particular Remarks on Securities Lending........................................... 555 20.4 Financial Assistance ............................................................................ 556 20.5 Debt ..................................................................................................... 564 20.5.1 General Remarks ...................................................................... 564 20.5.2 Commitment of Banks ............................................................. 567 20.5.3 Many Legal Entities on the Side of the Borrower .................... 570 20.5.4 Internal Coherence of Contracts............................................... 576 20.6 Shareholders’ Capital .......................................................................... 579 20.7 Mezzanine ........................................................................................... 580 References .......................................................................................................... 583 1 Introduction 1.1 Cash Flow, Risk, Agency, Information, Investments The first volume dealt with the management of: cash flow (and the exchange of goods and services); risk; agency relationships; and information. The firm manages these aspects by legal tools and practices in the context of all commercial transactions. The second volume discussed investments. As voluntary contracts belong to the most important legal tools available to the firm, the second volume provided an introduction to the general legal aspects of generic investment contracts and payment obligations. This volume discusses funding transactions, exit, and a particular category of decisions raising existential questions (business acquisitions). Transactions which can be regarded as funding transactions from the perspective of a firm raising the funding can be regarded as investment transactions from the perspective of an investor that provides the funding. Although the perspective chosen in this volume is that of a firm raising funding, this volume will simultaneously provide information about the legal aspects of many investment transactions. 1.2 Funding, Exit, Acquisitions Funding transactions are obviously an important way to manage cash flow. All investments will have to be funded in some way or another. The firm’s funding mix will also influence risk in many ways. Funding. The most important way to raise funding is through retained profits and by using existing assets more efficiently. The firm can also borrow money from a bank, or issue debt, equity, or mezzanine securities to a small group of investors. Securities can also be issued to the public. In this case, the management of information will play a central role. For example, the marketing of securities to the public is constrained by the mandatory provisions of securities markets laws, and there can be ongoing disclosure and other obligations for issuers. Exit. The firm must manage exit-related questions in two contexts. First, the firm’s own investors will want an exit at some point of time. There is a very wide range of exit forms depending on the investment. For example, an investor can sell his claims to another investor, the company can make payments to an investor P. Mäntysaari, The Law of Corporate Finance: General Principles and EU Law, DOI 10.1007/ 978-3-642-03058-1_1, © Springer-Verlag Berlin Heidelberg 2010 2 1 Introduction who wants out, the company can merge with another company, or there can be an IPO. Exit can influence the firm’s cash flow and create risks. Second, the firm will act as an investor itself. In this case, it must manage its own exit. Business acquisitions (existential decisions). Business acquisitions belong to the largest investments that the firm will make. The acquisition must also be funded in some way or another. For example, the buyer might issue securities to the public, a small number of investors, or the sellers. Alternatively, it might borrow money from a bank. For the target firm, business acquisitions can raise existential questions. For example, the target’s board may have to decide whether the target should remain independent or accept a takeover proposal. In addition to business acquisitions, existential questions are normally raised by corporate insolvency (which will fall outside the scope of this book). Business acquisitions are legally complicated, and they involve the use of most legal instruments discussed in Volumes I–II. Typically, there is a contract between the buyer and the seller. The management of information plays a major role in this context. 