The Relationship between Debt and Equity

Question 1

In a Solvent and Insolvent Company, who between Creditor and the Shareholder takes Preeminence?

Answer 1

1. In solvency, the shareholder.
2. In insolvency, the creditor.

Question 2

What is Insolvency?

Answer 2

The state of inability to repay one’s debts.

Question 3

How can Insolvency be determined?

Answer 3

1. Through determination of whether a firm is capable of repaying its debt by application of either the Balance Sheet Test and the Cashflow Test.

Question 4

What is the Balance Sheet Test?

Answer 4

An assessment of whether the companiy’s on-sheet liabilities outweight its on-sheet assets, accounting for contingencies.

§123(2) IA 1986.

Question 5

What is the Cashflow Test?

Answer 5

An assessment of whether the company is capable of meetings its debts as they are due.

§123(1)(e) IA 1986.

Question 6

What is the Source of Shareholder Power (Primacy) in Solvent UK Companies?

Answer 6

Shareholders’ status as the company’s residual risk-bearers under §172 CA 2006.

Question 7

What is the Source of Creditors’ Power in Solvent and Insolvent UK Companies?

Answer 7

Contracts.

Question 8

What are Adjusting and Non-Adjusting Creditors?

Answer 8

Creditors who are and aren’t able to enact protective measures against insolvency, respectively.

Question 9

What is the Risk Tolerance of Creditors and Shareholders, generally speaking?

Answer 9

Risk-averse and Risk-prone, respectively.

Question 10

What explains the Discrepancy between Creditors’ and Shareholders’ risk tolerance?

Answer 10

A creditor’s income is fixed, meaning that risky but explosive growth serves him no additional benefit, and vice versa for the shareholder.

Question 11

Ultimately, what are the Goals of Creditors and Shareholders when investing their capital?

Answer 11

1. A creditor wishes a return of principle and to extract as much interest as possible.
2. A shareholder wishes an explosion in the value of his company.

Question 12

What is a Creditor’s Greatest Risk?

Answer 12

Solvency Risk, i.e. non-repayment of capital.

Question 13

What are a Creditor’s most pressing Risks? (LLMSO)

Answer 13

1. Liquity Risk.
2. Legal Risk.
3. Market Risk.
4. Solvency Risk.
5. Operations Risk.

Question 14

How might Shareholders’ divergent goals and higher risk tolerance Harm Creditors’ interests?

Answer 14

1. Claim dilution through serial borrowing.
2. Withdrawal of assets from the repayment pool.
3. Increase of solvency risk for profit gain.
4. Underinvestment where there is little more for shareholders to gain from further capital injections.

Question 15

What is the Main way in which Creditors are Legally assuaged?

Answer 15

Minimum capital adequacy requirements for publicly-traded and financial companies.

Question 16

Aside from Contractual and Proprietary Interests, how else may a Creditor seek to protect himself?

Answer 16

Covenants, i.e. restrictions on certain activities.

Question 17

How do Creditor protections effect the Cost of Capital?

Answer 17

Loans with more onerous creditor protections tend to be cheaper, and vice versa.

Question 18

Aside from Price, what else may Influence a Creditor’s desire to lend with or without onerous protections in place?

Answer 18

1. The borrower’s creditworthiness. (without)
2. The number of lenders involved. (with)

Question 19

Both Creditors and Shareholders influence the behaviors of companies, but in different ways. How so?

Answer 19

1. Creditors, through the use of covenants and other protections, influence what a company either must do or cannot do.
2. Shareholders, through their influence over the Board, influence which way the company is going subject to feasability (or sometimes infeasability).
3. in other words, one is prophylactic and the other is proactive.

Question 20

When is a Company officially Insolvent?

Answer 20

When formal insolvency proceedings begin.

§240(3) IA 1986.

Question 21

How do Holders of Proprietary Claims and other Secured Creditors rank in the Insolvency Process?

Answer 21

Those with either the reservation or grant of an absolute interest, or some such other secured claim, in an asset cannot be challenged whatsoever.

Question 22

What is the Order of Priority?

Answer 22

1. Secured Creditors.
2. Liquidiation or administration fees.
3. Preferential creditors.
4. Unsecured credtiros.
5. Preferential shareholders.
6. Ordinary Shareholders.

Question 23

Do Directors’ Duties encompass creditors?

Answer 23

Yes, when the company is insolvent. The obligation, however, is mediated through the company, i.e. it is in the company’s best interest to pay its creditors and act lawfully.

Question 24

Which legal presumptions apply to all Inter-Class Disputes at Common Law?

Answer 24

1. Presumption of Equality.
2. Presumption of Exhaustiveness.

Question 25

What is the Presumption of Equality?

Answer 25

The presumption that any two classes of shares will provide equal entitlements in the absence of express statements to the contrary.

Birch v Cropper (1889) 14 App Cas 525 (HL)

Question 26

What is the Presumption of Exhaustiveness?

Answer 26

The presumpttion that all express statements concerning a class of shares comprise an exhaustive description of its intended characteristics.

Re National Telephone Co. [1914] 1 Ch 755; Will v United Lankat Plantations Co. [1914] AC 11 (HL); Scottish Insurance Corporation. v Wilsons and Clyde Coal Co. [1949] AC 462.

Question 27

Which legal principles specifically apply to premium-listed Inter-Class Disputes at Common Law?

Answer 27

1. The Equality Principle.
2. The Proportionality Principle.

Question 28

What is the Equality Principle?

Answer 28

The notion that, “[a]ll equity shares in a class… must carry an equal number of votes on any shareholder.”

UK Listing Rule 7.2.1A, Premium Listing Principle 3.

Question 29

What is the Proportionality Principle?

Answer 29

The notion that, in a multi-class share structure, “the aggregate voting rights of the securities in each class should be broadly proportionate to the relative interests of those classes in the equity of the listed company.”

UK Listing Rules, Premium Listing Princple 4.