Summary: Corporate Law Endterm Notes

Read the summary and the most important questions on Corporate law Endterm notes

• 5 Transactions with creditors

• What is the dual role of a firm's creditors in relation to the other participants in the enterprise? TQ

  P 109. Under ordinary circumstances, most creditors are no more than contractual counterparties 
  
  However, if the firm default on payment obligations, its creditors are entitled to seize and sell its assets. At this point the creditors change roles: they become the owners of the firm's assets

• What are the different agency problems that creditors have to deal with? TQ

  
  p 109. 1. As contractual counterparties, they face the possibility of opportunistic behaviour by the firm acting in the interest of the shareholders, not the creditors 
  
  2. If the firm defaults there can arise a conflict between different creditors (creditor vs creditor), one group of owners of the assets vs another 

• What is the role of corporate law when dealing with corporate creditors? TQ

  
  P 109.Every corporate law includes some provisions protecting corporate creditors. They contain measures that aim to reduce agency costs, which helps lower the costs of raising debt finance. Also the corporate forms is used as a vehicle for contracting with creditors

• 5.1.1 Asset partitioning and corporate creditors

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• What are three examples of the impact of asset partitioning on the firm's creditors? TQ

  
  p 110.
  1. Creditors are limited to claiming corporate assets, which means they only need to evaluate and monitor these. This saves costs.
  
  2. It supports specialization by creditors, which makes it possible to offer cheaper credit.
  
  3. Permits firms to isolate different lines of business, or types of assets for the purpose of obtaining credit from specific specialised creditors.

• 5.1.2 Shareholder-creditor agency problems

• One shareholder-creditor agency problem is "asset dilution/ asset diversion". What is meant by this? TQ

  P 111
  
  Shareholders siphon (use assets for other purposes) assets out of the corporate pool in favour of themselves. This increases the shareholder's personal wealth but harms creditors by reducing the assets available to satisfy their claims

• Another shareholder-creditor agency problem is "asset substitution". What is meant by this? TQ

  P 111
  
  Shareholders sell assets used in low-risk business activities to pay for the acquisition of assets used in high-risk business activities.
  
  Shareholders can benefit from an increase in the riskiness of the firm's cash flows because
  1. If things go well, all the extras go to them
  2. Whereas if things go wrong they lose no more than they already had at stake.
  
  Creditors however can be harmed as it will increase the probability that the firm will not generate sufficient cash to repay them

• What are three mechanisms that give the creditors a certain amount of control over the debtor's activities? TQ

  
  P 112-113
  
  1. Restrictions on the firm's ability to engage in activities that might conflict with creditor's interest (significant assets transactions, payments of dividends to shareholders)
  
  2. Security interests incorporate assets which restrict the scope for asset substitution by requiring the firm to obtain the consent of the creditor
  
  3. Entity shielding: putting assets supporting a loan into a subsidiary, thus structurally subordinating all the borrower's other creditors

• What is one ex-ante and one ex-post shareholder-creditor agency problem? TQ

  
  p 111
  
  Ex-ante: entity shielding can assist shareholders in misrepresenting the value of corporate assets by falsely claiming that the firm holds title to assets that actually belong to other entities.
  
  Ex-post: shareholders benefit from the firm's successes, while owner shielding protects their personal assets from the consequences of its failure, given their incentives to engage in actions that benefit themselves at the expense of creditors

• What is "debt dilution?" And how does it benefit shareholders? TQ

  P 111-112
  
  Debt dilution: takes place by increasing the firm's overall borrowing. New creditors share the firm's assets with the old creditors in event of failure, which in return gives the old creditors fewer rights on the firm's assets. 
  
  Benefit shareholders: shareholders have more credit, from the new creditors, and relatively owe the old ones less credit. 

• 5.1.2.1 The vicinity of insolvency

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• What is meant by the "vicinity of insolvency?"

  When companies are in financial distress