The Anatomy of Corporate Law PDF
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H E AN A O MY O F CO R PO R A E L AW A W
Te Anatomy of Corporate Law A Comparative Comparative and Functional Functional Approach
Tird Edition REINIER KRAAKMAN J O H N A R M O U R PAU L D AVIE S LUCA ENRIQUES HENRY HANSMANN GERARD HERIG KLAUS HOP HIDEKI KANDA MARIANA PARGENDLER WO W OLF GEORG RINGE E D WARD W ARD RO CK With contributions from SOFIE COOLS and GEN GO G OO O
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Great Clarendon Street, Oxford, OX2 6DP, United Kingdom Oxford University University Press is a department of the University of Oxford. It furthers the University University’’s objective of excellence in research, scholarship, and education by publishing worldwide. Oxford is a registered trade mark of Oxford University University Press in the UK and in certain other countries 2017 © 2017 © R. Kraakman, J. Armour, P. P. Davies, L. Enriques, H. Hansmann, G. Hertig, 2017 K. Hopt, H. Kanda, M. Pargendler, W.-G. W.- G. Ringe, and E. Rock 2017 Te moral rights of the authors have been asserted First edition published in 2004 Tird edition published in 2017 Impression: 1 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, Press, or as expressly permitted by law, by licence or under terms agreed with the appropriate reprographics rights organization. Enquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this work in any other form You and you must impose this same condition on any acquirer Crown copyright material is reproduced under Class Licence L icence Number C01P0000148 with the permission of OPSI and the Queen’s Printer for Scotland Published in the United States of America by Oxford University Press 198 Madison Avenue, New York, NY 10016, United States of America British Library Cataloguing in Publication Data Data available Library of Congress Control Number: 2016953194 ISBN 978–0–19–872431–5 (pbk.) ISBN 978–0– 978–0–19– 19–873963– 873963–0 0 (hbk.) Printed and bound by CPI Group (UK) Ltd, Croydon, CR0 4YY Links to third party websites are provided by Oxford in good faith and for information only. Oxford disclaims any responsibility for the materials contained in any third party website referenced in this work.
Acknowledgments Te process of preparing the third edition was eased by the hospitality which we jointly enjoyed from the University of Oxford and the University of Pennsylvania Pennsylvania Law School. As with prior editions, we have drawn shamelessly on our friends and colleagues for for comment on various parts of the book. We list them here and apologize in advance to any whom we have omitted: Dan Awrey, Marcello Bianchi, Horst Eidenmüller, Martin Gelter, Sergio Gilotta, Amir Licht, Alessio Pacces, Jenny Payne, Viviane Muller Prado, Lorenzo Stanghellini, obias röger, Umakanth Varottil, Marco Ventoruzzo, and Andrea Zorzi. Once again, we should like to thank research centers and our home institutions for providing financial support as we worked on this book. We thank the University of Oxford for funding John Armour, Sofie Cools, Paul Davies, and Luca Enriques, and Martin Bengtzen and Antonios Chatzivasileiadis for research assistance; the Yale Law School for funding Henry Hansmann; the EH for funding Gerard Hertig; the Harvard Law School John M. Olin Center for Law, Economics, and Business for funding Reinier Kraakman; the Fundação de Amparo à Pesquisa do Estado de São Paulo (FAPESP) and FGV Law School in São Paulo (FGV Direito SP) for funding Mariana Pargendler, Pargendler, and Rafael Bresciani for research assistance; Copenhagen Business School for funding Wolf-Georg Ringe; and the Saul Fox Research Endowment at the University of Pennsylvania Law School for funding Edward Rock who held the Saul Fox Distinguished Professorship Professorship in Business Law from 2001 to 2016. As ever, ever, we thank our nearest and dearest, who who may legitimately wonder wonder why such a short book always involves so much toing and froing. Te Authors
Preface to the Tird Edition As the Preface to the Second Edition observed, the t he Anatomy is is the product of a longstanding collaboration. Te Tird Edition carries this collaboration forward for ward into a new generation of scholars. Although the authors of the First Edition lent a hand, their role was largely advisory advisory.. We called ourselves the t he “supe “supervisory rvisory board. board.”” Most of the credit for the conceptual innovation and new research evident in this edition rightfully goes to those co-authors co-authors who joined the Anatomy prior prior to the Second Edition or before the Tird Edition was underway. Tis is as it should be. Corporate law like other disciplines requires a steady infusion of new energy and fresh perspectives, if not to remain relevant then at least to reach closure while it is fresh. Tis is not to say that the Tird Edition abandons the aspirations and conceptual framework of prior editions. Wee remain committed to an approach to corporate law that is “international, W “i nternational,”” “functional,” “neutral,” and last but not least, “brief.” Indeed, the Tird Edition is considerably improved on three of these dimensions and, against all odds, steadfastly holds the line on its commitment to brevity brevity.. Te Anatomy has has always been “international” and comparative, yet it has inevitably been constrained in one sense, namely, the number of jurisdictions that it follows through its functional chapters. Concrete references to the law of particular jurisdictions is key to making our analysis credible; too many jurisdictions would overreach our collective expertise and invite the charge that we have cherry-picked cherry-picked examples to fit our conceptual framework. Te Second Edition added Italy to our initial set of five jurisdictions selected from a short list l ist of developed economies: France, Germany, Germany, Japan, the UK, and the U.S. U.S. Italy was chosen not not only because it fit our jurisdictional profile but also because a major scholar of Italian corporate law, law, Luca Enriques, joined our collaboration. John Armour, who joined the Anatomy at at the same time, broadened our conception of corporate law to include aspects of bankruptcy and related fields often located outside of our domain. Our new co-authors co-authors on this edition have similarly expanded our focus. Most visibly, visibly, we now include Brazil among our core jurisdictions. Tis may seem surprising given that prior editions relied exclusively on the legal regimes of developed economies. For the authors of the Anatomy , however, however, it is a considered step forward. Te inclusion of a large emerging market economy—the economy—the “B” in the so-called so-called BRICS—broadens BRICS—broadens our perspective and raises challenging new issues. We do not suggest that Brazil proxies for the diverse range of emerging-market jurisdictions, only that it is a reasonable choice for expanding the Anatomy ’s ’s jurisdictional reach. And as suggested above, we are pragmatic. Te decisive factor in the choice of Brazil was that Mariana Pargendler Pargendler,, a distinguished scholar of Brazilian corporate law, joined the Anatomy as as a major contributor to the Tird Edition. Although we are still constrained to referencing only a handful of jurisdictions, Professor Pargendler’ Pargendler’s integration of Brazilian law throughout significantly adds to the international scope of the Tird Edition. In yet another parallel with the Second Edition, our good fortune in enlisting Georg Ringe as an author and contributor to this edition not only adds a distinguished scholar of German and EU law to our bench but also contributes importantly to our analysis across all jurisdictions, particularly in the key areas of fundamental corporate transactions and corporate control.
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Readers of prior editions of the Anatomy can can rest assured that the Tird Edition follows the functional analysis of its predecessors. We begin with an effort to define “corporate “c orporate law” by addressing the economic functions of the corporate form, identifying key classes of corporate stakeholders, and proposing a basic set of “agency problems”—essentially lems”— essentially contracting problems—that problems—that corporate law addresses. We then set out a typology of legal strategies that jurisdictions employ to mitigate these agency problems. As before, we argue that corporate law must address basic agency problems everywhere but the legal strategies deployed by particular jurisdictions vary with circumstances ranging from their politics and enforcement resources to their economic development. Often legal regimes appear to have made functional adaptations to circumstances at hand; sometimes such adaptations appear to be missing. Te Anatomy reveals functional patterns across jurisdictions but has never purported to be a “theory of everything” in our field, still less a theory of legal convergence that reaches beyond the basic legal features of the corporate form that arose long ago a go (but are no less remarkable for that fact). Rather, it continues to be an analysis of basic agency problems and recurrent legal strategies that are intended to mitigate them. A striking extension of this analytical framework in the Tird Edition, however however,, is our recognition that the agency problems among the contractual participants in the corporation resemble in important respects a different set of problems that arise between parties affected by corporate activities but who lack any contractual leverage over the firm. We term such parties— who are not shareholders, shareholders, managers, employees, or creditors—the creditors—the firm’s firm’s “external constituencies.” constitu encies.” In many cases, corporate corpora te activiactivi ties may harm these outside parties. For example, members of the general public are harmed when large enterprises pollute the environment, fix prices, or violate human rights. In other cases, corporations are in a unique position to advance the interests of minorities or the social consensus of society at large by pursing policies that they would not otherwise ot herwise undertake; und ertake; policies poli cies designed to prevent or redress minority and a nd gender discrimination are paradigmatic examples. Because the welfare of such external constituencies depends on corporate activity, their relationship to the corporation in some ways resembles that of a principal who is left to depend on her agent’s actions. We note this parallel in the Tird Edition as well as the complementary point that many of the same legal strategies that mitigate agency problems among the core corporate constituencies can be—and be—and are—used are—used to protect or benefit its external constituencies. Te Tird Edition introduces other conceptual innovations that are less visible to readers but were no less energetically discussed by its authors. au thors. In particular, our chapters on creditor protection, fundamental corporate changes, and control transactions have been extensively revised and restructured. Our new author a uthor Professor Georg Ringe provided much of the energy as well as the research behind these changes, although many veterans—Paul veterans—Paul Davies, Hideki Kanda, Klaus Hopt, and Ed Rock—also contributed to these revisions. Professor Pargendler was the laboring oar on our many discussions of external constituencies. Despite the strong conceptual framework of the Anatomy , the Tird Edition remains “neutral” in the sense that it does not take t ake sides in important legal policy debates. Each of the contributors to the Anatomy has has strong views about questions such as economic and social value of worker codetermination and the t he extent to which jurisdictions ought to target the resources and organizational capabilities of large corporations to pursue extra-economic extraeconomic social ends. But the utility of the Anatomy ’s analytical framework is that it provides a context in which advocates of different positions on the major questions
Preface to the Tird Edition
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of the day can meet on common ground. We We do not suggest that other approaches to the analysis of corporate law are misguided. For example, accounts relying on political economy rather than functionality shed a great deal of light on legal developments in particular jurisdictions. Tey may be less useful, however, however, in sharpening policy discussions among competing advocates. Te last, and perhaps the key descriptor for a potential reader of the Anatomy is “short.” We have remained scrupulously loyal to the promise of previous editions to keep the Tird Edition no longer than its predecessor despite the considerable discussion and new research that underlies it. While academic traditions vary, I can speak personally to the temptation to lay aside even the most brilliant American law review articles before I reach their half- way way points. Academic journals elsewhere may be less taxing, but my co-authors co-authors assure me that there is no equivalent to the Geneva Conventions in the realm of legal treatises. Practitioners and those of our readers from other academic disciplines may not understand our “sacrifices,” individually and collectively, in pruning our prose and eviscerating our footnotes. Nor are they likely to appreciate the steely discipline of our general editors on this edition, John Armour and Luca Enriques, in resisting our collective drive to qualify, elaborate, and support our observations on almost every page of this volume. We We leave our readers to judge if the result has led us to overreach on some occasions and abandon nuance on others. But if so, we ask for forbearance. Our collective judgment at many points was that the risk of losing readership midway through this volume or of targeted consultation more than offset the danger of thin description and premature closure. A last point that deserves mention is the pervasive per vasive contribution of some authors to the Tird Edition that is not recognized in our attributions of authorship at the outset of each chapter of the book. All of us shared our expertise in the law of the jurisdictions that we knew best, but five contributors to this edition merit separate recognition for their work on behalf of the book as a whole. One is Mariana Pargendler who is not only a leading co-author co-author of Chapter 4 in the Tird Edition but also revised text in many chapters and added support to every chapter to t o reflect the inclusion of Brazil among our core jurisdictions. Elsewhere the law had evolved; with Brazil, we started from scratch. Our two Associate Authors, Sofie Cools and Gen Goto, have also made pervasive contributions to this edition through their indefatigable research efforts, especially (but not only) on recent French, EU, and Japanese developments. Tis is the first edition in which the Anatomy has has featured three generations of scholars. Te additions and refinement of Sofie and Gen appear in every chapter of the new Anatomy . Tey have also intervened actively in our internal discussions of big picture issues, including changes to our conceptual and expositional framework. I speak for all the authors of this edition in applauding their contributions to every chapter in the Tird Edition. Finally,, our two Finally t wo General Editors Editors— —John Armour and a nd Luca Enriques Enriques— —have literally made the Tird Edition possible after roughly the same number of years that separated the First and Second Editions. John and Luca have not only made major textual contributions to multiple chapters in this edition and its predecessor, they have also gracefully kept us on track for the past several years, counterbalanced the centripetal forces inflating our page numbers, and performed the final edits that allow us to speak in a distinctive voice across chapters and co-authors. co-authors. If coordinating academics is like herding cats, as the old saw goes, then not only coordinating their efforts but pruning and revising their prose is analogous to grooming cats while persuading them to march in parade formation.
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We are all immensely grateful. Tis edition of the Anatomy should We should be cited as John Armour,, Luca Enriques et al., Te Anatomy of Corporate Law: A Comparative and Armour Functional Approach (3rd edn., Oxford University Press 2017). Reinier Kraakman Harvard Law School September, 2016
Contents
List of Authors
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1. What Is Corporate Law? John Armour Armour,, Henry Hansmann, Hansmann, Reinier Kraakm Kraakman, an, and Mariana Pargendler 1.1 Introduction 1.2 What Is a Corporation? 1.2.1 1.2.2 1.2.3 1.2.4 1.2.5
Legal personality Limited liability ransfe ransferable rable shares Delegated management with a board structure structure Investor ownership
1.3 Sources of Corporate Law 1.3.1 Special and partial corporate forms 1.3.2 Other bodies of law
1.4 Law versus Contract in Corporate Affairs 1.4.1 Mandatory laws versus default default provisions provisions 1.4.2 benefits of legal rules 1.4.3 Te Choice of legal regime
1.5 What Is the Goal of Corporate Law? 1.6 What F Forces orces Shape Corporate Law? 2. Agency Probl Problems ems and Legal Strategies John Armour Armour,, Henry Hansmann, Hansmann, and Reinier Reinier Kraakman Kraakman 2.1 Tree Agency Problems 2.2 Legal Strategies Strategies for Reducing Reducing Agency Costs 2.2.1 2.2.2 2.2.3 2.2.4
Rules and standards Setting the the terms of entry and exit rustees rusteeship hip and reward Selection and removal removal
2.2.5 Initiation and ratification 2.2.6 Ex post and and ex ante strategies strategies
2.3 Disclosure 2.4 Compliance and Enforcement 2.4.1 Enforcement and intervention 2.4.2 Initiators of enforcement 2.4.3 Penalties
2.5 Legal Strategies Strategies in Corporate Corporate Context 2.6 Systematic Differences 3. Te Basic Governance Governance Structure: Te Interests of Shareholders as a Class John Armour Armour,, Luca Enriques, Enriques, Henry Hansmann, Hansmann, and Reinier Reinier Kraakman Kraakman 3.1 Delegated Management and Corporate Boards
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Contents
1
1 5 5 8 10 11 13 15 15 16 17 18 19 21 22 24 29 29 31 32 33 35 37 37 37 38 39 39 40 43 45 45 49 50
3.2 Appointment and Decision Decision Rights 3.2.1 3.2.2 3.2.3 3.2.4
Appointing directors Removing directors Decision rights Shareholder coordination
3.3 Agent Incentives 3.3.1 Te trusteeship strategy: Independent Independent directors directors 3.3.2 Te rewar reward d strategy: Executive compensation
3.4 Legal Constraints and Affiliation Affiliation Rights 3.4.1 Te constraints strategy 3.4.2 Corporate governancegovernance-related related disclosure
3.5 Explaini Explaining ng Jurisdiction Jurisdictional al Variatio ariation n 4. Te Basic Governance Structur Structure: e: Minority Minority Shareholde Shareholders rs and Non-Shareholder Non-Shareholder Constituencies Luca Enriques, Henry Hansmann, Reinier Kraakman, and Mariana Pargendler 4.1 Protecti Protecting ng Minority Minority Shareholder Shareholderss 4.1.1 Shareholder appointment rights and deviations deviations from one-share– one-share–oneone-vote vote 4.1.2 Minority shareholder decision rights 4.1.3 Te incentive strategy: rustees rusteeship hip and equal treatment Constraints and affiliation rights 4.2 4.1.4 Protecting Employees 4.2.1 Appointment and decision decision rights strategies 4.2.2 Te incentives incentives and constraints strategies
4.3 Protecti Protecting ng External Constituencies 4.3.1 Affiliation strategies 4.3.2 Appointment and decision decision rights strategies 4.3.3 Te incentives incentives and constraints strategies
4.4 Explaining Jurisdictional Jurisdictional Differences Differences and Similaritie Similaritiess 4.4.1 Te lawlaw-onon-thethe-books books 4.4.2 Te law in practice
5. ransac ransactions tions with Creditors John Armour Armour,, Gerard Gerard Hertig, Hertig, and Hideki Kanda Kanda 5.1 Asset Partitioning Partitioning and Agency Problems Problems
51 53 55 57 58 62 62 66 68 69 71 72 79
79 80 84 84 88 89 90 91 92 94 95 97 100 100 102 109
5.4.1 Regulatory or contractual controls for solvent firms?
110 110 111 116 119 119 124 127 128 135 140 141
5.4.2 Te role role of bankruptcy law
142
5.1.1 Asset partitioning and corporate creditors 5.1.2 Shareholder–creditor Shareholder–creditor agency problems 5.1.3 Creditor–creditor Creditor–creditor coordination and agency problems
5.2 Solvent Firms 5.2.1 Te affiliation strategy— strategy—mandatory mandatory disclosure 5.2.2 Te rules strategy: Legal capital
5.3 Distressed Firms 5.3.1 Te standards strategy 5.3.2 Governance strategies
5.4 Ownership Regimes Regimes and Creditor Protect Protection ion
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6. RelatedRelated-Party Party ransactions Luca Enriques, Gerard Hertig, Hideki Kanda, and Mariana Pargendler 6.1 Why Are RelatedRelated-Party Party ransactions Permitted at All? 6.2 Legal Strategies Strategie s for Related-Party ransac ransactions tions 6.2.1 6.2.2 6.2.3 6.2.4 6.2.5
Te affiliation strategy Agent incentives strategies Te decision decision rights strategy: strategy: Shareholder Shareholder voting Te rules strategy: Prohibiting Prohibiting conflicted conflicted transactions Te standards strategy: Te duty of loyalty and intra-group
transactions review 6.3 Ownership Regimes and RelatedRelated-Party Party ransact ransactions ions
7. Fundamental Changes Edward Rock, Paul Davies, Hideki Kanda, Reinier Kraakman, and Wolf-Georg Wolf-Georg Ringe 7.1 What are Fundamental Changes in the the Relationship among the Participants in the Firm? 7.2 Charter Amendments 7.2.1 Te management– management–shareholder shareholder conflict in charter amendments 7.2.2 Te majority–minority majority–minority shareholder conflict in charter amendments
7.3 Share Issuance 7.3.1 Te manager– manager–shareholder shareholder conflict 7.3.2 Te majority– majority–minority minority conflict
7.4 Mergers and Divisions 7.4.1 7.4.2 7.4.3 7.4.4
Te management– management–shareholder shareholder conflict in mergers Te majority– majority–minority minority shareholder conflict in mergers Te protection of non-shareholder non-shareholder constituencies in mergers Corporate divisions
7.5 Reincorporation and Conversion 7.6 General Provisions Provisions on Significan Significantt ransac ransactions tions 7.7 Explaining Differences Differences in the Regulation Regulation of Fundamental Fundamental Changes 8. Control ransact ransactions ions Paul Davies, Klaus Hopt, and a nd WolfWolf- Georg Ringe Rin ge 8.1 Regulato Regulatory ry Problems Problems in Control ransac ransactions tions 8.1.1 Control transactions 8.1.2 Agency and coordination coordination issues
8.2 Agency Problems in Control ransac ransactions tions 8.2.1 Te decision rights choice: Shareholders Shareholders only or shareholders and board jointly 8.2.2 Te “no frust frustration” ration” rule 8.2.3 Joint decisiondecision-making making 8.2.4 Pre-bid Pre-bid defensive measures
8.3 Coordina Coordination tion Problems Problems among arget Shareholders 8.3.1 8.3.2 8.3.3 8.3.4
Disclosure rustee rusteeship ship strate strategy gy Reward (sharing) strategy Exit rights: Mandatory Mandatory bid rule and keeping the the offer open
8.3.5 Acquisition of nonnon-accepting accepting minorities
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Contents
145 146 147 147 153 156 158 161 166 171
172 174 178 178 180 180 181 183 185 188 192 194 196 199 201 205 205 205 207 211 211 212 215 222 224 224 226 226 227 230
8.4 Specific Issues upon upon Acquisition from a Controlling Controlling Shareholder Shareholder 8.4.1 Exit rights and premiumpremium-sharing sharing 8.4.2 Facilitating bids for controlled companies companies
8.5 Explaini Explaining ng Differences in the Regulatio Regulation n of Control ransac ransaction tion 8.5.1 8.5.2 8.5.3 8.5.4
Differences in form and differences in substance Different regulatory environments Political economy considerations Regulatory uncertainty
9. Corporate Law and Securities Markets Luca Enriques, Gerard Hertig, Reinier Kraakman, and Edward Rock 9.1 Securities Regulation and Legal Strategies 9.1.1 Why securities regulation? 9.1.2 Affiliation terms strategies 9.1.3 Governance and regulatory regulatory strategies
9.2 Securities Law Enforcement 9.2.1 Public enforcement 9.2.2 Private enforcement 9.2.3 Gatekeeper control
9.3 Convergence and Persistence Persistence in in Securities Regulation
231 232 234 236 237 238 239 240 243 244 244 245 256 258 259 260 263 264
10. Beyond the Anatomy 10. John Armour Armour,, Luca Enriques, Enriques, Mariana Pargendler Pargendler,, and Wolfolf-Georg Georg Ringe 10.1 Beyond the Analysis 10.2 Beyond the Scope 10.3 Beyond the Present
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Index
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267 268 269
List of Authors John Armour is is Hogan Lovells Professor of Law and Finance at Oxford and a Fellow of the European Corporate Governance Institute. He was previously a member of the Faculty of Law and the interdisciplinary Centre for Business Research at the University of Cambridge. He has held visiting posts at various institutions including the University of Chicago, Columbia Law School, the University of Frankfurt, the Max Planck Institute for Comparative Private Law, Hamburg, and the University of Pennsylvania Law School. His main research interests lie in company law, corporate insolvency law and financial regulation, in which areas he has published widely. He has been involved in policy projects commissioned by the UK’s Department of rade and Industry, Financial Services Authority and Insolvency Service, the Commonwealth Secretariat and the World Bank. He currently serves as a member of the European Commission’s Informal Company Law Expert Group. Paul Davies Davies is a Senior Research Fellow in the Centre for Commercial Law at Harris Manchester College, University of Oxford. He was the Allen & Overy Professor of Corporate Law, University of Oxford, between 2009 and 2014. Between 1998 and 2009 he was the Cassel Professor of Commercial Law at the London School of Economics and Political Science. He was a member of the Steering Group for the Company Law Review which preceded the enactment of the Companies Act 2006, and has been involved recently in policy-related policy-related work for the UK reasury. His most recent works include the 10th edition of Gower and Davies, P M C L L (Sweet & Maxwell 2016, with Sarah Worthington); Worthington); and I C L L (2nd edn., OUP 2010). He is a Fellow of the European Corporate Governance Institute, a Fellow of the British Academy and an honorary Queen’s Counsel. Luca Enriques Enriques is the Allen & Overy Professor of Corporate Law in the Faculty of Law, University of Oxford and an ECGI Research Fellow. He has been Professor of Business Law at the University of Bologna and LUISS-Rome. LUISS-Rome. Between 2007 and 2012 he served as a Commissioner at Consob, the Italian Securities and Exchange Commission. He has been Visiting Professor at various institutions, including Harvard Law School, Instituto de Impresa (Madrid), and IDC Herzliya. He has published several books and articles on topics relating to corporate law, corporate governance, and financial regulation. Recent publications include Creeping Acquisitions in Europe: Enabling Companies to Be Better Safe than Sorry (with (with Matteo Gatti), 15 J C L S 55 (2015), and Disclosure and Financial Market Regulation (with Sergio Gilotta), in O H F R (OUP 2015). He is a co-author, co-author, together with John Armour, Paul Davies, and others, of P F R R (OUP 2016). Henry Hansmann is Hansmann is the Oscar M. Ruebhausen Professor of Law at the Yale Law School. His scholarship has focused principally on the law and economics of organizational ownership and structure, and has dealt with all types of legal entities, both profit-seeking profit- seeking and nonprofit, private and public. He has been Professor or Visiting Professor at Harvard University, University, New York York University,, and the University of Pennsylvania Law Schools. Recent publications include Legal University Entitiess as ransferable Bundles Entitie Bundl es of Contracts (with (with Kenneth Ayotte), 111 M L L R 715 (2013), and External and Internal Asset Partitioning: Corporations and Teir Subsidiaries (with Richard Squire), in Jeffrey Gordon and Georg Ringe (eds.), O H C G G (OUP 2017). He is a Fellow of the American Academy of Arts Ar ts and Sciences and the European Corporate Governance Institute. Gerard Hertig is is Professor of Law at EH Zurich and a ECGI research fellow. He was previously Professor of Administrative Law and Director of the Centre d’Etudes Juridiques
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List of Authors
Européennes at the University of Geneva Law School (1987–95). (1987–95). He has been a Visiting
Professor at leading law schools in Asia, Europe, and the U.S. and practiced law as a member Making During the Crisis: Why Did of the Geneva bar. Recent publications include Decision- Making the reasury Let Commercial Banks Fail? (with Ettore Croci and Eric Nowak), J World , in E F (2016); Governance by Institutional Investors in a Stakeholder World O H C L G (OUP 2017); Shadow Resolutions as a No-No No-No in a Sound Banking Union, with Luca Enriques, in F R: A P (CUP, 2015). Klaus Hopt was Director of the Max Planck Institute for Comparative and International Private Law in Hamburg, Germany Germany.. His main areas of specialization include commercial law, corporate law, law, banking, and securities regulation. He has been Professor of Law in übingen, übingen, Florence, Bern, and Munich, Visiting Professor at numerous universities in Europe, Japan, and the U.S. including University of Pennsylvania, University of Chicago, NYU, Harvard, and Columbia, and Judge at the Court of Appeals, Stuttgart, Germany. Germany. He served as a member of the High Level Group of Experts mandated by the European Commission to recommend EU company and takeover law reforms. He is a Member of the German National Academy (Leopoldina). Recent publications include C C G (CUP, 2013, with Andreas Fleckner (eds.)) and C B L P (OUP, 2013, with Paul Davies et al. (eds.)). Hideki Kanda is is Professor of Law at Gakushuin University Law School since 2016. His main areas of specialization include in clude commercial law, corporate law, law, banking regulation, and securities regulation. He was Professor of Law at the University of okyo until 2016. He also was Visiting Professor of Law at the University of Chicago Law School (1989, 1991, and 1993) and at Harvard Law School (1996). Recent publications include C C L (18th edn., Kobundo, 2016, in Japanese), C C G (OUP, 1998, with Klaus Hopt et al. (eds.)), and E C L (University of okyo Press, 1998, with Yoshiro Yoshiro Miwa and Noriyuki Yanagawa Yanagawa (eds.), in Japanese). Reinier Kraakman is Kraakman is the Ezra Ripley Tayer Professor of Law at Harvard Law School and a Fellow of the European Corporate Governance Institute. He has written numerous articles on corporate law and the economic analysis of corporate liability regimes. He teaches courses in corporate law, law, corporate finances, and seminars on the theory of corporate law and comparative corporate governance. He is the author, with William . Allen, of C C L B C, which is now in its fifth edition (Wolters Kluwer, 2016). His more recent articles include Market Efficiency after the Financial Crisis: It’s Still a Matter of Information Costs (with Ronald J. Gilson), 100 V L R 313 (2014); Economic Policy and the Vicarious Liability of Firms , in R H E (Edgar Elgar, 2013); Law and the Rise of the Firm (with Henry Hansmann and Richard Squire), 119 H L R 1333 (2006); and Property, Contract, and Verification: Te Numerus Numerus Clausus Problem and the Divisibility of Rights (with (with Henry Hansmann), 31 J L S S373 (2002). Mariana Pargendler is is Professor of Law at FGV Law School in São Paulo (FGV Direito SP), where she directs the Center for Law Law,, Economics, and Governance. She is also Global Associate Professor of Law at New York University School of Law and has been a Visiting Professor of Law at Stanford Law School. She is the author of numerous articles on corporate law and comparative corporate governance. Her main recent publications include Te Evolution of Shareholder Voting Voting Rights: Separation of Ownership and Consumption (with Henry Hansmann), 123 Y L J (2014), Politics in the Origins: Te Making of Corporate Law in Nineteenth-Century NineteenthCentury Brazil , 60 A J C L 805 (2013), and State Ownership and Corporate Governance , 80 F L R 2917 (2012).
List of Authors
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is Professor of Law at the University of Hamburg where he directs the Wolf W olf-Georg Georg Ringe Ringe is
Institute of Law & Economics. He is also Visiting Professor at the University of Oxford, Faculty of Law. Between 2012–17, he was Professor of International Commercial Law at Copenhagen Business School. He has held visiting positions at various institutions in Europe and North America, including Columbia Law School and Vanderbilt University. He is the editor of the new J F R, R, which is published by the OUP since 2015. Professor Ringe has been involved in policy work with both the European Commission and the European Parliament on issues of European Corporate Law. His current research interests are in the general areas of law and finance, comparative corporate governance, capital and financial markets, insolvency law, and conflict of laws. Recent publications include D E (OUPwith 2016) and Gordon O L L G (OUP 2017, Jeffrey (eds.)).H C Edward Rock is is Professor of Law at New York York University Law School and director of NYU’s NYU’s Institute for Corporate Governance and Finance. He writes widely on corporate law, has been Visiting Professor at the Universities of Frankfurt am Main, Jerusalem, and Columbia, and has practiced law as a member of the Pennsylvania bar. Recent publications include Does Majority Voting Improve Board Accountability? (with Stephen Choi, Jill Fisch, and Marcel Kahan), 83 U C L R (2016), Institutional Investors in Corporate Governance , in O H C L G (OUP 2017), and Symbolic Corporate Governance Politics (with (with Marcel Kahan), 94 B U L R 1997 (2014).
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What Is Corporate Law? John Armour Armour,, Henry Hansmann, Hansmann, Reinier Reinier Kraakman, Kraakman, and Mariana Pargendler
1.1 Introduction What is the common structure of of corporate (or company) law across different jurisdictions? Although this question is rarely asked by corporate law scholars, it is critically important for the comparative investigation of the subject. Existing scholarship often emphasizes the divergence among European, American, Japanese, and emerging market corporations in terms of corporate governance, share ownership, capital markets, and business culture.¹ But, despite the very real differences across jurisdictions along these dimensions, the underlying uniformity of the corporate form is at least as impressive. Business corporations have a fundamentally similar set of legal characteristics— and face a fundamentally similar set of legal l egal problems—in problems—in all jurisdictions. regard, the basic legalarecharacteristics of the businessmost corporation. oConsider, anticipateinourthis discussion below, there five of these characteristics, of which will be easily recognizable to anyone familiar with business affairs. Tey are: legal personality, limited liability, transferable shares, delegated management under a board structure, and investor ownership. Tese characteristics respond—in respond—in ways we will explore—to explore— to the economic exigencies of the large modern business enterprise. Tus, corporate law everywhere must, of necessity, provide for them. o be sure, there are other forms of business enterprise that lack one or more of these characteristics. But the remarkable fact—and fact—and the fact that we wish to stress—is stress—is that, in market economies, almost all large-scale large-scale business firms adopt a legal form that possesses all five of the basic characteristics of the business corporation. Indeed, most small jointly owned firms adopt this corporate form as well, although sometimes with deviations from one or more of the five basic characteristics to fit their special needs. It follows that athat principal function corporate law is toBy provide business enterprises with a legal form possesses these offive core attributes. making this form widely available and user-friendly user-friendly,, corporate law enables business participants to transact easily through the medium of the t he corporate entity, entity, and thus lowers the costs of conducting business. Of course, the number of provisions that the typical corporation statute devotes to defining the corporate form is likely to be only a small part of the statute as a ¹ See e.g. Ronald J. Gilson and Mark J. Roe, Roe, Understa Understanding nding the Japanese Keiretsu: Overlaps Between Corporation Governance and Industrial Organization, Organization, 102 Y L J 871 (1993); Bernard S. Black and John C. Coffee, Hail Britannia? Institutional Investor Behavior Under Limited Regulation, Regulation, 92 M L R 1997 (1994); V V C (Peter A. Hall and David Soskice eds., 2001); Mark J. Roe, P D C G (2003); C G C: C, S, M E, J, US (Klaus J. Hopt al. eds., eds., 2005); C C L: A C-B A (Mathias C Siems and Davidet Cabrelli 2013). Te Anatomy of Corporate Law. Tird Edition. Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry Hansmann, Gerard Hertig, Klaus Hopt, Hideki Kanda, Mariana Pargendler, Wolf-Georg Ringe, and Edward Rock. Chapter 1 © John Armour Armo ur,, Henry Henry Han Hansman smann, n, Reinie Reinierr Kraakm Kraakman, an, and Mar Mariana iana Pa Pargen rgendler dler,, 2017. 2017. Pub Publish lished ed 2017 2017 by Oxfor Oxfordd Unive Universit rsityy Press Press..
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whole.² Nevertheless, Nevertheless, these are the provisions that comprise the legal core of corporate law that is shared by every jurisdiction. In this chapter chapter,, we briefly explore the contract-
ing efficiencies that accompany these five features of the corporate form, and that, we believe, have helped to propel the worldwide diffusion of the corporate form. However, our principal focus in this book is not on the basic attributes that define the corporate form. Rather, it is on a second, equally important function of corporate law: namely, namely, reducing the ongoing costs of organizing business through the corporate form. Corporate law does this by facilitating coordination between participants in corporate enterprise, and by reducing the scope for value-reducing value-reducing forms of opportunism among different constituencies. As we outline in Section 1.2, corporate laws everywhere shareofcore featurestheir which can be in understood as serving to reduce the costs for participants organizing activities business firms.³ Most of corporate law can be understood as responding to three principal sources of opportunism that are endemic to such organization: conflicts between managers and shareholders, conflicts between controlling and nonnon-controlling controlling shareholders, and conflicts between shareholders and the corporation’s other contractual counterparties, including particularly creditors and employees. All three of these generic conflicts may usefully be characterized as what economists call “agency problems.” problems.” Chapter 2 examines these three agency problems, both in general and as they arise in the corporate context, and surveys the range of legal strategies that can be employed to tackle those problems. Te reader might object that these three types of coordination costs and agency conflicts are not uniquely “corporate.” After all, any form form of jointly owned enterprise faces coordination costs and engenders conflicts among its owners, managers, and thirdparty contractors. We We agree; insofar as the t he corporation is only one of several legal forms for the jointly owned firm, it faces the same generic functional challenges that confront all jointly owned firms. Nevertheless, the particular characteristics of the corporate form matter a great deal, since it is the form chosen by most large-scale large- scale enterprises— and, as a practical matter, the only form that firms with widely dispersed ownership can choose in many jurisdictions. In our view, view, this is because its particular characteristics make it uniquely effective at minimizing coordination costs. More Moreover over,, these same features determine the particular contours of its agency problems. o o take an obvious example, the fact that shareholders enjoy limited liability— liabili ty—while, while, say, general partners in a partnership do not—has not—has traditionally made creditor protection far more salient in corporate law than it is in partnership law. Similarly, the fact that corporate investors may trade their shares is the foundation of the anonymous trading stock market—an market—an institution that has encouraged the separation of ownership from control, and so has sharpened the management–shareholder management–shareholder agency problem. In this book, we explore the role of corporate law in minimizing coordination and agency problems—and problems—and thus, making the corporate form practicable—in practicable—in the most ² We use the term “corporation statute” statute” to refer to the general law that governs corporations, and not to a corporation corporation’’s individual charter (or “articles of incorporation,” as that document is sometimes also called). ³ Tese include the costs of searching for contracting partners and negotiating and drafting the the relevant agreements. Although such costs are often referred to as “transaction costs,” we eschew this term because it is also used more broadly in other contexts, rendering it a fertile source of confusion. Tis is because in most jurisdictions, only firms taking the corporate form may raise equity finance from capital markets. However, there are exceptions to this general proposition. For example, in the U.S., theregistered equity securities of trading. so-called “master” limited partnerships and limited liability comso-called panies may be for public
Introduction
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important categories of corporate actions a ctions and decisions. More particularly, particularly, Chapters 3 to 9 address seven categories of transactions and decisions that involve the corporation, its owners, its managers, and the other parties with whom it deals. Most of
these categories of firm activity acti vity are, again, generic, rather than uniquely corporate. For example, Chapters 3 and 4 address governance mechanisms that operate over the firm’s ordinary business decisions, while Chapter 5 turns to the checks that operate on the corporation’s transactions with creditors. As before, however, although similar agency problems arise in similar contexts across all forms of jointly owned enterprise, the response of corporate law turns in part on the unique legal features that characterize the corporate form. aken together, the law book how coverthe nearly of the important i mportant problems in corporate lalatter w. Inseven eachchapters chapter, of weour describe basicallcoordination costs and agency problems of the corporate form manifest themselves in a given category of corporate activity activi ty,, and then explore the range of alternative alt ernative legal responses that tha t are available. We illustrate these alternative approaches with examples from the corporate laws of various prominent jurisdictions. jurisdi ctions. We We explore the patterns of homogeneity homogeneit y and heterogeneity that appear. Where there are significant differences across jurisdictions, we seek to address both the sources and the consequences conseq uences of those differences. Our examples are drawn principally from a handful of major representative jurisdictions, which we label our “core jurisdictions.” Tese are Brazil, France, Germany, Germany, Italy, Italy, Japan, the UK, and the U.S., though we sometimes make incidental reference to the laws of other jurisdictions to make particular points. We do not—and not—and cannot, in a short book—attempt book—attempt to be comprehensive in our coverage of the substantive law; rather we make reference to the laws of these jurisdictions as appropriate to illustrate and develop analytic propositions. In focusing on the jurisdictions we know best, an element of subjectivity is of course introduced. Tis reflects a heuristic endeavor on our part: the goal is not so much to provide a definitive account of corporate laws anywhere (let alone everywhere), but a common language for understanding them. In emphasizing a strongly functional approach to the issues of comparative law, this book differs from some of the more traditional comparative law scholarship, both in the field of corporate law and elsewhere. We join an emerging tendency in comparative law scholarship by seeking to give a highly integrated view of the role and structure of corporate law that provides a clear framework within which to organize an understanding of individual systems, both alone and in comparison with each other. other. Moreover More over,, while comparative law scholarship often has a tendency to emphasize differences between jurisdictions, our approach is to highlight similarities similarit ies as well. Doing so illuminates an underlying commonality of structure that transcends national boundaries. It also provides an important perspective on the basis for the international crossfertilization of corporate law that has become more common in the wake of the growth of global economic activity. activity. Wee realize that the term “fun W “functional, ctional,”” which we have used here and in our title, means different things to different people, and that some of the uses to which that term has been put in the past—particularly past—particularly in the field of sociology— sociology—have have made it justifiably Compare e.g. L B C C G P H C: C: A C C A (Arthur R. Pinto and Gustavo Visentini eds., 1998); Gunther H. Roth and Peter Kindler, S C L (2013). Other examples of this approach include John Armour et al., P F R Curtis Milhaupt (2016); and Katharina Gregor Bachmann Pistor, Let al., C R(2008). C C (2012);
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suspect. It would perhaps be more accurate to call our approach “economic” rather than “functional,” “functional,” though the sometimes tendentious use of economic argumentation in legal literature to support particular (generally laissez-faire) laissez-faire) policy positions, as well
as the tendency in economic analysis to neglect non-pecuniary non-pecuniary motivations or assume an unrealistic degree of rationality in human action, have also caused many scholars— particularly outside the U.S.—to U.S.—to be as wary of “economic analysis” anal ysis” as they are of “functional analysis.” For the purposes at hand, however, we need not commit ourselves on fine points of social science methodology. We need simply note that the exigencies of commercial activity and organization present practical problems that are roughly similar in market economies throughout the world. Our analysis is “fu “functional” nctional” in the sense that we organize around ways which corporate lawstorespond these problems, and thediscussion various forces thatthe have ledindifferent jurisdictions choose to roughly similar—though similar— though by no means always the same—solutions same—solutions to them. Tat is not to say that our objective here is just to explore the commonality of corporate law across jurisdictions. Of equal importance, we wish to offer a common and a general analytic framework with with which to understand the purposes that language and can potentially be served by corporate law, and with which to compare and evaluate the efficacy of different legal regimes in serving those purposes. Indeed, it is our hope that the analysis offered in this book will be of use not only to students of comparative law, but also to those who simply wish to have a more solid framework within which to view their own country’s corporation law. Nor does emphasizing similarities in underlying structure str ucture mean ignoring differences between countries’ corporate laws. Even if, as we think, corporate laws everywhere respond similar economic problems, thereother mayaspects be differences in the way they do so, oftentoreflecting local variety in the way of the system of economic production are organized. Te basis for such differences in corporate law rules is consequently illuminated by reference to the broader economic environment. Yet Yet in other cases, differences may result from the various concerns of domestic politics over distribution or from diverse interest group dynamics. Our unitary account cannot explain the presence of such differences, but it does have implications for their persistence. o o the extent that such matters impede corporate law’s ability to respond to economic exigencies, they will in time ti me face economically motivated pressure for reform. Tat said, we take no strong stand here in the enduring debate on the extent to which corporate law is or should be “converging, “converging,”” much less on to what it might converge. Tat is a subject on which reasonable minds (including, indeed, the authors of this book) can reasonably disagree.¹ Rather, Rather, we are seeking to set out a conceptual In very general terms, our approach echoes that taken by Robert Clark in his important treatise, treatise, C L (1986), and Frank Easterbrook and Daniel Fischel, in their discussion of U.S. law, E S C L (1991). However, our analysis differs from—and from— and goes beyond—that beyond—that offered by these and other commentators in several key respects. Most obviously, we both present a comparative analysis that addresses the corporate law of multiple jurisdictions and provide an integrated functional overview that stresses the agency problems at the core of corporate law,, rather than focusing on more law mo re particular legal institutions i nstitutions and solutions. See Section 1.6. See e.g. C P C G (Jeffrey N. Gordon and Mark J. Roe eds., 2004), C C G: A F I I A (Andreas M. Fleckner and Klaus J. Hopt eds., 2013). 2 013). ¹ Te views of the authors of this chapter are briefly set out in Henry Hansmann and Reinier Kraakman, Te End of History for Corporate Law , 89 G L J 439 (2001); Henry Hansmann and Reinier Kraakman, Reflections on the End of History for Corporate Law , in C C G: P P (Abdul Rasheed and oru
What Is a Corporation?
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framework and a factual basis with which that and other important issues facing corporate law can be fruitfully explored.
1.2 What Is Is a Corporation? As anticipated, the five core structural characteristics of the business corporation are: (1) legal personality, (2) limited liability, (3) transferable shares, (4) centralized management under a board structure, and (5) shared ownership by contributors of equity capital. In virtually all economically important jurisdictions, there is a basic statute that suggests, provides for formation ofhave firmsstrongly with allcomplementary of these characteristics. As this pattern thesethecharacteristics qualities for many firms. ogether, they make the corporation especially attractive for organizing productive activity. But these characteristics also generate tensions and tradeoffs that lend a distinctively corporate character to the agency problems that corporate law must address. 1.2.1 Legal personality In the economics literature, a firm is often characterized as a “nexus of contracts.”¹¹ As commonly used, this description is ambiguous. It is often invoked simply to emphasize that most of the important relationships within a firm—including, firm—including, in particular, those among the firm’s firm’s owners, managers, manager s, and employees— empl oyees—are are essentially contractual in character. Tis is anrelationships. important insight, but it does notaccurate distinguish firms from other of contractual It is perhaps more to describe a firm as networks a “nexus contracts,” in the sense that a firm serves, fundamentally, as the common counter for contracts,” party in numerous contracts with suppliers, employees, and customers, coordinating the actions of these multiple persons through exercise of its contractual rights. Te first and most important contribution of corporate law, as of other forms of organizational law, is to permit a firm to serve this coordinating role by operating as a single contracting party that is distinct from the various individuals who own or manage the firm. In so doing, it enhances the ability of these individuals indiv iduals to engage together in joint projects. Te core element of the firm as a nexus for contracts is what civil lawyers refer to as “separate “se parate patrimony. patrimony.” Tis involves the demarcation of a pool of assets that are distinct dist inct from other assets owned, singly or jointly, by the firm’s owners (the shareholders),¹² and of which the firm itself, acting through its designated managers, is viewed in law as being the owner. Te firm’s entitlements of ownership over its designated assets include Yoshikawa eds., 2012); John Armour, Simon Deakin, Priya Lele, and Mathias Siems, How Do Legal Yoshikawa Rules Evolve? Evidence from a CrossCross-Country Country Comparison of Shareholder, Creditor, and Worker Protection, Protection , 57 A J C C L L 579, 619– 619–29 29 (2009); and Mariana Pargendler, Pargendler, Corporate Governance in Emerging Markets , in O H C L G (Jeffrey N. Gordon and Wolfolf-Georg Georg Ringe eds., 2017). ¹¹ Te characterization of a firm as a “nexus of contracts” originates with Michael Jensen and William Meckling, Teory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure , 3 J F E 305 3 05 (1976), (1976 ), building on Armen Alchian and Harold Demsetz, Production, Information Costs, and Economic Organization, Organization, 62 A E R 777 (1972). ¹² We use the term “owners” “owners” simply to refer to the group who have the entitlement to control the firm’’s assets. For an account of how this relates to the legal firm le gal concept of “o “ownership” wnership” see John Armour and Michael J. Whincop, Te Proprietary Foundations of Corporate Law , 27 O J L S 429, 436–48 436–48 (2007).
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What Is Corporate Law?
the rights to use the assets, to sell them, and—of particular importance— importance—to to make them available for attachment by its creditors. Conversely, because these assets are conceived as belonging to the firm, rather than the firm’s owners, they are unavailable for attachment by the owners’ personal creditors. Te core function of this separate
patrimony has been termed “entity shielding,” to emphasize that it involves shielding the assets of the entity—the entity—the corporation—from corporation—from the creditors of the entity’s owners.¹³ Entity shielding involves two relatively distinct rules of law. Te first is a priority rule that grants to creditors of the firm, as security for the firm’s debts, a claim on the firm’s assets that is prior to the claims of the personal creditors of the firm firm’’s owners. Tis rule is shared by modern legal forms for enterprise organization, including partnerships.¹ Te consequence of available this priority is that a firm’ firm’of s assets are, as aliabilities default rule of law law,¹ ,¹ automatically made for rule the enforcement contractual entered into in the name of the firm.¹ By thus bonding the firm’s contractual commitments, the rule makes these commitments credible. Te second component of entity shielding—a shielding—a rule of “liquidation protection”— provides that the individual owners of the corporation (the shareholders) cannot withdraw their share of firm assets at will, nor can the personal creditors of an individual owner foreclose on the owner’s share of firm assets.¹ Such withdrawal or foreclosure would force partial or complete liquidation of the firm. So the liquidation protection rule serves to protect the going concern value of the firm against destruction by individual shareholders or their creditors.¹ In contrast to the priority rule just discussed, di scussed, it is not found in some other standard legal forms for enterprise organization, such as the partnership.¹ Legal entities, such as the business corporation, that are characterized by both these rules—priority rules—priority for business creditors and shielding, liquidationasprotection—can protection— therefore be thought of as having “strong-form” entity opposed to can the “weak-form” entity shielding found in partnerships, which are usually characterized only by the priority rule and not by liquidation protection. By isolating the value of the firm from the personal financial affairs of the firm’s owners, strong-form entity shielding facilitates tradability of the firm’s shares, which is the third characteristic of the corporate form. ² ¹³ Te term “entity shielding” derives from Henry Hansmann, Reinier Kraakman, and Richard Richard Squire, Law and the Rise of the Firm Firm,, 119 H H L L R 1333 (2006). Te centrality of entity shielding to organizational law is explored in Henry Hansmann and Reinier Kraakman, Te Essential Role of Organizational Law , 110 Y L L J 387 (2000), where w here this same attribute was labelled “affirmative asset partitioning. partitioning.”” While evenrecognize unregistered common law partnerships to this rule priority priority rule, many civil law¹jurisdictions a class of unregistered u nregistered “partnershare “partnerships” ips”subject that lack rul e of priority. In effect, such partnerships are just special forms for the joint management of assets rather than distinct entities for purposes of contracting. ¹ On default rules, see Section 1.4.1. ¹ Te effect is the same as if the firm’s firm’s owners had themselves entered into a joint contract and granted non-recourse non-recourse security over certain personal assets to the counterparty, as opposed to transferring those assets to the corporate entity, entity, and then procuring the company to enter into the contract. ¹ Hansmann and Kraakman, note 13, at 411–13. ¹ Edward B. Rock and Michael L. Wachter Wachter,, Waiting for the Omelet to Set: Match-Specific Match- Specific Assets and Minority Oppression in Close Clo se Corporations , 24 J C L 913, 918–20 918– 20 (1999); Margaret M. Blair, Locking in Capital: What Corporate Law Achieved for Business Organizers in the Nineteenth Century , 51 UCLA L L R 387, 441–9 441– 9 (2003). ¹ Tat said, it is possible in many jurisdictions to effect liquidation protection by agreement amongst the owners of a partnership. ² While strong-form entity shielding seems essential for free tradability of shares shares (see Hansmann and Kraakman, note 13), limited liability does not: so long as shareholder liability for a firm’s debts is pro rata rather than joint and several, free tradability of shares is feasible with unlimited personal
What Is a Corporation?
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Te benefits of these two rules—creditor rules—creditor priority and liquidation protection— reinforce one another where the “assets” in question comprise contractual agreements.²¹ An increasingly important part of a firm’s value creation comes from the interaction of the various contracts it has negotiated. Tese two rules assure counter-
parties that their t heir performance will be delivered by reference to the value generated by that bundle of contracts and the associated assets, amongst which there will typically be complementarities. Not only does this make it easier to negotiate such contracts, but it also facilitates liquidity on the part of shareholders. It It is far easier for the owner of a corporation to transfer her shares than it would be for a sole proprietor to transfer her contracts. For a firm servemust effectively as specifying a contracting party,parties two other types of rules arehave also needed. First,tothere be rules to third the individuals who authority to buy and sell assets in the name of the firm, and to enter into contracts that are bonded by those assets.²² While participants in a firm are to a large extent free to specify the delegation of authority by contract amongst themselves, background rules are needed—beyond needed—beyond such contractual agreement— agreement—to to deal with situations where agents induce third parties to rely on the mere appearance of their authority. Such rules differ according to organizational form. Te particular rules r ules of authority governing the corporation are treated below as a separate core characteristic, “delegated management.” Tey provide that a subset of corporate managers (such as the board of directors or certain officers), as opposed to individual owners, has power to bind the company in contract.²³ Second, there must be rules specifying the procedures by which both the firm and its counterparties can bring lawsuits on the contracts entered into in the name of the firm. are subject rules thatany make such suits easy to bring as aon, procedural Corporations matter. In particular, theytoeliminate need to name, or serve notice the firm’s individual owners—procedures owners—procedures that plagued the Anglo- American American partnership until the late l ate nineteenth century. Te outcomes achieved by each of these three types of rules—entity shielding, authority, and procedure—require procedure—require dedicated legal doctrines to be effective in the sense that, absent such doctrines, they could not be replicated simply by contracting among a business’s owners and their suppliers and customers. Tat is, the law here serves to reduce the costs of doing business. Entity shielding doctrine is needed to create common expectations, among a firm and its various present and potential creditors, concerning the effect that a contract between a firm and one of its creditors will have on the security available to the firm’ firm’s other creditors.² Rules governing the allocation shareholder liability for corporate debts: see Henry Hansmann and Reinier Kraakman, oward Unlimited Shareholder Liability for Corporate orts , 100 Y L J 1879 (1991); Charles R. Hickson and John D. urner, Te rading of Unlimited Liability Bank Shares in Nineteenth-Century Nineteenth- Century Ireland: Te Bagehot Hypothesis , 63 J E H 931 (2003). (20 03). ²¹ Kenneth Ayotte and Henry Hansmann, Hansmann, Legal Entities as ransferable Bundles of Contracts , 111 M L R 715 (2013). ²² Armour and Whincop, note 12, at 441–2. 441–2. ²³ Associated rules—such rules—such as the doctrine of ultra vires —may also prescribe limits as to the extent to which managers may bind the company in contract. ² o establish the priority of business creditors by contract, a firm’s owners would have to contract with its business creditors to include subordination provisions, with respect to business assets, in all contracts between individual owners and individual creditors. Not only would such provisions be cumbersome to draft and costly to monitor, but they would be subject to a high degree of moral hazard—an hazard— an individual owner could breach her promise to subordinate the claims of her personal creditors on the firm’s assets with impunity, since this promise would be unenforceable against personal creditors who were not party to the bargain. See Hansmann and Kraakman, note 13, at 407–9. 407–9.
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What Is Corporate Law?
of authority are needed to establish common expectations as to who has authority to transfer rights relating to corporate assets prior to entering into a contract for their transfer.² And procedures for lawsuits need to be specified by the state, whose thirdparty authority is invoked by those procedures. Tis need for special rules of law dis-
tinguishes these three types of rules from the other basic elements of the corporate form discussed here, almost all of which could in theory be crafted by contract even if the law did not provide for a standard form of enterprise organization that embodies them.² Te concept of the “separate legal personality” of the corporation, as understood in the legal literature, is in our terms a convenient heuristic formula for describing organizational forms Starting which enjoy eachthe of company the three isforegoing “foundational” rule types. fromthe thebenefit premiseofthat itself a person, in the eyes of the law, it is straightforward to deduce that it should be capable of entering into contracts and owning its own property; capable of delegating authority to agents; and capable of suing and being sued in its own name. For expository convenience, we use the term “legal personality” to refer to organizational forms—such forms—such as the corporation—that corporation—that share these three attributes. However, However, we should make clear that legal personality in the lawyer’s lawyer’s sense is not in itself an attribute at tribute that is a necessary precondition for the existence of any—or any—or indeed all—of all—of these rules,² but merely a handy label for a package that conveniently bundles them together. Although it is common in the legal literature to extend syllogistic deduction from the premise of legal personality to the existence of other characteristics of “personhood” beyond the three foundational features we have described in this section, such as ethnicity,² or the protected enjoyment of civil rights,² we see no functional rationale that compels this.
1.2.2 Limited liability Te corporate form effectively provides a default term in contracts between a firm and its creditors whereby the creditors are limited to making claims against assets that are held in the name of (or “owned by”) the firm itself, and have no claim against assets that the firm firm’’s shareholders hold in their own names. While this rule of “limited “l imited liability” was not, historically, always associated with the corporate form,³ the association
² o leave questions of authority to be determined simply by agreement between the owners of the firm will make it costly for parties wishing to deal with the firm to discover whether authority has in fact been granted in relation to any particular transaction. Authority rules must therefore trade off contracting parties’ “due diligence” costs against preserving flexibility for owners to customize their allocations of authority. See Armour and Whincop, note 12, at 442– 442 –7. ² See Hansmann and Kraakman, note 13, at 407–9. Te exception is limited shareholder liability to corporate tort victims. See Section 1.2.2. ² Tus, a common law partnership, which is commonly said by lawyers to lack legal personality, personality, can under English law enjoy each of the three foundational features described in this section: see §§ 31, 33, 39 Partnership Act 1890 (UK); Armour and Whincop, note 12, at 460–1; 460– 1; Burnes v. Pennell (1849) 2 HL Cas 497, 521; 9 ER 1181, 1191; PD 7A, para. 5A Civil Procedure Rules (UK). ² Richard R.W. R.W. Brooks, Incorpor Incorporating ating Race , 106 C L L R 2023 (2006). ² See Cnty. of Santa Clara v. S. Pac. R.R. Co., Co., 118 U S S R 394 (1886), and, more recently, Burwell v. Hobby Lobby , 134 S C R 2751 (2014). ³ For example, limited liability was not a standard feature feature of the English law of joint stock companies until the mid-nineteenth mid-nineteenth century, and in California, shareholders bore unlimited personal liability for corporation obligations until 1931. See e.g. Paul L. Davies, G D’ P M C L L 40– 6 (6th edn., 1997); Phillip Blumberg, Limited Liability and Corporate Groups , 11 J C L L 573 (1986).
What Is a Corporation?
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has over time become nearly universal. Tis evolution indicates strongly the value of limited liability as a contracting tool and financing device. Limited liability shields the firm’s owners—the owners—the shareholders—from shareholders—from creditors’ claims. Importantly, this facilitates diversification.³¹ With unlimited liability, the downside risk borne by shareholders depends on the way the business is carried on.
Shareholders will therefore generally prefer to be actively involved in the running of the business, to keep this risk under control. Tis need to be “hands-on” “hands- on” makes investing in multiple businesses difficult. Limited liability, by contrast, imposes a finite cap on downside losses, making it feasible for shareholders to diversify their holdings.³² It lowers the aggregate risk of shareholders’ portfolios, portfoli os, reducing the risk premium they will demand, and so lowers the firm’s cost of equity capital. Te “owner “owner shielding” provided by limited liability l iability is the converse of the “e “entity ntity shielding” described above as a component of legal personality.³³ Entity shielding protects the assets of the firm from the creditors of the firm’s owners, while limited liability protects the assets of the firm’s owners from the claims of the firm’s creditors. ogether, these forms of asset shielding (or “asset partitioning”) ensure that business assets are pledged as security to business creditors, while the personal assets of the business’s owners are reserved for the owners’ personal creditors.³ As creditors of the firm commonly have a comparative advantage in evaluating and monitoring the value of the firm’s assets, and an owner’s personal creditors are likely to have a comparative advantage in evaluating and monitoring the individual’s individual’s personal assets, such asset shielding can reduce the overall cost of capital to the firm and its owners. It also permits firms to isolate different lines of business—and business— and focus creditors’ monitoring efforts accordingly—by accordingly—by incorporating separate subsidiaries.³ Wee should emphasize that, when we refer to limite W limitedd liabi liability, lity, we mean specifically limited liability in contract —that is, limited liability to creditors who have contractual claims on the corporation. Te compelling reasons for limited liability in contract generally do not extend to limited liability to persons who are unable to adjust the terms on which they extend credit to the corporation, such as third parties who have been injured as a consequence of the corporation’s negligent behavior. Limited liability to such persons is arguably not a necessary feature of the corporate form, and perhaps not even a socially valuable one, as we discuss more thoroughly in Chapter 5.
³¹ Henry Manne, Our wo Corporation Systems: Law and Economics , 53 V L R 259, 262 (1967). ³² “Unlimited liability” would ordinarily be joint and several amongst business owners. In terms of the incentives discussed in the text, a form of liability that is imposed i mposed pro rata to the number of shares held—but held— but without pre-agreed pre-agreed limitation—falls limitation—falls somewhere between this and the case of fully limited liability.. Shareholders with pro rata liability can reduce their downside exposure liability e xposure either by holding only a small stake—hence stake—hence facilitating diversification—or diversification—or by exerting control over the way the business is run: see Hansmann and Kraakman, note 20. ³³ Hansmann, Kraakman, and Squire, note 13. Owner shielding established by a rule of limited liability is less fundamental than entity shielding, in the sense that it can be achieved by contract, without statutory fiat. ³ By “creditors” “creditors” we mean here all persons who have a contractual claim on the firm, including employees, suppliers, and customers. ³ Of course, asset shielding through group group structures can also be used to reduce transparency transparency as to the location of assets. Tis concern underlies an important part of corporate law’s law’s creditor-oriented creditor-oriented rules: see Chapter 5.2.1.3.
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What Is Corporate Law?
1.2.3 ransfer ransferable able shares Fully transferable shares in ownership are yet another basic characteristic of the business corporation that distinguishes the corporation from the partnership and various other standard-form standard-form legal entities. ransferability ransferability permits the t he firm to conduct business
uninterruptedly as the identity of its owners changes, thus avoiding the complications of member withdrawal that are common among, for example, partnerships, cooperatives, and mutuals.³ Tis in turn enhances the liquidity of shareholders’ interests and makes it easier for shareholders to construct and maintain diversified investment portfolios. ransferability of shares is the flipside of the liquidation protection that the corporation tion’ ’s legalcan personality assures its contractual counterparties. Precisely because counterparties be confident thattothe “bundle of contracts” that constitutes the firm will be kept together, together, there is no need for a rule requiring owners to continue to participate. In the absence of a legal entity—that entity—that is, if the t he owner contracts as sole proprietor—then proprietor—then counterparties would be concerned that assignment of their contracts would reduce the value of their expected performance and hence wish to restrict it. It is precisely for these reasons that all jurisdictions have a default rule prohibiting the assignment of most contracts without the prior consent of the other contracting party. At the same time, however, however, these consent requirements make it more difficult for the owner to sell the business and liquidate her investment. Legal personality addresses these problems by enabling the simultaneous transfer of all, but no less than all, of a firm firm’’s contracts by transferring the corporation’s shares. In other words, it permits the free transferability of all of a firm’ firm’s contracts taken together (“bundle assignability”), while preserving the general default rule that makes individual contracts non-assignable without consent of the contractual counterparty counterparty.³ .³ Fully transferable shares do not necessarily mean freely tradable shares. shares. Even if shares are transferable, they may not be tradable without restriction in public markets, but rather just transferable among limited groups of individuals or with the approval of the current shareholders or of the corporation. Free tradability maximizes the liquidity of shareholdings and the ability of shareholders to diversify their investments. It also gives the firm maximal flexibility in raising capital. For these reasons, all jurisdictions provide for free tradability for at least one class of corporation. However, free tradability can also make it difficult to maintain negotiated arrangements for sharing control and participating in management. Consequently, Consequently, all jurisdictions also provide mechanisms for restricting transferability. Sometimes this is done by means of a separate statute, while other jurisdictions simply provide for restraints on transferability as an option under a general corporation statute. As a matter of terminol terminology ogy,, we will refer to corpora corporations tions with freely trada tradable ble shares as “open” “open” or “public” corporations, and we will correspondingly use the terms “closed” or “private” corporations to refer to corporations that have restrictions on the tradability of their shares. In addition to this general division, two other distinctions are important. First, the shares of open corporations may be listed for trading on a stock exchange, in which case we will refer to the firm as a “listed” or “publicly traded” corporation, in contrast to an “unlisted” corporation. Second, a company’s ³ See Henry Hansmann, O E 152–5 152–5 (1996). ³ Ayotte and Hansmann, note 21. o o be sure, the parties partie s to individual contracts may—and may— and at times do—opt do—opt out of such a general rule of bundle assignability by requiring counterparty consent in the event of a change of control of the firm.
What Is a Corporation?
11
shares may be held by a small number of individuals whose interpersonal relationships are important to the management of the firm, in which case we refer to it as “closely held,” as opposed to “widely held.” It is common to speak, loosely, as if all companies can be categorized as either “public” or “closed” corporations, bundling these distinctions together (and the widely used term “close corporation” corporation” itself
embodies this ambiguity, being used sometimes to mean closed corporation, sometimes to mean “closely held corporation,” and sometimes to mean both). But not all companies with freely tradable shares in fact have widely held share ownership, or are listed on stock exchanges. Conversely, it is common in some jurisdictions to find corporations which, though their shares are not freely tradable, have hundreds or thousands of shareholders, and consequently have little in common with a typical closely held corporation that has only a handful of shareholders, some or all of whom are from the same family. ransferabilit ransferabilityy of shares, as we have already suggested, suggest ed, is closely connected both with the liquidation protection that is a feature of strong-form legal personality, and with limited liability. Absent either of these features, the creditworthiness of the firm as a whole could change, perhaps fundamentally, as the identity of its shareholders sharehold ers changed. Consequently, the value of shares would be difficult for potential purchasers to judge.³ Ensuring a single price for shares, independent of the wealth of the purchaser, permits securities markets to aggregate information about the firm’s expected future performance through its stock price.³ Moreover, a seller of shares could impose negative or positive externalities on his fellow shareholders depending on the wealth of the person to whom he chose to sell. It is therefore not surprising that strong-form strong-form legal personality, limited liability, and transferable shares tend to go together, and are all features of the standard corporate form everywhere. Tis is in contrast to the conventional general partnership, which lacks all of these features.
1.2.4 Delegated management management with with a board structure Standard legal forms for enterprise organization differ in their allocation of control rights, including the authority to bind the firm to contracts, the authority to exercise the powers granted to the firm by its contracts, and the authority to direct the uses made of assets owned by the firm. For example, the default rules applicable to general partnership forms usually grant power to a majority of partners to manage the firm in the ordinary course of business, while more fundamental decisions require unanimity. unanimity. Both aspects of this allocation al location are unworkable for business corporc orporations with numerous and constantly changing owners, because of information and ³ Paul Halpern, Michael rebilc rebilcock, ock, and Stuart Stuart urnbu urnbull, ll, An An Economic Analysis of Limited Limited Liability in Corporation Law , 30 U L L J 117, 1 17, 136–8 136– 8 (1980). ³ Ibid. See also Chapter 9.1.1. We have already observed that an important precondition for a firm to serve as a nexus for contracts is a rule designating, for the benefit of third parties, the individuals who have authority to enter into contracts that bind the firm and its assets (text accompanying notes 22–3). 22– 3). Because there is often overlap in practice between the scope of such external authority and the internal division of power to control assets, the former, unlike the latter, cannot be based purely on agreement between participants in the firm, but rather must be designated to some degree by rules of law. Te underlying problem being one of notice to third parties, the law governing closely held firms often leaves these matters to be designated at will in the firm’s charter, while for widely held (and presumably large) firms, in which it is advantageous to let multiple shareholders, creditors, and other third parties know the allocation of authority without incurring the cost of reading the charter, the law is generally more rigid in designating the allocation of authority.
What Is Corporate Law? 12 coordination costs.¹ Consequently, corporate law typically vests principal authority over corporate affairs in a board of directors or similar body that is periodically elected, exclusively exclusivel y or primarily, by the firm’s firm’s shareholders. shareholder s. More specifically specificall y, business corporations are distinguished by a governance structure in which all but the most fundamental decisions are generally delegated to a board of directors that has four basic features.
First, the board is, at least as a formal matter, matter, separate from the operational managers of the corporation.² Te legal distinction between them formally divides all corporate decisions that do not require shareholder approval into those requiring approval by the board of directors and those that can be made by the firm’s hired officers on their own authority. authority. Tis formal distinction between the board and a nd hired officers facilitates a separation between, on the one hand, initiation and execution of business decisions, which is the province of hired officers, and on the other hand the monitoring and ratification of decisions, and the hiring of the officers themselves, which are the province of the board. Tat separation serves as a useful check on the quality of decision-making decision-making by hired officers.³ Second, the board of a corporation is elected—at elected—at least in substantial part—by part—by the firm’’s shareholders. Te obvious utility of this approach is to help assure that the firm t he board remains responsive to the interests of the firm’s owners, who bear the costs and benefits of the firm’s firm’s decisions and whose interests, unlike those of other corporate constituencies, are not strongly protected by contract. Tis requirement of an elected board distinguishes the corporate form from other legal forms, such as nonprofit corporations or business trusts, which permit or require a board structure, but do not require election of the board by the firm’s (beneficial) owners. Tird, though largely or entirely chosen by the firm’s shareholders, the board is formally distinct from them. Tis separation economizes on the costs of decision-making decision-making by avoiding the need to inform the firm’s firm’s ultimate owners and obtain their consent for all but the most fundamental decisions regarding the firm. It also permits the board to serve as a mechanism for protecting the interests of minority shareholders and other corporate constituencies, in ways we explore in Chapter 4. Fourth, the board ordinarily has multiple members. Tis structure—as structure—as opposed, for example, to a structure concentrating authority in a single trustee, as in many private trusts—facilitates trusts—facilitates mutual monitoring and checks idiosyncratic decision-making. decision-making. However, there are exceptions. Many corporation statutes permit business planners to dispense with a collective board in favor of a single general director or one-person one- person board—the board— the evident reason being that, for a very small corporation, most of the ¹ See Clark, note 7, at 23–4 23–4 and 801–16; 801–16; Sofie Cools, Te Dividing Line Between Shareholder Democracy and Board Autonomy , 11 E C F L R 258, 272–3 272– 3 (2014). ² Te nature of this separation varies according to whether the the board has one or two tiers. In twotier boards, top corporate officers occupy the board’s board’s second (managing) tier, but are generally absent from the first (supervisor) tier, which is at least nominally independent from the firm’s hired officers (i.e. from the firm’s senior managerial employees, though employees may sit in the codetermined supervisory boards). See Chapter 3.1. ³ See Eugene Fama and Michael Jensen, Jensen, Agency Agency Problems and Residual Residual Claims , 26 J J L E 327 (1983). Tis is true not only of most statutes designed principally for private corporations, such as France’s SARL (Art. L. 223-18 223-18 Code de commerce) and SAS (Art. L. 227-6 227-6 Code de commerce) and Germany’s GmbH (§ 6 GmbH-Gesetz), GmbH-Gesetz), but also of the general corporate laws in the UK (§ 154(1) Companies Act 2006), Italy (Art. 2380–II 2380–II Civil Code), and the U.S. state of Delaware, § 141(b) Delaware General Corporation Law Law..
What Is a Corporation? 13 board’ss legal functions, including its service board’ servi ce as shareholder representative and focus of liability,, can be discharged effectively by a single elected director who also liability al so serves as the firm’’s principal firm pri ncipal manager.
1.2.5 Investor ownership
Tere are two key elements in the ownership of a firm, as we use the term “ownership” here: the right to control the firm, and the right to receive the firm’ firm’s net earnings. Te law of business corporations is principally designed to facilitate the organization of investor-owned investorowned firms—that firms—that is, firms in which both elements of ownership are tied to investment of equity capital in the firm. More specifically, specifically, in an investor-owned investor-owned firm, both the right to participate in control—which control—which generally involves voting in the election of directors and voting to approve major transactions—and transactions—and the right to receive the firm’s residual earnings, or profits, are typically proportional to the amount of capital contributed to the firm. Business corporation statutes generally provide for this allocation of control and earnings as the default rule. Tere are other forms of ownership that play an important role in contemporary economies, and other bodies of organizational law—including law—including other bodies of corporate law—that law—that are specifically designed to facilitate the formation of those other types of firms. For example, cooperative corporation statutes— which provide for all of the four features of the corporate form just described except for transferable shares, and often permit the latter la tter as an option as well—allocate voting power and shares in profits proportionally to acts of patronage, which may be the amount of inputs supplied to the firm (in the case of a producer cooperative), or the amount of the firm’s products purchased from the firm (in the case of a consumer cooperative). Te facilitation of investor ownership became a feature of the corporate form only in the second half of the nineteenth century. century. Until then, both investor- and consumerowned firms worldwide had been routinely organized under a single corporate form. Te subsequent specialization toward investor ownership followed from the dominant role that investor-owned investor-owned firms have come to play in i n contemporary economies, and the consequent advantages of having a form that is specialized to the particular needs of such firms, and that signals clearly to all interested parties the particular character of the firm with which they are dealing. Te dominance of investor ownership among large firms, in turn, reflects several conspicuous efficiency advantages of that form. One is that, among the various participants in i n the firm, investors are often the most difficult to protect simply by contractual means. Another is that investors of capital have (or, through the design of their shares, can be induced to have) relatively homogeneous interests among themselves, hence reducing—though reducing—though definitely not eliminating—the eliminating—the potential for costly conflict among those who share governance of the firm. For a recently recently enacted rule providing for a different default (double voting rights for longer term shareholders in French listed corporations), see Chapter 4.1.1. For a discussion of the varieties of forms of ownership found in contemporary contemporary economies, of their respective economic roles, and of the relationship between these forms and the different bodies of organizational law that govern them, see Hansmann, note 36. Voting Rights: Righ ts: Separation Henry Hansmann and Mariana Pargendler Pargendler,, Te Evolution of Shareholder Voting of Ownership and Consumption, Consumption, 123 Y L J 948 (2014). See e.g. Oliver Williamson, Corporate Governance , 93 Y L J 1197 (1984). See Hansmann, note 36. For a discussion of the consequences of different risk preferences of diversified and undiversified investors, see John Armour and Jeffrey N. Gordon, Systemic Harms and Shareholder Value , 6 J L A 35, 50–6 50– 6 (2014).
What Is Corporate Law? 14 Specialization to investor ownership is yet another respect in which the law of business corporations differs from the law of partnership. Te partnership form typically does not presume that ownership is tied to contribution of capital, and though it is often used in that fashion, it is also commonly employed to assign ownership of the firm in whole or in part to contributors of labor or of other factors of production—as production—as in partnerships of lawyers and other service ser vice professionals, or simply in the prototypical
two-person partnership in which one partner supplies labor and the other capital. As a two-person consequence, the business corporation is less flexible than the partnership in terms of assigning ownership. o o be sure, with sufficient special contracting and manipulation of the form, ownership of shares in a business corporation can be granted to contributors of labor or other factors of production, or in proportion to consumption of the firm’’s services. firm servic es. Moreover, Moreover, as the corporate corporat e form has evolved, it has achieved achi eved greater flexibility in assigning ownership, either by permitting greater deviation from the default rules in the basic corporate form (e.g. through restrictions on share ownership or transfer), or by developing a separate and more adaptable form for closed corporations. Nevertheless, the default rules of corporate law continue to be generally designed for investor ownership, and deviation from this pattern can be awkward. Te complex arrangements for sharing rights to earnings, assets, and control between entrepreneurs and investors in high-tech high-tech start-up start-up firms are a good example. Tere has been further specialization even amongst investori nvestor-owned owned companies, with the recent emergence of special forms of “public benefit” or “community interest” corporations designed to accommodate the needs of hybrid firms that, while investor owned, also commit to the pursuit of a specified social objective.¹ In other instances, state-owned stateowned enterprises (SOEs) embrace the corporate form, hence permitting the government to share ownership with private investors. Because the state is seldom, if ever,, a typical financial investor, ever investor, state ownership entails a degree of heterogeneity in the shareholder base that exceeds that of the typical investor-owned investor-owned firm, with potential for unique conflicts of interest.² Sometimes core corporate law itself deviates from the assumption of investor ownership to permit persons other than investors of capital— for example, creditors or employees— employees—to to participate in either control or profit-sharing, profit-sharing, or both. Worker codetermination is a conspicuous example. Te wisdom and means of providing for such non-investor non-investor participation in firms that are otherwise investorowned remains one of the central controversies in corporate law, which we address further in Chapter 4. Most jurisdictions also have one or more statutory forms—such forms—such as the U.S. nonprofit corporation, the civil law foundation, and the UK company limited by guarantee— that provide for formation of nonprofit firms. Tese are firms in which no person may participate simultaneously in both the right to control and the right to residual earnings (which is to say, the firms have no owners). While nonprofit organizations, like cooperatives, are sometimes labelled “corporations,” however, they will not be within the specific focus of our attention here—even here—even though a number of successful industrial
Stephen N. Kaplan and Per Per Strömberg, Financial Contracting Teory Meets the Real World: An Empirical Analysis of Venture Capital Contracts , 70 R E S 281 (2003). ¹ See e.g. Jesse Finfrock and Eric L. alley, Social Entrepreneurship and Uncorporations , 2014 I L R 1867; Regulator of Community Interest Companies (UK), A R / / (). ² See e.g. Mariana Pargendler, Pargendler, Aldo Musacchio, Musacchio, and Sergio G. Lazzarini, In In Strange Company: Te Puzzle of Private Investment in State-Controlled State-Controlled Firms , 46 C C I L L J 569 (2013).
Sources of Corporate Law 15 firms around the world are organized as nonprofits.³ Tus, when we use the term “corporation “co rporation”” in this book, we refer only to the business corporation, and not to cooperative corporations, nonprofit corporations, municipal corporations, or other types of incorporated entities. When there is potential for ambiguity ambiguity,, we will explicitly use the term “business corporation” corporation” to make specific reference to the investor-owned investor-owned company that is our principal focus.
1.3 Sources of Corporate Law All jurisdictions with wellwell-developed developed market economies have a least one core statute that establishes a basicparticularly corporate form with the characteristics described above, and that is designed to permit the five formation of public corporations. Nevertheless, Neverthele ss, corporate law as a s we understand it here— here—in in functional terms—generally terms—generally extends well beyond the bounds of this core statute. 1.3.1 Special and partial corporate forms First, major jurisdictions commonly have at least one distinct statutory form specialized for the formation of closed corporations or limited liability companies. Tese forms—including forms— including the Brazilian Ltda, the French SARL, the German GmbH, the Italian Srl, the Japanese godo kaisha , the American limited liability company, and the UK private company—typically company—typically exhibit most of the canonical features of the corporate form. Tey differ from open, or “public,” companies chiefly because their shares, though generally transferable at least in principle, are presumed—and presumed—and in some cases required—not required— not to trade freely in a public market. Sometimes these forms also permit departure from one of our five core characteristics—delegated characteristics—delegated management—by management—by permitting elimination of the board in favor of direct management by shareholders. Te statutes creating these forms also commonly permit, and sometimes facilitate, special allocations of control, earnings rights, and rights to employment among shareholders that go beyond those permitted in the core public corporation statute. Second, some jurisdictions have, in addition to these special closed corporation forms, quasi -corporate statutory forms that can be used to form business corporations with all of our five core characteristics, though some of these characteristics must be added by contract. One example is the limited liability partnership, par tnership, which has recently been added to the forms available in the law of the U.S., Japan, and some European jurisdictions. Tis Tis form simply grafts limited liability onto the traditional general partnership. U.S. and UK law now allow a limited partnership to have something close to strong-form entity shielding (by limiting the rights of partners or their creditors to force liquidation). Consequently, with appropriate governance provisions in the partnership agreement, it is effectively possible to create a closed corporation as a limited liability partnership. ³ On the soso-called called “industrial foundations, foundations,”” see Steen Tomsen and Henry Hansmann, Managerial Hansmann, Managerial Distance and Virtual Ownership: Te Governance of Industrial Foundations Foundations , Working Working Paper (2013), at ssrn.com. In the case of the UK private company, company, the standard form is provided not by a separate statute, but by a range of provisions in a single statute with differential application to public and private companies. Se Seee no note te 44 44.. Se Seee Ha Hans nsma mann nn,, Kr Kraa aakm kman an an andd Sq Squi uire re,, no note te 13 13,, at 13 1391 91––4.
What Is Corporate Law? 16 Te U.S. statutory statutor y business trust offers another example. It provides for strong-form legal personality and limited liability, but leaves all elements of internal organization to be specified in the organization’s governing instrument (charter), failing even to provide statutory default rules for most such matters. With appropriate charter provisions, a statutory business trust can be made equivalent to a public corporation, with the trust’s trust’s beneficiaries in the role of shareholders. Te analysis we offer in this book extends to all these special and quasi-corporate quasi-corporate
forms insofar as they display most or all of the core corporate characteristics. Although we make occasional reference to some of these forms to underscore certain peculiarities, the description of our core jurisdictions’ corporate laws in Chapters 3 to 9 focuses mainly on public corporations. 1.3.2 Other bodies of law Tere are bodies of law that, at least in some jurisdictions, are contained in statutes st atutes or case law that are separate from the core corporation statutes, and from the special and quasi-corporation quasicorporation statutes just described, but that are nonetheless instrumental to the functioning of the five core characteristics of the corporate form or to addressing the corporate agency problems we describe in Chapter 2. Hence, we view them functionally as part par t of corporate law. o begin, the German law of groups, or Konzernrecht , qualifies limited liability and limits the discretion of boards of directors in corporations that are closely related through common ownership, seeking to protect the creditors and minority shareholders of corporations with controlling shareholders. Although the Konzernrecht — touched upon in more detail in Chapters 5 and 6—is 6—is embodied in statutory law that is formally distinct from the corporation statutes and case law, it is clearly an integral part of German corporate law. law. Similarly, Similarly, the statutory statutor y rules in many jurisdictions that require employee representation on a corporation’s board of directors—such directors—such as, conspicuously,, the German law of codetermination—qualify spicuously codetermination—qualify as elements of corporate law, even though they occasionally originate outside the principal corporate law statutes, because they impose a detailed structure of employee participation on the boards of directors of large corporations. Securities laws in many jurisdictions, including conspicuously the U.S., have strong effects on corporate governance through rules mandating disclosure, and sometimes regulating sale and resale of corporate securities, mergers and acquisitions, and corporate elections. Stock exchange rules, which can regulate numerous aspects of the internal affairs of exchange-listed exchange-listed firms, can also serve as an additional source of corporate law, as can other forms of self-regulation, self-regulation, such as the UK’s City Code on akeovers and Mergers. Tese supplemental sources of law are necessarily part of the overall structure of corporate law, law, and we shall be concerned here with all of them. It differs from the common law private trust, from which it evolved, principally in providing unambiguously for limited liability for the trust’s beneficiaries even if they exercise control. A claim strongly put by Robert Robert B. Tompson and Hillary A. Sale, Securities Fraud as Corporate Governance: Reflections upon Feder Federalism alism,, 56 V L R 859 (2003). We term such self-regulation self-regulation a source of “law” in part because it is commonly supported, directly or indirectly, indirectly, by law in the narrow sense. Te selfself -regulatory authority of the American stock exchanges, for example, is both reinforced and constrained by the U.S. Securities Exchange Act and the administrative rules promulgated by the Securities and Exchange Commission under that Act. Similarly,, the authority of the UK’s akeover Similarly akeover Panel was supported indirectly until 2006 200 6 by the recognition that if its rulings were not observed, obser ved, formal regulation would follow. Since then, it has enjoyed
Law versus Contract in Corporate Affairs 17 Tere are many constraints imposed on companies by bodies of law designed to serve ser ve objectives that are, in general, independent of the form taken by the organizations they t hey affect. While we will not explore these bodies in general, we will discuss those that have important effects on corporate structure and conduct. Bankruptcy law—or law—or “insolvency law,” as it is termed in some jurisdictions—is jurisdictions—is an example. Bankruptcy effects a shift in the ownership of the firm from one group of investors to another—from another—from shareholders to creditors. By providing creditors with an ultimate sanction against
defaulting firms, it casts a shadow over firms relations with their creditors, and affects the extent to which creditors may need generalized protections in corporate law. We thus consider the role of bankruptcy law in Chapter 5. ax law also affects directly the internal governance of corporations at various points; the U.S. denial of deductibility from corporate for tax of executive of $1 million unless it isincome, in the form of purposes, incentive pay, pay , discussedcompensation in Chapter 3, in is aexcess clear example. And, beyond providing for board representation of employees, labor law in some countries—as countries—as emphasized in Chapter 4—involves 4—involves employees or unions in the corporate decision-making decision-making process, as in requirements that works councils or other workers’’ organs be consulted prior to taking specified types of actions. workers
1.4 Law versus versus Contract in Corporate Corporate Affairs Te relationships among the participants in a corporation are, to an important degree, contractual. Te principal contract that binds them is the corporation’s charter (or “articles of association” or “constitution,” as it is termed in some jurisdictions). Te charter sets out the basic terms of the relationship among the firm’s shareholders, and between the shareholders and the firm firm’’s directors and other managers.¹ By explicit or implicit reference, the charter can also become part of the contract between the firm and its employees or creditors. credi tors. One or more shareholders’ agreements agreement s may, may, in addition, addition , bind some or all of a corporation’s shareholders. At the same time, time, corporations corporations are the subject subject of a large body body of statutory law. law. Tat body of law is the principal focus of this book. Before examining the details of that law, however, we must address a fundamental—and fundamental—and surprisingly difficult—question: difficult—question: What role does this law play? As we have already seen, with few exceptions, the defining elements of the corporate form could in theory be established simply by contract. And the same is true of most of the other rules of law that we examine throughout this book. If those rules of law did not exist, the relationships they establish could still be created by means of contract, just by placing similar provisions in the organization’s charter. Indeed, this was the approach taken by the numerous unincorporated joint stock companies formed in England during the eighteenth and early nineteenth centuries, before incorporation became widely available in 1844. Tose companies obtained their legal personality from partnership and trust law, and created the rest of their corporate structure—including structure— including limited limi ted liability— liabil ity—by means of contract.² contr act.² Why, Why, then, do we today t oday formal statutory authority (Part 28 Companies Act 2006 (UK)), and so is no longer l onger,, strictly speaking, “self-regulatory.” “selfregulatory.” § 162(m) Internal Revenue Revenue Code (U.S.). ¹ Te charter may be supplemented by a separate set of bylaws, which commonly govern less fundamental matters and are subject to different—generally different— generally more flexible—amendment flexible—amendment rules than is the charter. ² Ron Harris, I E L (2000); Hansmann, Kraakman, and Squire, note 13.
