Financing the Corporation

• Author: Christopher C. Nicholls
• Pages: 343-385

343

CHAPTER TWELVE

Financing the Corporation

INTRODUCTION1

The business corporation is, perhaps above all, a means of pooling capital from many

investors to carry on productive business. Financial pooling lies at the heart of the

corporate form, although the law has been willing to permit the “separate entity” meta-

phor to be carried to its logical conclusion in the case of sole-shareholder companies.2

Legal rules concerning a corporation’s finances are related to the law that governs the

protection of those who buy and sell corporate financial instruments, such as shares,

debentures, and other securities. Investor protection, since the early 20th century, has

become the subject of a separate branch of law: securities regulation.3 The boundaries of

corporate law and securities regulation are often rather hazy.4 This chapter, however, will

endeavour to focus on the corporate law rules surrounding corporate finance, leaving the

reader to seek an introduction to Canadian securities regulation from other sources.5

1The subject of corporate finance can be, and indeed has been, the subject of book-length studies,

including one by the present author. See, e.g., Christopher C. Nicholls, Corporate Finance and Canad-

ian Law (Toronto: Carswell, 2000). The discussion in this chapter offers only a very brief summary of

some of the broad principles affecting the financing of the corporation.

2But see Hansmann and Kraakman’s discussion of asset partitioning as a rationale for sole-shareholder

business corporations. Henry Hansmann and Reinier Kraakman, “The Essential Role of Organizational

Law” (2000), 110 Yale Law Journal 387, at 404-10. The authors of this paper refer to a sole-shareholder

business corporation as a “corporation sole.” This use of the phrase “corporation sole” is unconven-

tional. Traditionally, a corporation sole was said to be “always the holder of a public office” such as the

English monarchy. (John Burke, Jowitt’s Dictionary of English Law, 2nd ed. (London: Sweet & Maxwell,

1977.) Thus, as Professor Sealy has said, “[t]he newly-sanctioned single-member company seems to be

an anomalous institution which does not fit the criteria for either of these traditional classifications” (that

is, the corporation aggregate or the corporation sole). L.S. Sealy, Cases and Materials in Company Law,

7th ed. (London: Butterworths, 2001), at 77.

3The phrase “securities regulation” was coined by the late Professor Louis Loss. See Louis Loss,

Anecdotes of a Securities Lawyer (Boston: Little, Brown and Company, 1995), at 51.

4For an excellent examination of the close relationship between corporate law and securities regulation,

see Philip Anisman, “Regulation of Public Corporations: The Boundaries of Corporate and Securities

Law,” in The Future of Corporation Law: Issues and Perspectives, Papers Presented at the Queen’s

Annual Business Law Symposium 1997 (Toronto: Carswell, 1999), 63.

5The author will, one hopes, be forgiven for suggesting one book in particular for this edifying purpose:

Jeffrey G. MacIntosh and Christopher C. Nicholls, Securities Law (Toronto: Irwin, 2002).

Copyright © 2005 Emond Montgomery Publications. All Rights Reserved.

344 Chapter 12 Financing the Corporation

Corporations invariably need money to carry on their business operations. Of course,

as they sell their goods or are paid for their services, cash will flow into the business. But,

often, corporations will need more money than they generate in the ordinary course of

their business operations. The need for additional cash does not arise simply because

corporations wish to “live beyond their means.” More often, this need relates to a timing

mismatch: the corporation may have bills that it must pay today, even though payment

from its own customers or clients is still some days or weeks away. Or, again, the need

for more money may have nothing at all to do with paying ordinary expenses. The

corporation may have identified an excellent investment opportunity—a project or per-

haps even another whole business that will cost it a great deal of money to acquire, but

that will, over time, enable it to save or earn even more money.