1.3 Financial Crisis The financial market crisis that began in mid-2007 affected the funding of firms on a very large scale. There was a “Minsky moment”. The legal aspects of funding and exit transactions nevertheless remain unchanged. The same legal tools and practices that were available before the crisis will be available even after the crisis. On the other hand, the financial crisis increased risk-awareness. One can therefore assume that risks will be managed more carefully immediately after the crisis (before firms again become less risk averse and start reacting to the fear of negative things occurring rather than risk as such). Before the crisis, there was a trend towards higher and higher leverage. During the crisis, it became more difficult for non-financial firms to raise debt funding. As a result, it became vital for firms to have enough equity on the balance sheet and to ensure liquidity by hoarding cash. After the crisis, firms may again have better access to debt funding. One of the things that could change the funding mix of firms after the financial crisis is the choice of principal. The trend towards higher leverage was partly caused by the choice of shareholders as the most important principal in corporate governance. However, firms whose managers choose to further the long-term interests of the firm rather than the short-term interests of its shareholders are more likely to survive in the long term. 2 Funding: Introduction 2.1 General Remarks The purpose of Chapters 2–7 is to discuss the legal aspects of the most important forms of funding from the perspective of a non-financial firm. There are various forms of external funding ranging from traditional debt and shareholders’ capital to mezzanine capital. The firm can also release capital and retain earnings. The purpose of this chapter is to provide an overview. 2.2 Separation of Investment and Funding Decisions? There can be different views in financial economics and corporate finance law (as well as business practice) about whether investment and funding decisions are separate decisions. Financial economics. In financial economics, funding and investment decisions are separate decisions. When the firm considers the acquisition of an asset, it should estimate the cash flows that are expected to arise from the ownership of the asset. These should then be discounted at a rate that reflects the risk associated with those cash flows. The asset should be acquired if the net present value (NPV) is positive. How the acquisition should be financed is another matter.1 According to the separation theorem, investment and financing decisions can be separated if there is an opportunity to borrow and lend money (the Fisher-Hirshleifer separation theorem first identified by Irving Fisher). Investment decisions and financing decisions should thus be made independently of one another. The separation theorem has three important implications: First, the firm should invest in projects that make it wealthier. Second, the personal investment preferences of individual “owners” are irrelevant in making corporate investment decisions, because individual “owners” can maximise their personal preferences for themselves Third, the financing method does not affect the “owners’” wealth. The separation theorem is complemented by the unanimity proposition according to which firms need not worry about making decisions which reconcile conflicting shareholder interests, because all shareholders are thought to share the same interests and should therefore support the same decisions. 1 See, for example, McLaney E, Business Finance. Sixth edition. Pearson Education, Harlow (2003) p 237. P. Mäntysaari, The Law of Corporate Finance: General Principles and EU Law, DOI 10.1007/ 978-3-642-03058-1_2, © Springer-Verlag Berlin Heidelberg 2010 4 2 Funding: Introduction However, the unanimity proposition does not describe corporate reality very well. For example, because of private benefits of control, company decisions affect the interests of the controlling shareholder in ways other than through the decision’s impact on the value of the company. In company groups, the business interests of the parent or the group as a whole normally affect decision-making in companies belonging to the group.2 In Volume I, it was argued that shareholders cannot be regarded as the firm’s “owners” in the first place and that they do not share the same interests. Corporate finance law. In corporate finance law, questions of funding and investment are, for four reasons, very often connected. First, the providers of funding also provide ancillary services (section 2.3 below). Who holds the claim in general matters.3 Some investments are not possible without the ancillary services of certain finance providers. Second, the firm cannot acquire any asset without funding. (a) Very often the acquisition and funding are part of the same contractual framework. Such cases range from simple purchases of supplies or equipment (section 3.4.2) and simple financial leasing transactions (section 3.3.3) to asset-backed or structured finance (section 3.4.4), and generally to large transactions in which the availability of funding is a typical condition precedent to closing (Chapter 20). (b) Even where the acquisition and funding are not part of the same contract framework, the availability of external funding can influence the amount that the firm can invest or the price that it can pay. For example, the availability of debt funding can depend on whether potential lenders believe that the cash flows from the asset enable those debts to be repaid or whether the asset can be used as collateral. The structuring of the acquisition can therefore be influenced by the interests of the lenders and other investors and depend on the structuring of the funding transaction. The