What Is Corporate Law? 18 have, in every advanced economy, elaborate statutes providing numerous detailed rules for the internal governance of corporations?
1.4.1 Mandatory laws versus versus default provisions In addressing this question, it is important to distinguish between legal provisions that are merely default rules, in the sense that they govern only if the parties do not explicitly provide for something different, and laws that are mandatory, leaving parties no
option but to conform to them.³ A significant part of corporate law— law—more more in some jurisdictions, less in others— consists of default provisions. o this extent, corporate law simply offers a standard form contract that athe parties can adopt, at theirform option, in whole in part.specifically, A familiar advantage of such legally provided standard is that it savesorcosts—specifically, costs— it simplifies contracting among the parties involved by requiring that they specify only those elements of their relationship that deviate from the standard terms. Corporate law’ss provision of such standard terms as default is thereby seen in economic terms as a law’ “public good.” Default provisions can serve this function best if they are “majoritarian” in content—that content—that is, if they reflect the terms that the majority of wellwell-informed informed parties would themselves most commonly choose. Default provisions can be supplied in a variety of ways, the choice of which affects the ease and means of “contracting around” them. A common form of corporate law default is a statutory provision that will govern unless the parties explicitly provide an alternative. Te common provision that each share carries one vote is an example. A charter clause can deviate from that default by by,, for instance, providing for the issuance of a class of corporate stock carr ying carrying no voting right. specifies the rule that will govern if Alternatively, cor porate law itself sometimes the default provision is not chosen—an chosen—an “either-or” “either-or” provision. An example is offered by French corporate law la w, which allows al lows companies’ charters to opt for a two- tier board structure as an alternative to the default single-tier single-tier one. In other words, the law in this case gives the corporation a choice between two statutory provisions: one is the default and the other is the “secondary” provision, with the latter applying only if the firm opts out of the default (or, equivalently, “opts in” to the secondary provision). Te law may also impose special procedures for altering a default rule, such as by requiring minority approval to alter default rules that protect their interests. An extension of the binary two-alternativetwo-alternative-provisions provisions approach just described is to provide corporations with a choice among a “menu” of more than two specified rules. ³ See generally the papers in the symposium edition entitled Contractual Freedom and Corporate Law , in 89 8 9 C L L R 1395–774 1395– 774 (1989). Tey are “defaults” “defaults” in the sense that they apply (as with computer settings) “in default ” of the parties stipulating something else. Easterbrook and Fischel, note 7, at 34– 34–5. 5. Te ease with which parties can “contract around” a default provision will affect the way it operates. For a nuanced discussion of these and other issues, see Ian Ayres, Regulating Opt-Out: Opt-Out: An Economic Teory of Altering Rules , 121 Y L J 2032 (2012). For an empirical perspective, see Yair Listokin, What do Corporate Default Rules and Menus Do? An Empirical Examination Examination,, 6 J E E L S 279 (2009). See Art. 225225-57 57 Code de commerce. See Lucian A. Bebchuk and Assaf Hamdani, Optimal Defaults For Corporate Law Evolution, Evolution, 96 N U L R 489 (2002). Michael Klausner, Corporations, Corporate Law, and Networks of Contracts , 81 V L R 757, 839–41 839–41 (1995).
Law versus Contract in Corporate Affairs 19 Tere are also important rules of corporate law that are mandatory. Large German corporations, for example, have no alternative but to give half of their supervisory board seats to representatives of their employees, and publicly traded U.S. corporations have no alternative but to provide regular detailed financial disclosure in a closely prescribed format.¹ Te rationale for mandatory terms of these types is usually based on some form of “contracting failure”: some parties might otherwise be exploited because they are not well informed; the interests of third parties might be affected; or collective action problems might otherwise lead to
contractual provisions that are inefficient or unfair.² Mandatory terms may also serve a useful standardizing function, in circumstances (such as with accounting rules) where the benefits of compliance increase if everyone adheres to the same provision. Mandatory rules need not just serve a prescriptive function, however. When used in conjunction with a choice of corporate forms , they can perform an enabling function similar to that served by default rules. More particularly, mandatory rules can facilitate freedom of contract by helping corporate actors to signal the terms they offer and to bond themselves to those terms. Te law accomplishes this by creating corporate forms that are to some degree inflexible (i.e. are subject to mandatory rules), but then permitting choice among different corporate forms.³ Tere are two principal variants to this approach. First, a given jurisdiction can provide for a menu of different standard form legal entities from which parties may choose in structuring an organization. In some U.S. jurisdictions, for example, a firm with the five basic attributes of the business corporation can be formed, alternatively, alternatively, under a general business corporation statute, anership close corporation a limited liability with company a limited liability partstatute, or astatute, business trust statute—with statute— each statute, statute providing a somewhat different set of mandatory and default rules. Second, even with respect to a particular type of legal entity, entity, such as the publicly traded t raded business corporation, the organizers of a firm may often choose among different jurisdictions’ laws. Tis leads us to the general issue of choice of law and the related debate about “r “regulatory egulatory competition” competition” in corporation law. Before addressing that topic, however, we need to say more about the role of corporation law in general.
1.4.2 Te benefits of legal legal rules Default rules of corporate law do more than simply provide convenient standard forms, encourage revelation of information, and facilitate choice of the most efficient among several alternative rules. Tey also provide a means of accommodating, over time, developments that cannot easily be foreseen at the outset. A contract that, like a corporation corporation’’s charter, charter, must govern complex relationships relationships over over a long period of time, is necessarily incomplete . Situations will arise for which the See Jeffrey Jeffrey N. Gordon, Gordon, Te Mandatory Structure of Corporate Law , 89 C L R 1549 (1989). ¹ See Chapter 4.2.1 (codetermination) and 6.2.1 and 9.1.1 (disclosure). ² See generally Michael J. rebilcock, rebilcock, L F C (1993). ³ Larry E. Ribstein, Statutory Forms for Closely Held Firms: Teories and Evidence From LLCs , 73 W U L Q 369 (1995); John Armour and Michael J. Whincop, An Economic Analysis of Shared Property in Partn Partnership ership and Close Corporations Law , 26 J C C L 983 (2001).
What Is Corporate Law? 20 contract fails to provide clear guidance, either because the situation was not foreseeable at the time the contract was drafted or because the situation, though foreseeable, seemed too unlikely to justify the costs of making clear provision for it in the contract. Statutory amendments, administrative rulings, and judicial decisions can provide for such situations as they arise, by either altering or interpreting existing rules. Tis is the gap- filling filling role role of corporation law. Courts play a key role in filling gaps, simply by interpreting privately drafted contractual terms in a corporation’s charter. A firm will get the greatest advantage
from the courts interpretive activity if it adopts standard charter terms used by many other firms, since those standard terms are likely to be subject to repeated interpretation by the courts. And the most widely used standard charter terms are often the default embodied in therather corporation law. So, another charter advantage of sticking to therules default provisions, than drafting specialized terms, is to benefit from the constant gap-filling gap-filling activity stimulated by the body of precedents developed as a result of other corporations that are also subject to those rules. Tis is one example of a network effect that that creates an incentive to choose a common approach. Te problem of contractual incompleteness goes beyond mere gap-filling, gap-filling, however. Given the long lifespan of many corporations, it is likely that some of a firm’s initial charter terms, no matter how carefully chosen, will become obsolete with the passage of time owing to changes in the economic and legal environment. Default rules of law have the feature that they are altered over time—by time—by statutory amendments and by judicial interpretation—to interpretation—to adapt them to such changing circumstances. Consequently, by adopting a statutory default rule, a firm has a degree of assurance that theaprovision not provision become anachronistic. If, statutory in contrast, the firm its charter specially will drafted in place of the default, onlyputs the infirm itself can amend the provision when, over time, a change is called for. Tis runs into the problem that the firm’s own mechanisms for charter amendment may be vetoed or hijacked by particular constituencies in order, respectively, to protect or further their partial interests. Simply adopting the statutory default rules, and delegating to the state the responsibility for altering those rules over time as circumstances change, avoids these latter problems. It follows from much of the foregoing that, for many corporations, there may often be little practical difference between mandatory and default rules. Firms end up, as a practical matter, adopting default rules as well as the mandatory rules. Te most empirically significant dimensions of selection lie in the ability of participants to select from a range of different business forms—which forms—which we have discussed—and discussed—and of corporations choosetothe jurisdiction whose corporation law they t hey will be governed, which is the to subject which we turn by next. Ian Ayres, Making A Difference: Te Contractual Contributions of Easterbrook and Fischel , 59 U C L R 1391, 1403–8 1403–8 (1992). Klausner, note 69, at 826–9. 826–9. A related network effect that may encourage firms to adopt standardized charter terms, and in particular to accept default rules of law, is that those provisions are more familiar to analysts and investors, thus reducing their costs of evaluating the firm as an investment. Similar network effects may cause legal services to be less expensive for firms that adopt default rules of law. See Marcel Kahan and Michael Klausner Klausner,, Standar Standardization dization and Innovation In Corporate Contracting (or “Te Economics of Boilerplate”),, 83 V L R 713 (1997). Boilerplate”) See Henry Hansmann, Corporation and Contract , 8 A L E R 1 (2006).
21
Law versus Contract in Corporate Affairs 1.4.3 Choice of legal legal regime regime Te various forms of flexibility in corporate law on which we have so far concentrated— the choice of specially drafted charter provisions versus default provisions, the choice of one default rule in a given statute as opposed to another, and the choice of one statutory form versus another—can another—can all be provided within any given jurisdiction. As we have noted, however, however, there can be yet another a nother dimension of choice—namely, choice—namely, choice of the jurisdiction in which to incorporate. In the U.S., for example, the prevailing choice of law rule for corporate law is the
place of incorporation rule, which permits a business corporation to be incorporated under—and under—and hence governed by—the law of any of the fifty individual states (or any foreign country), regardless of where the firm’s principal place of business, or other assets and activities, are located. Tat form of choice, long available within the U.S. and in a number of other countries as well, has now been largely extended to entrepreneurs throughout the European Union as a consequence of European Court of Justice decisions requiring the domestic recognition of corporations formed in other member states adopting the place of incorporation rule. Tese denied the efficacy of the “real seat” doctrine under which, in many European countries, firms were formerly required to incorporate under the law of the state where the firm had its principal place of business. Te consequence of choice amongst jurisdictions is not simply to enlarge the range of governance rules from which a given firm can choose. It also creates the opportunity for a jurisdiction to induce firms to incorporate under its law—and law—and thereby bring revenue to the state directly (through franchise fees) and indirectly (through increased demand for local services)—by services)—by making that jurisdiction jurisdiction’’s corporate law attractive. Tis permits the emergence of corporate law systems that are driven primarily by market forces based on companies’ demand, and less influenced by other political forces that typically shape democratic lawmaking. Whether such “regulatory competition” competition” exists at all—and all—and if it does, whether it is a good thing—has thing—has long been the subject of vigorous debate.¹ Pessimists argue that it creates a “race to the bottom” in which the state st ate that wins is that which goes furthest in stripping its law of protections for constituencies who do not control the (re)incorporation decision. Optimists argue that, on the contrary, regulatory competition in corporate law creates a virtuous “race to the
Case C-212/ C-212/97, 97, Centros Ltd v. Erhvervs-og Erhvervs-og Selskabssyrelsen [1999] Selskabssyrelsen [1999] E C R I-1459; Case C-208/ I-1459; C-208/00, 00, Überseering BV v. Nordic Construction Company Baumanagement GmbH (NCC) [2002] E C R I-9919; I-9919; Case C-167/ C-167/01, 01, Kamel van Koophandel en Fabrieken voor Amsterdam v. Inspire Art Ltd [2003] [2003] E C R I-10155; I-10155; Case C-210/ C-210/ 06, Cartesio Oktató és Szolgáltató bt [2008] [2008] E C R R I-9641; I- 9641; Case C-378/ C-378/10 10 VALE Építési kft ECLI:EU:C:2012:440. See Marco Becht, Colin Mayer, and Hannes F. Wagner, Where Do Firms Incorporate? Deregulation and the Cost of Entry , 14 J C F 241 (2008); John Armour and Wolf-Georg Wolf-Georg Ringe, European Company Law 1999– 2010: Renaissance and Crisis , 48 C M L R 125, 131–43. 131–43. Te position as respects change of corporate law for existing companies is more complex: see ibid., 158–69. 158– 69. However However,, insolvency law rules are more likely to be applied according to the place of business: see Art. 3(1) and preamble para (30) Regulation (EU) 2015/848, 2015/848, 2015 O.J. (L 141) 19; Case C-341/ 341/04 04 Eurofood IFSC ltd [2006] [2006] E C R I-3813; I- 3813; Case C-306/ C-306/09 09 Re Interedil Srl [2011] [2011] E C R I-9915; I-9915; Case C-594/ C-594/14 14 Kornhaas v Dithmar ECLI:EU:C:2015:806. ECLI:EU:C:2015:806. See Section 1.6; Ronald J. Gilson, Henry Hansmann, and Mariana Pargendler, Corporate Chartering and Feder Federalism: alism: A New View , Working Paper (2015). ¹ On the existential question, see e.g. Marcel Kahan and Ehud Kamar, Te Myth of State Competition in Corporate Law , 55 S L R 679 (2002); Luca Enriques, EC Company Law and the Fears of a European Delaware, Delaware, 15 15 E B L R 1259 (2004). (200 4).
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What Is Corporate Law?
top”: because the capital markets price, more or less accurately, top”: accurately, the effects of corporate law choice, the state that wins is that whose law maximizes shareholder welfare.² welfare.² Of course, there is dispute as to what constitutes an “optimal” body of corporate law, even in theory—a theory—a topic to which we will turn shortly. Yet an important benefit associated with the existence of choice among among multiple regulatory regimes is that it creates opportunities for regulatory experimentation. Tat is, diverse legal regimes serve as laboratories from which regulators and firms can learn more about the merits and drawbacks of different modes of regulation.³ Moreover, there is unlikely to be a single optimal body of corporate law applicable to all firms, since companies vary in
their needs for regulation. Choice among jurisdictions (or statutory menus) therefore enables diverse legal regimes to cater to the needs of different types of firms. While much of the literature on regulatory competition tends to assume corporate law is a single uniform commodity, commodity, this is not always what we observe in practice. Finally, even if the optimal corporate law regime were uniform and known to parties, the existence of dual—or even multiple— multiple—regulatory regulatory regimes might be justified by referencee to politics. Reform of inefficient rules may be blocked by powerful interests— referenc such as those of managers, controlling shareholders, or workers—who workers—who benefit from the status quo. In such instances, framing a reform as voluntary can disable opposition by creating a more efficient parallel regime which, because it only applies to those who opt into it, does not impinge on the t he entitlements of incumbents. Both the establishment of the Novo Mercado Mercado premium listing segment in Brazil and certain EU measures such as the creation of the European Company (Societas Europaea—SE Europaea—SE ) can be interpreted as bypassing the political clout of interest groups in existing companies.
1.5 What Is the Goal of Corporate Corporate Law? What is the goal of corporate law, law, as distinct from its immediate functions of defining a form of enterprise and containing the conflicts among the participants par ticipants in this enterprise? As a normative matter, matter, the overall objective of corporate law—as law—as of any branch of law—is law—is presumably to serve the interests of society as a whole. More particularly, the appropriate goal of corporate law is to advance the aggregate welfare of all who are affected by a firm’s activities, including the firm’s shareholders, employees, suppliers, and customers, as well as third parties such as local communities and beneficiaries of
² Te classical statements of the two polar views are William Cary, Federalism and Corporate Law: Reflections upon Delaware , 83 Y L J 663 (1974), and Ralph Winter, State Law, Shareholder Protection and the Teory of the Corporation, Corporation , 6 J L S 251 (1977). For a recent review of this literature, see Roberta Romano, Te Market for Corporate Law Redux , in O H L E (Francesco Parisi ed., 2015). 201 5). ³ See Simon Deakin, Regulatory Competition Versus Versus Harmonization in European Company Law in in R C E I 190, 216–17 216–1 7 (Daniel Esty and Damien Gerardin eds., 2001). See John Armour, Who Should Make Corporate Law? EC Legislation versus Regulatory Competition, Competition, 58 C L P 369 (2005). See K.J. Martin Cremers and Simone M. Sepe, Te Financial Value of Corporate Law: Evidence from (Re)incorpor (Re)incorporations ations , Working Paper (2015), at ssrn.com ssrn.com;; Jens Dammann and Matthias Schündeln, Te Incorporation Choices of Privately Held Corporations , 27 J L, E, O O 79 (2011). (20 11). Ronald J. Gilson, Henry Hansmann, and Mariana Pargendler, Regulatory Dualism as a Development Strategy: Corporate Reform in Brazil, the United States, and the European Union, Union , 63 S L R 475 (2011).
What Is the Goal of Corporate Law?
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the natural environment. Tis is what economists would characterize as the pursuit of overall social welfare. At least in theory theory,, however, however, the pursuit of overall social welfare may be compatible with different immediate goals for corporate law. One view is that corporate law best advances social welfare by reducing the costs of contracting among the corporation’s contractual constituencies—which constituencies—which include not only managers and shareholders but also certain creditors and employees. Te underlying assumption is that any externalities that the corporation generates are best addressed by regulatory constraints from other areas of law. Indeed, legal strategies designed to maximize the value of firms
adopting the corporate structure constitute both the lions lion s share of corporate law l aw as it is generally understood and the primary object of our analysis. It is sometimes said that the goals of core corporate law should be even narrower. In particular, it is sometimes said that the appropriate role of corporate law is simply to assure that the corporation serves the best interests of its shareholders or, more specifically, to maximize financial returns to shareholders or, more specifically still, to maximize the current market price of corporate shares. Such claims can be viewed in two ways. First, these claims can be taken at face value, in which case they neither describe corporate law as we observe it nor offer a normatively appealing aspiration for that body of law. Tere would be little to recommend a body of law that, for example, permits corporate shareholders to enrich themselves through transactions that make creditors or employees worse off by $2 for every $1 that the shareholders gain. Second, such claims can be understood as saying, more modestly, that focusing principally on the maximization of shareholder returns is, in general, the best means by which corporate law can serve the broader goal of advancing overall social welfare. In general, creditors, workers, and customers will consent to deal with a corporation only if they expect themselves to be better off as a result. Consequently, the corporation—and, corporation— and, in particular, its shareholders, as the firm’ firm’s residual claimants clai mants and risk-bearers— riskbearers—have have a direct pecuniary interest in making sure that corporate transactions are beneficial, not just to the shareholders, but to all parties who deal with the firm. We believe that this second view is—and is—and surely ought to be—the be—the appropriate interpretation of statements by legal scholars and economists asserting that shareholder value is the proper object of corporate law. Wee should keep in mind, as well, that to say that shareholder value is the prin W cipal objective toward which corporations should be managed is not to say that the corporation should maximize pecuniary profits regardless of the means employed. In particular, an unappealing implication of the unrestrained pursuit of profit is that firms should not take the legal as pre-determined, pre-determined, but instead become actively involved in seeking to relax r ulesregime rules that constrain their imposition of externalities. Such corporate influence in the rule-making rule-making process is clearly problematic, and to the extent We speak here of maximizing the “aggregate “aggregate welfare” of society more as a loose metaphor than a precise yardstick. Tere is no coherent way to put a number on society’s aggregate welfare, much less to maximize maximi ze that number— and particularly so when many benefits are in appreciable part nonpecuniary. What we are suggesting here might be put more precisely in the language of welfare economics as pursuing Kaldor-Hicks Kaldor-Hicks efficiency within acceptable patterns of distribution. Shareholders are a corporation’ corporation’s “residual claimants” claimants” in the sense that they are entitled to appropriate all (and only) the net assets and earnings of the corporation after all contractual claimants— such as employees, suppliers, and customers—have customers— have been paid in full. For firms in industries subject to regulation to control externalities, corporate political spendspending is universal: John C. Coates IV, Corporate Politics, Governance, and Value Before and After Citizens Citizens United, 9 J E L S 657 (2012).
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What Is Corporate Law?
that regulation is consequently compromised, it may be appropriate a ppropriate for corporate law to seek to modify internal governance arrangements accordingly. accordingly. How generally the pursuit of shareholder value is an effective means of advancing overall social welfare is an empirical question, on which reasonable minds can differ. While each of the authors of this book has individual views on this claim, we do not take a strong position on it in the chapters that follow follow.. Rather, Rather, we undertake the broader task of offering an analytic framework within which this question can be explored and debated. Another view is that, given the prominent role of the business corporation in the modern economy, corporate law can be harnessed to promote social welfare directly through more tailored interventions, for example by imposing socially oriented dis-
closure obligations or molding the corporation’s corporation’s internal governance arrangements to address broader social problems. From this perspective, corporate law may be used to promote economic or social objectives beyond maximizing the value of the firm, such as reducing systemic risk, mitigating gender inequity inequity,, or protecting the environment.¹ Although as old as corporate law itself,² the deployment of corporate law to protect the interests of parties external to the firm has found renewed favor among lawmakers law makers in the wake of the recent financial crisis. We consider some examples of this in Chapter 4, but otherwise concentrate on the role of corporate law in maximizing the value of the firm by protecting the interests of its contractual constituencies.
1.6 What Forces Forces Shape Shape Corporate Law? o say that the pursuit of aggregate social welfare is the appropriate goal of corporate law is not to say, say, of course, that the t he law always pursues it in the same way. Te particular contours of the problems to which corporate law responds may be, at least in part, determined by other aspects of the corporate governance environment—for example, predominant industry type, institutions governing employee relations, and the structure of share ownership. Tese may consequently complement particular particular features of corporate law.³ Similarly, other features of the environment—for environment—for example, the quality of legal institutions—may institutions—may make certain aspects of corporate law more or less effective in performing these functions. In each case, these point to particular ways in which corporate law can enhance social welfare—the welfare—the selection of which might be termed an “efficiency” effect on corporate law.
Leo E. Strine, Jr. and Nicholas Walter, Conservative Collision Course: Te ension between Conservative Lawmost Teory and Citizens , 100 C LtoR ¹ By far the popular means toUnited protect inter interests ests external the firm335 is through t(2015). hrough the imposition of substantive rules or standards of different stripes (as those of antitrust law, environmental laws, human rights laws, antidiscrimination laws, financial regulation, etc.). For our purposes, as in general parlance, the use of legal rules for purposes other than increasing the value of the firm is the boundary bou ndary separating corporate from other areas of law law.. On the use of corporate governance to address a variety of economic and social problems, see Mariana Pargendler, Te Corporate Governance Obsession, Obsession, 42 J C C L L 101 (2016). ² See e.g. Herbert Hovenkamp, E A L, 1836–1937, 1836– 1937, 63–4 63–4 (1991); Hansmann and Pargendler, Pargendler, note 47, 47 , at 145. ³ For instance, an educational system that favors vocational and firm-specific firm-specific training will work best under a labor law regime that protects employees against dismissal and under a system of corporate finance that is more relational and immune to short-term short-term oscillations in market conditions. Germany traditionally embodied this institutional bundle. In the U.S., by contrast, a labor regime of at-will atwill employment favors a more generalist style of education and facilitates vibrant capital markets subject to dispersed ownership and hostile takeovers. See Hall and Soskice, note 1.
What Forces Shape Corporate Law?
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Nor indeed does saying that the pursuit of social welfare is the appropriate goal of corporate law imply that corporate law always does serve that goal. Understanding Understanding how corporate law comes to pursue particular goals is a question of political economy—that economy—that is, the political and economic forces that shape lawmaking. Te political economy of corporate law generally reflects the interests of influential constituencies, such as controlling shareholders, corporate managers, or organized workers. In the presence of competitive markets, these interests often coalesce on welfare-enhancing welfare-enhancing laws, producing the “efficiency” effect on corporate law. Yet in some circumstances, lawmakers pay undue regard to the interests of particular constituencies, a fondness for which might be termed a “political” effect on corporate law.
Another politi Another political cal effec effectt is the phen phenomen omenon on of popu populist list refo reforms rms after a scand scandal al or crisis crisis.. In the period after a crisis, lawmakers feel strong pressure from the electorate to implement reforms, the content of which is determined by what appeals generally, generally, which may be quite different from what will actually solve the underlying economic problems. Te extent to which there is a divergence is another political effect on corporate law. Corporate law everywhere continues to bear the imprint of the historical path through which it has evolved, reflecting both political and efficiency effects along the way. way. Reforms triggered by the recent financial crisis illustrate both efficiency and political concerns. In the immediate aftermath of the crisis, many asked whether it did not call into question effectiveness of corporate law in promoting social welfare. As the dust settled, it became tolerably clear—at clear—at least to us—that us—that the implications of the crisis were mostly confined to the governance regimes applicable to banks and other financial institutions, which have an unusual degree of interconnection and propensity to contagion. Consequently, Consequently, there are good functional reasons for introducing special regimes for bank governance that differ from ordinary business firms. However, However, some post-crisis postcrisis reforms have been more general in their scope—which scope—which may be understood as reflecting populist political concerns triggered t riggered by the crisis. Wee touch W t ouch here briefly on perhaps the most conspicuous of the various forces that help shape—and, shape—and, in turn, are shaped by—corporate by—corporate law: the pattern of corporate ownership. Te nature and number of corporate shareholders differ markedly even among the most developed market economies. In recent years, the t he extent of these differences has lessened, but their historic and remaining contours surely leave a mark on the structure of corporate law la w. Its relevance for our account is twofold: ownership structure affects the functionality of different legal strategies, and also the interest group dynamics that govern changes in corporate law law.. In the U.S. and the UK, there are large numbers of publicly traded corporations that have dispersed share ownership, such that no single shareholder, shareholder, or affiliated affilia ted group of shareholders, is capable of exercising control over the firm. Shareholdings among
See e.g. Mark J. Roe, P P D C C G (2003); Peter Peter A. Gourevitch and James Shinn, P P C C (2005). See Pepper D. Culpepper, Culpepper, Q P B B P (2011). For a discussion of the goals of corporate corporate law, law, see Section 1.5. See Armour and Gordon, Gordon, note 49; Armour et al., note 6, ch 17. See e.g. Roberta Romano, Regulating in the Dark , 1 J F P 23 (2013). Rafael La Porta, Porta, Florencio LopezLopez-dede-Silanes, Silanes, and Andrei Shleifer, Corporate Ownership Around the World , 54 J F 471, 492–3 492–3 (1999); Mara Faccio and Larry H.P. Lang, Te Ultimate Ownership of Western European Corporations , 65 J F E 365, 379–80 379– 80 (2002). But see Clifford G. Holderness, Te Myth of Diffuse Ownership in the United States , 22 R F S 1377 (2009).
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What Is Corporate Law?
major Japanese firms are also often highly dispersed,¹ though in the second half of the twentieth century it was common for a substantial fraction of a firm’s stock to be held by other firms in a loose group with substantial reciprocal cross-shareholdings.¹¹ cross-shareholdings.¹¹ In our other jurisdictions, in contrast, even firms with publicly trading shares have traditionally had a controlling shareholder , in the form of another firm often at the top of a closely coordinated group of other firms,¹² individuals, families, or the state.¹³ Te types of entities by or through which non-controlling non-controlling stakes are held also differ substantially from one country to another. Te U.S. traditionally had high levels of ownership by retail investors . In contrast, UK stock ownership in the late twentieth century was dominated by institutional investors —primarily domestic pension funds and insurance companies.¹ In Germany, large commercial banks traditionally held
substantial blocks of shares on their own account, and also served as custodians for large amounts of stock owned by individuals, whose votes were often effectively exercised by the banks themselves.¹ However How ever,, this pattern has changed in recent years. A secular growth in assets under management by U.S. institutional investors—principally mutual funds and employerestablished pension funds¹—means funds¹—means their ownership of stock now dwarves that of retail investors. Tis growth has also led U.S. institutions to t o invest in other stock markets around the world. Tus in the t he UK, domestic institutions have, since the turn of the century, ceded ownership of the majority of stock to international investors, thought to be mainly U.S. institutions.¹ In Germany, many large companies also now have a majority of foreign shareholders. And even elsewhere international investors hold a substantial chunk of listed companies companies’’ free float. While there is a certain degree of convergence in ownership structures across jurisdictions, there is arguably greater variance in the shareholding patterns of different firms within any given jurisdiction. Te past two decades have also seen the rise of new types of institutional investor. Conspicuous among these are hedge funds and and private equity funds. Hedge funds are ¹ By some accounts, share ownership in Japanese Japanese publicly held corporations is more dispersed than in the U.S.: see Holderness, note 99; Julian Franks, Colin Mayer, and Hideaki Miyajima, Te Ownership of Japanese Corporations in the 20th Century , 27 R F S 2580 (2014). ¹¹ See S E, S O S, 4 (2014); Franks et al., note 100, at 29–40. 29–40. For recent unwinding of cross-shareholdings, cross-shareholdings, see Gen Goto, Legally “Strong” Shareholders of Japan Japan,, 3 M J P E V C 125, 144–6 144–6 (2014). ¹² However, there are indications that the traditional position in some jurisdictions, notably Germany, is starting to change in favor of more dispersed stock ownership: see Steen Tomsen, Convergence of Corporate Governance during the Stock Market Bubble: owards Anglo- American American or European ed., Standards? inolfC G and F O 306– 12 306–12 (Anna Grandori 2004); W olf-Georg Georg Ringe, Changing Law Ownership Patterns in297, Germany: Corporate Governance and the Erosion of Deutschland AG , 63 A J C L 493 (2015). ¹³ See Alexander Aganin and Paolo Volpin, Te History of Corporate Ownership in Italy , in A H C G A W W (Randall K. Morck ed., 2005); Mariana Pargendler, State Ownership and Corporate Governance , 80 F L R 2917 (2012); Aldo Musacchio and Sergio Lazzarini, R S C: L B, B B (2014). ¹ See Geof P. P. Stapledon, I S C G G (1996). ¹ See e.g. Ralf Elsas and Jan P. P. Krahnen, Universal Banks and Relationships with Firms , in G F S 197 (Jan P. Krahnen and Reinhard H. Schmidt eds., 2006). See also sources cited note 102. ¹ Board of Governors of the the Federal Reserve System, F F F A U U S: A F O, 2005–13, 2005–13, 98 (able L.213) (2014). ¹ Office for National Statistics Statistics (UK), O UK Q Q S, (2014).
What Forces Shape Corporate Law?
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relatively unregulated collective investment funds which, despite their name, often adopt highly speculative strategies including purchasing substantial stakes in individual firms,¹ and sometimes agitate for major changes in the t he firms’ structure, strategy, strategy, or management. Private equity firms, in turn, are (typically) investment vehicles that acquire, at least temporarily temporarily,, control, and then complete ownership of formerly public companies to effect major changes in the firms’ structure, strategy, strategy, or management.¹ management.¹ Wee have also seen the proliferation of state W state-controlled controlled institutional investors, such as sovereignn wealth funds. sovereig Plausibly,, differences in patterns Plausibly patt erns of shareholding across countries correlate with differences in the structure of corporate law. An influential series of empirical studies on “law and finance” reported that, at the end of the twentieth century, countries
with greater legal protection for shareholders (against opportunism by managers and controlling shareholders) had less concentrated shareholdings,¹¹ although subsequent studies found the results to be sensitive to the way in which “protection protection”” is measured.¹ measured.¹¹¹ ¹¹ Such a pattern is consistent with both changes in the configuration of interest groups who call for changes in corporate laws, and changes in the types of corporate law rules that yield functional outcomes. o some extent, therefore, the structure of corporate law in any given country is a consequence of that country’s country’s pattern of corporate ownership. Tis in turn is determined at least in part by forces exogenous to corporate law.¹¹² It It has been argued, for example, that the traditionally retail-oriented retail-oriented pattern of U.S. shareholdings was a product of that country’s history of populist politics, which generated a number of policies successfully designed to frustrate family and institutional control of industrial enterprise.¹¹³ Correspondingly,, it is said that the traditionally more concentrated share ownership patCorrespondingly terns in continental Europe and Japan complemented particular patterns of industrial development.¹¹ On this view, a controlling shareholder may, under certain circumstances, be better placed to make credible long-term long-term commitments to employee employees,s, which in turn may facilitate labor relations—and relations—and hence productivity—where productivity—where the goal is to motivate workers to use existing technology, technology, rather than t han to develop new technologies.¹¹ ¹ Marcel Kahan and Edward B. Rock, Hedge Funds in Corporate Governance and Corporate Control , 155 U P L R 1021 (2007); Ronald J. Gilson and Jeffrey N. Gordon, Te Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights , 113 C L R R 863 (2013). (201 3). ¹ See Brian R. Cheffins and John Armour, Armour, Te Eclipse of Private Equity , 33 D J C L 1 (2008); Viral V. Acharya, Oliver F. Gottschalg, and Moritz Hahn, Corporate Governance and Value Creation: Evidence from Private Equity , 26 R F S 368 (2013). ¹¹ For a review review, , seeOrigins Rafael, La PJ orta, Florencio Lopez-de-Silanes, Lopez-deSilanes, and285 Andrei Shleifer, Te Economic Consequences of Legal 46 Porta, E L (2008). ¹¹¹ See Sofie Cools, Te Real Difference in Corporate Law Between the United States and Continental Europe: Distribution of Powers , 30 D D J C L L 697 (2005); (2005) ; John Armou Armour, r, Simon Deakin, Prabirjit Sarkar, and Ajit Singh, Shareholder Protection and Stock Market Development: An Empirical est of the Legal Origins Hypothesis , 2 J E L S 343 (2009); Holger Spamann, Te “Antidirector Rights Index” Revisited , 23 R F S 467 (2010). ¹¹² Brian R. Cheffins, Does Law Matter? Te Separation of Ownership and Control in the United Kingdom,, 30 J L S 459 (2001); John C. Coffee, Jr., Te Rise of Dispersed Kingdom Ownership: Te Roles of Law and the State in the Separation of Ownership and Control , Control , 111 Y L J 1 (2001). ¹¹³ Mark J. Roe, S M, M, W W O (1994). ¹¹ See Wendy Wendy Carlin and Colin Mayer, Mayer, Finance, Investment and Growth, Growth, 69 J F E 191 (2003). ¹¹ See Hall and Soskice, note 1; Barry Eichengreen, E’ E S (2006); Colin Mayer, F C C (2013). Compare also Chapter 4.4.1.
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What Is Corporate Law?
Tis is principally a book about the structure and functions of corporate law, not about its origins. Nonetheless, in the chapters that follow we will here and there explore, briefly and somewhat speculatively, the influence of ownership structure— and of other forces as well—in well—in shaping the patterns of corporate law that we see across jurisdictions.
2 Agency Problems and Legal Strategies John Armour Armour,, Henry Hansmann, Hansmann, and and Reinier Kraakman Kraakman
2.1 Tree Agency Problems
As we explained in Chapter 1,¹ corporate law performs two general functions: first, it establishes the structure of the corporate form as well as ancillary housekeeping rules necessary to support this structure; second, it attempts to control conflicts of interest among corporate constituencies, including those between corporate “insiders, “insiders,”” such as controlling shareholders and top managers, and “outsiders,” such as minority shareholders or creditors. Tese conflicts all have the character of what economists refer to as “agency problems” or “principal-agent” “principal-agent” problems. For readers unfamiliar with the jargon of economists, an “agency problem”— problem”—in in the most general sense of the term— arises whenever one party, termed the “principal,” “principal,” relies upon actions taken by another party, termed the “agent,” which will affect the principal’s welfare. Te problem lies in motivating the agent to act in the principal’s interest rather than simply in the agent’ agent’ss own interest. Viewed in these broad terms, agency problems arise in a broad range of contexts that go well beyond those that would formally be classified as agency relationships by lawyers. In particular, almost any contractual relationship, in which one party (the “agent”) promises performance to another (the “principal”), “principal”), is potentially potent ially subject to an agency problem. Te core of the difficulty is that, because the agent commonly has better information than does the principal about the relevant facts, the principal cannot easily assure himself that the agent’s performance is precisely what was promised. As a consequence, the agent has an incentive to act opportunistically,² skimping on the quality of his performance, or even diverting to himself some of what was promised to the principal. Tis means, in turn, that the value of the agent’s performance to the principal will be reduced, either directly or because, to assure the quality of the agent’s performance, the principal must engage in costly monitoring of the agent. Te greater the complexity of the tasks undertaken by the agent, and the greater the discretion the agent must be given, the larger these “agency costs” are likely to be.³ As we we noted in Chapter Chapter 1, three generic agency problems arise in business firms. Te first involves the conflict between the firm’s owners and its hired managers. Here the owners are the principals and the managers are the agents. Te problem lies in assuring ¹ See Chapter 1.1. ² We use the term “opportunism” “opportunism” here, following the usage of Oliver Williamson, to refer to selfinterested behavior that involves some element of guile, deception, misrepresentation, or bad faith. See Oliver Williamson, Willi amson, E I C C 47–9 47– 9 (1985). ³ See e.g. Steven Ross, Te Economic Teory of Agency: Te Principal’s Problem, Problem , 63 A E R 134 (1973); P A: S B (John W. Pratt and Richard J. Zeckhauser eds., 1984). Te Anatomy of Corporate Law. Tird Edition. Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry Hansmann, Hertig, KlausHansmann, Hopt, Hideki Pargendler, Wolf-Georg Ringe, andUniversity Edward Press. Rock. Chapter 2 © Gerard John Armour, Armour , Henry and Kanda, Reinier Mariana Kraakman, 2017. Published 2017 by Oxford
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that the managers are responsive to the owners’ interests rather than pursuing their own personal interests. Te second agency problem involves the conflict between, on one hand, owners who possess the majority or controlling interest in the firm and, on the other hand, the minority or noncontrolling owners. Here the noncontrolling owners can be thought of as the principals and the controlling owners as the agents, and the difficulty lies in assuring that the former are not expropriated by the latter. While this problem is most conspicuous in tensions between majority and minority shareholders, it appears whenever some subset of a firm’s owners can control decisions affecting the class of owners as a whole. Tus if minority shareholders enjoy veto rights in relation to particular decisions, it can give rise to a species of this second agency problem. Similar problems can arise between ordinary and preference shareholders, and between senior and
junior in bankruptcy (when creditors cthe reditors arebetween the effective effective owneitself—including, owners rs of the firm). Te creditors third agency problem involves conflict the firm itself— including, particularly, its owners—and owners—and the other parties with whom the firm contracts, such as creditors, employees, employees, and customers. Here the difficulty lies in assuring that the firm, as agent, does not behave opportunistically toward these various other principals—such as by expropriating creditors, exploiting workers, or misleading consumers. In addition to these agency problems—which we view as fundamentally voluntary in nature— there are also situations where a firm imposes costs on parties who do not contract with it—soit—so-called called “externalities.” “externalities.” We We treat these issues specifically in Chapters 4 and 5. In each of the foregoing problems, the challenge of assuring agents’ responsiveness is greater where there are multiple principals—and principals—and especially so where they have diverging interests, or “heterogeneous preferences” as economists say. Multiple principals will face information and coordination costs , which will inhibit their ability to engage in collective Tese in between turn willprincipals interact with problems in twomore ways. difficultiesaction. of coordinating will agency lead them to delegate of First, their decision-making decisionmaking to agents. Second, the more difficult it is for principals to coordinate on a single set of goals for the agent, the harder it is to ensure that the agent does the “right” thing. Coordination costs as between principals thereby exacerbate agency problems. Law can play an important role in reducing agency costs. Obvious examples are rules r ules and procedures that enhance disclosure by agents or facilitate enforcement actions brought by principals against dishonest or negligent agents. Paradoxically Paradoxically,, mechanisms that impose constraints on agents’ ability to exploit their principals tend to benefit agents as much as—or as—or even more than—they than—they benefit the principals. Te reason is that a principal will be willing to t o offer greater compensation to an agent when the principal is assured of performance that is honest and of high quality. o take a conspicuous example in the corporate context, rules of law that protect creditors from opportunistic behavior on the part of corporations should reduce the interest rate that corporations Tese problems become more severe the smaller the degree of ownership of the firm that is enjoyed by the controlling shareholder. See Luca Enriques and Paolo Volpin, Corporate Governance Reforms in Continental Europe , 21 J E P 117, 122–5 122–5 (2007). Classic statements of this problem are found in James M. Buchanan and Gordon ullock, ullock, C C 63–116 63–116 (1962) and Mancur Olsen, L C A (1965). Frank H. Easterbrook and Daniel R. Fischel, E S C L L 66–77 (1991). 66– See Hideki Kanda, Debtholders and Equityholders , 21 J L S 431, 440–1, 440– 1, 444–55 (1992); Henry Hansmann, 444– O E 39–44 39– 44 (1996).
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must pay for credit, thus benefiting corporations as well as creditors. Likewise, legal constraints on the ability of controlling shareholders to expropriate minority shareholders should increase the price at which shares can be sold to noncontrolling shareholders, hence reducing the cost of outside equity capital for corporations. And rules of law that inhibit insider trading by corporate managers should increase the compensation that shareholders are willing to offer the managers. In general, reducing agency costs is in the interests of all parties to a transaction, principals and agents alike. It follows that the normative goal of advancing aggregate social welfare, as discussed in Chapter 1, is generally equivalent to searching for optimal solutions to the corporation’s agency problems, in the sense of finding solutions that maximize the aggregate welfare of the parties involved—that involved—that is, of both principals and agents taken together. together.
2.2 Legal Strategies Strategies for Reducing Agency Costs In addressing agency problems, the law turns repeatedly to a basic set of strategies. We We use the term “legal strategy” strategy” to mean a generic method of deploying law instrumentally in a functional way—the way—the function in this context being to mitigate the vulnerability of principals to the opportunism of their agents. A rule of law implementing a legal strategy may be, as discussed in Chapter 1, either a mandatory or a default rule, or one among a menu of alternative rules. Indeed, most such strategies do not necessarily require generally applicable legal norms for their implementation: a practice of contracting may be an effective substitute, or contracts may complement a general rule by tailoring it to particular circumstances. We observed in Chapter 1 that, of the five defining characteristics of the corporate form, only one—legal one—legal personality—clearly personality—clearly requires specialforrules of law.¹ Te other characteristics could, in principle, adopted by contract—for contract— example, through appropriate provision provisions s in the articles of be association agreed to by the firm’s owners.¹¹ Te same is true of the various strategies we set out in this section.¹² It follows that the contribution of “the law” in implementing legal strategies will vary depending on the strategy in question. Legal strategies for controlling agency costs can be loosely categorized into two subsets, which we term, respectively, “regulatory strategies” and “governance strategies.” Regulatory strategies are prescriptive: they dictate substantive terms that govern the content of the principal-agent principal-agent relationship, tending to constrain the agent’s behavior directly.. By contrast, governance strategies seek to facilitate the principals’ control over directly their agent’s behavior.¹³ Te efficacy of governance strategies depends crucially on the ability of the principals to exercise their control rights. Coordination costs between principals will make it more difficult for them either to monitor the the agent so as to determine the See Chapter 1.5. See the discussion of the the various forms that rules can take in Chapter Chapter 1.3–1.4. 1.3–1.4. ¹ See Chapter 1.2.1. ¹¹ Law can, however, however, provide useful assistance to parties in relation to these other characteristics characteristics through the provision of “standar “standardd forms.” See Chapter 1.4.1. 1.4.1 . ¹² For evidence on the role of contractual solutions to agency problems adopted by individual firms, see Paul Gompers, Joy Ishii, and Andrew A ndrew Metrick, Corporate Governance and Equity Prices , 118 Q J E 107 (2003); Lucian Bebchuk, Alma Cohen, and Allen Ferrell, What Matters in Corporate Governance? 22 22 R F S 783 (2009). ¹³ An alternative labelling would w ould therefore be a distinction between “agent-constraining” and “principal-empowering” “principalempowering” strategies.
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able 2–1 2–1 Legal Strategies for Protecting Principals
E A E P
Agent Constraints
Affiliation erms
Incentive Alignment
Appointment Rights
Decision Rights
R S
E E
R
S R
I V
appropriateness of her actions, or to decide whether, whether, and how, to take action to sanction nonperformance. High coordination costs thus render governance strategies less successful in controlling agents, and—other and—other things equal—make equal—make regulatory strategies more attractive.
Regulatory strategies preconditions for success.a Most they depend for efficacy have on thedifferent ability of an external authority—a authority— court obviously, or regulatory body—with body—with sufficient expertise to determine whether or not the agent complied with particular prescriptions. o be sure, governance strategies rely too on legal institutions to protect the principals’ decision-making decision-making entitlements as respects corporate assets—that assets— that is, their “property rights.”¹ But governance strategies themselves do not specify appropriate courses of action. Specification of agents’ required behavior also presupposes effective disclosure mechanisms to ensure that information about the actions of agents can be “verified” by the relevant external body. In contrast, governance strategies—where strategies—where the principals are able to exercise them usefully—require usefully—require for effective decisions only that the principals themselves are able to observe the actions taken by the agent, for which purpose “softer” “softer” information may suffice. able 2–1 2–1 sets out ten legal strategies which, taken together, together, span the law’ law’ss principal methods of dealing agency problems. Tesenearly strategies are not limited to theagent corporate context; theywith can be deployed to protect vulnerable principalprincipal-agent any vulnerable relationship. Our focus here, however however, is naturally nat urally on the ways that these strategies are deployed in corporate law. law. At the outset, we should emphasize that the aim of this exercise is not to provide an authoritative taxonomy, taxonomy, but simply to t o offer a heuristic device for thinking about the functional role of law in corporate affairs. As a result, the various strategies are not entirely discrete but sometimes overlap, and our categorization of these strategies does not correlate perfectly with corporate law doctrine. More Moreover over,, their use in practice is not mutually exclusive: they may be applied, as appropriate, in combination or individually individually..
2.2.1 Rules and standards Te pair ofof regulatory constrains agentsofbytheir commanding themmost not tofamiliar take courses action thatstrategies would harm the interests principals. Lawmakers can frame such constraints as rules , which require or prohibit specific behaviors, or as general standards , which leave the precise determination of compliance to adjudicators after the fact. Both rules and standards attempt to regulate the substance of agency relationships directly.. Rules, which prescribe specific behaviors ex ante ,¹ directly ,¹ are commonly used in the ¹ See Oliver D. Hart, Incomplete Contracts and the Teory of the Firm, Firm, 4 J L, E, O 119, at 123–5 123–5 (1988). ¹ For the canonical comparison of the merits of rules and standards as regulatory techniques, see Louis Kaplow Kaplow,, Rules Versus Standards: An Economic Analysis , 42 D L J 557 (1992).
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corporate context to protect a corporation’s creditors and public investors. Tus corporation statutes universally include creditor protection rules such as dividend restrictions, minimum capitalization requirements, or rules requiring action to be taken following serious loss of capital.¹ Similarly, Similarly, capital market authorities frequently promulgate detailed rules to govern takeovers takeovers and proxy voting.¹ By contrast, few jurisdictions rely solely on rules for regulating complex, intracorporate relations, such as, for example, self-dealing self-dealing transactions initiated by controlling shareholders. Such matters are presumably too complex to regulate with just a matrix of prohibitions and exemptions, which would threaten to codify loopholes and create pointless rigidities. Rather than rule-based rule-based regulation, then, intra-corporate intra-corporate topics such as insider self-dealing self-dealing tend to be governed by open standards that leave discretion for adjudicators to determine ex post whether whether violations have occurred.¹
Standardsofarestandards-based also usedbased to protect creditors investors, but theaffairs, paradigmatic examples standardsregulation relateand to the tpublic he company’s company’ s internal as when the law requires directors to act in “good faith” or mandates that self-dealing self-dealing transactions be “entirely fair.”¹ Te efficacy of both rules and standards depends in large measure on the vigor with which they are enforced. In principle, rules can be mechanically enforced, but require effort to be invested ex ante by by rule-making rule-making bodies to ensure they are appropriately drafted. Standards, in contrast, require courts (or other adjudicators) to become more deeply involved in evaluating and sometimes molding corporate decisions ex post .² .² Tese decisions themselves then prescribe the standard to future parties, over time building up to a body of guidance.
2.2.2 Setting the terms terms of entry and exit A second set of regulatory strategies open to the law involve regulating the terms on which principals affiliate with with agents rather than—as with rules and standards— regulating the actions of agents after the principal-agent principal-agent relationship is established. Te law can dictate terms of entry by, by, for example, requiring agents to disclose information about the likely quality of their performance before contracting with principals.²¹ Alternatively,, the Alternatively t he law can prescribe exit opportunities for for principals, such as awarding to a shareholder the right to sell her stock, or awarding to a creditor the right to call for repayment of a loan. In publicly traded companies, the way in which these strategies are deployed affects directly the operation of capital markets and the market for corporate control. Te entry strategy is particularly important in screening out opportunistic agents in the public capital markets.²² Outside investors know little about public companies unless they are told. Tus, it is widely accepted that public investors require some ¹ See Chapter 5.2.2. ¹ See e.g. Chapter 8.1.2.4 (takeovers) and Chapter 3.2.4 (proxy voting). ¹ See Chapter 6.2.5. Tis is not to say that rules are wholly absent from such situations: some jurisdictions regulate forms of self-dealing self-dealing judged to merit particular suspicion through rules in combination with a more general standards strategy strategy.. ¹ See Chapter 6.2.5. ² In this sense, standards standards lie between rules (which simply require a decision-maker decision-maker to determine compliance) and another strategy that we will address below—the below—the trusteeship strategy strategy,, which requires a neutral decision-maker decision-maker to exercise his or her own good faith best judgment in making a corporate decision. ²¹ Se Seee Ch Chap aptter 5. 5.2. 2.11 an andd Ch Chap aptter 9. 9.1. 1.2. 2. ²² Se Seee Ch Chap aptter 9. 9.1. 1.2. 2.
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form of systematic disclosure to obtain an adequate supply of information. Legal rules mandating such disclosure provide an example of an entry strategy because stocks cannot be sold unless the requisite information is supplied, generally by the corporation itself.²³ A similar but more extreme form of the entry strategy is a requirement that the purchasers of certain securities meet a threshold of net worth or financial sophistication.² Te exit strategy, which is also pervasive in corporate law, allows principals to escape opportunistic agents. Broadly speaking, there are two kinds of exit rights. Te first is the value of one’s investment. Te best example of such a right the right to withdraw the in corporate law is the technique, employed in some jurisdictions, of awarding an appraisal right to shareholders who dissent from certain major transactions such as mergers.² As we discuss in Chapter 7,² appraisal permits shareholders who object to
to the atransaction— significant transaction to claim the valueloss thatif,their sharesview, had prior transaction—thus thus avoiding a prospective in their the firm hasdisputed made a value-reducing valuereducing decision. Te second type of exit right is the right of transfer —the right to sell shares— shares—which which is of obvious importance to public shareholders. (Recall that transferability of shares is a core characteristic of the corporate form.) Standing alone, a transfer right provides less protection than a withdrawal right, since an informed transferee steps into the shoes of the transferor, and will therefore offer a price that impounds the expected future loss of value from insider mismanagement or opportunism. But the transfer right permits the replacement of the current shareholder/principal(s) shareholder/principal(s) by a new one that may be more effective in controlling the firm’s management. Tus, unimpeded transfer rights allow hostile takeovers in which the disaggregated shareholders of a mismanaged company can sell their shares to a single active shareholder with a strong financial interest in
efficient management.² Such transfer of control rights, orMoreover, even the threat of it, can be a highly effective device foradisciplining management.² transfer rights are a prerequisite for stock markets, which also empower disaggregated shareholders by providing a continuous assessment of managerial performance (among other things) in ²³ Te role of disclosure rules in facilitating entry is most intuitive in relation to prospectus disclosure for initial public offerings, and new issues of seasoned equity. Ongoing disclosure rules may to some extent also facilitate entry, by new shareholders in the secondary market, while at the same time facilitating exit by existing shareholders— an example of a single set of rules implementing more than one strategy. However, the function of ongoing disclosure rules is more general: see Section 2.3 and Chapter 9.1.2. ² See Chapter 9.1.2.4. ² Te withdrawal right is a dominant dom inant governance device for the regulation of some non-corporate forms of enterprise such as the common law partnership at will, which can be dissolved at any time by any partner. Bcharter usinessprovisions. corporations grant similar withdrawal rightsbytoopen-ended theirended shareholders through special Business Tesometimes most conspicuous example is provided openinvestment companies, such as mutual funds in the U.S., which are frequently formed as business corporations under the general corporation statutes. Te universal default regime in corporate law, however, provides for a much more limited set of withdrawal rights for shareholders, and in some jurisdictions none at all. See John Morley and Quinn Curtis, aking Exit Rights Seriously: Why Governance and Fee Litigation Don’t Work in Mutual Funds , 120 Y L J 84 (2010). ² See Chapter Chapter 7.2.2, 7.4.1.2. ² Many firms introduce contractual provisions which serve to restrict restrict transfer rights, such as “poi“poison pills”: see Bebchuk et al., note 12. Some jurisdictions impose limits on the extent to which transfer rights may be impeded. impeded . An example is the EU’s EU’s “breakthrough rule” for takeovers, implemented in a few European countries. See Chapter 8.4.2.2. ² Viewed this way, way, of course, legal rules that enhance transferability serve not just as an instance of the exit strategy but, simultaneously simultaneousl y, as an instance of the entry strategy and incentive i ncentive strategy as well. Te same legal device can serve multiple protective functions.
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the form of share prices.² Mandated disclosure also assists with this version of the exit strategy, by increasing transparency for existing investors and potential bidders about whether the company is underperforming under its current management team.³
2.2.3 rustee rusteeship ship and reward Tus far we have described regulatory strategies that might be extended for the protection of vulnerable parties in any class of contractual relationships. We now move to strategies that relate to the hierarchical elements of the principal-agent principal-agent relationship. Wee consider first incentive alignment strategies , which straddle the boundary between W regulatory and governance strategies. Te first incentive alignment strategy—the trusteeship strategy —seeks to remove conflicts of interest ex ante to ensure that an agent will not obtain personal gain from disserving her principal. In many contexts—including its origin in the role of a
“trustee” proper—this proper—this involves a regulatory strategy, which does not define what the agent can do, but rather what she can’t do.³¹ do.³¹ Tis strategy assumes that, in the absence a bsence of strongly focused—or focused—or “high-powered”— “high-powered”—monetary monetary incentives to behave opportunistically, agents will respond to the “low-powered” “low-powered” incentives of conscience, pride, and reputation,³² and are thus more likely to manage in the interests of their principals. One well-known well-known example of the trusteeship strategy is the “independent director,” now relied upon in many jurisdictions to monitor management. Such directors will not personally profit from actions that disproportionately benefit the firm’s managers or controlling shareholders, and hence are expected to be guided more strongly by conscience and reputation in making decisions.³³ Similarly, reliance on auditors to approve financial statements and certain corporate transactions is also an example of trusteeship, provided the auditors are motivated principally by reputational concerns.³ In certain circumstances other agents external to the corporation may be called ² See James Dow and Gary Gorton, Stock Market Efficiency and Economic Efficiency: Is Tere a Connection? 52 52 J F 1087 (1997). And see Chapter 9.1.1. ³ See John Armour and Brian Brian Cheffins, Stock Market Prices and the Market for Corporate Control , 2016 U I L L R 101 (2016). ³¹ See Matthew Conaglen, F L L: : P D P NF D (2010). F (20 10). ³² We use the terms “high-powered “high-powered incentives” and “low-powered “low-powered incentives” as they are conventionally used in the economics literature, to refer to the distinction between economic incentives on the one hand and ethical or moral incentives on the other. Tese correspond to some degree with the distinction drawn in the psychology literature between “extrinsic” (instrumental) and “intrinsic” (for an activity’s own sake) motivation. Economic incentives are high-powered high-powered in the sense that they are concrete and sharply focused. See e.g. Williamson, note 2, 137– 137–41; 41; Bengt Hölmstrom and Paul Milgrom, Te Firm as an powered” Incentive System, System , 84 we A E R 972 are (1994). By referring to moral norms as “low-powered” “lowincentives do not mean to imply that they generally less important in governing human behavior than are monetary incentives. Surely, for most individuals in most circumstances, the opposite is true, and civilization would not have come very far if this were not the case. ³³ On the reputational consequences for independent directors of poor performance, see David Yermack, Y ermack, Remuneration, Retention, and Reputation Incentives for Outside Directors , 54 J F 2281 (2004); Eliezer M. Fich and Anil Shivdasani, Financial Fraud, Director Reputation, and Shareholder Wealth, Wealth, 86 J F E 306 (2007); Ronald W. Masulis and Shawn Mobbs, Independent Director Incentives: Where do alented Directors Spend their Limited ime and Energy? 111 111 J F E 406 (2014). ³ While auditors face reputational sanctions for failure (see e.g. Jan Barton, Who Cares About Auditor Reputation? 22 22 C A R 549 (2005)), their independence and hence trustee status may be compromised by financial incentives in the form of consulting contracts: see John C. Coffee, What Caused Enron? A Capsule Social and Economic History of the 1990s , 89 C L L R 269, 291–3 291– 3 (2004).
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upon to serve as trustees, as when the law requires an investment banker, banker, a state official, or a court to approve corporate action. Te second incentive strategy is the reward strategy, which— which—as as the name implies— rewards agents for successfully advancing the interests of their principals. Broadly speaking, there are two major reward mechanisms in corporate law. law. Te more common form of reward is a sharing rule that that motivates loyalty by tying the agent’s monetary returns directly to those of the principal. A conspicuous example is the protection that minority shareholders enjoy from the equal treatment norm, which requires a strictly pro rata distribution of dividends.³ As a consequence of this rule, controlling shareholders—here holders— here the “agents”—have “agents”—have an incentive to maximize the returns of the firm’s minority shareholders—here shareholders—here the “principals”—at “principals”—at least to the extent that corporate returns are paid out as dividends. Te reward mechanism less commonly the focus of corporate law is the pay- for for performance regime, in which an agent, although not sharing in his principal’ principal’ss returns,
is nonetheless paid for successfully advancing her interests. Even though no jurisdiction imposes such such a scheme on shareholders, legal rules often either facilitate or discourage high-powered high-powered incentives of this sort.³ American law, for example, has actively encouraged incentive compensation devices such as stock option plans,³ while more skeptical jurisdictions seek to restrict their use.³ Because of the peculiarly firm-specific firm-specific (and even executive-specific) executive-specific) nature of pay-forpay-for-performance performance packages, this reward strategy is typically implemented by contract. Te process of writing such contracts is itself potentially susceptible to agency costs.³ In a development that illustrates how multiple legal strategies may be deployed in combination, many jurisdictions have in recent years prescribed decision rights regarding this process, typically granting shareholders a type of veto over compensation proposals, known as “say on pay.” Tere is potential for tension between trusteeship and reward. High-caliber High-caliber agents will not adopt trusteeship roles without meaningful payment. Yet trustee compensation arrangements require careful thought, because they can generate high-powered high-powered incentives that weaken or even overpower low-powered low-powered incentives.¹ Heavy reliance on stock options, for example, encourages risk-taking, risk-taking, whereas the payment of a large fixed stipend may discourage critical engagement. Neither approach would be desirable in a trustee. Te key is therefore to ensure that trustees are paid enough to make their role worth doing, but not so much as to sideline low-powere low-poweredd incentives.²
³ See Chapter 4.1.3.2. On rules requiring pro rata sharing of takeover takeover premia see Chapter 8.3.3 and 8.3.4. ³ See Chapter 3.3.2. ³ U.S. tax per law annum, has sinceexcept 1993 so limited tax-deductibility tax-deductibility of executive compensation to a maximum of $1m far asthe payments are “performance based” (IRC §162(m)). Tis greatly encouraged the use of incentive compensation: see Brian J. Hall and Kevin J. Murphy, Te rouble with Stock Options , 17 J E P 49 (2003). ³ See e.g. European Commission, Recommendation 2009/3177/ 2009/ 3177/EC EC on Strengthening the Regime for the Remuneration of Directors of Listed Companies. ³ See Lucian Bebchuk and Jesse Fried, Fried, P P W W P: P : U P E C (2004). See Chapter 3.3.2 and Chapter 6.2.3. ¹ See e.g. Bruno S. Frey and Felix Oberholzer- Gee, Te Cost of Price Incentives: An Empirical Analysis of Motivation CrowdingCrowding-Out Out , 87 A E R 746 (1997). Te sorry saga of the banking sector provides a salient illustration: see Alain Cohn, Ernst Fehr, and Michel André Maréchal, Business Culture and Dishonesty in the Banking Industry , 516 N 86 (2014). ² See e.g. Yermack, Yermack, note 33, at 2286–9 (outside directors of U.S. firms commonly receive stock and option awards, but with a pay-performance sensitivity much mu ch lower than for executives).
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2.2.4 Selection and remova removall Given the central role of delegated management in the corporate form, it is no surprise that appointment rights —the power to select or remove directors directors (or other managers)—are agers)— are key strategies for controlling the enterprise. Indeed, these strategies are at the very core of corporate governance. As we will discuss in Chapters 3 and 4, moreover moreov er,, the power to appoint directors is a core strategy not only for addressing the agency problems of shareholders in relation to managers, but also, in some jurisdictions, for addressing agency problems of minority shareholders in relation to controlling shareholders, and of employees in relationship to the shareholder class as a whole. 2.2.5 Initiation and ratification Te pair of legal strategies expands the which powergrant of principals intervene in inithe firm’sfinal management. Tese are decision rights, principalstothe power to
or ratify management management decisions. Again, it is no surprise that this set of decision tiate or rights strategies is much less prominent in corporate law than are appointment rights strategies. Tis disparity is a logical consequence of the fact that the corporate form is designed as a vehicle for the delegation of managerial power and authority to the board of directors. Only the largest and most fundamental corporate decisions (such as mergers and charter amendments) require the ratification of shareholders under existing corporation statutes, and no jurisdiction to our knowledge requires shareholders to initiate managerial decisions.³ 2.2.6 Ex post and and ex ante strategies strategies Te bottom rows in able 2–1 2–1 arrange our ten legal strategies into five pairs, each with an “ex ante ” and an “ex post ” strategy. Tis presentation merely highlights the fact that half of the strategies take full effect before an an agent acts, while the other half respond—at respond— at least potentially—to potentially—to the quality of the agent’s action ex post. In the case of agent constraints, for example, rules specify what the agent may or may not do ex ante , while standards specify the general norm against which an agent’ agent’ss actions will be judged ex post. Tus, a rule might prohibit a class of self-dealing self-dealing transactions outright, while a standard might mandate that these transactions will be judged against a norm of fairness ex post. Similarly, in the case of setting the terms of entry and exit, an entry strategy, such as mandatory disclosure, specifies what must be done before an agent can deal with a principal, while an exit device such as appraisal rights permits the principal to respond after the quality of the agent’s action is revealed. urning to incentive alignment, trusteeship is an ex ante strategy strategy in the sense that it neutralizes an agent’ss adverse interests prior to agent’ t o her appointment by the t he principal, while most reward strategies are ex post in in the sense that their t heir payouts are contingent on uncertain future outcomes, and thus remain less than fully specified until after the agent acts. Te appointment and removal strategies also fall into ex ante and and ex post pairs. pairs. If principals can appoint their agents ex ante , they can screen for loyalty; if principals can ³ See Chapter 3.2.3. Te utility, utility, for reducing agency costs, of separating the initiation of decisions from their ratification was first emphasized by Eugene Fama and Michael Jensen, Separa Separation tion of Ownership and Control , 26 J L E 301 (1983). (198 3). Compare Chapter Chapter 6.2.4 (ex ante prohibitions) prohibitions) and 6.2.5 (ex ( ex post standards). standards). Compare e.g. Chapters 5.2.1, 6.2.1.1, 9.1.2.5 (mandatory disclosure), and 7.2.2 (appraisal).
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remove their agents ex post, they can punish disloyalty. Similarly, shareholders might have the power to initiate a major corporate transaction such as a merger, or—as or—as is ordinarily the case—they case—they might be restricted to ratifying a motion to merge offered by the board of directors. Wee do not wish, however W however,, to overemp overemphasize hasize the clarity or analytic power of this categorization of legal strategies into ex ante and and ex post types. types. One could well argue, for example, that the reward strategy should not be considered an ex post strategy strategy but rather an ex ante strategy strategy because, like the t he trusteeship strategy, strategy, it establishes in advance the terms on which the agent will be compensated. Likewise, one could argue that appointment rights cannot easily be broken into ex ante and and ex post types, types, since an election of directors might involve, simultaneously, simultaneously, the selection of new directors and the removal of old ones. We offer the ex post/ex distinction only as a classification post/ex ante distinction heuristic helpful for purposes of exposition. Indeed, as we have already noted, it is in the same heuristic spirit that we offer our categorization of legal strategies in general. Te ten strategies arrayed in able 2–1 2–1
clearly overlap, and any given legal rule might well be classified as an instance of two or more of those strategies. Again, our purpose here is simply to emphasize the various ways in which law can be used as an instrument, not to provide a new formalistic schema that displaces rather than aids functional understanding.
2.3 Disclosure Disclosure plays a fundamental role in controlling corporate agency costs. As we have already noted, it is an important part of the affiliation terms strategies. Most obviously,, prospectus disclosure forces agents to provide prospective principals with inforously mation that helps them to decide upon which terms, if any, they wish to enter the the firm as owners. o a lesser extent, periodic financial disclosure and ad hoc disclosure—for disclosure—for example, of information relevant to share prices, and of the terms of related party transactions—also transactions— also permits principals to determine the extent to which they wish to remain owners, or rather exit the the firm. However, continuing disclosure also has more general auxiliary effects in relation to each of the other strategies; hence we treat it separately at this point in our discussion. In relation to regulatory strategies that require enforcement, disclosure of related party transactions helps to reveal the existence of transactions that may be subject to challenge, and provides potential litigants lit igants with information to bring bri ng before a court. In relation to governance strategies, disclosure can be used in several different, but complementary,, ways. First, and most generally, mandating disclosure of the mentary t he terms of the t he governance arrangements that are in place allows principals to assess appropriate intervention tactics. Second, and specifically in relation to decision rights, mandatory disclosure of the details of a proposed transaction for which the principals’ approval is sought can improve the principals’ decision. Tird, disclosure of those serving in trustee roles serves to bond their reputations publicly to the effective monitoring of agents. Tere is of course a need to ensure compliance with disclosure obligations themselves. Tis is a microcosm of the more general problem of securing agent compliance. See Chapter 7.4. See Section 2.2.2; see also Chapter Chapter 9.1.2. See e.g. Simeon Djankov, Djankov, Rafael La Porta, Florencio Florencio Lopes-deLopes-de-Silanes, Silanes, and Andrei Shleifer, Te Law and Economics of Self-Dealing Self-Dealing , 88 J F E 430 (2008).
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For periodic disclosures, where the type of information is expected but the content is not yet known (so-called (so-called “known unknowns”), no additional compliance mechanism may be required beyond a public statement that the disclosure is expected. If the principals are made aware that a particular piece of information (e.g. annual financial statements, the structure and composition of the board, or executive compensation arrangements) is expected to be disclosed in a particular format, then non- disclosure itself can send a negative signal to principals, stimulating them to act. Te compliance issue with periodic disclosure is not so much whether it happens, but its quality, and hence a trusteeship strategy—in strategy—in the form of auditors—is auditors—is typically used to assist in assuring this. For ad hoc disclosure, disclosure, the compliance issues are different, because by definition, principals do not expect particular disclosures in advance. Here vigorous legal enforcement seems to be needed to ensure compliance.
2.4 Compliance and Enforcement
Legal strategies are relevant only to the extent that they help to induce agents to act in the principal’s principal’s interest, which for brevity we term agent compliance. In this t his regard, each strategy depends on the existence of other legal institutions—such institutions—such as courts, regulators, and procedural rules—to rules—to secure enforcement of of the legal norms. In this section, we consider the relationship between enforcement and compliance. We then discuss three modalities by which enforcement may be effected. 2.4.1 Enforcement and intervention Enforcement Enforceme nt is most directly relevant as regards regulatory regulatory strategies such as rules and standards. operate constrain the behavior. cannot enforcement do this credibly unless Tese they are in facttoenforced.¹ Tisagent’s necessitates well-Tey well-functioning functioning institutions, such as courts and regulators, along with appropriately structured incentives to initiate cases. In contrast, governance strategies rely largely upon intervention by principals to generate agent compliance.² Formal enforcement enforcement (of regulatory strategies) and intervention (by governance strategies) are therefore substitutes; both impose penalties on agents in a bid to secure compliance. Whether this intervention takes the form of appropriate selection of agents and structure of rewards, credible threats of removal, or effective decision-making decision-making on key issues, its success in securing agent compliance depends primarily upon the ability of principals to coordinate and act at low cost. o be sure, governance strategies rely upon background legal rules to support their Tis mechanism is used to enforce disclosure of governance arrangements arrangements in the UK and elsewhere under so-called so-called “comply or explain explain”” provisions. See Utpal Bhattacharya and Hazem Daouk, Te World Price of Insider rading , 57 J F 75 (2002); John C. Coffee, Jr., Law and the Market: Te Impact of Enforcement , 156 U P P L L R 229, 2 29, at 263– 263–66 66 (2007). ¹ Tis point is not new. new. For early recognition, recognition, see Roscoe Pound, Pound, Law in Books and Law in Action, Action, 44 A L R 12 (1910); Gary Becker, Crime and Punishment: An Economic Approach, Approach, 76 J P E 169 (1968). ² It is possible to talk of such interventions as an informal form of “enforcement, “enforcement,”” in the sense that they make the impact of the governance strategies credible to the agent (see John Armour, Enforcement Strategies in UK Corporate Governance: A Roadmap and Empirical Assessment , in R C L L 71, at 73–6 73– 6 (John Armour and Jennifer Payne Payne eds., 2009). 200 9). However, However, to avoid confusion with the more specific sense of enforcement understood by lawyers, we eschew here this wider sense.
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operation; particular, they rely on therefore rules defining the decision-making decisionmaking authority of the variousincorporate actors.³ Tey also require legal enforcement institutions to make such delineations of authority effective. However, However, governance strategies require less sophistication and information on the part of courts and regulators than is required to enforce agent compliance more directly through regulatory strategies. Enforcement Enforceme nt institutions, therefore, are of first-order first-order importance for regulatory strategies, but only of second-order second-order importance for governance strategies.
2.4.2 Initiators of enforcement urning now to the nature of these “enforcement institutions,” we distinguish three modalities of enforcement, according to the character of the actors responsible for taking the initiative : (1) public officials, (2) private parties acting in their own interests, and (3) strategically placed private parties (“gatekeepers”) conscripted to act in the public interest. Modalities of enforcement might of course be classified across a
number of other dimensions. Our goal here is not to categorize for its own sake, but to provoke thought about how the impact of substantive legal strategies is mediated by different modalities of enforcement. We therefore simply sketch out a heuristic classification based on one dimension—the dimension—the type of enforcers—and enforcers—and encourage readers to think about how matters might be affected by other dimensions along which enforcementt may vary enforcemen var y. Te categorization we have chosen, we believe, has the advantage that it likely reflects the way in which agents involved in running a firm perceive enforcement—as enforcement— as affecting them through the actions of public officials, interested private parties, and gatekeepers.
2.4.2.1 Public enforcement enforcement
By “public “public enforcement,” enforcement,” we refer to all legal and regulatory actions brought by organs of the state. Tis mode includes criminal and civil suits brought by public officials and agencies, as well as various ex ante rights rights of approval exercised by public actors. For example, in many jurisdictions, issuers making a public offer must submit the required documents for review by securities regulators. Public enforcement action can be initiated by a wide variety of state organs, ranging from local prosecutors’ prosecutors’ offices to national regulatory authorities that monitor corporate actions in real time—such time—such as the U.S. Securities and Exchange Commission (SEC) monitoring corporate disclosures— disclosures—and and have the power to intervene to prevent breaches. We also describe some self-regulatory self-regulatory and quasi-regulatory quasi-regulatory authorities, such as national stock exchanges and the UK’s Financial Reporting Council, as “public enforcers.” Such bodies are enforcers to the extent that they are able in practice to
³ For example, decision rights strategies require courts to deny validity to a purported decision made by a process that does not reflect the principals’ decision rights. In the absence of legal institutions capable of protecting principals’ entitlements in relation to corporate assets, even purely governancebased strategies will wi ll be ineffective: see Bernard Black, Reinier Kraakman, and Anna arassova, arassova, Russian Privatization and Corporate Governance: What Went Wrong? 52 52 S S L R 1731 (2000). See Alan Schwartz, Relational Contracts in the Courts: An Analysis of Incomplete Agreements and Judicial Strategies , 21 J L S 271 (1992); Edward B. Rock and Michael L. Wachter W achter,, Islands of Conscious Power: Law, Norms, and the Self-Governing Self- Governing Corporation, Corporation, 149 U P L R 1619 (2001). Te UK’s UK’s Financial Reporting Council, through its Conduct Committee, reviews reviews the financial statements of publicly traded companies for compliance with the law.
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ex ante or compel compliance their rules or tocontractual, impose penalties forMoreover, rule violations thesewith penalties are reputational, or civil. they ex post , whether are meaningfully described as public enforcers enforcers where their regulatory efficacy is spurred by a credible threat of state intervention, and they can be seen as public franchisees. Where no such credible threat exists, then such organizations are better viewed as purely private. In theory, public enforcement suffers from the limitation—as limitation—as compared with private enforcemen enforcement— t—that that the officials responsible for initiating suits have weaker incentives to do so than private plaintiffs, because they do not retain any financial payments recovered. However, this distinction is increasingly eroded in cases where public enforcers are permitted to retain some or all of penalties levied from corporate defendants, which may bias enforcement decisions according to ability to pay rather than culpability. In practice, public enforcement is an important modality for securing
corporate agent compliance in almost all jurisdictions.
2.4.2.2 Private enforcement enforcement As with public enforcement, private enforcement embraces a wide range of institutions. At the formal end of the spectrum, these include class actions and derivative suits, which require considerable legal and institutional infrastructure in the form of a plaintiffs’ bar, bar, cooperative judges, and favorable procedural law that facilitates actions through matters as diverse as discovery rights, class actions, and legal fees. Te U.S. is an international outlier in the availability of these institutional complements to private enforcement, with an “opt out” approach to class action certification and support for contingency fees. As a result, rates of private enforcement in corporate law appear far higher in the U.S. than any other of our core jurisdictions.¹ Indeed, the probability Te concept of “coerced self-regulation” self-regulation” is developed in Ian Ayres and John Braithwaite, R R: D D 101–32 101–32 (1992). Jonathan R. Hay and Andrei Shleifer, Private Enforcement of Public Laws: A Teory of Legal Reform,, 88 A E R 398 (1998). Reform Margaret H. Lemos and Max Minzner, ForFor-Profit Profit Public Enforcement , 127 H L R 853 (2014); Brandon L. Garrett, B J: H P C C C (2014). (201 4). See e.g. Armour, Armour, note 52, at 87–102; 87–102; John Armour and Caroline Schmidt, Building Enforcement Capacity for Brazilian Corporate and Securities Law , in P P E: C W (Robin Huang and Nico Howson eds., forthcoming 2017); Coffee, Law and the Market , note 50, at 258–63; 258–63; Howell E. Jackson and Mark J. Roe, Public and Private Enforcement of Securities Laws: Resource-Based Resource-Based Evidence , 93 J F E 207 (2009); Rafael La Porta, Florencio Lopes-dede-Silanes, Silanes, and Andrei Shleifer, What Works in Securities Laws? 61 61 J F 1 (2006). For example, enhancements across several of these dimensions have been credited credited with triggering a significant increase in private enforcement in Japan: om Ginsburg and Glenn Hoetker, Te Unreluctant Litigant? Liti gant? An Empirical Empiri cal Analysis Analys is of Japan’s Japan’s urn urn to Litigation Liti gation,, 35 J L S 31 (2006). ¹ See e.g. John Armour, Armour, Bernard Black, Brian Cheffins, and Richard Nolan, Nolan, Private Enforcement of Corporate Law: An Empirical Comparison of the United Kingdom and the United States , 6 J E L S 687 (2009) (absence of UK shareholder litigation); Guido Ferrarini Parmalat Case , in John and Paolo Giudici, Financial Scandals and the Role of Private Enforcement: Te Parmalat Armour and Joseph A. McCahery McCahery,, A E: I C C L M S R E US 159 (2006) (lack of private enforcement in Italy); Teodore Baums et al., Fortschritte bei Klagen Gegen Hauptversammlungsbeschlüsse?: Eine Empirische Studie , ZIP 2007, 1629 (modest levels of shareholder litigation in Germany). While rates of shareholder litigation increased significantly in Japan during the 1990s (see Mark D. West, Why Shareholders
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of lawsuits being launched alleging misfeasance by corporate directors in large merger transactions was approaching 100 percent by 2012.² Unlike public enforcement, the modality we term private enforcement depends chiefly on the mechanism of deterrence—namely, deterrence—namely, the imposition of penalties ex post upon the discovery of misconduct. Tere are few direct analogs in private enforcement to the ex ante regulatory regulatory approval we have included within the mode of public enforcement. One example of such enforcement may be the UK’s “scheme of arrangement” procedure, whereby a company wishing to undertake a major restructuring transaction and having obtained requisite votes from shareholders (and creditors, if they are parties) may seek court approval of the arrangement.³ Te court will scrutinize the procedural steps taken at this point, and if its sanction is given to the scheme, it cannot be challenged ex post . However, if the focus is widened to include not only enforcement in the strict sense, but means of securing agent compliance more generally, generally, there is an important counterpart: privatecompliance actors are ofbycourse muchwhile involved in ex ante governance interventions to secure agents.very Indeed, the discussion in this section has focused on public and private actors as initiators of law enforcement,
the same conceptual distinction can also be made in relation to governance interventions. Public actors may also be involved in governance interventions, for instance where the state is a significant stockholder. Although Although not observed in most of the jurisdictions we survey, in some countries—for countries—for example, France, Italy, and Brazil—state Brazil—state ownership of controlling shares in publicly traded companies is common. Under such circumstances, public actors—namely actors—namely government agencies—take agencies—take decisions regarding governance intervention.
2.4.2.3 Gatekeepe Gatekeeperr control Gatekeeper control involves the conscription of noncorporate actors, such as accountants and lawyers, in policing the conduct of corporate actors. Tis conscription generally involves exposing the gatekeepers to the threat of sanction for participation in corporate misbehavior, or for failure to prevent or disclose misbehavior. Te actors so conscripted are “gatekeepers” “gatekeepers” in the sense that their participation par ticipation is generally necessary,, whether as a matter of practice or of law, sary law, to accomplish the corporate transactions that are the ultimate focus of the enforcement efforts. We call the mode “gatekeeper control ” to emphasize that it works by harnessing the control that gatekeepers have over corporate transactions, and giving them a strong incentive to use that control to prevent unwanted conduct. Gatekeeper control is probably best viewed as a form of delegated intervention: principals do not themselves engage in scrutiny of the agent, but leave this to the gatekeeper. Compliance is generally secured through the ex ante mechanism mechanism of Sue: Te Evidence from Japan, Japan, 30 J L S 351 (2001)), they are still nothing like the same level of frequency as in the U.S. ² John Armour, Armour, Bernard Black, and Brian Brian Cheffins, Is Delaware Losing its Cases? 9 9 J E L S 605, at 623, 627 (2012). Tere is, however, no mechanism for public enforcement by the state of Delaware. ³ Companies Act 2006 (UK), Part Part 26. See Aldo Musacchio and Sérgio Lazzarini, R S S C C (2014). See Reinier Kraakman, Gatekeepers: Te Anatomy of a Tird-Party Tird-Party Enforcement Strategy , 2 J L L E O O 53 (1986); John C. Coffee, Jr., Jr., G: G: P C G (2006).
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constraint (e.g. auditors refuse towrongdoers. issue an unqualified report) rather thancreates through the mechanism of penalizing Such delegation of course a new ex post mechanism agency problem between the gatekeeper and the principals. Tis is dealt with through the application of the basic legal strategies to the gatekeepers themselves, with chief reliance on the standards and trusteeship strategies.