Just as many Canadian families need financial help when they buy a home, so when

business corporations decide to make major investments, they too may need to raise

additional cash. In the broadest sense, corporations that need to raise money over and

above amounts generated from their operations have three choices: they may sell or lease

some of their corporate assets; they may borrow cash from a bank or other lender; or they

may issue shares or some other type of corporate securities.6

We will not say much here about the first option, selling corporate assets. Selling

assets does not raise many uniquely corporate law issues, unless, perhaps, the sale

involves the sale of “all or substantially all” of the corporation’s property, as discussed

further in chapter 14. It is true that asset sales are actually an important aspect of a very

sophisticated form of financing—securitization. But, again, the many interesting and

challenging legal issues that securitizations raise do not relate primarily to corporate

law.7 The focus here will be instead on corporate borrowing and, more particularly, on

some of the corporate law issues surrounding the issue of corporate securities, especially

corporate shares.

In an economic sense, deciding how a corporation is to be financed Klein has de-

scribed as an exercise in negotiating the terms of one or more implicit or explicit

contracts with a view to determining how to allocate risk, how to allocate returns from

the business, determining where control of the business will lie, and specifying the

duration of each participant’s investment.8 It is useful to keep this helpful fourfold

paradigm in mind when reviewing the various methods by which corporations may

finance their businesses.

6There are other methods of financing available to corporations as well, such as factoring and asset

securitization. But even these techniques involve some combination of asset sale or lease, borrowing,

and sale of securities.

7For a brief introduction to securitization, see Nicholls, supra footnote 1, at 60ff.

8See William A. Klein, “The Modern Business Organization: Bargaining Under Constraints” (1982), 91

Yale Law Journal 1521.

Copyright © 2005 Emond Montgomery Publications. All Rights Reserved.

Debt and Equity 345

DEBT AND EQUITY

When a corporation borrows money, the obligation to repay the money is a debt. Raising

money by borrowing is referred to as debt financing. When a corporation raises money

by offering new shares to purchasers, the shareholders’ interest in the corporation is

referred to as equity. Raising money in this way is referred to as equity financing.

It is often helpful to introduce the concepts of debt and equity by comparing the

differences between them from the perspective of the corporation as well as from the

perspective of investors. Some of the major differences are discussed below.

Debt Ranks Ahead of Equity

Perhaps the most fundamental difference between debt and equity is this: when a corpo-

ration that has borrowed money is wound up or liquidated, the assets of the corporation

are sold. The proceeds of sale go first to satisfy the claims of outstanding creditors. Until

all the creditors of the corporation have been repaid every penny they are owed, the

corporation’s shareholders receive nothing at all. This is true even if the shareholders

hold so-called preferred shares, as discussed later in the chapter.

Debt Must Be Repaid

When a corporation borrows money, it is under a legal obligation to repay it. However,

when a corporation raises money by selling equity—at least in its humblest form, com-

mon or ordinary shares—the money received from investors never needs to be repaid. It

becomes part of the corporation’s permanent capital.9

Interest Payment Deductibility

When a corporation makes interest payments on any money it has borrowed, the amount

of those payments may be deducted from the corporation’s income calculated for tax

purposes. As a result, the corporation will pay less income tax. That means that, for a

taxpaying corporation, every dollar distributed to a lender in interest actually costs the

corporation something less than a dollar after taxes. By contrast, when a corporation

makes a distribution to its shareholders, that distribution—a dividend—is not deductible

by the corporation in calculating its income for tax purposes.

Taxa tion of Interest Payments and Dividend Payments

Interest payments received by debtholders are taxed as ordinary income. Dividend pay-

ments, on the other hand, benefit from the Income Tax Act’s “dividend tax credit.” The

9This statement is subject to two qualifications. Shares can be created with “redemption” or “retraction”

features that anticipate that the corporation may, at some future date, return the shareholders’ capital and

cancel the shares. Common or ordinary shares would not typically have such features, however. Further-

more, as discussed in chapter 14, in certain circumstances, shareholders may be entitled to dissent from

certain corporate decisions and seek an appraisal remedy. When a shareholder is entitled to an appraisal

remedy, the corporation will be required to purchase his or her shares for fair value.

Copyright © 2005 Emond Montgomery Publications. All Rights Reserved.