Labor omnia vicit improbus Virgil, Georgics (Book I, 145-146) London School of Economics and Political Science Capital Structure and Corporate Governance: The Role of Hybrid Financial Instruments Lorenzo Sasso A thesis submitted to the Department of Law of the London School of Economics and Political Science for the degree of Doctor of Philosophy April 2012 Declaration I certify that the thesis I have presented for examination for the MPhil/PhD degree of the London School of Economics and Political Science is solely my own work other than where I have clearly indicated that it is the work of others (in which case the extent of any work carried out jointly by me and any other person is clearly identified in it). The copyright of this thesis rests with the author. Quotation from it is permitted, provided that full acknowledgement is made. This thesis may not be reproduced without the prior written consent of the author. I warrant that this authorization does not, to the best of my belief, infringe the rights of any third party. Abstract This thesis consists of a study of English and US corporate finance law and, in particular, the law in relation to hybrid financial instruments. I consider hybrids any financial instrument that presents a mix of equity and debt characteristics. Therefore this thesis excludes from examination all the derivative instruments, while it focuses on two main types of hybrid security, in relation to their relevance to the situation studied: preference shares and convertible bonds. Despite a clear distinction in law between equity and debt, the development of sophisticated hybrid financial instruments has forced regulators to look beyond the legal form of an instrument to its practical substance. As observable in practice, the increase in financial innovation reflects the necessity of the parties to allocate control and cash-flow rights in a way that diverges from the classic allocation resulting from equity and debt. Most of the empirical and theoretical research in this area has focused on the tax advantages of issuing hybrids as a way of reducing the cost of capital or on their capacity to be subordinated to all the creditors and to be unable to trigger the liquidation of the firm in case of default on its payouts. However, very little contribution has been made to the analysis of these securities with regard to their implications for corporate governance. This thesis aims to discuss the rationale for issuing hybrids, and to evaluate the law relative to these instruments against the background of both agency costs and property rights theories. The functional approach unveils an important rationale for issuing hybrids. The UK and US have legal systems characterised by transactional flexibility. They rely heavily on ex post standards strategies to protect preference shareholders and on the judiciary to evaluate the fairness of a transaction. This flexibility places the UK and US legal systems among the most business-friendly countries. The vacuum left by mandatory company law in favour of a major flexibility in the market has pushed the parties to fill it contracting for their rights. In so doing they have facilitated the business relations and better protected themselves with careful drafting. 4 Table of Contents Abstract ........................................................................................................................ 4 Acknowledgements ...................................................................................................... 8 INTRODUCTION ....................................................................................................... 9 PART I – REGULATORY ISSUES OF HYBRID FINANCIAL INSTRUMENTS: THE CLASSIFICATION APPROACH .................................. 16 Chapter 1. A Historical Perspective ........................................................................ 16 1.1. The birth and evolution of preference shares in the British legal system .......... 16 1.2. Particular features of the preference shares ....................................................... 26 1.2.1. The preferential dividend ....................................................................... 26 1.2.2. Priority to the repayment of capital in event of liquidation ................... 31 1.2.3. Conversion and redemption of preference shares .................................. 36 1.2.3.1. Failure to redeem ....................................................................... 42 1.3. Elements of convertible obligations ................................................................... 45 1.4. Debt holding restrictive covenants and veto rights ............................................ 49 Chapter 2. Distinguishing between Equity and Debt ............................................. 54 2.1. Does capital structure matter? ............................................................................ 54 2.2. Definition of equity and share capital ................................................................ 58 2.3. Why distinguish between equity and debt: the role of accounting as control over regulations .................................................................................................. 60 2.4. Classification of financial instruments in different regulatory areas ................. 63 2.5. Hybrid financial instruments’ implications for corporate law ........................... 66 Chapter 3. Setting the theoretical background ...................................................... 69 3.1. Transaction costs and company law ................................................................... 70 3.2. The company as a “nexus of contracts” and the theory of agency costs ............ 71 3.3. Contract incompleteness and ex post conflicts .................................................. 76 3.4. The modern theory of property rights ................................................................ 78 3.5 Summary of the analysis .................................................................................... 83 PART II – GOVERNANCE REGULATION OF HYBRID FINANCIAL INSTRUMENTS: THE FUNCTIONAL APPROACH ......................................... 85 Chapter 4. From the Classification to the Functional Approach ......................... 85 5 4.1. Governance implications of issuing hybrid instruments .................................... 86 4.1.1. Large publicly traded companies ........................................................... 89 4.1.2. Small closely held start-up firms ............................................................ 91 4.2. The structure of Part II ....................................................................................... 93 Chapter 5. Significant corporate decisions ............................................................. 97 5.1. Contracting for governance rights at a company’s start-up ............................... 97 5.1.1. Limits to the control power of a lender ................................................ 102 5.1.2. The use of hybrid instruments to align the “ex ante” incentives of managers: stage financing and contingent convertible debt ................ 105 5.1.2.1. Preference shares as incentive contracts ................................. 107 5.1.3. The use of hybrid instruments to reduce the “ex post” hold-up problems ............................................................................................... 109 5.2. The manager-shareholder conflict in charter amendments: variation of class rights ........................................................................................................ 112 5.2.1. The position of preference shareholders and their protections: a UK - US comparative analysis ...................................................................... 114 5.2.2. What constitutes a variation of class rights? ........................................ 120 5.2.3. Legal strategies for preference shareholders ........................................ 122 5.3. Shareholder-convertible bondholder agency problems .................................... 125 5.3.1. The protection of convertible bondholders in mergers and acquisitions ........................................................................................... 127 5.3.2. The protection of convertible bondholders in assets disposal .............. 131 5.3.3. Other situations of potential dilution: the distribution of dividends .... 134 5.4. An evaluation of the rationale and protection for hybrids ............................... 139 Chapter 6. Financing through hybrid instruments: risks of opportunism and legal strategies for mitigation ................................................................................. 141 6.1. The use of convertible bonds to reorganise and restructure a firm .................. 141 6.2. The manager-convertible bondholder conflict ................................................. 143 6.2.1. The timing of the conversion and the issuer’s call option ................... 145 6.2.2. Value dilution of the conversion option ............................................... 148 6.2.2.1. Price-based methods of anti-dilution ...................................... 151 6 6.2.2.2. Full ratchet and weighted average ratchet anti-dilution provisions ............................................................................................. 153 6.3. The majority-minority conflict in venture capital financing: the investor’s claim dilution ................................................................................................... 157