2.4.3 Penalties Enforcement Enforceme nt by the modalities described, or indeed governance interventions, secures compliance either by introducing an ex ante requirement requirement for approval, or imposing an ex post penalty. penalty. We use the term “penalty” here as a broad functional category, to encompass all consequences of enforcement that are likely to be costly for the defendant and thereby serve to deter misconduct. In many cases, the calibration of such penalties rather more subtleform thanofatpenalty first might be imagined. Perhapsis the most obvious is a payment of money. A preliminary issue concerns who should bear the liability. For legal strategies seeking to control
manager shareholder and shareholder shareholder agency problems, the most obvious defendant is the agent in question. Whereas for the control of externalities, making the corporation pay the penalty encourages managers to take the expected costs of penalties into account. However How ever,, it is common practice in some jurisdictions—such jurisdictions—such as the U.S., Germany, and others—for others—for corporations to provide indemnities and insurance for managers (“D&O insurance”), which has the effect of shifting the burden from the individual to the firm. Tis generally reduces the effective size of financial obligations imposed by civil liability on managers, so much so that even in jurisdictions where shareholder shareholder litigation is frequent, outside directors rarely, if ever, are required to make payments from their personal assets following a shareholder lawsuit. Te functional rationale for this is that too-zealous too-zealous imposition of personal liability on managers might induce them to behave in a risk-averse risk-averse fashion, contrary to the wishes of diversified shareholders. Conversely, it may be desirable in some cases to shift liability for failure to control externalities from the firm to individual agents. Where corporate assets are insufficient to cover expected losses, then limited shareholder liability means that there may be insufficient incentive to internalize the costs of hazardous activities. Imposing penalties on individuals associated with the firm can enhance the effectiveness of relevant legal strategies. See e.g. Selangor United Rubber Estates v Cradock (No (No 3) 3) [1968] 1 WLR 1555 (UK Ch D); RBC Capital Markets LLC v Jervis 129 129 A.3d 816 (Del. 2015) (secondary liability for bankers who knowingly assist boards’ of duty). or In dishonestly keeping with theinbroad usebreaches of the term “penalty,” we include here both compensatory and “penalty,” punitive—more punitive— more narrowly defined—payments. defined—payments. Bernard Black, Black, Brian Cheffins, and Michael Michael Klausner, Klausner, Liability Risk for Outside Directors: A CrossBorder Analysis , 11 E F M 153 (2005); om om Baker and Sean J. Griffith, How the Merits Matter: Directors’ and Officers’ Insurance and Securities Settlements , 157 U P L R 755 (2009). Reinier Kraakman, Corporate Liability Strategies and the Costs of Legal Controls , 93 Y L J 957 (1984). See also G G E . D J J: : R O M H D P U (Gregor Bachmann ed., 2014); cf. Regional Court (Landgericht) München 10.12.2013 Zeitschrift für Wirtschaftsrecht (ZIP) 2014, 570 (the Siemens/ Siemens/Neubürger Neubürger case). case). Kraakman, note 69; John John Armour and Jeffrey Jeffrey N. Gordon, Gordon, Systemic Harms and Shareholde Sh areholderr Value Value , 6 J L A 35 (2014). See Chapter 4.3.
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ex post Such In many countries, another important consequence consequence of violating company lawcivil ruleslawis annulment of corporate decisions.¹ orders deny the legal efficacy of corporate actions reached on the basis of a process that failed to conform to applicable rules. Tis mechanism is useful for ensuring compliance with standards and process rules regarding various governance strategies used to control the first two varieties of agency cost on which we focus. Te costs to a corporation of cancelling or delaying its actions until the process has been regularized may be substantial, and for this reason such annulments function as penalties in the sense we use the term here. Where misconduct is deemed sufficiently serious to be classed as “crim “criminal, inal,”” then incarceration may also be available as a penalty for individual—although individual—although not corporate—defendants.² corporate— defendants.² For corporate defendants in regulated industries, perhaps the most severe penalty that may be inflicted is loss of a firm firm’’s regulatory license, which will effectively shut down its business. Te threat of criminal sanctions and/or and/or loss of
regulatory licenses can, without careful calibration of expected sanctions, easily result in over-deterrence.³ over-deterrence.³ Defendants may face a range of extra-legal— extra-legal—principally principally reputational—consequences reputational—consequences flowing from enforcement enforcement actions. For individual agents, these may include loss of jobs
and greater difficulty finding other employment. For For firms, reputational harm can be understood as the downward revision by contracting partners of their expectations of performance, with a consequently adverse impact on the firm’s terms of trade. Tis can greatly exceed the size of financial penalties—indeed, penalties—indeed, no financial penalty need be imposed to trigger reputational loss, simply the credible dissemination of information about malfeasance. While the potential for reputational loss both makes the total effective penalty larger, it also makes it less predictable. Moreover, corporate misconduct that does not harm contracting counterparties, but rather imposes purely external costs, does not necessarily imply any change in expectations about contractual
¹ See Holger Fleischer, Fehlerhafte Aufsichtsratsbeschlüsse: Rechtsdogmatik— Rechtsvergleichung— Rechtspolitik , D B 2013, 160–7 160–7 and 217–24; 217–24; Martin Gelter, Why do Shareholder Derivative Suits Remain Rare in Continental Europe? 37 37 B J I L 843–92 843– 92 (2012). ² Whether criminal sanctions can be used at all against legal persons is controversial. controversial. While most jurisdictions now permit pe rmit this, some, such as Germany Germany,, refuse to do so. See generally Guy Stessens, Corporate Criminal Liability: A Comparativ Comparativee Perspective , 43 I C L Q 493 (1994). ³ See e.g. Jennifer Arlen, Te Potentially Perverse Effects of Corporate Criminal Liability , 23 J L S 833 (1994); Daniel R. Fischel and Alan O. Sykes, Corporate Crime , 25 J L S 319 (1996). A particular concern in the EU context is competition law enforcement: see Case C-172/ C-172/12 12 P, EI du Pont de Nemours v Commission [2013] Commission [2013] E C R R I-0000, I0000, ECLI: EU: C:2013:605 (parent fined for breaches of competition law l aw by subsidiary, with fine amount as a percentage parent’ parent’s turnover). Seecalculated e.g. Fich and Shivdasani,ofnote Shivdasani, 33; sMaria Correia and Michael Michael Klausner, Are Klausner, Are Securities Class Actions “Supplemental” to SEC Enforcement Enforcement?? An Empirical Analysis , Working Paper, Stanford Law School (2012). See Jonathan Karpoff and John John Lott, Jr., Jr., Te Reputational Penalty Firms Face from Committing Criminal Fraud , 36 J L E 757 (1993); Cindy Alexander, On the Nature of the Reputational Penalty for Corporate Crime: Evidence , 42 J L E 489 (1999); Jonathan Karpoff, D. Scott Lee, and Gerald Martin, Te Cost to Firms of Cooking the Books , 43 J F Q Q A 581 (2008). See e.g. Benjamin Benjamin L. Liebman and Curtis J. Milhaupt, Reputational Sanctions in China’s Securities Market , 108 C C L L R 929 (2008). See John Armour, Armour, Colin Mayer, Mayer, and Andrea Polo, Polo, Regulatory Sanctions and Reputational Damage in Financial Markets , forthcoming, J F Q A (2017) (finding no correlation between size of reputational loss and financial penalty).
Systematic Differences
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performance, and doesofnot to lead to reputational losses. Tis has implications for the selection legalappear penalties in relation to the control of externalities.
2.5 Legal Strategies Strategies in Corporate Context Te law does not apply legal strategies in the abstract but only in specific regulatory contexts. For purposes of exposition and analysis, we have grouped those contexts into six basic categories of corporate decisions and transactions. Each of the next seven chapters focuses on one of those categories. Necessarily, the boundaries of these categories are to some degree arbitrary and overlapping. Nevertheless, each category has a degree of functional unity, unity, and the typical deployment of legal strategies in each is at least moderately distinct. Chapters 3 and 4 examine the legal strategies at play in the regulation of ordinary business transactions and decisions. Not surprisingly, governance strategies predominate in this context. Chapter 5 turns to corporate debt relationships and the problem of creditor protection— protection—aa context in which regulatory strategies st rategies are common,
except when the firm is insolvent, when the emphasis shifts to governance strategies. Chapter 6 examines the legal regulation of related party (or self-dealing) transactions; Chapter 7 investigates the corporate law treatment of “significant” transactions, such as mergers and major sales of assets, and Chapter 8 assesses the legal treatment of control transactions such as sales of control blocks and hostile takeovers. As the discussion below will show, show, jurisdictions adopt a fluid mix of regulatory and governance strategies in all of the last three transactional contexts. Ten, Chapter 9 turns to the regulation of issuers on the public market, where regulatory strategies predominate. While we do not claim that these transactional and decisional categories exhaust all of corporate theyallcover of what and is conventionally understood to be corporate law, and law, nearly of themost interesting controversial issues that the subject presents today. Within each of of our our seven seven substantive chapters, our analysis proceeds proceeds functionally functionally.. In In most chapters, our analytic discussion is organized by agency problems and legal strategies: for a given category of corporate decisions, we review the legal strategies that are actively deployed by our core jurisdictions. In two chapters, however, however, the analytic discussion is organized somewhat differently—by categories of transactions in Chapter 7 (significant transactions), and by agency problems in Chapter 8 (control transactions). Tis variation in structure responds to the greater heterogeneity of the transactions dealt with in those chapters. Finally, Finally, to the extent that there are significant differences across jurisdictions in the legal strategies employed to regulate a given class of corporate decisions, we attempt to assess the origins of these differences.
2.6 Systematic Differences Wee might W might expect the use use of the various legal strategies for controlling controlling agency agency costs, and of the associated modes of enforcement, to differ systematically across jurisdictions. See Jonathan M. Karpoff, John R. Lott, Jr., and Eric W. Wehrly, Te Reputational Penalties for Environmental Violations: Empirical Evidence , 48 J L E 653 (2005); Armour et al., note 77. See Chapter 4.3.
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In particular, we would expect to see strong complementarities between the structure of share ownership and the types of legal strategies relied upon most heavily to control agency costs. Since the efficacy of governance mechanisms mechanisms is closely linked l inked to the extent to which principals are able to coordinate, it would be surprising if the structure of share ownership did not affect the extent to which these strategies are employed to control managers. In most jurisdictions around the world, the ownership of shares in publicly traded firms is concentrated in the hands of relatively few shareholders— whether families or institutional investors. With such ownership patterns, owners face relatively low coordination costs as between themselves, and are able to rely on governance strategies to control managers—although managers—although of course the control of controlling shareholders themselves becomes more problematic. Where ownership of shares is more diffuse, however however,, governance mechanisms are less effective in controlling managers, and there is more need for regulatory mechanisms to take the fore. Just Ju st asthe thepattern choice of choice strategies strategies for controll controlling agency problems agency problemsbyisthe likenature likely ly to complement of legal ownership, it will in turn ing be complemented and sophistication of the enforcement institutions. In systems relying heavily on regulatory strategies, enforcement institutions will likely have a greater role to play in securing
compliance by agents, as opposed to intervention by principals themselves. At a more micro level, particular regulatory strategies complement and are supported by different enforcement institutions. Rules require a sophisticated and responsive regulator to promulgate them, if they are not to end up imposing greater hindrance than benefit on parties. Standards, on the other hand, require independent and sophisticated courts and lawyers, if they are to be deployed effectively. Similarly, reliance on complex contracts will likely place greater demands on enforcement institutions than simple legal rules.¹ In addition, the appropriate scope of continuing disclosure obligations may vary depending on the extent to which particular legal strategies are employed.² Tus in the U.S., where regulatory strategies are extensively used,incontinuing disclosure traditionally focused on self-dealing self-dealing transactions, so assisting formal enforcement activities. In the EU, by contrast, where greater reliance is placed on governance mechanisms, disclosure obligations traditionally emphasized details of board structure. However, these differences have narrowed in recent years—in years—in step with a more general convergence in ownership structure st ructure we discuss in Chapter 3—with enhancements to disclosure of related-party related-party transactions in the EU and of board composition and functioning in the U.S.³ Te necessary extent of of disclosure will also vary depending on the ownership structure. Where owners owners are highly coordinated, frequent disclosure may be less important as a response to managerial agency costs: owners are better able to discover information for themselves, and governance strategies can be used to stimulate disclosure of
Te existence of a demand for regulatory, regulatory, as opposed to governance, strategies may be expected to spur the development of regulatory expertise. Tus in jurisdictions with widely dispersed retail shareholdings, such as the U.S., specialist courts tend to be more active because they are more in demand. See Zohar Goshen, Te Efficiency of Controlling Co ntrolling Corporate Self-Dealing: Self-Dealing: Teory Meets Reality , 91 C L R R 393 (2003). (20 03). ¹ Edward Glaeser, Glaeser, Simon Johnson, Johnson, and Andrei Shleifer, Shleifer, Coase Versus the Coasians , 116 Q J E 853 (2001). ² See e.g. para. 9 Recommendation 2005/162/ 2005/ 162/EC EC on the role of non-executive non-executive or supervisory directors of listed companies and on committees of the (supervisory) board, 2005 O.J. (L 52) 51. ³ See Chapter 3.2.4, 3.4.2, and Chapter Chapter 6.2.1.1. See John Armour and Jeffrey N. Gordon, Te Berle- Means Means Corporation in the 21st Century , Working W orking Paper Paper (2008), at .
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greater information. Tis is not to say say,, however, however, that effective and adequately enforced disclosure obligations do not matter in systems with coordinated owners. Rather, the problem with coordinated owners is not the first of our three agency problems but the second: conflicts between shareholders. Here disclosure ensures that information about how powerful owners exercise their control rights—including rights—including related party transactions—is tions— is disseminated to minority shareholders, and that information management transmits to controllers makes its way to all owners equally, equally, preventing so-called so-called “selective disclosure.” Many such institutional differences may make little littl e overall difference to the success of firms’ control of their agency costs, as various combinations of strategies and associated institutions may be functionally equivalent. However, However, there are some institutions whose presence or absence is likely to be important in any jurisdiction. In particular, given the fundamental role played by disclosure in supporting both the enforcement of regulatory and the exerciseregulator of governance, institutions accounting supporting disclosure— disclosure—a a strongstrategies and effective securities and a sophisticated profession, for example—are example—are always likely to make an overall difference to the success of firms in controlling agency costs.
See Bernard Black, Te Legal and Institutional Preconditions for Strong Securities Markets , 48 UCLA L R 781 (2001).
3
Te Basic Governance Structure: Te Interests of Shareholders as a Class John Jo hn Armour, Armour, Luca Enriques, Enriques, Henry Henry Hansmann, Hansmann, and Reinier Kraakman
As we saw in Chapter 2, corporate law must address three fundamental agency problems: the conflict between managers (executives and directors) and shareholders, the conflict between controlling and minority shareholders, and the conflict between shareholders and non-shareholder non-shareholder constituencies. Tis chapter examines how the legal
strategies employed in corporate governance mitigate the manager shareholder con flict in our core jurisdictions; Chapter 4 then explores the role of governance in safeguarding minority shareholder and non-shareholder non-shareholder interests. wo of the core features of the corporate form underlie corporate governance. Te first is investor ownership, which, given the breadth of contemporary capital markets, implies that ultimate control over the firm often lies in the hands of shareholders who are far f ar removed from the t he firm fir m’s dayd ay-toto-day day operations and who face significant information and coordination costs.¹ Te second is delegated management, which is functional because of itshareholders shareholders’ ’ information and coordination costs. Such delegation precisely in turn brings with shareholder– shareholder–manager manager agency costs. Corporate laws address the shareholder–manager shareholder–manager agency problem through both governance and regulatory strategies. As this chapter outlines, however, their deployment and relative efficacy differ according to share ownership patterns. In countries where controlling shareholders are common, appointment and and decision rights are are often relatively strong, enabling such shareholders to exert influence directly over the management.² At the opposite extreme, where share ownership is dispersed in the hands of passive, uninformed investors, as was the case in i n the U.S. for much of the twentieth t wentieth century,, appointment and decision rights are less effective, and century a nd more work is done by for managers and a agent incentives , in the form of appropriately calibrated rewards for trusteeship role for non-management non-management directors in overseeing executives. Such strategies have been further supported by standards of of conduct for directors and affiliation rights disclosure , namely rights to ensure more informed shareshares pricesinand greatertakeover liquidity, which in turn make rules exit to , including by tendering a hostile bid, more effective. Somewhere between these extremes—and extremes—and perhaps increasingly
¹ Shareholder “coordination and information costs” can be understood as the costs of actually making decisions among multiple shareholders (i.e. of getting informed and forging a majority preference), combined with the costs flowing from such decisions being suboptimal (because shareholders are uninformed or conflicted). See Chapters 2.1 and 2.2. One of us has termed this combination “ownership costs.” costs.” See Henry Hansmann, O E 35 (1996). ² Tese strategies similarly enable nonnon-controlling controlling institutional shareholders in the few companies in these countries that have no dominant shareholder. Te Anatomy of Corporate Law. Tird Edition. Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry Hansmann, Gerard Hertig, Klaus Hopt, Hideki Kanda, Mariana Pargendler, Wolf-Georg Wolf-Georg Ringe, and Edward Rock. Chapter Chapt er 3 © John Armour, Luca Luca Enriques, Henry Hansmann, and Reinier Reinie r Kraakman, 2017. Published 2017 by Oxford University Press.
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commonly—lie ownership patterns where, although controlling shareholders are not commonly—lie the norm, share ownership is concentrated in the portfolios of institutional investors, with collective action being facilitated by both the sheer size of the largest shareholders’ shareholders’ holdings and specialized hedge funds’ activism.³ Before we describe the extent to which our core jurisdictions make use of the various legal strategies, a few general observations on boards of directors—the directors—the key internal governance institution in each of them—will them—will be useful.
3.1 Delegated Management Management and Corporate Boards Boards Te governance law of public corporations has a similar basic structure in all of our core jurisdictions. Reflecting investor ownership, it reserves certain fundamental decisions to the general shareholders’ meeting, while delegated management implies assigning much decision-making decision-making power to boards of directors. Wee have already W al ready seen that delegation of decisiondecision-making making power in relation to the management of the company’s business makes sense as a way of economizing on the information and coordination costs shareholders would face if they t hey tried to make these t hese decisions themselves. So we might see the most basic task of boards as being to manage
the company’s business. However, many jurisdictions expect boards also to engage in oversight of management, implying a second, trusteeship, role for directors. Jurisdictions reflect different choices as respects formal board structures: in some countries boards are a re “one-tier, tier,”” whereas in others oth ers they the y are “two-tier.” “two-tier.” In jurisdictions with one-tier one-tier boards, such as the U.S., UK, and Japan, a unitary unitar y board has legal power both to manage and supervise supervise the management of a corporation, either directly or through the board’s board’s committees. By contrast, jurisdictions using two-tier two-tier board structures prescribe a formal separation between the management and monitoring functions. Monitoring powers are allocated to elected supervisory boards of non-management non-management directors, which then appoint and supervise management boards that include the principal executive officers in charge of designing and implementing business strategy st rategy.. Germany and Brazil mandate two-tier two-tier boards for public corporations, while Italy and France—as France— as well as the EU for the European Company—offer Company—offer a choice between one and two-tier two-tier boards. In theory, one-tier one-tier boards concentrate decision-making decision-making power in the hands of directors, because they combine the managerial and supervisory roles in one group. Tus in some jurisdictions, such as the U.S. and France, it is common to combine the roles of board Chairman and Chief Executive Officer (“CEO”) in a ³ See Ronald J. Gilson and Jeffrey N. Gordon, Te Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights , 113 C L L R 863 (2013). Tere are also intermediate board structures in other jurisdictions, such as the “Nordic” “Nordic” board of directors. See Per Lekvall, A Lekvall, A Consolidated Co nsolidated Nordic Governance Model , in N C G M 52, 59–63 59–63 (Per Lekvall ed., 2014). Some jurisdictions—such jurisdictions—such as Italy, Brazil, and East Asian jurisdictions influenced by German law—retain law— retain vestigial supervisory boards such as the “board of auditors” (Japan and Italy) or the “board of supervisors” (Brazil and China). Te powers of these secondary boards, which are functionally similar to those of audit committees on a unitary board, are generally limited, limi ted, especially in Japan and Italy. Italy. We use “non-management” “non-management” in the sense of non-participation non-participation in management. Such nonparticipation in executive decision-making decision-making is frequently mandated for supervisory boards in two-tier two- tier jurisdictions such as Germany. Germany. See §§ 105 and 111 IV Aktiengesetz. §§ 76– 76–116 116 Aktiengesetz (Germany); Art. 138 Lei das Sociedades Sociedade s por Ações (Brazil); Art. L. 225– 57 Code de commerce (France); Art. 2380 Civil Code (Italy); Art. 38 Council Regulation (EC) No 2157/2001 2157/ 2001 of 8 October 2001 on the Statute for a European company (SE).
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single-tier board. By contrast, two-tier single-tier two-tier jurisdictions such as Germany bar supervisory boards from making managerial decisions. However, board practices can blur the distinction between the two structures.¹ Informal leadership coalitions can short-circuit short-circuit the legal separation between management and supervisory boards. In companies with no controlling shareholder, the management board can often de facto select the supervisory board.¹¹ At the same time, hiving out “supervisory” functions to committees composed exclusively of independent directors gives single-tier single-tier boards a quasi-supervisory quasi-supervisory flavor flavor.. Further,, in jurisdictions with labor codetermination—such Further codetermination—such as Germany, among our core countries—a countries—a two-tier two-tier board performs an additional function. Here the supervisory board is not devoted exclusively to the interests of the shareholder class, but rather serves the function of lowering the costs of coordination between two different constituencies, namely shareholders and employees. We address the governance features of codetermination further in Chapter 4. At this point we merely note that the two-tier two-tier board structure facilitates strong labor participation in corporate governance as full access to sensitive information and business decision-making decision-making can remain with the management board, thereby mitigating potential conflicts of interest on the supervisory board. Codetermination imposes a minimum number of supervisory board members—20 members—20
for its largest companies¹²—which companies¹²—which makes Germany something of an outlier when it comes to board size. As we documented in the previous edition of this book,¹³ most jurisdictions have broadly converged on a similar size for boards, at around 9–12 9– 12 members. Smaller boards are thought to be more effective in performing their monitoring role.¹ With a view to adapting their board size to the international norm, several major German companies such as Allianz, BASF, and Porsche have converted into the EU-wide EU-wide Societas Europaea (SE), (SE), which allows for a minimum of only 12 directors.¹
3.2 Appointment and Decision Rights Te most basic legal strategies implied by investor ownership are appointment rights : the shareholders retain powers to appoint (and remove) members members of the t he board of directors. In addition, on matters where delegated management may lead to suboptimal outcomes due to badly aligned incentives, such as conflicted and end-game end-game transactions, Tis is not universally the case. In the the UK, Art. A.2.1 of the UK Corporate Corporate Governance Code calls for a clear division of responsibility between a company’s chairman and chief executive officer, which is by far the most common arrangement in UK listed companies. See note 6. Convergence , ¹ See Paul Paul Davies and Klaus J. Hopt, Hopt, Corporate Boards in Europe— Accountability and Convergence 61 A J C C L L 301 (2013). ¹¹ See Klaus J. Hopt and Patrick C. Leyens, Board Models in Europe—Recent Europe—Recent Developments of Internal Corporate Governance Structures in Germany, the United Kingdom, France and Italy , 1 E C F L L R 135, 141 (2004). ¹² See § 7 Mitbestimmungsgesetz (Codetermination Law) (at least 20 directors for supervisory boards of firms with more than 20,000 employees). ¹³ At 69–70. 69–70. ¹ See e.g. David Yermack, Higher Market Valuation Valuation of Companies with a Small Board of Directors , 40 J F E 185 (1996); Jeffrey L. Coles, Naveen D. Daniel, and Lalitha Naveen, Boards: Does One Size Fit All? 87 87 J F E 329 (2008). ¹ See Jochem Reichert, Experience with the SE in Germany , 4 U L R 22, 27–8 27–8 (2008).
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corporate laws also grant shareholders decision rights . Te efficacy of these mechanisms in controlling agency costs are a function of shareholders’ information and coordination costs on the one hand, and the severity of managerial agency costs on the other. Te easier it is for shareholders to become informed, coordinate among themselves, and make collective choices that maximize their collective welfare, the more efficiently appointment and decision rights will control agency costs. But where shareholder information and coordination costs are high, greater insulation for managers may be in the joint interest of shareholders as well. In other words, shareholder coordination has two faces: easier coordination can decrease shareholder–manager shareholder–manager agency costs—by costs—by permitting shareholders to control managers more effectively—while effectively—while at the same time it might increase shareholder– shareholder agency costs—by costs—by permitting a faction to gain control to the detriment of the shareholders as a group. Shareholders as a group may suffer from control by a faction, either because that faction may divert corporate value to itself or because, owing to asymmetric information or distorted incentives, it may wrongly displace a good management team or force it to adopt inappropriate strategies.¹ When shares are aggregated in the portfolios of institutional asset managers, as is nowadays the case in many jurisdictions, in addition to the agency problem of delegated management at the firm level, a second tier of agency costs arises between the institutional asset managers and their ultimate clients.¹ Because such asset managers
are generally compensated on the basis of relative performance, they are unwilling to invest resources in determining the appropriate exercise of governance rights in individual firms—this firms—this would confer a gratuitous benefit on their competitors. However, a lead is often set by “activist” funds, which compensate their managers on the basis of absolute returns and earn a return by taking significant stakes in the companies in which they invest.¹ Whether such activist hedge funds are in a good position to identify companies with weak strategies and/or and/or disloyal managers, or rather simply target companies that stock markets fail to price adequately, forcing these companies to engage in suboptimal, often “short-term” “short-term” business strategies, is one of the most disputed issues in the current corporate governance debate.¹ Te empirical evidence about the merits of this new corporate governance paradigm is as yet inconclusive,² and the debate will continue on whether the new corporate governance paradigm
¹ See Zohar Goshen and Richard Squire, Principal Costs: A New Teory for Corporate Law and Governance , Working Working Paper (2015), available at ssrn.com. ¹ Bernard S. Black, Agents Black, Agents Watching Watching Agents: Te Promise of Institutional Investor Voice Voice , 39 UCLA L L R 811 (1991). ¹ Marcel Kahan and Edward Edward B. Rock, Hedge Funds in Corporate Governance and Corporate Control , 155 U P L R 1021 (2007); Gilson and Gordon, note 3; Marco Becht, Julian Juli an R. Franks, Jeremy Grant, and Hannes Hann es F. F. Wagner, Wagner, Te Returns to Hedge Fund Activism: An Internationall Study , 21 E F M 106 (2015). Internationa ¹ See e.g. Alon Brav, Wei Jiang, Frank Partnoy, and Randall Tomas, Hedge Fund Activism, Corporate Governance, and Firm Performance , 63 J F 1729 (2008); Gilson and Gordon, note 3; April Klein and Emanuel Zur, Entrepreneurial Shareholder Activism: Hedge Funds and Other Private Investors , 64 J F 187 (2009); Lucian A. Bebchuk, Alon Brav Brav,, and Wei W ei Jiang, Te Long-erm Long-erm Effects of Hedge Fund Activism, Activism, 115 C L R 1085 (2015); Yvan Yv an Allaire and Francois Dauphin, Te Game of “Activist” Hedge Funds: Cui Bono? Working Working Paper (2015), available at ssrn.com at ssrn.com;; Emiliano Catan and Marcel Kahan, Te Law and Finance of Antitakeover Statutes , 68 S S L R 629 (2016). ² For a comprehensive comprehensive review see John C. Coffee, Jr. Jr. and Darius Palia, Te Wolf at the Door: Te Impact of Hedge Fund Activism on Corporate Governance , 1 A C G 1 (2016).
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based on activist hedge funds and institutional shareholders as arbiters of corporate strategy net benefits to society.²¹ society. ²¹ Beforebrings analyzing individual legal strategies across jurisdictions, we should bear in mind that shareholder-centric shareholder-centric corporate laws are not a priori superior to board-centric board-centric ones. Solving the trade-off trade-off between managerial agency costs and shareholder information and coordination costs turns out to be one of the hardest challenges for corporate policymakers. Even within a particular jurisdiction and a specific industry, the dynamics between the two constituencies will play out differently due to a number of factors: chief among them is the question of how easily management can convey information about its business strategy without destroying its value. Personalities, including entrepreneurial genius, will also play a role. With this caveat in mind, we can begin our tour of legal strategies used in this area, by considering appointment rights first.
3.2.1 Appointing directors At the core of appointment rights lies shareholders shareholders’’ power to vote on the selection of directors. Te impact of this power is much greater if shareholders also have the power to nominate the candidates for election. Te allocation of these entitlements reflects the balance between shareholder information and coordination costs and managerial agency costs. Te latter are most tightly ti ghtly controlled by permitting shareholders to select
candidates for appointment. However, However, in the presence of high information and coordination costs, it may be preferable to let the board, possibly acting through its independent members, perform the search function that precedes nomination of candidates, and have the shareholders simply vote on them. Tis latter approach is common practice in most jurisdictions: the board usually proposes a slate of nominees, which is rarely opposed at the annual shareholders’ shareholders’ meeting. Te exceptions are Brazil and Italy, where concentrated ownership prevails and formal director nominations by (controlling) shareholders are commonplace.²² As a check on agency costs, almost all jurisdi jurisdictions ctions permit a qualifie qualifiedd minorit minorityy (usually a small percentage) of shareholders to contest the board’s slate by adding additional nominees to the agenda of the shareholders’ meeting.²³ Insurgent candidates nominated in this fashion face the same up-orup-or-down down majority vote as the company’s own nominees other than in jurisdictions where shareholders usually vote
²¹ It is certainly plausible that the mechanisms mechanisms employed to disclose information about publicly traded companies might lead to stock price valuations which are less accurate for some types of business project—“exploratory project—“exploratory”” innovation for example (see John Armour and Luca Enriques, Financing Disruption,, Working Paper (2016))—but Disruption (2016))—but it is unclear whether such effects explain the pattern of activist investing. ²² In Italy theSee lawArt. on listed companies itself Act drives thFinancial is outcome, by treating shareholder-proposed shareholder-proposed slates as default. 147-III 147-III Consolidated onthis Supervision. ²³ In the UK the default rule is that any shareholder can present her own board candidates for appointment by ordinary resolution (Schedule 3, Model Articles for Public Companies, Companies (Model Articles) Regulations 2008 No. 3229, Art. 20). In Japan a qualified minority (1 percent of votes or 300 votes) may propose its own slate of candidates, which the company must include in its mail voting/proxy voting/proxy documents (Art. 303 and 305 Companies Act; see also Gen Goto, Legally “Strong” Shareholders of Japan Japan,, 3 M J P E V C 125, 131–6 131–6 (2014)). In Italy the quorum for the proposal of a slate of candidates varies from 0.5 percent for the largest companies (by capitalization) to 4.5 percent for the smallest. Art. 144-4 144- 4 Consob Regulation on Issuers. In Brazil, the relevant threshold for proxy access (or reimbursement of expenses) by insurgents in public companies is 0.5 percent of the total capital. CVM Instruction No. 481 (2009) Arts. 31 and 32.
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on the slates as a package, as in Germany and Italy.² Finally, special rules apply to allow Brazil for andminority Italy.² shareholder representation on the boards of listed companies in Matters are more complex in the U.S., where board elections electi ons have always been a contencont entious issue attracting policymakers’ poli cymakers’ attention. First of all, the statutory default in Delaware is a “plurality” voting rule, r ule, under which—when an election electi on is uncontested, uncont ested, that is, the number of candidates equals the number of directors to be elected—any elected—any number of votes suffices to elect a nominee to a board seat.² Following institutional investors’ dismay at reappointment of candidates for whom large la rge numbers of votes had been “withheld,” “withheld,” most large companies have opted out of the default, switching to majority voting.² Moreover, Delaware law was amended to facilitate shareholder initiatives to switch to majority voting.² And, while plurality remains relatively common in smaller companies, their boards often yield to “withholding” campaign demands.² Shareholders in U.S. companies have other tools to obtain representation on the board. One suchsotool is proxy access—that access— that is, placingbetween nominees the candidates company’s proxy materials all shareholders will have a choice theon board and the insurgents’ ones, without any need for the latter to circulate their own proxy materials. Te default in Delaware is against proxy access and federal rules regulating proxies have traditionally refrained from mandating such access. After the Dodd-Frank Dodd-Frank Act of 2010 explicitly granted the SEC power to make rules facilitating inclusion of
shareholder nominations in the corporate proxy form,³ the SEC adopted a rule to this effect, but the D.C. Circuit struck it down, ostensibly for failing to consider adequately its economic effects.³¹ Currently Currently,, federal proxy rules allow shareholders to include proposals for proxy access in the company’s proxy materials and Delaware law has also eased shareholders’ initiatives in favor of proxy access at individual companies.³² As a consequence, shareholder proposals to adopt proxy access have become increasingly common for U.S. listed companies, and many such companies now provide for it.³³ Insurgents who wish to obtain control of the board, which is usually the case in connection with a hostile takeover bid,³ may launch a full-blown full-blown proxy contest. In this case, the insurgent bears all the costs of soliciting their own proxies and distributing
² In German public companies any shareholder can add her own candidates up to two weeks before the meeting (§ 127 AktG). Of course, that applies to German companies subject to codetermination for the subset of supervisory board members appointed by shareholders only. ² Se Seee Ch Chap apte terr 4. 4.1. 1.1. 1. ² Se Seee e. e.g. g. § 21 216( 6(3) 3) De Dela lawa ware re Ge Gene nera rall Co Corp rpor orat atio ionn La Law w. ² Stephen J. Choi, Jill E. Fisch, Fisch, Marcel Kahan, and Edward Edward B. Rock, Does Majority Majori ty Voting Voting Improve Board Accountability? U U C L R 1119 (2016). ² See § 216(4) Delaware General Corporation Law (barring the board from revoking a stockholder bylaw requiring a majority vote for directors). ² R Marcel 1997, Kahan2011 Kahan and Edward L L (2014).Rock, Symbolic Corporate Governance Politics , 94 B U ³ § 971, DoddDodd-Frank Frank Act (2010). ³¹ Business Roundtable v. Securities and Exchange Commission, Commission , 647 F R 3d 1144. According to one study study,, the D.C. Circuit’ Circuit’ss decision itself had a negative impact on the valuation of potentially affected firms: see Bo Becker, Daniel Bergstresser, and Guhan Subramanian, Does Shareholder Proxy Access Improve Firm Value? Evidence from the Business Roundtable’s Challenge , 56 J L L E 127 (2013). ³² § 112 Delaware General Corporation Law. Law. ³³ See e.g. Howard Howard B. Dicker, Dicker, 2016 2016 Proxy Season: Season: Engagement, ranspar ransparency ency,, Proxy Access , Harvard Law School Forum on Corporate Governance and Financial Regulation, 4 February 2016, available at corpgov.law.harvard.edu corpgov.law.harvard.edu.. ³ See Chapter 8.2.3.
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their own materials—that materials—that is, ballots, registration statements (subject to SEC review), andFinally, supporting materials.³ a popular tool among activists is what is known as a “short slate” proxy solicitation.³ Since 1992, when the SEC amended its proxy rules to reduce obstacles to shareholder activism, an insurgent in a proxy contest, typically a hedge fund, may solicit proxies to vote in favor both of its nominees for a minority of directorships and of a majority of the nominees in the company’s company’s proxy materials.³ A “sh “short ort slate” makes it easier for a hedge fund activist to persuade institutional investors to support its nominees and to push for a change in the company’s company’s strategy from within the board.
3.2.2 Removing directors Te power to remove directors, if shareholders can exercise it effectively, is a very potent mechanism for controlling agency costs, perhaps even more so than appointment rights. Many jurisdictions— including theright UK, to France, Italy, Japan, and Brazil— accord shareholder majorities a non-waivable nonwaivable remove directors at any time, regardless of cause or the nominal duration of their term.³ Coupled with powers to requisition a shareholders’ meeting—for meeting—for which the agenda will be circulated at the company’s expense—this expense—this creates a powerful check on agency costs. Boards recognize the credibility of this threat, and consequently will often accede to shareholder demands for change in the boardroom without the need for a shareholders’ meeting
actually to be called.³ Our other jurisdictions provide weaker removal rights. German law encourages accountability to shareholders of shareholder-elected shareholder-elected members of the supervisory board by permitting their removal without cause, although only by a 75 percent majority. ity . By contrast, shareholders may not remove the labor representatives, nor may the supervisory board remove members of the management board without cause.¹ Tis latter rule reflects idea that(as in opposed the presence of representatives representatives very different constituencies, makingthemanagers to supervisors) tightlyofaccountable to their constituency might be counter-productive, counter-productive, undermining effective day-today-to-day day decisionmaking. In the end, however, the possibility of direct shareholder influence mitigates the limitation on managerial board member dismissal. Where a simple majority of the general meeting approves a “no confidence” resolution against the management board, this satisfies the “cause” requirement; requirement; in other words, the supervisory board is entitled (and probably obliged) to remove the management board in such a situation.² ³ See e.g. Sofie Cools, Te Real Difference in Corporate Law Between the United States and Continental Europe: Distribution of Powers , 30 D J C L 697, 746 (2005). ³ See Coffee and Palia, note 20, at 24– 24–55. ³ Se See 17 C.F.R. §240.14a-4(d)(4). Sections (France); 168 and 303 2006 (UK), L. 225225-75,forand 225-75, 225-61within 225-61 Code de ³commerce Arts.Companies 2367 and Act 2383 Civil CodeArts. (Italy) (all 18, providing removal term and setting minimum thresholds to call special meetings in publicly traded companies). Art. 339(1) Companies Act (Japan) (simple majority required for removal without cause). Art. 140 Lei das Sociedades por Ações (Brazil) (same). ³ See e.g. Marco Becht, Julian Franks, Colin Mayer, and Stefano Rossi, Returns to Shareholder Activism: Evidence from a Clinical Study of the Hermes UK Focus Fund , 23 R F S 3093 (2010). § 103 AktG (Germany). Companies’ Companies’ charters may provide for a higher higher or lower majority (ibid.), which they rarely, if ever, do. ¹ § 103 and 84(3) AktG (Germany). (Germany). ² § 84(3) AktG (Germany). In In practice the management board board member will not wait until the supervisory board votes on the removal, but will step down “voluntarily. “voluntarily.”
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Many U.S. jurisdictions treat the right to remove directors without cause as a statutory defaultmay subject reversal by a charter provision on ifpoint.³ In Delaware, however however, companies onlyto disallow removal without cause they choose a staggered (or, “classified”) “c lassified”) board, that is, a board where only a fraction of the members is elected each year. Staggered boards used to be common until the mid-2000s. mid-2000s. In keeping with the general trend towards greater shareholder shareholder appointment rights in the U.S., their use has been in decline for several years, in parallel with a heated scholarly debate over their corporate governance merits. Yet, Yet, Delaware indirectly cabins removal rights by denying shareholders the power to call a special shareholders’ meeting unless the company’s company’s charter expressly so provides. Especially where removal without cause is not permitted, the standard stand ard mode of director “removal” is dropping their names from the company’s slate or failing to re-elect them. As a consequence, the length of directorial terms can be critical. Longer terms provide insulation from proxy contests, temporary shareholder majorities, and even powerful CEOs. core jurisdictions, directorial terms the case shortest (one year) in the U.S. Among (unless our the company has a staggered board, in are which the term is typically three years) and, as a matter of practice and corporate governance recommendations for the largest publicly traded companies, in the UK. erms are short (two years) in Japan as well, while in Italy and Brazil they are three years. At the opposite end of the spectrum lie German and French corporations, which usually elect (supervisory) directors for five- or six-year six-year terms respectively, the maximum that their
corporation laws permit. Tus, removal rights generally track appointment rights: jurisdictions with “shareholder-centric” “shareholdercentric” laws on the books—the books—the UK, France, Japan, Italy, and Brazil— provide shareholders with non-waivable non-waivable removal powers as well as robust nomination powers. Delaware—the Delaware—the dominant U.S. jurisdiction—weakens jurisdiction—weakens removal powers by allowing staggered boards and discouraging special shareholders shareholders’’ meetings, but has an ever more commonly adopted default directorialfriendly term ofrules one year which, together have with the recent introduction of more shareholdershareholder-friendly on appointment,¹ brought it broadly in line with other jurisdictions. Te correlation between appointment and removal powers does not hold for German companies, whose shareholders have strong appointment rights for “their” supervisory board members but can only oust them from lengthy terms by means of a
³ See § 8.08(a) Revised Model Business Corporation Act. See § 141(k) Delaware General Corporation Law. Law. Delaware General Corporation Law requires that at least one-third one-third of the directors be elected annually (§141(d)) where there is a single class of voting stock. Longer terms are possible, possible , however, however, where corporate charters provide for multiple classes of voting stock. CEOs , 88 Kahan and Edward Edwar d Rock, Embattled L R 987, 1007–9 1007– (2009). Marcel Compare e.g. Lucian A. Bebchuk, John C. Coates IV, IV, and Guhan Subramanian, Te9Powerful Antitakeover Antitakeov er Force of Staggered Boards: Teory Teory,, Evidence, and Policy , 54 S L R 887 (2002) and Lucian A. Bebchuk, Alma Cohen, and Allen Ferrell, What Matters in Corporate Governance? , 22 R F S 783 (2009), with Martijn Cremers, Lubomir P. P. Litov, Litov, and Simone M. Sepe, Staggered Boards and Firm Value, Revisited , Working Working Paper (2014), available at ssrn.com.. ssrn.com See §§ 211(b) and 211(d) Delaware General Corporation Law. Law. UK Corporate Governance Governance Code (2014), B.7.1. Art. 332(1) Companies Act (Japan); Art. 2383, Civil Code (Italy) (companies may opt for shorter terms, but that is exceedingly rare); Art. 140, III Lei das Sociedades por Ações (Brazil). § 102 I AktG (Germany); Art. L. 225-18 225-18 Code de commerce (France). ¹ See notes 28 and 32 and accompanying text.
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supermajority vote. German law favors stability on the management board as well, by insulating its members from removal without cause to some degree.²
3.2.3 Decision rights Since the corporate form seeks to facilitate delegated decision-making, decision-making, striking the balance between shareholder decision rights and the powers reserved to managers is a delicate exercise for corporate lawmakers. As we explain in later chapters, shareholders obtain mandatory decision rights principally when directors (or their equivalents) have conflicted interests or when decisions call for basic changes in governance structure or fundamental transactions that potentially restructure the firm (Chapters 6 and 7). Further attribution of decision rights closely tracks appointment rights—it rights—it depends on the nature of the shareholders and the coordination costs they face. Almost all jurisdictio jurisdictions ns requir requiree shareh shareholders olders to appro approve ve some corporate actions, whether upon a board proposal a shareholder’s. raditionally, U.S. law mandates shareholder ratification forora even relatively narrow range of fundamental decisions (in short: charter amendment and mergers), while our other core jurisdictions grant shareholders a broader range of decision rights, including certain routine but important matters. For example, they require the general shareholders’ meeting to approve dividend distributions.³ For UK listed companies, the premium Listing Rules require shareholder approval of so-called so-called “Class 1” transactions, transact ions, which exceed a threshold of sig-
nificance (25 percent) measured by reference to a range of corporate valuation metrics. Equally important, all EU member states give shareholders the right to appoint and a nd dismiss the auditors of listed and publicly traded companies, while shareholders shareholder s also elect the “statutory auditors” or “supervisors” of Japanese, Italian, Italian, and Brazilian Brazil ian companies. On one dimension—shareholder dimension—shareholder voting on executive pay—convergence pay—convergence is fast approaching, on a rule that permits the shareholders’ meeting to cast a vote on managers’ compensation packages. Welatitude deal with “sayinitiation on pay” in Chapter Jurisdictions also differ in the of the rights they 6. grant shareholders. At one end of the spectrum, the UK and Brazil confer extensive powers on shareholders. Te statutory default in the UK permits a 75 percent majority shareholder vote to overrule the board on any matter, even if it is within the board’s competence. Brazil does not contain a similar rule, but permits a simple majority of shareholders to make the lion’s lion’s share of business decisions beyond the very few matters matt ers that necessarily require board action. In addition, duly filed shareholder agreements can even bind ² See text following note note 41. ³ §§ 58 and 174 AktG (Germany); Art. L. 232-12 232-12 Code de commerce (France); Art. 2434 Civil Code (Italy); Art. 454(1) Companies Act (Japan); Art. 132, II Lei das Sociedades por Ações. For the UK, see 2008 Art. 70 Regulations No.Schedule 3229. 3, Model Articles for Public Companies, Companies (Model Articles) LR 10, UK Listing Listing Rules. Rules. Art. 37(1) EU Audit Directive Directive (Directive (Directive 2006/43/ 2006/43/EC EC on statutory audits of annual accounts and consolidated accounts, 2006 O.J. (L 43) 1, as amended by Directive 2014/ 56, 2014 O.J. (L 158) 196). Ibid. See also Art. 329(1) Companies Act (Japan); (Japan); Art. 2400 Civil Code (Italy); Art. 162 Lei das Sociedades por Ações (Brazil). See Chapter 6.2.3. See Schedule 3, Art. 4 Model Articles for Public Public Companies, note 53. Tis power’s power’s significance is more symbolic than practical. A supermajority is hard to muster, yet a simple majority is enough to remove the board (note 38) and consequently to induce it to do what the shareholders want. Arts. 121 and 142 Lei das Sociedades por Ações.
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the vote of corporate directors, to the effect that votes contradicting the agreement are notElsewhere, counted inshareholders shareholder and less board meetings. shareho lders have extensive rights. Routine business decisions generally fall within the (management) board’s board’s exclusive authority to “manage” the corporation.¹ Nevertheless, continental European jurisdictions and Japan allow qualified percentages of shareholders to initiate and approve resolutions on a wide range of matters including questions that may have fundamental importance to the company’s company’s management and strategic direction, such as amendments to the corporate charter.² By contrast, U.S.—or U.S.—or at least Delaware—law Delaware—law is the least shareholder-centric shareholder-centric jurisdiction. As we discuss in Chapter 7, shareholders of Delaware corporations must ratify fundamental corporate decisions such as mergers and charter amendments but lack the power to initiate them.³ Even though shareholder decision rights in public companies diverge across jurisdictions, in closely held companies they converge on flexible and extensive shareholder decision rights. A good the German limited liabilityofcompany (GmbH), which may become veryexample large inis capitalization and number shareholders. Te GmbH not only mandates shareholder approval of financial statements and dividends, but also authorizes the general shareholders’ meeting to instruct i nstruct the company’s board (or general director) on all aspects of company policy. policy. Te GmbH form, then, allows all ows shareholders complete authority to manage the business by direct voting—unless the company is subject to codetermination law by virtue of the size of its workforce. Our other core jurisdictions are similarly flexible.
Finally, at the level of the individual shareholder, many jurisdictions permit derivaFinally, tive actions, which are not only an enforcement mechanism but also a right granted to individual shareholders to manage a corporate cause of action. We discuss derivative suits further in Chapter 6 and the directors’ duties upon which they are based in Section 3.4.1.
3.2.4 Shar Shareholder eholder coordination Closely related to shareholders’ appointment and decision rights is the extent to which the law seeks to assist dispersed shareholders in overcoming their collective action problems. All of our target jurisdictions do this, up to a point. Voting mechanisms are a conspicuous example. Small shareholders everywhere may exercise their voice at shareholders’ meetings through attendance in person, which is obviously cumbersome, or through at least one of four mechanisms meant to make voting less costly: voting by mail (or “distance voting”), proxy solicitation by corporate partisans, Art. 118 Lei das Sociedades por Ações. ¹ See E.g.Dirk § 141(a) Delaware Delaware GeneralInteraction Corporation Law; Shareholder § 76 Aktiengesetz (Germany). ² Zetzsche, Shareholder Intera ction Preceding Meetings of Public Corporations— A Six Country Comparison, Comparison , 2 E C F L R 107, 120–8 120– 8 (2005) (France and Germany). For Italy see Art. 2367 Civil Code and Art. 126-II 126- II Consolidated Act on Financial Intermediation. For Japan, Japan, see Goto, note 23, 2 3, at 129–31, 129– 31, 135–6. 135–6. ³ See Chapters 7.2 and 7.4. However, However, shareholders in U.S. corporations do have have initiation rights with respect to amendments of corporate bylaws. While some action has taken place in this area, it appears less than one might expect, given the relatively high stakes compared with other contentious areas of corporate governance. See Kahan and Rock, note 29, at 2019. §§ 37, 38, 46 GmbHG. A GmbH subject to codetermination must have a twotwo-tier tier board and is subject to AG rules on the division of functions between the boards, and between boards and shareholders. Karsten Schmidt, G 482–3 482–3 (4th edn., 2002).
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proxy voting through custodial institutions or other intermediaries, and participation in an electronic meeting. For example, Japanese law allows firms with significant numbers of shareholders to choose voting either by proxy or by mail. France, Germany, Italy, and the UK allow corporations to opt for distance dista nce voting. As a consequence of the EU Shareholder Rights Directive, all of these jurisdictions also now permit electronic meetings and voting. Te U.S. traditionally relied on proxy voting, but has also made it possible for companies to establish “electronic forums” for communication with, and between, shareholders, and for proxy solicitation and appointment to be conducted via the internet (so-called (so-called “e-proxies”). “e-proxies”). Finally, Brazilian law now enables distance voting and permits companies to hold live electronic meetings and voting.¹ Whenn inve Whe investor storss hold shares shares in indi individu vidual al com compani panies, es, they usu usually ally do so via inst institu itu-tions such as banks (in most jurisdictions) or broker-dealers broker-dealers (in the U.S.) acting as their custodians. As such, these intermediaries have no financial interest in the shares deposited with them. Yet they may face conflicts of interest owing to actual or prospective business relationships withthey listedgenerally companies. For the thiscorporate reason, when they were vote custodial shares, favored nominees. Tisempowered practice wasto once common among U.S. broker-dealers,² broker-dealers,² and European custodians, such as banks, played an even stronger, pro-incumbent pro-incumbent role in corporate governance. In Germany, for example, where supervisory boards have traditionally not engaged in partisan proxy solicitation,³ banks serving as custodians for retail investors used to vote the shares in favor of corporate nominees. Tis custodial exercise of voting rights was justified by reference to investors’ “implicit consent.” After market pressure and legal reform restricted this practice, vot-
ing outcomes in widely held German companies have occasionally become less predictably pro-management. pro-management.
Japanese firms with 1000 or more shareholders must make this choice: Arts. 298(1)(iii) and 298(2) Act.allVoting VJapanese oting by mail is also optional for smaller smalCompanies ler companies, bymost el ectronic electronic means isCompanies optional for companies: Art. 298(1)(iv) Act.and Invoting practice large public Japanese firms adopt voting by mail rather than proxy voting. Art. L. 225225-107 107 Code de commerce (France); Art. 2370(4) Civil Code and Art. 127 Consolidated Act on Financial Intermediation (Italy). For Germany, Germany, see the 2001 law on registered shares and on facilitating the exercise of the right to vote (NaStraG). In the UK, this can be done by inserting a provision in the company’s company’s articles: Companies Act (UK) 2006, s 284(4). 28 4(4). Art. 8 Directive 2007/ 2007/36/ 36/EU, EU, 2007 O.J. (L 184) 17. Te NYSE mandates proxy solicitation for “operating” “operating” listed U.S. firms except except where solicitation would be impossible (Rule 402.04(A) Listed Company Manual). See also Rules 4350(g) and 4360(g) NASDAQ Marketplace Rules (same). No such law or listing requirement exists in Germany, France, France, Italy, the UK, or Japan. SEC Rules 14a14a-16, 16, 14a-17. 14a-17. ¹ CVM Instruction No. No. 481 (2009), as amended by CVM Instruction No. No. 561 (2015). ² Since 2009 U.S. brokerage houses have been prohibited from voting shares shares held as nominees (in “street name”) in directorial elections in the absence of direct instructions from beneficial owners: NYSE Rule 452. Te Dodd-Frank Dodd- Frank Act broadened the prohibition to voting on executive compensation, including say-onsay-on-pay pay (§ 957). ³ See Schmidt, note 65, at 854. Te shareholders could always instruct their banks as to how to to vote their shares, shares, but rarely gave explicit instructions. See Wolfolf-Georg Georg Ringe, Changing Law and Ownership Patterns in Germany: Corporate Governance and the Erosion of Deutschland AG , 63 A J C C L 493, 506–7 506–7 (2015). For example, the Chairs of Deutsche Börse’s supervisory and management boards agreed to resign after activist investor pressure made it clear that they would face a vote of dismissal at the general meeting. See Norma Cohen and Patrick Jenkins, D Börse Chiefs Agree to Step Down, Down, F (Europe), 10 May 2005, at 1. For evidence of the decline in bank influence in Germany see Ringe, note 75, 522–4. 522–4. For recent anecdotal evidence of increasingly successful hedge fund activism in Germany, see Stada and Deliver , E, 3 September 2016, at 58.
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Such outcomes have also been furthered by the increasing internationalization and institutionalization of share ownership in German companies. A similar ownership pattern can be observed in other core jurisdictions: in each of them, shareholdings (or minority shareholdings in companies with a controlling shareholder) are increasingly in the hands of institutions, mostly asset managers acting for pension funds and insurance companies, with the largest among them often holding average stakes around 5 percent of the most liquid shares in many markets. Institutions that invest in the market on behalf of multiple beneficiaries can aggregate control rights, thereby reducing the collective action problems faced by disaggregated investors. Indeed, many institutions with financial obligations to their beneficiaries or customers—including customers—including pension funds, mutual funds, and insurance companies—have companies—have long been champions of shareholder interests in the UK, and are increasingly so in the U.S., especially after policymakers shifted from a legal framework that discouraged shareholder activism and coordination to one which overall favors it. U.S. federal proxy regulation risk that a faction of shareholders wouldwas gainhistorically control, tomore the concerned detriment with of thetheshareholders in general, than with managerial agency costs. Tat translated into rules that not only discouraged insurgents seeking to gain control via proxy contests, but also chilled coordination attempts among shareholders generally. generally. Along with the advent of ubiquitous institutional investor ownership ownership,, the proxy rules r ules restrictions on intershareholder communication were greatly relaxed in 1992.¹ And while barriers to shareholder collective action still remain, including registration and disclosure
requirements for any 5 percent group of shareholders whose members agree to coordinate their votes,² hedge fund activists’ tactics have shown how favorable the overall framework now is to shareholder engagement. Indeed, the U.S. rules prove looser than those of our other jurisdictions when it comes to treating shareholders as “acting in concert” with a view to engaging a target company’ company’ss management. Tey are also more effective in nudging institutional investors into voting their portfolio shares. In the U.S., activist hedge funds may alert other hedge fund managers of their intention to start a campaign without falling foul of insider trading laws.³ And if, as a result, both the initial activist and other hedge funds buy shares in the target company, company, they need not aggregate their holdings for disclosure purposes. On the contrary, European insider trading rules would treat the intention to start a campaign as price sensitive information, which would prevent those who learn about it from buying additional shares. In addition, hazier definitions of “acting in concert” for mandatory bid rule purposes, especially in countries such as Germany and France, which have not
Ringe, note note 75 at 524–6. 524–6. Kingdom, R H See e.g. Paul Davies, Shareholders in the United Kingdom, S P P 355, 357– 357–99 (Jennifer G. Hill and Randall S. Tomas eds., 2015) (UK); Edward B. Rock, Institutional Investors in Corporate Governance , in O H C L L G (Jeffrey N. Gordon Gordon and WolfWolf-Georg Georg Ringe eds., 2017) (U.S.). See Geof P. P. Stapledon, I S C C G (1996). See e.g. John John Pound, Pound, Proxy Voting and the SEC: Investor Protection Versus Market Efficiency , 29 J F F E 241 (1991). ¹ See Regulation of Communication among Shareholders, Exchange Exchange Act Release No. 34-31326 34-31326 (1992). See SEC Rule 13d-5 13d-5 (17 C.F C.F.R. .R. § 240.13d240.13 d-55 (2008)). ² See SEC Rule 13d13d-55 (17 C.F.R. § 240.13d-5 240.13d-5 (2008)). ³ See Coffe ffeee and Pali liaa, note 20, at 35. See ibid id.. at 28–42. See Arts. 7– 7–99 Market Abuse Regulation, 2014 O.J. (L 173) 1).
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tried to dissipate doubts via regulatory exemptions or guidance, mean that activists have to beware the risk of jointly crossing the relevant thresholds. Moreover More over,, since the 1980s, U.S. rules on institutional investors’ voting of portfolio shares have proved hospitable to shareholder activism. A rule that first covered pension funds, and was later extended to other asset managers, declared fiduciary duties applicable to decisions regarding the exercise of portfolio shares’ voting rights. In addition, since 2003, mutual funds have had to disclose their proxy voting policies. Tese regulations have helped to raise participation rates at both U.S. and foreign portfolio companies and to standardize asset managers’ views on corporate governance issues, usually in the direction of more pro-shareholder pro-shareholder corporate governance policies at the portfolio company level. As importantly, such rules have hugely increased the demand for proxy advisory services and therefore the influence on corporate governance of ISS and Glass Lewis, the two dominant global proxy advisers. In Europe policymakers policymakers have moved much less in the direction of mandating institutional investors’ involvement in corporate governance, although they have similarly sought to ensure that, as responsible owners, institutions engage with their portfolio companies. Te UK, followed by Japan, took the lead in this area by adopting a ‘Stewardship Code,” Code,” which aimed to increase asset managers managers’’ accountability as a s regards their exercise of ownership (mainly voting) rights. Te Stewardship Code, however, however, has no mandatory component: like for Corporate Governance Codes, Codes, the only obligation is for UK asset managers to declare whether they comply with it or otherwise explain why they do not. Judging from both mandated statements by UK asset managers and voluntary ones by foreign institutions, the Stewardship Code’s principles,
perhaps because of their generality, generality, seem broadly shared within the industry industry.¹ .¹ Harder to tell is whether compliance with the Stewardship Code’s principles and, in the U.S., with mandatory voting and voting policies disclosure requirements also translates into improved governance governance and/or and/or management and financial performance at portfolio companies.² A cause for skepticism is that—unlike that—unlike Corporate Governan Governance ce See Chapter 8.3.4. Te UK akeovers Panel issued guidance on acting in concert by active shareholders. See akeover akeover Panel, Practice Statement No. 26. Shareholder Activism (2009) (available at www. at www.thetakeoverpanel.org thetakeoverpanel.org ). ). Italy’s Italy’s securities regulator (Consob) similarly clarified cl arified which coordinating actions, such as agreement to vote against a given board proposal, are not per se relevant for acting in concert purposes: Art. 44-IV 44-IV Consob Regulation on Issuers. See e.g. Robert B. Tompson, Te Power of Shareholders in the United States , in R H S P P ,, note 78, 441, 451. SEC, Proxy Voting Voting by Investment Advisers, Release No. IA-2106, IA-2106, 68 FR 6585 (7 Feb. 2003). Te European Commission is following suit in this area by championing a prescriptive approach along the lines of the SEC rules. See Art. 3f Shareholders Rights Directive, as envisaged by the Proposed Directive amending Directive 2007/36/ 2007/36/EC EC as regards the encouragement of long-term shareholder engagement, Directive 2013/34/ 2013/34/EU EU as regards certain elements of the corporate governance statement and Directive 2004/109/ 2004/109/EC, EC, as approved by the European Parliament on 8 July 2015. 2015 . Financial Reporting Council (UK), UK S S C (2012); Council of Experts Concerning the Japanese Version Version of Stewardship Code, Code , P R R I I— J J’’ S S C (2014). See Chapter 3.3.1. ¹ As the time of writing (June 2016), the Financial Financial Reporting Council website lists 306 asset managers, owners, and service providers (such as proxy advisers), including Blackrock, Fidelity, Fidelity, Vanguard, Vanguard, ISS, and Glass Lewis, who have stated their commitment to the Code. See www.frc.org.uk . Te Japanese Stewardship Stewardship Code is a form of pure soft law, law, in that even Japanese Japanese institutional investors are under no obligation to comply or explain. Te Financial Services Agency’s website lists 207 institutional investors who have undertaken to comply or explain as of end of May 2016. ² A review of the empirical evidence by one of this book’ book’s authors gives few grounds for optimism. See Rock, note 78.
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Codes—there are few obvious mechanisms through which the information disclosed Codes—there will be aggregated and acted upon by the asset managers’ ultimate principals, retail investors in institutional investment vehicles.
3.3 Agent Incentives Within the framework of the law law,, market forces play an important role in molding corporate agents’ behavior. Tey have levered upon both the low-powere poweredd incentives of independent directors within boards tasked with a monitoring role (a trusteeship strategy), and the high-powere high-poweredd incentives created by seeking to align managers’ incentives with shareholders shareholders’’ interests through t hrough equity-linked equity-linked compensation (a reward strategy). Te law has intervened in these two areas, sometimes to support and reinforce market practices, and sometimes to curb distortions in their t heir use that might result from the very agency problems such practices seek to ameliorate. rusteeship and reward strategies have also been used as complements, as where independent directors are charged with the task of ensuring that executive compensation packages genuinely align incentives rather than serving simply as ways for managers to transfer wealth to themselves. While we discuss these two t wo strategies separately below below,, it is therefore useful to remember that board effectiveness is the outcome of the interaction, inter alia, of both rewards and trusteeship: disentangling their separate contributions is one of the many challenges that empirical studies must address in this area.³
3.3.1 Te trusteeship strategy: Independent directors Among our core jurisdictions, the principal trusteeship strategy for protecting the interests of disaggregated shareholders is the inclusion of “independent” directors amongst those comprising Because their they compensation tend to be less sensitive than managers’the managers ’ toboard. share performance, are free(r) packages from high-powered highpowered incentives. And because they are not themselves making day- toto-day day management decisions, they can be expected to identify less with management and to be more willing to be critical. Te board—whether board—whether one-tier one-tier or two-tier— two-tier—then then comprises both managers, man agers, whose incentives are shaped mainly by the rewards strategy, and nonexecutives, whose incentives are rather shaped by the trusteeship strategy. strategy. Te increasingly common requirement that some or most members of a corporation’s board of directors not be executives of the firm reflects the trusteeship strategy in that it removes one conspicuous high-powered high-powered incentive for directors to favor the interests of the firm’s management at the expense of other constituencies. ruly independent directors are board members who are not strongly tied by high-powered high-powered financial incentives to any of the t he company’s company’s constituencies and consequently are motivated principally a trustee. by ethical and reputational concerns. Tat is, of course, our definition of ³ See also end of section 3.3.1. Structure in the Modern Corporation: Officers, Melvin A. Eisenberg, Legal Models of Management Structure Directors, and Accountants , 63 C L R 375 (1975). See Section 3.5. See Ronald W. W. Masulis and Shawn Mobbs, Independent Director Incentives: Where Do alented Directors Spend Teir Limited ime and Energy? 111 111 J F E 406 (2014). See Chapter 2.2.2.3.
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All of our core jurisdictions now recognize recognize a class of “independent” “independent” directors directors in this sense, and most jurisdictions actively support at least some participation by these directors to key board committees (audit, nomination, and compensation). Complementing its traditionally limited reliance on shareholder control rights, the U.S. is the originator of this form of trusteeship and still its most enthusiastic proponent. U.S. case law generally encourages independent directors, while U.S. exchange rules now require that company boards include a majority of independent directors and that key board committees be composed by a majority, or entirely, of independent directors. In addition, the Sarbanes-Oxley Sarbanes-Oxley Act of 2002 (“SOX”) mandated wholly independent audit committees; eight years later, the Dodd-Frank Dodd-Frank Act mandated wholly independent compensation committees.¹ Similarly, the SOX-inspired SOX-inspired EU Audit Directive requires publicly traded companies to have audit committees with a majority of independent directors, including an independent chair.¹¹ chair.¹¹ Other than that, our EU jurisdictions promote independent directors mainly through soft law, in the form of “corporate governance codes.” Tese are guidelines for listed companies that address board composition, structure, and operation, and are drafted by market participants under the aegis of an exchange or a public body. Listed companies are not legally bound to follow these these guidelines. Instead, they have an obligation to report annually whether they comply with code provisions and, if they do not comply, comply, the reasons for their noncompliance—a noncompliance—a so-called so-called “comply or explain” obligation.¹² Tis device is intended to enlist reputation, shareholder voice, and market pressure to push companies toward best practices, while simultaneously avoiding rigid rules in an area where one size clearly does not fit all.¹³ a ll.¹³
Te UK s code is most enthusiastic in its reliance on independence. It recommends that at least half the board of listed companies (other than smaller ones) be composed of independents,¹ who should also fill the audit and remuneration committees as well as a majority of the nomination committee.¹ France, France, Germany, Germany, and Italy follow the same direction, although they are less whole-hearted whole-hearted in their embrace of independence. Te French Fre nch code distinguishes dist inguishes between widely held companies (recommending independence for half of the board) and companies with a controlling shareholder (recommending
In particular, particular, Delaware courts have have repeatedly emphasised the importance importance of independence as a criterion for review of conflicted transactions or litigation decisions. See Chapter 6.2.2.1. See Rules 303A.01 (listed companies must have a majority of independent directors) and 303A.04–05 303A.04– 05 (nominating/corporate (nominating/corporate governance and compensation committees composed entirely of independent directors) NYSE Listed Company Manual; Rule 4350(c)(1) (majority of independent directors required) and Rules 4350(c)(3)–(4) 4350(c)(3)–(4) (compensation and nominations committees comprised solely of independent directors; one out of three members may lack independence provided that she is not an officer or a family member of an officer) NASDAQ Marketplace Rules. ¹ SOX, § 301; DoddDodd-Frank Frank Act of 2010, § 952. ¹¹ Art. 39(1) Directive 2006/43/ 2006/43/EC EC (note 55). However, Art. 39(5) Audit Directive allows member states to opt out of the independence requirements where all members of the audit committee are also members of the supervisory board. Germany has made use of this opt-out. See Abschlussprüfungsreformgesetz of 10 May 2016, Art. 5 Nr. Nr. 1, 2. ¹² See e.g. LR 9.8.6 UK Listing Rules; for Germany, Germany, § 161 AktG. ¹³ For example, it appears that compliance with code provisions is associated with increased performance in UK firms with dispersed ownership, but has no measurable impact for firms with a controlling shareholder: see Aridhar Arcot and Valentina Bruno, Corporate Governance and Ownership: Evidence from a Non- Mandatory Mandatory Regulation Regulation,, Working Paper (2014), available at ssrn. com.. See also Alain Pietrancosta, Enforcement of Corporate Governance Codes: A Legal Perspective , in com F K J. H 1, 1109, 1130 11 30 (Stefan Grundmann et al. eds., 2010). 2 010). ¹ UK C C G C (2014), Provisions Provisions B.1.2. ¹ Ibid., Provisions Provisions B.2.1, C.3.1, and D.2.1. D.2.1.
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independence for one-third),¹ one-third),¹ while the German and Italian codes only recommend an “adequate number” of independent directors/members directors/members of the supervisory board, leaving broad discretion to individual companies.¹ Te case of independent directors in Germany is particularly delicate, as shareholders may fear that directors who are “independent” of shareholders might side with labor representatives on a divided board. In all three countries the codes recommend an independent audit committee,¹ France and Italy a remuneration committee, and Germany, with France, a nomination committee.¹ Brazilian corporate law does not impose any director independence requirements, but the premium listing segments of the São Paulo stock exchange (such as the Novo Mercado and Level 2) mandate a minimum of 20 percent independent directors.¹¹ As a response to criticisms of the traditional system of insiderinsider-dominated dominated boards coupled with a nominally independent but weak board of statutory auditors,¹¹¹ the Japanese Companies Act permitted companies to t o adopt a U.S.U.S.-style, style, tripartite committee structure in 2002. While a few firms with greater international exposure have chosen this new structure,¹¹² it has not proven particularly popular.¹¹³ However, the reform of the Companies Act in 2014 push listed companies, on a comply or explain basis, to appoint at least one outside director. Tis and a recommendation, in the Corporate Governance Code of 2015,¹¹ to appoint two independent directors, has triggered a rapid increase in the number of listed companies appointing one or two independent directors.¹¹ Nevertheless, it remains infrequent for Japanese companies to appoint any more independent directors.¹¹
French Corporate Governance Governance Code, Principle 9.2. ¹ See Recommendation 5.4.2 German Corporate Governance Code; Principle 3.P.1, Italian Corporate Governance Code (for the 40 most traded stocks, the recommendation is for one third of independent directors: ibid., criterion 3.C.3). ¹ On EU requirements for an audit committee see note note 158. ¹ See French Corporate Governance Code, Principle 15 and 17; Recommendation Recommendation 5.3 German Corporate Governance Code; Arts. 5–7 5–7 Italian Corporate Governance Code. In Germany, a majority of the larger listed companies has set up remuneration committees as well. See Klaus J. Hopt and Patrick C. Leyens, Board Models in Europe—Recent Europe—Recent Developments of Internal Corporate Governance Structures in Germany, the United Kingdom, France, and Italy , 1 E C F L L R 135, 141 (2004). ¹¹ Novo Mer ¹¹ erca cado do Re Regu gula lati tion onss Art Art.. 4.3 4.3;; Le Levvel 2 Reg Regul ulat atio ions ns Ar Art. t. 5. 5.3. 3. ¹¹¹¹ Se ¹¹ Seee not notee 5. 5. ¹¹² See Ronald J. Gilson and Curtis J. Milhaupt, Choice As Regulatory Reform: Te Case of Japan Japanese ese Corporate Governance , 53 A J C L 343, 349 (2005); Amon Chizema and Yoshikatsu Shinozawa, Te “Company with Committees”: Change or Continuity in Japanese Japan ese Corporate Governance? Governance? , 49 J M S 77 (2012). ¹¹³ As of July 2014, only 58 out of 3414 (or 1.7 percent of) of ) listed companies at the okyo okyo Stock Exchange took the form of a company with three committees. See S E, SEL C W W P P C C G 2015, at 15 (available at http:// http://www. www. jpx.co.jp/english/ jpx.co.jp/ english/equities/ equities/listing/ listing/cg/ cg/02.html 02.html). ). ¹¹ Te Council of Experts Concerning the Corporate Governance Code, J’ C G C [F P] (2015). ¹¹ For details and Japan analysis of thel recent reforms in Japan, seeDirectors: Gen Goto, Matsunaka, and Souichirou Kozuka, Japan’s ’s Gradua Gradual Reception of Independent AnManabu Empirical and PoliticalEconomic Analysis , in I D A (Harald Baum et al. eds.) (forthcoming). Te ratio of companies listed in the First Section of the okyo Stock Exchange (the top-tier top-tier market of Japan) appointing at least one outside director has increased from 30.2 percent in 2004 to 94.3 percent in 2015, and the ratio of the same companies appointing at least two independent directors has increased from 12.9 percent in 2010 to 48.4 percent in 2015. See okyo Stock Exchange, Inc., Appointment of Outside Directors by SESE-Listed Listed Companies [Final Report] (29 July 2015), available at http:// http://www.jpx.co.jp/ www.jpx.co.jp/english/ english/listing/ listing/stocks/ stocks/indind-executive/ executive/index.html index.html.. ¹¹ Ibid. As of July 2015, the ratio of companies listed l isted in the 1st Section of okyo okyo Stock Exchange Exchange having one third or more of independent directors was 12.2 percent, and the ratio of those having a majority of independent directors majority was 2.7 percent.
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rustee-like directors are thus increasingly considered to be a key element of rustee-like good governance in all of our core jurisdictions. In the U.S. and the UK, they are most often seen as monitors of managers (although this task might be better performed by directors who were dependent on on shareholder interests).¹¹ In EU jurisdi juri sdicti ctions ons wit withh conc concent entrat rated ed owner ownershi shipp str struct uctures ures and Braz Brazil, il, tru truly ly inde indepenpendent directors are more likely to be seen as champions of minority shareholders or non-shareholder non-shareholder constituencies. Put differently, trustee-like trustee-like directors can be seen as a wide-spectrum wide-spectrum prophylactic. Tey are potentially valuable for treating all agency problems (as well as externalities), but not exclusively dedicated to treating any.¹¹ Nevertheless, it is questionable whether nominally independent directors appointed by a controlling shareholder can properly function as “trustees” who will protect the interests of minority shareholders, rather than as agents for the controller.¹¹ Moreover, independent directors come at a price, as there is inevitably a tradeoff between a director’s director’s independence and her knowledge about the company.¹² According to many, independent boards, with their limited understanding of risk management and the technicalities of bank management, contributed to the bank failures in 2008–9.¹²¹ 2008–9.¹²¹ As a result, policymakers’ emphasis, especially (but not exclusively) for financial institutions, is nowadays as much on competence as independence.¹²² Unfortunately, the crucial empirical question whether independent directors have a positive impact on firm performance is exceptionally difficult to answer.¹²³ Because board structure is primarily a matter for individual firms to decide, the proportion of independent directors is likely as much a response to, as a cause of, variation in performance. Moreover Moreover,, the aspects of board structure that affect performance vary by country
¹¹ See e.g. Ronald J. Gilson and Reinier Kraakman, Reinventing the Outside Director: An Agenda for Institutiona Institutionall Investors , 43 S L R 863 (1991); Jonathan R. Macey, C G: P K, P B 90–2 90– 2 (2008). ¹¹ On the use of independent directors to tackle a variety of agency and non-agency problems over time, see se e Mariana Pargendler Pargendler,, Te Corporate Governance Obsession, Obsession, 42 J C L L 101 (2016). ¹¹ See Wolf-Georg Wolf-Georg Ringe, Independent Directors: After the Crisis , 14 E B O L R 401 (2013); Arcot and Bruno, note 103. See also Chapter 4.1.3.1 and Chapter 6.2.2.1. ¹² For discussion of tradeoffs tradeoffs between independence and information on the board see Arnoud Objectivity,, W.A. W .A. Boot and Jonathan R. Macey Macey,, Monitoring Corporate Performance: Te Role of Objectivity Proximity, and Adaptability in Corporate Governance , 89 C C L R R 356 (2003). (20 03). Cf. Jeffrey N. Gordon, Te Rise of Independent Directors in the United States, 1950– 2005: 1950– 2005: Of Shareholders Value Value and Stock Market Prices , 59 S L L R 1465, at 1541– 1541–63 63 (2007) (increasingly informed share prices in the U.S. facilitate facil itate monitoring by independent directors); Enrichetta Ravina and Paola Sapienza, What do Independent Independe nt Directors Know? Know ? Evidence From Teir rading rading , 23 R F S 962 (2008) (independent directors do almost as well as insiders in trading company stock, suggesting no lack of information). Governance of Banks: A Survey , 30 J See e.g. Jacob JS acob de Haan and Razvan Vlahu, Corporate Governance ¹²¹ E 228 (2016). ¹²² See e.g. Art. 91(1) Council Directive 2013/ 2013/36 36 of the European Parliament and of the Council of 26 June 2013 on Access to the Activity of Credit Institutions and the Prudential Supervision of Credit Institutions and Investment Firms, 2013 O.J. (L 176) 338: “Members of the management body shall at all times be of sufficiently good repute and possess sufficient knowledge, skills and experience to perform their duties. Te overall composition of the management body shall reflect an adequately broad range of experiences.” For non-financial non-financial firms, see e.g. Principle B.1 Corporate Governance Code (2014) (UK). ¹²³ For a comprehensive review, see Renée B. Adams, Benjamin E. Hermalin, and Michael S. Weisbach, W eisbach, Te Role of Boards of Directors in Corporate Governance: A Conceptual Framework and Survey , 48 J E L 58 (2010).
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as much as by firm.¹² Finally, Finally, no matter what definition the law or corporate governance codes provide of independence, whether directors labeled as “independent” will act as such a congeries of factors,process, such as which personal anddifficult the actual remoteness ofdepends insiderson from the appointment arecharacter formidably to measure.
3.3.2 Te reward reward strategy: Executive Executive compensation compensation Te other technique used to modify agent incentives is the reward strategy. Like the trusteeship of independent directors, this strategy is sometimes said to substitute for direct shareholder monitoring and exercise of control rights when shareholders are dispersed and face high coordination costs.¹² Te theory is that optimally structured pay packages can align the interests of managers with those of shareholders as a class. Te reality is that managerial rewards can—depending can—depending on their terms—be terms—be as much a strategy for controlling agency costs as a symptom of them. In addition, if alignment of managers’ and shareholders’ shareholders’ interests is achieved by taking the stock price as a proxy for the latter, deviation from what is optimal even for shareholders may occur at companies for which markets do an imperfect job in reflecting the “true” “true” value of their investment policies and business strategies, such as in sectors where innovation is more relevant and harder to understand.¹² Corporate law generally does not stipulate rewards directly, directly, but regulates how companies can compensate their managers in order to advance the interests of the firm. Te most important reward for managers of publicly traded firms today is equity-based compensation, which comes in many forms—namely forms—namely,, stock options, restricted stock, and stock appreciation rights—and rights—and now comprises large (albeit varying) portions of
total compensation for top managers in all of our core jurisdictions. Consistently with the idea that the rewards strategy may substitute for shareholder decision rights, the U.S.—which U.S.—which has traditionally accorded shareholders the weakest decision rights our core jurisdictions—has jurisdictions— has embraced high-powered high-powered incentives mostamongst comprehensively. Although Delaware courts initially regardedequity stock options with suspicion,¹² they soon made their peace, aided by the wide discretion U.S. firms enjoy to issue rights and repurchase shares.¹² Moreover Moreover,, a 1994 change in U.S. tax law¹² gave options an enormous (if unintentional) boost by barring corporations from expensing executive compensation compensation in excess of $1 million per year that was not tied to firm performance.¹³ For the rewards strategy to operate effectively, compensation must be appropriately calibrated. Te U.S. has long l ong relied on disclosure to avoid excessive or incentivedistorting compensation. Nevertheless, objections of miscalibration have repeatedly been voiced, with some cause.¹³¹ As hinted in previous sections, the DoddDodd-Frank Frank Act
What(and Matters for ¹² Bernard Black, Antonio Gledson de Carvalho, and Érica Gorga, Which Firms forS.Corporate Governance in Emerging Markets? Evidence from Brazil other and BRIKC Countries),, 18 J C F 934 (2012). Countries) ¹² Marcel Kahan and Edward Rock, How I Learned to Stop Worrying and Love the Pill: Adaptive Responses to akeover Law , 69 U C L R R 871 (2002). (200 2). ¹² See text preceding note note 21. ¹² See e.g. Krebs v. California Eastern Airways , 90 A R 2d 562 (Del. Ch. 1952). ¹² E.g. § 157 Delaware General Corporation Law. Law. ¹² Internal Revenue Code § 162(m). ¹³ See John John C. Coffee, Coffee, A A Teory of Corporate Corporate Scandals: Scandals: Why Why the USA and Europe Europe Differ Differ , 21 O R E P 198, 202 (2005). ¹³¹ See Chapter 6 and especially 6.2.2.1.
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of 2010 sought to strengthen the efficacy of the trusteeship strategy’s control over reward calibration, by requiring that compensation committees be composed entirely of independent directors.¹³² At the time,compensation, it mandated the holder decision rights in relation to same executive by introduction providing for of anshareadvisory “say on pay” vote.¹³³ Our other core jurisdictions have relied less heavily on the rewards strategy. Tus, there is less linkage between executive pay and corporate performance outside the U.S., even in jurisdictions where ownership is similarly dispersed such as Japan and the UK. In the UK, shareholder decision rights have traditionally been stronger st ronger,, meaning that there has been less need for the reward strategy.¹³ In Japan, while recent policy discussions suggest increased favor for the reward strategy, strategy, the emphasis has traditionally been on creating a sense of unity between management and employees, which clearly makes the reward strategy an unlikely fit.¹³ And in other jurisdictions, the common presence of a controlling shareholder is associated with significantly lower CEO compensation,¹³ presumably because the controlling shareholder can rely on his own decision rights both to ensure good performance from managers and to curb excessive pay. Tese differences in the use of the rewards strategy also track differences in the legal framework as regards the discretion of the board (as opposed to shareholders) to set pay. pay. Tis is nicely illustrated by comparing the roughly contemporaneous Delaware civil litigation against Michael Eisner (Disney, Inc.’s former CEO) and other Disney directors over a termination payment that awarded $140 million to Disney’s President¹³ with the criminal prosecution of Josef Ackermann, at the time Deutsche Bank’s CEO and a Mannesmann AG director, director, and two other members of Mannesmann supervisory board, for paying Mannesmann’s CEO and members of his executive team “appreciation awards” (of approximately $20 million in the case of the CEO) for having
extracted an extraordinarily high premium from a hostile acquirer (Vodafone) after a drawn-out drawnout takeover battle.¹³ Te two cases differed importantly on their facts. In Disney , the amount in issue was contractually fixed ex ante , and the dispute turned on whether Disney’s directors had been so grossly negligent as to have acted in bad faith, either in negotiating the original contract or in not contesting a “no fault termination clause” that triggered the $140 million payment to Disney’s ex-President. ex-President. In Mannesmann, the payments at issue were gratuitous (ex post bonuses bonuses granted by Ackermann and one other member of the ¹³² Dodd-Frank Dodd-Frank Act of 2010, § 952. Te SOX had previously introduced modest controls on executive compensation: see §§ 304 (mandating disgorgement of CEO/CFO CEO/CFO incentive compensation received following a financial misstatement); 402 (banning corporate loans to senior executives to use for exercising options). ¹³³ Dodd-Frank Dodd-Frank Act of 2010, § 951. ¹³ See Martin J. Conyon and Kevin J. Murphy, Murphy, Te Prince and the Pauper? CEO Pay in the United States and United Kingdom, Kingdom, 110 E J 467 (2002). Te greater performance-sensitivity in U.S.Martin means J. executives mo reand more firmfirm-specific specific which pushes upward si ze size of overall the awards: Conyon,there Johnbear E. Core, Wayne R. risk, Guay, Guay, Are Are U.S. CEOs Paid the More than U.K. CEOs? Inferences from Risk- Adjusted Adjusted Pay Pay , 24 R F S 402 (2011). (2 011). ¹³ See Robert J. Jackson, Jr. and Curtis J. Milhaupt, Corporate Governance and Executive Compensation: Evidence from Japan Japan,, 2014 C B B L J 111. ¹³ See Martin J. Conyon et al., Te Executive Compensation Controversy: A ransatlantic Analysis 55, Working Paper (2011); Marcos Barbosa Pinto and Ricardo Pereira Câmara Leal, Ownership Concentration, op Management and Board Compensation, Compensation, 17 R A C 304 (2013) (finding a negative correlation between the levels of ownership concentration and executive compensation in Brazil). ¹³ In re Walt Disney Co. Derivative Litigation, Litigation , 906 A R 2d 27 (Del. 2006). ¹³ See e.g. Curtis J. Milhaupt and Katharina Pistor, Pistor, L L C C 69–86 69–86 (2008).