connection between investment and funding decisions can be illustrated by the takeovers of Chrysler, an American car manufacturer, and ABN Amro, a Dutch bank. Chrysler. In 2007, the suddenly tightening market for corporate debt and the high volalitility of stock markets meant that many leveraged buyouts either collapsed or had to be renegotiated because the banks that had agreed to lend money began to press for better terms. Cerberus Capital Management, which agreed to acquire the Chrysler Group from DaimlerChrysler, had to re-negotiate its deal just before closing. Cerberus had to provide more equity, and the seller had to lend some of the money to Cerberus. ABN Amro. In the ABN Amro case, there were two competing bids in 2007. Barclays Bank, an English bank, noticed that a consortium led by Royal Bank of Scotland, a Scottish Bank, had submitted a higher bid for ABN Amro. Barclays Bank then brought on board two strategic investors, China Development Bank, a state-owned bank, and Temasek, Singapore’s government investment vehicle. They agreed to subscribe for shares in Barclays Bank. This enabled Barclays Bank to revise its offer. 2 3 See also Gilson RJ, Controlling Shareholders and Corporate Governance: Complicating the Comparative Taxonomy, Harv L R 119 (2006) p 1665. Tirole J, The Theory of Corporate Finance. Princeton U P, Princeton and Oxford (2006) p 75. 2.3 Forms of Funding, Funding Mix, Ancillary Services 5 Third, when choosing the funding mix, part of the firm’s risk management is to take into account the assets being financed. Firms that are safe, produce steady cash flows, and have easily redeployable assets that they can pledge as collateral can afford high debt-to-equity ratios. In contrast, risky firms, firms with little current cash flows, and firms with intangible assets, tend to have low leverage. Companies whose value consists largely of intangible growth options have significantly lower leverage ratios than companies whose value is represented primarily by tangible assets.4 The fate of Northern Rock, a British mortgage bank, is an example of the relationship between the assets being financed and funding. Northern Rock relied largely on short-term borrowing from the capital market to fund its mortgage lending practices and to offer more attractive mortgage rates than its conservative competitors. When the interbank market was temporarily disrupted, Northern Rock faced a liquidity crisis and anxious customers queued up wanting to take their money out. In 2007, Northern Rock became the first British lender in 30 years to be granted a bailout by the Bank of England. The problems of Northern Rock were largely caused by its business model. Fourth, a funding transaction can be someone else’s investment transaction, and the legal framework of the transaction must address the concerns of both parties. 2.3 Forms of Funding, Funding Mix, Ancillary Services All investments must be funded in one way or another. In addition to other investments, the firm will need to hoard reserves as part of its overall liquidity and risk management in order to mitigate the risk of liquidity shortages.5 Funding mix, ancillary services. From the firm’s perspective, the typical forms of funding are: retained earnings; capital released by the firm; debt; shareholders’ capital (equity); and mezzanine. There can be even other forms of funding ranging from the investments of asset investors (sections 3.3.1 and 9.2) to state aids (see Volume II). The firm will thus choose a funding mix by weighing up the financial, commercial, and legal advantages and disadvantages of different sources of funding. The funding mix depends on: the availability and cost of capital; corporate risk management and the management of agency relationships between the firm as principal and investors as agents (Volume I); the ancillary services provided by the investors; and other things. Providers of external funding can provide ancillary services such as signalling services, monitoring services, management services, access to markets, access to technology, and so forth. For example, shareholders’ company law rights partly 4 5 Tirole J, op cit, pp 99–100. See also Ferran E, Principles of Corporate Finance Law. OUP, Oxford (2008) p 63, citing Myers SC, Capital Structure, J Econ Persp 15 (2001) pp 81–102 at pp 82–84. Tirole J, op cit, pp 199–200. See also Desperately seeking a cash cure, The Economist, November 2008. 