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compensation committee), but made with the full approval of Vodafone—which, Vodafone—which, by the time of the payout, held 98.66 percent of Mannesmann’s shares. these factual thebusiness differingjudgment outcomesrule of the two casesEisner are revealing.Despite Te Delaware courtdifferences, deployed the to exonerate and the Disney board from civil liability despite evidence of negligence and an odor of conflict of interest (the discharged President had been a close personal friend of the CEO). By contrast, the German Supreme Court (BGH), ruled that Ackermann might be criminally liable for breach of trust in the form of dissipating corporate assets.¹³ From the perspective of Delaware law, law, it is nearly inconceivable that a disinterested director (Ackermann) would face civil liability for approving a gratuitous bonus ratified by a 98 percent disinterested shareholder, let alone a criminal penalty.¹ penalty.¹ Delaware has long l ong permitted disinterested boards to reward departing executives with compensation in excess of their contractual entitlements.¹¹ For the BGH, criminal liability followed as a matter of course from the penal code, the fact that Mannesmann’s independent existence was ending, and the absence of a pre-negotiated pre-negotiated golden parachute.¹² While the U.S. hasaretraditionally constrained managerial pay has less now thanintroduced elsewhere, signs of convergence emerging. As we have noted, the U.S. limited shareholder ratification of executive compensation, in the form of “say on pay.” At the same time, the mandatory disclosure of individual directors’ pay and global competition for executives have driven overall compensation upwards even in Germany, where the pattern of reliance on rewards has been even more pronounced in the financial industry and in sectors most exposed to international competition.¹³
3.4 Legal Constraints Constraints and Affiliation Affiliation Rights
Legal constraints and affiliation rights play an important role in the structure of corporate governance by protecting the interests of shareholders as a class. All managerial and board decisions are constrained by general fiduciary norms, such as the duties of loyalty and care. Moreover, affiliation rights in the form of mandatory disclosure inform both shareholders and boards of directors by providing a metric for evaluating managerial performance in the form of well-informed well-informed share prices.¹ And, of course, ¹³ BGH, Decision of 21 December 2005, 3 StR StR 470/04. 470/04. Unlike the lower court, the BGH relied on criminal law alone (§ 266 Strafgesetzbuch (Criminal Code)), and did not pin its holding to § 87 AktG, which requires managerial compensation to be reasonable. reasonable. ¹ See Franklin Franklin A. Gevurtz, Disney in a Comparative Light , 55 A J C C L 453, 484 (2007). Under Delaware law, shareholder ratification would also have protected the second member of the Mannesmann executive committee, who, unlike Ackermann, stood to benefit monetarily from the ex post bonuses bonuses as a former Mannesmann officer. ¹¹ See Zupnick See Zupnick v. v. Goizueta , 698 A R 2d 384 (Del. Ch. 1997) (upholding options granted for past services at the end of o f tenure) and Blish v. Tompson Automatic Arms Corporation Corporation,, Del. Supr.,., 64where Supr A R 2d is 581 (1948to) exist (1948) compensation is not made without consideration an implied contract shown e(retroactive xist or where the amount awarded is not unreasonable in view of the services rendered). ¹² Te Mannesmann decision is thought to to be wrong by a clear majority of German German commentators. Te Mannesmann court remanded the case to the lower instance that was courageous enough to drop the criminal case. Te main consequence of the Mannesmann case was that many corporations introduced a clause in the directors’ contracts allowing such rewards. See also Chapter 8.2.3.5. ¹³ Francesca Fabbri Fabbri and Dalia Marin, What Explains the Rise in CEO Pay in Germany? A Panel Data Analysis for 1977– 2009 , IZA Discussion Paper No 6420 (2012). See also Alex Barker, Barker, Germany Overtakes UK in Corporate Executive Pay Stakes , F , , 5 January 2015. 2 015. On the recent legal reform of managerial compensation in Germany see Chapter 6.2.2.1. ¹ See Gordon, note 120. See also Chapter 9.1.1.
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the right to exit by freely selling shares underpins the market for corporate control, an essential component of governance in dispersed ownership firms that we discuss in By contrast, rights by means of withdrawal of one’s investment in theChapter firm are 8. made available exit less frequently in general corporate governance. Corporate law makes use of them only in special circumstances, detailed in later chapters: for example, as a remedy for minority shareholder abuse (Chapter 6) or as a check on certain fundamental transactions such as mergers (Chapter 7).
3.4.1 Te constraints strategy Both hard-edged hard-edged rules and fiduciary standards would seem to be of little use, if not counterproductive, to protect the interests of shareholders. shareholder s. After all, shareholders who can appoint and remove managers should have no need to hobble managerial discretion with legal constraints—except, constraints—except, perhaps, in the context of related party transactions, which we address in Chapter 6. Yet, all of our core jurisdictions impose a very broad on corporate and officers taketrivial reasonable care inofthetheexercise of theirduty offices— offices—the the dutydirectors of care. Tis duty is atonon-trivial noncomponent wider corporate governance system: in some jurisdictions there is a real risk of being held liable for its breach; in jurisdictions where this is not the case, compliance with other sets of legal obligations, such as disclosure disc losure requirements, will implicitly force directors to exercise due care in a number of situations, lest their disclosures prove wanting.¹ It is tempting to view violations of the director’s or officer’s duty of care as a kind of corporate “malpractice,” analogous to malpractice committed by other professionals such as doctors. But the analogy is weak because defining “reasonable care” is far more difficult for directors than for doctors: business decisions are even more idiosyncratic
than medical decisions. Tis is why courts in all jurisdictions display at least some deference to corporate directors directors’’ decision-making. decision-making. At the very least, most most of them will refrain refrain from secondsecond-guessing guessing business decisions on their merits.¹ Yet, courts will usually review the process by which a given decision has been made, inquiring whether directors were sufficiently informed and took reasonable steps, such as obtaining appropriate advice, to reach their decision. Tis is the case in continental Europe, where some jurisdictions explicitly articulate a duty to make well-informed well-informed decisions.¹ For example, under the German law on public corporations, management board members members shall not be deemed to have violated their duty of care if they prove that, at the time of taking a business decision, they had “good reason to assume that they were acting on the basis of adequate information for the benefit of the company,” a provision that goes under the name of “business ¹ See Robert B. Tompson and Hillary A. Sale, Securities Fraud as Corporate Governance: Reflections upon Federalism, Federalism, 56 V L R 859 (2003). Liability for Breach of the (available Duty of Care? Law ¹School See e.g. John Holger M. Olin Spamann, Spamann, Monetary Center Monetary Discussion Paper No. 835 (2015) at ssrn.com); 18–19, Harvard 18–19, see also Re Barings plc (No 5) [2000]1 5) [2000]1 B B C L L R 523 at 536 (rejecting analogy with medical malpractice and declining admissibility of expert evidence). ¹ Even in Japan, Japan, where this is not the case, courts will only review decisions based on whether they are “extremely unreasonable”: Supreme Court of Japan, 15 July 2010, 2091 HANREI JIHO 90. For details of this case, see Dan W. W. Puchniak and Masafumi Nakahigashi, Comment , in Business Law in Japan—Cases Japan—Cases and Comments (Moritz (Moritz Bälz et al. eds., 2012). ¹ Art. 2381 Civil Code (Italy); § 93 AktG (Germany). (Germany). For a comparative discussion of the scope and contours of the business judgment rule in Brazil, see Mariana Pargendler, Responsabilidade Civil dos Administradores e Business Judgment Rule no Direito Brasileiro, Brasileiro , 953 R 51 (2015).
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judgment rule” in that jurisdiction jurisdiction but the exculpatory exculpatory reach of which the case law has restricted.¹ A post-crisis post-crisis surge in liability suits (and criminal prosecutions) against directors, especially at banks, is testing the wisdom of granting courts such wide-rangwide-ranging discretion in reviewing business decisions.¹ Unsurprisingly, the jurisdiction that is traditionally most open to private enforcement of corporate law via shareholder litigation, the U.S., is also the one that has gone furthest in insulating managers from legal challenges of business decisions taken in good faith (that is, in the honest belief that they would benefit the company’s business). Combined with ancillary institutions such as a s the (ubiquitously exercised) power to introduce charter provisions waiving directors’ liability for good faith breaches of duty¹¹ and comprehensive D&O insurance, the U.S. business judgment rule significantly reduces the likelihood of a director ever having to make a payment in relation to a duty of care suit.¹² By contrast, other jurisdictions, including the UK, do proclaim an objective negligence standard for directors’ duty of care, without a business judgment rule or any power to modify the duty amendment the company’s articles of association.¹³ However, these have been by combined with ofprocedural obstacles to enforcement such that, outside bankruptcy, directors are rarely sued.¹ Te law’s deference to corporate decision-making decision-making has two main justifications. Te first, already hinted at, is that judges are poorly equipped to evaluate highly contextual business decisions. In particular, absent clear standards, hindsight bias can make even the most reasonable managerial decision seem reckless ex post . Te second is that, given hazy standards and hindsight bias, the risk of legal error associated with aggressively enforcing the duty of care might lead corporate decision-makers to prefer safe pro jects with lower returns over risky projects projects with with higher expected returns.¹ returns.¹ Ultimately Ultimately,, shareholders may stand to lose more from such “defensive management” than they
stand to gain from deterring occasional negligence.¹
¹ § 93 AktG (Germany). (Germany). See Klaus J. Hopt and Markus Roth, Roth, Sorgfaltspflicht und Verantwortlichkeit Verantwortlichkeit der Vorstandsmitglieder , in A, G (Heribert Hirte et al. eds., 5th edn., 2015), § 93 comments 61–131; 61–131; Klaus J. Hopt, Die Verantwortlichkeit von Vorstand und Aufsichtsrat , Z W W 2013, 1793. 1 793. ¹ Klaus J. Hopt, Responsibility of Banks and Teir Directors, Including Liability and Enforcement , in F D— D— L C 159 (Lars Gorton, Jan Kleineman, and Hans Wibom eds., 2014). ¹¹ DGCL § 102(b)(7). ¹² See Bernard Black, Brian Cheffins, and Michael Klausner, Outside Director Liability , 58 S S L R 1055 (2006). ¹³ UK Companies Act 2006 sections 174, 232; Art. 2381 and 2392, Civil Code (Italy). For France, see Bruno Dondero, Chronique de jurisprudence de droit des sociétés , G P, 12 May 2015, No. 132, 19. ¹ Practically no shareholder lawsuits are launched against against directors of UK publicly traded companies (John Armour, Bernard Black, Brian Cheffins, and Richard Nolan, Private Enforcement of Corporate Law: An Empirical Comparison of the United Kingdom and the United States , 6 J E L S 687 (2009)). Tis likely reflects both procedural obstacles to litigation and the usefulness of shareholders’ governance rights. In any event, UK courts have discretion to grant relief for breach of duty where directors acted “honestly and reasonably” (UK Companies Act 2006 section 1157). Te UK reformed its law relating to derivative actions in 2008, making it easier for shareholders to challenge duty of care violations. If this ever results in high levels of litigation, it is to be expected that there will be pressure to dilute the standard of care. ¹ See e.g. Gagliardi v. rifoods International, Inc. 683 Inc. 683 A R 2d 1049 at 1052–3 1052–3 (Del. Ch. 1996). ¹ In the U.S., the rare cases in which courts hold directors personally personally liable for gross negligence in decision-making decisionmaking tend to involve unusual circumstances, such as a merger or sale of the entire company
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Te general duty of care applies—as applies—as far as it goes—to goes—to all functions of the board. As the monitoring role of the board has grown, a natural step has been to develop the duty of care as regards oversight, which into corporate serves part to protect shareholder interests. Forplays example, case law ingovernance Delaware and the UKinholds that the duty of care extends to creating “information and reporting systems” that can allow the board to assess corporate compliance with applicable laws.¹ Similarly, in the EU and Japan the law tasks supervisory boards, audit committees, and statutory auditors with ensuring that publicly traded companies have adequate auditing checks and risk management controls in place.¹ And SOX Section 404, a milder version of which was adopted in the EU, requires CEOs and CFOs of U.S. firms to report on the effectiveness of their firms firms’’ internal financial control.¹ Such provisions are mainly enforced by outside auditor attestation.¹
3.4.2 Corporate governancegovernance-related related disclosure While mandatory disclosure is not itself one of the legal strategies that we articulated in Chapter 2, it plays a critical supporting role in the functioning of all legal strategies, and in all aspects of corporate law—at law—at least for publicly traded companies. Te structure of the corporate governance system is no exception. All our core jurisdictions mandate extensive public disclosure as a condition for allowing companies into the public markets. Tat is the focus of Chapter 9. Tere is considerable convergence in disclosure obligations, including on aspects of continuing or the onset of insolvency. See Chapter 5.3.1.1. Moreover, Moreover, even in these cases, the courts often hint at something more than negligence—bad negligence—bad faith or a conflict of interest that is difficult to prove—as prove—as the real basis for liability. Te famous Delaware example is Smith v. Van Gorkom, Gorkom, 488 A R
2d 858 (Del. 1985), in which the Delaware Supreme Court clearly believed belie ved that a retiring CEO had a strong personal interest in selling his company, which added an element of disloyalty to the arguably negligent process followed by the board in consummating the sale. ¹ See In re Caremark Int’l Inc. Derivative Litigation, Litigation, 698 A R 2d. 959 (Del. Ch. 1996), reaffirmed by the Del. Supreme Court in In re Citigroup Inc. S’holder Derivative Litig., Litig. , 964 A R 2d 106 (Del. Ch. 2009). Breach of this duty entails e ntails that the corporation had in place no information and reporting system whatsoever or that directors knew of of its inadequacy. German law is less deferential. def erential. See LG München, decision of 10 December 2013 (5 HKO 1387/10— 1387/10— Neubürger ), ), ZIP 2014, 570 (management board member held liable for having failed to implement a comprehensive compliance system to detect unlawful activities). Te UK adopts a straightforward negligence standard: see Re Barings plc (No.5), (No.5), note 146, especially at 486–9, 486–9, and Companies Act 2006 s 174. ¹ See FSA Disclosure Rules and ransparency ransparency Rules DR 7.1 (UK); § 91(2) AktG (Germany); Art. L. 225– 225–235 235 Code de Commerce (France); Art. 149 Consolidated Act on Financial intermediation (Italy). For Japan, see Arts. 362(4)(iv), 390(2), 399-2(3), 399- 2(3), 399-13(1), 399-13(1), 404(2), and 416(1) of the Companies Act, and Arts. 24-424-4-4(1) 4(1) and 193-2(2) 193-2(2) of the Financial Instruments and Exchange Act. Te EU directive on statutory audits (Directive 2006/43/ 2006/43/EC, EC, note 55) requires companies to have an audit committee (comprised of directors or established as a separate body under national law) that shall, inter alia, “monitor the effectiveness of the [company’ [company’s] s] internal quality control and a nd risk management systems and, where applicable, its i ts internal audit, regarding the financial reporting of the audited entity.” Art. 39(6)(c). ¹ SOX § 404. See Art. 2424-44-44 Financial Instruments and Exchange Act (Japan). In the EU, the directive on company reporting (Art. 20(1)(c) Directive 2013/34/ 2013/34/EU, EU, 2013 O.J. (L 182) 19) requires listed companies to include in their annual corporate governance statement “a description of the main features of the [their] internal control and risk management systems in relation to the financial reporting process. process.”” ¹ SOX § 404(b). Art. 193-2(2) 193-2(2) Financial Instruments and Exchange Act (Japan). In the EU the external auditor has to report to the audit committee “on any significant deficiencies in the audited entity’s … internal financial control system, and/or and/or in the accounting system. system .” Art. 11(2)(j) Regulation (EU) 537/2014, 537/2014, 2014 O.J. (L 158) 77.
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disclosure that are governance governance--related. For example, all of our core jurisdictions require firms to disclose their ownership structure (significant shareholdings and voting agreements), executive compensation, and the details of board composition and functioning.¹¹ It is quite plausible that such extensive disclosure obligations make both a direct contribution to the quality of corporate governance, by informing shareholders, and an indirect contribution, by enlisting market prices in evaluating the performance of corporate insiders.¹² In particular, by making stock prices more informative, i nformative, mandatory disclosure makes hostile takeovers less risky. Arguably, the comprehensive nature of U.S. proxy statements, and the large potential liability that t hat attaches to misrepresentations, builds on this assumption. Even continental European jurisdictions, which have no such strong tradition of mandatory disclosures, attach serious consequences to a company’s withholding of material information bearing on a shareholder vote. Shareholder litigation aimed at voiding shareholder resolutions taken on the basis of incomplete or misleading disclosure common Germany, courts take such matters very seriously, bothisinparticularly publicly traded and in privately heldwhere companies.¹³
3.5 Explaini Explaining ng Jurisdictional Variation A review of major jurisdictions reveals reveals that they often use the same strategies to shape corporate governance in fundamentally similar ways. For example, all our sample jurisdictions mandate that shareholders elect directors (or a voting majority of them) and all require a shareholder majority to approve fundamental changes, such as mergers and charter amendments. As highlighted in Section 3.3.1, each of our jurisdictions
has adopted the trusteeship strategy as part of the now global norms of good corporate governance.. Alongside universal reliance on independent directors, all major jurisdicgovernance tions also of relypublic on mandatory to enlist the market as a monitor of thetheir performance companiesdisclosure and aid disaggregated shareholders in exercising appointment, decision, and exit rights. Despite these global similarities, however however,, there are differences in how and to what extent the governance laws of our target jurisdictions are structured to protect shareholder interests against managerial opportunism. Moreover, the law-onlaw-on-thethe-books, books, whether hard or soft, only imperfectly reflects each jurisdiction’ jurisdiction’s distinctive balance of power among shareholders, managers, labor, and the state. If we were to array our seven core jurisdictions on a spectrum from the most to t o the least empowering for shareholders vis-àvis-à-vis vis managers in publicly traded t raded companies, we
¹¹ For ownership ownership and compensation disclosure requirements, see Chapter 6.2.1.1. U.S. Regulation S-K, SK, 17 C.F.R. Part 229 Item 601(b)(3)(i)–(ii), 601(b)(3)(i)–(ii), requires filing the corporate charter and bylaws in financial reports. In addition, any voting trust agreement and corporate code of ethics must be filed in Form 10Q. See Item 601(b) Exhibit able. Disclosure of voting agreements is also required by the EC akeover Bids Directive (Art. 10 Directive 2004/25/ 2004/ 25/EC, EC, 2004 O.J. (L 142) 12). For board structure, see European Commission, Recommendation 2014/ 208/ 208/EU EU on the Quality of Corporate Governance Reporting, 2014 O.J. (L 109) 43. ¹² See generally John Armour, Enforcement Strategies in UK Corporate Governance: A Roadmap and Empirical Assessment , in R C L 71, at 102–4 102– 4 (John Armour and Jennifer Payne eds., 2009); Gordon, note 120. ¹³ See e.g. Ulrick Noack and and Dirk Zetzsche, Zetzsche, Corporate Governance Governance Reform in Germany: Te Second Decade , 15 E B L L R 1033, 1044 (2005).
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would most likely put Brazil and the UK at one extreme. However, while both these countries lean heavily toward shareholder power, power, the similarities end there. In the UK, the corporate governance environment environment fully accords with the shareholderfriendly legal framework: despite the fact that shareholdings are diffuse, UK governance is heavily influenced by institutional shareholders, who are well equipped to represent the interests of shareholders as a class.¹ cla ss.¹ Brazil has much more in common with continental European countries such as Italy and France than with the UK. As in those countries, dominant shareholders, or stable coalitions of blockholders, are prevalent in Brazilian companies.¹ Tis ownership structure largely neutralizes the management–shareholder management–shareholder agency conflict. Large blockholders, like traditional business principals, hire and fire as they wish; they do not need, and probably do not want, anything more than appointment, removal, and decision rights to protect their interests. It seems natural, then, that jurisdictions dominated by large-block large-block shareholders should have company laws that empower shareholdshareholders as a class. Tis is exactly what the law does in France, Italy, and especially Brazil. Each accords shareholders significant sucha as the nonnon-waivable waivable rights to initiate a shareholders’ meeting, torights, initiate resolution to amendminority the corporate charter, to place board nominees on the agenda of shareholders’ meeting, and the right to remove directors without cause by majority vote. Each of these powers, which correspondingly constrain managerial discretion, require a shareholders’ meeting resolution, the outcome of which dominant shareholders will be able to determine. As a byproduct, governance at the few listed companies in those countries with no dominant shareholder will also be heavily tilted in the direction of shareholder power power. Tat, in turn, helps make such companies a rarity rarity,, because strong shareholder power makes dispersed ownership companies more prone to hostile takeovers. Te second way in which the governance landscape shifts in continental Europe and in Brazil is that, to a greater degree than in the U.S. or UK, corporate gover-
nance is a three-party three-party game that revolves around more than the interests of shareholders and managers. In Italy, regulator, France, and Brazil,shareholder,¹ the third party and is thea state, which is simultaneously an intrusive a major defender of “national champions,” champions,” in which it may or may not hold an equity stake.¹ In France there is a well-travelled well-travelled career track between elite state bureaucracies and the corporate
¹ See text accompanying note note 79. ¹ See e.g. Julian Juli an Franks, Colin Coli n Mayer, Paolo Paolo Volpin Volpin,, and Hannes F. F. Wagner, Wagner, Te Life Cycle of Family Ownership: International Evidence , 25 R F S 1675 (2012) (controlled ownership structures appear stable over time in our core jurisdictions). ¹ See Mariana Pargendler Pargendler,, State Ownership and Corporate Governance , 80 F L R 2917 (2012). For instance, as of May 2016, the Italian Government controlled Italian companies representing almost 30 per cent of the total capitalization of the blue chips index (S&P Mib) (source: authors’ elaboration, based on Consob data). ¹ A good example is the French state’ state’ss failed attempt to prevent General Electric from taking over Alstom’ Alstom’s electricity generation business. In 2014, the French government opposed such proposed acquisition, mainly out of concern for its effects on Alstom’s rail transport activities and on employment. For that purpose, it issued a decree granting itself a veto over takeovers of companies in the energy supply, water, water, transport, telecommunications, and public health sectors (Decree No. 2014-479 2014- 479 of 14 May 2014). Te French government also encouraged Siemens to make a rival bid. In the end, however, GE secured the deal after making a number of commitments with the French government regarding the exercise of voting rights and director positions. See David Jolly and Jack Ewing, G.E.’s Bid for Alstom Is Blessed by France , N Y , , 21 June 2014, at B1). In Brazil, the development bank has made generous debt and minority equity investments to support the creation of national champions.
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headquarters of France’s largest companies.¹ In Brazil, not only is the state the controlling shareholder in numerous listed firms, but the main institutional investors in the country—the country—the pension funds of state-owned state-owned enterprises and the development bank—are bank— are themselves under governme government nt control.¹ Te role of the state in corporate governance reinforces both shareholder-friendly shareholder-friendly governance law and concentrated ownership in these jurisdictions—though jurisdictions—though strengthening the power of the state as a controlling shareholder does not necessarily serve the interests of minority shareholders.¹ On the one hand, the politicians and civil servants who control the state shareholdings in these jurisdictions have a natural incentive to favor strong shareholder rights, both because they represent the state as a shareholder and because they can discreetly act through other large-block shareholders to ensure that corporate policies reflect the state’s priorities. On the other hand, wellconnected blockholders can be an economic asset for firms in a politicized environment, to the extent that these “owners “owners”” have more legitimacy and resources to protect their companies from political intervention than mere managers backed by dispersed shareholders could muster.¹¹ muster.¹¹ Tus, an interventionist state, concentrated ownership, and shareholder-friendly shareholder-friendly law may be mutually reinforcing, especially when the state holds large blocks of stock in its own right.¹² Germany’s corporate law is similar to that of other continental European states in terms of shareholder powers, but with two important qualifications. First, board members’ insulation from shareholder pressures is greater, thanks to lengthier terms of office and less shareholder-friendly shareholder-friendly removal rules. Second, the codetermination statute mandates labor directors on the board with interests that tend to be opposed to those of the shareholder class. As an outcome, German law for companies without a dominant shareholder appears to be more manager-oriented than in other countries with a prevalence of concentrated ownership.¹³ In contrast to Italy, France, and Brazil, the third actor in German corporate gover-
nance is not the state but labor. la bor. As discussed further in Chapter Cha pter 4, German law provides forthe quasiquasi-parity parity codeterminat codetermination, in which employees representatives fill half of seats on the supervisoryion, boards of large firms.¹and Ofunion course, labor directors, like shareholder directors, have a fiduciary obligation to further the interests of “the company” rather than those of their own constituency. Nevertheless, labor’s interests have significantly less in common with those of large-block large-block German shareholders than the state’ss interests might have with those of blockholders in France and Italy, state’ Italy, especially at a time when their governments are experiencing public budgets constraints, which make ¹ See e.g. William Lazonick, C C G, I I E E D, 49– D, 49–56 56 (2006) (describing the elite education and civil service experience of typical French CEOs). ¹ See e.g. Mariana Pargendler, Governing State Capitalism: Te Case of Brazil , in R V H I I C S C 377, 385–8 385– 8 (Benjamin Curtis ¹ See Pargendler, PLiebman argendler,and note 166.J. Milhaupt eds., 2015). ¹¹ Tis observation tracks Mark Roe’s Roe’s similar point that strong labor favors strong capital, in the form of controlling shareholders. See Mark J. Roe, Legal Origin, Politics, and the Modern Stock Market , 120 H L R 460 (2006). ¹² See generally, Pargendler, Pargendler, note 169; Ben Ross Schneider, H C C L A (2013); Aldo Musacchio and Sergio G. Lazzarini, L L B: V V S C I E P (2014). ¹³ Perhaps relatedly relatedly,, the ownership structure of the largest German companies is now much more similar to that in the U.S. and the UK than has for long been the case. See Ringe, note 75, 507–9. 507– 9. ¹ See Chapter 4.2.1.
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their financial interest qua shareholders more salient. In addition, state intervention in corporate governance is likely to be sporadic, while labor directors continuously monitor German firms. We We suspect (and we are not the first to do so¹) so¹ ) that the net effect of Germany’ss closely divided Germany’ divid ed supervisory supervisor y board is to enhance the power of top managers— ma nagers— that is, of the management board—relative board—relative to that of shareholders (or even labor). Put differently, the average large German company is likely to be more managerialist than a similar firm in a large blockholder jurisdiction such as Italy or France.¹ U.S. corporate law is harder to encapsulate. While Delaware law has traditionally been viewed as board-centric, board-centric, the shift toward shareholder empowerment that has taken place in the last couple of decades¹ has occurred with very little change in state law and only in part par t due to federal law reforms. In other words, changes changes in the relative power of shareholders and managers following the reconcentration of shares in institutional investors’ hands led to changes in corporate governance practices that flexible existing laws could accommodate and corporate law reforms have mainly followed. As an outcome, the U.S. is nowadays much less of a poster child for managerialist corporate law than in the past. Finally, Japanese corporate law also has a plausible claim to shareholder-friendly shareholder- friendly law on the basis of its short director terms and easy removal rights. But in Japan the gap in spirit between a shareholder-friendly shareholder-friendly corporate law and the reality of Japanese corporate governance appears to be larger than in any other core jurisdiction. Japan is a dispersed-shareholder dispersed-shareholder jurisdiction, like the U.S. and UK,¹ but its shareholders are weak, and its managers are strong, even compared to the U.S. Moreover Moreover, although there are hints of change in response to recent reforms, Japanese boards remain overwhelmingly dominated by inside directors. So, how can Japanese governance practice entrench managers while its corporate law empowers shareholders? A number of factors help explain this puzzle, including the dispersion of Japanese shareholdings since World W orld War II, a statutory law derived derived from from early—and early—and shareholder-friendly— shareholder-friendly—German German
law,, the role of the state in mobilizing Japanese recovery after the war law war,, a strong reliance on debt than equity prices forrather four decades after financing, the war.¹ war.¹and the continuous increase in Japanese share But there is another partial answer that seems especially salient today. Japan has a tradition of stable friendly shareholdings among operating firms (kabushiki mochiai or cross-shareholdings) cross-shareholdings) that cement business relationships and insulate top managers from challenge. Tese business-tobusiness-to-business business holdings are numerous but generally not
¹ See Katharina Pistor, Codetermination: A Sociopolitical Model with Governance Externalities in in E C C G 171 (Margaret M. Blair and Mark J. Roe eds., 1999). ¹ It can hardly hardly be otherwise if Germany’s Germany’s two-tier two-tier board structure functions in part to insulate companies’ business decisions from dissension on their supervisory boards by assigning these decisions to their management boards. A revealing indication of the power of the management board is that often in widely held companies the management board itself, rather than the supervisory board, informally nominates shareholder nominees to theCentric supervisory board. note 11. ¹ See e.g. Edwardthe B. company’s Rock, Adapting Rock, Adapting to the New Shareholder-Centric ShareholderReality , 161 See U P L R 1907, 1917–26 1917–26 (2013). ¹ One recent study finds that listed companies in the UK and Japan have have the most dispersed ownership structures in the world, while the U.S. trails some distance d istance behind. See Clifford G. Holderness, Te Myth of Diffuse Ownership in the United States , 22 R F S 1377 (2009). ¹ See Masahiko Aoki, oward an Economic Economi c Model of the Japanese Japane se Firm, Firm, 28 J E L L 1 (1990); Ronald J. Gilson and Mark J. Roe, Understandin Understandingg the Japanese Keiretsu: Overlaps Between Corporate Governance and Industrial Organization, Organization, 102 Y L J 871 (1993); Steven Kaplan, op Executive Rewards and Firm Performance: A Comparison of Japan and the U.S .,., 102 J P P E 510 (1994).
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large, and they are frequently not even reciprocal. But the important point is that they are stable stab le and management-friendly friendly.¹ .¹ In prior decades these “captive” shareholders sha reholders accounted for a much higher percentage of the outstanding shares of Japanese listed companies than they do today, when they represent around one-third one-third of outstanding shares—only shares—only slightly more than the share percentage held by foreign investors in Japanese Japan ese firms.¹¹ firms.¹¹ While While U.S.U.S.-style hedge fund activism against Japanese companies in the 2000s has been largely unsuccessful, mostly because of cross-shareholdings,¹² cross- shareholdings,¹² this change in shareholder identity, as well as the stagnant economy since the 1990s, has made large listed companies and the Japanese government more sensitive to investors’ demands.¹³ At the same time, once cross-shareholdings cross-shareholdings are unwound, the legislator may deem existing Japanese corporate law too shareholder-friendly shareholder-friendly and make it less so. A final puzzle that we have encountered in this chapter is why a single model of best practices (independent directors and a tripartite committee structure) increasingly dominates governance reform in all core jurisdictions when the agency problem that gave rise to this model—managerial model—managerial opportunism vis-àvis-à-vis vis the shareholder class—is class—is paramount only in diffuse shareholding jurisdictions such as the U.S. and UK. Te obvious question with respect to best practices is: why should one size fit all, given the dramatic differences in ownership structure across our target jurisdictions? One plausible explanation is the wide- spectrum prophylactic hypothesis:¹ the same global good governance recipe of independent directors and independent committees somehow responds responds effectively to the various agency a gency problems: not only the problem of managerial opportunism, but also the conflict between majority shareholders on one hand, and minority shareholders or non-shareholder non-shareholder constituencies on the other. We explore this issue in Chapter 4. In essence, this must imply that the formula means different things in different contexts. For example, adding independent directors may empowerr Japanese shareholders and reinforce shareholder dominance in the UK, while empowe it traditionally served to justify allocating power to the board rather than shareholders in the U.S. Te question, then, is whether convergence on the substance of best
governance practices is true functional convergence or mere stylistic convergence that hides persistent differences in the actual structure of corporate governance across jurisdictions.¹
¹ See Julian Franks, Franks, Colin Mayer, Mayer, and Hideaki Miyajima, Te Ownership of Japanes Japanesee Corporations in the 20th Century , 27 R F S 2580 (2014). We We take no position on the continuing debate about the importance of the Keiretsu Keiretsu,, or networks of companies bound by cross shareholding and relations with a “main bank.” bank.” Compare Curtis Milhaupt and Mark D. West, E O C G J: I F I R (2004) with J. Mark Ramseyer and Yoshiro Miwa, F K, U L J E, ch. 2 (2006). ¹¹ As of 1986, manager-friendly manager- friendly business companies, banks, and insurance companies together held more than 60 percent of market capitalization. Tis Ti s ratio fell to slightly sli ghtly more than 30 percent in 2012. On the other hand, holdings by foreign investors rose from 5 percent in 1986 to 28 percent in 2012. Note, companies however, that of cross-shareholding crossshareholding is taking in large public andthis lessunwinding in small and mediummedium-sized sized listedrelationships ones. See Goto, noteplace 23, atmostly 144– 6. ¹² See Goto, note 23, at 140– 4. Whether U.S.-style U.S.-style hedge fund activists will come back to Japan making the most of its shareholder-friendly shareholder-friendly law remains to be seen. ¹³ An example of such attitude by the the government is the the adoption of the Stewardship Stewardship Code and the Corporate Governance Code. See notes 89 and 114. ¹ See Section 3.3.1. ¹ Formal convergence that obscures substantive divergence in corporate law is the natural converse of formal divergence that obscures functional convergence. See Ronald J. Gilson, Globalizing Corporate Governance: Governance: Convergence of Form or Function, Function, 49 A J C L 329 (2001).
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However, a second plausible explanation is that international best practices are largely ornamental in blockholder jurisdictions, since dominant shareholder coalitions retain the power to hire and fire the entire board, including its nominally independent directors. On this account, controlling blockholders may not lose much in terms of real power, power, while their controlled corporations will display all the features that institutional investors expect. More puzzling perhaps is why investors should accord any significance to such compliance. Here we simply note that the coordination costs investors face in the domestic environment are multiplied many times over when they invest overseas. Even activist investors, whom we saw earlier to be the most willing to invest in gathering firm-specific firm-specific governance information, do significantly worse in their cross-border cross-border interventions than in their t heir domestic engagements.¹
¹ Becht et al., note 18.
4 Te Basic Governance Structure: Minority Shareholders and Non-Shareho Non-Shareholder lder Constituencies Luca Enriques, Henry Hansmann, Reinier Kraakman, and Mariana Pargendler
Te corporate governance system law principally supports interests of shareholders as a class. Nevertheless, corporate can—and can—and to somethedegree must— must—also also address the agency conflicts jeopardizing the interests of minority shareholder and nonshareholder contractual constituencies. And herein lies the rub. o mitigate either the minority shareholder or the non-shareholder non-shareholder agency problems, a governance regime must necessarily constrain the power of the shareholder majority and thereby aggravate the managerial agency problem. Conversely, governance arrangements that reduce managerial agency costs by empowering the shareholder majority are likely to exacerbate the agency problems faced by minority shareholders and non-shareholders non- shareholders at the hands of controlling shareholders. In this chapter, we first address the protection of minority shareholders, and then turn to governance arrangements arr angements that th at protect the firm’s firm’s employees—the employees—the principal nonshareholder constituency to enjoy such protections as a matter of right in some juris-
dictions. In Chapter 5, we address the protections granted to corporate creditors. While corporate law mostly deals with the relationship between the corporation and its contractual counterparties, it is sometimes called upon to protect the interests of constituencies external to the corporate form as well.¹ Te final part of this chapter explores how the legal strategies of corporate law can also be directed to serve the interests of non-contractual non-contractual stakeholders.
4.1 Protecting Minority Shar Shareholders eholders It is well-documented well-documented by empirical research that dominant shareholders enjoy “private “private benefits of control”—that control”—that is, disproportionate returns—often returns—often at the expense of minority shareholders.² Tese benefits are impounded in the control premia charged for controlling blocks and in the price differentials that obtain between publicly traded ¹ See Chapter 1.5. ² See atiana Nenova, Te Value Value of Corporate Cor porate Voting Voting Rights Ri ghts and Control: Cont rol: A Cross-Country Cross- Country Analysis , 68 J F F E E 325, 336 (2003) (employing share share price differentials for dual class firms to calculate private benefits); Alexander Al exander Dyck and Luigi Zingales, Private Benefits of Control: An International Comparison, Comparison, 59 J F 537, 551 (2004) (employing control premia in sales of control blocks to calculate private benefits). Te Anatomy of Corporate Law. Tird Edition. Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry Hansmann, Gerard Hertig, Klaus Hopt, Hideki Kanda, Mariana Pargendler, Wolf-Georg Ringe, and Edward Rock. Chapter 4 © Luca Enriques, Henry Hansmann, Reinier Kraakman, and Mariana Pargendler, 2017. Published 2017 by Oxford University Press.
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high- and low-vote low-vote shares in the same sa me companies. Both measures are often assumed to be rough indicators of the extent of minority shareholder expropriation.³ Te varying degrees of protection accorded to minority shareholders by differing corporate governance systems explain at least some of the variation in these indicators. 4.1.1 Shareholder appointment rights and deviations from one-share– one-share–oneone- vote vote One way to protect minority shareholders is by granting them the right to appoint one or more directors. Specifically, company law can enhance minority appointment rights by reserving board seats for minority shareholders or over-weighting over-weighting minority votes in the election of directors. Even if they only select a fraction of the board, a minority can still benefit from access to information and, in some cases, the opportunity to form coalitions with independent directors. Of course, shareholder agreements or charters can—and can—and sometimes do—require do—require the appointment of minority directors for individual firms. Te law can achieve a similar result on a broader scale by mandating cumulative or proportional voting, which allow relatively large blocks of minority shares to elect one or more directors. Moreover, lawmakers can further increase the power of minority directors by assigning them key committee roles or by permitting them to exercise veto powers over certain classes of board decisions. Significantly, however, general corporate law rules granting minority board representation are relatively uncommon among our core jurisdictions. Italy mandates board representation for minority shareholders in listed companies. Brazil grants minority shareholders who hold more than a 10 or 15 percent stake (of preferred or common stock, respectively) the right to appoint a board member, member, as well as cumulative voting at the request of shareholders representing at least 10 percent of voting capital. Howe However ver,, the high coordination costs associated with these thresholds mean that generally only blockholders, rather than dispersed minority shareholders, benefit from the associated rights. Cumulative voting is the statutory default in Japan, but it is routinely avoided
by charter provisions. In France, the UK, and the U.S. firms may adopt a cumulative voting rule, but publicly traded firms rarely do so; and in Germany, commentators dispute whether cumulative voting is permissible at all in public corporations. In the ³ See note 136 and accompanying text. text. For example, Art. 78 Russian Joint-Stock Joint-Stock Companies Law requires that major transactions, including those that implicate the interests of controlling shareholders, be unanimously approved by directors. Consequently, “disinterested” minority directors can block major transactions between the company and its controlling shareholders or managers. In Brazil, directors elected by minority shareholders have veto rights over the appointment and removal of independent auditors: Art. 142, § 2º Lei das Sociedades por Ações. Art. 147-3 147-3 Consolidated Act on Financial Intermediation (requiring that at least lea st one director be elected by minority shareholders). Art. 141 Lei das Sociedades por Ações. If neither group satisfies the relevant threshold, they may pool votes to make a joint board appointment. See also Art. 239 (granting minority shareholders the right to elect one board member in government-controlled government-controlled firms). Art. 342 Companies Act. At the turn of the twentieth century, century, cumulative voting was common in the U.S. See e.g. Jeffrey Jeffrey N. Gordon, Institutions as Relational Investors: A New Look at Cumulative Voting , 94 C L R 124 (1994); cf. §§ 708(a) and 301.5(a) 3 01.5(a) California Corporation Code (respectively mandating cumulative voting and authorizing opt-out opt- out from cumulative voting for listed companies). See Mathias Siems, C S S L L 172 (2008). Even though the the majority agrees that proportional voting is permissible, no important German corporation has included such a charter provision. See also Paul L. Davies and Klaus J. Hopt, Boards in Europe— Accountability and
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UK, the new premium listing rules for companies with controlling shareholders grant minority investors what may be called an “expressive” veto on the appointment of independent directors. Teir appointment is initially subject to separate approval by all shareholders and minority shareholders. If such approval is notoff” obtained, the shareholder majority can determine the election after a “coo “coolinglingperiod, then between 90 and 120 days later.¹ While the use of appointment rights directly to protect minorities is rare, all jurisdictions regulate the apportionment of voting rights in relation to share ownership—a central mechanism that affects both the appointment and decision rights of shareholders. Corporate laws generally embrace a default rule that each share carries one vote. Awarding voting rights in direct proportion to share ownership has the benefit of aligning economic exposure and control within the firm, but may leave minority shareholders vulnerable to opportunistic behavior by controlling shareholders. At the same time, where the value of incumbents’ control is high—whether high—whether because the law fails to restrict dominant shareholders’ opportunism or because, in the absence of a dominant shareholder, managerial agency costs would be high—proportionality high—proportionality between cash-flow cash-flow voting rights may impair opportunities.¹¹ a company’s ability to raise further equity finance and and secure profitable investment Consequently, our jurisdictions often contemplate contemplate adjustments to shareholder shareholder appointment and decision decision rights in both directions, that is, both by limiting the power of dominant shareholders and by allowing them to enhance it in various ways. All jurisdictions permit at least some some deviations from the oneone-share– share–oneone-vote vote norm to let dominant shareholders enhance their control over the corporation. Tese mechanisms include dual-class dual-class equity structures with disparate voting rights, circular shareholdings, and pyramidal ownership structures. While our core jurisdictions universally restrict circular shareholding schemes¹² and vote-buying vote-buying by parties antagonistic to the interests of shareholders as a class,¹³ they diverge with respect to the availability and use of other similar devices. Germany and Brazil go furthest in limiting deviations from one-share– one-share–oneone-vote vote that
increase the power of controlling shareholders: both countries ban shares with multiple Convergence , 61 A J C C L L 301 (2013) (noting that cumulative cum ulative voting has failed to gain much traction in Europe). ¹ UK Listing Rules, 9.2.2E and 9.2.2F. 9.2.2F. ¹¹ See e.g. Kristian Rydkvist, DualDual-class class Shares: A Review , 8 O R E P 45 (1992). ¹² Most jurisdictions forbid subsidiaries from voting the shares of their parent companies: Art. L. 233–31 233–31 Code de commerce (France); Art. 2359–II 2359–II Civil Code (Italy); Art. 308(1) Companies Act (Japan); § 160(c) Delaware General Corporation Law; § 135 Companies Act 2006 (UK). German, Brazilian, and Japanese laws bar subsidiaries subsidiarie s from owning shares of their parents except in special circumstances (§71d AktG; Art. 244 Lei das Sociedades por Ações; Art. 135 Companies Act). A number of countries, such as Italy, France, and Germany, also ban voting in the case of cross- shareholdings by companies that are in no parent-subsidiary parent- subsidiary relationship. See S S, LLP, P B O C EU L C: C L S 17 (2007) at http:// http://www.ecgi.de/ www.ecgi.de/osov/ osov/final_ final_report.php report.php.. ¹³ A less traditional example of separating control control rights from cashcash-flow flow rights is so-called so-called “empty voting,” in which investors use stock lending, equity swaps, or other derivatives to acquire “naked” votes in corporations in which they may even hold a negative economic interest (i.e. gain if the stock price goes down rather than up). See Henry .C. .C. Hu and Bernard Black, Te New Vote Buying: Empty Voting and Hidden (Morphable) Ownership, Ownership, 79 S C L R 811 (2006). Empty voting, like vote buying, can be used to undermine shareholder welfare. Despite efforts at increasing transparency over economic interests, as opposed to formal ownership rights, no jurisdiction provides for ownership disclosure rules that are geared for disclosure of empty voting per se. See Wolf-Georg W olf-Georg Ringe, D E 162–99 162–99 (2016).
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votes and cap the issuance of non-voting or limitedlimited-voting voting preference shares to 50 percent of outstanding shares.¹ In Brazil, where dual-class dual-class firms were historically common, non-voting non-voting shares are prohibited outright in the Novo Mercado, the premium corporate governance of the São Paulo Stock Exchange.¹ Even these jurisdictions, however, do segment not regulate pyramidal ownership structures (where company A owns owns a majority of the voting shares of company company B, which which in turn owns owns a majority of the voting shares of company C, and so on),¹ which have identical effects to dual-class dual-class shares in separating cash flow and voting rights.¹ Te U.S., by contrast, goes furthest in banning or discouraging the use of pyramidal structures through holding company regulations and the taxation taxa tion of inter-corporate distributions.¹ Similarly,, some European jurisdictions permit the issuance Similarly i ssuance of so-called so-called fidelity shares, which condition the award of additional voting rights on a minimum holding period as a shareholder. For instance, Italian law recently enabled corporations to award double voting rights to shareholders who have held onto their shares for at least two years.¹ Tis mechanism had long been available in France on an opt-in opt- in basis, but in 2014, as part of an openly protectionist law on takeovers, it became the default rule for listed companies. Unless opt out, their voting rights after two years in thesuch samecompanies hands.² Although such shares “tenurespawn voting”double systems are usually justifiedd as protecti justifie protecting ng the interes interests ts of longlong-term term over short-term short-term shareholders,²¹ they tend also to embed the power of controlling shareholders relative to outside investors. Te U.S. and UK permit different classes of shares to carry any combination of cash flow and voting rights, but U.S. and Japanese exchange listing rules bar recapitalizations that dilute the voting rights of outstanding shares.²² While the New York York Stock
¹ See §§ 12 II and 139 II Aktiengesetz AktG (Germany); and Arts. 15, § 2, and 110, § 2, Lei das Sociedades por Ações (Brazil). In Brazil, however, companies have recently circumvented the ban on multi-voting multi-voting stock by adopting a functionally equivalent equ ivalent dual- class structure where the public float fl oat carries economic rights rights that are a multiple of those granted to insiders. Brazil’s Securities Commission Azul
(CVM) blessed this structure the case in 2013. case non20voting by listed companies at 25 percentinofthe Azul al l Azul all outstanding shares.France Arts. L.caps 228the11issue to L.of228 Codeshares de com merce. In 2014, Italy partially repealed the ban on multiple voting shares: it now allows non-listed non-listed companies to issue shares with up to three votes. Such companies may later go public, but cannot subsequently increase the proportion of multiple voting shares. Te 50 percent cap on non-voting non-voting and limited voting shares has, instead, been maintained. See Art. 2351 Civil Code, as amended (Italy). Similarly to Germany and Brazil, Japan imposes a 50 percent cap on non-voting non-voting and limited voting shares: Arts. 108(1)(iii) and 115 Companies Act. ¹ For a discussion, see Ronald J. Gilson, Henry Hansmann, and and Mariana Pargendler, Pargendler, Regulatory Dualism as a Development Strategy: Corporate Reform in Brazil, the United States, and the European Union,, 63 S Union S L R 475, 489–90 489–90 (2011). ¹ As a result, pyramidal firms have emerged in Brazil’s Novo Mercado, Mercado, as elsewhere. ¹ See e.g. Lucian A. Bebchuk, Reinier Reinier Kraakman, and George riantis, Pyramids, Cross-Ownership, Cross-Ownership, and Dual Class Equity: Te Mechanisms and Agency Costs of Separatin Separatingg Control from Cash-Flow Cash-Flow Rights , in C C C O 445 (Randall K. Morck ed., 2000). ¹ See Steven A. Bank and Brian Brian R. Cheffins, Te Corporate Pyramid Fable , 84 B H R 435 (2010); Eugene Kandel, Konstantin Kosenko, Randall Morck, and Yishay Yafeh, Te Great Pyramids of America: A Revised History of US Business Groups, Corporate Ownership and Regulation, 1930–1950 1930–1950 , NBER Working Paper Paper No w19691 (2015). ¹ Art. 129-V 129-V Consolidated Act on Financial Intermediation, as amended in 2014. Tis mechanism may actually serve to enhance the power of the state as shareholder. ² Art. L. 225-123 225-123 Code de commerce, as amended by Loi. No. 2014-384 2014-384 of 29 March 2014 (known as the “Loi Florange”). See also Chapter 8.2.3. ²¹ See Chapter 3.2. ²² See Rule 313 NYSE Listed Company Manual and Rule 4351 NASDAQ Marketplace Rules (voting rights of existing shareholders of publicly traded common stock cannot be disparately reduced or restricted through any corporate action or issuance). See also okyo Stock Exchange, Securities
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Exchange (NYSE) listing rules banned deviations from proportional voting for most of the twentieth century, dual-class dual-class shares have recently enjoyed something of a renaissance in media and hi-tech hi-tech corporations.²³ Te U.S. has even attracted high profile dualdual-class abroad:after forbeing instance, Chinese Aliba ba optedclass to gocompanies public onfrom the NYSE unable to list e-oncommerce the Honggiant KongAlibaba Stock Exchange, which still adheres to a strict one-share– one-share–oneone-vote vote rule. In the UK, where institutional investors had successfully discouraged dual-class shares altogether,² the Premium Prem ium market segment is now exclusively for companies listing classes of shares with proportionate voting rights.² Tus, although legal support for a one-share– one-share–oneone-vote vote norm is limited, all our core jurisdictions restrict some ways of leveraging l everaging voting rights that are regarded as particularly harmful. Much rarer than devices that empower a certain group of shareholders are legal devices that simply dilute the voting power of large shareholders, to benefit small shareholders. Perhaps Perhaps the best known technique of this sort is “vote capping,” capping,” that is, imposing a ceiling on the control rights of large shareholders and correlatively inflating the voting power of small shareholders. For For example, a stipulation that no shareholder may than 5 percent would of the otherwise votes reallocates of the with control rights that acast 20 more percent shareholder exercise75topercent shareholders stakes of less than 5 percent. Except for Germany and Japan,² all our core jurisdictions permit publicly traded corporations to opt into voting caps by charter provision. oday, however, the real motivation for voting caps is more likely to be the deterrence of takeovers than the protection of minority investors. Tey are more commonly adopted where no controlling block exists, to dissuade the building of one, rather than to constrain the voting power of an a n existing block-holder holder.. Voting Voting caps survive today t oday chiefly in France and, to a lesser extent, in Italy and Brazil.²
Listing Regulations, Rule 601(1)(xvii) and Enforcement Rules for Securities Listing Regulations, Rule 601(4)(xiv) (prohibiting unreasonable ex post restrictions restrictions on shareholder voting rights).
²³ Prominent examples include News Corporation, Google (now Alphabet), Facebook, and LinkedIn, where the use of “super-voting” “super-voting” shares has allowed the founding shareholders, who arguably have a strategic role in the value of the company, to keep control of the corporation without holding the majority of the share capital. ² See Julian Franks, Colin Mayer, and Stefano Rossi, Spending Less ime with the Family: Te Decline of Family Ownership in the United Kingdom, Kingdom , in A H C G A W W 581, 604 (Randall K. Morck ed., 2005). ² UK Listing Rule 7.2.1A, Premium Listing Principle 4. ² Voting caps were banned for German publicly traded (listed) companies in 1998. See § 134 I Aktiengesetz (AktG) (AktG) (as amended by Kon KonraG). raG). Still, Still, there was one important exception: exception: Volkswagen Volkswagen AG, which is regulated by a special law, was subject to a 20 percent voting cap. Te European Court of Justice ruled that the voting cap (together with other provisions of the VW Act) impeded the free movement of capital which was guaranteed by Art. 56(1) EC (now Art. 63 FEU); see Case C-112/ C-112/05, 05, Commission v. Germany , Judgment of 23 October 2007, E C R [2007] I‐8995. Japan adopts the rule of one-share, one- share, one-vote and does not allow voting caps. See Art. 308(1) Companies Act. Italy banned voting caps from 2003 to 2014 (other than for privatized companies). See Art. 2351 Civil Code, as amended (Italy). ² For France France see Art. L. 225-125 Code de commerce; Art. 231-54 231- 54 Règlement Général de l’AMF (declaring, however, voting caps ineffective at the first general meeting after a bidder has acquired two thirds or more of the voting shares). For Brazil, see Art. 110, § 1º Lei das Sociedades por Ações, (permitting voting caps); Novo Mercado Regulations, Art. 3.1.1 (prohibiting voting caps below 5 percent, except as required by privatization laws or industry regulations). Although extremely rare in the UK and the U.S. today today,, voting caps were common in the nineteenth century in i n the U.S., Europe, and Brazil. See Mariana Pargendler and Henry Hansmann, A Hansmann, A New View of Shareholder Voting Voting in the Nineteenth Century , 55 B H 585 (2013).
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4.1.2 Minority shareholder decision rights rights As in the case of appointment rights, the law l aw sometimes protects minority shareholders by enhancing their direct decision rights. Minority decision rights are strongest when the law entrusts individual shareholders (or a small minority of them) with the power to make a corporate decision. Such is the t he case for instance when the law allows individual shareholders, or a small shareholder minority, to bring suit in the corporation’’s name against directors or other parties tion par ties against whom the corporation may have a cause of action.² Granting decision rights to a majority of minority shareholders is also an effective governance strategy. strategy. For this reason, corporate laws sometimes impose a majority-ofmajority-of-thethe-minority minority approval requirement on transactions between controlling shareholders and their corporations.² In addition, all our core jurisdictions fortify minority decision rights over fundamental corporate decisions by imposing special majority or supermajority approval requirements. As we discuss in Chapter 7, the range of significant decisions subject to shareholder voting varies, as does the particular voting threshold required for approval.³ As a practical matter, however, the relevant threshold is almost always higher than the simple majority of the votes cast at a general shareholders’ meeting. Arguably,, then, most Arguably most jurisdictions use use decision rights rights to protect large blocks of minority shares against expropriation effected via major transactions such as mergers. Several European European jurisdictions pursue this end explicitly by awarding the holders of a sufficient percentage of minority shares (25 percent or more of voting shares) a statutory blocking right—to right—to prevent a “bare” majority from trumping the will of a “near” majority.³¹ majority .³¹ Most U.S. states and Brazil require a majority of the outstanding shares to approve fundamental transactions such as mergers, which implies a supermajority of the votes that are actually cast.³² Te size of the supermajority in this case depends on the percentage of shares represented at the meeting, which, in turn, reflects the salience of the transaction for minority shareholders. Nevertheless, requirement of approval by a majority of the outstanding shares is no protection for minority investors if the controlling shareholder enjoys such a majority.³³
4.1.3 Te incentive strategy: rusteeship rusteeship and equal treatment treatment Te incentive strategy for protecting minority shareholders takes two forms. One is the familiar device of populating boards and key board committees with independent directors. As noted in Chapter 3, lawmakers seem to view independent directors as a kind of broad-spectrum broad-spectrum prophylactic, suitable for treating both the agency problems of minority shareholders and those of shareholders as a class. Te second mode of protecting minority shareholders is strong enforcement of the equal treatment norm, particularly with respect to distribution and voting rights. Tis norm applies to both closely held and publicly traded firms, and blurs into an aspect of the constraints strategy: a fiduciary fiduciar y duty of loyalty to the corporation that implicitly extends as well. towards minority shareholders and perhaps other corporate constituencies ² Se Seee Ch Chap apte terr 3. 3.2. 2.33 an andd Ch Chap apte terr 6. 6.2. 2.5. 5.4. 4. ² Se Seee Ch Chap apte terr 6. 6.2. 2.33 an andd Ch Chap apte terr 7. 7.4. 4.2. 2.3. 3. ³ See Chapter 7.7. ³¹ See Chapter 7.2 and 7.4. ³² See e.g. § 251 Delaware General Corporation Law (merger); § 242 (charter amendment); Art. 136 Lei das Sociedades por Ações. ³³ Such levels of control control are common in Brazil, for example.
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4.1.3.1 Te trusteeship strategy and independent independent directors directors Te addition of independent directors to the board is a popular device, not only as a solution to shareholder–manager shareholder–manager agency problems,³ but also for protecting minority non-shareholder non-shareholder implicitly thatshareholders independent and directors— directors—motivated motivated constituencies. by “low-powered “low-poweredLawmakers incentives”— incentives”—namely, namely, assume morality, professionalism, and personal reputation—will reputation—will stand up to controlling shareholders in the interest of the enterprise as a whole,³ including its minority shareholders and, to varying degrees, its non-shareholder non-shareholder constituencies. Strong forms of trusteeship reduce the possibility of controlling the board by shareholders (or by anyone else). In the extreme case, no constituency, including shareholders, can directly appoint representatives to the company’s board. Tis was the core principle of the Netherlands’ old “structure regime,”³ under which the boards of some large companies became selfappointing organs, much like the boards of many nonprofit corporations or foundations. Alternatively, investors themselves may contract to give one or more mutually selected independent directors the decisive voice on the board as a governance solution to intra-shareholder intra-shareholder opportunism. Tis pattern is common in venture capital-backed capital-backed firms.³ In our core jurisdictions, however, most “independent” directors are neither selfappointing nor rigorously screened for independence by savvy investors. Instead, director “independence” “independence” typically means at most financial and familial independence from controlling shareholders (as well as from the company and its top corporate officers).³ A director qualifies as independent under such a definition even if she is vetted and approved by the company’s controlling shareholder—and shareholder—and even if she has social ties to the controller—as controller—as long as she has no close family or financial ties, such as an employment position or a consulting relationship, with the controller. controller. A conventional example is that an officer of an unrelated, third-party third-party company qualifies as an independent director of the corporation, but an officer of a holding company with a controlling block of stock in the corporation does not. Moreover, the fact that in many jurisdictions shareholders have the right to remove directors directors (including independent directors) at any time further exacerbates concerns about the lack of actual independence in
controlled firms. Finally, the most modest and basic form of a director-based director-based trusteeship strategy abandons all pretense to independence and simply requires board approval for important company decisions. For example, the authority to initiate proposals to merge the company can be vested exclusively in the board of directors under U.S. and Italian law.³ Alternatively, shareholders may be barred from directly making any decisions
³ See Chapter 3.3.1. ³ For a critical assessment, see Wolf-Georg Wolf- Georg Ringe, Independent Directors: After the Crisis , 14 E B O L L R 401 (2013). ³ See e.g. Edo Groenewald, Groenewald, Corporate Governance in the Netherlands: From the Verdam Report of 1964 to theJesse abaksblat Code 2003Ganor, 2003, , 6 E O O L R (2005). ³ See M. Fried andofMira AgencyB Co sts of Venture Costs Vent ure Capitalist Control in 291 Startups , 81 N Y Y U L R 967, 988 (2006). ³ And, according to the listing rules of U.S. stock exchanges, not even that: they only require independence from the company and top management. Jurisdictions with concentrated ownership structures, however, usually impose some form of independence from controlling shareholders. For a comprehensive survey, see Dan W. Puchniak and Luh Luh Lan, Independent Directors in Singapore: Puzzling Compliance Requiring Explanation, Explanation, A J C L (forthcoming). ³ See § 251 (b) Delaware General Corporation Law; Chapter Chapter 3.4; Art. 2367 Civil Code (Italy). (Italy).
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about the company’s business without the board’s invitation, as under German law. Tese measures constrain the controlling shareholder to pursue her policies through directors who, although appointed by her, nevertheless face different responsibilities, incentives, and potential liabilities from controlling shareholders. Of course, how well the director-based director-based trusteeship strategy works, even when some or most directors are financially independent of controlling shareholders, remains an open question. We have already expressed our skepticism about the efficacy of these directors as trustees for minority shareholders.¹ Nevertheless, U.S. case law provides anecdotal evidence that independent boards or committees can make a difference in cash-out cashout mergers,² or when controlling shareholders egregiously overreach.³ overreach.³
4.1.3.2 Te equal treatment norm Te equal treatment of shares (and shareholders) of the same class is a fundamental norm of corporate law law.. Although this norm can be viewed as a rule-based constraint on corporate controllers, it can also be seen as a species of the incentive strategy. o the that effectively binds t he controlling the shareholder shareholder, , it motivates her tosharea ct in act the extent interests of itshareholders as a class, which includes the interests of minority holders. As with all abstract norms, however, its functioning is subject to at least two important qualifications. Te first concerns the range of corporate decisions or shareholder actions that trigger this norm. Te second qualification concerns the meaning of the norm itself. For example, are two shareholders treated equally when a corporate decision has the same formal implications for each, even though it favors the distribution or the risk preferences of the controlling shareholder over those of the minority shareholder? Insofar as shareholder preferences are heterogeneous and controlling shareholders have legitimate power to shape corporate policy, some level of unequal treatment seems endemic to the corporate form. Our core jurisdictions differ with respect to these qualifications of the equal treatment norm. In general, civil law jurisdictions—and jurisdictions—and particularly those that have been
§ 119 II AktG (shareholders may only only vote on management issues if asked by the management board). But see Chapter 7.6 for the case law on implicit shareholders’ meeting prerogatives (the socalled Holzmüller doctrine). doctrine). ¹ See Chapter 3.3.1. See also Ringe, note 35. For a broad discussion of the value of independent directors in U.S. family controlled listed companies see Deborah A. DeMott, Guests at the able: Independent Directors in Family-Influenced Family-Influenced Public Companies , 33 J C L L 819 (2008). ² See Chapter 7.4.2. ³ An example is the Hollinger case, in which the the Delaware Chancery Court backed a majority of independent directors who ousted the dominant shareholder from the board, and prevented him from disposing of his controlling stake in the company as he wished. See Hollinger Int’l, Inc. v. Black , 844 A R 2d 1022 (Del. Ch. 2004). Te independent directors in Hollinger acted, however, only after the controlling shareholder’s misdeeds were already under investigation by the Securities and Exchange Commission (SEC), and the controller had openly violated a contract with the board as a whole to promote the sale of the company in a fashion that would benefit all shareholders rather than the controller alone. See also Chapter 8.4. For an instructive instructive U.S. example on the point, compare Donahue v. Rodd Electrotype Co., Co ., 328 N E R 2d 505 (Mass. 1975), in which the court mandates that closely held corporations must purchase shares pro rata from minority and controlling shareholders, with Wilkes v. Springside Nursing Home, Inc .,., 353 N E R 2d 637 (Mass. 1976), in which the same court recognizes that controlling shareholders may pursue their right of “selfish ownership” at a cost to minority shareholders as long as they have a legitimate business purpose.
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heavily influenced by German law—tend law—tend to view equal treatment as a broad principle (or source of law) that suffuses all aspects of corporate law. Germany and Japan also frame the principle of equal treatment as a general statutory provision. By contrast, the common law jurisdictions—the jurisdictions—the U.S. and UK—specify UK—specify equal treatment by case law or statute in particular contexts, but are less inclined to embrace a general legal standard of equal treatment as distinct from constraint-like constraint-like standards such as the controlling shareholder’s shareholder’s duty to act fairly vis-àvis-à-vis vis minority shareholders. Tese jurisdictional differences in the deference accorded to equal treatment have important consequences in a number of corporate law areas. As we discuss in Chapter 8, respect for equal treatment t reatment makes American-style American-style poison pills more difficult to implement in jurisdictions that discourage companies from distinguishing among shareholders in awarding benefits, including stock purchase rights. Indeed, it is arguable that the law in the U.S.—or U.S.—or at least Delaware—accords Delaware—accords the widest latitude for unequal treatment of identical shares among a mong all of our core jurisdictions, though there are some isolated areas in which it enforces the equal treatment norm with exceptional vigor.. Although most jurisdictions enforce the equal treatment norm most strongly in vigor the area of corporate distributions (that is, dividends and share repurchases) and share issues, U.S. law in practice limits categorical enforcement only to the payment of dividends. In general, targeted share repurchases, even at prices above market, are permissible in the U.S., and companies may issue shares to third parties without providing preemption rights to incumbent i ncumbent shareholders. Another area in which which deference to the equal treatment norm has important implications is the law of corporate groups (i.e. groups of companies under the common control of another company, often managed as a single, integrated business). As we discuss in Chapters 5 and 6, some jurisdictions—such jurisdictions— such as Germany, France, Italy, and Brazil—provide Brazil— provide for special regulation in this area, permitting judicial evaluation of intra-group intragroup transactions in aggregate. Equal treatment is thus interpreted as applying not to individual transactions, but to aggregates of transactions. o conclude, the reach of the equality norm varies greatly, both within and between jurisdictions. However How , all our jurisdictions ju rely onminority this device, in at least some circumstances, to align theever, incentives ofrisdictions controllingrely andon shareholders.
§ 53a Aktiengesetz (Germany) and Art. 109(1) Companies Act (Japan). Tere is also a gray gray area in German law when it comes to the preferential provision of information to blockholders vis-àvis- à-vis vis other shareholders. A number of EU directives provisions more or less broadly impose the equal treatment principle upon EU publicly traded companies as well. See Art. 46 Directive 2012/30/ 2012/30/EU, EU, 2012 O.J. (L 315) 74; Art. 3(1)(a) Directive 2004/25/ 2004/25/EC, EC, 2004 O.J. (L 345) 64; Art. 17(1) Directive 2004/ 109/EC, 109/ EC, 2004 O.J. (L 390) 38; Art. 4 Directive 2007/36/ 2007/ 36/EC, EC, 2007 O.J. (L 184) 17. Under Delaware law, equal treatment of minority shareholders determines whether a given transaction is conceived as self-dealing self-dealing and scrutinized as such. Insofar as minority shareholders have received formally equal treatment (i.e. controlling shareholders have not benefited at the minority’s expense), the business judgment rule applies. Sinclair Oil Corp. v. Levien, Levien, 280 A R 2d 717 (Del 1971). On the treatment of related-party related- party transactions by controlling shareholders, see Chapter 6.2.2 and 6.2.5. Given Japan’s strong statutory provision enshrining the equal treatment norm, the evolving Japanese case law on warrantwarrant-based based takeover defenses is particularly interesting in this regard. See Bull-dog Bulldog Sauce v. Steel Partners , Minshu 61–561–5-2215 2215 (Japan. S. Ct. 2007) (permitting a discriminatory distribution of warrants where the warrant plan, overwhelmingly approved by an informed shareholder vote, provided compensation for discriminatory treatment to the defeated tender offeror). See Chapter 8.2.3. See Chapter 5.2.1.3 and 5.3.1.2, and Chapter 6.2.5.3.
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4.1.4 Constraints and affiliation affiliation rights rights Wee group together the remaining strategies for protecting minority shareholders W because there is less to say about a bout them in a chapter devoted devot ed to the governance system. Legal constraints— constraints—principally principally in theofform of standards as the duty the oppression standard, a nd abuse and majorit majority y voting—such are widely used of to loyalty, protect the interests of minority shareholders. In fact, these standards are often specific applications of the equal treatment norm, as when courts allow only “fair” transactions between companies and their controllers—meaning, controllers—meaning, in effect, that controlling shareholders cannot accept unauthorized distributions from the corporate treasury at the expense of the firm firm’’s minority shareholders. We We examine these t hese standards more closely in Chapters 6 and 7, although we must stress here that they may help minority shareholders in settings involving neither a related-party related-party transaction nor a fundamental change. Finally, the affiliation strategy, in the guise of mandatory disclosure, is at least as important for protecting minority shareholders as it is for protecting shareholders as a class. o the extent that disclosure, as a condition for entering and trading in the publicmarket markets, reveals structures conflicted transactions, prices may controlling bring homeshareholder to controllers the costsand of their opportunism. Moreover, mandatory disclosure provides the information necessary to protect minority shareholders through other mechanisms, such as voting or litigation.¹ By contrast, the exit strategy goes only so far in protecting minority shareholders. On the one hand, free transferability of shares, one of the five key elements of the business corporation, is helpful but incomplete as a minority protection tool. It permits dissatisfied minority shareholders to sell their shares on the market, but only if there is a market for the company’s company’s shares, and even then, usually at a price that already reflects the controlling shareholder’s abuses.² On the other hand, minority shareholders are generally unable to exit the firm by taking with them their proportional share of the corporation’’s assets. After all, permanency of investment is a hallmark of the corporate corporation form. As we address in Chapters 6, 7, and 8, corporate law sometimes does provide stronger exit rights, in particular for closely held companies, but usually only upon
egregious abuse of power by a controlling shareholder or in conjunction with a major transformation of the enterprise. Examples include the availability of appraisal rights (essentially, a put option) upon the occurrence of a fundamental transaction in many jurisdictions;³ or the mandatory bid rule triggered by a sale of control and sellsell-out out rights in Europe and Brazil.
For instance, instance, in some jurisdictions a minority shareholder shareholder in a closely held firm may challenge as oppressive or abusive a controlling shareholder’s decision to discharge the minority shareholder as an employee or to remove her from the board when all of the company’ company’ss distributions to shareholders take the form of employee or director compensation. See Chapter 6.2.1.1. ¹ See Chapter 9.1.2.3. ² Informed blockholders can also use the threat of exit, and its impact on stock price, to discipline managers, thereby improving firm governance ex ante —although this mechanism is likely to be more effective in firms lacking l acking a controlling shareholder. See Alex Edmans, Blockholders and Corporate Governance , 6 A R F E 23 (2014) (reviewing the use of exit by blockholders as a governance device). ³ See Chapter 7.2.2 and 7.4.1.2. See Chapter 8.3.4.
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4.2 Protecting Employees In addition to protecting minority shareholders, the corporate governance system extends protections toCorporate non-shareholder non-shareholder constituencies a contractual relationshipimportant with the corporation. law in all jurisdictions inprovides specialized protections to corporate creditors, which we consider separately in Chapter 5. Here we focus principally on the governance protections accorded to employee employees. s. As contractual contractual counterpartie counterpartiess to the corporatio corporation, n, employee employeess may deserve deserve the protec protec-tion of corporate law insofar as they are particularly susceptible to exploitation by the firm—and firm— and labor law regulations are held to be insufficient to protect workers or costlier to implement. From an economic perspective, this vulnerability emerges from the specific nature of the human capital c apital investments invest ments that workers may make in their employer’s employer’s business, such as by learning learni ng to use the firm’s technology or relocating relocati ng to a remote region where a particular facility is located. When these investments are firm-specific firm-specific (in the sense that they are useful only in the context of this employment), a profit-seeking profit-seeking corporation may subsequently exploit an employee’s lack of outside options to “hold up” the employee. Tisthecould be to done renegotiating contract to transfer surplus from worker the by firm, for examplethe by employment decreasing wages and benefits, or worsening working conditions. o the extent that employees are able to foresee the prospect of such opportunistic behavior by the firm, they will be less willing to undertake firm-specific firm-specific investments to begin with, thus ultimately harming profits. Our core jurisdictions differ profoundly in the extent to which they rely on corporate law for the t he protection of employees. Where Where they do, appointment rights, decision rights, and incentives are the principal strategies of choice. Of course, employees may also benefit indirectly from strategies designed to protect shareholders and creditors. For instance, mandated financial disclosures can assist employees, as well as investors, in their affiliation decisions. Disclosure rules have recently been harnessed to protect employeess in a different way: labor unions in the U.S. have pushed for a rule requiring employee companies to disclose the “pay ratio” between the CEO and the median worker, a figure that might arguably theiralso bargaining in corporate wage negotiations. Finally, Finally, a recent legal change in help the UK purportsposition to rely on law as a substitute for the labor law protections by permitting the elimination of various labor rights for
“employee “e mployee shareholders” shareholders” having received a grant of at least £2,000 in i n company stock. Moreover Moreover,, employees may also have have firm-specific firm-specific financial investments in the form of unfunded defined-benefit definedbenefit pension obligations, which are more common in Germany and Japan. See Martin Gelter, Te Pension System and the Rise of Shareholder Primacy , 43 S H L R 909, 966 (2013). See generally Margaret M. Blair, O C: R C G - C (1995); Paul L. Davies, Efficiency Arguments for the Collective Representation of Workers: A Sketch, Sketch, in A L L 367 (Alan Bogg et al. eds., 2015). For a thorough articulation of the view that corporate law should protect parties making specific investments in the firm, see Margaret Blair and Lynn Stout, A eam Production Teory of Corporate Law , 85 V L R 247 (1999); Martin Gelter, Te Dark Side of Shareholder Influence: Managerial Autonomy and Stakeholder Orientation in Comparative Corporate Corporate Governance , 50 H I L J 129 (2009). On the “pay “pay ratio” ratio” rule, see Section 4.3.1. See s. 205A, Employment Rights Act 1996, as introduced by the Growth and Infrastructure Act 2013 (s. 31).
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A minority shareholding in the employer is, howeve howeverr, an implausible substitute: an undiversified position only compounds workers’ vulnerability to firmfirm-specific specific risks and opportunism.
4.2.1 Appointmen Appointmentt and decision rights strategies Te widespread introduction of employee-appointed employee-appointed directors to the boards of large European corporations is one of the most remarkable experiments in corporate governance of the twentieth century. Many European countries now mandate employeeappointed directors in at least l east some large companies, although our core jurisdictions are not fully representative in this respect. Te U.S., UK, Italy Italy,, and Japan do not mandate employee board participation. Even French requirements are tame by the standards of most other countries imposing worker participation, which typically require that employee representatives constitute one-third one-third of the board.¹ France requires some employee board representation for listed companies in which employees own more than 3 percent of the shares.² Since 2013, large companies must also stipulate in their articles of association that one or two directors will be appointed as employee representatives.³ However, in the majority of French companies (with over 50 employees) employeess may only select two (sometimes four) non-voting employee non-voting representatives to attend board meetings. Employee participation requirements are also mild in Brazil: they apply solely to firms controlled by the federal government and mandate the appointment of only one employee representative, who is not permitted to vote on laborrelated matters. By contrast, German law establishes “quasi-parity “quasi-parity codetermination,” in which employee directors comprise half the members of supervisory boards in German companies with over 2,000 (German-based) (German-based) employees. Just as importantly, some of these labor directors must be union nominees, who generally come from outside the enterprise. Moreover, only German-based German-based employees and German trade unions have a right to appoint labor directors—though directors—though such differential treatment of foreign employees has recently become questionable under EU law. Although Altho ugh share shareholde holders rs and work workers ers appoi appoint nt equa equall numb numbers ers of direc directors tors to the supe supervirvisory boards of large German companies (as the term “quasi-parity” “quasi-parity” denotes), this does not mean that they share power equally as a formal legal matter, since the supervisory board’s board’s
Te only EU countries that have not introduced introduced any significant form of worker board representation are Belgium, Bulgaria, Cyprus, Estonia, Italy, Latvia, Lithuania, Malta, Romania, and the UK. Many countries, however, provide for employee board representation only in state-owned companies. See www.workerwww.worker-participation.eu/ participation.eu/.. ¹ Tis is the case for instance in Austria, Denmark, Luxembourg, and Hungary. See Aline Conchon, BoardBoard-level level Employee Representation Rights in Europe: Facts and rends , European rade Union Institute Report No. 121 (2011), www.etui.org . ² Arts. L. 225225-23 23 and L. 225-71 225-71 Code de commerce (for a one-tier one- tier board and a supervisory board respectively). ³ Arts. L. 225-27225-27-11 and L. 225-79225-79-22 Code de commerce (for one-tier one-tier boards and supervisory boards respectively), introduced by Loi No. 2013-504 2013- 504 of 14 June 2013. Art. L. 432432-66 Cod Codee du du tra travvai ail.l. Le Leii 12. 12.35 353, 3, de 28 de de dezzem embr broo de de 201 20100 (B (Bra raz. z.). ). §§ 1 and 7 Mitbestimmungsgesetz. German companies with between 500 and 2,000 employees must grant one-third one-third of their board seats to employees. §§ 1 and 4 Drittelbeteiligungsgesetz. In the largest companies seven members are elected by employees and three are appointed appointed by trade unions. § 7 II Mitbestimmungsgesetz. See Kammergericht, decision of 16 October 2015, 14 W 89/15, Z W W 2172 (2015) (requesting a preliminary ruling by the Court of Justice of the European Union on the issue. As of our writing, the case is still pending).
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chairman, who is elected from among the shareholder representatives, has the statutory right to cast a tie-breaking tie-breaking vote in a second round of balloting in case of deadlock. Nevertheless, employee representatives retain considerable power, formally through a statutory right to veto nominees to the management board, and informally, because they are in a position to disrupt the proceedings of the supervisory board. In addition, the German codetermination statute allocates one seat on the management board to a “human resources director, director,” who often has close ties with unions and employees.¹ Tus, German codetermination gives labor significant leverage over corporate policy by according it influence over the composition of the management board, access to information, and the power to withhold consent from contentious company decisions. Tis latter point is especially critical, because the usual practice of supervisory boards is to take decisions by consensus and because the shareholder bench of the supervisory board may not act monolithically, monolithically, owing to the presence of independent board members.² With the exception of Germany Germany,, whose laws permit works councils to coco-decide decide (with management) on a number of employee-sensitive employee-sensitive matters,³ corporate laws never confer direct decision-making decision-making rights on workers. EU directives on works councils do provide employee information and consultation (but not decision) rights on matters of particular employee concern, such as the prospective trend of employment, any substantial change in a firm’s organization, collective redundancies or sales of undertakings. Such rights give labor lead time to organize resistance, make its case, or otherwise protect employees’ interests. Even if works councils cannot influence major corporate decisions, the information flow that they provide, from top management to the shop floor and vice versa, arguably creates as much trust between companies and their employees as mandatory employee representation on the board, especially since labor representatives on works councils are typically the firm’s own employees rather than outside union appointees.
4.2.2 Te incentives incentives and constraints strategies Incentive devices are less important in protecting employees than they are in protecting minority shareholders. Consider the trusteeship strategy first. Of course independent directors appointed by shareholders may function as weak trustees on behalf of employees, just as they do for minority shareholders, if law and local business culture
motivate them to do so. And to some extent the law does facilitate such weak trusteeship even in the U.S., where many states other than Delaware permit—but permit—but do not § 29 II Mitbestimmungsgesetz. Mitbestimmungsgesetz. Election to the management board is by a two-thirds two-thirds majority vote of the supervisory board (§ 31 II Mitbestimmungsgesetz). If there is no two-thirds two-thirds majority for a candidate, lengthy proceedings are instituted which finally award the tietie-breaking breaking vote in a simple majority vote to the chairman of the supervisory board. ¹ § 33 Mit itbe best stim immu mung ngsg sges eset etzz. (Ge Germ rman any) y).. ² See Ch Chap apte terr 3. 3.3. 3.1. 1. ³ §§ 87 et seq. Betriebsverfassungsgesetz seq. Betriebsverfassungsgesetz (Germany). See European Works Works Council Directive (Recast Directive Directive 2009/38/ 2009/38/EC, EC, 2009 O.J. (L 122) 28); Art. 4 General Framework Directive Directive (Directive 2002/14/ 2002/14/EC, EC, 2002 O.J. (L 80) 29); Art. 2 Collective Redundancies Directive (Council Directive 98/59/ 59/EC, EC, 1998 O.J. (L 224) 16); Art. 7 Sale of Undertakings Directive (Council Directive 2001/23/ 2001/23/EC, EC, 2001 O.J. (L 82) 16). Works councils can provide a better framework for information-sharing information- sharing than the supervisory board also because, unlike trade unions, they are usually not involved in negotiations of employment terms: see Annette Van Den Berg, Te Contribution of Work Representation Representation to Solving the Governance Structure Problem, Problem, 8 J M G 129 (2004). See also Davies, note 56.
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require—directors to consider the interests of employees and other non-shareholder require—directors non-shareholder constituencies in making important decisions, especially in the context of a hostile takeover. Unlikee minority shareholders, non-shareholder contractual constituencies do not— Unlik and usually cannot— cannot—enjoy enjoy the protection of the equalcompensation sharing norm.asEmployees, Employees , lenders, and suppliers generally receive the bulk of their fixed payments rather than volatile claims on the net income of the firm as a whole. Where employees employees invest in developing firm-specific firm-specific human huma n capital, capital , such fixed payments may ma y be the firm’ firm’s dominant risk-sharing risk-sharing arrangement, as the stockholders are generally able to diversify their financial investments across firms. Employee stock ownership might seem to be a weak variant of the equal sharing device. Some jurisdictions encourage firms to share equity ownership with employees, on the theory that this will improve corporate governance and diminish tensions within the firm. Yet Yet share ownership entails different, and a nd less satisfactory satisfactory,, consequences for employeess than for outside investors with diversified portfolios. For employees, owneremployee ownership of their firm’s firm’s shares increases the already large—and largely undiversified— undiversified—firmfirmspecific risk that they bear. Moreover, it is unclear whether employee share ownership serves to protect the interests of employees as a class, as employee-shareholders employee-shareholders generally remain a minority minority,, without significant governance rights. Nevertheless, Nevertheless, the grant of stock options to lowerlower-level level employees is surprisingly frequent in practice, especially in high-tech hightech industries: stock options can help alleviate financing and capital constraints facing the firm, as well as promote retention and the sorting of optimistic employees. Finally,, the constraints strategy for protecting employees is largely embodied in dedFinally icated regulatory structures, such as labor law, which, for reasons of space, we exclude from the purview of this book except in the context of fundamental corporate decisions, addressed in Chapter 7 below below. . Otherwise, the laws that permit or mandate corporate directors to have regard to non-shareholder non-shareholder constituencies typically encompass the interests of employees as well. Nevertheless, these other corporate law l aw constraints for protecting non-shareholder non-shareholder constituencies are usually toothless or narrowly targeted, as discussed further below.
4.3 Pro Protecting tecting External Constituencies
Corporate laws everywhere focus primarily on the relationships between the corporation and its contractual constituencies—notably constituencies—notably,, managers and shareholders, but also creditors and employees. Yet there is no doubt that the corporation’s economic relevance and impact go well beyond its relationships with contractual counterparties. See Chapter 8.1.2.3. For a trustee-like trustee-like analysis of the U.S. board, see Blair and Stout, note 57. Tere are also instances of the reward strategy in the form of legally sanctioned sharing regimes. For example, the U.S. has tax- favored employee stock ownership plans: see Henry Hansmann, O E 87 (1996). France mandates both extensive information and limited employee profit-sharing profit-sharing rights in all firms with more than 50 workers. See Arts. L. 2322-1, 2322-1, 2323-6 2323-6 to 2323-23232323-60, 60, 3322-2, 3322-2, 3324-1 3324-1 and 3324-10 3324-10 Code du travail. See e.g. John E. Core and Wayne Wayne R. Guay, Stock Option Plans for Non-executive Non-executive Employees , 61 J F E 253 (2001) (finding an association between the use of stock options and financing and capital constraints); Paul Oyer and Scott Schaefer, Why Do Some Firms Give Stock Options to All Employees? An Empirical Examination of Alternative Teories , 76 J F E 99 (2005) (attributing the widespread use of stock options to sorting and retention goals, rather than incentives). See Chapter 7.4.3.2. See Section 4.3.3.
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Left unchecked, corporations may engage in socially harmful behavior, such as environmental degradation, violations of human rights, anticompetitive behavior, or practices that pose systemic risk to the economy. Te recent scandal involving German car manufacturer Volkswagen—which Volkswagen—which designed its cars’ software to cheat emissions tests— tests—illustrates illustratesboth this concern. Te and company’ company’s s relentless pursuit of growth,choices which that initially benefited shareholders workers, encouraged managerial clearly conflicted with the wider interests of society. society. Of course, corporations have no monopoly on socially harmful activities: individuals and other organizational forms engage in them as well. Yet because the corporate form is particularly conducive to large-scale large-scale enterprise, the social harms it engenders are correspondingly large-scale. large-scale. Moreover, Moreover, limited liability— lia bility—an essential feature of the corporate form—serves form—serves to compound the problem, by permitting shareholders to bear only a fraction of the costs their companies’ activities cause for third parties.¹ And precisely because they cannot protect themselves through contract, the corporation’s non-contractual noncontractual stakeholders have a greater need for legal protection than do its contractual constituencies. Te crucial question is not whether the corporation’s non-contractual non-contractual stakeholders deserve legal protection of some sort—they sort—they clearly do—but do—but whether corporate law is the proper channel through which to deliver this. A simple answer is that protection of interests extraneous to the firm should come from other areas of law, such as environmental law, human rights law, antitrust law, or financial regulation. Indeed, the use of legal rules and standards—the standards—the constraints strategy—to promote interests extraneous to the corporate form is, almost by definition, not corporate corporate law, but the application to corporations—as corporations— as legal persons—of persons—of norms from other fields of law. On occasion, however, however, regulators from our core jurisdictions resort to the same governance strategies and incentive strategies outlined in Chapter 2, not (only) to mitigate agency problems within the firm, but (also) to achieve broader societal objectives. Such an approach may be necessitated when—owing when—owing to regulators’ information gaps or to successful industry lobbying—more lobbying—more direct regulatory responses to externalities and other social problems are not feasible.² On the other hand, corporate law may become an easy target of populist or misguided reform efforts that can easily decrease the efficiency of its regime without generating any meaningful gains for other constituencies. Te use of corporate law to protect external constituencies is by no means new. Historically, the very availability of incorporation was conditioned on the showing of
a specific public benefit resulting from the enterprise. Other features of early corporate laws were specifically devised to mitigate monopoly problems or otherwise protect the interests of consumers.³ In fact, the historical and contemporary uses of corporate law to protect non-contractual non-contractual stakeholders are too numerous to describe in full. It is worth noting, however, that in recent years—and years—and in particular, in the wake of the recent financial crisis—there crisis—there has been a visible resurgence in the use of legal strategies that shape the internal governance of business corporations, in particular in the financial sector, to tackle broader social and economic problems.
¹ See Chapter 1.2.2 and Chapter 5.1.2.3. Obsession, 42 J C ² See Mariana Pargendler, Te Corporate Governance Obsession, L L 101 (2016). ³ Henry Hansmann and Mariana Pargendler Pargendler,, Te Evolution of Shareholder Voting Voting Rights: Righ ts: Separation of Ownership and Consumption, Consumption, 123 Y L J 948 (2014). Tis is particularly conspicuous with respect to takeover takeover regulation, which is often shaped by by the interests of labor, local communities, and the national economy. economy. For examples, see Chapter 8.
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Before proceeding, one caveat is necessary. Most attempts to protect external interests—from interests— from gender equality in the boardroom to the reduction of systemic risk and the protection of human rights—can rights—can be, and have been, rationalized in terms of promoting long-term long-term shareholder value. Nevertheless, while the long-term long-term interests of shareholders may isatimplausible. times coincide those of society at large, perfect alignment in all circumstances In with the following discussion, we consider instances in which the legal strategies of corporate law are deployed with the interests of external constituencies in mind, without taking a firm stance on the extent to which they also benefit investors.
4.3.1 Affiliation strategies Te vast majority of the disclosure requirements imposed on publicly traded companies concern factual matters that assist investors in evaluating the corporation’s financial condition and, to a lesser extent, in exercising their governance rights. By increasing the quality and quantity of information available to the public, mandating such disclosures enhances the efficiency of stock prices and supports financially motivated affiliation to a lesser voting) decisions shareholders as or a class. In recent years,(and, h owever, however, thereextent, has been a rise in t he use by the of “non-financial” “nonfinancial” “social”” “social disclosure requirements. Tese new obligations relate to information that, while arguably valuable from a social standpoint, may not always be relevant for shareholder affiliation decisions motivated solely by financial considerations. Rather, their goal is to facilitate entry and exit decisions by shareholders (and consumers) on socially minded criteria and, where such decisions are taken on a sufficiently large scale, to shape substantive corporate conduct. For instance, the U.S. Dodd-Frank Dodd-Frank Act of 2010 requires publicly traded companies to disclose their use of conflict minerals from the Democratic Republic of the Congo— Congo—aa rule intended ultimately to discourage the use of such minerals and thereby alleviate the humanitarian crisis in the t he region. Similarly, Similarly, a new SEC requirement that U.S. public companies must disclose the extent to which they consider diversity in director nominations is at least partly motivated by fairness concerns towards women and minorities. Te Dodd-Frank Dodd-Frank Act also includes a provision mandating disclosure of the ratio of CEO compensation to that of their company’s median employee. Tis rule is best understood as a response to growing apprehension about inequality, rather than as a
metric for evaluating corporate financial performance. In Japan, too, new executive compensation disclosure obligations in part reflect growing unease about pay gaps between CEOs and their average employees. For the first time, Japan now requires individualized reporting of executive compensation packages, but only for those executives whose annual pay exceeds ¥100 million (approximately US$1 million)—a million)— a high threshold that is not met in most Japanese companies. See Chapter 3.4.2 and Chapter 9. “Publicness” ” in Contemporary Securities See e.g. Donald Donald C. Langevoort Lang and Robert Robert Tompson, Regulation after the JOBS Act , evoort 101 G G B.L J“Publicness 337 (2013). Te D.C. Circuit has found that the the portion of such a rule requiring a company to report report that its products have not been found to be b e “DRC conflict free” violates freedom of speech under the U.S. Constitution: Nat’l Ass’n of Mfrs. v. SEC , 2014 W 1408274 (D.C. Cir., Apr. 14, 2014). See Robert J. Jackson, Jr. and Curtis J. Milhaupt, Corporate Governance and Executive Compensation: Evidence from Japan Japan,, 2014 C B L L R 111, 129. Cabinet Office Ordinance on Disclosure of Corporate Affairs, Form 2 (Precautions for Recording (57)d) and Form 3 (Precautions for Recording (37)).
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Non-financial disclosure has also gained particular traction in the EU. Te Non-financial Accounting Directive now requires companies that operate in extractive industries to publish details on payments they make to local governments in the countries in which they operate. Moreover Moreover, a 2014 directive mandates disclosure of non-financial non-financial information in “environmental, management reports, the company’s company’ policyfor andhuman performance with respect to “environ mental, socialincluding and employee matters, srespect rights, anticorruption and bribery matters.”¹ Tese new reporting requirements have a broad footprint: they apply to all large “public interest entities,” a category which includes not only listed companies, but also large closely held banks and insurance firms with more than 500 employees. Te goal is i s presumably to focus pressure from shareholders, consumers, and civil society at large so as to steer corporations towards socially desirable outcomes. In Japan, there is relatively little mandatory disclosure of non-financial information to protect external constituencies, although the okyo Stock Exchange requires companies to describe how they respect the interests of various stakeholders in their governance reports. Whether Whe ther disc disclosu losure re is an appr appropri opriate ate mean meanss to acco accompl mplish ish the these se ambi ambitiou tiouss goal goalss remains an open question, which we consider further below.
4.3.2 Appointment and decision rights strategies Te interests of external constituencies could in theory also be advanced through the allocation of appointment and decision rights. Although reformers have argued for “constituency directors” at various points in time (especially in the 1970s),² none of our core jurisdi jur isdictio ctions ns conf confers ers gen general eral appo appointm intment ent righ rights ts on on nonnon-shareholder shareholder constituencies other than employees. Te only exception is the appointment rights conferred by certain “golden shares”—such shares”— such as France’s action spécifique —which permit governments to appoint board representatives in privatized firms.³ Yet Y et mos mostt jur jurisdi isdictio ctions ns have director director qual qualifica ification tion requirem requirements ents that cons constrai trainn shar shareeholders’ choice of appointees in view of broader economic or social purposes. A classical example is the prohibition, in countries such as the U.S., Germany, and Italy, of interlocking directorates across financial institutions, which aims to preserve competition by preventing directors from simultaneously serving on the boards of rival firms. More recently, Germany, Italy, and France and other countries have instituted mandatory minimum quotas on corporate boards, and Japan has concurrently introduced
voluntary targets. Gender quotas are best viewed as a constraint on the exercise of See Arts. 41– 41–88 Directive 2013/34/ 2013/34/EU, EU, 2013 O.J. (L 182) 19. 1 9. “Extractive industries” encompass the exploration and extraction of minerals, oil, natural gas deposits, or other o ther materials. Te disclosure provisions also apply to firms engaged in logging activity in primary forests (Art. 41). ¹ Directive 2014/ 2014/95/ 95/EU, EU, 2014 O.J. (L 330) 4, which inserted Art. 19A to Directive 2013/34/ 2013/34/EU. EU. ² See e.g. Ralph Nader, Mark Green, and Joel Seligman, G C () (advocating the presence of an informed representative on the board for each public concern, such as environmental matters, consumer interests, compliance, among others). ³ Art. 31-1 Ordonnance No. 2014-948 31-1 2014-948 of 20 August 2014, inserted by Loi No. 2015-990 2015-990 of 6 August 2015. Section 8 of the Clayton Act (U.S.); § 100 section 2 No. 3 AktG (Germany); Art. 36, DecreeLaw 6 December 2011, No. 201 (Italy). Aktiengesetz § 96(2) (30 percent of supervisory board seats for the largest companies with employee board representation); Arts. 225-18225-18-11 and 225-69225-69-11 Code de commerce (in force, respectively, as of 1 January 2017 and 2020); Art. 147-III 147- III Consolidated Act on Financial Intermediation (Italy) (one-third (one-third of board seats). Te Italian law on gender quota only applies to three board elections following its entry into force in 2012.
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appointment rights that seeks to further more than simply the interests of shareholders. Te empirical literature does not evidence any clear link between board diversity and corporate performance. While a similar absence of evidence has not stopped independent directors being promoted as a means of securing shareholders’ interests, a likely alternative motivation for these is the to promote gender fairness. Perhaps also,new theyquota may requirements seek to further the political interestsdesire of nonshareholder constituencies, as some studies suggest that female directors exhibit different preferences from male directors with respect to risk-taking risk-taking and the protection of stakeholders. Decision rights are also occasionally used to protect the interests of nonshareholder constituencies. Tis is not done directly, at least in our core jurisdictions, but indirectly, by conferring decision rights on the state. An example is the retention by governments of “golden shares” in privatized firms. Tese first emerged in the UK during privatizations in the 1980s, and then spread to Brazil, France, Germany, and Italy. Golden shares grant the state veto rights over certain fundamental corporate decisions (such as mergers, dissolutions, and sales of assets) disproportionately to, or sometimes irrespective of, any ownership interest in the firm. Governments with golden gol den shares can be b eowners “shareholders” in nameTe onlrationale only— y—they are not necessarily investors in, or beneficial of, the firm.¹ for awarding such outsize decision rights to governments is presumably to protect the public interest at large.¹¹ Golden shares are not the only instrument by which governments can exercise direct corporate power to promote social objectives. Another is direct state ownership of enterprise, either via majority stakes or significant blockholdings.¹² Despite waves of See e.g. Deborah Deborah H. Rhode and Amanda Packel, Packel, Diversity on Boards: How Much Difference Does Difference Make? 39 39 D D J C L 363 (2014) (reviewing the empirical literature on female participation on boards b oards and concluding that “the relationship between diversity and financial performance has not been convincingly established”); Renee B. Adams, Women on Boards: Te Superheroes of omorrow? , ECGI Finance WP No 466/ 2016 (2016) (2016 ) (similar). See Chapter 3.2. See e.g. George Georg e R. Franke, Deborah F. F. Crown, and Deborah F. F. Spake, Gender Differences in Ethical Perceptions of Business Practices , 82 J A P 920 (1997) (women more likely than men to perceive certain business practices unethical); Renée B. Adams and Daniel Ferreira, Women in the Boardroom and Teir Impact on Governance and Performance , 94 J F E 291 (2009) (diverse boards devote more effort to monitoring); David
A. Matsa and Amalia R. Miller, Miller, A A Female Style in Corporate Leadership? Evidence from Quotas , 5 A E J: A E 136 (2013) (boards subject to gender quotas increased relative labor costs and made fewer workforce reductions). But see Renée B. Adams and Vanitha Ragunathan, Lehman Sisters , Working Paper (2015), at ssrn.com ssrn.com (banks (banks with more women directors no less prone to risk-taking). risk-taking). However However,, golden shares have been successfully challenged in the EU as an impediment to the free movement of capital. See e.g. Wolf-Georg Wolf-Georg Ringe, Company Law and Free Movement of Capital , 69 C L L J 378 (2010). ¹ Whether golden shares entitle governments to cash-flow cash- flow rights varies by jurisdiction. Even where they do, the associated decision rights are disproportionately powerful. However, However , corporate taxationofmakes mak the government a residual residua claimant of sorts in all a firms firms in ¹¹ a way that serves to alignincome the interests theesgovernment with those of lshareholders. Indeed, high rate of tax compliance is associated with lower private benefits of control. See Dyck and Zingales, note 2. ¹² Bernardo Bortolotti and Mara Faccio, Faccio, Government Control of Privatized Firms , 22 R F S 2907, 2924 (2009) (common law governments resort to golden shares more frequently; civil law governments relying more on continued equity ownership in privatized firms); Aldo Musacchio and Sergio G. Lazzarini, L B, B B (2014) (examining different varieties of state capitalism).
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privatizations, significant state ownership persists in several of our core jurisdictions— most conspicuously in France, Germany, Germany, Italy, Italy, and Brazil.¹³ Brazi l.¹³ By exercising appointment and voting rights through its role as shareholder, the state may steer the firm to achieve political objectives, even at the expense of financial returns. State-owned State-owned enterprises (SOEs)generally are usually subject the same corporate shareholder law regime applicable to private firms, which affords thetostate as controlling wide discretion to pursue public goals.¹ For example, Brazil’s corporations statute applies to the state the same fiduciary duties applicable to private controlling shareholders, but otherwise specifically authorizes it to pursue the public interest that justified an SOE’s creation.¹ Finally, scholars and policymakers have at times expressed hope that shareholders themselves might exercise decision rights in ways that promote the interests of society at large. Te basic premise is that the rise in institutional investors pursuing indexing strategies entailing economy-wide economy-wide exposure, together with the broader spread of equity ownership across various segments of society in some jurisdictions (especially the U.S.), created a natural alignment between the interests of these “universal owners” and the public interest.¹ Te expansion of shareholder rights following the 2008 financial crisis—as crisis—as exemplified by the rise of “say on pay” around the globe— globe—is is at least partly premised on this assumption.¹
4.3.3 Te incentives incentives and constraints strategies As discussed above, above, the widespread use of of the constraints strategy to protect the interinterests of external constituencies is usually thought to happen beyond the perimeter of “corporate law.” Tere are, however, limited exceptions to this. First, other areas of law can harness the mechanisms and enforcement tools of corporate law to pursue their goals, which can make disciplinary boundaries more porous. For example, the U.S. Foreign Corrupt Practices Act of 1977 (FCPA) on accounting and internal control rules, on the one hand, and on SEC enforcemen enforcementt against public issuers, on the other, in the pursuit of corruption. Another exception is the imposition on directors of duties to consider the interests of constituencies shareholders—an shareholders— expression the standards corporate laws of other manythan jurisdictions provideanthat directorsofowe their dutystrategy. of loyaltyTe to the company rather than to any of its constituencies.¹ Such a duty is most naturally understood as an exhortation to maximize the net aggregate returns (pecuniary and non-pecuniary) nonpecuniary) of all corporate constituencies.
¹³ See Mariana Pargendler Pargendler,, State Ownership and Corporate Governance , 80 F L R 2917 (2012). ¹ Marcel Kahan and Edward Edward Rock, When the Government is the Controlling Shareholder , 89 L R 1293 (2011); Mariana Pargendler, Governing State Capitalism: Te Case of Brazil , in in C S C I C: D G I 385 (Curtis J. Milhaupt and Benjamin Liebman eds., 2015). ¹ Art. 4º § 1º Lei Lei 10.303, de 30 de junho de 2016 (Braz.). (Braz.). See e.g. Robe rt A..G.Williams, Monks and W W W W 121 (1996); (1996 James P. ¹ Hawley and Robert Andrew Nell RMinow, F C (2000); Gelter, Te);Pension System,, note 55. System ¹ Te same idea has inspired recent proposals to employ the the constraints strategy to impose more stringent liability standards on managers of systemically important firms. See John Armour and Jeffrey N. Gordon, Systemic Harms and Shareholder Value , 6 J L A 35 (2014) (suggesting diversified shareholders would act “as a proxy for society” in enforcing such liability). ¹ E.g. Germany: §§ 76 I and 93 I 2 AktG; Japan: Japan: Art. 355 Companies Act.
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In theory, implementing this obligation might (or might not) require division of company surplus between shareholders and non-shareholder non-shareholder constituencies such as employees, employee s, in order to maximize the aggregate private welfare of all corporate constituencies.¹ In practice, however, however, courts are not well-placed well-placed to determine which policies maximize aggregate private welfare. Tis explains why, why, even where it is spelt out, a duty to pursue the corporation’s interest (in this broad sense) is unenforceable. Even fairminded directors are unlikely to know how best to distribute surplus among a mong multiple corporate constituencies. Tus, the exhortation to boards to pursue their corporations’ interests is less an equal sharing norm than, at best, a vague counsel of virtue, and, at worst, a smokescreen for board pursuit of their own interests. For instance, the UK Companies Act 2006 requires directors to seek to promote “the benefit of [the company’s] ny’ s] members as a s a whole, and in doing so [to] have regard (amongst (amongst other matters) to … the interests of the company’s employees, … [and] the impact of the company’s operations on the community and the environment.”¹¹ environment.”¹¹ However, However, the obligation is framed subjectively, extending only to “act[ing] in the way he considers, in good faith” would bring about that result, which encourages judicial deference to directors. Moreover, third parties have no standing to enforce the duty. Similarly, Brazil’s corporations statute provides that directors should act social in the function best interests of the company, company , “subject to the exigencies of public good and the of enterprise”; controlling shareholders, in turn, have duties and responsibilities towards “the “the remaining shareholders, workers, and the community in which [the company] operates.”¹¹¹ Yet this type of language appears to have no constraining force, much like similar language in the typical American constituency statute.¹¹² None of our core jurisdictions deploy duties to advance the interests of nonshareholder constituencies with quite such ambition as the new regime introduced by India’s Companies Act of 2013. Tis requires companies to create a corporate social responsibility committee and spend at least 2 percent of average net profits on promoting their “corporate social responsibility policy”—preferably policy”—preferably in local areas—or areas—or to explain their reasons for noncompliance. Te Indian statute’s statute’s definition of “corporate social responsibility” is particularly broad, encompassing not only social objectives closely to the firms’ primary activities, but alsoreducing general child humanitarian such as related the eradication of extreme hunger and poverty, mortality,goals and combating various diseases.¹¹³ Unsu Unsurprisingly rprisingly,, given its ambition, the effectiveness of this regime remains very much open to question. Yet Y et while our core jurisdictions do not compel spending on social causes, they do
not prohibit it, either. A number of them explicitly sanction corporations ability to make reasonable charitable contributions.¹¹ Legal systems may also encourage corporate charitable contributions through various tax deductions. And even in the United States, where fiduciary duties to shareholders are formally perhaps the strongest,¹¹ ¹ Note that maximizing the the private welfare of all of the firm’ firm’s current constituencies is not equivalent to maximizing overall social welfare, which would include, for example, the welfare of potential employees who are never Act hired2006 because the high wages of current employees limit firm expansion. ¹¹ § 172 Companies (UK). ¹¹¹¹ Ar ¹¹ Artts. 16 1644 an andd 11 1166 Le Leii da dass Soc ocie ieda dade dess po porr Açõ ções es.. ¹¹²² Se ¹¹ Seee Ch Chap apte terr 8. 8.5. 5. ¹¹³ Companies Act 2013 (India), Art. 135 and Schedule VII. ¹¹ See e.g. § 122(9) Delaware General Corporation Law; Art. 154, § 4º Lei das Sociedades por Ações. ¹¹ Te most famous articulation of the the shareholder primacy ideal comes from the case of Dodge v. Ford Motor Company , 170 NW 668 (Mich. 1919) (“it is not within the lawful powers of a board of directors to shape and conduct the affairs of a corporation for the merely incidental benefit of
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in practice directors enjoy wide latitude to further the interests of non-shareholder non-shareholder constituencies so long as the decision is framed in terms of promoting long-term shareholder value.¹¹ Corporate law may also indirectly protect non-shareholder non-shareholder constituencies through the imposition of oversight liability on directors for failures to implement and monitor internal systems of compliance against illegal activity. By making it likelier that illegal activities will be detected and their effects contained, such oversight obligations, which we touched upon briefly in Section 3.4.1, can also protect external constituencies.¹¹ Some jurisdictions also impose liability for damages caused to third parties by the directors’ negligence (or gross negligence) in breaching a duty to the corporation.¹¹ In practice, however, this duty is principally read to protect the creditors of closely held corporations.¹¹ Finally, another (blunt) use of the constraints strategy to protect the interests of external constituencies is through the imposition of personal liability on directors and officers—or officers— or even shareholders—for shareholders—for violations of law.¹² All of our core jurisdictions occasionally deviate from the general rule that only the corporation—as corporation—as a distinct legal person—is person— is liable for its actions to accommodate the deterrence and compensation goals of other branches of law, such as product liability, social securities law, tax law, patent include law, environmental law, laborforlaw, antitrust or law,reckless and financial regulation.¹²¹ Tese both direct sanctions intentional violations of law and secondary liability to pay damages to third parties if the firm becomes insolvent. Irrespective of the scope and content of corporate fiduciary duties, the trusteeship strategy in the form of independent directors—as directors—as the “broad-spectrum “broad-spectrum prophylactic” previously mentioned—is mentioned—is also used to protect both contractual constituencies and stakeholders external to the firm.¹²² For instance, the New York Stock Exchange first required the inclusion of independent directors in audit committees in the late 1970s as a response to the corruption scandals of that era, even though corporate corruption can easily serve the financial interests of investors (if to the detriment of society at large). Indeed, one may argue that t hat such ambiguity with respect to the function served by independent directors—the directors—the protection of shareholders as a class, of minority shareholders, of non-shareholder non-shareholder contractual constituencies, or of external shareholders and for the primary purpose of benefiting others”). See, more recently, eBay Domestic Holdings, Inc. v. Newmark , 16 A R 3d 1, 33 (Del. Ch. 2010) (“Promoting, protecting, or pursuing non-stockholder non-stockholder considerations must lead at some point to value for stockholders”). ¹¹ Einer Elhauge, Sacrificing Corporate Profits in the Public Interest , 80 N Y U L R 733 (2005) (business judgment rule deference entails significant managerial discretion
to sacrifice profits in the public interest). ¹¹ Claire Hill and Brett Brett McDonnell, McDonnell, Reconsidering Board Oversight Duties after the Financial Crisis , U I L R 859, 866–7 866–7 (2013). ¹¹ Art. 429(1) Companies Act (Japan); Art. 2395 Civil Code (Italy); Art. L. 225- 251 Code de commerce (France). However, However, French courts virtually never impose liability on directors on behalf of third parties as long as the company is solvent. See Maurice Cozian et al., D 179 (28th edn., 2015). ¹¹ See Chapter 5.3.1.1. ¹² See Reinier H. Kraakman, Corporate Liability Strategies Strategies and the Costs of Legal Controls , 93 Y L L ¹²¹J See e.g.857Klaus (1984). J. Hopt and Markus Roth, Sorgfaltspflicht und Verantwortlichkeit der Vorstandsmitglieder , in A: G G (Heribert Hirte et al. al . eds., 5th edn., 2015), 2015 ), § 93 comments 656 et seq (discussing controversial imposition of personal liability liabi lity on corporate directors in Germany for product liability cases). ¹²² See e.g. Victor Brudney, Te Independent Director—Heavenly Director—Heavenly City or Potemkin Village? 95 H L R 597, 597 (1981–2) (1981–2) (“Numerous observers have argued that the addition of independent directors to corporate boards would solve the problem of corporate social responsibility without incurring the costs of external regulation”). regulation”).
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stakeholders—has in fact facilitated political consensus and contributed to the spread stakeholders—has of this mechanism in our core jurisdictions over time.¹²³ Te reward strategy has also been increasingly deployed to protect the interests of non-shareholder non-shareholder constituencies. Rather than attempting to tie executive remuneration to benefits conferred by the corporation on society as a whole—which whole—which would clearly be impractical—the impractical—the reward strategy has rather been used to discourage certain practices considered to be especially harmful from a social standpoint. In the wake of the financial crisis, there has been considerable concern that, by tying executive remuneration to short-term short-term returns, compensation packages in financial institutions contributed to the system’ system’s collapse by encouraging managers to take risks ri sks that were excessive from a social standpoint.¹² In systemically important financial institutions, the interests of undiversified shareholders conflict with those of society as a whole—both whole—both because financial crises have disastrous macroeconomic consequences and because taxpayers are left to pick up the bill to bail out failing banks. Yet, Y et, given the the countervailing countervailing advantages advantages of equityequity-based based compensation, none of our core jurisdictions has completely banned its use in financial institutions, inst itutions, though the EU has capped the variable component at twice fixed pay.¹² Nor has there been any permanent imposition of ceilings on the level of compensation, notwithstanding populist demands and growing concern about inequality. Except for the EU’s cap on variable pay pay,, most reforms in this area took the form of decision strategies, as in the global spread of the “say on pay” rule,¹² of trusteeship strategies, as in the most stringent independence requirements for members of compensation committees imposed in the U.S,¹² and of affiliation strategies, as in the greater disclosure requirements in the U.S. and Japan.¹²
4.4 Explaining Jurisdictional Jurisdictional Differences and Similarities Similarities As with our discussion of the primary manager– manager–shareholder shareholder agency problem in Chapter 3, we first assess our core jurisdictions according to the protection that substantive law offers to minority shareholders, employees, and external stakeholders, respectively, and then according to the protection that these constituencies enjoy in practice, considering not only corporate law but also societal and legal institutions more generally. 4.4.1 Te lawlaw-onon-thethe-books books
Te substantive law on the books gives little guidance as to which jurisdictions place more emphasis on protecting minority shareholders and external constituencies. It does, however, however, provide an indication i ndication of which countries go furthest to t o protect employees through corporate law. ¹²³ Pargendler Pargendler,, note 82. ¹² See e.g. Lucian A. Bebchuk and Holger Spamann, Spamann, Regulating Bankers’ Pay , 98 G L L J 247 (2010). ¹² Art. 94(1)(g) Capital Requirements Directive IV, IV, 2013 O.J. (L 176) 338. Te basic cap is set at 100 percent of fixed pay, which may be increased to 200 percent with shareholder approval. See generally John Armour et al., P F R 380–8 380– 8 (2016). Moreover, the supervisory board members of most large l arge German firms no longer receive stock options, though their fixed salary has increased considerably. ¹² Se ¹² Seee Sec ecti tion on 4. 4.3. 3.22 an andd Ch Chap aptter 6. 6.2. 2.3. 3. ¹² See Ch ¹² Chap apte terr 3. 3.3. 3.1. 1. ¹² See Section 4.3.1.
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Consider minority shareholders first. Our analysis has shown that only Brazil and Italy among our core jurisdictions rely on appointment rights, in the form of minorityelected board members, to protect minority shareholders. Elsewhere the long-term long-term trend is in the opposite direction—namely, direction—namely, away from minority empowerment through devices such as cumulative voting and strong supermajority voting rules.¹² Why do so few juris jurisdict dictions ions manda mandate te minor minorityity-friendly friendly appointment rights for listed companies? One answer is that “partisan” representation of minority shareholders in controlled companies can be costly, by introducing conflict in board meetings, discouraging candid business discussions, and, at its worst, providing competitors with access to sensitive information.¹³ Another answer is that minority shareholders in publicly traded corporations are a heterogeneous group. On the one hand, retail investors are the most vulnerable minority but, as a consequence of collective action problems, are also the group least able to pursue their interests effectively through appointment and decision rights. Tis is especially so under the high ownership percentage thresholds required for the exercise of such rights in Brazil and Italy. On the other hand, the minority shareholders best able to use appointment rights are large-block large-block investors, who are also best able to contract for governance protections (e.g. in a shareholder agreement) even without the addition of mandatory terms in the law. Board representation for minority shareholders might make more sense if, as is relatively often the case in Brazil and Italy for the largest companies,¹³¹ institutional investors, as opposed to other blockholders, nominate minority directors. At least in the U.S., however, however, stringent laws on insider trading and onerous ownership disclosure rules that prevent coordination among shareholders¹³² historically discouraged most institutional investors from exercising appointment rights, making this strategy less appealing. For activist investors such as hedge funds, however, board representation for minority investors has proved to be a potent tool, even in the U.S.—especially U.S.—especially in light of the growing collaboration between hedge funds and traditional institutional investors.¹³³ What, then, of other legal strategies strat egies for protecting minority investors? Among our core jurisdictions the U.S., followed by the UK, appears relysomost on independent directors (in publicly traded companies), eventomore afterextensively the SarbanesOxley and Dodd-Frank Dodd-Frank Acts enhanced their role. But since independent directors may be appointed by controlling shareholders, even in the U.S. and the UK, their allegiance is always suspect unless their interest in maintaining a good reputation among outside shareholders at large is greater than their desire to be re-elected re- elected in a particular firm
(or in other firms with controlling shareholders). Te U.S., however, complements the trusteeship strategy with the strongest mandatory disclosure system of all our core jurisdictions.¹³ ¹² See Chapter 3.2.1 and Chapter 4.1.1. ¹³ See e.g. Gordon, note 8, at 167 (discussing traditional critiques of cumulative voting). voting). ¹³¹ Institutional investors nominate around one-third one-third of the minority-appointed minority-appointed directors in companies voluntarily providing such information. See Assonime, C G I: C CG C D’ (Y ) 62–70 62– 70 (2013), at http:// http://www.assonime.it www.assonime.it.. ¹³² See Mark J. Roe, S M, W W O: P P R A C F 273 (1994). ¹³³ See Kobi Kastiel, Against All Odds: Shareholder Activism in Controlled Companies , 2016 C B L R 60. ¹³ See Chapter 6.2.1.1 and Chapter 9.
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Alternatively Alternativ ely,, consi consider der the equal treat treatment ment norm as a mino minority rity safeg safeguard uard.. He Here, re, Japan— Jap an—followed followed by continental European jurisdictions and Brazil—is Brazil—is the country with the most stringent standards, at least on-theon-the-books. books. Te UK also gives substance to the equal treatment norm in the form of preemption rights and minority-protective minority-protective takeover rules, while Delaware appears to rely on it the least. Put differently, all we know from reviewing the law-onlaw-on-thethe-books books is that jurisdictions pursue different strategies to protect minority interests. How well these strategies work in practice is a totally different story stor y. When it comes to governance governance strategies that protect labor’s labor’s interest, Germany’ Germany’ss system of quasi-parity quasi-parity codetermination, coupled with works council co-decision co-decision rights, clearly stands out.¹³ France follows, a considerable distance dist ance behind Germany, Germany, by mandating a far more attenuated labor presence on company boards and, for companies with more than fifty employees, a works council with mere information and consultation rights.¹³ But France, like Japan, Germany, Italy, and Brazil, has strong labor law rules governing basic employee interests, ranging from pension rights to terms of dismissal.¹³ Te U.S., followed by the UK, is the least protective of our core jurisdictions, both in direct regulation of employee rights and in structuring the corporate governance system to reflect employee interests. Overall, the observed pattern seems consistent with the view that the presence of powerful shareholders increases the risk of exploitation of workers.¹³ Conversely,, different jurisdictions embrace a variety of strategies with respect to the Conversely protection of external constituencies, making it difficult to establish a clear pecking order.. Te use of the affiliation strategy through mandatory order mandator y disclosure of non-financial information is currently most extensive in EU countries, and least so in Brazil. Whether explicitly or implicitly, implicitly, all jurisdictions require or at least permit the board to take into account the interests of non-shareholder non-shareholder constituencies.¹³ State influence through ownership or golden shares is strongest in Brazil, France, and Italy, and again weakest in the U.S., with other jurisdictions falling somewhere in between. On the other hand, the decision rights of shareholders are weakest in the U.S., thus arguably insulating boards from shareholder pressure and enabling them, t hem, if only de facto, to promote a broader set of interests.¹
4.4.2 Te law in practice As we argue above, above, the lawlaw-onon-thethe-books books provides an imperfect measure of the protection accorded to corporate constituencies. Tis is particularly the case for minority shareholders.
¹³ For reviews of the empirical literature on these mechanisms, see John . . Addison and Claus Schnabel, Worker Directors: A German Product that Did Not Export , 50 I R 354, 354 (2011); Davies, note 56. ¹³ See Rebecca Gumbrell-McCormick Gumbrell-McCormick and Richard Hyman, Embedded Collectivism? Workplace Representation in France and Germany , 37 I R J 473, 482 (2006). ¹³ See e.g. Juan C. Botero, Simeon Djankov, Rafael La Porta, Florencio Lopez-deLopez- de-Silanes, Silanes, and Andrei Shleifer, Te Regulation of Labor , 119 Q J E 1339 (2004) (France’’s labor law is most restrictive among our jurisdictions). (France ¹³ Gelter, Te Dark Side , note 57. But see Mark J. Roe, Political Preconditions to Separating Ownership from Control , 53 S L R 539 (2000) (for the different view that social democracies induce concentrated ownership in order to counterbalance the influence of labor in firm management). ¹³ See notes 111– 111–12 12 and accompanying text. ¹ See Chapter 3.4. See also Christopher M. Bruner, Bruner, C C G C L W 105 (2013).
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4.4.2.1 Minority shareholders wo prominent empirical papers, applying different methodologies to data from the 1990s, suggest that controlling shareholders obtained private benefits that ranged from small to negligible in the UK, U.S., and Japan respectively, respectively, through moderately larger in Germany (approximately 10 percent),large very (65 largepercent) in Italy in (30Brazil.¹¹ percent orTus, more) France (28 percent), to extraordinarily to and the extent that private benefits of control measure the severity of the majority–minority majority–minority shareholder agency problem, our core jurisdictions differed dramatically in the extent of protection that they offered to minority shareholders, even if these differences were not evident a priori from the law-onlaw-on-thethe-books.¹² books.¹² Moreover More over,, these variations followed a clear pattern. Te three jurisdictions in which large corporations ordinarily have dispersed ownership also had low private benefits of control, while the three countries in which concentrated ownership dominates had moderate to large private benefits. Tis association between dispersed ownership and low private benefits of control is not accidental. In fact, widely held firms can only thrive in contexts where private benefits bene fits of control are relatively small. Whenever private benefits of control are sufficiently large,much dispersed ownership becomes inherently unstable, a potential raider would have to gain from acquiring a controlling block since and expropriating the remaining minority.¹³ Nevertheless, the numerous corporate reforms implemented in our core jurisdictions since the 1990s, combined with the modest rise in ownership dispersion in some contexts (Brazil)¹ and the reduction of the wedge between ownership and control in others (Italy),¹ cast doubt on the continued accuracy of these earlier measurements of private benefits of control. Strikingly, there are no cross-country cross-country studies that update the earlier estimates of private benefits of control—which control—which would be a critical element in assessing whether and how the recent wave of corporate law reforms mattered. In any case, the data from the 1990s suggest that the award of appointment rights to minority shareholders in Italy and Brazil was a response—albeit response—albeit not necessarily a solution—to solution— to the mistreatment of minority shareholders. Moreover, it indicates that the strong minority equal treatment normsnor found civil law low jurisdictions necessarily protect shareholders, did in a relatively percentagedidofnot independent directors (as in Japan) necessarily inflate private benefits of control. Even domination by a controlling shareholder is not a reliable predictor, since Scandinavian jurisdictions ¹¹ Te two papers are Nenova, Nenova, note 2, at 336 (employing share price differentials differentials for dual-class
firms to calculate private benefits) and Dyck and Zingales, note 2 (employing control premia in sales of control blocks to calculate private benefits). Although these two papers present similar results across all other jurisdictions, they differ sharply for France (2 percent vs. 28 percent). Here Nenova’ Nenova’s finding of 28 percent is more plausible because it is based on nine observations of French firms, while Dyck and Zingales have only four observations of French control transactions. ¹² But see Sofie Cools, Te Real Difference in Corporate Law Between the United States and Continental Europe: Distribution of Power Powers s , 30 D J C L 697, 760–1 760–1 (2005) (the sizeable difference in scope of shareholder voting rights across jurisdictions may lead to different values of control, even without private benefits). ¹³ See e.g. Lucian Bebchuk Bebchuk and Mark Roe, Roe, A A Teory of Pa Path th Dependence in Corporate Ownership and Governance , 52 S L L R 127 (1999). ¹ Érica Gorga, Changing the Paradigm of Stock Ownership from Concentrated owards Dispersed Ownership? Evidence from Brazil and Consequences for Emerging Countries , 29 N J I I L L B 439 (2009). ¹ Massimo Belcredi and Luca Enriques, in R H S P P 383, 385 (Jennifer G. Hill and Randall S. Tomas eds., 2015).
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generally manifested low levels of private benefits despite concentrated ownership structures.¹ What, then, predicts the efficacy of minority shareholder shareholder protections protections and, by by implication, the extent of private benefits of control? Te literature suggests that many disparate factors matter, including legal rules, the general business culture, and even the competitiveness of the product markets.¹ In line with the analysis of Chapter 3, we suggest that ownership structures, on the one hand, and legal protection of minority shareholders, on the other, are mutually reinforcing.¹ In jurisdictions where concentrated ownership prevails, controlling shareholders tend to block the enactment of laws that could curb their private benefits. By contrast, in jurisdictions where ownership is dispersed, institutions and the investing public are likely to have greater political clout in pushing for reforms that reduce minority expropriation. Our core jurisdictions seem to confirm this pattern. In the UK, the interests of institutional shareholders dominate the institutions of lawmaking and enforcement, such as the Financial Conduct Authority (as UK Listing Authority), the Financial Reporting Council and the akeover akeover Panel. Large institutional investors are normally hands-off hands-off shareholders with every reason to oppose any form of suspected favoritism toward corporate controllers. In the U.S., political influence is more evenly balanced between institutional investors and professional managers. But again, neither managers and institutional investors nor state courts and the SEC have reason to treat controlling shareholders with kid gloves. Stringent U.S. disclosure requirements, holding company regulations,¹ and taxation of intra-corporate intra-corporate distributions¹ are all indications of the comparative weakness of controlling shareholders under U.S. law. Delaware courts also take a tougher stance toward self-dealing self-dealing by controlling shareholders than by officers and directors.¹¹ Finally, shareholder class actions and enforcement by the SEC are, respectively, very common and increasingly severe. Te case of Japan would seem to be similar in one respect. As we argue in Chapter 3, while a large percentage of shares of listed companies still lies in the hands of stable corporate shareholders, the amount held by each is usually small. As there is no controlling shareholder in these companies, the equal treatment norm is accepted without much opposition.¹² By contrast, in jurisdictions jurisdicti ons such as France, Italy, Italy, and Brazil, where large shareholders control most listed companies, one assumes that controlling shareholders are a potent political influence. Te fact that the state is a major shareholder in many companies in these countries—and countries—and is often a member of the controlling coalition in the companies in which it holds a non-controlling non-controlling stake—further stake—further compounds the influence of
¹ See Ronald J. Gilson, Controlling Shareholders and Corporate Governance: Complicating the Comparative axonomy , 119 H H L R R 1641 (2006). ¹ Se ¹ Seee Dy Dyck ck an andd Zin inga gale les, s, no note te 2. ¹ Se ¹ Seee al also so Be Bebc bchu hukk an andd Ro Roe, e, no note te 14 143. 3. ¹ Roe, S M, M, W W O, note 132, at 98. ¹ Randall Morck and Bernard Yeung, Yeung, Dividend axation and Corporate Governance , 19 J E P 163 (2005). ¹¹ Chapter 6.2.5. ¹² See Note, however however, , that managers who dominate listed companies do have an interest in providing benefits to friendly shareholders in order to maintain their support. For example, a company may financially assist employees’ purchases of the company’s shares. Provided Provided there is a reasonable motivation (such as promotion of employees’ welfare), this is not prevented by the equal treatment norm. Also, once hostile acquirers become a significant threat threat despite friendly shareholder support, managers gain an interest in discriminating among shareholders in order to facilitate warrant or rights-based rights- based takeover defenses. See Chapter 8.2.3.2.
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controlling shareholders, as we noted in Chapter 3. Anecdotal evidence concords with the existing (albeit dated) empirical evidence to suggest that the minority–majority minority–majority agency problem remains severe in these jurisdictions, despite legal efforts to mitigate it through increased mandatory disclosure, appointment rights for minority shareholders in Italy and Brazil, and pressure to add independent directors arising from listing standards or codes of best practice.¹³
4.4.2.2 Employee protection In contrast to the weak correlation between formal law and minority shareholder protection, the correlation between law and employee protection is strong. German company law does, in fact, reallocate corporate power to unions and works councils through quasiparity codetermination and co-decision co-decision rights. Te question then becomes: how effective is codetermination codetermination as an employee protection tool? In other words, what exactly can labor directors accomplish apart from the narrow goal of enhancing labor’s bargaining power? In Germany they can influence business policies.¹ Tere is also evidence that codetermination may provide valuable insurance to skilled workers, protecting them against layoffs due to external shocks in exchange for lower wages.¹ But in addition to this, labor directors may also play an important informational role, at least leas t in theory. Mutually Mutually wasteful bargaining barga ining behavior such as strikes st rikes and lock-outs lockouts result in part from distrust distr ust between firms and employees.¹ By credibly informing employees, labor directors might limit such costly bargaining behavior. Likewise, by revealing the firm’ firm’s intentions, labor directors di rectors can alert workers about possible future plant closings and related layoffs. Whether employee representation at the board level actually improves industrial relations based on trust between labor and shareholders is impossible to say in the absence of econometric studies on the issue. An alternative theory theory,, with some empirical support in the literature, argues that codetermination can provide German supervisory boards with “valuable first-hand first-hand operational knowledge” knowledge” that improves board decision-making decision-making and increases firm value in the subset of firms in which the need for intra-firm intra-firm coordination is greatest.¹ Yet there is also evidence that quasi-parity quasi-parity codetermination in larger German firms reduces firm value¹—and value¹—and still other, non-comparable, non-comparable, studies finding that codetermination increases employee productivity or firm profitability.¹ profitability.¹ ¹³ Se ¹³ Seee Ch Chap apte terr 3. 3.3. 3.1, 1, an andd Se Sect ctio ions ns 4. 4.1. 1.11 an andd 4. 4.1. 1.3. 3.1. 1. ¹ Se ¹ Seee Ch Chap apte terr 3. 3.5. 5. ¹ E. Han Kim, Ernst Maug, and Christoph Schneider, Labor Representation in Governance as an Insurance Mechanism, Mechanism, Working Paper (2016), at ssrn.com ssrn.com (skilled (skilled workers in German firms with quasi-parity quasiparity codetermination receive wages that are 3.5 percent lower in exchange for protection
against layoffs). ¹ See R.B. Freeman and E.P. Lazear, An Economic Analysis of Works Councils , in W C: C, R C I R 27 (J. Roger and W. Streek eds., 1995). See generally John Kennan and Robert Wilson, Bargaining with Incomplete Information, Information, 31 J E L L 45 (1993). ¹ Larry Fauver and Michael E. Fuerst, Does Good Corporate Governance Include Employee Representation? Representa tion? Evidence from German Corporate Boards , 82 J F E 673, 679¹(2006). See ibid. at 698– 698–701; 701; Gary Gorton and Frank A. Schmid, Capital, Labor, and the Firm: A Study of German Codetermination, Codetermination, 2 J E E A 863 (2004). ¹ For a useful if partisan review, see Simon Renaud, Dynamic Efficiency of Supervisory Board Codetermination in Germany , 21 L 689 (2007). Renaud’s strongly positive findings about the effects of quasi-parity quasi-parity codetermination on profitability and productivity are suspect because they rely on balance sheet data and fail to include the range of control variables found in the finance-oriented finance- oriented literature such as Fauver and Fuerst, note 157.
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Moreover, the question remains: if large efficiencies result from codetermination, why do the parties fail to contract for labor directors voluntarily and divide the surplus? Why do we seldom see labor l abor directors where they are not mandated by law? And if mandatory law is needed to overcome collective action problems associated with the introduction of voluntary codetermination, why is mandatory regulation necessary to sustain once answers it has been introduced? Although have offered codetermination speculative economic to these questions,¹ the commentators empirical literature again remains sparse. Tere may also be ideological or cultural explanations for the dearth of employee directors outside of continental Europe. But a competing explanation is that the costs of labor representation exceed its benefits, or at least are feared to do so. One source of concern is the difficulty of bridging the sharply divergent interests of the board’s constituent groups of employees and shareholders, or even among employees themselves, in framing policy or supervising management. Voting Voting is a highly imperfect way of making decisions in the presence of such conflicts. Majority decision-making decision-making by a divided board risks opportunistic outcomes that diminish the value of the firm as a whole,¹¹ and is also likely to make for a costly and cumbersome decision-making process.¹² In addition, strong labor representation on the board may exacerbate the agency conflict between managers and shareholders as a class. Managerial discretion plausibly increases if shareholder and labor directors split over corporate policy, or if large and divided supervisory boards lack the institutional capacity to monitor managers closely.¹³ closely .¹³ Indeed, managers may withhold information from boards with the acquiescence of shareholders to limit leaks to employees and competitors.¹ Strong labor may benefit managers, just as strong managers have proven to be loyal protectors of labor’s labor’s interests in large Japanese companies, even without a regime of codetermination.¹
¹ See e.g. Fauver Fauver and Fuerst, note 157, at 679 (proposing that firms may be deterred from adopting codetermination voluntarily by adverse selection in recruiting employees and managers, even if codetermination would increase firm value). ¹¹ Perhaps for this reason, reason, the double voting right of the chairman of the supervisory board of codetermined co determined corporations in Germany is very rarely used (its use is thought to undermine labor relations). ¹² It is nearly always the case that, in any given given firm (whether investor-, investor-, employee-, employee-, customer-, customer-, or supplier-owned), supplierowned), the group of persons sharing ownership is remarkable for its homogeneity of interest. Even within investor-owned investor-owned firms, for example, it is highly unusual for both preferred and common shareholders to share significant voting rights. Likewise, within entirely employee-owned employee- owned firms it is rare for both managerial and line li ne employees to share control (and voting rights are often given to the line employees, who tend to be more homogeneous). See Hansmann, note 75, at 62–4 62–4 and 91–2. 91–2. Tis
suggests that the appointment strategy is not easily adapted to resolve significant conflicts of interest. ¹³ But see Fauver Fauver and Fuerst, note 157 (in some instances employee board representation may increase supervisory boards’ b oards’ monitoring capacity and thereby reduce agency agency costs). ¹ See Katharina Pistor, CoCo-Determination Determination in Germany: A Socio Political Model with Governance Externalities , in E C G 163, 188–91 188–91 (Margaret M. Blair and Mark J. Roe eds., 1999). Pistor also provides an illuminating account of the practice of codetermination in German firms as forcing segmentation of the supervisory board into employee and management “benches,” which meet to board meetingscodetermination, (a practice that the Germanand Corporate Governance Code, in the oneseparately and onlyprior provision addressing endorses) always present a common front in formal meetings of the supervisory board. Te common practice of forcing supervisory boards to review the auditor’s report at the board meeting , but not permitting board members to receive a copy for close review, is emblematic of the informational restrictions placed by the management board on the supervisory board (ibid, 191). ¹ See Masahiko Aoki, oward an Economic Economi c Model of the Japanese Japanes e Firm, Firm, 28 J E L L 1 (1990).
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Most directors in Japanese firms are managers who were promoted from within the ranks of the companies, and they tend to take the interests of core employees to heart. So which side of the ledger dominates, the costs or the benefits of codetermination? At least in the case of German-style German-style codetermination, the empirical literature is, as hinted, surprisingly mixed. Certainly large German firms survive and even flourish under quasi-parity regime quasi-parity of employeetorepresentation, and it seems likely thatthe codetermination has contributed the heavy orientation of theintuitively German economy toward manufacturing exports. Nevertheless, it is difficult to tease out the opportunity costs suffered by the German economy as a result of strong-form strong- form codetermination.
4.4.2.3 External constituencies Evaluating the correlation between formal law and the actual protection of non-connon-contractual constituencies is exceedingly difficult. Te interests of different stakeholders might conflict with one another, and measuring the impact of various strategies on overall social welfare is simply impossible. Moreover Moreover,, the desirability of using corporate law to protect non-contractual non-contractual constituencies hinges not only on its ability to protect stakeholders, but also on how it fares regulation other law fields law. As a result, result, any normative assessm assessment ent compared of existing with approache approaches s to corporate coby rporate in of different jurisdictions will be tentative at best. Tere is good reason to be cautious about the use of corporate law to tackle broad social problems. Sometimes such attempts simply lack teeth. When fiduciary duties are enlarged to encompass non-contractual non-contractual constituencies, they are usually unenforceable by those constituencies. Not only are there procedural constraints to enforceability (non-shareholders (non-shareholders usually lack standing to sue), but even determining what general social welfare requires at any point in time is an insurmountable task even for directors—let directors— let alone for courts. By contrast, state influence in corporate governance (by means of state ownership and, to a lesser extent, golden shares) is far more consequential. SOEs often pursue social (usually political) objectives that conflict with shareholder wealth maximization. Y Yet et the effects of state ownership owne rshipinto on overall oaccount.¹ verall social welfare welfare are dubious, dubious, especially when when regulatory alternatives are taken More recently, policymakers have hoped that institutional investors, as “universal owners” exposed to the entire market, will act as stewards of the public good.¹ Te new non-financial non-financial disclosure requirements, as well as recent reforms leading to greater shareholder empowerment in executive compensation decisions and otherwise, are at least partly premised (or at least gained further political traction based) on this assumption. However, diversified institutional shareholders usually lack both the knowledge
and the incentives necessary for such interventions. And the undiversified shareholders ¹ See e.g. World Bank, B B: E P G O (1995) (finding that state-owned state-owned factories pollute more than private facVersus Private best Ownership Ownership, tories); Andrei Shleifer Shleife r, State , 34 by J E P 133 (1998) (arguing that social goals are usually addressed government contracting and regulation). ¹ See e.g. European Commission, G P: EU C G F F (2011); http:// http://ec.europa.eu ec.europa.eu;; John Kay, K R UK E M L- L- D M: F R 74 (2012) (“institutional investors acting in the best interest of their clients should consider the environmental and social impact of companies’ companie s’ activities and associated risks among a range of factors which might impact on the performance of a company, or the wider interests of savers, in the long-term”). long-term”).
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who are more likely to be influential, such as hedge funds, are usually uninterested in promoting goals other than financial returns.¹ In fact, a study on the reputational consequences for firms found liable of financial regulation violations in the UK found that breaches of rules designed to protect third parties actually resulted in a positive stock market reaction for the companies, suggesting the shareholders like firms to push theNevertheless, boundaries.¹there seems to be a clear recent trend toward employing the legal strategies of corporate law to tackle broad social problems. Whether this is a functional response to government failures in addressing externalities, or merely window-dressing window-dressing to deflect more fundamental regulatory reforms, remains an open question.¹ Tere is, howeverr, reason to be skeptical about the ability of corporate law to significantly tackle howeve concerns which reach far beyond the agency problems that form its i ts core competency. competency.
¹ Edward B. Rock, Institutional Investors in Corporate Governance , in O H C L L G (Jeffrey N. Gordon and Wolf-Georg Wolf-Georg Ringe eds., 2016). ¹ John Armour, Colin Mayer, and Andrea Polo, Polo, Regulatory Sanctions and Reputational Damage in Financial Markets , Working Paper (2015), at ssrn.com ssrn.com.. ¹ Pargendler Pargendler,, note 82.
5 ransacti ransactions ons with Creditors John Armour Armour,, Gerard Gerard Hertig, Hertig, and Hideki Kanda Kanda
In Chapter 1, we saw that two of the core structural characteristics of the business corporation—legal poration— legal personality and limited liability—involve liability—involve partitioning pools of assets, both to and from creditors’ claims. As we explained, these facilitate contracting and investment by making certain cert ain which assets will—and will not— not—be be available to support particular claims. However, these features also bring with them potential for agency costs. Although both shareholders and creditors are interested in the corporate assets, these assets ordinarily under the shareholders’ control. Indeed, a firm’ firm’s creditors have a dual role in relation to the other participants in the enterprise. Under ordinary circumstances, most creditors are no more than contractual counterparties. However, if the firm defaults on payment obligations, its creditors become entitled to seize and sell its assets.¹ At this point, the creditors change roles: they become, in a meaningful sense, the owners of the firm’s assets.² Tis dual role means that creditors may experience different agency problems at different points in time. As contractual counterparties, they face the possibility of opportunistic behavior by the firm acting in the interests of its shareholders. Yet if the firm defaults, the problem can morph into assuring that one group of owners is not expropriated by another: that is, a creditor–creditor creditor–creditor conflict of interest. Moreover, the creditors’ contingent ownership will cast a shadow over how relations among participants in the firm are conducted, even while it is financially healthy. healthy. Consequently, every corporate law includes some provisions protecting corporate creditors. serving and to reduce agency costs, these helpforlower the cost Of of raising debtByfinance,³ of using the corporate formmeasures as a vehicle contracting. course, the general law of debtor-creditor debtor-creditor relations will apply a pply to such transactions. We We focus here on legal strategies specifically directed at creditors of corporate debtors, debtors, commonly justified as responding to particular problems stemming from the partitioning of corporate assets. Tis chapter considers the way in which the features of the corporate form give rise to such agency problems, and the legal strategies employed by our major jurisdictions to address them.
¹ See Section 5.1.2. ² See Jean irole, C F 389–95 389– 95 (2006); Patrick Bolton, Corporate Finance, Incomplete Contracts, and Corporate Control , 30 J L, E O O 164 (2014); (2014 ); On “ownership” “ownership” for these purposes, see Chapter 1.2.5. ³ StrongerKatharina creditors’Pistor, rightsand areVikrant associated increased availability: Rainer Haselmann, Vig, with How Law Affectscredit Lending , 23 Rseee.g. F S 549 (2010). Tis is especially so given effective debt enforcement: Simeon Djankov, Oliver Hart, Caralee McLiesh, and Andrei Shleifer, Debt Enforcement Around the World , 116 J P E 1105 (2008). For a review, see John Armour, Antonia Menezes, Mahesh Uttamchandani, and Kristin van Zwieten, How Do Creditor Rights Matter for Debt Finance? A Review of Empirical Evidence , in S L, E I R 1 (Frederique (Frederi que Dahan ed., 2015). Te Anatomy of Corporate Law. Tird Edition. Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry Hansmann, Gerard Hertig, Klaus Hopt, Hideki Kanda, Mariana Pargendler, Wolf-Georg Ringe, and Edward Rock. Chapter 5 © John Armour, Armour, Gerard Hertig, and Hideki Kanda, 2017. Published 2017 by Oxford University Press.
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One of the general themes of this chapter will be that the mix of legal strategies deployed to protect creditors depends on how easy it is for different suppliers of capital to coordinate. Tere has been a major shift, over the past decade or so, in the way in which large firms in many of our countries raise debt finance. Tey now raise more through markets, and less from banks. Tis has increased coordination costs for creditors, and the mix of legal strategies that functions best to ameliorate agency costs has consequently changed.
5.1 Asset Partitioning Partitioning and Agency Problems Problems 5.1.1 Asset partitioning partitioning and and corporate creditors Wee saw in Chapter 1 that the asset partitioning function of corporate law has two W aspects. First, entity shielding—a shielding—a consequence of legal personality—which personality—which ensures that the claims of corporate creditors have priority over shareholders (and their creditors) to the company’s asset pool. Tis makes credible the firm’s pledge to make its assets available for its it s creditors. Secondly, Secondly, limited liability (or “o “owner wner shielding”) shields the assets of the firm’s owners (the shareholders) from the claims of the firm’s creditors, which amongst other things facilitates diversification by shareholders. Asset partitioning also has a subtle impact on the firm firm’’s creditors. As creditors creditors’’ recourse is limited to corporate assets, lenders need only evaluate and monitor these assets, lowering their overall costs. Te limitation also facilitates specialization by creditors, because those with expertise in evaluating and monitoring assets of the type owned by the firm will—all will—all other things equal—be equal—be able to offer cheaper credit. Te cost savings from matching creditors’ monitoring capabilities with the assets to which they have recourse also provides a rationale for corporate group structures. Tat is, asset partitioning permits firms to isolate different lines of business, or types of asset, for the purpose of obtaining credit. By separately incorporating—as subsidiaries—distinct subsidiaries—distinct ventures or lines of business, the assets associated with each venture can conveniently be made available just to the creditors who deal with that venture. Tis in turn allows creditors to specialize in monitoring the asset types they understand best, even if they have little ability to monitor the assets of the group’s other ventures. For this matching of creditors to assets to work best, the creditors’ claims must be backed only by the assets of the entity to which they have lent. If the creditors can also look elsewhere for recourse, this not only increases the cost of their informationgathering, but also undermines their incentives to monitor the assets of the entity in question. Tis is illustrated by the travails of securitization. In a securitization, assets are partitioned from an originating firm by transfer to a separate entity, which raises credit by issuing securities backed by these assets only. In theory, theory, this could capture the
benefits of creditor specialization in monitoring, if the securities are issued to creditors who are knowledgeable about the assets. However, this benefit is diluted if—as if—as was common in many securitization deals prior to the financial crisis—such crisis—such creditors are offered additional rights of recourse (known as a “credit enhancement”) from the originating company and/or and/or a third party. An exception is the U.S., for which which market-based market-based debt finance has long been more significant. Creditors of the parent company are are said to be “structurally subordinated” subordinated” because their only claim to the subsidiary’ subsidiary’ss assets is i s via the parent company’s company’s shareholding. See Richard Squire, Te Case for Symmetry Symmetr y in Creditors’ Creditors’ Rights , 118 Y Y L J J 806 80 6 (2009). (2009) .
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5.1.2 Shareholder–creditor Shareholder–creditor agency problems Corporate law’s asset partitioning functions bring with them potential to exacerbate agency problems that arise between debtors and creditors. Ex ante , the entity shielding performed by corporate personality can assist shareholders in misrepresenting the value of corporate assets by falsely claiming that the firm holds title to assets that actually belong to the shareholders in their personal capacity, or to other entities. Ex post, the fact that shareholders benefit from the firm’s successes, while owner shielding protects their personal assets from the consequences of its failure, gives them incentives to engage in actions that benefit themselves at the expense of creditors. Such actions may take a variety of forms. Most basically, the shareholders may siphon assets out of the corporate pool in favor of themselves. Tis kind of action, which is sometimes referred to as “asset dilution” (or asset diversion), increases shareholders’’ personal wealth, but harms creditors by reducing the assets available to satisfy holders their claims. Second, creditors’ interests may be harmed by an increase in the riskiness—that riskiness—that is, the volatility—of volatility—of the firm’s business, in particular through “asset substitution.” Here shareholders do not take the firm’s assets for themselves, but rather sell assets used in low-risk lowrisk business activities to pay for the t he 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 if things go well, all the extra goes to them, whereas if things go badly, they lose no more than they already had at stake. Creditors, however, will be harmed by this change. It will increase the probability that the t he firm will not generate sufficient cash to repay them, with no countervailing benefit if things go well, given that creditors’ claims against the firm are fixed.¹ o o make things worse, such a substitution may be attractive to shareholders even if it reduces the overall value of the firm firm’’s assets: that is, the shareholders may prefer a larger slice of a smaller overall pie.¹¹ A third way in which shareholders shareholders may benefit at creditors’ creditors’ expense is by by increasing the firm’s firm’s overall borrowing. b orrowing. If the th e “new” “new” creditors credit ors end up sharing s haring the t he firm’s assets asset s with the “old” creditors in the event of failure, this reduces the expected recoveries of the old creditors should the firm default. Tis benefits the shareholders by enabling them, in effect, to have the benefit of finance from the old creditors on terms which, in light For a classic account, see Robert C. Clark, Te Duties of the Corporate Debtor to its Creditors , 90 H L R 505, 506–17 506–17 (1977). See Michael C. Jensen and William H. Meckling, Teory of the Firm: Managerial Behavior, Agency Costs and Ownership Ownership Structure Structure , 3 J F E 305, 334–7 334–7 (1976); Dan Galai and Ronald W. Masulis, Te Option Pricing Model and the Risk Factor of Stock , 3 J F E 53 (1976). However However,, empirical evidence regarding the significance of asset substitution (or risk-shifting) risk-shifting) is mixed: see Gregor Andrade and Steven Kaplan, How Costly is Financial (not Economic) Distress?
Evidence from Highly Leveraged ransactions that Became Distressed , 53 J F 1443 (1998); Assaf Eisdorfer, Empirical Evidence of Risk Shifting in Financially Distressed Firms , 63 J F 609 (2008); Pablo Hernández, Paul Povel, and Giogo Sertsios, Does Risk Shifting Really Happen? Results from an Experiment , Working Paper (2014). ¹ Te firm need not actually default on its debts for its creditors to be harmed: the value of their claims in the secondary market will be reduced immediately by the shareholders’ action. ¹¹ Te phenomenon of firms investing in business projects that a rational investor investor would reject as yielding too low a rate of return is sometimes referred to as “o “overinvestment. verinvestment.”” Te inverse problem— proble m— referred to as “un “underinvestment”— derinvestment”—may may also arise in situations where the firm has liabilities exceeding its assets. Such a firm may have growth opportunities that require further investments of capital, but shareholders will be unwilling to make such an investment as the resulting payoffs will accrue to, or at least be shared with, creditors: Stewart C. Myers, Determinants of Corporate Borrowing , 5 J F E 147 (1977).
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of the addition of the new creditors, now look too favorable. Tis effect is sometimes referred to as “debt dilution.”¹² dilution.”¹² Te ultimate impact on the old creditors will of course depend on what the firm does with the new funds. But because the new borrowing is subsidized (by the old lenders), the new lenders may be persuaded to fund projects that are value-decreasing, value-decreasing, and which, without such a subsidy subsidy,, they would decline to fund.¹³ Te intensity of the shareholder–creditor shareholder–creditor agency problem will be influenced by managerial risk aversion and shareholder control over firm decision-making. decision-making. Managers of widely held firms who do not have significant equity stakes of their own will share little of the “upside” payoffs received by shareholders, and may be more averse to increasing the risk of default because of harm to t o their reputations if the firm becomes financially distressed.¹ As a result, they are less likely to be tempted to take actions that benefit shareholders at the expense of creditors than are managers who are accountable to a controlling shareholder, shareholder, or who have a significant personal stake in enhancing the firm’s share price, as for example through stock options. In general, the more successful the various strategies described in Chapter 3 are in aligning managers’ interests with shareholders’,’, the stronger will be managers’ incentives to act in a way that may benefit shareholders shareholders at creditors’ expense. Control transactions can affect creditors adversely along several of these dimensionsfor at example, once—a phenomenon once—a known the as “event risk.”load, A leveraged management buyout, may jointly increase firm’s debt firm’s change the direction of its business and tightly tie managers to shareholder returns through significant personal stockholdings.¹ Shareholder–creditor Shareholder– creditor conflicts have the potential to reduce the overall value of the firm’s assets.¹ Tus both creditors and shareholders can benefit from appropriate restrictions on the ability to divert or substitute assets, because such restrictions are likely to reduce a firm’s cost of debt finance.¹ Indeed, creditors and corporate borrowers frequently agree to a range of debt covenants in addition to their basic obligations to repay principal and interest. Often these include restrictions on the firm firm’’s ability to engage in activities a ctivities that might conflict with creditors’ interests—such as payments of dividends to shareholders, significant asset transactions, or increases in borrowing.¹ Creditors may also take security interests in corporate assets, which restrict the scope
¹² See e.g. e.g. Alan Schwartz, Schwartz, A A Teory of Loan Priorities Priorities , 18 J L S 209 (1989). ¹³ A version of this conflict involves granting contingent debt obligations—such obligations— such as personal guarantees—for guarantees— for which liability is correlated with the firm’s insolvency risk. Tese reduce the assets available for other creditors precisely at the time they would be needed most. See Richard Squire, Shareholder Opportunism in a World of Risky Debt , 123 H H L R 1151 (2010). ¹ E.g. managers of U.S. firms undergoing debt restructurings frequently lose their jobs: Edith Hotchkiss, PostPost-Bankruptcy Bankruptcy Performance and Management urnover , 50 J F 21 (1995); Kenneth M. Ayotte and Edward R. Morrison, Creditor Control and Conflict in Chapter 11, 11, 1
J L A A 511 (2009). ¹ See Paul Asquith and Tierry A. Wizman, Event Risk, Covenants, and Bondholder Returns in Leveraged Buyouts , 27 J F E 195 (1990); Sudheer Chava, Dmitry Livdan, and Amiyatosh Purnanandam, Do Shareholder Rights Affect the Cost of Bank Loans? 22 22 R F S 2973 (2009) (takeover defenses, reducing event risk, associated with lower costs of credit). ¹ See e.g. Jensen Jensen and Meckling, Meckling, note 8. ¹ Clifford W. Smith, Jr. and Jerold B. Warner, On Financial Contracting: An Analysis of Bond Covenants , 7 J F E 117 (1979); Michael H. Bradley and Michael R. Roberts, Te Structure and Pricing of Corporate Debt Covenants , 5 Q J F 1 (2015). ¹ See Smith and Warner, note 17; William W. Bratton, Bond Covenants and Creditor Protection: Economics and Law, Teory and Practice, Substance and Process, Process, 7 E B O L R 39 (2006). In addition to these non- financial financial covenants, debtors
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for asset substitution by requiring the firm to obtain the consent of the creditor before the asset can be alienated free from the creditor’s interest,¹ and prevent the creditor from being diluted.² More effective protection still can be achieved by using entity shielding: putting assets supporting a loan into a subsidiary, thus “structurally subordinating” all the borrower’s other creditors.²¹ Each of these mechanisms gives the creditors a certain amount a mount of control over the debtor’s debtor’s activities.²² As creditors and firms frequently frequently expend expend resources in writing writing covenants or agreeing agreeing upon security interests, one might ask whether corporate law could reduce these transaction costs. However, as we shall see, corporate law largely abjures from regulating transactions with creditors as such. Tis general reliance on contract, rather than legal provisions, calls for explanation. Wee believe three factors are particularly salient. First, W First, there is a risk of overkill: overkill: having too many restrictions on the firm’s behavior can be as harmful as too few. Just as shareholders have incentives to steer the firm to take too much risk, creditors have incentives to encourage it to take too little .²³ .²³ Te appropriate balance is likely to vary depending on the firm’s business model,² and so leaving its determination to contract, rather than the general law, allows it to be set with greater sensitivity. Consistently with this analysis, empirical studies report that contractual protection granted by firms to their creditors can be just as effective as creditor protection conferred generally by the law.² law.² Second, creditors’ creditors’ interests in i n the firm—their firm—their time and risk horizons—are horizons—are likely to be much more heterogeneous than those of shareholders.² As a result, the provision commonly agree to a range of so-called so- called financial covenants: promises to maintain a certain level of financial health. Tese serve as “tripwires,” the violation of which gives creditors greater control through the renegotiation of debt terms: See Greg Nini, David C. Smith, and Amir Sufi, Creditor Control Rights, Corporate Governance, and Firm Value Value , 25 R F S 1713 (2012). (201 2). ¹ Clifford W. Smith, Jr. and Jerold B. Warner, Bankruptcy, Secured Debt, and Optimal Capital Structure: Comment , 34 J F 247 (1979). For overviews of the literature on secured credit, see Barry E. Adler Adler,, Secured Credit Contracts , in N P D E E L L, , Vol. Vol. 3, 405 40 5 (Peter Newman ed., 1998); 199 8); Jean irole, note 2, 164– 1 64–70, 70, 251–4; 251–4; Efraim Benmelech and Nittai K. Bergman, Collateral Pricing , 91 J F E 339 (2009). ² Dilution can also beinrestricted in theof lending agreement (with aAlan “negative “negative pledge”), but Contracts a security interest is self-enforcing self-enforcing its protection the creditor’s priority: Schwartz, Priority and Priority in Bankruptcy , 82 C L L R 1396 (1996). ²¹ See Kenneth Ayotte and Stav Gaon, Asset Asset-Backed Backed Securities: Costs and Benefits of “Bankruptcy Remoteness” , 24 R F S 1299 (2011); Douglas G. Baird and Anthony Casey, No Exit? Withdrawal Withdrawal Rights and the Law of Corporate Reorganizations , 113 C L R 1 (2013). ²² See Ronald J. Daniels and George G. riantis, Te Role of Debt in Interactive Corporate Governance , 83 C L R 1073 (1995); Douglas G. Baird and Robert K. Rasmussen, Private Debt and the Missing Lever of Corporate Governance , 154 U P L R 1209 (2006). ²³ Viral V. Acharya and Krishnamurthy V. Subramanian, Bankruptcy Codes and Innovation, Innovation, 22
R F S 4949 (2009); Greg Nini, David C. Smith, and Amir Sufi, Creditor Control Rights and Firm Investment Policy , 92 J F E 400 (2009); Viral V. V. Acharya, Yakov Yakov Amihud, and Lubimor Litov Litov, Creditor Rights and Corporate Risk-aking Risk-aking , 102 J F E 150 (2011). ² See e.g. Efraim Benmelech and Nittai K. Bergman, Vintage Capital and Creditor Protection, Protection, 99 J F F E 308 (2011). ² See Paul Brockman and Emre Unlu, Dividend Policy, Creditor Rights, and the Agency Costs of Debt , 92 J F E 276 (2009); Darius P. Miller and Natalia Reisel, Do Country-Level CountryLevel Investor Protections Affect Security-Level Security- Level Contract Design? Evidence from Foreign Bond Covenants , 25 R F S 408 (2012). ² Hideki Kanda, Debtholders and Equityholders , 21 J L S 431, 440–1, 440–1, 444–5 444–5 (1992); Marcel Kahan, Te Qualified Case Against Mandatory erms in Bonds , 89 N U L R 565, 609–10 609–10 (1995).
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of standard-form standard-form “terms” to protect creditors may be at once over-protective over-protective of some creditors and under-protective under-protective of others. And third, the appropriate content of creditor-protective creditorprotective restrictions may change over time, making it necessary to renegotiate them. Te ease of renegotiation (and hence the appropriate initial tightness of the restrictions) will depend on creditors’ coordination and information costs—largely costs—largely tracking the number and identity of the creditors. It is harder for many bondholders, for example, to renegotiate, than for a few bank lenders.² Restrictions seeking to govern relations with all of of a firm’s creditors would create significant renegotiation problems unless they are set at a very lax level at the outset—so outset—so much so, that in most cases it would not be worth doing at all.² However, in three particular instances—which instances—which we now consider—it consider—it appears that these general conditions do not hold, and consequently the benefits of corporate law responding to shareholder–creditor shareholder–creditor agency problems relations plausibly outweigh their costs.
5.1.2.1 Te vicinity of insolvency All our jurisdictions specifically deal with shareholder– shareholder–creditor creditor agency problems in relation to.” corporations are financially distressed— is, in “invalue-decreasing the vicinity of insolvency. insolvency Te incentivesthat for shareholders or distressed—that managers tothat engage valuedecreasing transactions, such as asset substitution, become particularly intense when a firm’s solvency is in doubt. Correspondingly, legal restrictions targeting corporations in financial distress are likely to have benefits. Moreover, lawmakers may view the costs as modest, because such provisions directly affect only a small subset of the firms in the economy.² A common theme in these restrictions restrictions is for the law to seek to encourage managers managers of distressed corporations—who are, by and large, well-placed to assess the firm’s firm’s financial situation—to situation—to act in the interests of creditors, rather than shareholders, and to initiate, if appropriate, a transition to informal debt restructuring or formal bankruptcy proceedings.³ In many jurisdictions, this approach is also extended to controlling shareholders, through a variety of mechanisms such as liability as de facto or shadow directors, equitable subordination shareholder in bankruptcy, “piercing the corporate veil.” Moreover Moreo ver,, thirdofparties par ties may beloans recruited as monitorsand through the operation of fraudulent conveyance laws and their equivalents. At the same time, the laws in all our jurisdictions give creditors the right to trigger bankruptcy proceedings against firms that are insolvent.
² Tus bond agreements commonly have fewer (and weaker) covenants covenants than bank lending agreements: compare Bradley and Roberts, note 17 with Robert C. Nash, Jeffry M. Netter, and Annette B. Poulsen, Determinants of Contractual Relations Between Shareholders and Bondholders: Investment
Opportunities and Restrictive Covenants , 9 J C F 201 (2003). ² John Armour, Legal Capital: An Outdated Concept ?,?, 7 E B O L R 5, 21–2 21–2 (2006). ² However, this may be a little simplistic, as the effects of such provisions will be taken into ante Michelle account in ex see decision-J.making. decision-making. Excessive financial distress dull risk-taking risktaking in, solvent firms: White, Te Costs ofsanctions CorporateinBankruptcy: A U.S.-European U.S.-may European Comparison Comparison, in C B: L E P, 467 (Jagdeep S. Bhandari and Lawrence A. Weiss Weiss eds., 1996); Acharya and Subramanian, note 23. ³ See e.g. UNCIRAL, L G I L, P F: D’ O O P A I (2013).
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5.1.2.2 Groups Corporate groups are multi-company multi-company structures under a common controller, be it the shareholders of a dominant company, coalitions of shareholders controlling it, or even its managers. Group structures make extensive use of corporate law’s asset partitioning functions within a single economic firm. As we have seen, this can be used to facilitate the allocation of credit to give creditors best placed to t o evaluate and monitor particular assets. However, groupsrisk also rise to particularly intense agency problems. Subsidiary corporations are by definition subject to a controlling shareholder, which as we have seen increases the potential for shareholder–creditor agency costs. And groups present opportunities—increasing opportunities— increasing with the complexity of their structure—for structure—for opaque transfers of assets and creation of intraintra-group group liabilities that have the t he potential to undermine creditors’ positions.³¹ Such injury could occur by design, or simply as fallout from transactions undertaken in the interests of the controlling shareholder.³² shareholder.³² For example, the entire group might gain a production, distribution, or tax advantage by shifting assets from one member to another, even though this shift makes the transferor’s debt riskier and thus injures its creditors. Tese problems are compounded by the fact that identifying corporate groups itself is sometimes difficult. “Control” over group members—a necessary prerequ prerequisite isite of groups— groups—is is hard torules agreements that create control go undisclosed; and simple rdefine;³³ ules basedvoting on a putative controller’ controller’s s voting rightsblocks can beoften misleading.³
5.1.2.3 Externalities So-called “non-adjusting” So-called “non-adjusting” creditors—those creditors—those parties who for whatever reason are owed money by a corporate entity, but are unable to adjust the terms of their exposure to reflect the risk that they bear—pose bear—pose a particular challenge.³ Most obviously, obviously, this group includes victims of corporate torts and the state in right of regulatory claims.³ In ³¹ See Simon Johnson, Johnson, Rafael La Porta, Florencio Lopez-DeLopez-De-Silanes, Silanes, and Andrei Shleifer, Shleifer,unneling unneling , 90 A E R, P P 22 (2000); Vladimir Atanasov, Bernard Black, and Conrad Ciccotello, Unbundling and Measuring unneling , 2014 U I L R 1697 (2014). Te issue of minority shareholder protection is addressed in Chapters 6 and 7. ³² See Jaap Winter et al., R H L E G C C L E E A M R F C L E (2002), 94–9; 94– 9; Richard Squire, Strategic Liability in the Corporate Group, Group, 78 U C L R 605 (2011). ³³ See e.g. Art. 22 Directive 2013/ 2013/34/ 34/EU, EU, 2013 O.J. (L 182) 19 (articulating seven different tests for “control” for the purposes of parent/subsidiary parent/subsidiary status); Art. 2(13)–(14) 2(13)–(14) Regulation (EU) 2015/ 848, 2015 O.J. (L 141) 19. ³ E.g. control of a closely held company might require 51 percent of its voting voting rights, while control of a publicly held company might only require 10–20 10– 20 percent of its voting rights.
³ For a taxonomy of such claimants, see Lucian A. Bebchuk and Jesse Jesse M. Fried, Te Uneasy Case for the Priority Priority of Secured Secured Claims in Bankruptcy Bankruptcy , 105 Y L L J 857 (1996). Even contractual creditors such as workers, consumers, and trade creditors can be incompletely adjusting due to the small size of their claims relative to the cost of adjusting. However, while trade creditors frequently terms on do not adjust theriskiness onofwhich they lend,see they nevertheless adjust and the amount of credit of extended according to the the borrower: Mitchell A. Petersen Raghuram J. Rajan, rade Credit: Teories and Evidence , 10 R F S 661, 678–9 678–9 (1997). ³ Although the state is able to adjust the intensity intensity of enforcement: see e.g. Katharina Pistor, Pistor, Who olls the Bells for Firms? ales from ransition Economies , 46 C J L L 612 (2007).
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economic terms, rights to compensation force injurers to bear the social costs of their actions, and consequently encourage them to take appropriate precautions. However However,, when limited liability shields the assets of those controlling, and profiting from, the company’s activities, tort law’s economic function is undermined.³ Tis is especially the case when shareholders undercapitalize, or shift assets out of, risky operating companies precisely in order to minimize their potential tort liability liability.³ .³ Victims of corporate torts consequently need greater protections than do other creditors of distressed companies, and many measures have been proposed to that end. For example, non-adjusting non-adjusting creditors might be given priority over other creditors in insolvency proceedings.³ Alternatively, shareholders might be held liable for excess tort liability, either on a pro rata basis in every case of tort liability l iability,, or to the full extent of damages in cases in which shareholders control risky activities directly. Yet effective protection to non-adjusting non-adjusting creditors is rare in our core jurisdictions, although Brazil perhaps goes furthest in this regard: unlimited shareholder liability through veilpiercing is the norm whenever corporate assets are insufficient to compensate the damages caused to workers, consumers, and the environment.¹ One regulatory strategy that is adopted in a number of jurisdictions—although jurisdictions—although not strictly speaking part of corporate law—is law—is to require firms pursuing hazardous activities to carry carr y a certain minimum level of insurance. For example, many European countries, Brazil, and Japan have such requirements in relation to automobile and workplace accidents or the processing of toxic waste. Tese requirements are often supplemented by legislation providing that, on the insolvency of the tortfeasor t ortfeasor,, entitlement to payment by the liability insurer is automatically transferred to the victim. However How ever,, while these requirements make it less attractive for entrepreneurs to opt for the corporate form for the purpose of opportunistically externalizing costs, they are typically not corporation-specific. corporation-specific.
5.1.3 Creditor–creditor Creditor–creditor coordination and agency problems Te entity shielding function of organizational law gives priority to the claims of a legal entity’s creditors against its assets, ahead of the claims of its owners—in owners—in the case of a company, its shareholders—and shareholders—and their creditors. o be effective, this requires the law to block owners (and their creditors) from having recourse to an entity’s assets at a time when its creditors would wish to do so. Te dividing line is insolvency: if the entity cannot pay its creditors in full from its assets, then the law must ensure shareholders receive no further payment. Te way in which this is done is, in essence, to give creditors the power to substitute themselves as owners, ousting the shareholders. Creditors have a real option to ³ See Steven Shavell, F F E A L, L, 230–2 230–2 (2004). ³ Empirical studies of firms operating in hazardous industries suggest that this occurs: see Al
H. Ringleb and Steven N. Wiggins, Liability and Large-Scale, Large-Scale, Long-erm Long-erm Hazards , 98 J P E 574 (1990). ³ David W. Leebron, Limited Liability, orts Victims, and Creditors , 91 C L R 1565 (1991). For a pro rata approach, see Henry Hansmann and Reinier Kraakman, oward Unlimited Shareholder Liability for Corporate orts , 100 Y L L J 1879 (1991); for a control approach, see Nina A. Mendelson, A ControlControl-Based Based Approach to Shareholder Liability , 102 C L R 1203 (2002). ¹ Art. 28 Consumer Protection Code (consumers); Lei 9.605 of 1998 (environment). Courts apply unlimited shareholder liability in favor of workers by analogy to consumer protection legislation. See Bruno Salama, O F R L L B (2014).