6 2 Funding: Introduction facilitate the provision of ancillary services (Volume I). The provision of ancillary services is sometimes based on particular contract terms (joint-venture agreements, venture capital, project finance, shareholders’ agreements, and so forth). The scope of ancillary services depends on the form of funding, the investor, the firm’s needs, and other things. For example, shareholders have particular functions in a limited-liability company (Volume I). In a large listed company with dispersed share ownership and mainly short-term shareholders, few shareholders have actually provided funding by subscribing for new shares. However, many shareholders have a pricing and monitoring role. In an industrial firm, block-ownership can facilitate an industrial partnership. In a venture capital transaction, an equity investment is often combined with the provision of management services. The Second Company Law Directive provides that the subscribed capital may be formed only of assets capable of economic assessment and that an undertaking to perform work or supply services may not form part of these assets.6 The overall cost of funding is not limited to the direct costs of capital. The overall cost of funding depends also on the value and cost of ancillary services. The firm’s choices can reflect the relative weight of different parties as providers of funding and ancillary services. For example, a listed company’s share buyback programme can decrease the value of its publicly-traded bonds and lower its credit rating. Its choices can therefore reflect the relative weight of bondholders and shareholders as providers of funding and ancillary services. Before the financial crisis that began in 2007, share buyback programmes were used as a takeover defence designed to increase the share price and the cost of a takeover. During the crisis, it became important to hoard liquidity. Share buyback programmes were not necessary, because the hostile bidders would have been unable to finance their bids.7 Furthermore, corporate risk management plays a very important role, because the firm’s funding mix influences its risk profile (Volume I). This has also been recognised by the Bank for International Settlements: “A bank’s ability to withstand uncertain market conditions is bolstered by maintaining a strong capital position that accounts for potential changes in the bank’s strategy and volatility in market conditions over time. Banks should focus on effective and efficient capital planning, as well as long-term capital maintenance.”8 Different forms of funding have different legal and commercial characteristics. There are differences relating to both funding aspects and the typical ancillary services. (a) For example, borrowing is flexible, but the firm must repay its debts and 6 7 8 Article 7 of Directive 77/91/EEC (Second Company Law Directive). See also Articles 10, 10a, and 10b on consideration other than in cash. Knop C, Koch B, Köhn R, Frühauf M, Psotta M, Preuß S, Das Ende der Aktienrückkauf-Programme, FAZ, 26 March 2009 p 15. BIS, Basel Committee on Banking Supervision, Proposed enhancements to the Basel II framework. Consultative Document (January 2009), Supplemental Pillar 2 Guidance, paragraph 10. 2.3 Forms of Funding, Funding Mix, Ancillary Services 7 pay interest.9 (b) In contrast, the repayment of shareholders’ capital is subject to restrictions, but shareholders typically demand a higher return because of the equity nature of their claims. Furthermore, shareholders may increase the cost of shareholders’ capital by using their legal and de facto powers. For example, they may be able to force the company to distribute more funds to shareholders in the short term. In addition, the issuing of shares can change the share ownership structure of the company and vest shareholders’ rights in the subscribers of the new shares. (c) The cost of debt and shareholders’ capital is normally influenced by tax laws. As a result, some forms of funding are more popular than others. Tirole has summarised the result of several studies as follows: “In all [studied] countries, internal financing (retained earnings) constitutes the dominant source of finance. Bank loans usually provide the bulk of external financing, well ahead of new equity issues, which account for a small fraction of new financing in all major OECD countries.”10 Corporate finance has not succeeded in explaining the capital structure of firms. In two papers, published in 1958 and 1963, Franco Modigliani and Merton Miller argued that a firm’s financial structure made no difference to its total value and was therefore irrelevant. According to them, managers and owners should therefore devote themselves to maximising the value of their firms and waste no time thinking about gearing and dividends. However, the Modigliani-Miller theorem does not hold in a world with agency costs, asymmetric information, and other market imperfections. The choice of the financial structure of the firm can affect its value. The irrelevance theory is true only in circumstances so rare that they are the exception rather than the rule.11 There is no universal theory of the debt-equity choice. There are several conditional theories. The three major competing theories of capital structure are the trade-off theory, the pecking-order theory, and the free cash flow theory.12 Shareholders’ capital. In perfect capital markets, shareholders’ capital is the most expensive form of funding for the firm. Shareholders should require a higher return because of legal constraints on repayment and on distributions to shareholders. On the other hand, the firm needs some amount of shareholders’ capital as equity. Equity increases the survival chances of the firm in hard times, and shareholders’ capital makes it easier for the firm to raise debt capital, because it decreases risk for debt investors. The rights of shareholders are part of the price that the firm has to pay for investor lock-up.13 Too much shareholders’ capital can nevertheless be bad for the firm for corporate governance reasons (see Volume I). For example, the lack of debt removes an 9 10 11 12 13 For the optimal amount of debt, see Smith CW, Warner JB, On Financial Contracting. An Analysis of Bond Covenants, J Fin Econ 7 (1979) pp 117–161 at p 154. Tirole J, op cit, p 96. Generally, see Tirole J, op cit. Myers SC, Capital Structure, J Econ Persp 15 (2001) p 81. See Hansmann H, Kraakman R, Squire R, Law and the Rise of the Firm, Harv L R 119 (2006) p 1343. 8 2 Funding: Introduction incentive to be effective. Furthermore, a listed company can attract hostile bidders if it is not lean. If the firm is on the market for control and the firm wants to remain independent and survive in the long term, the firm must signal several important points to potential buyers: that its capital is already being employed in an efficient way; that the amount of assets that can be distributed to shareholders is limited; that the buyer would not be able to finance a hostile bid by loading the firm with new debt; and that a takeover would bring a low rate of return. A company that is on the market for control therefore prefers to keep the amount of shareholders’ capital and the amount of funds that can be distributed to owners low. The real cost of shareholders’ capital can be higher or lower compared with abstract financial theory. Capital markets are not far advanced in all countries. Even in highly developed countries, the cost of shareholders’ capital depends on the firm. For example, shareholders’ capital may sometimes cost less because of certain ancillary services provided by block-holders or shareholders acting as business partners. The cost of shareholders’ capital can also be reduced by the private nonpecuniary benefits of controlling shareholders. Protection against hostile takeovers is a common ancillary service provided by controlling shareholders. Even in countries with highly developed capital markets, a company is not yet on the market for control if it is controlled, directly or indirectly, by an owner who has no intention to sell and who holds a block of shares large enough to make it impossible for anyone else to obtain control. The company is typically not on the market for control if it is controlled by a long-term shareholder or shareholders, such as a family, a foundation, or a state. On the other hand, the cost of shareholders’ capital can be increased when influential shareholders have a very short investment perspective and only try to maximise their own short-term profits regardless of the interests of the firm. This is one of the main differences between, say, large listed companies and family-owned firms. Even information management can play a role. Investors might be uncertain about the motive behind the firm’s financing decision. For example, the issuing of new shares could be interpreted by the market as a sign of overvaluation, and firms do tend to issue shares during good times when share prices are high.14 Alternatively, it could be interpreted as a sign of a profitable investment opportunity. In order to convince investors that the latter is true and make them forget what they should know about the rational behaviour of issuers, the issuer can mask the issuance as one made necessary by a profitable investment decision such as a takeover and communicate the investment decision clearly to the equity market.15 14 15 See, for example, Tirole J, op cit, p 244 See Schlingemann FP, Financing decisions and bidder gains, J Corp Fin 10 (2004) pp 683–701, citing Myers SC, Majluf NS, J Fin Econ 1984 pp 187–221 (overvaluation) and Cooney JW Jr, Kalay A, J Fin Econ 33 (1993) pp 149–172 (profitable investment opportunity). 2.3 Forms of Funding, Funding Mix, Ancillary Services 9 Debt. Increasing debt and gearing can increase return on shareholders’ capital, provided that the firm makes a profit. Increasing debt is often used as a corporate governance tool, because regular and compulsory payments to lenders force the firm to be efficient in order to survive. The market for corporate control, the activities of private-equity firms, and corporate takeovers in general can increase the indebtedness of companies. On the other hand, a very high gearing increases the risk of business failure and can make it more difficult for the firm to survive in the long term. A very high gearing can also increase the cost of debt and reduce its availability. If the firm has too much debt, the firm must pay more for debt capital. Too much debt can do many things: increase the risk for banks, suppliers and other providers of debt capital; decrease the credit rating of the firm; decrease the availability of debt; and increase its cost. The risks inherent in high leverage can be illustrated by German takeover targets and the fate of Carlyle Capital Corporation in 2008. In Germany, companies taken over by privateequity firms in 2004–2008 were typically highly leveraged following the takeover. In 2008–2009, many such companies filed for bankruptcy.16 The Carlyle Group is a highprofile private-equity firm. It operates as a private partnership and is owned by a group of