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become the owners of the firm’s assets, insofar as is necessary to repay their claims, which becomes exercisable if the firm defaults on its obligations to them.² An unpaid creditor may seek a court order enforcing its claim against the debtor’s debtor’s assets, and ordinarily it is the threat of such enforcement that gives the debtor an incentive to repay. It follows that where the firm has defaulted generally on on its credit obligations, then its creditors have the option, between them, to become owners of all its assets.³ However How ever,, the creditors will then face a coordination problem. If each acts individually to enforce, this will very quickly result in the t he break-up break-up of the firm firm’’s business. busines s. When the firm’s assets are worth more kept together than broken up, this is an inefficient outcome and creditors would collectively be better off by agreeing not to enforce, and instead to restructure the firm’s debts. Each creditor nevertheless has an incentive to enforce individually: those who do so first will get full payment, rather than a lessthan-complete thancomplete payout in a restructuring. Resolving these problems is bankruptcy law’s law’s core function. As indicated, all our jurisdictions give creditors the right to trigger bankruptcy proceedings against firms that are insolvent. Tis transforms creditors’ individual entitlements to seize or attach particular assets into entitlements to participate in a collective process. Bankruptcy law introduces a new structure for the firm that typically retains the five basic features of the corporate form described in Chapter 1, with the difference that the creditors , rather than the shareholders, are now the owners. First, the staying of creditors’ individual claims means that the firm’s assets are subject to strong-form strongform entity shielding: personal creditors of the firm’s creditors can no longer seize the corporate assets to which the firm’s creditors lay claim, so that the specific value of the assets may be retained. Second, creditors have limited liability for the firm’s post-bankruptcy post-bankruptcy debts, which facilitates continuation of the firm’s business if appropriate. Tird, creditors’ claims are usually freely transferable in bankruptcy bankruptcy,, as are those of shareholders in the solvent firm. Fourth, the bankruptcy procedure will typically specify a form of delegated management, distinct from individual creditors and with associated authority rules, usually taking the form of a “crisis manager” of some description. Fifth, this “crisis manager” is generally accountable to creditors. Reflecting the importance of the decision to continue or close down the business, jurisdictions often provide a choice of more than one bankruptcy procedure, ² See George G. riantis, Te Interplay Between Liquidation and Reorganization in Bankruptcy: Te Role of Screens, Gatekeepers, and Guillotines , 16 I R L E 101 (1996); Douglas G. Baird and Robert K. Rasmussen, Control Rights, Property Rights and the Conceptual Foundations of Corporate Reorganizations , 87 V L R 921 (2001); Robert K. Rasmussen, Secured Debts, Control Rights and Options , 25 C L R R 1935 (2004). (2004 ). ³ We assume, as can normally be observed in practice, that equity is wiped out in firms that default generally on their obligations. Tomas H. Jackson, L L B L L 7–19 7–19 (1986). Tere are a variety of definitions of insolvency, insolvency, but two criteria predominate: a debtor is insolvent when its liabilities exceed its assets asse ts (“balance- sheet test,” or “overindebtedness”); “overindebtedness”); or when w hen it is is
durably unable to pay its debts as they fall due ( cash-flow cash- flow test or commercial insolvency). Here we use the term “owners” in the functional sense articulated in Chapter 1, namely the group entitled to control the firm firm’’s assets (see Chapter 1.2.5). Te extent to which bankruptcy transferssuch Tiscontrol is an important from shareholders functional to creditors difference varies from across bankruptcy jurisdictions laws(see applicable Section 5.3.2). to individuals, which often do not provide for such effective entity shielding, at least against secured creditors. Te creditors’ liability is generally limited to the value of their pro rata share of the debtor’s assets: that is, they cannot lose more than what is left le ft of the debtor’s assets. See Victoria Ivashina, Ivashina, Benjamin Iverson, and David David C. Smith, Te Ownership and rading of Debt Claims in Chapter 11 Restructurings , 119 J F E 316 (2016); Wei Jiang, Kai Li, and Wei Wang, Wang, Hedge Funds and Chapter 11, 11, 67 J F 513 (2012).
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with different associated authority and control structures. Liquidation procedures are geared towards a sale of the firm’s assets by auction, whereas reorganization , or “rescue,” procedures seek to facilitate a renegotiation of the firm’s obligations to its creditors. Of course, creditors often would rather not have a distressed firm actually go into “formal” bankruptcy proceedings. Tis is because a firm’s bankruptcy calls its future into question, with the consequence that its suppliers and customers downgrade its commitment performance— performance—which, which, turn reduces the their valueexpectations that can be about obtained by selling thetofirm’s assets. Hence it isincommon for firms to seek, and creditors to agree to, a course of action that avoids formal bankruptcy,, but yields similar outcomes. Tis might take the bankruptcy t he form of a “workout”—a “workout”—a reorganization in the shadow of bankruptcy proceedings—if creditors are supportive of the firm’s firm’s management and business model. Alternatively, Al ternatively, it might take the form of a sale—liquidation— sale—liquidation—of of the firm’s business, “pre-packaged” “pre-packaged” before the start of formal proceedings. Inter-creditor Inter-creditor coordination and agency costs mean that the chances of achieving a workout or “pre-pack” “pre-pack” reduce with the number, and heterogeneity, of creditors involved in renegotiation,¹ making bankruptcy law’s role correspondingly more important.² While creditors have significant influence over the selection between bankruptcy procedures (for example, by agreeing to “pre-packaged” “pre-packaged” restructuring plans), few, if any,, jurisdictions permit firms to contract with their creditors to use a particular any parti cular procedure,³ and none permits firms to design their own. Tis approach can be supported on similar grounds to the availability of a number of different organizational forms for legal entities, each with mandatory features. A limited menu of such bankruptcy procedures can generate a body of judicial precedent regarding their interpretation. Tis in turn renders them more valuable to future parties, because there is greater certainty as to the court’ court’ss approach. Consequently, Consequently, at a step before that, it influences how much creditors will be willing to lend in the first place. In other words, standardization through bankruptcy law is likely to make it easier for parties to determine the background against which they are negotiating. Moreover, mandatory rules prevent
See e.g. UNCIRAL, L L G I I L L 26–31 26–31 (2004). ¹ See e.g. Stuart C. Gilson, Kose John, and Larry L.P. Lang, roubled Debt Restructurings: An Empirical Study of Private Reorganization of Firms in Default , 27 J F E 315, 354 (1990); Paul Asquith, Robert Gertner, and David Scharfstein, Anatomy of Financial Distress: An Examination of Junk-Bond Junk-Bond Issuers , 109 Q J E 625, 655 (1994); Antje Brunner and Jan Pieter Krahnan, Multiple Krahnan, Multiple Lenders and Corporate Distress: Evidence on Debt Restructuring , 75 R E S 415 (2008). ² Claims trading by activist investors can also help to concentrate concentrate debt structure and lower coordination costs: see Ivashina et al., note 49. ³ Te UK formerly permitted firms to grant a secured creditor the right to enforce against against the entirety of their assets, through a procedure known as “r “receivership. eceivership.”” Tis was, however, abolished for most firms by the Enterprise Act 2002. See John Armour and Sandra Frisby, Frisby, Rethinking Receivership, Receivership, 21 O J L S 73 (2001). (20 01).
For bankruptcy contracting contracting to work, a firm must be able to make a choice which binds all its creditors, otherwise the coordination problem is not solved: see Alan Schwartz, A Schwartz, A Contract Teory Approach to Bankruptcy , 107 Y L J 1807 (1998); Stanley D. Longhofer and Stephen Protection Whom? Creditor Conflict Bankruptcy R. Peters,249 , 6 across A L which E R (2004). for However However, , parties remain freeand to partition assets subsidiaries, permits them to tailor the scope of the pool of assets which will be subject to bankruptcy: see Baird and Casey, note 21. See Chapter 1.3.1 and 1.4.1. See Oliver Hart, F, C, F S (1995); Alan Schwartz, A Normativee Teory of Business Bankruptcy , 91 V L R 1199 (2005). Normativ
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parties from agreeing on bankruptcy procedures that benefit them at the expense of non-adjusting nonadjusting creditors. Wee now W now turn to the legal strategies deployed by our jurisdictions to respond to these problems. We We look first at the (modest) control of shareholder– shareholder–creditor creditor agency problems in firms that are solvent, and second, the (intensive) control of such problems, and also creditor–creditor creditor–creditor coordination and agency problems, in insolvent firms.
5.2 Solvent Firms o the extent that corporate law seeks to control shareholder–creditor shareholder–creditor agency problems in solvent firms, it does so through ex ante strategies: strategies: affiliation and rules. Te affiliation strategy, as we shall see, is primarily geared towards credit raised from markets, whereas the rules strategy is more appropriate for bank-based bank-based debt finance. 5.2.1 Te affiliation strategy— strategy—mandatory mandatory disclosure Creditors generally do not contract without obtaining information from the borrower about its financial performance, unless they can rely on reputation and other publicly available information. In addition, larger creditors often create exit opportunities for themselves in the form of acceleration clauses (whereby the debt becomes due and payable upon violation of contractual covenants) and/or and/or security interests (whereby payment is expedited through enforcement against particular assets). Corporate law facilitates these transactions by requiring companies to disclose certain basic information. Most obviously, obviously, all jurisdictions require that the names of corporate entities reflect their status through a suffix, such as “Inc.,” “Ltd.,” “GmbH,” “SA,” or the like. Companies are also required to file their charters in public registers, which makes available information about company name, legal capital, classes of shares, and so forth.¹ Beyond this common core of obligations, there are differences regarding mandatory disclosure to creditors—which creditors—which increasingly depend on the type of company, company, rather than the jurisdiction of incorporation. Mandatory disclosure obligations are likely to be more beneficial for creditors supplying finance by way ofinmarkets thancompanies, for bank lenders.² Banks generallytomake relatively large investments borrower and so have incentives engage in screening and monitoring of debtors. o o this end, banks typically develop sophisticated capabilities for assessing credit risk and monitoring debtor behavior. It is worthwhile for banks to invest in gathering and analyzing private information because once they have it, they can offer better priced terms than less-informed less-informed competitors. Tis is the See generally Lucian Ayre Bebchuk, and Jesse M. Fried, Te Uneasy Case for the Priority of Secured Claims in Bankruptcy , 105 Y L L J 857, 882– 882–91 91 (1996). Tis is because the very event that triggers the operation of ex post strategies strategies in this context is the firm’s lack of of solvency.
See e.g. Robert E. Scott, Te ruth about Secured Financing , 82 C L R 1436 (1997). Te Limited See Jonathan R. Macey, W W U L Q L Q 433,Liability 439–40Company: 439–40 (1995). Lessons for Corporate Law , 73 ¹ See e.g. e.g. Arts. 2– 2–33 Directive 2009/101/ 2009/101/EC, EC, 2009 O.J. (L 258) 11 (EU); Revised Model Business Corporation Act § 2.02(a) (U.S.); Art. 32, II, a Lei Lei 8.934 of 1984 (Brazil); Art. 911(3) Companies Act (Japan). ² Te question of whether disclosure needs to be mandatory, as opposed to voluntary, voluntary, is discussed in Chapter 9.1.2.
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model of “relationship lending,” lending,” under which it will be more expensive for a borrower to switch to a different lender who does not understand the risks and rewards of their business as well as the current lender. lender. Of course, financial information about debtors is useful for banks, but if its disclosure is not mandated, the bank has the incentives and the power simply to demand the information from the debtor on an ongoing basis as part of the terms of the loan. Matters are different for investors in public for two important reasons.s First, such investors typically each supply a muchmarkets, smaller proportion of the borrower’s borrower’ debt finance than would a bank. Consequently, they face higher coordination costs in gathering and analyzing information about the debtor. Second, gathering new private information might impede their ability to sell their investment in the marketplace, because of restrictions on insider trading. As a result, the affiliation strategy— channeled through mandatory disclosure—likely disclosure—likely complements public debt more than bank loan markets.
5.2.1.1 Closely held corporations Banks are the principal supplier of outside finance to small companies.³ Hence disclosure seems less obviously functional than for larger companies. While closely held corporations in all our jurisdictions are required to keep financial accounts, those in the U.S. are subject to no duty to disclose these to persons other than their shareholders. In contrast, our other jurisdictions in principle require close companies to prepare financial statements (in accordance with applicable accounting standards) and make these available for public inspection. However, the rules in these jurisdictions are often softened for smaller firms, on the basis that the fixed costs of compliance fall disproportionately upon them.
5.2.1.2 Publicly traded corporations Disclosure by publicly traded companies is extensively regulated in all our jurisdictions. Under U.S. securities law, a company issuing publicly traded securities— including bonds— bonds—must must disclose material information bearing on thefiled valuewith of the issue and the issuer’s financialallcondition in a registration statement the SEC. EU initial disclosure requirements have become increasingly similar to U.S. requireme requirements. nts. Tere has also been considerable convergence as regards financial statements. U.S. publicly traded firms must periodically file financial statements that are prepared ³ See Alicia M. Robb and David . . Robinson, Te Capital Structure Decisions of New Firms , 27 R F S 153 (2014). See William William J. Carney Carney,, Te Production of Corporate Law , 71 S C L L R 715, 761 (1998).
See Art. 2(1)(f ) Directive Directive 2009/ 2009/101/ 101/EC EC ( First Company Law Directive (Recast) ), 2009 O.J. (L 258) 11 and Accounting Directive 2013/14/ 2013/14/EU, EU, 2013 O.J. (L 182) 19 (EU); Arts. 176 and 289 LeidasSee Sociedades e.g. Art. 14 porAccounting AcAções counting (Brazil); Directive Art. 440 (EU:Companies applying a Act graduated (Japan). scale such that the very very smallest firms have the greatest permitted exemptions); Art. 440 Companies Act (Japan: obligation to disclose profit and loss accounts applicable only to large companies). See also Chapter 9. 9.1. 1.2. 2.5. 5. Secur urit itiies Act 19 19333 §§ 5–7. See Prospectus Directive 2003/71/ 2003/71/EC, EC, 2003 O.J. (L 345) 64; ransparency Directive 2004/ 109/EC, 109/ EC, 2004 O.J. (L 390) 38, both as amended by Directive 2010/73/ 2010/ 73/EU. EU.
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in accordance with U.S. GAAP. Where EU member states once imposed a congeries of different domestic accounting standards, publicly traded firms listed on EU markets have since 2005 been required to apply the International Financial Reporting Standards (“IFRS”)—which (“IFRS”)—which are closer to the Anglo- American American tradition of financial reporting—to reporting— to their consolidated financial statements.¹ Publicly traded firms in Brazil must also follow IFRS.² Japan too has undertaken disclosure and accounting reforms, which have rendered Japanese GAAP closer tofirms.³ IFRS, and the voluntary adoption of IFRS by Japanese On has the increasingly other hand, encouraged as we shall see in Chapter 9, there t here remain real differences in the intensity of enforcement of these disclosure obligations.
5.2.1.3 Groups Disclosure has particular significance in the context of corporate groups, as creditors of group companies are especially vulnerable to shareholder opportunism. Perhaps because of its significance, group accounting is an area in which convergence is highly visible. Hence, as discussed, listed groups in all of our core jurisdictions are required to prepare consolidated accounts in conformity with “equivalent” GAAP and IFRS standards. However, regulatory efforts to get all listed groups to use IFRS standards still face hurdles, especially in the U.S. In addition, real differences remain when it comes to non-listed non-listed groups. In particular, only Brazil (with respect to formal groups) and the EU (with respect to larger groups) extend the consolidation requirement to closely held groups. Moreover Moreover,, while most jurisdictions require public companies to disclose intragroup transactions, German law curiously provides creditors with less protection than one might expect given the traditional conservativeness of its accounting. In particular, apart from the limited number of companies belonging to so-called so-called “formal” contractual groups, the German Konzernrecht merely merely obligates controlled firms to provide creditors with an audited summary of of the extensive report—termed report—termed the Ab Abhängig hängigkeitsb keitsberich ericht t or “dependence” report—that report—that these companies must deliver to their supervisory board.
SeeChapter e.g. Securities Exchange Act 1934, § 13; Sarbanes-Oxley Sarbanes-Oxley Act, §§ 401, 409; Regulation S- X. X. Seealso 9.1.2.6.Exchange ¹ Regulation 1606/2002 1606/2002 on the Application of International Accounting Standards (Te “IAS Regulation”), Regulation ”), 2002 O.J. (L 243) 1. See Chapter 9.1.2.6. ² CVM Instruction No. 457 of 2010, Art. 1º. ³ See Accounting Standards Standards Board of Japan Japan and IASB, Agreement IASB, Agreement on Initiatives to Accelerate the Convergence of Accounting Standards (8 (8 August 2007); IFRS, IFRS Application Around the World— Jurisdictional Profile: Profile: Japan Japan (2014). (2014). See See Chapter 9.2. See Section 5.1.2.2. See e.g. SEC (U.S.), Work Plan for the Consolidation of Incorporating IFRS into the Financial Reporting System for U.S. Issuers , Final Staff Report (2012); SEC (U.S.), Strategic Plan: Fiscal Years 2014–18 2014– 18 , 8 (2014); European Commission, State of Play on Convergence Between IFRS and Tird Country GAAP , Staff Working Working Paper SEC(2011) 991 9 91 final. Arts. 22–3 22–3 Accounting Directive (EU); Art. 275 Lei das Sociedades por Ações (Brazil; such formal groups are however rare in Brazilian corporate practice).
So-called So-called formal groups are those listed as such in the trade register as having entered into a “control “cont rol agreement”: see §§ 291, 294 2 94 Aktiengesetz. Although the exact numbers are uncertain, only a minority of German corporate groups are thought to have opted for this formal structure: stru cture: see Volker Volker Emmerich and Mathias Habersack, K 198 (10th edn., 2013). See also Section 5.3.1.2. Compare Art. 2497–II 2497–II Civil Code (Italy), under which a controlled company must disclose the effect effe ct of the controlling entity’s entity’s dominance on its management and results. See § 312 Aktiengesetz; Uwe Hüffer Hüffer and Jens Koch, Koch, A (12th edn., 2016), § 312 para 38. See also Chapter 6.2.1.1 (disclosure requirements for related-party related- party transactions).
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5.2.1.4 Te role of gatekeepers Te quality of mandated disclosures can be enhanced through verification by trusted third parties, or “gatekeepers.” Indeed, auditors are universally employed to verify accounting disclosures, and credit bureaus have become increasingly important in aggregating and disseminating information about borrowers’ credit histories.¹ For larger borrowers, credit rating agencies (“CRAs”) have emerged as key gatekeepers, to which many of creditors’ traditional investigation functions have been delegated, especially where debt is widely dispersed through the use of bonds or securitization of bank loans.² All major jurisdictions require require publicly traded companies companies to use outside auditors to verify their financial statements. Moreover, many of our jurisdictions require professional audits for larger closely held companies.³ In screening debtor financial statements and assessing bond issuers’ default risk respectively, auditors and CRAs can in theory reduce borrowers’ cost of capital, by pledging their reputational capital. Tis aspect of gatekeeping is reinforced in all our jurisdictions by licensing requirements, requirements, the setting of operational standards and ex post liability for auditors and CRAs, which together provide a framework for dealing with gatekeeper “failure.” Auditors must ensure that a company company’’s financial statements reflect the applicable laws and accounting standards. Shareholders and creditors increasingly also rely on them to monitor for breaches of managers’ fiduciary duties. Although auditors disclaim any duties beyond verifying financial statements, they are increasingly pressed to accept a broader scope of responsibility. responsibility. Te 1990s saw a number of legislative moves to rein in auditor liability li ability, , only to be rolled back during the outcry following Enron, Parmalat, and other accounting scandals in the early 2000s. Ten again the implosion of Arthur Andersen after its EnronEnron-related related criminal investigation highlighted the dangers of tampering with auditor reputation and provided further impetus for limiting auditor liability liability. .
See Chapter 2.4.2.3. ¹ See Simeon Djankov, Djankov, Caralee McLiesh, and Andrei Andrei Shleifer, Private Credit in 129 Countries , 84 J F F E 299 (2007). ² See Arnoud W.A. W.A. Boot, odd odd . . Milbourn, and Anjolein Anjol ein Schmeits, Schmei ts, Credit Ratings as Coordination Mechanisms , 19 R F S 80 (2006). ³ See Art. 34 Accounting Directive Directive (EU); Art. 328 Companies Act (Japan); Art. 3º Lei 11.638 of 2007 (Brazil). See John Armour et al., P F R R ch. 6 (2016). See Chapter 6.2.1.1. See John C. Coffee, Jr., G: P C G, at 168 (2006); Paul L. Davies and Sarah Worthington, G D’ P M C L 847–53 847–53 (9th edn., 2012). See, for the U.S., John John C. Coffee, What Caused Enron? A Capsule Social and Economic History of the 1990s , 89 C L R 269 (2004); for Japan, Arts. 34-234- 2-22 et seq. Certified Public Accountant Act (revised, 2007); for France, Art. L. 822822-18 18 Code de commerce (three-year (three-year limitation period); for Italy Italy,, Art. 164 esto esto Unico della Finanza; for the UK, Limited Liability Partnership
Act 2000. Reinforcing See §§ 101–9 101– Sarbanes-Audit Sarbanes-Oxley OxleyinAct 2001 (U.S.); Communication COM(2003) 286, the9Statutory the EU , 2003 O.J.Commission (C 236) 2; Directive 2006/ 43/EC 2006/43/ EC on statutory audits of annual accounts and consolidated accounts, 2006 O.J. (L 157) 87. See e.g. Commission Recommendation concerning the limitation of the civil liability of statutory auditors and audit firms, fi rms, 2008 O.J. (L 162) 39 (EU); Walter Walter Doralt, Alexander Hellgardt, Klaus
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Following the Enron scandal, both the U.S. and the EU introduced requirements to safeguard the independence of auditors of publicly traded firms, including a prohibition on the provision of other, non-audit non-audit services by audit firms, and mandatory rotation of audit partners. Te EU has recently gone further by mandating rotation of publicly traded companies’ audit firms every every ten years.¹ While there is some evidence that mandatory partner rotation helps reduce the incidence of accounting restatements,² auditthefirm rotation is on difficult to implement a concentrated for auditors, given prohibitions non-audit non-audit services, in and the evidence market for its efficacy is rather more questionable.³ Similarly, the failure of CRAs to rate mortgage-based mortgage-based financial products effectively in the run-up run-up to the financial crisis has triggered increased regulatory scrutiny for these agencies. While CRAs make positive contributions to the mitigation of information asymmetry, they are also subject to conflicts of interest, int erest, because their ratings are generally paid for by the issuer. Hence, regulation introducing measures such as licensing requirements, liability for gross negligence, transparency in rating methodology, and/or and/or seeking to foster competition in the sector sect or,, has been introduced in all our jurisdictions. jurisdic tions. A particular problem for the efficacy of CRAs as gatekeepers has been the t he use, in prudential regulation applicable to institutional investors, of minimum rating requirements as a precondition for investment in an asset class. o the extent that investors use ratings simplydemand to satisfyfor regulatory conditions, opposed to relying on their information content, CRAs’ services needasnot be reduced by poor quality. o counter this problem, lawmakers around the world have sought to reduce such mandated reliance on credit ratings by institutional investors.
J. Hopt, Patrick C. Leyens, Markus Roth, and Reinhard Zimmermann, Zimmermann, Auditors Auditors’’ Liability and its Impact on the European Financial Markets , 67 C L J 62 (2008). Sarbanes-Oxley Sarbanes-Oxley Act of 2002, §§ 201, 202 2 02 (U.S.: rotation after 5 years); Arts. 22 and 42 Directive 2006/43/ 2006/ 43/EC EC on statutory audits, 2006 O.J. (L 157) 1 57) 87, as amended by Directive 2014/56/ 2014/ 56/EU, EU, 2014 O.J. (L 158) 196 (EU: rotation after 7 years). ¹ Art. 17 Regulation (EU) No 537/2014 on specific requirements regarding statutory audit of public-interest publicinterest entities, 2014 O.J. (L 158) 77. ² Henry Laurion, Alastair Lawrence, and James Ryans, U.S. Audit Partner Rotations , Working Paper,, Berkeley Haas School of Business (2015). Paper ³ See e.g. Mara Cameran, Giulia Negri, and Angela K. Pettinicchio, Pettinicchio, Te Audit Mandatory Rotation Rule: Te State of the Art , 3(2) J F P (2015). Brazil also has a 5- year audit firm rotation requirement, although no partner rotation rule: ibid. See Amir Sufi, Te Real Effect of Debt Certification: Evidence from the Introduction of Bank Loan Ratings , 22 R F S 1659 (2009). See Lawrence J. White, Markets: Te Credit Rating Agencies , 24 J E P 211 (2010); John M. Griffin and Dragon Y. ang, Did Credit Rating Agencies Make Unbiased Assumptions on CDOs?, 101 CDOs?, 101 A E R: P P 125 (2011). See Regulation (EC) No 1060/2009 1060/ 2009 on Credit Rating Agencies, 2009 O.J. (L 302) 1, as amended by Regulation (EC) No 462/2013, 462/2013, 2013 O.J. (L 146) 1 (EU); Dodd-Frank Dodd-Frank Act of 2010, §§931–939H §§931– 939H (U.S.); CVM Instruction No. 521 of 2012 201 2 (Brazil); Art. 38(iii), Arts. 66-27– 66- 27– Art. 66-49 66-49 Financial Instruments and Exchange Act (Japan) (the Japanese regulation does not impose liability on CRAs).
See Christian C. Opp, Marcus M. Opp, and Milton Harris, Rating Agencies in the Face of Regulation Regulation, , 108 J F E See e.g. SEC (U.S.), (U.S.), Report on Review of Reliance46on(2013). Credit Rating Agencies, Staff Agencies, Staff Report (2011); European Commission, EU Response to the Financial Stability Board (FSB): EU Action Plan to Reduce Reliance on Credit Rating Agency (CRA) Ratings , Directorate General Internal Market and Services Staff Working W orking Paper Paper (2014).
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5.2.2 Te rules strategy: Legal capital If mandatory disclosure helps creditors to protect themselves, then the rules strategy seeks to provide protection for them in a standardized form. Te most important rules traditionally relate to “legal capital.” Tese can apply to at least three separate aspects of corporate finance, which we consider in turn: (1) prescribing a minimum initial investment of equity capital; (2) restrictions on payments out to shareholders; and (3) triggering actions that must be taken following serious depletion of capital. As discussed,¹ the t he law’ law’ss provision of such standardized terms t erms is most functional when creditors are (relatively) homogeneous, and can coordinate (relatively) easily: in other words, when banks are the primary lenders. Tis helps to explain why this strategy has traditionally been used less in the U.S. than elsewhere, and now appears to be falling into desuetude more generally.
5.2.2.1 Minimum capital Amongst our jurisdictions, only those in Europe impose minimum equity investment thresholds for access to the corporate form (i.e. “minimum capital” rules). EU law requires public corporations to have initial legal capital of no less than €25,000, although states mayofsetour higher if they wish.¹¹ Although number is largemember by the standards otherthresholds jurisdictions, which require nothingthis at all,¹² it appears small compared to the actual capital capita l needs of businesses organized as public firms. As a consequence, the EU’s minimum capital requirement does not appear to impose a significant barrier to entry to public corporation status.¹³ Moreover, all of our core jurisdictions now permit incorporation of a private company without any minimum capital requireme requirement.¹ nt.¹ It seems unlikely that minimum capital requirements on formation provide any real protection to creditors, as a firm’s initial capital will be long gone if it ever files for bankruptcy. In addition, the reduction or abolition of minimum capital rules throughout
shares (typically In “par “par value” lowerjurisdictions, than the issue legal price), capital and is at may least bethe extended aggregate to the nominal entire(“par”) (“issue par”)price value(soof issued called “share premium”). In jurisdictions permitting “no par” shares, legal capital is initially set by a company’ss organizers at any amount up to the issue price of a company’ pany’ company’ss shares. ¹ Section 5.1.2. ¹¹ See Art. 6 Directive 2012/30/EU 2012/30/EU (“Second Company Law Directive (Recast)”), 2012 O.J. (L 315) 74 (applicable to AG, SA, SpA, plc, etc). ¹² On the U.S., see Bayless Manning and James J. Hanks, L C C (4th edn., 2013). Japan Japan abolished minimum capital requirements in its Companies Act of 2005. Similarly, Brazil imposes no minimum capital requirement. ¹³ KPMG, Feasibility Study on an Alternative to the Capital Maintenance Regime Established by the Second Company Law Directive 77/91/ 77/91/EEC EEC of 13 December 1976 and an Examination of the Impact on Profit Distribution of the New EU- Accounting Accounting Regime: Main Report (2008). (2008). In theory, capital regulation could go further and require companies to maintain a specific debt- equity ratio. Yet given that different businesses carry different risks, it is hard to see how any such general ratio could be useful. ¹ See Reiner Braun, Horst Eidenmüller, Andreas Engert, and Lars Hornuf, Does Charter
Competition Foster Entrepreneurship? A Difference-inDifference-in-Difference Difference Approach to European Company Law Reforms , 51 J C M S 399 (2013). Italy was the last of our core jurisdictions to permit incorporation without minimum initial capital, making the change in 2013: see Art. 24632463-II II Civil Code (Italy). Proposals for a European single-member single-member company form will, if implemented, make incorporation without minimum capital available across the EU: see European Commission, Proposal for a Directive on Single- Member Member Private Limited Liability Companies , 2014/ 0120 (COD).
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Europe has been associated with an increase in entrepreneurship.¹ Nevertheless, Nevertheless, most entrepreneurs entreprene urs appear to t o invest some capital capital in newly formed firms, even in the absence of minimum capital rules.¹ Tis finding is hard to interpret: it may indicate that the presence of capital is a rough-andrough-and-ready ready proxy for the “seriousness” of entrepreneurs, by showing that they commit a nonnon-trivial trivial amount of money to their project;¹ or it may simply reflect a desire to avoid potential liability for trading while insolvent.¹
5.2.2.2 Distribution restrictions Company laws generally restrict distributions to shareholders—including shareholders—including dividends and share repurchases—in repurchases—in order to prevent asset dilution.¹ Although these distribution restrictions vary across jurisdictions, the most common is on the payment of dividends which impair the company’s company’s legal capital— capital—that that is, distributions that exceed the difference between the book value of the company’s assets and the amount of its legal capital, as shown in the balance sheet.¹¹ Rules restricting distributions can be viewed as an “opt-in” “opt-in” set of standard terms. On this view, any firm that has legal capital in excess of minimum requirements does so by choice, not because of a mandatory requirement.¹¹¹ In such a situation, distribution constraints simply reinforce the credibility of the shareholders’ promise to retain capital investment the are firm.multiple From a debtor perspective, such an “opt-in” “optin” has thetheir advantage that when in there creditors, transaction costs are low compared to the repeated negotiation of a (possibly diverse) set of contractual covenants.¹¹² From a creditor perspective, however, legal capital may not be sufficient protection. Heterogeneity among creditors will result in some of them demanding covenant protections as well as “one size fits all” legal capital, thus reducing transaction cost savings.¹¹³
¹ See John Armour and Douglas J. Cumming, Bankruptcy Law and Entrepreneurship, Entrepreneurship, 10 A L L E R 303 (2008); Braun et al., note 104. ¹ See Marco Becht, Colin Coli n Mayer, and Hannes F. F. Wagner, Wagner, Where Do Firms Incorporate? Deregulation Deregulatio n and the Cost of Entry , 14 J C F 241 (2008) (after France removed minimum capital requirements for SaRL form in 2003, 86.8 percent of new firms set their initial capital below the previous minimum of €7,500, but only 4.9 percent had a minimum capital as low as €1). ¹ See John Hudson, Te Limited Liability Company: Success, Failure and Future , 161 R B S R 26 (1989); Horst Eidenmüller, Barbara Grunewald, and Ulrich Noack, Minimum Capital and the System of Legal Capital , in L C E, 1, 25–7 25– 7 (Marcus Lutter ed., 2006). ¹ See Section 5.3.1. ¹ See text to note 7. ¹¹ For an overview of a variety of dividend restriction rules, see Brian R. Cheffins, C L: , S O 534–5 534–5 (1997); Holger Fleischer, Disguised Distributions and Capital Maintenance in European Company Law , in Lutter, note 107, 94. ¹¹¹ Wolfgang Schön, Te Future of Legal Capital , 5 E B O L R 429, 438–9 438–9 (2004). However, firms have no real choice in jurisdictions where the entire share issue price is treated as capital, as in the UK, and so equity finance cannot be raised without application of distribution restrictions: see Eilís Ferran, Te Place for Creditor Protection on the Agenda for Modernisation of Company Law in the European Union, Union, 3 E C F L R 178, 196 (2006).
See Yaxuan Xi and John Wald, State Laws and Debt Covenants , 51 J L E (2008) in (firms U.S. statesagreements). with “tighter” restrictions in company have less debt179 covenants theirinborrowing But dividend see also Edward B. Rock, Adapting Rock, Adaptinglaw to the New Shareholder-Centric Shareholder-Centric Reality , 161 U P L R 1907, 1984–6 1984–6 (2012) (questioning these results by pointing out that there are no meaningful differences in dividend restrictions between states). ¹¹³ See Kanda, note note 26, 440; Kahan, note 26, 609–10. 609–10.
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Te extent to which distribution restrictions block payments to shareholders is affected by the scope of the transactions they cover. In many jurisdictions, such as Germany, the U.S., and the UK, the restriction on distributions is applied not only to transactions formally structured as dividend payments or share repurchases, but also to undervalued transactions between a company and its shareholders, which the courts may recharacterize as “disguised distributions.”¹¹ In the U.S., the efficacy of even the basic distribution restriction is undermined in many states by giving the shareholders, or in some cases the board of directors, power to reduce a company’s company’s legal capital— capi tal—and and hence the level at which the distribution restriction is set—without set—without creditor consent.¹¹ By contrast, our other jurisdictions require any reduction in legal l egal capital to be preceded by adequate protection— protect ion—for example, a third party guarantee or veto rights—for rights—for existing creditors.¹¹ Te efficacy of distribution restrictions also depends upon accounting methodology. While Whi le conserv conservativ ativee accounti accounting ng provi provides des less less inform informatio ationn about about the ongoin ongoingg value value of the firms, it is more protective of creditors’ interests than “true and fair view” accounting when it comes to reducing the discretion to pay dividends or otherwise transfer assets to shareholders from the pool that bonds the company’s debts.¹¹ Hence, the increasing reliance on “marking-to“marking-to-market” market” in U.S. GAAP may be one of the reasons for f or the declining use of profit distribution covenants by U.S. publicly traded corporations.¹¹ Tis, in turn, calls into question the continued utility of legal capital restrictions following the move to IFRS accounting by many listed European firms.¹¹
5.2.2.3 Loss of capital In some jurisdictions—particularly jurisdictions—particularly in Europe, but not in the U.S.—there U.S.—there are rules governing actions that must be taken following a serious loss of capital. EU law requires public companies to call a shareholders’ meeting to consider dissolution or other appropriate measures after a “serious loss of capital,” defined as net assets falling below half the company’s company’s legal capital.¹² Several European jurisdictions have adopted ¹¹ On the UK, see Progress Property Property Co Ltd v Moorgarth Group Ltd [2010] [2010] UKSC 55; on Germany, see Fleischer, Fleischer, note 110; on the U.S., see e.g. Rock, note 112, at 1953– 195 3–66 (Delaware). For Brazil, see Art. 177, § 1º, VI Criminal Code (distribution of “fictional” dividends is a crime). Tere is no such extension in France and Italy: see Pierre-Henri Pierre- Henri Conac, Luca Enriques, and Martin Gelter, Constraining Dominant Shareholders’ Self-Dealing: Self-Dealing: Te Legal Framework in France, Germany, and Italy , 4 E C F L L R 491 (2007). ¹¹ However However,, there is a residual constraint that dividends of such magnitude that they “diminish “diminish the company’s ability to pay its debts” will be held unlawful: in re Int’l Radiator Co., Co., 92 A R 255, 255 (Del. Cl., 1914). Moreover, fraudulent conveyance law restricts dividend payments by insolvent companies: see Section 5.3.1.3. ¹¹ See Art. 36 Second Company Law Directive (Recast) (EU); Arts. 447 and 449 Japanese Companies Act (Japan); Art. 174 Lei das Sociedades por Ações (Brazil). Tese rules are sometimes called “capital maintenance” rules in the EU and “capital unchangeability” unchangeability” rules in Japan. ¹¹ See Bernhard Pellens and Torsten Sellhorn, Creditor Protection through IFRS Reporting and Solvencyy ests Solvenc ests , in Lutter, note 107, 365; see also Schön, note 111. ¹¹ See Joy Begley and R. Freedman, Freedman, Te Changing Role of Accounting Numbers in Public Lending Agreements s , 18 A H 81 (2004); Christoph Kuhner, Te Future of Creditor Agreement Protection through Capital Maintenance Rules in European Company Law— An Law— An Economic Perspective ,
in ¹¹ Lutter, notenote 107,111, 341.200– Ferran, 200–15. 15. See also Section 5.2.1.2. ¹² See Art. 19 Second Company Law Directive (Recast). (Recast). EU law also protects creditors against capital reduction through charter amendments or share repurchases (but not against capital reduction to reflect permanent losses, shareholder opportunism then being less of an issue): ibid., Arts. 20–21, 20– 21, 36–37. 36–37.
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yet stronger rules, mandating those running the firm either to obtain fresh equity finance or stop trading when a certain level of depletion of net assets has occurred.¹²¹ In France and Italy, Italy, the company must be put into liquidation should its it s net assets fall below half its legal capital (France) or, jointly, below two-thirds two-thirds of its legal capital and the statutory minimum capital (Italy), and the shareholders fail to remedy the problem.¹²² In Germany, the company must file for insolvency when the value of its net assets falls below zero.¹²³ zero.¹²³ In theory, such rules could reinforce the credibility of legal capital as a financial cushion for creditors by acting as capital adequacy provisions similar to those governing financial institutions. Yet given low minimum capital thresholds, even the most stringent loss of capital requirements are concerned more with promoting early filing for bankruptcy than with capital adequacy.¹² o be sure, encouraging earlier liquidation or insolvency proceedings will serve to shorten the “twilight period” during which shareholder opportunism can harm creditors. Yet the costs of initiating bankruptcy proceedings too soon may be even higher. While While such costs can be avoided by a renegotiation, renegotiation, the more heterogeneous the firm’s creditors, the less likely this will be to succeed.¹²
5.3 Distressed Firms If a debtor becomes financially distressed, its assets are probably insufficient to pay all its creditors and permit them a collective exit. Under these circumstances, governance strategies move to the fore: in bankruptcy, bankruptcy, the creditors may have appointment rights as respects the firm’s “crisis manager” and generally have decision rights as respects its plan. Tese are complemented by other strategies, principally standards and trusteeship. Teir application covers two phases: first, the period of transit ransition into bankruptcy, and second the bankruptcy procedure itself.¹² Te relevant strategies deal largely—but not exclusively— exclusively—with with shareholder–creditor shareholder–creditor conflicts in the first phase and creditor–creditor creditor–creditor conflicts in the second. Te understanding that these strategies will be employed ex post necessarily necessarily influences private contracting
¹²¹ Tis is a balancebalance-sheet sheet test, not a cash-flow cash-flow test. See note 45. ¹²² See Art. L. 224-2 224-2 Code de commerce (France); Arts. 2447 and 2482–3 2482–3 Civil Code (Italy). However, Art. 182-VI 182-VI Legge Fallimentare disapplies the obligation if the company files for reorganization. ¹²³ §§ 15a and 19 Insolvenzordnung (Germany). However However,, there is an exclusion for companies which have negative net assets (“overindebtedness”), (“overindebtedness”), but for which the probability probabili ty of continued operation is otherwise “highly likely” (§ 19(2) Insolvenzordnung). ¹² See Lorenzo Stanghellini, Directors Directors’’ Duties and the Optimal iming iming of Insolvency: A Reassessment of the “Recapitalize or Liquidate Liquidate”” Rule , in I D S O. I P 731 (Paolo Benazzo, Mario Cera, and Sergio Patriarca eds., 2011). ¹² Moreover Moreover,, a “guillotine” “guillotine” rule may simply result in (some) creditors being forced to to accept less of the restructuring surplus in any renegotiation. In the out-ofout-of-court court restructuring of Ferruzzi Finanziaria in 1993, those in control of the firm (the largest creditors) were able, by virtue of the imminent need to file for bankruptcy, to make a “take it or leave it” restructuring offer that appropriated most of
the restructuring surplus atintheFinancial expense Restructuring: of other creditors: see Alessandro Penati and, Luigi Zingales, Efficiency and Distribution Te Case of the Ferruzzi Group Group, Working Paper (1997), at http:// http://faculty.chicagobooth.edu faculty.chicagobooth.edu.. ¹² Before it begins and once it is over, the bankruptcy process might also be viewed as a form of affiliation strategy, as it permits a collective exit by creditors. Yet, as it unfolds, it is unmistakably concerned with governance.
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with creditors, both at the ex ante stage stage of determining debt structure, and later in any renegotiation.
5.3.1 Te standards strategy Standards are used widely to protect corporate creditors. While the implementing provisions have various labels (examples include faute de gestion, wrongful trading, and fraudulent conveyances), each imposes a species of ex post liability according to an open-textured opentextured standard on persons associated with a distressed company. Te ex post nature of the standards strategy means that it tends t ends only to be employed if something has gone wrong in a lending relationship—that relationship—that is, where the debtor company is in financial distress. More particularly, these duties divide into three categories according to whom they target: (1) directors; (2) controlling shareholders; and (3) “favored” “favored” creditors. Precisely Precisely because they are not relevant unless the firm has failed, the application of standards is less sensitive to the coordination costs of creditors than the rules strategy.. Instead, they are, as with all instances of the standards strategy, highly sensitive strategy to the efficacy of the judicial institutions called on to apply them.
5.3.1.1 Directors In each of our jurisdictions, directors, including de facto or shadow directors, may be held personally liable for net increases in losses to creditors resulting from the board’s board’s negligence or fraud to creditors when the company is, or is nearly, insolvent.¹² Such duties can be framed and enforced with differing levels of intensity, influencing the extent to which they affect directors’ incentives. First, for the substantive content of the duty, a less onerous standard (“fraud” or “scienter ”) ”) is triggered only by actions so harmful to creditors as to call into question directors’ subjective good faith. A more intensive standard (“negligence”) (“negligence”) imposes liability l iability for negligently worsening the financial position of the insolvent company. company. Second, the intensity can be varied through the trigger for the duty’s imposition: the greater the degree of financial distress in which the company must be before the duty kicks in, the more targeted will be its effect on incentives. A third dimension over which intensity varies is enforcement. Enforcement Enforcement is likely to facilitated if thetoduties are owedwhich directly creditors, and reduced forbe duties owed only the company, willtobeindividual unlikely to be enforced unless the company enters bankruptcy proceedings.¹² Te appropriate intensity of such director liability depends on the ownership structure and/or and/or governance of the debtor firm.¹² Shareholder–creditor Shareholder–creditor agency problems are likely to be most pronounced in firms where managers’ and shareholders’ shareholders’ interests are closely aligned, that is, where ownership ownership is concentrated or incentive compensation schemes and governance arrangements effectively prompt managers to pursue shareholder interests. For larger firms with dispersed shareholders and no such mechanisms, managers have fewer incentives to pursue measures that benefit shareholders at creditors’ expense. Under the latter circumstances directorial liability based on creditors’
¹² See also Chapter 3.4.1. ¹² However However,, some jurisdictions (e.g. Delaware) Delaware) permit creditors of an insolvent company to launch a derivative action: see Quadrant Structured Products Co. Ltd. v. Vertin, Vertin , 115 A R 3d 535 (Del. Ch., 2015). ¹² See text to note note 14.
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interests may over-deter over-deter directors, resulting in less risk-taking risk-taking than would be optimal.¹³ Directorial liability may therefore be expected to be most useful where shareholders’’ and managers holders managers’’ interests are a re aligned. Among our jurisdictions, the lowestlowest-intensity intensity standard for directorial liability to creditors is employed in the U.S. Tat is consistent with its long history of both dispersed ownership and managerial autonomy autonomy.¹³¹ .¹³¹ Most U.S. states st ates employ the technique of a shift in the content of directors’ duty of loyalty in relation to insolvent firms and the duty is owed to the corporation, rather than individual creditors.¹³² Tere was flirtation in some states with a direct tortious claim against directors for “deepening insolvency”—that insolvency”— that is, marginal losses incurred by creditors as a result of directors’ failure to shut down an insolvent firm,¹³³ but this was explicitly ruled out in Delaware.¹³ In addition, if a transaction amounts to a direct or indirect breach of the residual distribution restrictions discussed in Section 5.2.2.2, this can trigger negligence-based negligence-based liability for directors who approved or oversaw it.¹³ In the UK, like in the U.S., there is a shift in the content of the duties of directors of insolvent firms, these being owed only to the company company.¹³ .¹³ Tis includes directors’ duty of care.¹³ Te UK also imposes additional negligence-based negligence- based liability on directors for “wrongful “wr ongful trading,” trading,” if they fail to take reasonable care in protecting creditors’ creditors’ interests once insolvency proceedings have become inevitable.¹³ Continental European jurisdictions deploy more intensive standards against directors, consistent with the generally more concentrated ownership structure of their large firms. In these countries, not only do directors of financially distressed firms face liability for negligence, generally based on duties mediated through the company,¹³ company,¹³ but in some jurisdictions—such jurisdictions—such as France and Italy—directors Italy—directors can potentially be held liable simply for failing to take action following serious loss of capital.¹ In Japan, duties to creditors are triggered even earlier, as creditors have standing to bring a direct action against directors for damage they suffer as a result of the directors’ gross negligence in the performance of their duties to the company, even if the company ¹³ See also Cheffins, note note 110, 537– 537–48; 48; Henry .C. Hu and Jay Lawrence Westbrook, Abolition Westbrook, Abolition of the Corporate Duty to Creditors , 107 C L L R 1321 (2007). ¹³¹ See e.g. Mark J. Roe, S M, W W O: P R R A C ¹³² NorthF American(1994). Catholic Education Programming Foundation v. Gheewalla , 930 A R 2d 92, 98–102 98–102 (Del., 2007); Quadrant Structured Products , note 128. ¹³³ See e.g. Official Committee Co mmittee of Unsecured Unsecu red Creditors v. R.F. R.F. Laffertey & Co, Co , 267 F R 3d 340 (3d. Circuit, 2001) (Pennsylvania). ¹³ renwick America Litigation rust v. Ernst & Young LLP , 906 A R 2d 168, 204–77 (Delaware Chancery 204– Chancer y, 2006). ¹³ Delaware General Corporation Law §174. Significantly, Significantly, this negligence-based negligence-based liability is not excluded by a waiver of directors’ general duty of care under §102(b)(7). ¹³ West Mercia Safetywear Ltd v. Dodd [1989] [1989] 4 B C L C 30, 33; § 172(3) Companies Act 2006 (UK); Kuwait Asia Bank EC v. National Mutual Life Nominees Ltd [1991] 1 Appeal Cases 187, 217–19. 217–19. ¹³ Roberts v Frohlich Frohlich [2011] EWHC 257 (Ch), [2011] 2 B C L C 625. ¹³ Insolvency Act 1986 §§ 214, 246ZA (UK). Tere Tere is also negligence-based negligence-based liability for directors who permit the company to pay an unlawful distribution: Bairstow v Queens Moat House plc [2001] [2001]
EWCA Civfor712. ¹³ See France, L. 225–251 225–251 Code de commerce, as well wel l as the much feared Art. L. 651-2 651- 2 Code de commerce (insuffisance (insuffisance d’actifs)—see d’actifs)—see also text to note 155; for Germany, § 43 GmbH-Gesetz, GmbH- Gesetz, §§ 93 and 116 Aktiengesetz; for Italy, Italy, Art. 2394 and 2394-II 2394-II Civil Code. ¹ On loss of capital, see Section 5.2.2.3. On liability liabili ty,, see note 151 (Germany and Italy); Art. L. 651–2 651–2 Code de commerce (France).
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is solvent.¹¹ Although this liability is rarely imposed on directors of publicly traded firms, it is frequently litigated in the case of closely held companies.¹² Te Japanese Supreme Court has also developed an oversight liability doctrine, under which nonexecutive directors are liable to creditors if they grossly fail to monitor misbehaving managers. Finally, while increased shareholder litigation during the 1990s prompted statutory limitation on director liability,¹³ liability,¹³ creditor rights were left unaffected. Brazil seems to be a special case insofar as the scope of managers’ fiduciary duties— which are always owed to the company—do company—do not formally change in the vicinity of insolvency.¹ insolvency .¹ Tis, of course, does not rule out the imposition of liability liabil ity if managers harm the company (and, consequently, consequently, its creditors) through an unlawful act or breach of fiduciary duty. Another important difference between our jurisdictions lies in the risk of public enforcement. Most have directors’ disqualification schemes that permit the state to sanction failure by directors to meet relevant standards of pro-creditor pro-creditor conduct (including breaches of accounting rules or fiduciary duties) by banning them from being involved in the management of a company.¹ Tis is a further way to increase the intensity of deterrence, especially when civil liability has limited deterrence value due to directors’ wealth constraints.¹ In the UK, for example, any possible misconduct must be investigated in corporate bankruptcy, with a view to initiating possible disqualification proceedings.¹ As a consequence, disqualification is approximately 100 times more common in the UK than is a judgment in a private suit against directors of an insolvent company.¹ Disqualification plays a more limited role in other jurisdictions, especially in the U.S., where it is only available for directors of publicly traded companies, and is not employed as a creditor protection measure. Criminal liability is also imposed on directors whose breaches of statutory duties worsen the financial position of their company. company. In the U.S., as we shall see in Chapter 9, the focus is on antifraud provisions that generally protect investors against losses resulting from negligent misrepresentation in issuer disclosures. Te scope of criminal provisions is much more specific in continental Europe and Brazil.¹ In France, directors who act opportunistically in the vicinity of insolvency face up to five years
¹¹ Art. 429 Companies Act. Although most suits under this provision provision are filed when the company is insolvent, plaintiffs benefit from not needing to prove that the company was insolvent at the relevant time. Italy also has a similar rule (Art. 2394 Civil Code), but such suits are rare. ¹² Over a hundred cases have been published in the second half of the twentieth century, century, with more than 90 percent brought by creditors. Of course, sometimes directors are not held liable. See e.g. Kochi District Court, 10 September 2014, 1452 145 2 Kinyu Shoji Hanrei 42. For the most comprehensive survey, see Kazushi Yoshihara, Commentaries to Art. 429 , in C C C A, V.9, at 337–419 337–419 (Shinsaku Iwahara ed., 2014) (in Japanese). ¹³ See Arts. 425– 425–77 Companies Act (Japan). ¹ Arts. 153 et seq. Lei das Sociedades por Ações (Brazil). (Brazil). ¹ See Art. L. 653-8 653-8 Code de commerce (France); Arts. 216–17 216– 17 and 223–24 223–24 Legge Fallimentare (Italy) (as an outcome of a finding of criminal liability, but with criminal liability extending to grossly negligent behavior); Art. 331(1)(iii) Companies Companie s Act (Japan); Company Directors Disqualification Act 1986 (UK); Securities Enforcement Remedies and Penny Stock Reform Act of 1990, 15 U.S. Code §§ 77t(e), 78u(d)(2) (U.S.); Art. 147, § 1º Lei das Sociedades por Ações (Brazil). ¹ ext to note 129. ¹ Company Directors Disqualification Act 1986, § 7. Since 2015, these proceedings can also
impose compensation orders: ibid., §§ 15A 15C. ¹ See Insolvency Service, Enforcement Outcomes April to June 2015 , able 1; John Armour, Enforcement Strategies in UK Company Law: A Roadmap and Empirical Assessment , Assessment , in R C L 71 (John Armour and Jennifer Payne eds., 2009). ¹ See Arts. 168 et seq. Lei 11.101 of 2005.
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imprisonment.¹ Germany and Italy adopt an even more inclusive approach, with directors facing criminal sanctions if they violate their duty to call a general meeting when legal capital is lost (Germany) or when they fail, if only negligently, negligently, to avoid the worsening of the financial position of the company (Italy).¹¹
5.3.1.2 Shareholders All jur jurisdi isdictio ctions ns offer doct doctrina rinall tools tools for hol holding ding shar shareho eholde lders rs liabl liablee for for the deb debts ts of of insol insol-vent corporations, although the use of these tools is generally restricted to controlling or managing shareholders who “abuse” the corporate form.¹² Te three principal tools are the doctrine of de facto or shadow directors, equitable subordination, and “piercing the corporate veil.”¹³ In addition, some jurisdictions apply enhanced standards to corporate groups. Te doctrine of de facto or shadow directors¹ involves extending the liabilities of directors to a person who acts as a member of, or exercises control over, the board, without formally having been appointed as such. For example, under French law, a controlling shareholder who directs a company’s management to violate their fiduciary duties may be required to indemnify the company for its losses (insuffisance d’actifs ).¹ ).¹ Versions of this doctrine are also applied in our other jurisdictions, apart from the U.S. and Brazil.¹ Te UK distinguishes between the case of solvent and insolvent subsidiaries: subsi diaries: a parent company will expressly not be be treated as a shadow director of a solvent subsidiary simply because it exercises control over the subsidiary’s board, but this proviso is inapplicable in respect of liabilities associated with the insolvency of the subsidiary.¹ A second form of shareholder liability involves the subordination of debt claims brought by controlling shareholders against the estates of their bankrupt companies.¹
¹ Arts. L. 654654-11 to L. 654-3 654-3 Code de commerce. ¹¹ For Germany, see § 401 Aktiengesetz and § 84 GmbH, as well as Heribert Hirte, K K 135– 135–66 (5th edn., 2006) (providing an overview of leading German cases). For Italy see Corte di Cassazione, Sez. V penale, 9 October 2014, 201 4, No. 8863 (criminal liability if failure to take action leads to, or worsens, the company’s company’s financial distress). France recently abolished criminal provisions of a similar content (former Arts. L. 241-6, 241- 6, 1° and. L. 242-29, 242- 29, 1° Code de commerce, as Brazil, repealedhowever, by Loi, No. 20122012-387 of 22isMarch 2012). ¹² In however where veil-387 piercing broadly applie d, minority shareholders are routinely applied, held liable for labor obligations. ¹³ Actions might also be brought against shareholders in many jurisdictions to challenge distridistributions by virtue of the breach of distribution rules discussed in Section 5.2.2.2 or using fraudulent conveyance or actio pauliana powers: powers: see Section 5.3.1.3. o o the extent that the liability is negligencebased, it takes on the quality of a standard, although it depends for efficacy on the underlying rules restricting distributions. ¹ In some jurisdictions, such as the UK, shadow directors are said to influence directors secretly secretly,, as distinguished from de facto directors facto directors who act openly as directors but are not (see e.g. Re Hydrodan (Corby) Ltd [1994] [1994] B B C L L C 161). We use the terms interchangeably. interchangeably. ¹ Art. L. 651-2 651-2 Code de commerce. See André Jacquemont, D E D, 605–9 605–9 (8th edn., 2013). ¹ See, for Germany, Germany, B Z Z 104, 44; for Italy, Italy, Corte di Cassazione, 14 September 1999, No. 9795, 27 G C II 167 (2000); for Japan, Art. 429 Companies Act; for the UK, §§ 250–1 250– 1 Companies Act 2006; Secretary of State for rade and Industry v. Deverell [2001] [2001] C D 340, 354–5. 354–5. ¹ Compare Companies Act 2006 (UK) (UK) §251(3); Insolvency Act 1986 (UK) §251. §251.
¹ See generally Martin Gelter and Juerg Roth, Roth, Subordination of Shareholder Loans from a Legal and Economic Perspective , 5 J I I C 40 (2007). echnically echnically,, subordination is a recharacterization of the shareholder’s claim from debt to equity, but the result is functionally similar to liability liability..
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In some jurisdictions (Germany and Brazil), major shareholders’ loans are automatically subordinated,¹ whereas in other jurisdictions (Italy and the U.S.) this depends on the circumstances or conduct of the shareholder.¹ Te rationale is to deter overinvestment in distressed firms, but such doctrines must walk a tightrope between deterring this and permitting controlling shareholders to make legitimate efforts to rescue failing firms through the injection of new debt capital.¹¹ Perhaps reflecting these difficulties, this doctrine is not applied in France or the UK.¹² Finally,circumstances; all our jurisdictions courts to “pierce the corporate veil” in extreme that is, topermit hold controlling shareholders or the controllers of corporate groups personally liable for the company’s debts. In general, courts do not set aside the corporate form easily.¹³ Te exception to this is Brazil, where veil-piercing veilpiercing is common. In no jurisdiction juri sdiction has ha s veil- piercing been directed di rected against publicly traded companies or—apart or—apart from in Brazil—passive Brazil—passive (non-controlling) (non-controlling) shareholders, and most successful cases involve fraud: that is, blatant misrepresentation or ex post opportunism opportunism by shareholders.¹ Tus, U.S. jurisdictions permit veil-piercing veilpiercing when (1) controlling shareholders disregard the integrity integrit y of their companies by failing to observe formalities, intermingling inter mingling personal and company assets, or failing to capitalize the company adequately—and adequately—and (2) there is an element of fraud or “injustice,” as when shareholders have clearly behaved opportunistically. Japan and most EU juris j urisdict dictions ions appl applyy the t he veil- pierc piercing ing doct doctrine rine simi similarl larlyy, as a s does d oes Brazil for adjusting creditors.¹ In France, for example, insolvency procedures can be extended to shareholders that disregard the integrity of their companies (action ).¹ Brazil is unique among our jurisdictions in permiten confusion de patrimoine ).¹ ting veil-piercing veil-piercing in the absence of fraud or abuse, for the benefit of certain nonadjusting creditors—notably creditors—notably workers, consumers, and victims of environmental harm.¹ ¹ See, for Germany, Germany, §§ 39 (subordination of loans by shareholder with >10 percent equity capital) and 135 (avoidance of repayments of such loans within wi thin one year of insolvency) Insolvenzordnung; Dirk A. Verse, Shareholder Loans in Corporate Insolvency— A New Approach to an Old Problem Problem,, 9 G L J 1109 (2008); for Brazil, Art. 83, VIII Lei 11.101 of 2005 (automatic subordination of shareholder loans). ¹ aylor v. Standard Gas and Electronic Corporation, Corporation , 306 U S R 307 (1939); Pepper v. Litton, LittonFor , 308 U S R 295 (1939) (U.S.: where shareholder “behaved inequitably”); Italy, Art. 2467 (close companies) and Art. 24972497-II II (within groups)hasCivil Code (where firm’s financial condition would have required an equity contribution rather than a loan). ¹¹ See Martin Gelter, Te Subordination of Shareholder Loans in Bankruptcy , 26 I R L L E 478 (2006). ¹² See, for France, France, Maurice Cozian et al., D S 152 (28th edn., 2015); for the UK, Salomon v. A. Salomon & Co Ltd [1897] [1897] A C 22. ¹³ See e.g. Prest v Petrodel Petrodel Resources Res ources Ltd [2013] [2013] UKSC 34 (UK); Stephen M. Bainbridge, Abolishing Bainbridge, Abolishing Veil Piercing , 26 J C L L 479 (2001) (20 01) (U.S.). ¹ See for the U.S.: Peter B. Oh, VeilVeil-Piercing Piercing , 89 L R 81 (2010); John H. Matheson, Why Courts Pierce: An Empirical Study of Piercing the Corporate Veil Veil , 7 B B L L J 1 (2010); for Germany: Uwe Hüffer and Jens Koch, A (12th edn., 2016), § 1 paras 15–33: 15–33: Durchgriffslehre; for the UK: Davies and Worthington, Worthington, note 86, 217–22; 217– 22; for Brazil: Meyerhof Salama, note 41. 4 1. In Japan, veil- piercing is a frequently litigated issue since its first applicaappli cation by Supreme Court Judgment 27 February 1969, 23 Minshu 511. ¹ Although German courts discuss policy considerations considerations in veil-piercing veil-piercing analyses, this has few practical implications: see Friedrich Kübler and Heinz-Dieter Heinz-Dieter Assmann, G § 23 I 2 (6th edn., 2006). For Brazil, see Art. 50 Civil Code; for Japan, see Marco Ventoruzzo et al.,
C C L 175 8 (2015). ¹ Arts. L. 621– 621–22 (sauvegarde (sauvegarde ), ), L. 631–7 631–7 (redressemen (redressementt judiciaire ) and L. 641–1 641–1 (liquidation (liquidation judiciaire ) Code de commerce (France). ¹ See note 41 and text thereto.
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Piercing the corporate veil can be seen as performing a broadly similar function to imposing liability on a shareholder as a de facto or shadow director or subordinating a shareholder’s loans. However, for the courts of some jurisdictions, “disregarding” the company’’s legal personality with regard to one party means that it must be disregarded company di sregarded for all—with all—with the result that veil-piercing veil-piercing acts as a much blunter instrument for controlling opportunism than do the other two doctrines, which by their nature may be targeted more precisely. Veil-piercing piercing doctrines aredoctrine also occasionally used toconsolidation” protect the t he creditors of corporateVeilgroups. In the U.S., the of “substantive gives bankruptcy courts the power to put assets and liabilities of two related corporations into a single pool.¹ Brazilian courts also have—and have—and very liberally employ—this employ—this power.¹ Like the French “action en confusion de patrimoine ,” ,” this is a means to respond to debtor opportunism taking the form of concealing assets in different corporate boxes, or of shunting assets around within a group. However, the doctrine makes the creditors of one corporate entity better off at the expense of those of the other and, therefore, is most appropriate where all creditors have been deceived as to the location of assets, or where the creditors that are made worse off acted collusively with the debtor.¹ debtor.¹ Veil-piercing Veilpiercing is, if anything, less common within groups of companies than it is between companies and controlling shareholders who are individuals.¹¹ Tat said, a special set of creditor protection standards covers groups of companies in some jurisKonzernrecht dictions. TetoGerman provides provides example such a law laand w, attempting balance the interests of groups the as amost wholeelaborate with those of the of creditors minority shareholders of their individual members.¹² In groups in which the parties enter into a “control agreement,” the parent must indemnify its subsidiaries for any losses that stem from acting in the group’s interests.¹³ Should this fail to happen, creditors of the subsidiary may challenge its indemnification claim or sue the parent’ss directors for damages.¹ If a controlling company has not entered into a control ent’ agreement (i.e. in a de facto group), it must compensate any subsidiaries that it causes to act contrary to those subsidiaries’ own interests.¹ Should the parent fail to do so, creditors of the subsidiary may sue the parent for damages.¹ ¹ See e.g. In Re Augie/Restivio Augie/Restivio Baking Co, Co, 860 F R 2d 506 (2d Cir. 1988). See Appropriate reatment of Corporate Groups in Insolvency , 8 E B also Irit Mevorach, O O LTe R 179 (2007). ¹ See e.g. In re Rede Energia S.A., S.A., Case No. 14-10078 14-10078 (SCC) (SCC ) (Bankr S.D.N.Y., S.D.N.Y., 2014) (unsuccessfully arguing that Brazil’s liberal use of substantive consolidation violates U.S. public policy). ¹ See Douglas G. Baird, E B B 158–66 158–66 (5th edn., 2010). ¹¹ In the U.S., Oh, note 164, at 130– 130–2, 2, and Matheson, note 164, at 58, both report that courts pierce the veil at higher rates to reach the assets of individual shareholders than those of corporate shareholders. In Brazil, labor laws formally impose joint and several liability for labor obligations on companies belonging to the same group (Art. 2º Consolidação das Leis do rabalho), rabalho), though judicial decisions have extended a similar treatment to individual controlling shareholders. ¹² See Emmerich and Habersack, note 78; for a comparative perspective, see Klaus J. Hopt, Groups of Companies: A Comparativ Comparativee Study of the Economics, Law, and Regulation of Corporate Groups , in O H C L G (Jeffrey N. Gordon and WolfGeorg Ringe eds., 2017). ¹³ See § 302 Aktiengesetz. For For the distinction between contractual and de facto groups, facto groups, see § 18 Aktiengesetz. ¹ See §§ 302 and 309 Aktiengesetz (subsidiary is an AG); Emmerich and Habersack, note 78, 566–77 (subsidiary is a GmbH). 566– ¹ See § 311 Aktiengesetz (subsidiary is an AG). Emmerich and Habersack, note 78, 535 (subsid(subsid-
iary is a GmbH). Te same approach has been adopted in Italy: see Art. 2497 Civil Code. ¹ See § 317 Aktiengesetz; B Z 149, 10 (Bremer ( Bremer Vulkan) Vulkan) and B Z Z 173, 246 (rihotel ).
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German law’s focus on protecting the interests of the individual entity contrasts with the cooperation-oriented cooperation-oriented French approach to the same issues. Under French case law, a group’s controller is not liable for instructing a subsidiary to act in the interests of the group rather than its own interests as long as the group is (1) stable, (2) pursuing a coherent business policy, and (3) distributing the group’s costs and revenues equitably among its members.¹ Te French focus on the “enterprise” has been perceived as having the advantage of reflecting a more functional approach,¹ while the indemnification requirements of Konzernrecht seem more seem protective of a given subsidiary’s creditors. However, French courts take serious consideration of creditor interests when applying the equitable cooperation doctrine,¹ whereas German courts have recently adopted a more balanced doctrine of “solvency threatening” parent intervention (Existenzvernichtungshaftung ) for closely held firms.¹ Similarly, in the UK, the greater likelihood of characterizing a parent company as a “shadow director” of an insolvent company operates to balance the interests of shareholders of solvent groups against those of creditors.¹¹
5.3.1.3 Cred Creditors itors and other third third parties Te standards strategy is also employed in a variety of guises as regards creditors and other third parties. In these applications, the focus is sometimes on recruiting third parties as gatekeepers, in others on preventing one creditor from getting a better position vis-àvis-à-vis vis the others, and in many cases, both. Te first approach targets third parties who enter into transactions with a debtor in the vicinity of insolvency that are manifestly disadvantageous to the debtor. Such third parties may find that the transaction is set aside ex post in in the debtor’s bankruptcy, and that they are required to return the benefits they received. Tese results are brought about under doctrines deriving from the actio pauliana in in continental Europe and Brazil, fraudulent conveyance in the U.S. and a nd Japan, and “undervalue transactions” transactions” in the t he UK.¹² Te standards strategy recruits third parties as gatekeepers by making them wary of desperate transactions entered into by a distressed debtor, debtor, whose shareholders may be engaging in asset substitution.¹³ Te gatekeeper will only be able to rely on the transaction if they ¹ Tis is the holding of the well-known well- known Rozenblum Rozenblum case (Cour de Cassation (Ch. Crim.) 4 February 1985, 1985 R S 648), a criminal “abus de biens sociaux” case. For a comparative law discussion see European Commission Informal Company Law Expert Group, Report on the Recognition of the Interest of the Group, Group, section 2.2 (2016). ¹ See e.g. R R G F EU C L (2011), 59–65. 59–65. ¹ See Marie-Emma Marie-Emma Boursier, Le Fait Justificatif de Groupe dans l’Abus de Biens Sociaux: Entre Efficacité et Clandestinité , 125 R S 273 (2005); (2005 ); R R G, G, note 178, at 63. ¹ See note 176; Mathias Habersack, rihotel— rihotel—Das Das Ende der Debatte ?, ?, 37 Z U- G 533 (2008); Hüffer and Koch, note 164, § 1 paras. 21–33. 21– 33. ¹¹ See note 154 and text thereto. ¹² See Arts. 130, 168, and 172, Lei 11.101 of 2005 (Brazil); (Brazil); Arts. L. 632-1 632-1 and L. 632-2 632-2 Code de commerce (France); § 129 Insolvenzordnung (Germany); Art. 64-7 64- 7 Legge Fallimentare (Italy); Uniform Fraudulent Conveyance Act and the Bankruptcy Code (11 U.S. Code) § 548 (U.S.); Art. 424 Civil Code and Art. 160 Bankruptcy Act (Japan); ( Japan); §§ 238, 241, 423– 5 Insolvency Act 1986 (UK). ¹³ See Douglas G. Baird and Tomas H. Jackson, Fraudulent Conveyance Law and Its Proper
Domain, 38 V L R 829 (1985); John Armour, ransactions at an Undervalue , in Domain, V C I 46–7 46–7 (John Armour and Howard N. Bennett eds., 2003).
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can show they were in “good faith,”¹ or more specifically, that there were reasonable grounds for believing, at the time, t ime, that it would benefit the debtor’s debtor’s business.¹ Te second type of application targets “insider” creditors who influence distressed debtors in a way harmful to other creditors. One version focuses on involvement in management decisions, whereby influential influential creditors such as banks may be made liable li able as de facto directors or, if an animus societatis can can be established, as partners of the insolvent firm. In some jurisdictions, such as the UK, liability attaches to any person knowingly carrying on aorcompany’s company’ with the intent to defraud whereas in others, like Italy the U.S.,s business there is no shortage of doctrines thatcreditors, impose liability upon lenders who deal with insolvent firms.¹ Tere is a real risk, however however,, of over-deterrence: overdeterrence: banks may be shy of entering into workout arrangements with failing companies for fear of such liability, even though courts rarely impose liability when banks merely attempt to protect their loans.¹ Another application of the standards strategy against “insider” creditors concerns so-called socalled “preferential” “preferential” transactions—resulting in a particular part icular creditor being placed in a better position than the others in the debtor’s debtor’s bankruptcy. bankruptcy. In continental Europe European an jurisdictions and Brazil, the actio pauliana may may also be used to challenge such transactions,¹ the principal requirement being that the creditor benefiting from it has acted in bad faith, fait h, which is presumed in some instances.¹ Similarly, Similarly, in Japan, the benefiting creditor must have been aware of the debtor’s insolvency.¹ In the U.S. and UK, by contrast, therealthough is no need badsome faith desire on thetopart of the creditor, the to UKdemonstrate requires thatany theknowledge debtor have haveorhad favor the creditor, creditor, and the U.S. only permits transactions to be set aside up to 90 days before bankruptcy.¹¹ Te rationale for reversing preferential transactions has, however, been questioned: to the extent such liability simply redistributes losses amongst creditors, and is costly to enforce, it may tend to reduce aggregate welfare.¹²
5.3.2 Governa Governance nce strategies
5.3.2.1 Appointment rights All our our jurisdictions jurisdictions give give creditors creditors power to initiate a change change in the control control of the assets of a financially distressed company by triggering bankruptcy proceedings. A single ¹ See § 8(a) Uniform Fraudulent ransfer Act (U.S.) (but primary transferees have no good faith defense under Bankruptcy Code, 11 U.S. Code § 548); Art. 67 Legge Fallimentare (Italy). ¹ See § 238(5) Insolvency Act Act 1986 (UK). ¹ See, for the UK, § 213 Insolvency Act Act 1986; Morris 1986; Morris v Bank of India [2005] [2005] 2 B C L C 328; for Italy, see Corte di Cassazione, 28 March 2006, No. 7029, D F II/630 II/630 (2006) (de (de facto director); facto director); for the U.S., Lynn M. LoPucki and Christopher R. Mirick, S C B P (6th edn., 2014). ¹ See for France, Cozian et al., al ., note 162, 1 62, at 161; for Germany Germany,, § 826 BGB (“Insolvenzverschleppung”); for Italy, Corte di Cassazione SU, 28 March 2006, No. 7028, 2007 D B M F 149; for the UK, see Davies and Worthington, Worthington, note 86, 232–3; 232–3; for the U.S. Baird and Rasmussen, note 22. ¹ See sources cited in note 182. ¹ See e.g. Arts. 66 and 67(1) Legge Fallimentare (Italy). See also § 135 Insolvenzordnung (Germany), discussed in note 159 (automatic avoidance of shareholder loans repaid within one year of insolvency). ¹ Bankruptcy Bankruptcy (Japan). ¹¹ Art. § 239162 Insolvency ActAct 1986 (UK); Bankruptcy Code, 11 U.S. Code § 547 (U.S. (UK); (U.S. Te “lookback” period extends to one year for insiders).
¹² Alan Schwartz, A Schwartz, A Normative Teory of Business Bankruptcy , 91 V L R 1199, 1224–31 (2005). 1224–31
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creditor can generally exercise this power by demonstrating that the debtor is insolvent in the “cash-flow” “cash-flow” sense—that sense—that is, unable to pay debts as they fall due.¹³ Te U.S., howeverr, requires that three creditors bring a petition together howeve together.¹ .¹ While most jurisdictions permit managers to commence proceedings prophylactically before their firm has actually become insolvent, the U.S. uniquely does so without imposing any requirement that the debtor be close to insolvency i nsolvency.¹ .¹ In most of our jurisdictions, a consequence of transition to bankruptcy is remov removal al of the board effective controlorof“crisis corporate assets,toand it s replacement its or supervision by, from an “administrator” manager” whom operationalwith, managers are accountable.¹ In general, creditors, rather than shareholders, have rights to appoint this person. However, the creditors’ appointment rights are often exercised subject to oversight by the court,¹ which plays a trusteeship role within our schema. In some jurisdictions this trusteeship role takes precedence, such that the court has exclusive power to select a crisis manager.¹ manager.¹ An alternative to appointing a crisis manager is to permit the incumbent managers to remain in situ.¹ Tis economizes on costs associated with getting an outsider up to speed with running the business, and capitalizes on any firm-specific firm-specific human capital the managers may possess. In this case, the trusteeship strategy—in strategy—in the form of court oversight—is sight— is relied upon even more heavily to control shareholder–creditor shareholder–creditor agency costs. “Reorganization” or “rescue” proceedings on this pattern have become more common in core jurisdictions. example, in reorganization Chapter 11 our of the U.S. BankruptcyFor Code, board members continueproceedings in office andunder maintain their powers to control the company’s assets, albeit with their fiduciary duties now owed to the creditors.² Creditors may apply to the court to appoint a trustee to take over control, or to switch the proceedings into Chapter 7—where 7—where a trustee in bankruptcy is appointed by creditors as crisis manager.²¹ manager.²¹ Japan, France, Germany Germany,, and Brazil have adopted more modest versions of the U.S. approach. In Germany, Germany, courts must allow all ow boards to remain in control of corporate assets—under assets—under the surveillance of a custodian—unless custodian—unless there is evidence that this ¹³ See Arts. L. 631631-11 Code de commerce (redressemen ( redressementt judiciaire ) and L. 640-1 640-1 and 640-5 640-5 (liqui(liquidation judiciare ) (France); § 14(1) Insolvenzordnung (Germany); Arts. 5 et seq. Legge Fallimentare (Italy); 97, IV Lei § 123(1)(e) 11.101 of Insolvency 2005 (Brazil). Act 1986 (UK); Arts. 15 and 16 Bankruptcy Act (Japan); Art. 94, I and ¹ Bankruptcy Code, 11 U.S. Code §§ 303(b)(1). ¹ See § 18 Insolvenzordnung Insolvenzordnung (Germany); Art. L. 620–1 620–1 Code de commerce (France: procédure (France: procédure de sauvegarde ); ); Art. 160 Legge Fallimentare (Italy: concordato preventivo); preventivo); Insolvency Act 1986 Sch B1 ¶¶ 22, 27(2)(a) (UK); Art. 97, IV Lei 11.101 of 2005 (Brazil); Art. 21 Civil Rehabilitation Act and Art. 17 Corporate Reorganization Act (Japan); ( Japan); compare Bankruptcy Code, 11 U.S. Code Co de § 301(a) (U.S.: voluntary petition—no petition—no requirement that debtor be financially distressed). ¹ See Arts. L. 622- 1 ( procédur ( procéduree de sauvegar sauvegarde de ), ), L. 631-9 631-9 (redressement judiciaire ) and L. 641-1 641-1 (liquidation judiciaire ) Code de commerce (France); § 56 Insolvenzordnung (Germany); Art. 21 Legge Fallimentare (Italy); Insolvency Act 1986 Schedule B1 ¶¶ 59, 61, 64 (UK); Bankruptcy Code, 11 U.S. Code § 323 (U.S.); Art. 22 Lei 11.101 of 2005 (Brazil). ¹ See § 56 Insolvenzordnung (Germany); Insolvency Act 1986 § 139 and Schedule B1 ¶ 14 (UK); Bankruptcy Code, 11 U.S. Code § 702 (U.S.). ¹ See Arts. L. 621-4 621-4 ( procédure procédure de sauvegarde ), ), L. 631-9 631-9 (redressement judiciaire ) and L. 6411 (liquidation judiciaire ) Code de commerce (France); Art. 27 Legge Fallimentare (Italy); Art. 74 Bankruptcy Act (Japan); Art. 99, IX Lei 11.101 of 2005 (Brazil). ¹ See European Commission, Recommendation of 12 March 2004 on a new approach to business failure and insolvency, C(2014) 1500 final (the “Restructuring Recommendation”), Recommendation”), ¶ 6. ² Bankruptcy Code, 11 U.S. Code § 1107 (U.S.). See note note 132 and text thereto. thereto.
²¹ Ibid., §§ 1104, 1112.
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will disadvantage creditors.²² In Japan, courts may forgo the appointment of a crisis manager if petitioned to that effect by a creditor or another interested party, whereas French courts may do so for smaller corporations.²³ Managers also retain their posts in reorganization proceedings in Brazil, unless they engage in proscribed conduct or the reorganization plan provides otherwise.² And in the UK, an administrator may elect to keep the incumbent management in post, subject to his oversight.² Italian law has moved closest to the U.S. model: when a reorganization proceeding is opened, management is not displaced unless the plan is declared not feasible or creditors reject it.² Practitioners have developed a technique whereby restructuring outcomes can be achieved with the debtor’s management in post regardless of the formal position in bankruptcy. Tis involves agreeing a prospective restructuring or sale, which is then executed through a “pre-packaged” “pre-packaged” insolvency process. Te crisis manager’s formal appointment lasts long enough only for her to execute the agreed sale on behalf b ehalf of the company. Tis saves both on the destruction of goodwill that occurs during formal proceedings and on the appointment costs of crisis managers.² Such “pre“pre-packaged” packaged” bankruptcies have long been common in the U.S. and UK,² and following recent reforms to facilitate their use, are growing in popularity in other jurisdictions as well.²
5.3.2.2 Decision rights In most jurisdictions, a proposal for “exit” from bankruptcy proceedings—whether proceedings—whether by a sale or closure of the business or a restructuring of its balance sheet—is sheet—is initiated by the crisis manager, subject to veto rights from creditors.
²² § 270 Insolvenzordnung (Germany). (Germany). If this has the unanimous unanimous support of the initial creditors’ creditors’ committee, then it is deemed to be beneficial to the creditors: ibid., § 270(3). ²³ See Arts. 38 and 64 et seq. Civil Rehabilitation Act 1999 (simple general reorganization proproceedings) and Art. 67 Corporate Reorganization Act 1952 (more formal proceedings for joint-stock joint-stock companies, amended in 2002 to introduce debtor-indebtor- in-possession possession schemes) (Japan); Arts. L. 621-4 621-4 (sauvegarde ) and L. 631-9 631-9 (redressemen ( redressementt judiciaire ) Code de commerce (France) (firms with less than 20 employees or turnover below €3,000,000: Art. R. 621-11 621- 11 Code de commerce). ² Arts. 50 IVIV-V V and 64 Lei 11.101 of 2005. ² Insolvency Act Act 1986 (UK) Sch B1, ¶¶ 5959-61. 61. preventivo) and 27 ( fallimento), fallimento), Legge Fallimentare. ² Arts. 167 (concordato preventivo) ² See John John Armour, Armour, Te Rise of the “Pre-Pack”: “Pre-Pack”: Corporate Restructuring in the UK and Proposals for Reform,, in R : D C P (Robert P. Reform Austin and Fady Fady J.G. Aoun eds., 2012), 43, 58–60. 58–60. ² See e.g. Elizabeth ashjian, ashjian, Ronald C. Lease, and John J. McConnell, An McConnell, An Empirical Analysis Analysis of Prepackaged Prepacka ged Bankruptcies , 40 J F E 135 (1996) (U.S.); Sandra Frisby Frisby,, A Preliminary Prelimina ry Analysis of Pre-Packaged Pre-Packaged Administrations (2007); (2007); Andrea Polo, Secured Creditor Control in Bankruptcy: Costs and Conflict (2012), (2012), at ssrn.com (UK). ² See e.g. § 270b Insolvenzordnung (Germany, (Germany, from 2012); Art. L. 611-7 611-7 Code de commerce, as amended by Decree No. 2014-326 2014- 326 (France). Italy allows out-ofout-of-court court pre-packs pre-packs which are binding only to consenting creditors; a majority rule applies, however, to financial creditors: Art. 182-II 182- II and 182-VII 182-VII Legge Fallimentare (Italy) (however, pre-packs pre- packs using “Chapter-11”“Chapter-11”-style style reorganizations, a broad equivalent of which had been introduced in 2005, are no longer available: Art. 163-II 163- II Legge Fallimentare, as amended in 2015). Tese developments were encouraged at EU level by the Restructuring Recommendation (noteBusiness 199), ¶Enterprise: 7. See generally Eidenmüller and Kristinonvana Zwieten, Restructuring the European Te EUHorst Commission Recommendation New Approach to Business Failur Failuree and Insolvency , 16 E B O L R 625 (2015).
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However, exceptions include However, incl ude France, Italy, Italy, and the U.S., where for debtors entering “reorganization” proceedings, the restructuring plan in the first instance is proposed by the debtor.²¹ Te leverage this grants to debtors has, however, been reduced. In France, creditors now have initiation rights concurrent with debtors or crisis managers in relation to plans for large corporations.²¹¹ Similarly, in Italy, significant creditors now also enjoy concurrent initiation rights.²¹² In the U.S., although the debtor enjoys the exclusive right to initiate a plan for the first 120 days after entry into bankruptcy,²¹³ creditors now use the debtor’s need for financing in bankruptcy as a lever to exert control over the development of the restructuring plan.²¹ Te resulting plans have consequently become more favorable to creditors over time.²¹ Deciding upon a plan for exiting bankruptcy also runs into problems of intercreditor conflicts.²¹ Creditors who are in a junior class that is “out of the money” money” will, analogously to shareholders in a financially distressed firm, tend to prefer more risky outcomes. Creditors who are in a senior class that is “oversecured”— “oversecured”—that that is, the assets are more than enough to pay them off—will off—will prefer a less risky plan. Giving either group a say in the outcome will at best add to transaction costs and at worst lead to an inappropriate decision about the firm’ firm’s future. Jurisdictions that give veto rights to creditors over the confirmation of a restructuring plan try to reduce this problem by seeking to give only those creditors who are “residual claimants” a say in the process. Hence, most jurisdictions do not allow voting by who eitherarecreditors will recover in full or, in some jurisdictions, by junior creditors “out of who the money” under the plan.²¹ Where the bankruptcy proceedings are “prepre-packaged”— packaged”—as as we have seen, an increasingly common phenomenon²¹—any phenomenon²¹—any necessary agreements to secure approval are obtained in advance—including, advance—including, where appropriate, a creditor vote. Te agreements reached must be congruent with the decision rights available in formal proceedings, otherwise parties will have an incentive to trigger formal proceedings instead.