individuals. Carlyle Capital Corporation (CCC) was a publicly-listed company on Euronext Amsterdam N.V. Although part of the Carlyle family, The Carlyle Group and CCC were separate legal entities. A bond fund of CCC had used gearing of 32 times to buy AAA-rated paper.17 As a result of the subprime mortgage crisis, the market value of those assets fell and their liquidity was reduced. At the same time, banks became more risk averse and reluctant to lend money to private-equity firms. CCC had to sell assets to meet margin calls. The Carlyle Group supported CCC by extending a $150 million line of credit. After failing to reach an agreement with its creditors in March 2008, CCC defaulted on $16.6 billion of debt. The Carlyle Group said that it expected CCC to default on the rest as well. CCC’s lenders took possession of CCC’s remaining assets and sold collateral. Mezzanine. There is a wide range of mezzanine instruments. The purpose of mezzanine instruments is to combine the benefits of shareholders’ capital and debt while avoiding some of their drawbacks. Equity and debt components can be combined in various ways. Whereas some mezzanine instruments are regarded as equity in the balance sheet of the company (equity mezzanine), other mezzanine instruments are regarded as debt (debt mezzanine). There are also mezzanine instruments that consist of an equity component and a debt component (hybrid mezzanine). As equity and debt components can be combined in various ways, the firm can benefit from the wide range of investors’ risk preferences. The firm can issue a wide range of securities with different levels of seniority, that is, different rights to payment. 16 17 See, for example, Paul H, Am Ende entscheidet die Persönlichkeit des Private-EquityManagers, FAZ, 19 March 2009 p 16. See, for example, Fehr B, Ruhkamp S, Die dritte Welle der Finanzkrise, FAZ, 14 March 2008 p 29; If at first you don’t succeed, The Economist, March 2008. 10 2 Funding: Introduction For example, securities issued by the firm may belong to different tranches. One tranche will be regarded as more senior and repaid before securities that belong to other tranches can be repaid. Another tranche will be regarded as less senior and repaid only provided that securities belonging to other tranches have been repaid. Terminology. In corporate finance law, the meaning of the terms “equity”, “debt” and “mezzanine” can depend on the context and the perspective. From a legal perspective, different forms of capital will be treated differently depending on the applicable legal rules. For example, capital that, according to traditional national accounting rules, is regarded as “equity” may be regarded as “debt” under IFRS. According to the provisions of company law, a company can have different forms of capital. Moreover, the tax treatment of different forms of capital can vary. Even the subjective perspective can play a role. A certain “debt” instrument may thus be regarded as an “equity” investment by an investor buying an instrument with a better ranking or, if the capital amount of that instrument does not have to be repaid soon, by the company issuing the instrument. In this book, “equity” and “mezzanine” are regarded as techniques rather than distinct categories of funding. “Equity” is understood as the result of the use of the “equity technique” (section 5.1), and “mezzanine” as the result of the use of the “mezzanine technique” (section 6.1). A distinction is made between shareholders’ capital and other forms of equity. The Basel II Accord has its own terminology. For supervisory purposes, capital is defined in two tiers, core capital (Tier 1) and supplementary capital (Tier 2). At least 50% of a bank’s capital base must consist of a core element comprised of equity capital and published reserves from post-tax retained earnings (Tier 1) as defined in the Basel II Accord. Elements of supplementary capital will be admitted into Tier 2 limited to 100% of Tier 1.18 Tier 1 capital means equity capital and disclosed reserves. Equity capital means “issued and fully paid ordinary shares/common stock and non-cumulative perpetual preferred stock (but excluding cumulative preferred stock)”.19 Tier 2 capital or supplementary consists of undisclosed reserves, revaluation reserves, general provisions/general loan-loss reserves, hybrid debt capital instruments, and certain subordinated term debt.20 Reduction of external funding needs, retentions. Whereas equity, debt and mezzanine capital are regarded as the three main forms of external funding, internal financing constitutes the dominant source of finance.21 Typical ways to reduce the firm’s external funding needs include: retained earnings, reducing the amount of invested capital, as well as chain structures and pyramids. Most firms retain a substantial portion of the earnings left over after the firm’s contractual obligations have been met rather than pay them out in the form of dividends to shareholders or bonuses to employees. 18 19 20 21 Paragraph 49(iii) of the Basel II Accord. Paragraph 49(i) and footnote 13 of the Basel II Accord. Paragraphs 49(iv), 49(v), 49(vii), 49(xi), and 49(xii) of the Basel II Accord. See Tirole J, op cit, p 96.