²¹ In France France and Italy, Italy, this occurs in sauvegarde proceedings proceedings (Art. L. 626-2 626-2 Code de commerce) and in concordato preventivo (Art. preventivo (Art. 161 Legge Fallimentare), respectively. In the U.S., this occurs in Chapter 11 proceedings: Bankruptcy Code, 11 U.S. Code § 1121. ²¹¹ Any member of a creditors’ committee may submit an alternative plan to the debtor’s; to be implemented a plan must be approved by a two-thirds two-thirds majority of each committee of creditors: Arts. L. 626-30626-30-22 and 626-31 626-31 (sauvegarde ( sauvegarde ) and L. 631-19 631-19 (redressem ( redressement ent judiciaire ) Code de commerce, as amended in 2014. However, for corporations with less than 150 employees em ployees and turnover of less than €20m, the court retains discretion regarding the outcome of proceedings: Arts. L. 626-9, 626-9, L. 626-3434-1, 1, L. 631-19, 631-19, and R. 626-52 626-52 Code de commerce. ²¹² Creditors holding at least 10 percent of the debtor’ debtor’s debt may also propose a plan in concordato preventivo (Art. preventivo (Art. 163, as amended in 2015). ²¹³ Bankruptcy Code, 11 U.S. Code § 1121. Tis may be extended by the court to 180 days. ²¹ David A. Skeel, Jr., Creditors’ Ball: Te “New” New Corporate Governance in Chapter 11, 11 , 152 U P P L R 917 (2003). ²¹ See Ayotte and Morrison, note 14; Barry E. Adler, Vedran Capkun, and Lawrence A. Weiss, Value Destruction in the New Era of Chapter 11, 11, 29 J L, E O 461 (2013). ²¹ See Philippe Aghion, Oliver Hart, and John Moore, Te Economics of Bankruptcy Reform, Reform, 8 J L, L, E, O O 523 (1992). ²¹ See §§ 237 Insolvenzordnung (Germany); Arts. 127 and 177 Legge Fallimentare (Italy); Schedule ¶ 52 Insolvency ActL.1986 Bankruptcy Code,(France) 11 U.S.(vote Codeof§§ 1126(f )–(g) (g) Compare B1 Arts. L. 626-3062630-22 and 626-(UK); 626-32 32 Code de commerce all1126(f)– creditors not(U.S.). being paid in full, but subject to court decision); Art. 45, § 3º Lei 11.101 of 2005 (Brazil). ²¹ See Section 5.3.2.1.
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5.3.2.3 Incentive strategies Te trusteeship strategy arguably plays a more important role in our jurisdictions for creditor than for shareholder protection purposes, whereas the converse is true for the rewards strategy. Tere seem to be two reasons for this. Te first reflects basic differences in the payoffs to creditors and shareholders. Te rewards strategy, which incentivizes agents to act in principals’ interests by sharing the payoffs, cannot function so effectively in relation to agents acting for creditors, for the creditors’ maximum payoffs are fixedofby their contracts.²¹ Instead, creditors are more about the possibility losses— losses—hence hence a reward strategy, which relies uponconcerned offering participation in upsides, does not seem an obvious fit.²² Te second reason stems from the problems of inter-creditor inter-creditor agency costs that arise once a firm moves under the control of its creditors. Because the value of a firm firm’’s assets is uncertain and a nd creditors are often grouped in differing classes of priority, it is unlikely to be clear to which group any reward should be offered and how it should be calibrated. Tere are two principal types of trusteeship in relation to bankrupt firms. Te first is the “crisis manager” who runs or oversees a bankrupt firm. Indeed, in many procedures this person is known as a “trustee in bankruptcy” to capture the idea that they have custody of the corporate assets not for their own financial gain, but for the benefit of the various claimants interested therein.²²¹ Te second significant trusteeship role in the governance of bankrupt firms is the oversight role ofofcourts. Courts’ is principally to actTe as arbiters between the the many different classes claimant in an role insolvency proceeding. more fundamental potential conflict, the greater the role for court oversight qua trustee. trustee. France still relies perhaps most heavily on courts, entrusting entrusti ng them with the ultimate decision regarding the future deployment of the firm’s assets, although their power has been reduced considerably in recent years, especially for large firms.²²² Courts in our other jurisdictions—and jurisdictions—and in France for large firms—are firms—are not primarily responsible for making the t he decision how to exit formal proceedings.²²³ Rather, they confirm significant decisions and resolve questions and disputes arising between different classes of claimant. Tey also oversee decisions to sell assets.²²
²¹ Compensation structures may, however, mitigate the asset substitution problem. See James Brander and Michel Poitevin, Poitevin, Managerial Managerial Compensation and and the Agency Problem Problem,, 13 M Management Compensation and D E 55 (1992); Kose John and eresa John, op- Management Capital Structure , 48 J F 949 (1993). ²² However, to the extent that rewards take the form of claims against their firms for pension entitlements, the rewards strategy aligns managers’ interests with creditors: see Alex Edmans and Qi Liu, Inside Debt , 15 R F 75 (2011); Chenyang Wei and David Yermack, Investor Reactions to CEOs’ Inside Debt Incentives , 24 R F S 3813 (2011). ²²¹ On the analogy of a “t “trust,” rust,” see see Ayers Ayerstt v C&K Constr Construction uction Ltd [1976] [1976] A C 167, 176–80. 176–80. ²²² See note 211 and text thereto. ²²³ See e.g. for Germany, Germany, § 248 Insolvenzordnung (confirmation of plan); for Japan, Patrick Patrick Shea and Kaori Miyake, InsolvencyInsolvency-Related Related Reorganization Procedures in Japan: Te Four Cornerstones , 14 U C L A P B L R 243 (1996) (applicable to Chapter 11-type 11-type procedures only); for the UK, Insolvency Act 1986 Schedule B1 ¶¶ 63, 68 (administrator may apply to court for directions), 70–3 70– 3 (court to authorize sale of assets subject to security), 76–99 (extension or termination of administration proceedings); for Italy, 76– Italy, Art. 180 Legge Fallimentare (confirmation of plan); for the U.S. Bankruptcy Code, 11 U.S. Code §§ 1129 (confirmation of plan) and 1104 (appointment of trustee or examiner where requested); for Brazil, Art. 58 Lei 11.101 of 2005 of plan the lack of approval by all class of creditors). ²² (judicial See e.g. confirmation Bankruptcy Code, 11despite U.S. Code § 363(b) (U.S.) (court approval for sale of assets other than in the ordinary course of business); Insolvency Act 1986 Sch B1, ¶ 60A (UK: power to require court approval for sale of assets to connected party).
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While cou While courts rts lack the hig highh-powered powered financial incentives of market participants, which may make their valuation analyses less incisive, their lack of financial interest also means that their actions are less likely to be motivated by strategic considerations. Consistently with this, there is some evidence that bankruptcy procedures controlled by courts achieve no worse returns for creditors, on average, than do decisions made by market participants.²²
5.4 Ownership Regimes Regimes and Creditor Creditor Pro Protection tection Corporate law in every jurisdiction supplements debtor-creditor law in facilitating facilit ating transactions between corporations and their creditors. All our jurisdictions, moreover, moreover, have adopted the same set of broad legal strategies: regulatory strategies in relation to firms not in default (mandatory disclosure, with some rule-based rule-based controls, and a range of standards applied to firms that are in financial difficulties), coupled with governance strategies for firms that are in default. However, this similarity at the framework level masks variation at a more micro level. One way of characterizing these t hese variations is to describe countries’ legal regimes as being “debtor-friendly” “debtor-friendly” or “creditor-friendly,” “creditor-friendly,” according to the extent to which they facilitate or restrict creditor enforcement against a financially distressed debtor.²² Tus, the U.S., and to a lesser extent, Japanese, approaches are said to be debtorfriendly; the UK and, to a lesser extent, German approaches are said to be creditorfriendly. However, the existence of different classes of creditors suggests that a binary division into pro-creditor pro-creditor pro-debtor pro-debtor may be too simplistic. For example, is the presence of an automatic stay of secured creditors’ claims in bankruptcy proceedings “creditor friendly”? Te answer likely depends on whether the “creditor” is secured or unsecured. While some have sought to attribute differences in creditor protection to the civil law or common law origins of a jurisdiction,²² this account is called into question not only by the framework similarities across jurisdictions jurisdictions that we document in this chapter, but also the considerable micro-level micro-level variation in creditor rights within the civil and common law families.²² As indicated in Chapter 1, legal strategies appear to be significantly significantly related to ownership structures, although perhaps less directly in relation to creditor rights than when it comes to the t he basic governance structure. Some systems’ systems’ concentration of debt finance inrights, the hands banks those has both distributional consequences for creditor whichofmirror we efficiency have seenand vis-à-vis vis-àvis share ownership structure in Chapters 3 and 4. Concentrated debt claims lower creditors’ coordination costs, ²² See Edward R. Morrison, Bankruptcy Decision Making: An Empirical Study of Continuation Bias in Small-Business Small-Business Bankruptcies , 50 J L E 381 (2007); Régis Blazy, Bertrand Chopard, Agnès Fimayer, and Jean-Daniel Jean- Daniel Guigou, Employment Preservation vs. Creditors’ Repayment Under Bankruptcy Law: Te French Dilemma? 31 I R L E 126 (2011). ²² See e.g. Julian R. Franks, Kjell G. Nyborg, and Walter Walter N. orous, orous, A A Comparison of U.S., UK, and German Insolvency Codes , 25 F M 86 (1996); Sefa Franken, Creditor- and Debtor-Oriented DebtorOriented Corporate Bankruptcy Regimes Revisited , 5 E B O L R 645 (2004). ²² See Djankov Djankov et al., Private Credit , note 81. Formation Institutions for Bankruptcy: A Comparative Legislative ²² See Erik Berglöf, Howard Rosenthal,Study and of ErnstLudwigHistory von Tadden, , Working WorkingTe Paper (2001),ofatLegal vwl. uni-mannheim.de; unimannheim.de; John Armour, Armour, Simon Deakin, Priya Lele, and Mathias Siems, How Do Legal Rules Evolve? Evidence from a Cross-Country Cross-Country Comparison of Shareholder, Creditor and Worker Protection, Protection, 57 A J C C L L 579, 612–5 612–5 (2009).
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permitting more effective use of control rights as a means of controlling shareholder– creditor agency costs. At the same time, the aggregate financial interest of banks allows them to influence politics as much as any other constituencies, including shareholders or managers in borrower firms.²² Banks’ interest group activism, however, is likely to vary with the nature of the financial system as well as with the structure of share ownership.
5.4.1 Regulatory or contractual controls controls for solvent firms? firms? As regards solvent firms, Germany and Italy have traditionally gone furthest amongst our jurisdictions in providing standard terms to facilitate contracting with creditors— in the form of creditor-oriented creditor-oriented accounting principles and legal capital rules. Te U.S. has taken the opposite approach, having adopted market-oriented market-oriented disclosure requirements requireme nts and abstained from imposing capital constraints. Our other jurisdictions lie somewhere in between, with France being closer to Germany and the UK closer to the U.S. Te traditional approach of German—and German—and to a lesser extent, Italian—law Italian—law complements a typical capital structure in which firms’ debt finance is largely raised from banks. If debt is “concentrated”—both “concentrated”—both at the firm and country level—in level—in the hands of these institutions, this makes creditor coordination coordination relatively straightforward. In turn, this facilitates both monitoring and—where and—where necessary—renegotiation. necessary—renegotiation. Under these circumstances, the drawbacks of standard terms are minimized,²³ but their potential benefits remain. More generally, because concentrated debt facilitates creditors’ response to shareholder–creditor shareholder–creditor agency costs, it complements concentrated share ownership,, which otherwise tends to increase these costs.²³¹ ownership In the U.S., by contrast, banking ba nking concentration was restricted and share ownership was traditionally widely dispersed.²³² In such a regime, corporate debt tended to be more dispersed, increasing creditor heterogeneity and coordination coordination costs, and reducing the advantages of one-sizeone-size-fitsfits-all all standard terms. Consequently, Consequently, creditors derived few benefits from firms’ adherence adherence to such provisions, but debtors still bore their t heir costs. Tis complemented a relative absence of such mandatory standard terms. France and Brazil, like Germany, have concentrated share ownership, although the importance of the state as both equity and debt holder (through state-owned state-owned banks) allows for a more relaxed approach to the mandating of standard terms. While the UK and Japan, like the t he U.S., have relatively dispersed share ownership ownership,, their banking sectors have traditionally been far more concentrated.²³³ Associated with this, lending for UK and Japanese firms has tended, until recently, to be more bank-oriented. bank-oriented. Tis has been associated with a greater use of mandatory standard terms than in the U.S.
²² See Luca Enriques and Jonathan R. Macey, Macey, Creditors Versus Capital Formation: Te Case Against the European Legal Capital Rules , 86 C L R 1165, 1202–3 1202–3 (2001); see also Bruce G. Carruthers and erence C. Halliday, R B: M C B L L E U S S (1998). ²³ Discussed in text to notes 23–8. ²³¹ See John Armour, Armour, Brian R. Cheffins, and David A. Skeel, Corporate Ownership Structure and the Evolution of Bankruptcy Law: Lessons from the United Kingdom, Kingdom, 55 V L R 1699 (2002); Jan Mahrt-Smith, Mahrt-Smith, Te Interaction of Capital Structure and Ownership Structure , 78 J B 787 (2005). ²³² Roe, note note 131, at 54–9. 54–9. ²³³ See e.g. Brian R. Cheffins, C O C: B B (2008).
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However, as we saw in Chapters 1 and 3, patterns of share ownership are shifting in many jurisdictions. Te gradual fragmentation of share ownership in large German companies—because companies—because it increases shareholders’ coordination costs—will costs—will tend to reduce concerns about shareholder–creditor shareholder–creditor agency costs. By the same token, however, the concentration of U.S. stock ownership in the hands of increasingly activist institutional investors clearly has the propensity to increase shareholder–creditor shareholder–creditor agency costs.²³ Yet Y et on the analysis above, the implications of changes in share ownership for corporate law’s law’s protection of creditors depends on the structure st ructure of debt finance. In much of Europe, there has been a growth in secondary markets for debt finance, which has fragmented the ultimate holders of debt finance for public companies, even if many of the loans are still originated by banks.²³ Indeed, the change in debt finance has been at least as significant as the changes in share ownership.²³ Tis shift appears to have been accelerated by the aftermath of the financial crisis, which saw tightening of capital controls—and controls—and consequent reduction in credit supply— supply—at at many banks.²³ As a response to this reduction, the European Commission is launching a battery of policy proposals, known as the “Capital Markets Union,” Union,” designed to deepen capital market finance for both debt and equity.²³ Increased creditor heterogeneity and coordination costs make the standard “creditor terms” less useful, and more likely to cause hindrance. Tus, it seems broadly functional that strongly pro-creditor pro-creditor European measures such as minimum capital, historic cost accounting, and vigorous pro-creditor pro-creditor duties for directors should have been slightly relaxed in recent years. However, the inverse development—that development—that is, growth of bank financing at the expense of debt markets—has markets—has not occurred in the U.S. As a consequence, while more concentrated shareholders may increase shareholder– sha reholder–creditor creditor agency costs, the ability abilit y of creditors to coordinate coordinat e so as to make effective effecti ve use of “creditor terms” still remains low. Tis makes it less obviously functional for U.S. law to increase the supply of creditor terms in response to the greater potential shareholder opportunism.
5.4.2 Te role of bankruptcy law If firms have few creditors, then corporate bankruptcy law need only perform the role of liquidating failed firms: firms that have businesses worth saving can be restructured by a private However, as theand dispersion of creditors increases, so does the difficulty of “workout.”²³ achieving a private solution, it becomes increasingly valuable to have
²³ Rock, note 112. ²³ See e.g. Deutsche Bank, Bank, Corporate Bond Issuance in Europe: Where Do We Stand and Where Are We Heading? Headi ng? 31 31 January 2013. ²³ Te majority of large European firms are still not widely held: see Julian Julian Franks, Colin Mayer, Mayer, Paolo Volpin, and Hannes Wagner, Te Life Cycle of Family Ownership: International Evidence , 25 R F S 1675, 1689 (2012) (37 percent of largest 1,000 firms in each of France, Germany, Germany, and Italy widely held; 74 percent in the UK). ²³ See e.g. Fiorella Fiorella De Fiore Fiore and Harald Uhlig, Corporate Debt Structure and the Financial Crisis , ECB Working Paper No 1759 (2015). ²³ European Commission, Action Plan Plan on Building a Capital Market Market Union, COM(2015) 468 final (2015). ²³ In such a milieu, the absence of any governance governance strategies in bankruptcy law geared geared towards the continuation—as continuation—as opposed to the closure—of closure—of a distressed firm can actually serve to increase the chances of a successful workout. Te knowledge that the consequences of failing to agree will be highly destructive can focus creditors’ minds.
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the option of a bankruptcy procedure that uses governance strategies to help creditors take ownership of a firm that continues to operate.² As we have seen, Chapter 11 of the U.S. Bankruptcy Code gives managers of distressed companies discretion to orchestrate a court-supervised court-supervised turnaround while remaining at the helm. At the same time, large U.S. firms traditionally raised debt finance from a wider number of creditors—relying creditors—relying more on bonds and less on bank debt—than debt— than was the case in other jurisdictions.²¹ Tis corresponded with an environment in which banks were fragmented, and consequently posed no real opposition to the passage of the “manager-friendly “manager-friendly”” bankruptcy code in 1978.²² Te UK is at the opposite pole. It has traditionally been very favorable to the enforcement of individual creditors’ security with almost no judicial involvement, so much so that until recently a bank holding a security interest covering the entirety of the debtor’s assets was permitted to control privately the realization of the assets of the distressed firm.²³ Tis has corresponded to a strong, concentrated, banking sector, with relatively low use of bonds, as opposed to bank, finance.² As a consequence, private workouts play a significant role even for large public firms, with the threat of “tough” bankruptcy proceedings acting as a powerful mechanism for securing compliance from recalcitrant debtors ex ante and and creditors unwilling to negotiate ex post . Bankruptcy has, in this environment, tended to be reserved for more severe failures—an failures— an outcome reflecting the interests of both the debtor’s debtor’s institutional owners and its banks.² Germany, Italy, and Japan also follow a similar pattern. In France, bankruptcy proceedings have tended to be used more frequently, corresponding not with greater bank power power,, but with greater state involvement. However, these cross-country cross-country differences in debt structure appear less significant today in light of the growth in secondary markets for debt finance, which has facilitated disintermediation in European jurisdictions, and concentration—typically concentration—typically led by hedge funds—in funds—in the debt of distressed U.S. firms. As a result, differences in the structure of bankruptcy laws may increasingly come to be explicable by reference to differences in the functioning of judicial institutions, which limit the extent to which court oversight can effectively implement the trusteeship strategy to control creditor– creditor agency costs in bankruptcy.² bankruptcy.² Cross-Country Country Variations in ² See Viral V. Acharya, Rangarajan K. Sundaram, and Kose John, CrossCapital Structures: Te Corbett Role of Bankruptcy Codes , 20 J F I (2011). ²¹ See e.g. Jenny and im Jenkinson, Jen kinson, How is Investment Financed? A Study of25 Germany, Japan,, the United Kingdom and the United States , 65 (Suppl.) M S 69, 74–5, Japan 74–5, 80–1, 80– 1, 85 (1997); William R. Emmons and Frank A. Schmid, Corporate Governance and Corporate Performance , in C G G 59, 78 (Stephen S. Cohen and Gavin Boyd eds., 1998) (“Simply put, firms in the United States and Canada issue significant amounts of bonds but nowhere else in the G7 countries is this true”). ²² See Roe, note 131; on banks’ weak opposition to the 1978 Act, see Carruthers and Halliday, Halliday, note 229, at 166–94; 166–94; David A. Skeel, Jr., D’ D 180–3 180– 3 (2001). ²³ See Armour and Frisby Frisby,, note 53. ² See Peter Peter Brierley and Gertjan Vleighe, Corporate Workouts, Workouts, the London Approach and Financial Stability , 7 F S R 168, 175 (1999). ² See Stijn Claessens and Leora F. Klapper, Bankruptcy Around the World: Explanations of Its Relative Use , 7 A L E R 253, 262 (2005) (U.S. bankruptcy rate—proportion rate— proportion of firms filing for bankruptcy proceedings—was proceedings—was higher than all our other jurisdictions: U.S. 3.65 percent, France 2.62 percent, UK 1.65 percent, Germany 1.03 percent, Italy 0.54 Japan 0.22 percent). ²percent, See e.g.and Mehn Mehnaz az Safavian and Siddharth Sharma, When Do Creditor Rights Work? , 35 J C C E 484, 500– 500–2, 2, 506–7 506–7 (2007); Kenneth Ayotte and Hayong Yun, Yun, Matching Matching Bankruptcy Laws to Legal Environments , 25 J L L, , E O 2 (2009); Mark J. Roe and Federico Cenzi Venezze, A Capital Market, Corporate Law Approach to Creditor Conduct , 112 M L L R 59 (2013).
6 Related-PPar Relatedarty ty ran ransact sactions ions Luca Enriques, Gerard Hertig, Hideki Kanda, and Mariana Pargendler In Chapters 3 and 4, we reviewed the response of company law to agency problems in the context of the ordinary management of the corporation. Chapter 5 has shown that all jurisdictions have adopted legal strategies targeting transactions that siphon off assets to the detriment of creditors. Value diversion is, of course, also a core issue in the relationship between managers and shareholders and between controlling and non-controlling noncontrolling shareholders. Tis chapter centers upon a straightforward technique for value diversion: relatedparty transactions. As we use the term, these include both transactions in which related parties such as directors and controlling shareholders deal with the corporation— traditional self-dealing self-dealing and managerial compensation—and compensation—and transactions in which related parties may appropriate value belonging to the corporation—the corporation—the taking of corporate opportunities and trading in the company’s company’s shares.¹ In traditional self-dealing, self-dealing, the law’s concern is that an influential manager or a controlling shareholder will transact with the company on terms less favorable for the company than could be obtained in an arm’s length negotiation. negotia tion. Self-dealing Self-dealing typically refers to purchases or sales of assets, goods, or services by related parties, as when a controlling shareholder supplies components to the controlled company. But it also refers to other transactions, such as company guarantees in favor of its parent and transactions with close relatives of managers or with companies owned by their families. In such cases, the conflicts of interest are acute. Compensation agreements, while technically a form of self-dealing, self-dealing, are unavoidable for companies and thus less suspect. Nevertheless, as hinted at in Chapter 3, 3 , there is an obvious risk of collusion among senior managers ma nagers and the board in setting compensation levels. For example, directors might approve excessive compensation because they are richly compensated themselves, or because they fear losing their seats on the board if they refuse.² Controlling shareholders, in turn, might favor overly generous pay packages to themselves (if they occupy managerial positions) or to professional managers who acquiesce to minority abuse.³ In corporate opportunity cases, related parties take business opportunities that should have been offered to their companies instead. Similarly, when trading in the
¹ See Robert C. Clark, C L 141– 141–55 (1986). In this chapter, unless otherwise indicated, we refer to corporate law provisions on “public” or “open” corporations, whether or not listed on an organized securities exchange. ² See Lucian Bebchuk and Jesse Fried, P P W W P 25–7 25–7 (2004). ³ See e.g. Jacob Kastiel, Executive Compensation in Controlled Companies , 90 I e.g. I L L J 1131 (2015). A famous example is the personal acquisition of PepsiPepsi-Cola Cola by the executive of another beverage company. See Guth v. Loft, Inc .,., 5 A R 2d 503 (Delaware Supreme Court 1939). Te Anatomy of Corporate Law. Tird Edition. Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry Hansmann, Gerard Hertig, Klaus Hopt, Hideki Kanda, Mariana Pargendler, Wolf-Georg Wolf-Georg Ringe, and Edward Rock. Chapter Chapt er 6
© Luca Enriques, Gerard Hertig, Hideki Kanda, and Mariana Pargendler , 2017. Published 2017 by Oxford University Press.
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company’s shares on the basis of yet undisclosed price-sensitive company’ price-sensitive corporate information (so-called (socalled insider trading), officers, directors, and controlling shareholders appropriate part of the value of company information by selling or buying before it is reflected in stock prices. Related-party Relatedparty transactions fall under the broader category of “tunneling,” which covers all forms of misappropriation of value (assets, cash flows, or the company’s equity itself) by corporate insiders. We deal with other, more specialized forms of tunneling in later chapters, including tunneling associated with significant corporate actions, as extraction parent-subsidiary parent-subsidiary mergers andin freezeouts of minority (Chaptersuch 7), the of private benefits connection with controlshareholders transactions (Chapter 8), and misappropriation arising from securities fraud other than insider trading (Chapter 9).
6.1 Why Are RelatedRelated-Party Party ransactions Permitted at All? As a threshold matter matter,, we must ask why related-party related-party transactions are permitted at all, given their vulnerability to abuse by corporate insiders. Consider first traditional self-dealing self-dealing transactions and the taking of business opportunities. Directors, officers, and controlling shareholders are often the only parties with whom smaller companies can transact: outsiders may be unable to evaluate their prospects without facing disproportionate transaction costs or benefiting from the revelation of trade secrets or confidential plans that companies would better keep for themselves. Similarly, a self-dealing self-dealing transaction may be entered into and a corporate opportunity transferred to an insider on more favorable terms, because the insider may know the company—or company—or the profitability of the t he corporate opportunity—better opportunity—better than an unrelated but distrustful distr ustful party. Even more intuitively, prohibiting managerial compensation and trading in the company’s shares would simply be absurd. Just as no one would agree to work for the corporation for free, managers cannot reasonably be prevented from investing in their companies, or controlling shareholders from selling their company’s company’s shares. Equally important, per se prohibitions of related-party related-party transactions may not accomplish much. Tey are unlikely to reduce the incentives to engage in one-shot expropriations of firm assets (“steal-and(“steal-and-run run transactions”), these being in any event unlawful under general private or criminal law. Tey are arguably unnecessary for more modest forms of abusive self-dealing self-dealing that may be deterred by civil liability or a credible threat to the wrongdoer’s continuing employment. Further, unless the legal system and its enforcement agents can tackle tunneling in all its forms, the prohibition on related-party relatedparty transactions would just push insiders into using other tunneling techniques. Admittedly, Admittedly, the law-on-the-books and in action may be sophisticated enough to effectively deal with tunneling in all its forms. But then there should be no reason for using such a raw technique as a prohibition on related-party transactions to prevent See Simon Johnson, Johnson, Rafael La Porta, Porta, Florencio Lopez-deLopez-de-Silanes, Silanes, and Andrei Shleifer, unneling , 90(2) A E R 22 (2000): the term was “coined originally to characterize the expropriation of minority shareholders in the Czech Republic (as in removing assets through an underground tunnel). tunnel).” ” See Vladimir Atanasov, Bernard Black, and Conrad S. Ciccotello, Law and unneling , 37 J C C L L 1 (2011).
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corporate theft. Tis explains why jurisdictions permit related-party related-party transactions even when conflicts of interests are especially acute because of the dispersion of shareholder ownership or the use of control-enhancing control-enhancing mechanisms, such as pyramids and dual class shares.
6.2 Legal Strategies for RelatedRelated-Party Party ransact ransactions ions All jur jurisd isdict iction ions, s, ho howev wever er,, sub subjec jectt re relate latedd-party party transactions to legal constraints. Corporate laws resort to a wide range of legal strategies to constrain related-party related-party transactions, and more precisely to four of the five sets of legal strategies described in Chapter 2: affiliation terms (mandatory disclosure and dissolution rights), agent incentives (trusteeship in particular), decision rights (shareholder approval), as well as agent constraints (rules and standards). Appointment rights are not used directly to tackle such transactions, but they can constrain them indirectly: shareholders are less likely to reappoint (and, where possible, also more likely to remove) directors who have approved abusive related-party related-party transactions.¹ 6.2.1 Te affiliation strategy
6.2.1.1 Mandatory disclosure Mandatory disclosure that alerts shareholders and the market to related-party related-party transactions is an intuitively effective control against expropriation by managers or controlling shareholders. Te strategy enlists capital and labor markets as well as financial analysts and the media in deterring suspect transactions with the threat of lower share prices, dismissal, and the risk of reputational harm. It also supports internal decision-makers’ decision-makers’ independence, as they will act more assertively if they know the related-party related-party transaction they may approve will be subject to public scrutiny. Further, it facilitates private and public enforcement against the extraction of private benefits: compliance with the disclosure requirement conveys information about suspect transactions to enforcement actors, while failure to disclose is easier to punish than actual abuse, given that no proof of harm has to be given.¹¹ Finally, mandatory disclosure imposes no substantive or procedural constraint on legitimate self-dealing, self-dealing, compensation contracts, or trading in shares, although one can think of situations in which beneficial related-party relatedparty transactions would only be entered into if they could be kept confidential. At the same time, mandatory disclosure may lead to overover-enforcement: enforcement: enforcement actors will be more likely to challenge even legitimate related-party related-party transactions, either because they believe in good faith that they are harmful to the corporation or to obtain a lucrative settlement, relying on the fact that courts may well err in judging a transaction’ transa ction’ss legality.¹² lega lity.¹² See Luca Enriques, Enriques, Related Party ransactions: Policy Options and Real-World Real-World Challenges (with a Critique of the European Commission Proposal), Proposal), 16 E B O L R 1, 14 (2015). See Chapter 4.1.1. See Zohar Goshen, Te Efficiency of Controlling Corporate Self-Dealing: Self-Dealing: Teory Meets Reality , 91 C L L R 393 (2003). ¹ For instance, shareholders dissatisfied with executive compensation decisions often withhold support from members of compensation committees. ¹¹ R See e.g.3,Bernard Bern Black, Te Core Fiduciary Duties of Outside Directors , 2001 A B L 10.ard S. Black, ¹² Mandatory disclosure can also prove costly for other reasons, for example if it makes competitors aware of strategic changes or forces firms to set up information collection systems that are
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While all of our jurisdictions require public disclosure of self-dealing self-dealing transactions, managerial compensation, and trading in the company’s shares, the regulatory intensity varies. Let us start with self-dealing. self-dealing. U.S. securities law imposes disclosure duties to all companies, U.S. and (to some extent) foreign, that trade in the public market.¹³ Tese companies must report annually all transactions that exceed U.S. $120,000 in value and in which directors, executive officers, or a large shareholder have a “material interest.”¹ U.S. Generally Accepted Accounting Principles (“‘U.S.-GAAP”) (“‘U.S.-GAAP”) complement this company requirement annual disclosure of all shareholders.¹ “material” transactions between the andby itsimposing officers, directors, or controlling EU requirements, as distinct from the law of member states, used to be much less demanding. In the last fifteen years, however, the EU has made significant steps in the direction of greater disclosure of related-party related-party transactions. Under International Financial Reporting Standards (IFRS),¹ EU listed companies have to disclose annually any transaction with directors, senior executives, and controlling shareholders.¹ Similarly to the U.S., however, non-“material” non-“material” transactions can be omitted.¹ In addition, similar transactions can be disclosed in aggregate form.¹ Other EU accounting law provisions complement these disclosure mandates by requiring that member states, at a minimum, require companies (other than smaller ones) to reveal all material relatedparty transactions that have not been concluded under “normal” market conditions.² Some member states impose further disclosure requirements. Single firm accounting standards must are converging IFRS inprior manytoofentering them.²¹ In addition, UK listed companies circulate atowards form (circular) enterin g into material related-party relatedparty transactions.²² transa ctions.²² Italy, like Brazil,²³ requires listed firms to disclose dis close large related-party relatedparty transactions within seven days.² disproportionate to their size. All jurisdictions tackle the issue by limiting the addressees and scope of disclosure requirements. For a general discussion, see Chapter 9.1.2.4. ¹³ See Chapter 9.1.2.4. ¹ SEC Regulation S-K, S-K, Item 404 (applying more precisely to any shareholder with more than 5 percent of any class of the voting securities). ¹ See Statement of Financial Accounting Standards Standards (SFAS) 57, Related Party Party Disclosure. ¹ Regulation 1606/2002 1606/2002 on the Application of International Accounting Standards, 2002 O.J. (L 243) 1. ¹ See International Accounting Standard Standard (IAS) 24 (part of the International Financial Reporting Standards). Art. 5(4) ransparency Directive (Directive 2004/109/ 2004/ 109/EC, EC, 2004 O.J. (L 390) 38) provides for half-yearly half-yearly disclosure of “major related parties transactions. transactions.”” ¹ See IAS 1, para. 31 (“An (“An entity need not provide a specific disclosure required by an IFRS if the information is not material”). ¹ IAS 24, para. 24. ² Arts. 17(1)(r) and 28 Directive 2013/ 2013/34/ 34/EU, EU, 2013 O.J. (L 182) 19. It is up to member states to decide whether disclosure can be limited l imited to transactions that have not been concluded under “n “normal” ormal” market conditions. Te materiality principle is spelled out generally in Art. 6(1)(j). Smaller companies are those that do not satisfy at least two of the following criteria: (1) balance-sheet balance-sheet total: €4 million, (2) annual net turnover: €8 million, or (3) 50 employees on average during the financial year. See Art. 3 Directive 2013/34/ 2013/34/EU. EU. ²¹ See E C, R O IAS R 1606/2002 1606/ 2002 COM (2008) 215 F (2008), at www.ec.europa.eu www.ec.europa.eu.. ²² See Listing Rules, section 11.1.7 (non(non-routine routine transactions, other than smaller ones, by listed firms); §§ 188–226 188–226 Companies Act 2006 20 06 (various property, credit, and compensation transactions). ²³ CVM Instruction No. 480 (2009) (Brazil). Brazilian listed companies must also comply with IFRS and, like Italian ones, disclose their policies and practices to ensure the fairness of such transactions. ² See Art. 5 Commissione Nazionale per le Società Società e la Borsa (Consob) Regulation on Related Party ransactions (large transactions, by listed firms) (Italy). In the version approved by the European
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By contrast, Germany has remained lenient towards controlling shareholders. While the Corporate Governance Code recommends that listed companies inform the annual meeting about any conflict of interests that arose within the supervisory board,² statutory corporate law goes little further than the EU requires even in the context of corporate corporate groups: while parent companies must disclose the share of their profits and losses that is attributable to their subsidiaries taken as a whole,² Konzernrecht limits the information rights of minority shareholders in these subsidiaries to an audited summary of the legally required annual report on intra-group intra-group transactions Abhängigkeitsbericht ( Abhängigkeitsbericht ).² In Japan, ).² allor companies are required disclose detailsJapanese of their transactions with directors, officers, third parties acting ontotheir behest.² accounting regulations complement these disclosure mandates by requiring companies to list material transactions with controlling shareholders.² Jurisdictions have also broadly converged converged in requiring requiring disclosure disclosure of individual managers’ compensation. compensation. In the U.S., companies traded on a public market must disclose all compensation paid to the CEO, the CFO, and the three other most highly compensated executives.³ executives.³ European Union rules are more lenient, because IFRS impose annual disclosure of aggregate compensation compensation to directors and key managers of listed companies.³¹ Individual member states, however, go beyond EU requirements. In accord with European Commission recommendations, all major member states mandate that listed companies disclose individual directors’ compensation,³² and even in continental European juris-
dictions remuneration disclosure are closing theitsgap with traditionally more detailed U.S. and UK ones.³³ Japanpractices has recently reformed laws to impose individualized reporting of executive compensation for the first time, though the requirement is Parliament on 8 July 2015, proposed Art. 9c of the Shareholders Rights Directive, as envisaged by the Proposed Directive amending Directive 2007/ 36/ 36/EC EC as regards the encouragement of long-term long-term shareholder engagement, Directive 2013/34/ 2013/34/EU EU as regards certain elements of the corporate governance statement and Directive 2004/109/ 2004/109/EC EC (hereinafter, the Proposed Directive), would similarly impose ad hoc disclosure of larger related-party related- party transactions. ² See section 5.5.3 Corporate Governance Governance Code. Likewise, the management board has to inform the supervisory board about its own conflicts of interest. See section 4.3.4, ibid. ² § 307(2) Handelsgesetzbuch (HGB). ² § 312(1) and (3) Aktiengesetz (AktG). (AktG). Te annual report mentioned in the text, itself not availavailable to shareholders or the public, has to comprise all of the intra-group intra- group transactions and is subject to the company auditor’s auditor’s control. See also Chapter 5.2.1.3. ² Art. 118(v) Ministerial Ordinance for the Enforcement Enforcement of the Companies Act, Arts. 98(1)(xv) 98(1)(xv) and 112 Ministerial Ordinance for the Accounting of Companies. ² Accounting Standards Board of Japan (ASBJ), Disclosure of Related Party ransactions (17 October 2006) (applicable to reporting companies under the Financial Instruments and Exchange Act.) Regarding voluntary compliance with U.S. GAAP by closely held corporations, see Chapter 5.2.1.1. ³ SEC Regulation S-K, S-K, Item 402. Recent reforms have also extended the scope of mandatory disclosure to encompass the role of compensation consultants and their potential conflicts of interest. SEC Regulation S-K, S-K, Item 407. ³¹ See IAS 24. ³² See Commission Recommendation fostering an appropriate regime for the remuneration of directors of listed companies, 2004 O.J. (L 385) 55, and Commission Recommendation complementing Recommendations 2004/913/ 2004/913/EC EC and 2005/162/ 2005/162/EC EC as regards the regime for the remuneration of directors of listed companies, 2009 O.J. (L 120) 12 0) 28 (EU); Art. L. 225-102102-11 Code de commerce (France); § 285 No. 9 Handelsgesetzbuch (HGB) (Germany) (aggregate disclosure for all public companies, and individual disclosure for listed companies); Annex 3A, Schedule 7-2 7- 2 Consob Regulation on Issuers (Italy); et sections 420–1 Remunerations 420–1 Companies ActBefore 2006 and (UK). ³³ See Roberto Barontini Barontini al., Directors After the Crisis: Measuring the Impact of reforms in Europe , in B S E L C 251, 276–99 (Massimo Belcredi and Guido Ferrarini eds., 2013). 276–
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limited to executives earning ¥100 million or more a year.³ Tis figure is sufficiently low as to be unlikely to work as an indirect cap, but it is of course likely to induce some clustering of compensation packages just below the disclosure disclos ure threshold.³ Brazilian law, law, by contrast, is less rigorous: it requires disclosure of aggregate compensation and more recently also the minimum, maximum, and average compensation amounts paid in each governance body, body, though some executives have challenged the t he latter mandate mandat e as an unconstitutional violation of their fundamental right to privacy and personal security.³ Individualized compensation disclosure may actually have unintended consequences. Because prospective CEOs insist on o n being paid “above average” and boards find it difficult to justify the appointment of a “below average” CEO, such disclosure may lead to an increase of executive pay across the board.³ Finally, some convergence can also be observed in the area of disclosure of trading in the company’s shares, especially by managers and directors, a measure which may curb insider trading. Te U.S., Italy, and Japan Japan require officers, directors, and large la rge shareholders (typically above 10 percent) of a listed company to disclose transactions in the company’s shares.³ Similarly, under EU and Brazilian law, listed companies’ directors and senior executives are required to disclose their transactions in company shares, but shareholders must disclose such transactions only when they cross thresholds typically ranging from 5 percent to 75 percent of voting rights, which makes this a blunt tool to curb insider trading.³ Tere has thus been substantial convergence in the treatment of related-party related-party transactions in listed companies companies and that trend is likely to t o continue in coming years. Many jur jurisdi isdictio ctions nssupervision are subj subjecti ecting their the ir major major firm firms s to IFRS andEven regulat reg ulators ors importantly, everywh eve rywhere ere ,are tighttigh tening their supervis ion ofngthe reporting of insider t rades. trades. more importantly auditors around the world are tightening their scrutiny of transactions that may reflect asset diversion or profit manipulation. o begin with, the International Standards on Auditing, a set of non-binding non-binding principles on how to conduct audits issued by the International Federation of Accountants, require auditors to pay special attention to related-party related-party transactions. In addition, many jurisdictions have adopted statutory provisions that strengthen precisely this mandate.¹ And the growing use of firm-wide auditing standards by Big Four ³ Cabinet Office Ordinance on Disclosure of Corporate Affairs, Form 2 (Precautions for Recording (57)d) and Form 3 (Precautions for Recording (37)). ³ See Robert J. Jackson, Jr. and Curtis J. Milhaupt, Corporate Governance and Executive Compensation: Evidence from Japan Japan,, C B L L R 111, 156 (2014). ³ Most companies have however complied with these regulations. See Mariana Pargendler, Corporate Governance in Emerging Markets , in O H C L G (Jeffrey N. Gordon and WolfWolf-Georg Georg Ringe eds., 2017). ³ For a theoretical model, see Rachel M. Hayes and Scott Schaefer, Schaefer, CEO Pay and the th e Lake Wobegon Wobegon Effect , 94 J F E 280 (2009). ³ § 16(a) 1934 Securities Exchange Act (U.S.); Art. 114(7) Consolidated Act on Financial Intermediation (Italy); Art. 163 Financial Instruments and Exchange Act (Japan). ³ In the EU, see, for managers, managers, Art. 19 Market Abuse Regulation Regulation 596/2014, 596/2014, 2014 O.J. (L 173) 1; for shareholders, Art. 9 ransparency Directive 2004/109/ 2004/109/EC EC (the acquisition and disposal of voting rights must be disclosed at the 5 percent, 10 percent, 20 percent, 25 percent, 30 percent or 1/3, 1/3, 50 percent and 2/3, 2/3, or 75 percent thresholds thresholds); ); Arts. 116-A, 157, § 6º, and Art. 165-A Lei das Sociedades por Ações; Arts. 11 and 12 CVM Instruction No. 358 (2002) (Brazil) (requiring disclosure of trades by shareholders only when they cross thresholds of 5 percent, 10 percent, 15 percent, etc. of any given class of shares). See International Standard on Auditing 550. ¹ Art. 149149-50 50 Consolidated Financial Intermediation; Art.Code 23912391-II Civil Code(France); (Italy); § 313 AktG (Germany; and see Act also on Section 5.2.1.3); Art. L. 225-40 225-40 deIIcommerce Art. 193-2(1) 193-2(1) Financial Instruments and Exchange Act (Japan); Section 10A Securities Exchange Act.
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accounting firms magnifies the significance of this increased focus across jurisdictions. However, the effective impact of these developments remains an open question in jurisdictions where audit fees or auditor liability risks are comparatively low and in firms that have controlling shareholders.² When it comes to ex post enforcement, enforcement, the machinery is still much more effective in the U.S. than elsewhere. A failure to disclose related-party transactions, if detected, can give rise to SEC enforcement actions, criminal prosecution, and, occasionally, occasionally, a private securities fraud class action on behalf of shareholders. Outside the U.S., the use of securities fraud provisions to attack related- party transactions has thus far been much less common. Listed companies can opt into the more severe U.S. disclosure system by cross-listing cross-listing their shares in a U.S. stock market, thus bonding to more stringent securities laws.³ Nevertheless, the limited extraterritorial effects of U.S. securities laws mean that investors who acquire shares of crosslisted firms outside of the U.S. may be left without a remedy in case of disclosure violations. Te law on the books and in action is less comparable for non companies. non-listed listed companies. While U.S. law does not impose mandatory disclosure requireme requirements nts on nonnon-public public companies, they tend to reveal related-party related-party transactions through voluntary compliance with U.S. GAAP. In Europe, Brazil, and Japan, on the other hand, it is difficult to tell whether larger non-listed firms disclose di sclose material self-dealing transactions t ransactions and a nd unclear whether smaller firms voluntarily reveal such information, especially in i n countries a single set ofenforcement accounts foragainst corporate and related-party tax law party purposes. Aswith an aid to private enf orcement abusive relatedtransactions, targeted disclosure is sometimes available to shareholders suspicious of a given transaction. European jurisdictions allow minority shareholders to file a request for the designation of a business expert or special auditor to investigate specific transactions, often self-dealing selfdealing ones. Tese court-appointed court-appointed experts are a means for shareholders to obtain information needed to challenge unfair self-dealing. self-dealing. Tis can prove especially important in the absence of U.S.-style discovery mechanisms, which makes it harder for plaintiffs to obtain evidence on insiders’ wrongdoings. wrongdoings. But while this informationgathering mechanism is of increasing importance in France and Germany Germany,, it seems less effective elsewhere. On the other hand, U.S. law not only is favorable to plaintiffs ² See Yasuyuki Fuchita, Financial Gatekeepers in Japan, Japan, in F G, C P I 13, 23–9 23–9 (Yasuyuki Fuchita and Robert E. Litan eds., 2006); John C. Coffee Jr Jr.,., G: P C G 89–93 89–93 (2006). ³ For a review of the literature on dual listing and the “bonding hypothesis,” hypothesis,” see Olga Olga Dodd, Why Do Firms Cross-list Cross-list Teir Shares on For Foreign eign Exchanges? A Review of Cross-Listing Cross-Listing Teories and Empirical Evidence , 5 R B F 77 (2013). See Érica Gorga, Te Impact of the Financial Crisis on Nonfinancial Firms: Te Case of Brazilian Corporations and the “Double Circularity” Problem in ransnational Securities Litigation, Litigation, 16 I L 131 (2015). After the U.S. Supreme Court decision in Morrison v. National Australia Bank , 561 U S R 247 (2010), which denies extraterritorial effects to U.S. securities regulations, only investors purchasing securities in the U.S. are able to recover from such violations, thus leading to unequal treatment vis-àvis-à-vis vis domestic investors. See American Institute of Certified Public Accountants, Private Private Company Financial Reporting Reporting ask Force Report 8 (2005) (many private companies prepare their financial statements in accordance with U.S. GAAP). See Chapter 5.2.1.1. See e.g. § 142 AktG (Germany). (Germany). See, for France, France, Maurice Cozian et al., D D 249 (28th edn., 2015) (high (high numde gestion); gestion ber of petitions(Karsten to designate an expert ); for eds., Germany, Gerald Spindler, A K Schmidt and Marcus Lutter 3rd edn., 2015) § 142in para 7 (same). Compare, for the UK, Paul L. Davies and Sarah Worthington, G D P
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with its discovery rules, but also grants shareholders the right to inspect a company’s books and records, provided they prove “a proper purpose.” Japanese law grants both of these rights (designation of special auditor and inspection of company’s company’s books and records) to shareholders holding 3 percent or more of shares or voting rights. Brazilian law is similar (though more restrictive): shareholders holding 5 percent of total capital may sue to request access to the company’s books and records but only by pointing to wrongdoing or “justified suspicion of serious violations.”¹ violations.”¹
6.2.1.2 Dissolution and exit rights Voting power and influence over management make it possible for those in control to appropriate corporate profits, for example, in the form of salaries for the members of the controlling family. When such practices take the form of egregious abuse and occur systematically, systematically, most of our major jurisdictions give the minority a right to force a corporate dissolution.² Tis exit strategy, however, is limited to closely held com companies and, even in that context, actual dissolution is rare: courts tend to protect the going-concern goingconcern value of companies by encouraging or requiring their controllers to buy out minority shareholders.³ Brazil has relied on the exit strategy the most, as courts have recently permitted minority shareholders in closely held corporations to compel a partial dissolution (effectively forcing the company to buy out their shares) without the need to prove the existence of abuse—possibly abuse—possibly as a response to the procedural and evidentiary hurdles plaintiffs. In practice, then,generally minorityplaguing shareholders in closely held corporations typically get a kind of put option, conditional upon serious oppression: they can exercise a contractual or equitable right to sell their shares to the controller or the company. Exercise of this right normally involves litigation to determine the share price for the buy- out. Because litigation involving valuation issues is costly, the dissolution right is mainly a negotiating tool in situations of minority “oppression,” thus discouraging extreme forms of abuse ex ante . M C L 673 (9th edn., 2012); for Italy, Luca Enriques, Scelte Pubbliche e Interes Interessisi Particolari Pa rticolari nella Riforma del Diritto Societario, Societario, 2005 M C R 145, 170 (the 2003 corporate law reform emasculated a similar protection tool). For a comparative law discussion, see Forum Europaeum Corporate Co rporate Group Law, Corporate Group Law for Europe , 1 E B O O L R 165, 207– 207–17 17 (2000). Delaware GCL § 220; for more details, see William . . Allen, Reinier Kraakman, and Guhan Subramanian, C C L L B O 167–8 167–8 (4th edn., 2012). Arts. 358 and 433 Companies Act (Japan). ¹ Art. 105 Lei das Sociedades por Ações. ² Art. 1844-7 1844-7 Code Civil (France); § 61 GmbH-Gesetz GmbH- Gesetz (shareholders with 10 percent of the shares can seek dissolution) (Germany); Art. 833 Companies Act (10 percent shareholder can seek dissolution before the court) (Japan); ( Japan); section 122(1)(g) Insolvency Act 1986 (UK); § 14.30(2) RMBCA; § 40 Model Statutory Close Cl ose Corporation Supplement (U.S.). No such right exists under Italian law. ³ See, for France, Cozian et al., note 48, at 274–5 274– 5 (courts do not grant dissolution lightly); for Germany, Detlef Kleindiek, § 61 No. 8, in GH-G GH-G K (Walter Bayer, Peter Hommelhoff, Detlef Kleindiek, and Marcus Lutter eds., 19th edn. 2016) (dissolution will only be granted in exceptional circumstances); for the UK, Davies and Worthington, note 48, at 744–6 744– 6 (the unfair prejudice remedy has crowded out winding-up winding-up petitions). Te mere allegation of a breach of affectio societatis (the (the will to be part of a common organization) seems to suffice. See e.g. SJ, ERESP 419.174-SP 419.174-SP (2008). Brazil’s new Code of Civil Procedure now specifically provides that 5 percent shareholders may request the partial dissolution of a close corporation by demonstrating that the company cannot fulfill its purpose. Art. 599 § 2º Lei 13.105 of 2015.
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6.2.2 Agent incentives strategies Asset diversion is i s constrained everywhere through reward strategies. Minority shareholders are generally protected against discriminatory cash dividends through the pro rata rule, as we have seen in Chapter 4. In some European countries, minority shareholders are also protected by creditor-oriented creditor-oriented provisions on concealed distributions. In Germany and the UK, “undervalue transactions” between the corporation and its controlling shareholder can be characterized by courts as “disgu “disguised” ised” or “hidden” and, therefore, unlawful distributions, but rarely are such cases litigated outside bankruptcy ruptcy. . Most which jurisdictions, however , enlist the board tostrategy reviewatat least some conflicted transactions, we can however, categorize as a trusteeship lleast east wherever boards are independent or the law disqualifies non-independent non-independent directors from deciding on the transaction.
6.2.2.1 Letting the board decide One way to screen related-party related-party transactions is to require internal decision-makers decision-makers with no interest in the matter, or even better, independent from the related party, to approve the transaction. Most commonly, commonly, this means requiring the board to resolve on the transaction without the vote of the interested party. party. A variation on this theme is to reserve the matter to a subset of disinterested directors, the independent ones. Requiring or encouraging disinterested (or independent) director approval of conflicted transactions has several virtues: first, compliance is (relatively) cheap; second, fair, value-increasing value-increasing transactions will likely be approved and thereby, in some jurisdictions, insulated from outside attack; third, disinterested directors may well raise questions at least about suspect related-party related-party transactions. Te major costs of a board approval requirement are just the inverse of its virtues. Disinterested and even independent directors may not be the loyal trustees that the law contemplates. For For the most part, they are selected with the (interested) consent of top executive officers, controlling shareholders, or both. If they are unlikely to block fair transactions, they may also be unlikely or unable to object to unfair ones, especially at the margin. Te involvement of boards in the approval of related-party related-party transactions can come in many shapes. In increasing order of prophylactic potential, jurisdictions may, may, first of all, require that the board to be informed about related-party transactions— which amounts to implicitly subjecting them to a weak form of board authorization or ratification. Second, they may require or strongly encourage explicit board board approval of at least some related-party related-party transactions. Tird, they may require board approval and require the related party, its affiliates or more generally interested directors to abstain a bstain from voting. Finally, Finally, it may grant a veto power or exclusive decisionmaking power to independent directors or a committee exclusively only comprised of them.
See Chapter 4.1.3.2. See Holger Fleischer, Disguised Distributions and Capital Maintenance in European Company Law , in L C E 94 (Marcus Lutter ed., 2006). See Robert B. Tompson and Randall S. Tomas, Te Public and Private Faces of Derivative Law Suits , 57 V L R 1747, 1787 (2004). See Corporate Governance Code § 4.3.4 (Germany); (Germany); Art. 2391 Civil Code (Italy); section 177 Companies Act 2006 (UK).
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Whether explicitly or implicitly implicitly,, all jurisdictions impose, or strongly encourage, some form of board approval of at least some self-dealing self-dealing transactions. For instance, under UK law, listed companies’ boards de facto approve all related-party related-party transactions that have to be submitted to a shareholder vote, but for non-listed non-listed companies such approval is limited to a subset of them, namely substantial property transactions and credit transactions with directors.¹ By contrast, French and Japanese laws mandate disinterested board board authorization for all non-routine non-routine transactions between a company and its directors, general managers or, in the case of France, major shareholders.² In Italy, in turn, additional rules applying to listed companies heavily rely on independent directors. Tey require that a committee of independent directors provides its own advice on the related-party related-party transaction, which the board then has to vote on: the advice is non-binding non-binding for smaller transactions and binding for larger ones, unless the required company’s own internal code on such transactions provides that approval by disinterested shareholders is sufficient in the event of independent directors’ negative advice.³ Finally, in the absence of company law requirements, the Brazilian Securities Commission has promoted the use of the trusteeship strategy by suggesting that the approval by an independent special committee will serve as evidence of discharge of managers’ fiduciary duties in the context of a parent-subsidiary parent-subsidiary merger. Similarly, the best practice of obtaining approval by an independent special committee is also gaining ground in Japan in the context of freeze-out freeze-out and M&A transactions involving controlling shareholders. Although U.S. jurisdictions stop short of mandating board approval a pproval of managerial self-dealing, selfdealing, they strongly encourage it. State law creates incentives for interested managers to seek board approval by according transactions that are authorized (or ratified) rat ified) by the board business judgment rule protection. Board approval also plays a crucial Italian law mandates board approval merely for self-dealing self-dealing transactions in which directors otherwise having the authority to decide on them are self-interested. self-interested. Art. 2391 Civil Code. German requirements mainly apply to lending to, and significant services provided by, supervisory board members—and members— and German courts have been very strict in policing remunerated legal and management services and advice to the company by supervisory board members. See §§ 89, 114– 15 AktG; BGH, decision of 10 July 2012—II 2012— II ZR 48/11 48/11 (Fresenius (Fresenius ), ), NJW 2012, 3235. German law also imposes company representation by a member of the supervisory board for company transactions with members of the management board (§ 112 AktG). Finally, Germany’s Corporate Governance Code (§ 4.3.3) recommends supervisory board approval for transactions with members of the management board and for an “important” withapproval) persons they are close loans to. Brazilian law only oand nly requires (as alternativetransactions to shareholder for corporate to directors officers, board and forapproval the use of company assets or services. Art. 154, § 2°, b Lei das Sociedades por Ações. See Chapter 6.2.3. ¹ See sections 188– 188–226 226 Companies Act 2006 (also covering payments for loss of office and longterm service contracts). ² For France, France, see Arts. L. 225225-38 38 (one-tier (one-tier board) and L. 225-86 225-86 (two-tier (two-tier board) Code de commerce (also applicable to third parties acting for directors or general managers) and Arts. L. 225-39 225- 39 and L. 225-86 225-86 Code de commerce (exempting routine transactions). However, as a matter of practice, transactions between companies of the same group are often deemed to be routine ones. See Dominique Schmidt, L ’ 120 (2nd edn., 2004). For Japan, see Arts. 356(1)(ii)(iii) 3 56(1)(ii)(iii) and 365(1) Companies Act (all transactions with directors personally; no statutory exemption for routine ones). Japanese courts also require board approval for transactions between companies with interlocking directors. See e.g. Supreme Court of Japan, 23 December 1971, 19 71, 656 H J 85. ³ Arts. 7–8 7–8 Consob Regulation on Related Party ransactions. ransactions. CV CVM M Adv dvis isor oryy Opi pini nion on No. 35 (2 (200 008) 8).. See Ch Chap aptter 7. 7.4. 4.1. 1.2. 2. See § 8.31 Model Business Corporation Act; Flieger v. Lawrence , 361 A R 2d 218 (Delaware Supreme Court 1976); Kahn v. Lynch Communications Systems, Incorporated , 638 A R R 2d 1110 (Delaware Supreme Court 1994).
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role for transactions with controlling shareholders, which are usually subject to the stringent “entire fairness” fairness” standard. As an incentive for independent director approval, Delaware law shifts the burden of proof to the party challenging a transaction with a controlling shareholder when the board vests the task of negotiating the transaction in a committee of substantively independent directors and gives them the necessary resources (like access to independent legal and financial advice) to accomplish their task. But while this may be de facto necessary to to pass the “entire fairness” fairness” test applied by Delaware courts, it may not be sufficient , as Delaware courts tend to look at a wider range of facts. In the context of goinggoing-private private mergers with controlling shareholders, recent case law appears to have strengthened Delaware law’s law’s reliance on a combination of the trusteeship and decision rights strategies, by affording business judgment rule protection to transactions that are approved both by an independent and well-funcwell-functioning special committee of the board and by a majority of minority shareholders. It is, however, however, too early to tell whether companies will often take advantage of this safe harbor, given the risks of obtaining majority of the minority approval in the presence of activist hedge funds that may well coalesce to veto the transaction. Most major jurisdictions nowadays require boards of listed companies to approve the compensation of top executive officers.¹ As the level of executive compensation has soared, regulatory reforms and investor pressure have prompted listed companies to adopt implementation measures, such as assigning compensation decisions to specialized committees on the board staffed entirely by independent directors—a trend that has been reinforced by post-Enron and postpost-financial financial crisis reforms.² In the U.S., compensation committees of listed companies now must be fully independent and have the authority to retain their own consultants, counsel, and other advisers.³ At the same time, judges tend to defer to boards’ decision-making decision-making on compensation matters even more than for other related-party related-party transactions. Board approval of executive compensation is unlikely to be successfully questioned in the U.S., which otherwise strictly
See Allen et al., note 49, at 323; Kahn v. Lynch Communications Systems , note 66; Weinberger v. UOP, Inc., Inc., 457 A R 2d 701 (Delaware Supreme Court 1983). See Chapter 6.2.5.2. On the intricacies of Delaware case law on procedural procedural fairness in parent-subsidiary parent-subsidiary transactions, see William J. Carney and George B. Shepherd, Te Mystery of Delaware Law’s Continuing Success , 2009 U I L L R 1. Kahn§ v.8.11 M &Model F Worldwide Worldwide Corp., Corp. , 88 AAct R 635AktG (Delaware SupremeArt. Court 2014). ¹ See Business Corporation (U.S.); 3d § 87 (Germany); 2389(3) Civil Code (Italy); Art. 361(1) Companies Act (in Japanese companies with statutory auditors, approval of the shareholders’ meeting is required for aggregate amount payable to all directors, and the board is allowed to decide compensation for each director within that limit) and Art. 404(3) Companies Act (in “committee” companies, the compensation committee decides the individual amount of compensation for each director and officer) (Japan). In the UK, board approval is a default rule (see § 84 able A, Companies Regulations 1985, as amended), but it is unusual for firms to opt out of it, both for historical reasons (the alternative used to be shareholder approval) and, for listed firms, because the Combined Code recommends approval by a remuneration committee on a comply or explain basis (B.2.2). In France, shareholders determine the global amount of director remuneration, which the board then divides among the directors. Arts. L. 225-45, 225-45, L. 225-46, 22546, L. 225-63, 225-63, L. 225-83, 225-83, and L. 225-84 225-84 Code de commerce comm erce (France). Brazil is again distinctive in this regard, as its shareholder-centric shareholder- centric model of corporate governance has long lo ng attributed the determination of aggregate executive compensation to shareholders. Art. 152 Lei das Sociedades por Ações. ² For an overview of recent developments and proposed regulations in this area, see Guido Ferrarini and Maria Cristina Ungureanu, Executive Remuneration: A Comparative Overview , in O H C L G, note 36. ³ See Chapter 3.3.
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polices related-party related-party transactions. And even in Germany, Germany, where there is evidence of a more aggressive judicial approach towards compensation, courts are unlikely to question board approval unless there is gross inadequacy between compensation levels and job characteristics. Tings may change following a recent reform imposing liability on supervisory board members for setting “unreasonable” compensation, that is, that exceeds “usual compensation” without special reasons or does not promote a listed company’s “sustainable development.” Finally,, jurisdictions increasingly encourage their managers to obtain board approval Finally prior to the exploitation of information that could be of use to their corporation. In the U.S., the UK, and Japan directors who exploit a “corporate opportunity” to their personal advantage are deemed to have acted fairly only if they properly disclosed the business prospect to disinterested directors and took it with their approval. Virtually the same doctrine has also gained acceptance in Germany (under the rubric of the Geschäftschancen doctrine), Italy, Brazil, and even (as a possible abus de biens/ pouvoirs pouvoirs sociaux or or violation of the duty of loyalty) in France.
6.2.3 Te decision rights strategy: strategy: Shareholder voting As an alternative or complement to disinterested disinterested board approval of relatedrelated-party party transactions, jurisdictions may require or encourage shareholder approval. Shareholders, after all, are the parties who lose from managerial or controlling shareholder opportunism. Outside directors are (at best) disinterested , while shareholders are affirmatively interested in in preserving corporate value. It might therefore appear that the shareholders’ meeting should screen conflicted transactions. But, of course, this reasoning runs counter to the logic of delegated management which characterizes the corporate form. No jurisdiction mandates across-theacross-the-board board shareholder approval for related-party related-party transactions, not even with controlling shareholders. Tis is because doing so might be excessively cumbersome, especially for companies that are integrated into groups, where such transactions can be very frequent. Further Further,, either the self- interested shareholder (the controlling one, when one exists) is allowed to vote or a majority of the minority shareholders is needed to pass the resolution. In the former case, the outcome is a foregone conclusion and the requirement serves mainly an informative function. In the latter case, as policymakers in some jurisdictions fear fear,, the decision will be made by a minority that may well lack information or hold out opportunistically. opportunistically.
However, Delaware courts may apply the more onerous “entire fairness” test when directors approve their own compensation, unless shareholders have properly ratified the decision. Calma v. empleton,, 114 A R 3d 563 (Del. Ch. 2015). See also Chapter 3.3.2 for an account empleton of the deployment of the business judgment rule in the Disney case. case. § 87 AktG (supervisory board approval for compensation compensation of executives that are are members of the Vorstand ). ). See also Chapter 3.3.2 for an account of the (quite unusual) Mannesmann unusual) Mannesmann case. case. § 87 AktG. See also Klaus. J. Hopt, Conflict of Interest Secrecy and Insider Information of Directors— A Comparative Analysis , 10 E C F L R 167, 181 (2013) (noting that the reform is i s plagued by “many doctrinal and practical difficulties”). di fficulties”). See e.g. Allen et al., note 49, at 315. See also section 175 Companies Act 2006 (UK) and Arts. 356(1)(i) and 365(1) Companies Act (Japan). See, for Germany, Germany, Tomas E. Abeltshauser, L L K K 373 (1998); Art. 2391(5) Civil Code (Italy); Art. 155 Lei das Sociedades por Ações (Brazil); for France, see abusive). Cozian et al., note 48, at 164, 186, and 373 (causing the loss of a profit opportunity is potentially See Chapter 1.2.4.
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“Majority of the minority” shareholder approval is a well-established well-established institution in the U.S. and UK, two jurisdictions in which large companies typically typically lack a controlling shareholder, but is much less developed in continental Europe, where controlling shareholders have significant voting (and lobbying) power. It is, however, gaining ground in Japan with respect to freeze-out freeze-out and M&A transactions with controlling shareholders, as a result of Delaware influence.¹ In Brazil, the question of whether a conflicted controlling shareholder can vote to approve a related-party related-party transaction is controversial and remains unsettled.² Convergence among our jurisdictions in the use of decision rights is greater when it comes to executive compensation. All of our jurisdictions require listed firms to submit some forms ofa executive compensation to shareholder approval. ³ Allvote jurisdictions also comgrant shareholders binding (in the UK, Japan, and Brazil)approval.³ or advisory on executive pensation packages (a regime known as “say on pay”). Moreover, U.S. stock exchanges require a shareholder vote on all equity compensation plans whereas some states mandate shareholder approval approval of stock option plans. In the EU, most member states have adopted rules on prior shareholder approval of share-based share-based incentive schemes (Germany, Italy, and the UK being the most demanding by mandating such a vote without limitations). Beyond the realm of executive compensation, the UK, followed by France, appears to be most inclined to give shareholders a say on related-party related-party transactions. Te UK mandates ex ante shareholder shareholder approval for large non-routine non-routine transactions with directors and large shareholders of listed companies. If controlled companies that have a premium listing fail to comply with the terms of the required “relationship “relationship agreement” with its controlling shareholders, ex ante approval approval by minority shareholders will be required for any transaction transaction with the controlling shareholder. For other companies, the Companies Act requires shareholder approval of some transactions with directors, in particular substantial property transactions and credit transactions. French
On Delaware law see e.g. Leo E. Strine, Strine, Jr., Jr., Te Delaware Way: How We Do Corporate Law and Some of the New Challenges We (and Europe) Face , 30 D J C L 673, 678 (2005). ¹ See Mori, Hamada, and Matsumoto, MA- MA- [C A MA L J] 761–6 761–6 (2015) (in Japanese). ² Te controversy centers on the interpretation of Art. 115 Lei das Sociedades por Ações. It is however uncontroversial that controlling shareholders can vote to approve parent-subsidiary parent-subsidiary mergers. Art. 264 Lei das Sociedades por Ações. ³ See §§ 113 and 120(4) 120 (4) AktG (Germany); Arts. L 225- 45, L. 225-53, 225- 53, L. 225-63, 225-63, and L. 22583 Code de commerce (France); Arts. 2389 Civil Code and 114–II 114– II Consolidated Act on Financial Intermediation (Italy); Art. 361(1) Companies Act (Japan). In Japan and Brazil, however, however, shareholders must only approve aggregate (rather than individual) executive compensation packages. Te proposed revisions to the Shareholder Rights Directive would introduce binding “say on pay” for listed companies across the EU (proposed Arts. 9a and 9b Shareholders Rights Directive, as envisaged by the Proposed Directive, note 24). See § 303A.08 New York Stock Exchange Listing Rules; Jeffrey N. Gordon, Executive Compensation: If Tere’s a Problem, What’s the Remedy? Te Case for “Compensation Discussion and Analysis” Analysis ” , 30 J C L 675, 699 (2005). Moreover, Section 162(m) of the Internal Revenue Code conditions the tax deductibility of performanceper formance-based based compensation on shareholder approval of the material terms of the compensation plan. See Commission Staff Working Document, Report on the application of the Commission Recommendation on directors’ remuneration (2007) 1022. See Davies and Worthington, note 48, 580– 580–1. 1. See Listing Rules, section 11.1.1. Te relationship agreement agreement with the controlling shareholder shareholder must contain certain “independence provisions, provisions,”” including the requirement that related-party related-party transactions conducted the at arm arm’ ’s length on normal commercial terms do notbecircumvent listing rules.and Listing Rules, section 6.1.4D R. and the controlling shareholder See note 61.
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statutory law requires shareholder ratification of all non-routine non-routine self-dealing self-dealing transactions entered into during the prior financial year. year. While the Fren French ch approach seems stringent and encompassing, in practice it may not prove as effective as UK law l aw.. As in the UK for listed companies, it leaves corporate decision-makers decisionmakers with wide discretion in deciding whether a transaction is non-routine non-routine and, thus, needs to be approved by shareholders.¹ But the timing of shareholder approval makes it much less meaningful as a tool to prevent misappropriation: unlike in the UK, shareholders cannot block abusive related-party related-party transactions before they become effective, but only express their (precatory) dissatisfaction dissa tisfaction ex post .² .² Othershareholder jurisdictions are less insistent on shareholder approval. Italy , for instance, only requires shareh older approval when a director of a publicly tradedItaly, corporation wants to sit on the board of a competing corporation.³
6.2.4 Te rules strategy: Prohibiting Prohibiting conflicted conflicted transactions Sweeping prohibitions of related-party related-party transactions were once common in company law. oday, for the reasons outlined in Section 6.1, they apply only to a handful of transactions, namely credit transactions, third party employment contracts, and some forms of trading by insiders. Only France and the U.S. currently prohibit loans between a company and a nd one of its directors. Te French French prohibition has a long tradition. tradit ion. By contrast, the U.S. prohibition is relatively new. In the 1990s and early 2000s, company loans were used by some managers to leverage their ownership of company shares, thus increasing their incentives to engage in questionable practices aimed at bolstering the share price. Further, they were often used as “stealth compensation,” as managers often failed to repay the loans and companies forgave them. As a response to Enron and other scandals, Congress prohibited public companies from making personal loans to executives. While the U.S. reaction is understandable, it remains unclear why loans to managers should be more suspect than other conflicted contracts (e.g. consulting contracts). At best, the logic must be that these loans are especially unlikely to generate efficiencies significant enough to offset their risks. Apart from bans on loans, loans, prohibitions tend to focus focus on transactions between manmanagers and third parties that are thought to divert the value of information property rights on which the law assigns to the company (or its shareholders). One example is Germany’ss nonGermany’ no n-compete compete rule for top executives in closely held companies. Of course, Arts. L. 225-40 225-40 (one-tier (one-tier board) and 225-88 225-88 (two-tier (two-tier board) Code de commerce (France). Conflicted shareholders or managers are forbidden from voting their shares to approve their own transactions—the transactions— the outcome being nullified if they are found to have voted. ¹ See Schmidt, note 62, at 117–21 117–21 (criticizing the French regime because it grants insiders too much discretion). ² Te practical effect of a shareholder vote rejecting rejecting a properly boardboard-approved approved transaction is virtually nil. See Luca Enriques, Te Law on Company Directors’ Self-Dealing: Self-Dealing: A Comparat Comparative ive Analysis , 2 I C C L J 297, 327–8 327–8 (2000). ³ Art. 2390 Civil Code (Italy). See also text preceding preceding note 63. Of course, specific rules on conflicted conflicted transactions, usually not banning banning them outright, exist for certain industries, such as banking. See Arts. L. 225225-43 43 and L. 225-91 225-91 Code de commerce (France). See Bebchuk and and Fried, Fried, note 2, at 112–17. 112–17. § 402 SarbanesSarbanes-Oxley Oxley Act. See the Peter Hommelhoff Hommelhoff andofDetlef Kleindiek No. 20 Anhang § 6 intop Bayer Bayer et al., to note 53. By contrast, supervisory boards German public companies may allow managers compete. See § 88 AktG.
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barring executives from competing with their companies often makes sense, as executives who serve two competing firms will inevitably favor one over the other in allocating time and sensitive information. Nevertheless, there may be circumstances in which companies will reasonably prefer to allow their managers to compete. For example, smaller companies may need to permit competition to attract competent executives, and larger firms may benefit from the know-how gathered by their executives as directors of competitors in the same industry. For For this reason, most jurisdictions deal with competition issues through other legal strategies. “Insider trading” is a third—and third—and much more important— import ant—class of transactions tra nsactions that jur jurisdi isdictio ctions typicall typi cally y sub subject ject to res restric triction tions. o beexamined o sure, sur e, insi insider trading tradi ng is not strictly ctly speaking ansrelated-party relatedparty transaction like thes.others inderthis chapter, for atstri least two reasons. First, the counterparty to the typical insider trading transaction is not the corporation itself, but an unrelated third party. Second, insider trading bans no longer apply exclusively to “insiders” but also encompass certain outsiders who are under a duty of confidentiality and, in jurisdictions with wider-reaching wider-reaching insider trading laws, anyone who otherwise knows that they are in possession of material non-public non-public information: when that is the case, as we further discuss in Chapter 9, the rationale is more broadly to ensure securities markets’ liquidity and efficiency than to prevent self-dealing. self-dealing. Tat said, we address insider trading also in this chapter in view of one of the rationales of the prohibition: namely, the idea that insiders trading on non-public non-public information are misappropriating information that belongs to the corporation for their own benefit. Tere are two sorts of rules against trading by insiders: prophylactic restrictions on shortshort-term trading and directrules bansare onrestrictions trading ononmaterial Te most term important prophylactic “short inside swing” information. (within less than six months) purchase-andpurchase-and-sale sale or sale-andsale-and-purchase purchase transactions by “statutory insiders” of U.S. and Japanese registered companies, including directors, officers, and holders of 10 percent or more of a company’s equity.¹ Tese rules effectively prohibit short-term short-term trading by allocating the resulting profits (or losses avoided) to t o the corporate treasury, on the theory that these gains are likely to derive from non-public non-public corporate information. Te UK adopts similar restrictions in their listing requireme requirements nts for the same purpose.¹¹ Still more significantly, all major jurisdictions now impose some kind of ban on insiders’ trading on the basis of non-public non-public price-sensitive price-sensitive information. European jurisdictions and Brazil bar anyone in possession of material, undisclosed inside information from trading in the relevant company’s publicly traded securities based on that information.¹² Te scope of insider trading prohibitions is however narrower in Japan and the U.S. Japan only prohibits managers, employees, shareholders holding more than 3 percent of the shares, as well as direct tippees thereof, from trading on non-public non- public information.¹³ Te U.S., by contrast, bars trading by insiders who possess non-public non-public See notes 102– 102–44 and accompanying text. ¹ See § 16(b) 1934 Securities Exchange Exchange Act (U.S.); Art. 164 Financial Financial Instruments and Exchange Exchange Act (Japan). ¹¹ See the minimum requirements set by the UK Listing Authority’s Model Code (Listing Rules 9, Annex 1): a director may only deal in securities of the listed company after clearance by the board chairman, but clearance must not be given on considerations of a short-term short- term nature (§ 8(b)). ¹² For the EU, see Art. 8 Market Abuse Regulation Regulation 596/2014. 596/2014. For an interpretation of the meaning of “use” of inside information in the EU context, see se e ECJ, Case C- 45/ 45/08 08 Spector Photo Group NV (ruling that the act of trading while in possession of inside information gives rise to a rebuttable presumption that he or she has used such information). i nformation). In Brazil, however, however, criminal penalties only apply to persons who under a legal le galand duty to 13 keep the information confidential. Art. 27-D Lei 6.385, de 7 de dezembro deare 1976 (Brazil), Art. CVM Instruction No. 358 (2002). ¹³ Art. 166 Financial Financial Instruments and Exchange Exchange Act (Japan). (Japan).
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information, by outsiders who misappropriate inside information in breach of a duty to the source of the information, and by direct and indirect tippees thereof who knew that the information was obtained through the tipper’s breach of duty.¹ Although all jurisdictions mandate stiff civil, administrative, and/or and/or criminal sanctions for illegal insider trading (e.g. disgorgement of profits, treble damages, other civil penalties, and prison sentences),¹ the U.S. has traditionally mounted a much larger enforcement effort than other jurisdictions.¹ Lower enforcement levels in other contexts probably reflect the higher burden of proof faced by prosecutors due to a statutory preference for criminal over civil sanctions in Europe and Japan, as well as moremight limited enforcement resources.¹ Te divergence in enforcement approaches wellpublic increase in the future. While prosecutions prosecu tions of insider trading in the U.S. have intensified in recent years, the European Court of Human Rights has held that the structure st ructure of Italian (and, by implication, European) regulation of insider trading might run afoul of fundamental rights, such as procedural protections and the prohibition of double jeopardy.¹ Why are (select (selective) ive) bans the strat strategy egy of choice for inside insiderr tradi trading? ng? Te reason must be that potential benefits are much less visible, and therefore less plausible, than those t hose resulting from self- dealing transactions. Mu Mutually tually advantageous transactions between directors and (small) corporations are easy to imagine: for example, the director with superior information may be the only party willing to transact with the firm. o o date, lawmakers remain unpersuaded that trading based on undisclosed information might sometimes have similar benefits. Some academics have argued that lawmakers underestimate the channel advantages it haspublic as an information efficient forminto of incentive compensation or as a superior of non-public nonshare prices.¹ Other scholars, however, however, have questioned the t he informational benefits
¹ However However,, the specific contours of insider trading liability in the U.S. remain fuzzy. fuzzy. For a discussion see John C. Coffee Jr., Introduction: Mapping the Future of Insider rading Law , 2013 C B L L R 281. 2 81. ¹ For the U.S., see Louis Loss, Joel Seligman, and roy roy Paredes, F F S R R 1412– 141 2–19 19 (6th edn., 2011) (also discussing special sanctions such as disgorgement, civil penalties, and bounty provisions); for France, see Daniel Ohl, D 351 (3rd edn., 2008) (criminal sanctions and administrative fines); for Germany, Rolf Sethe, Insiderrecht No. No. 13-17, 1317, in Heinz-Dieter Heinz-Dieter Assmann and Rolf A. Schütze, H K (4th edn., 2015) (criminal sanctions and disgorgement of profits); for the UK, see se e Davies and Worthington, note 1167– sanctions, fines,ofdisgorgement of profits). ¹48, Te1167–71 U.S.71has(criminal historically had a administrative very high number public and private enforcement actions actions against insider trading compared to other jurisdictions, though the latter jurisdictions’ record seems to have improved in recent years. For a recent study on the level of enforcement against market abuse in the EU, see Douglas Cumming, Alexander Peter Groh, and Sofia Johan, Same Rules, Different Enforcement: Market Abuse in Europe , Working Paper (2014), at ssrn.com ssrn.com (finding (finding that Germany and France had the highest number of detected offences for market abuse between 2008 and 2010). In Japan, between 2000 and March 2015 the Securities and Exchange Surveillance Surveillance Commission (SESC) has reported 64 cases of insider trading to prosecutors. Also, civil penalties against insider trading have been enforced vigorously since their introduction in 2005. See SESC’s Annual Reports, fsa.go.jp/sesc/ english/reports/ english/ reports/reports.htm. reports.htm. In Brazil, the Securities Commission (CVM) opened 40 administrative proceedings related to insider trading between 2002 and 2014. Of a total of 187 defendants, 51 were convicted by the Commission. Viviane Muller Prado and Renato Vilela, Insider rading rading XX-Ray Ray in the Brazilian Securities Commission (CVM) 2002– 2014 , Working Paper (2015), ssrn.com ssrn.com.. ¹ See Chapter 9.2.1. ¹ Grande Stevens et autres c. Italie (App (App No. 18640/10, 18640/10, 18647/10, 18647/10, 18663/10, 18663/10, 18668/10) 18668/10) (2014) ECHR 4 March 2014.G. Manne, I S M (1966); Dennis W. ¹ See e.g. Henry Carlton and Daniel R. Fischel, Te Regulation of Insider rading , 35 S L R 857
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of trading based upon non-public non-public information and provided evidence that it may have a negative impact on market liquidity by increasing bid-ask bid-ask spreads.¹¹ A recent review of the literature on the effects of insider trading laws has described the existing evidence as inconclusive.¹¹¹
6.2.5 Te standards strategy: Te duty of loyalty and intra-group intra-group transactions review If nowadays rules are rarely used to regulate conflicted transactions, standards are pervasive. jurisdictions impose standards— standards—which which we under umbrella phrase “duty ofAll loyalty”— loyalty”—to to control relatedrelated-party party conflicts andgroup limit the riskthe of asset or information diversion. In essence, the duty of loyalty is a fairness standard which requires judges to determine ex post whether whether shareholders—as shareholders—as a class or as a minority—are minority—are worse off as an outcome of the related-party related-party transaction transaction.. Duty-ofDutyof-loyalty loyalty doctrines encompass a variety of labels across jurisdictions, such as the duty of entire fairness, the prohibition against “wrongful profiting from position,” or the crimes of “abuse of corporate assets” (in France), and breach of trust (in Germany).¹¹² Whatever the labels and the details, these doctrines have a similar thrust: unfair related-party related-party transactions are unlawful and it is for the courts to determine unfairness after the fact. Te strictness of enforcement, not to mention courts’ ability to understand and evaluate business transactions, varies.¹¹³ Some courts, like Delaware’s, tend to be strict, and only consider fair those transactions in which the company deal terms those wouldparty have following obtained proin a transactioneither with obtains a non-related non-related party comparable or negotiatestowith theitrelated cedural steps that mimic those that are typical of an arm’s length transaction. For other courts, like Italy’s, Italy’s, it is enough that the transaction is not harmful to the company (i.e. the sale price is no lower than the company’s reservation price). Finally, some courts, like the UK’s, focus on the existence of a conflict of interest as defined by law and observance of the procedure for handling it, the fairness of the transaction only being relevant to the measure of damages.¹¹ (1983). See also the empirical study by Nihat Aktas, Eric de Bodt, and Hervé Van Oppens, Legal Insider rading and Market Efficiency , 32 J B F 1379 (2008). ¹¹ Reinier Kraakman, Te Legal Teory of Insider rading Regulation in the United States, States, in E IParchomovsky, D 39 On (Klaus J. Hopt and Markets, Eddy Wymeersch eds., Property 1991); Zohar Goshen and Gideon Insider rading, and “Negative” Rights in Information, Information, 87 V L R 1229 (2001); Raymond P.H. Fishe and Michel A. Robe, Te Impact of Illegal Insider rading in Dealer and Specialist Markets , 71 J F E 461 (2004). ¹¹¹ Utpal Bhattacharya, Insider rading Controversies: A Literature Review , 6 A R F E 385 (2014). ¹¹² See note 78 for France; for Germany see § 266 I StGB (Criminal Code). ¹¹³ How sophisticated courts are will be a function of their specialization in corporate law. From From this perspective, a fundamental difference exists between countries, such as Germany and France, where standards are expressed in criminal provisions and enforced by (non-specialized) (non-specialized) criminal courts, and countries where civil law courts dealing mainly with corporate law cases, like Delaware’s, hear breach of fiduciary duty cases. ¹¹ See Davies and Worthington, Worthington, note 48, at 561: if there is a conflict of interest of the type covered covered by self-dealing self-dealing law, British courts will find a breach of duty on the part of the director, even if the transaction is fair. But But if, as it is usually the case, specific rules apply on related-party related-party transactions and there no violation nottolook intointhestandard-based fairness based of thereview transaction. See ibid., at 569.hasAsbeen an outcome, it isthereof, rare for judges Britishwill courts engage standardof related-party relatedparty transactions.
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In addition, rules allocating the burden of proof are relevant to how effective the fairness standard will be in protecting shareholder interests. In Delaware, defendants have the burden of proving the transaction’s transaction’s fairness, unless procedural steps have been taken to mimic the dynamics of an arms’ length negotiation (such as entrusting a committee of independent directors with the exclusive power to negotiate with the controlling shareholder).¹¹ Other jurisdictions usually allocate the burden of proving unfairness of related-party related-party transactions upon plaintiffs.
6.2.5.1 Directors and officers As we described in Section 6.2.2, most of our jurisdictions assign responsibility for ensuring compliance with the duty of loyalty to disinterested directors, through the widely required—or required—or encouraged—screening encouraged—screening of related-party related-party transactions. Tus, the standards strategy frequently operates in conjunction with the trusteeship strategy. Jurisdictions differ, however, however, in the extent to which the standards strategy functions independently of other strategies. Te duty of loyalty plays the largest autonomous role in the U.S., where courts generally review the fairness of transactions with directors that have not been preapproved by disinterested directors. Delaware courts, in particular, are well-known well-known for their careful scrutiny of procedural fairness issues and for aggressively articulating norms of fair corporate behavior including admonishing managers when the transaction’s terms are not in line with those of an arms’ length transaction.¹¹ European, Japanese, and Brazilian courts, by contrast, seldom question the “fairness” of conflicted transactions and even self-interested self-interested managers are unlikely to be sued, let alone held liable, for breaches of the duty of loyalty. We will revert to this in Section 6.2.5.4. 6.2.5.2 Controlling shareholders In all jurisdictions, controlling shareholders may be held accountable for having engaged in “unfair” self-dealing. self-dealing. Te liability risk is highest in U.S. jurisdictions. Courts apply tough standards—the standards—the “entire fairness” test (in Delaware) and the “utmost good faith and loyalty” test (in some other states)—to states)—to self-dealing self-dealing by controlling shareholders, even when such transactions have been preapproved by independent directors— althoughisDelaware recently appliedrights business judgment when the trusteeship tr usteeship strategy combinedhaswith a decision strategy in thereview form of a “majority of the minority”” vote.¹¹ European jurisdictions, Brazil, and Japan are not as strict. minority Te European approach reflects a general reluctance to hold controlling shareholders liable so long as they are not directly involved in the company’s company’s management. But when controlling shareholders assume actual control, European jurisdictions become more demanding. Controlling shareholders who actively intervene in corporate affairs ¹¹ See e.g. Allen et al., note 49, at 289–92, 308–9. 308–9. ¹¹ See Edward B. Rock, Saints and Sinners: How Does Delaware Corporate Law Work? 44 UCLA L R 1009 (1997). While such procedures can be costly for directors in terms of time and reputation, personal liability of independent directors is extremely rare. See Bernard Black and Brian R. Cheffins, Outside Director Liability across Countries , 84 L R 1385 (2006). Indemnification provisions and insurance protection make the liability risk even lower. See Chapter 3.4.1. ¹¹ See note 70 and accompanying text. text.
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may become de facto or “shadow” directors and face civil liability and even criminal sanctions as directors, for example, under the Fre French nch abus de biens sociaux provisions.¹¹ provisions.¹¹
6.2.5.3 Groups Upon the premise that companies belonging to a group enter into transactions with each other as a matter of routine and that the efficiency of the t he group structure depends on such transactions, Germany, France, Italy, and Brazil allow courts to evaluate whether the overall operations of an individual subsidiary, and especially its interactions with challenge the parentofand affiliates, are fair harming as a whole.¹¹ Tis implies that a successful an other individual transaction a subsidiary will become more difficult, because the defendants will win, if they persuade the judge that that the t he damage from the individual transaction is offset once the overall management of the group is taken into account. Te German law of corporate groups (Konzernrecht ) is the most elaborate, but ultimately relies on a simple fairness standard. Corporate parents in contractual groups have the power to instruct their subsidiaries subsidiari es to follow group interests rather than their own individual ones.¹² But, as a quid pro quo, they must indemnify their subsidiaries for any losses that stem from acting in the group’s interests.¹²¹ In de facto groups, the parent company similarly cannot force its subsidiaries to act contrary to their interests without providing compensation.¹²² Should a parent fail to do so, any minority shareholder would have the right to gather evidence via a special auditor appointed by the court and to sue directors and the parent company for damages on behalf of the subsidiary.¹²³ In practice, it is often difficult to establish whether the subsidiary has been harmed or not.¹² Whether the German regime strikes the right balance between the need for flexibility in the management of connected firms and minority shareholder protection remains disputed.¹² In the past, parent companies frequently ignored the indemnification or compensation requirements—unless the subsidiary was insolvent, in which case not much was left for minority shareholders anyway a nyway.¹² .¹² Nowadays, improvements improvements
¹¹ Art. L. 246-2 246-2 Code de commerce. In Germany, AG shareholders using their influence on the company to instruct supervisory or management board members membe rs to act to the detriment of the firm or its shareholders may be liable for damages. § 117(1) AktG. See also section 251 Companies Act (UK). ¹¹ For the argument that that focusing on each single transaction to prevent prevent controlling shareholders’ shareholders’ abuse, as most jurisdictions disfavoring (and especially Delaware) do, may lead toseeinefficient allocationCorporate of control rights by systematically control by business partners, Jens Dammann, Ostracism: Freezing-Out Freezing-Out Controlling Shareholders , 33 J C L 681 (2008). ¹² On the difference between contractual and de facto groups facto groups under German law, see Chapter 5.2.1.3 and 5.3.1.2. ¹²¹ See § 302 AktG. Similarly, Similarly, in Brazil, parent parent companies can sacrifice the interests of subsidiaries only in formally registered corporate groups (which are very rare in practice) and subject to the compensation mechanisms described in the group’s convention. Art. 245 Lei das Sociedades por Ações. ¹²² § 311 AktG. In Brazil, Brazil, where de facto corporate facto corporate groups are common, all related-party related-party transactions between affiliates must, at least in theory, be “strictly fair” or subject to the payment of adequate ade quate compensation. Art. 276 Lei das Sociedades por Ações. ¹²³ §§ 142 II, 315 and 317 AktG. AktG. See also Chapter 6.2.1.1. ¹² Te main tests are whether parentparent-subsidiary subsidiary transactions are at arm’s length and whether the subsidiary’s directors have otherwise exceeded their business discretion. Uwe Hüffer and Jens Koch, A, § 311 AktG No. No. 31-36 31-36 (11th edn., 2014). ¹² See Jochen Vetter, in Schmidt and Lutter, note 48, § 311 paras. 8– 9 (for AGs); obias H. roeger, Corporate Groups , Working Working Paper (2014), at ssrn.com. ¹² See Forum Europaeum Europaeum Corporate Group Law, Law, Corporate Group Law for Europe , 1 E B O L L R 165, 16 5, 202–4 202– 4 (2000).
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in business practices and an increase in litigation risks seem to have resulted in a more adequate treatment of minority shareholders.¹² Italy’’s approach to corporate groups is less articulate than Germany’s, Italy Germany’s, but still recognizes the specificities of this organizational form. It allows parent companies to manage their subsidiaries as a mere business unit and provides for ex post review review of the overall fairness of a subsidiary’s management. Minority shareholders of subsidiary corporations can sue the parent company and its directors for pro rata damages if their powers over the subsidiary’s business are abused. However, the parent cannot be held liable if it proves that there is no damage “in light l ight of the overall results of the parent’s parent’s management and co-ordination co-ordination activity.”¹² French case law allows for even more flexibility:¹² parent companies may instruct their subsidiaries to sacrifice their own interests for those of the corporate group without incurring criminal liability for abuse of corporate assets.¹³ Te Rozenblum doctrine holds that a French corporate parent may legitimately divert value from one of its subsidiaries if three conditions are met: the structure of the group is stable, the parent is implementing a coherent group policy, and there is an overall equitable intra-group intra-group distribution of costs and revenues. As a practical matter, judges tend to accept this defense and hold the distribution of costs and revenues overall equitable so long as intra-group intra- group transactions do not pose a threat to the company’s solvency.¹³¹
6.2.5.4 In its coreEnforcement content (fairness), the duty of loyalty is similar in common and civil law jurisdictions, but its bite crucially depends on how often and how stringently courts enforce it. From this perspective, managers and dominant shareholders face greater risks in the U.S. than in most other jurisdictions, with Japan and France falling somewhere in between.¹³² U.S. (and especially Delaware) courts are much more willing than courts elsewhere to review conflicted transactions for fairness even when it requires second-guessing second-guessing the merits of business choices that are tainted by self-interest.¹³³ Further, Further, U.S. law greatly facilitates shareholder lawsuits. Not only are the procedural hurdles for shareholder suits comparatively low in the U.S., but a unique combination of contingent fees, discovery mechanisms, pleading rules, generous attorney’s attorney’s fee awards, and the absence of the “loser pays” rule have concurred to support a specialized and highly active plaintiff’s plaintiff’s ¹² See Vetter, Vetter, note 125, para. 8. ¹² Art. 2497 Civil Code. See Corte di Cassazione, 24 August 2004, No. No. 16707, G 2005/II, 2005/II, 40. ¹² See Klaus J. Hopt, Groups of Companies , in O H C L G, note 36. ¹³ (1985) R S 648 (Cour de Cassation); see also Cozian et al., note 48, at 792. ¹³¹ See Marie-Emma Marie-Emma Boursier, Le Fait Justificatif de Groupe dans l’Abus de Biens Sociaux: Entre Efficacité et Clandestinité , 2005 R S 273. ¹³² See also Klaus J. Hopt, Common Principles of Corporate Governance in Europe , in C C L C L 105, 109 (Basil S. Markesinis ed., 2000). ¹³³ Cf. Luca Enriques, Do Corporate Law Judges Matter? Some Evidence from Milan, Milan, 3 E B O L R 765, 795–801 795–801 (2002) (contrasting Delaware judges’ judicial style with Italian courts’ reluctance to second-guess second-guess solvent companies’ business decisions, even when w hen tainted by conflicts of interest).
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bar.¹³ bar .¹³ In addition to that, federal securities regulation complements state-level state-level private
enforcement of director and dominant shareholder duties, ensuring that the critical facts are available to plaintiffs.¹³ In other jurisdictions, private litigation of duty of loyalty issues is much less common. Limitations to standing to sue, such as minimum ownership thresholds and other procedural hurdles, make it hard for minority shareholders to challenge self-dealing self-dealing by both managers and controlling shareholders, sharehold ers, especially in i n Germany, Germany, Italy, Italy, and Brazil. As a result, in Germany, Germany, private litigation litiga tion is mostly limited limit ed to transactions transacti ons which have to be approved by the shareholders’ meeting (e.g. mergers and recapitalizations) and takes ta kes the form of challenges to the validity of the meeting resolution (usually for incomplete disclosure) or the price for the appraisal appraisa l remedy.¹³ remedy.¹³ In the UK, litigation concerning closed companies is relatively common, both as fiduciary duty claims and as unfair prejudice petitions. In Japan, a modest procedural reform sparked an explosion in derivative suits against managers in the early 1990s.¹³ In the absence of discovery mechanisms similar to U.S. ones, most Japanese suits concentrate on misbehavior identified by public prosecutors, and rely on the evidence unearthed in criminal proceedings.¹³ A peculiar peculiar case isis France, France, where where certain certain forms forms of selfself-dealing dealing amounting to a vaguely defined “abuse of corporate assets” asset s” (abus de biens sociaux ) face a non-trivial non-trivial risk of criminal sanctions. Prosecutions for abus de biens sociaux , most often upon minority shareholders’ shareholders’ petitions, are common, making it the most prosecuted corporate crime in France.¹³ So, enforcementt there is privately initiated, but then is exclusively in public hands. enforcemen In Brazil, it is the Securities Commission that plays an active role: it has the power to impose fines and other sanctions (such as suspension from office or board position) for violations of the fiduciary duty of loyalty and does exercise it from time to time.¹ Yet Yet such administrative action is not an adequate substitute for court enforcement. Fines, unlike damages, provide no compensation to the company or its shareholders, and their low value in Brazil compromises deterrence. Similarly, in the last ten years or so the Italian Securities Commission has prioritized supervision on related-party transact ransactions and has been particularly parti cularly active in ensuring compliance with its regulation, both ex ante , via formal and informal interventions to ensure more comprehensive disclosure, and ex post , sanctioning members of the board of auditors for failure to monitor compliance with the regulation.¹¹ ¹³ See e.g. Martin Gelter, Gelter, Why Do Shareholder Derivative Suits Remain Rare in Continental Europe? 37¹³ B J I L 843 (2012). L See Sections 6.2.1.1 and 6.2.4. ¹³ See PierrePierre-Henri Henri Conac, Luca Enriques, and Martin Gelter, Constraining Dominant Shareholders Sharehol ders’’ Self-Dealing: SelfDealing: Te Legal Framework in France, Germany, and Italy , 4 E C F L L R 491, 513– 513–14 14 and 526 (2007). See also Chapter 7.4.1. ¹³ See Dan W. W. Puchniak and and Masafumi Nakahigashi, Japan Nakahigashi, Japan’s’s Love for Derivative Actions: Irrational Irrational Behavior and Non-Economic Non-Economic Motives as Rational Explanations for Shareholder Litigation, Litigation, 45 V J L L 1 (2012). ¹³ See Mark D. West, Why Shareholders Sue: Te Evidence from Japan, Japan, 30 J L S 351, 378 (2001). ¹³ See Art. L. 242-6 242-6 Code de commerce (jail up to 5 years, fine up to €375,000). Paul Le Cannu and Bruno Dondero, D 536 (6th edn., 2015). ¹ Art. 11 Lei 6.385, de 7 de dezembro de 1976 (Brazil) (authorizing (authorizing the Commission to impose various sanctions, including fines, for violations of the Corporations Law as well as of securities regulations). ¹¹ See Consob, R ’ 26, 194–7, 194–7, and 262 (2015); Consob, R ’ 274–5 274–5 (2015) (both available at www.consob.it www.consob.it). ).
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6.3 Ownership Regimes and RelatedRelated-Party Party ransact ransactions ions In broad outline, our major jurisdictions resemble each other in their reliance on the same legal strategies to address related-party transactions. In all jurisdictions, periodic disclosure, especially for listed companies, features as an important mechanism to prevent tunneling, while the opposite is true for exit rights in listed companies. Prohibitions are rare, and are mainly used for insider trading. With the notable exception of Germany and Brazil, trusteeship (in the form of disinterested or independent director approval) and, to a lesser degree, decision rights (in the form of shareholders’ meeting approval, or without are commonly used. Y Yet, et, a closer look atwith look substantive rulecounting rules s and therelated-parties’ consideration votes) consideration of differences differen ces in the inteninte nsity in enforcement reveal that similarities are less striking than they look. In general, continental European and Brazilian laws tend not to impose stringent constraints on related-party related-party transactions, especially as regards transactions with the dominant shareholder. Continental European jurisdictions leave considerable discretion to a company’s board and management, which face no serious risk of liability unless the firm becomes insolvent—in which case shareholders are unlikely to benefit from any enforcement action. In Germany, Italy, and Brazil, where families have long controlled many public firms, corporate law defers most to directors’ and managers’ judgment. Follow Following ing scandals in the early 2000s, however however,, Italian rules for listed companies have improved: tighter disclosure requirements have gone hand in hand with a greater role for independent directors in screening related-party related-party transactions. Te question of course grounded reliance on independent directors be in a countryiswhere, withhow the wellexception of one minorityminority-elected elected director,¹² thecan controlling shareholder selects the board members. No corresponding hard law reforms have taken place in Germany, where neither statutory law nor the Corporate Governance Code place any reliance on the trusteeship strategy in the form of independent director approval, unlike in Italy, or on shareholder decision rights, unlike in the UK and France; infrequent enforcement of standards outside bankruptcy make them of little relevance in practice, especially compared to the U.S.¹³ Te likelihood of Germany’s Germany’s converging to stricter standards appears to be low, as illustrated by Germany’s strong opposition to the European Commission’s proposal for a European regime on relatedparty transactions,¹ which led to a Council and Europe European an Parliament proposal allowing member states to retain the status quo.¹ In France, corporate law grants disinterested (as opposed to independent) board members a screening role and also mandates a shareholder vote on all non-routine non-routine transactions. Te vote, however, however, takes place once a year and ultimately may not affect ¹² See Chapter 4.1.1. ¹³ German scholars frequently point out that the equivalent minority protection in Germany would be achieved in three ways: (1) the supervisory super visory board represents the company for direct transactions with the management board; (2) corporate group law polices transactions with controlling shareholders; and (3) elaborate case law on hidden distributions, equality equal ity of shareholders, and shareholders’ fiduciary duties addresses specific suspicious transactions with shareholders generally. See Holger Fleischer, Related Party ransactions bei börsennotierten Gesellschaften: Deutsches Aktien(konzern)recht und Europäische Reformvorschläge , B-B B-B 2691 (2014). (20 14). Nevertheless, even the cumulative cumul ative impact of these measures does not appear to catch all situations that may present problems of minority protection. ¹ See e.g. Jochen Jochen Vetter, Vetter, Regelungsbedarf für Related Party ransactions? 179 179 Z W 273 (2015). ¹ SeeH note 147.
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a transaction’s validity or directors directors’’ liability other than to insulate i nsulate the transaction from
judicial review in case of a favorable vote. Further, Further, in all three countries special, more lenient rules or doctrines on intra-group intra-group transactions apply. Brazilian law is probably even more lax in policing related-party related-party transactions involving either controlling shareholders or managers: trusteeship and decisions strategies are used only sparingly, while enforcementt problems hamper the efficacy of disclosure mandates and duty of loyalty enforcemen standards. Tis, perhaps, can help explain why Brazil has had uniquely high levels of private benefits of control,¹ and, more speculatively, why its courts have been so liberal in granting requests for partial dissolution by minority shareholders in closely held corporations. Te situation is quite different in the other countries. Te UK has long relied on disclosure and decision rights (in the hands of shareholders other than the related parties and their affiliates) as the main strategy to address large related-party related-party transactions in listed companies.¹ In the U.S., courts do not shy away from imposing liability on managers for selfdealing transactions, but, contrary to continental European jurisdictions, tend to be even stricter when it comes to transactions between dominant shareholders and their controlled companies. While appropriate board approval typically leads courts to review transactions with directors under the business judgment rule, approval by both a special committee of independent directors and a “majority of the minority” of shareholders is required to obtain the same degree of deference for significant transactions with controlling shareholders. At the same time, U.S. courts do shy away from second-guessing executive compensation decisions. Curbs on excessive managerial pay thus depend on independent directors as trustees and on disclosure. It is doubtful whether these strategies work well to constrain compensation practices. Independent directors are often themselves executives at other companies or former executives. Disclosure, which is otherwise an effective curb on tunneling and is quite intensive in the t he U.S. when it comes to relatedparty transactions (including executive compensation arrangements), can have unintended consequences on compensation levels: it may in fact result in higher pay across companies, given that each board will feel pressured to pay their CEOs higher than the industry average, lest it signals the hiring of a subpar CEO. Similarly,, little convergence can be observed with respect to the enforcement mechaSimilarly nisms employed to police related-party related-party transactions. Shareholder derivative suits are significant only in the U.S. and, to a lesser degree, Japan (where they are not available against controlling shareholders). Consequently, as discussed, board approval of transactions with managers or controlling shareholders is more likely to be subject to judicial review in the U.S. than elsewhere. Similarly, the use of securities fraud provisions for failure to disclose transactions with related parties is also more common in the U.S., reflecting its unique institutions of private enforcement (such as class actions and a plaintiffs bar). In Germany, shareholder suits are used, in practice, only to challenge shareholders’ shareholders’ meeting resolutions (which may approve related-party related-party transactions like parent-subsidiary parent-subsidiary mergers) or to obtain judicial review of the appraisal ¹ See Chapter 4.4.2.1. ¹ A model the European Commission had tried to extend to all EU countries. However, as approved in the plenary session of the European Parliament on 8 July 2015, proposed Art. 9c(2), as envisaged by the Proposed Directive would leave member states free to decide whether to require majority of the minority approval of material transactions board approval (with safeguards to prevent the related party from influencing the outcome of theor board vote).
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price. Disgruntled shareholders in a French company having engaged in a related-party related-party transaction will have to file a complaint with the criminal court for abuse of corpor-
ate assets, which implies a higher threshold for a successful challenge. In Brazil and Italy,, shareholder litigation is rare, albeit not unheard of, and the bulk of enforcement Italy efforts is borne by securities regulators via both formal and informal actions. Finally, Finally, in the UK, enforcement is more informal and governancegovernance-based based than elsewhere as far as publicly traded companies are concerned, chiefly relying upon institutional investors’ pressure.¹ Tis model, however, has recently been tested at East Asian companies listed in the UK.¹ Indeed, the recognition that institutional investor pressure could do little against controllers willing to extract significant private benefits prompted a change in the listing rules granting a greater say to independent directors and minority shareholders. Te differences we have highlighted so far reflect the by now well-known well-known distinction between concentrated and diffused ownership systems. Shareholdings in listed companies are more concentrated in continental Europe and Brazil than in Japan, the UK, or the U.S.¹ In theory, given that opportunistic managerial behavior is more likely in the U.S. (historically lower ownership concentration going hand in hand with reduced shareholder monitoring), it would be reasonable for courts or lawmakers to address the issue by imposing tougher constraints on managers than those prevailing in continental Europe. Conversely, Conversely, given the higher risk of minority shareholder expropriation by controlling shareholders, one would expect courts or lawmakers in continental Europe to subject controlling shareholders to more stringent constraints than their U.S. counterparts. But interest group dynamics have led to a partially different outcome: it would appear that managers (in the U.S. and Japan) and large shareholders (in Europe and Brazil) have made effective use of their political clout to oppose stronger curbs on their opportunism.¹¹ In the case of the UK, the rigor of the related-party related-party regime for listed companies reflects the political influence of strong institutional investors. In France, in turn, the emphasis on ex post shareholder shareholder approval may also reflect the historically strong role of the state as a shareholder: unlike a controlling family’s member, to keep a close eye on directors and top managers, the state cannot sit on the board in any meaningful way, but it can have a different bureaucracy exercise its voting rights (and therefore monitor board members’ self-dealing, self-dealing, so to speak, “from a distance,” i.e. reducing the risk of collusion between directors and top managers). Tat may also help explain why French requirements requirem ents for shareholder ratification are perfunctory: they provide a focal point for shareholders’’ attention and allow shareholders allow,, as the case may be, for the exercise of more effective powers, including removal, vis-àvis-à-vis vis unfaithful directors and managers. Te relevant role of the state as a controlling shareholder may also explain the controller-friendly controller-friendly regime applicable to related-party related-party transactions in Brazil.¹² ¹ With respect to closed companies see Chapter 6.2.5.4. ¹ See Roger Barker and Iris H.Y. H.Y. Chiu, Protecting Minority Shareholders in Blockholder-Controlled Blockholder-Controlled Companies: Evaluating the UK’s Enhanced Listing Regime in Comparison with Investor Protection Regimes in New York and Hong Kong , 10 C C M L J 98, 104–5 104– 5 (2014). ¹ See Chapter 1.6. ¹¹ Tis does not necessarily translate into high, let alone uniform, level level of tunneling across jurisdictions. We We have in fact seen see n that the level of private benefits of control has differed across countries. See Chapter 4.4.2.1. Other factors, whether economic or cultural, may be at work to compensate for weaker legal constraints in some jurisdictions. ¹² (2012). See Mariana Mariana Pargendler, Pargendler, State Ownership and Corporate Governance , 80 F L R 2917
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Differences in enforcement intensity again correlate with ownership structures. Here, however, ownership patterns also interact with the dynamics of enforcement
institutions. In fact, the relevant interest groups here are not just managers and dominant shareholders, on the one hand, and investors on the other. Tose involved in the functioning of the enforcement system (such as the bar, securities regulators, and judges themselves) may be wellwell-organized organized and politically connected enough, whether alone or coalescing with investor organizations, to achieve the goal of having corporate law rules in place that increase enforcement activity. activity. Te plaintiff bar and the securities regulator have traditionally been much stronger in the U.S. than in any other of our core jurisdictions. In addition, the U.S. experience seems to indicate that high levels of private litigation can prompt public enforcers to be more active themselves: prosecutors and the SEC risk public criticism if they cannot show that they are doing as much as the private bar.. Increased public enforcement, in turn, spurs private litigation that piggybacks on bar the evidence unearthed.¹³ In sum, competition between private and public enforcers seems to lead to an overall higher level of enforcement. Outside the U.S., then, the absence of a specialized plaintiffs’ bar has a negative impact on public enforcement as well; and public enforcement, where relevant, is insufficient to spur private enforcement in the presence of procedural hurdles. Finally,, it goes without saying that Finally t hat ownership structures are not static— static—and and neither is the law. In a number of jurisdictions where ownership is concentrated, namely Italy and Brazil, recent increases in institutional investor ownership, on the one hand, and expansion and family succession considerations, on the other, have led to the tightening, at least on the books, of regulations on related-party related-party transactions. What is puzzling is that, despite an even stronger trend trend toward dispersed and institutional ownership,¹ no similar reform efforts have gained momentum in Germany Germany.. An optimistic answer would be that the smaller smaller size of private benefits in that country country compared to Brazil and Italy¹ is evidence that related-party related-party transactions and tunneling more generally are not a serious concern for shareholders of German listed companies, possibly because other tools of minority protection are doing the job.¹ But once again, path dependence and interest group dynamics may provide an equally plausible explanation. Te law of corporate groups, by accommodating the frequent use of intragroup transactions, reinforces group-based group-based organizational structures. Teir operation would be more burdensome under the set of rules prevailing elsewhere, which raise the costs of individual related-party related-party transactions.¹ In addition, and relatedly, powerful interest groups, public notaries, and lawyers, including many legal scholars, strongly support traditional group law as the most effective mechanism to address transactions with dominant shareholders.
¹³ See James D. Cox, Randall S. Tomas, and Dana Kiku, SEC Enforcement Heuristics: An Empirical Enquiry , 53 D L J 737, 761 (2003). ¹ Wolf-Georg Wolf-Georg Ringe, Changing Law and Ownership Patterns in Germany: Corporate Governance and¹theSee Erosion of Deutschland 63 A J ¹C Lnote L 493 119. (2 015). (2015). Chapter 4.4.2.1. AG , ¹ See note 143. See Dammann,
7
Fundamental Changes Edward Rock, Paul Paul Davies, Hideki Kanda, Reinier Kraakman, and Wolf-Georg Wolf-Georg Ringe
In Chapters 3 and 4, we discussed the basic governance structure of the corporation. In this chapter, we discuss fundamental or structural changes in the relationship among the participants in the firm, and how corporate law mitigates the opportunism that can accompany these changes. Examples for such fundamental changes include mergers, share issuances or other structural changes; however, it is difficult to find a generalizable notion of what makes changes “fundamental.” Te key rationale for regulating fundamental changes by law is to protect certain constituencies such as minority shareholders against the threat of opportunistic midstream changes in the life of a corporation. In the absence of legal rules, those in control of the corporation could successfully adopt changes that would unilaterally benefit them at the expense of other constituencies. Collective action problems, asymmetric information, and contractual incompleteness in long-lived long-lived corporations make midstream changes in the fundamental relationships among the firm’s participants ripe for abuse. Whilst there is some disagreement about the need to protect corporate constituencies at the formation stage by by mandatory legal rules,¹ most commentators agree that there is a stronger case for legislative interference in midstream situations .² .² As initial investors reasonably anticipate later opportunistic changes, they would discount for this risk at the stage of their investment decision. o overcome this problem, firms need a credible commitment signal to convince investors that no opportunistic amendments will occur in the future. Mandatory legal protection devices arguably provide a solution to this problem.³ Tis assessment is consistent with the limited extent of private ordering: several studies suggest that contractual freedom is rarely exercised in corporate law and that t hat default arrangements and mandatory mandator y rules matter.
¹ A rich academic debate focuses on the question of whether IPO markets price charter terms correctly. See Lucian A. Bebchuk, Why Firms Adopt Antitakeover Arrangements , 152 U P L R 713, 740 (2003); Bernard S. Black, Is Corporate Law rivial? A Political and Economic Analysis , 84 N U L R 542, 571–2 571– 2 (1990). See also Jeffrey N. Gordon, Gordon, Te Mandatory Structure of Corporate Law , 89 C C L L R 1549, 1563 (1989). ² On the distinction between formation stage and midstream changes see e.g. Gordon, Gordon, note 1, at 1593; Lucian A. Bebchuk, Te Debate on Contractual Freedom Freedom in Corporate Law , 89 C L R 1395, 1401 (1989). ³ Gordon, note note 1, at 1593. Yair Listokin, What Do Corporate Default Rules and Menus Do? An Empirical Examination, Examination , 6 J E L S 279 (2009); Henry Hansmann, Corporation and Contract , 8 A L L E R R 1 (2006). For the specific case of IPOs see John John C. Coates IV, IV, Explaining Variation in akeover Defenses: Blame Do the IPO Lawyers Charters Maximize Firm Value? Antitakeover (2001); Robert Daines and Michael Klausner, , 89 C L R 1301, 1357 Te Anatomy of Corporate Law. Tird Edition. Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry Hansmann, Gerard Hertig, Klaus Hopt, Hideki Kanda, Mariana Pargendler, Wolf-Georg Ringe, and Edward Rock. Chapter 7 © Edward Rock, Paul Davies, Hideki Kanda, Reinier Kraakman, and Wolf-Georg Ringe, 2017. Published 2017 by Oxford University Press.
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Jurisdictions differ in their assessment assessment of this problem along two dimensions. dimensions. First, there is disagreement on which situations require a statutory protection mechanism: put differently, differently, which changes are so “fundam “fundamental” ental” that they should trigger legal inter-
ference? Secondly, Secondly, the legal strategies that are used to address the problem vary significantly across jurisdictions. Depending on the jurisdiction, these strategies include: a judicial review of the fairness of the change, change, double-majority double-majority or supermajority requirements for the effectiveness of the change, majority-ofmajority-of-the-minority the-minority requirements, exit rights, or a combination of these. Many of the legal devices utilized in this context can be classified along the categories that we develop in Chapter 2. Te functionality of a particular parti cular jurisdiction’ jurisdiction’s approach might depend—again— depend—again—on on the prevailingchanges agency that conflict that it in seeks address. shallsalient see, some of the fundamental we discuss thistochapter willAsbewemore in a certain ownership environment environment than in another another.. Te same holds true for the effectiveness of a remedy. For example, a shareholder approval requirement by simple majority would be of little use in countries where controlling shareholders shareholders are the norm. Tese jurisdictions are more likely to require a supermajority or a majority-ofmajority-of-thethe-minority minority consent. o complicate matters further, fundamental changes do not only concern shareholder or minority shareholder expropriation. o the extent that other stakeholders might be affected, the law might also come to the help of creditors or employees, for example. Fundamental changes affecting a company’s financial structure or delisting decisions, for instance, might have negative consequences for creditors; mergers may have repercussions on the employment of the combined firms. o the extent that these constituencies are held to be unable to protect themselves, some of our core jurisdictions also provide protective measures for them.
7.1 What are are Fundamental Changes in the Relationship among the Participants in the Firm? Corporate law worldwide provides for special regulation of many fundamental changes. Centralized management exercises most decision-making decision-making power in the corporate form, but this rule does not extend to decisions that have the potential of fundamentally reallocating rea llocating power among the firm’ firm’s participants. No jurisdiction, for example, authorizes the board of directors to amend the company’s charter in a material way or to effect unilaterall unila terallyy a merger that alters alte rs the company’s company’s risk and return profile. Te board’ boa rd’ss power over such basic decisions is always circumscribed, usually by shareholder decision rights and sometimes by other forms of legal intervention as well. Even a traditionally board-centered board-centered jurisdiction such as Delaware must grapple with the problem of protecting settled expectations against attempts by managers to grab power allocated to shareholders, by majority shareholders to take advantage of minority shareholders, and by shareholders to benefit at the expense of creditors or employees. Indeed, in Chapter 6, we have already reviewed the limits on board authority to approve transactions involving high-powered high-powered conflicts of interest between the company and its directors or controlling shareholders. Provisions in IPOs , 17 J L, E O 83, 95 (2001). For an overall assessment, see Michael Klausner, Fact and Fiction in Corporate Governance , 65 S L R 1325, 1346 et seq. (2013). See Chapter 6.2.3. See See Chapter 3.4. See See Chapter 6.2.2 and 6.2.3.
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In this chapter, we address how corporate law limits board authority to change the fundamental allocation of power. power. Although there is no single set of characteristics that marks the limits of the board’s board’s power to decide unilaterally unilaterally,, either across jurisdictions
or within them, there are some general tendencies. Corporate law seldom limits board discretion unless corporate corporate actions or decisions share at least one of the following characteristics: (1) they are large relative to the participants’ stake in the company; (2) they create a possible conflict of interests i nterests for directors, even if this conflict does not qualify as a related-party related-party transaction; or (3) they involve general, non-firm non-firm specific, investmentlike judgments that shareholders are arguably equipped to make for themselves. Althoug Alth oughh the these se thr three ee char characte acterist ristics ics larg largely ely des describ cribee the limi limitatio tations ns on boar boardd disc discret retion ion,, jur jurisdi isdictio ctions ns ine inevitab vitably diverge rge tothey some som e exte extent nt in how they select and reg regulat ulatee “fun fundadamental changes.” Tatlyisdive because weigh the interests of shareholders, minority shareholders, and stakeholders differently, and because the dominant agency problem differs depending on the prevailing pattern of share ownership. With this caveat in mind, let us turn to the three key characteristics associated with significant corporate transformations. Consider first the size of of a corporate action. At first glance, it is not obvious why size should matter to board discretion. One might suppose that if the board’s board’s expertise is critical in ordinary business decisions, it is even more so for decisions that involve very large stakes for participants or for the company. company. Te response to this point, however, is that the relative size of a corporate action also increases the value of any legal intervention that affects the company’s decision-making. decision-making. o take the classic example, given that shareholders’ meetings to authorize corporate transactions are costly, they are more likely to be efficient (if they are efficient at all) for large transactions than for small ones. In(asother words, to thea higher associated a shareholders’ meeting compared board transaction meeting) arecosts justified whenwith agency costs are potentially high. In addition, shareholders’ meetings are more likely to be effective if the stakes are large enough to overcome shareholders’ information and coordination problems. On the other hand, it seems that the size of a decision alone does not trigger heightened regulation; corporate law generally delegates even the largest investment and borrowing decisions to the board alone. Te second key characteristic of corporate actions that is i s often associated with constraints on board discretion is a risk of selfself-interested interested decision-making decision-making by the board. Low-powered Lowpowered conflicts of interest frequently dog major transactions, even without signs of flagrant self-dealing. self-dealing. For example, directors and officers who negotiate to sell their companies enter a “final period” or “end game,” in which their incentives turn less on the interests of their current shareholders than on side deals with, or future employment by, by, their acquiring companies.¹ Unlike the case of related-party transactions, these conflicts of interests do not depend on who is the counterparty or on other factual circumstances, but inherently ensue from the subject matter of the corporate action itself.¹¹ Even such low-powered low-powered conflicts of interest can seriously harm shareholders, and are thus a focus of regulation.
Sofie Cools, Te Dividing Line Between Shareholder Democracy and Board Autonomy: Inherent Conflicts of Inter Interest est as Normative Criterion, Criterion, 11 E C F L L R 258, 273–55 (2014). 273– Edward B. Rock, Institutional Investors in Corporate Governance , in O H C L L G (Jeffrey N. Gordon and Wolf-Georg Wolf-Georg Ringe eds., 2017). ¹ See Ronald J. Gilson and Reinier Kraakman, What riggers Revlon?, Revlon?, 25 W F L R 37 (1990). ¹¹ Cools, note 8, at 275– 275–8. 8.
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Finally, a third characteristic often associated with transformative corporate actions Finally, that are subject to t o special rules is that they are such as not to require a firm-specific judgment, but rather rather one one that resembles resembles a decision decision on on how how to allocate portfolio money money.. Hence, shareholders’ shareholders’ comparative disadvantage in decisiondecision-making making vis-àvis-à-vis vis the com-
pany’s management will be lower, despite the inevitable information asymmetries, than for typical business decisions. For instance, shareholders shareholders in company A may find it more congenial to decide on whether A should merge with company B than on whether A should make R&D investments to market a product that may compete with company B’s. B’s. In the former case, the point is whether an aggregate AB company resulting from a merger at a given exchange ratio is a better investment than one in A as a stand-alone standcompany company. . In the latter case,has specific knowledge, knowledge among resources many other things, aboutalone whether the R&D department the right mix of,human to successfully develop a product like B’s will be necessary and shareholders are unlikely to ever have access to the relevant information. In the following, we consider several corporate transformations that trigger special scrutiny,, including charter amendments, share issuances, mergers, corporate divisions scrutiny and asset sales, reincorporations, reincorporations, and conversions. As we shall see, many of these corporate-level poratelevel restructurings can be used to freeze out minority shareholders. In addition, in some jurisdictions controllers can employ a compulsory share exchange to freeze out minority shareholders even without a corporate-level corporate-level restructuring. Given this, and the fact that the legal strategies used to protect minority shareholders in corporate-level corporate-level freeze-outs freezeouts often track those used in shareholder-level restructurings, we extend our discussion to cover freeze-out freeze-out (or squeeze-out) squeeze-out) transactions more generally.¹² Interestingly, Interestingly vulnerability of minority shareholders in freezefreeze-out outcorportransactions, none of, despite our corethe jurisdictions prohibits controllers from taking public ations private, or parent companies from forcing the sale of minority shares in their subsidiaries. Te reason may be that such transactions can generate efficiency gains despite the deep conflicts that they entail. First, they eliminate the chronic conflicts of interest between parent companies and partly owned subsidiaries that arise from intragroup self-dealing self-dealing transactions and allocations of business opportunities.¹³ Secondly, by allowing for a collective solution, they may motivate controllers to allow minority shareholders to cash out of otherwise illiquid investments. Tird, controlling shareholders may be less inclined to invest additional capital in positive net present-value present-value projects if they are forced to share their returns with minorities.¹ Finally, in many jurisdictions going-private going-private transactions eliminate the costs of being a public company, company, such as preparing disclosure documents and the opportunity costs of disclosing information of value to the firm’s competitors.
7.2 Charter Amendments Althoughh many of the relationships among participants in the firm are structured by Althoug contract, including contracts with creditors and shareholder agreements, corporate law ¹² However However,, we postpone full discussion of postpost-public public offer squeeze-outs squeeze-outs until Chapter 8. ¹³ See Chapter 4.1.3.2. ¹ Tis rationale for freeze-outs freeze- outs requires additional assumptions to be plausible. Imagine, for example, a risk-averse risk-averse controlling shareholder with private information about a prospect of lucrative but risky returns from expanding the company’s operations. Such a controller might not be able to raise outside capital without jeopardizing his control, and might not be willing to provide additional capital himself.
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contains a special sort of contractual device that allows for flexibility, constitutional commitments, and publicity: the corporate charter.¹ Like other constitutions, corporate charters establish a basic governance structure and allow the entrenchment of terms, typically through a special amendment process. Unlike ordinary contracts, corporate
charters can be amended with less than unanimous approval by the parties to the charter, must be filed in a public register and are generally available to anyone who asks. In addition, charters bind all the shareholders, including new ones, without the need to obtain their contractual consent. Each of these features serves important functions. All the jurisdictions considered here treat a charter amendment as a fundamental change.¹ Te most pervasive regulatory strategy employed is that of an ex post decision right are called to ratify thefundamental charter amendment. saw indistribution Chapter 2, this is: shareholders a typical strategy for regulating changes: As thewe regular of powers in the corporation, that is, the delegation of authority to the management, is reversed in extreme situations which are deemed important for the principals.¹ However, such decision rights come in different variations across jurisdictions: under Delaware law, law, for example, a charter char ter amendment must be proposed by the board and ratified by a majority of the outstanding stock.¹ By contrast, in i n European jurisdictions and in Japan, the charter can normally be amended by a supermajority shareholder vote, and without board initiative.¹ Te U.S. rule creates a bilateral veto; that is, neither the board nor the shareholders can amend the charter alone. By contrast, requiring only supermajority shareholder approval allows large minority shareholders to veto proposed charter amendments, but gives management no formal say in the matter. Both sets of amendment rules permit corporate planners to entrench governance
provisions in the an optionnot thatinisconflict particularly since our core jurisdictions allow anycharter— charter provision with valuable the law. By means of charter provisions, shareholders can make credible pre-commitments. pre-commitments. For example, under the Delaware approach, dispersed shareholders who approve an antitakeover provision in the charter—such charter—such as a classified board—strengthen board—strengthen the bargaining role of the board in an attempted takeover by reducing the likelihood that they would accept, or that an acquirer would make, a takeover offer without the approval of the board.² Under the supermajority shareholder approval mechanism, shareholders bond themselves to consider (large) minority interests. Te extent to which charter provisions entrench governance rules depends on the structure of share ownership. As described above, where shareholdings are dispersed, the Delaware approach creates a bilateral veto between managers and shareholders, ¹ Marcel Kahan and Edward Rock, Corporate Constitutionalism: Antitakeover Charter Provisions as Precommitment , 152 U P P L L R 473 (2003). (2 003). Note that what we term the “charter” often has another name according to jurisdiction, such as the “certificate of incorporation,” the “articles of association,” the “statutes,” or the “constitution.” However, when we refer to the charter we do not include what in the U.S. are known as the “bylaws,” a separate document specifying specifyi ng the internal structure and rules of the organization. See note 32 and accompanying text. ¹ Although jurisdictions disagree on the mandatory scope of corporate charters, see text accomaccompanying notes 28–33. ¹ See Chapter 2.2.2.2. ¹ Delaware General Corporation Corporation Law (hereafter (hereafter DGCL) § 242. ¹ UK Companies Act 2006, section 21; France: France: Art. L. 225-96 225-96 Code de commerce; Germany: AktG § 119(1) no no 5; Italy: Art. 2365 Civil Code; Japan: Japan: Art. 466 Companies Act. Tese systems may permit changes to be effected in exceptional cases by the board alone, but generally only where the change is regarded as minor or there are strong public policy reasons for board-alone board-alone decision-making. decision-making. Of course, in practice most proposals for charter amendments originate from the board. ² See Kahan and Rock, note 15.
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which allows current shareholders to guard against uninformed decision-making by future shareholders (through charter provisions such as the staggered board), at the risk of facilitating management entrenchment.²¹ While Delaware’s board-centered board-centered corporate law system views the bilateral veto as an attractive feature of corporate law,
shareholder centered systems, such as the UK, are more concerned with management entrenchment,t, and the charter amendment regime is thus one which formally excludes entrenchmen management from the decision on whether to amend a mend the charter. In a system with concentrated holdings, by contrast, a bilateral board-shareholder board-shareholder veto is likely to be empty, since controlling shareholders can generally choose boards that will do their bidding. In these systems, however, a supermajority voting requirement gives (large) minority shareholders a veto, thus creating a bilateral veto among shareholders. In this way the majority may be able to make credible pre-commitments pre-commitments to the minority through appropriate provisions in the charter, providing that minority shareholders can ensure that their holdings are not diluted below the veto threshold. Perhaps to obviate this risk, some corporate law systems permit the shareholders to increase the supermajority requirement for certain provisions, even to the level of unanimity.²² Brazil is exceptional among our core jurisdictions in generally allowing for charter amendments without board initiative and by a simple majority of shareholders, though certain changes (such as alterations to the rights of preferred shares, reduction of the mandatory dividend or modification of the corporate purpose) require the affirmative vote of a majority of the common shares outstanding and entitle dissenting shareholders to appraisal rights.²³ In lieu of stronger decision rights, Brazilian law relies on a standardsthat strategy thatinimposes liability on controlling shareholders amendments are “not the interest of the company” and that “seekfortocharter that harm” minority shareholders, workers, and bondholders— bondholders—aa standard that is arguably overly demanding to be effective in constraining abuse.² Combined with a prohibition on supermajority approval requirements in publicly traded corporations’ charters,² this regime in practice reduces the ability of controlling shareholders to make credible precommitments in the corporate charter. Of course, in Brazil as well as elsewhere, shareholder agreements existing separately from the charter can be used to entrench governance provisions as well. One disadvantage of a shareholder agreement is that, like other contracts, it would ordinarily require unanimous consent to amend, but it is usually possible to structure a shareholder agreement so that amendments are binding on all al l upon approval by a majority. Ultimately,, the great advantage of entrenchmen Ultimately entrenchmentt in the charter is that it operates more smoothly, by automatically binding new shareholders, than the an disclosure extra-charter extra-charter agreement. However, because many jurisdictions do not require of shareholder agreements, at least if the company is not listed, that may be perceived as a countervailing advantage.² Of course, a shareholder agreement to which only some
²¹ Of course management entrenchment entrenchment can be constrained constrained in other ways. See Chapter 8.2.3.1. ²² See e.g. Companies Act 2006, section 22 (UK). Te commitment must be present on formation or be introduced later with the unanimous consent of the shareholders. ²³ Arts. 122, 129, 136, and 137 Lei das Sociedades por Ações. ² Art. 117, § 1º, c ibid. ² Art. 136 ibid. ² Italy is an example of a jurisdiction mandating disclosure of shareholder shareholder agreements. See e.g. Vincenzo V. Chionna, L (2008). Another example is Brazil, where shareholder agreements must be publicly filed in order to bind the company: Art. 118 Lei das Sociedades por Ações.
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shareholders are party may also operate as a mechanism for entrenching control rather than for protecting the minority minority.. In recognition of the governance and publicity functions of charters, jurisdictions typically mandate the inclusion of specific governance arrangements in them. For example, “dual-class” “dualclass” capital structures in which some shares have more votes than others, where
permitted,² may be required to appear in the charter; similarly, similarly, where permitted, limitations on directorial liability.² Te more prescriptive a jurisdiction is about the mandatory contents of corporate charters, the more important is the amendment procedure. Whilstt some jurisdictions Whils jurisdictions specify only a few rudimentary issues that charte charters rs need to address, and leave the remainder to the company’s discretion, the German concept of Satzungsstrenge (“strictness (“strictness of the charter”) means that the charter may only include provisions (or deviate from the default regime) in the fields where it is expressly permitted to do so.² Against this backdrop, it appears that lawmakers can influence the effectiveness of the corporate charter not only by specifying the procedure for its modification, but also by regulating the substantial scope of the charter charter.. Tis has indirect consequences for what subject matters would qualify as fundamental changes in any given jurisdiction. For example, all jurisdictions require corporate charters to deal with the company’s company’s share capital in a significant si gnificant way, way, inter alia by stating the number of authorized shares, the number of share classes, and the powers, rights, qualifications, and restrictions on these shares. Te extent to which such terms constrain the board in the issuance of shares depends, however, however, on a larger set of rules. Tus, in Delaware, while the charter must state the number of authorized shares, the board has authority to issue stock below the number of shares fixed in the charter. By contrast, European jurisdictions contain statutory default rules requiring shareholder authorization of share issues or at preleast preemption emption rights.³ Another example of divergence is the structure st ructure of the board of directors. In several European jurisdictions, matters of board structure, such as the number of board seats (but not the number or function of board committees) must be memorialized in the charter,, and may thus be changed only by a supermajority shareholder vote.³¹ By concharter trast, in the U.S., such provisions are typically included in the t he “bylaws”—the “bylaws”—the rules for the day-today-to-day day running of the corporation, typically adopted by the board—although they can be placed in the charter, if desired.³² UK law has also traditionally regarded ² See Chapter 4.1.1. ² DGCL § 102(b)(7); Arts. 426 and 427 Companies Act (Japan). Even Even in jurisdictions which do not insist that such requirements appear in the charter, the charter provides a convenient way of making them public or giving them binding force. See e.g. Art. 3 Second EU Directive (2012/ 30/ EU), requiring certain information about shareholder rights to appear “in either the statutes or the instrument of incorporation or a separate document published in accordance with the procedure laid down in the laws of each Member State … ” Restrictions on the transfer of shares, in Delaware, may be in the charter, the bylaws, or a shareholder agreement: DGCL § 202(b). Te UK does not insist on the rights of classes of shareholders being set out in the charter (as opposed to the terms of issue of the shares), though they often are dealt with in the articles of association. ² Ak AktG tG § 23 23(5 (5). ). ³ Sha harre is issu suan ance ce ru rule less ar aree di disc scus usse sedd in Se Sect ctio ionn 7. 7.3. 3. ³¹ Te charter must specify the number of supervisory board seats for German AGs if it is to comprise more than the mandatory mandator y minimum (§ 95 9 5 AktG). For the French SA, the charter only sets a maximum number of seats within the range (3–18) (3–18) allowed by law (Art. L. 225-17 225- 17 Code de commerce). By contrast, the law allows German GmbHs great freedom regarding the number of board seats: the charter may e.g. e .g. specify a number, set a range, or leave the decision to another body. body. ³² Bylaws, under Delaware law, have a curious status. Formally, if the certificate of incorporation is thought of as the corporate constitution, the bylaws can be understood to be the corporate statutes: they govern the day-today-to-day day operation of the firm but when the certificate of incorporation and the bylaws conflict, the certificate of incorporation governs: DGCL § 109. An odd provision of
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board structure (including committees) and composition to be quintessentially matters of “internal management,” that may either be enshrined in the charter or left to rules made by the board itself. Tese differences in mandatory content are of decreasing importance, however, however, because of the trend in all major jurisdictions to mandate, by law or rules of best practice, that key board committees in listed companies, especially the
audit committee, be independent and follow specific procedures.³ procedures.³³³
7.2.1 Te management– management–shareholder shareholder conflict in charter amendments Charter provisions can be used to entrench management vis-àvis-à-vis vis shareholders. For example, a charter provision establishing a classified (or staggered) board gives the directors a temporary veto over efforts by shareholders to oust them in response to a bid for control (unless directors are mandatorily subject to removal by an ordinary majority of the shareholders, irrespective of what the charter says).³ Te decision rights strategy is used to control management–shareholder management–shareholder agency costs: any midstream charter change must be approved by shareholder vote. 7.2.2 Te majority– majority–minority minority shareholder conflict in charter amendments Although the supermajority vote may provide a degree of protection for minorities, most jurisdictions go further. In many systems, charter amendments that adversely affect separate.³class must beright approved by isa particularly majority of important that class votingatogether.³ together Suchofa shareholders “reinforced” decision “reinforced” strategy for preferred shareholders, who often lack voting rights and who rely in consequence on the charter, and the rules r ules governing its amendment, to protect their interests. Such protection, however, must be carefully drafted to actually fulfil its purpose.³ For example, Delaware case law provides that unless the preferred stock clearly states that class approval is required for changes to the terms, whether by charter amendment or by merger, the protection offered is illusory.³ Equally, British and Italian courts have drawn a sharp distinction between variations of the formal rights of a class of shareholders (requiring separate approval) and changes in the charter reducing the value of those rights but not changing them formally (not requiring class approval). Tus, in the UK, increasing the voting rights of another class of shares or even eliminating preference shares entirely through a reduction of capital (provided the preference the Delaware law has made bylaws a focus of shareholder activism. While the power to adopt bylaws may be, and typically is, delegated to the board of directors, that delegation does not divest shareholders of the power to adopt, amend or repeal bylaws: DGCL § 109. Tis has sparked a variety of conflicts over the permissible scope of bylaws and left unanswered some fundamental questions such as what happens if the board, pursuant to its delegated power, repeals a shareholder-adopted shareholder- adopted bylaw bylaw.. See Chapter 3.2.1 and 3.2.3. ³³ See Chapter 3.3.2. ³ See Chapter 3.1.3. ³ See e.g. DGCL § 242; Art. 2376 Civil Code (Italy); Art. L. 225-99 Code de commerce (France); Companies Act 2006, Part 17, ch. 9 (UK); AktG § 179(3) (Germany); Art. 322 Companies Act (Japan); Art. 136, § 1º Lei das Sociedades por Ações (Brazil). ³ William Bratton, Venture Capital on the Downside: Preferred Stock and Corporate Control , 100 M L R 891, 922–39 922–39 (2002); William Will iam Bratton and Michael L. Wachter Wachter,, A Teory of Preferred Stock , 161 U P P L R R 1815, 1831 18 31 ff. (2013). ³ Bratton, note 36.
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shareholders are treated in accordance with the rights they would have on a liquidation of the company) have been held to fall outside the class protection.³ Most jurisdictions also use regulatory strategies alongside this. For example, they may have a fallback standard allowing courts to review the most egregious examples of self-interested selfinterested charter changes, whether involving class rights or not, but these stan-
dards are rarely invoked successfully. However, a more common protection is the exit right strategy, strategy, mostly in the t he form of an appraisal right . . Italy, Japan, Brazil, most U.S. states (though not Delaware), and France provide appraisal rights for charter amendments that materially affect the rights of dissenting shareholders (e.g. altering preferential preferen tial rights or limiting voting rights).¹ Charter provisions can also be used to solidify control by a controlling shareholder. shareholder. A dual-class dual- class capital structure (either high voting and low voting, or voting and nonvoting, stock), which must be in the charter to be valid, will allow shareholders with a minority of the cash-flow cash-flow rights to retain control.² As such, it is a powerful entrenchment device. Having been banned by the New York Stock Exchange (NYSE) listing rules for the most part par t of the twentieth t wentieth century, century, it has seen somewhat of a renaissance in both media and I corporations lately lately.³ .³ Midstream introductions of dual- class structures are frequently understood as efforts by would-be would-be controlling shareholders (often current managers) to exploit non-controlling non-controlling shareholders’ collective action problems to induce them to approve value-reducing value-reducing amendments. In response, former SEC rule 19c-4 required stock exchanges to refuse to list firms that had engaged in midstream dual-class dual-class recapitalizations. Although the SEC rule was ultimately held to be beyond its regulatory authority, the exchanges, which had already adopted conforming rules, left them in place. Japan is similar in that stock exchanges generally do not permit midstream dual- class recapitalizations that would exploit existing noncontrolling shareholders. ³ See Paul Davies and Sarah Worthington, G A D’ P O M C L L (9th edn., 2012), paras. 191 9-32 32 to 19-37. 19-37. ³ E.g. abus de majorité in in France (see Maurice Cozian, Alain Viandier, and Florence Deboissy, D S 239–41 239–41 (28th edn., 2015)); provisions prohibiting “unfair prejudice” in the UK (see Davies and Worthington, note 38, ch. 20). AktG § 243(2) permits a challenge by an individual shareholder to any decision of the general meeting on the grounds that another voting shareholder has acquired through the resolution “special benefits for himself or another person to the detriment of the company or other shareholders.” See Art. 831(1)(iii) Companies Act (Japan) (similar rule). Potentially more important, the UK has also developed a review standard in the specific context of charter changes i.e. the requirement that the change be effected “bona fide in the interests of the company.” Tis rather opaque formula tends to require simply that the majority act in good faith, except in cases of expropriation of shares where it has a larger impact. See Re Charterhouse Capital Limited [2014] EWHC 1410 (Ch) [230]–[237]. [230]–[237]. See Chapter 2.2.1.2. ¹ Art. 2437 Civil Code (Italy) (appraisal right granted for charter amendments regarding e.g. voting rights or significant changes in the scope of business); § 13.02 R M B C A (hereafter “RMBA”) (U.S.). For Brazil see note 23 and accompanying text. In France, when a controlling shareholder proposes to alter the charter of a listed company in a significant way, it must inform the market regulator (Autorité des Marchés Financiers, AMF) in advance, which may require the controllers to make a buy-out buy- out offer, on terms agreed with the AMF, for the minority shares. Art. L. 433-4 433-4 Code Monétaire et Financier; Art. 236-6 236-6 Règlement Général de l’AMF. ² See also Chapter 4.1.1. ³ Recent examples are the New York York imes, imes, News Corporation, and Comcast, as well as Google, Facebook, and LinkedIn, where the use of “super-voting” stocks has allowed the founding shareholders to keep control of the corporation without holding the majority of the share capital. Voting Rights Listing Standards, Standards, Release No. No. 34-25891, 34-25891, 53 Fed. Reg. 26376 (1988). Business Roundtable v. SEC , 905 F R 2d 406 (D.C. Cir. 1990). See okyo okyo Stock Exchange, Exchange, Listing System Improvement FY2008, 27 May 2008.
Fundamental al Changes Fundament 180 In Europe, dual-class dual-class recapitalizations are controversial although generally permitted; and they are regulated differently than in the U.S. Even if the charter confers on the board the discretion to issue classes of shares with differing cash-flow cash-flow or governance rights attached, mandatory rules of corporate law, derived from the Second Directive, require shareholder shareholder consent to any particular exercise of the power and also require preemptive rights to be given to the existing shareholders in the case of the issue of equity
shares for cash. Consequently, dual-class dual-class recapitalizations have been handled not through specific rules implementing the proportionality principle but rather through the general rules on charter char ter amendments.
7.3 Share Issuance ransactions involving the company’s share capital can realign interests: issuance of new shares can dilute the ownership of existing shareholders; their repurchase and capital reductions can entrench managers, create a controlling shareholder, shareholder, provide an exit to an advantaged shareholder, shareholder, and injure creditors. Most jurisdictions again a gain use predominantly a decision-rights approach to address a ddress these issues. 7.3.1 Te manager– manager–shareholder shareholder conflict Shareholders as a class have an interest in maintaining direct control over major decisions that can jeopardize their interests, most importantly by diluting their cash flow or voting rights.¹ Above all, this concerns the corporate decision to issue new shares . In such transactions, managers’ incentives may be problematic: share issuances can be used to build empires, entrench managers, and dilute shareholder influence. Not surprisingly,, then, we find the familiar requireme prisingly requirements nts of board and shareholder approval. In the U.S. and Japan the distinction between the number of shares authorized by the charter and the number of shares that are actually issued and outstanding is, in practice, highly relevant. An increase in the amount of authorized capital capital is an organic change that must be approved by a qualified vote of the shareholders. By contrast, a new issue of shares that leaves the number of issued shares below the authorization limit lies within the discretion of the board. Since most companies have actually issued only a fraction of their authorized shares at any particular point, the decision to issue shares is effectively a board decision that does not require shareholder approval.² But there are exceptions: U.S. listing requirements require a shareholder vote when a new See Arman Khachaturyan, rapped in Delusions: Delusi ons: Democracy, Fairness and the One-ShareOne- Share-OneOne-Vote Vote Rule in the European Union, Union, 8 E B O L R 335 (2007); Mike Burkart and Samuel Lee, One Share-One Share-One Vote: Te Teory , 12 R F 1 (2008); Renée Adams and Daniel Ferreira, One Share-One Share-One Vote: Te Empirical Evidence , 12 R F 51 (2008); Wolf-Georg Wolf-Georg Ringe, Deviations from Ownership-Control Ownership-Control Proportionality—Economic Proportionality—Economic Protectionism Revisited , in C L E P 209 (Ulf Bernitz and WolfGeorg Ringe eds., 2010). See Section 7.3. Te European Commission rejected proposals to to make the proportionality proportionality principle mandatory at the EU level. See European Commission, Impact Assessment on the Proportionality between Capital and Control in Listed Companies , SEC (2007) 1705, December 2007. Note, too, that some of these adjustments to capital are also organic changes, changes, since they require material amendments to company charters. ¹ See Section 7.1. Grimes v. Alteon, Alteon ² on , 804will A R 256 (Del. 2002).anFrequently Frequently, tion authorized shares be illusory. When 2d a charter contains authorized, the butcharter’s unissuedlimitaseries
Share Issuance 181 issue of shares is large enough to shift voting control over a listed l isted company, company, unless the new issue takes the form of an offering to dispersed public shareholders.³ In Japan, since 2014, the law requires shareholder approval approval when the subscriber of newly issued shares comes to own the majority of shares and 10 percent or more of shareholders oppose the issuance. By contrast, EU jurisdictions have a stronger tradition of putting new share issues
to the vote of shareholders, although the company companyss charter or the shareholders in general meeting may delegate that decision to the board, for periods of up to t o five years. Tis position may not appear as much different from that in the U.S., but European corporate practices give the shareholders more control over shareholder rights plans. Concerns about share dilution also arise whenever companies repurchase outstanding stock or reduce the company’s equity capital. EU law responds to these concerns in part by mandating that any reduction in subscribed legal capital in publicly held companies must be ratified by a qualified majority of shareholders. By contrast, most U.S. jurisdictions allow companies relatively broad flexibility with their legal capital without seeking shareholder approval—an approval—an approach that reflects the U.S. view of legal capital as a vestigial concept rather than a meaningful trigger for shareholder decision rights. Japan falls somewhere in the middle. While the minimum capital requirement requireme nt was abolished under the Companies Act of 2005, the notion of legal capital is maintained for the regulation of distributions, and the reduction of legal capital requires supermajority shareholder decision.
7.3.2 Te majority– majority–minority minority conflict Although all shareholders frombecause new equity minority shareholders facerisk thedilution largest risk they and are corporate often not distributions, protected by of preferred stock (“blank check preferred”), the board’s power under DGCL § 152 to fix the terms of the preferred stock upon issue gives the board the effective power to issue ownership and voting interests that may even allow the board to transfer control. Tis occurred in the bailout b ailout of AIG. Steven M. Davidoff and David . Zaring, Regulation by Deal: Te Government’s Response to the Financial Crisis , 61 A L L R 463 (2009). Te power conferred on the board by authorized but unissued preferred stock also provides the foundation for the board’s board’s power to issue “poison pill” shareholder rights plans without shareholder approval. See Chapter 8.2.3. ³ See § 312.03(c) NYSE L C M and §§ 712, 713 A S E C G. Te qualifications of these requirements in the U.S. make clear that they are directed at control transfers rather than at dilution. Art. 206-2 206-2 Companies Act. Te new requirement may not be enough to prevent managerial entrenchment. such a case, shareholders can seek a court’s of the stock asserting that it In is “significantly unfair,” a remedy unfair,” thatfor courts have injunction granted when the issuance primary of purpose of the issuance is to preserve the control of management. Art. 210(ii) Companies Act. Art. 29 Second Directive Directive (now 2012/30/ 2012/30/EU). EU). On this point see Vanessa Vanessa Edwards, EC C L 77–8 77–8 (1999). Member states may determine the majority required for such shareholder authorization and also add further limitations on the authority that may be delegated to the board, e.g. no more than half the par value of the existing capital in Germany: AktG § 202(3). UK institutional shareholder guidance indicates that such shareholders will w ill vote in favor of giving boards authorization to issue more than one-third one-third of the existing e xisting share capital (and in any event no more than two- thirds) only on the basis that the whole board should stand for re-election re-election at the following general meeting. In addition, the actual use of this authorization should comply with the preemption requirements, discussed below. See Association of British Insures, Directors’ Powers to Allot Share Capital and Disapply Shareholders’ Pre-emption Pre-emption Rights , December 2008. See Chapter 8. 8.2. 2.3. 3. See Art rt.. 34 Second Directiv ivee. § 244 DGCL (the reduction of the legal capital can be made by a decision of the board of directors). Arts. On the very limited r447(1) ole of legal capital in the U.S., see Chapter 5.2.2. 309(2)(ix) and role Companies Act.
Fundament Fundamental al Changes 182 shareholder decision rights. Instead, minority shareholders must depend on other legal strategies for protection, such as sharing norms, rules, and standards. Preemptive rights are are a paradigmatic example of the sharing strategy. By allowing existing shareholders to purchase new shares pro rata rat a before any shares are offered to outsiders, preemptive rights permit minority shareholders to safeguard their proportionate investment stakes and discourage controlling shareholders from acquiring additional shares from the firm at low prices.
Juris Jur isdi dict ctio ions ns di diffe fferr in th thei eirr ap appr proa oach ches es to pr pree eemp mpti tive ve ri righ ghts ts.. Te U. U.S. S. an andd Jap apan an on only ly enforce preemptive rights that are enshrined in company charters (opt-in).¹ (opt-in).¹ Brazil grants them as the statutory default, as do all European jurisdictions, due to requirements in the Second Directive.² European shareholders may opt out of this default for individual cases with qualified majority; and they may also delegate the power to issue the shares to the board, subject to some limitations.³ Consequently, the strength of the preemption rule depends in part on the willingness of the shareholders to waive it. In the UK, institutional shareholders strongly support it and have developed Preemption Guidelines Guidelines narrowly identifying the situations in which they will routinely vote in favor of disapplication disapplication resolutions put forward by listed companies. In France France the default rule is strengthened through regulation: the market regulator will in effect require that for listed companies a “priority subscription” period for existing shareholders is made available, even if preemption rights proper are removed. On the face of it, German law seems to take the strictest stance as waiving preemptive rights requires a material reason (sachlicher Grund ), which is subject to judicial review. Despite this hurdle, corporate practice has found its ways to comply with the requirement, and time-limited time-limited delegation to the board plus the waiver of preemptive rights appear common practice today. In Brazil, companies adopting the system of authorized capital may eliminate preemptive rights by charter provision under a limited set of circumstances, such as when the shares issued are to be sold in the public market; otherwise, preemptive rights will necessarily apply. Like other devices for protecting minority shareholders, preemptive rights have a cost. Above all, by forcing companies to solicit their own shareholders before turning to the market, they delay, and therefore increase execution risk of, new issues of shares. Tis became visibly apparent during the 2008/9 2008/9 financial crisis, where speedy ¹ See § 6.30 RMBCA. Japan does recognize them for closely held firms, see Art.199(2) and and 309(2) (v) Companies Act (two-thirds (two-thirds majority necessary for excluding preemptive preemptive rights). ² For Europe, Europe, see Art. 33 Second Directive (shareholders must be offered shares on a preemptive preemptive basis when capital is increased by consideration in cash, a right that cannot be restricted once and for all by the corporate charter, but only by general meeting resolution). ³ Second Directive, Directive, Arts. 29(2) and 33(4) and (5). Pre-Emption Pre-Emption A Statement Principles Preemption Group, (March (March no more than 5 percent of theDisapplying issued common shares inRights: any year or more of than 7.5 percent over2015): a rolling period of three years. Cozian et al., note 39, at 475– 475–7. 7. Tis is true for either the shareholder resolution resolution waiving the rights or the board decision, where authorized. See Bundesgerichtshof (BGH), March 13, 1978 – II ZR 142/76, 142/76, BGHZ 71, 40, 46 [Kali [Kali + Salz ]; ]; BGH, June 23, 1997 – II ZR 132/93, 132/93, BGHZ 136, 133, 139 [Siemens/ [ Siemens/Nold Nold ]. ]. Te insistence on preemptive rights appears to have been a major driver for the Holzmüller case, case, requiring shareholder approval for the transfer of major assets to a subsidiary subsid iary.. See Section 7.6. Te standard is relaxed if the share issuance does not exceed 10 percent of the current registered share capital and the issue price is not substantially below the current market price. See AktG § 186(3). Rüdiger Veil, Commentary on § 202, para 2 , in A K (Karsten Schmidt and Marcus Lutter eds., 3rd edn., 2015). Art. 172 Lei das Sociedades por Ações. In particular, particular, the shares of the company making the rights issue may come under pressure from short-sellers, shortsellers, even when the shares are issued at a substantial discount to the market price, at least where the issuer is seen to be in a weak financial position.
Mergers and Divisions Divisions 183 execution of decisions to raise fresh capital proved to be paramount. Tey also limit management’s ability to issue blocks of shares with significant voting power. Tese problems may explain why both Japan and U.S. states have abandoned preemptive rights as the statutory default, and why Japanese and U.S. shareholders almost never attempt to override this default by writing preemptive rights into their corporate charters.¹ In lieu of preemptive rights, U.S. jurisdictions rely on a standards strategy, the duty
of loyalty, to thwart opportunistic issues of shares. Enforcing the duty of loyalty is costly and litigation-intensive, litigation-intensive, but, where private enforcement institutions work reasonably well, it may protect minority shareholders no less effectively than preemptive rights do. Even in the UK, in small companies where minority shareholders may not be able to block the disapplication preemptive rights, out theyatmay fileprice.² a petition alleging alleging “unfair prejudice” and seeking aofright to be bought a fair Japan and Brazil combine the standards and the decision-rights decision-rights strategy here. In Japan, shareholders in non-public non-public companies enjoy preemptive rights, and all companies, including public ones, must receive supermajority shareholder approval to issue new shares to third parties at “particularly” favorable prices.³ Brazilian law, in turn, requires the price in new share issuances to be fixed “without unjustified dilution of existing shareholders,”” irrespective of the availability of preemptive rights. holders, Te European preemption rules apply only to share issues for cash. In non-cash non-cash issues the minority is also at risk if shares are issued to the majority or persons connected with them at an undervaluation. Again, the approach of EU law is to address the problem through rules, notably by requiring independent valuation of the noncash consideration in public companies.
7.4 Mergers and Divisions A merger can revolutionize the relationships among the participants in the firm. Mergers Merge rs and consolidations pool the assets and liabilities of two or more corporations into a single corporation, which is either one of the combining entities (the “surviving company”), or an entirely new company (the “emerging company”). In the process, a shareholder’s shareholder’s ownership stake can be diluted, transformed, or, or, in some jurisdictions, cashed out. A preferred stockholder’s accrued dividends can be wiped out. A shareholder in a widely dispersed firm can find itself a shareholder in a controlled firm. A shareholder in a firm with with no antitakeover antitakeover protections can wake up a shareholder in Pre-emption: emption: Knowing Yourmet Rights a Serious Issue , F See e.g.2010 Kate(reporting Burgess, Pre, 3 February on the difficulties HBOS withis its rights issue). Nevertheless the Government proposed to maintain the preemption principle whilst seeking to reduce the timetable for such issues. See Office of Public Sector Information, R R I R G, November 2008. ¹ See Robert C. Clark, C C L L 719 (1986) (U.S. public corporations very rarely recognize preemptive rights). By contrast, preemptive rights are more often granted in U.S. closely held corporations (Robert W. W. Hamilton, L C 196 (5th edn., 2000)) and especially at companies raising funds from venture capitalists (see e.g. George G. riantis, Financial Contract Design in the World of Venture Capital , 68 U C L R R 305, 312 (2001)). ² On unfair prejudice see note 39. ³ Arts. 199(2), 201(1), 309(2)(v) Companies Act (Japan). Art. 170 § 1º Lei das Sociedades por Ações. Ações. Art. 10 Second Directive, Directive, somewhat relaxed by Art. 11, introduced introduced in 2006. Terein lies the difference to the takeover; see Chapter 8.1. In a soso-called called cash-out cash-out merger, shareholders in one of the two merged companies have no choice but to accept cash in exchange for their shares.
Fundament Fundamental al Changes 184 a company that is effectively takeover-proof. takeover-proof. A shareholder in a privately held company can end up a shareholder of a publicly held company or vice versa. Te overwhelming problems, however, however, are related to price, that is, typically t ypically the exchange ratio in this context: a shareholder can be forced to exchange his shares for shares in the surviving or emerging company that are worth less. Because mergers can so fundamentally realign the relationships among the firm participants, every jurisdiction accords special treatment to mergers and other modes of
consolidation. Although some mergers result in no realignment of interests (and are typically exempted from the shareholder approval requirement), requirement), many mergers exhibit the functional characteristics of fundamental changes: they are large; they often give rise to agency problems; and they involve investmenti nvestment-like decisions. Tese problems require are predominantly addressed by a decision rightsfor strategy. Tus, most jurisdictions supermajority shareholder authorization a merger or consolidation. In the EU, the Tird Company Law Directive sets a minimum approval requirement of at least two-thirds two-thirds of the votes at the shareholders’ meeting (or, as an alternative, one half of outstanding shares). Some member states impose even higher voting thresholds. For example, Germany and the UK require 75 percent of voting shareholders to approve a merger merger,, while France and Japan require at least a twothirds majority of voting shares with a minimum quorum of one fourth and one-third one-third of the outstanding shares, respectively.¹ By contrast, Brazil and most U.S. jurisdictions require a majority of all outstanding shares to approve a merger or other organic change, although this might easily translate into 70 percent or more of shares that are actually voted.² Tese shareholder ratification requirements ordinarily apply to both (or all) participants in a merger or consolidation.³ Te fact that shareholders of acquiring companies Te jobs of the weaker merging firm’s managers are often as much at risk as those of managers in the targets of hostile takeovers (see Chapter 8.1.2.1), even if the merger is officially called a “merger of equals.” Regarding the similarity between hostile and friendly transactions, see G. William Schwert, Hostility in akeovers: In the Eyes of the Beholder? 55 55 J F 2599 (2000). Art. 7 Tird Tird Company Law Directive 2011/35/ 2011/35/EU, EU, 2011 O.J. (L 110) 1, applicable to domestic mergers of public companies. Tis article also requires the consent of each class of shareholders whose rights are affected, voting separately, not just of the shareholders’ meeting. On “class rights” see Section 7.2.2. Te UK is i s peculiar in not having a free-standing statutory merger procedure. Instead, the “scheme of arrangement” (Companies Act 2006, Part 26) can be used to this end. A “scheme” may be used more generally to adjust the mutual rights of shareholders and/or and/or creditors and the company, whether or not another company is involved in the scheme. It was originally designed (in the nineteenth century) for the itadjustment of the creditors’ rightsregulation in insolvency. the implementing scheme is usedthe to effect a merger or division, may attract additional of PartIf 27, Tird and Sixth EU Directives, though some mergers and divisions fall outside Part 27. Although the scheme is increasingly often used to effect a control shift (see Chapter 8.1.1), scheme mergers are relatively uncommon in the UK. See generally Jennifer Payne, S A: , , S O (2014). ¹ § 65 Umwandlungsgesetz (unless the charter charter sets a higher threshold) (Germany); ss. 899 and 907 of Companies Act 2006 (UK); Arts. L. 236-2 236- 2 and L. 225-96 225-96 Code de commerce (France). For Japan, see Arts. 783, 795, 804, 309(2)(xii) Companies Act. Similarly Similarly,, Italy requires a twotwo-thirds thirds majority of shares representing at least one-fifth one-fifth of the outstanding capital for listed companies (SPA) (in non-listed non-listed public companies, a simple majority of the voting shares may, however, approve the merger) (Arts. 2368-2369 2368-2369 Civil Code). ² Art. 136 Lei das Sociedades por Ações (Brazil); § 251(c) DGCL; DGCL; § 11.04(e) RMBCA. If only 70 percent of shareholders vote, more than 71 percent of voting shareholders must approve a transaction to provide a majority of outstanding shares. ³ Jurisdictions allowing for cash-out cash-out mergers, like Delaware and Japan, differ on whether they require approval of acquiring companies’ shareholders as well. Delaware law does not (§ 251(f)(3) DGCL), whereas Japanese law does (Arts.795(1), 796 Companies Act).
Mergers and Divisions Divisions 185 must often authorize mergers (even if there is no alteration of their charters) suggests that corporate law is less concerned with formal legal identity i dentity than with the sheer size of these transactions, and the possibility that they can radically alter the power and composition of the acquiring corporation’s management. Consistent with this focus on transactions that fundamentally re-order re-order relations is the fact that some jurisdictions do not require require the acquirer’s shareholder authorization when it is much larger than the company it targets, as long as the merger does not alter the surviving corporation’s charter. Here the implication is that a shareholder vote is unnecessary because the boards of acquiring
companies are merely making modest purchases that, for tax reasons or otherwise, are conveniently structured as a merger rather than as asset purchases or share acquisitions.
7.4.1 Te management– management–shareholder shareholder conflict in mergers Te two principal management–shareholder management–shareholder agency conflicts that potentially arise in mergers are: (a) management’s self-interested self-interested refusal to agree to a merger that shareholders support; and (b) self-interested self-interested attempts by management to build empires or to negotiate their future job status or compensation with an acquiring company at the t he expense of their shareholders. Because these agency problems primarily arise in dispersed ownership structures, we focus here mostly on the U.S., the UK, and Japan.
7.4.1.1 Managerial “entrenchment” What is to be done when managers managers resist a merger proposal proposal which shareholders would like to accept? How can a system distinguish between resistance that is driven by a sincere, well-founded well-founded belief that a merger is not in the interests of shareholders from resistance that is driven by self-interest? self-interest? In a board-centered board-centered system such as the U.S., managerial entrenchment is addressed through a combination of a trusteeship tr usteeship strategy (boards dominated by independent directors) combined with a rewards strategy (highpoweredd incentive compensation for managers triggered by a change in control) and an powere appointment rights strategy (although boards may veto a merger proposal, shareholders can vote in a new slate slat e of directors). Te UK deals with such issues broadly similarly but differs from the U.S. in two important respects: first, there is no board veto on merger proposals and, second, as seen in Chapter 3, it is easier for shareholders to remove directors. Yet, there are practical difficulties in convening the shareholders’ meeting without the cooperation of the board. Hence, like in the U.S., an acquirer can shift the form of the transaction to a straight share acquisition: as we shall see in Chapter 8, by doing so, unlike in the U.S., the acquirer can then invoke the akeover Code’s ban on frustrating action to neutralize any negative action the target management might take against the tender offer without shareholder approval.
See § 251(f) 251(f ) DGCL (Delaware) (voting (voting not required if surviving corporation issues less than 20 percent additional shares); Art. 796(3) Companies Act (Japan) (voting not required if surviving corporation pays consideration of 20 percent or less of its net worth, with some exceptions). A third conflict arises in management buyouts when managers, managers, with a financial sponsor, sponsor, seek to acquire the company from the public shareholders. It is discussed in Section 7.4.2, in the context of freeze-outs. freeze-outs. For maj major orit ity–m y–min inor orit ityy sh shar areh ehol older der co confl nflic ictt se seee Se Sect ction ion 7. 7.4. 4.2. 2. Se Seee Ch Chap apte terr 3. 3.2. 2.2. 2. For the difficulties an acquirer has in using the UK- style merger against a hostile target see Re Savoy Hotel Ltd [1981] [1981] Ch 351, discussed in Davies and Worthington, note 38, para. 29-5. 29-5. Tese issues are discussed more fully in Chapter 8 in the context of control control shifts. See Chapter 8.2.
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Fundamental al Changes Fundament
7.4.1.2 Managerial nest- feathering feathering A second manager–shareholder manager–shareholder agency problem arises where managers, in negotiating a merger agreement, put their own interests—in interests—in building an empire through acquisitions or in securing employment with the surviving firm—ahead firm—ahead of shareholders’. Here, interestingly, the strategies adopted by different jurisdictions are rather similar. First, the shareholder approval requirement gives shareholders a means of challenging a merger driven by managerialism. Large-block Large-block shareholders or coalitions of
blockholders, including hedge funds and institutional investors, will sometimes have the voting power to block corporate actions, especially when there is a clearly better alternative transaction proposed.¹ Secondly, with the purpose of improving the quality of shareholder decisionmaking, many jurisdictions require approval by gatekeepers of the terms of mergers, consolidations, and other organic changes (a trusteeship strategy). For example, EU law requires merging public companies to commission independent experts’ reports on the substantive terms of mergers prior to their shareholders’ meetings.² In Japan, when the proposed merger is one with the company’s controll controlling ing shareholder, sharehold er, the stock exchanges require require a third party to analyze a nalyze whether it is fair to the shareholders.³ And in the U.S., public companies pursuing a merger customarily seek to protect themselves from shareholder suits by soliciting fairness opinions from investment bankers, which shareholders can peruse before they vote. Tird, the U.S. and Japan also protect shareholders through an exit strategy—the strategy—the appraisal remedy—that remedy—that allows dissatisfied shareholders to escape the financial effects of organic changes approved by shareholder majorities by selling their shares back to the corporation at a “reasonable” price in certain circumstances. Brazil and Italy provide for a similar remedy, which however applies more selectively. Although EU law does not require appraisal in the event of a merger as such, French, French, German, as well as Italian corporate law provisions granting appraisal rights in case of significant changes in the charter of public companies will catch cat ch some mergers. Appraisal may be made available expressly where the merger involves a change in legal form or some other unusual restriction on shareholders’ rights. As a side benefit, the appraisal remedy also protects shareholders as a class by making unpopular decisions more expensive for the company to pursue. Te cost of these protections is that this same remedy may harm shareholders if note 81. ¹ For examples, see Marcel Kahan and Edward Rock, Hedge Funds in Corporate Governance and Corporate Control , 155 U P P L R 1021 (2007). Art. 10 (rinequiring third-party third-party reports the fairnessonofthe merger terms, though the²holders of Tird votingDirective securities (requiring the company can waive thison requirement basis of unanimity). ³ okyo Stock Exchange, Securities Listing Rules, Art. 441441 -2. See e.g. Smith v. Van Gorkom, Gorkom, 488 A R 2d 858 (Delaware Supreme Court 1985) (sale of a company without valuation report and with little deliberation is grossly negligent despite premium price). On the appraisal remedy under Japanese law, see Alan K. Koh, Appr Appraising aising Japan Japan’s’s Appr Appraisal aisal Remedy , 62 A J C C L 417 (2014). Dissenting shareholders shareholders in Brazil may seek appraisal only if their shares shares do not have sufficient liquidity after the merger: Arts. 136, IV, and 137, II Lei das Sociedades por Ações. In Italy, appraisal rights are granted in favor of shareholders of closed companies and of those of a listed company merging into a nonlisted one: Civil Code, Arts. 2505-IV 2505-IV (closed companies) and 2437-V 2437-V (listed into non-listed non-listed company). See text attached to note 41 and Alain Viandier, OPA, OPE A O P 460–11 (5th edn., 2014). 460– See Art. 236236-55 Règlement Général de l’AMF (France; transformation of an SA into a société en commandite par actions ); ); § 29 Unwandlungsgesetz (Germany); Article 2437 Civil Code (Italy). See Hideki Kanda and Saul Levmore, Te Appraisal Remedy and the Goals of Corporate Law , 32 UCLA L R R 429 (1985).
Divisions Mergers and Divisions 187 the need for cash to satisfy appraisal demands scuttles transactions that would otherwise increase the company’s value.¹ Te scope of the appraisal remedy varies widely among U.S. states and the nonU.S. jurisdictions that offer this exit right. In practice, however, cumbersome procedures, delay, delay, and uncertainty often discourage small shareholders from seeking appraisal in the jurisdictions that offer it. For example, shareholders seeking to perfect their appraisal rights in Delaware must first file a written dissent to the objectionable transaction before the shareholders’ meeting in which it will
be considered; they must refrain from voting for the transaction at the meeting; and they may be forced to pursue their valuation claims in court for two years or more before obtaining a judgment. In addition, many U.S. states, including RMBCA further appraisal rights by introducing aDelaware so-calledand so-called “stock marketjurisdictions, exception” to their limit availability in corporate mergers.¹¹ Underr this “ex Unde “exception, ception,”” shareholders do not receive appraisal rights if the merger consideration consists of stock in a widely traded tra ded company rather than cash, debt, or closely held equity—apparently equity—apparently on the theory either that appraisal rights ri ghts ought to protect the liquidity rather than the t he value of minority shares, or that the valuation provided by the market, while imperfect, is unlikely to be systematically less accurate than that provided by a court.¹² As a result, appraisal rights are of little use to shareholders who wish to challenge the price they receive in stock mergers between public corporations.¹³ Tese difficulties may explain why most European jurisdictions have never turned to the exit strategy—appraisal strategy—appraisal rights—as rights—as a general remedy to protect minority shareholders in mergers. Instead, as we have seen, EU law relies on a decision rights strategy (shareholder approval) by andindependent on the trusteeship strategy well,totoshareholders the extent for thattheir EU law requires valuation experts who are as liable misconduct.¹ Note, however, that some individual member states go beyond the minimum required by EU law and provide individual shareholders with a right to challenge the fairness of merger prices, a right that resembles the appraisal remedy in spirit if not in form. Tis is the case in both Germany and Italy where shareholders of merged companies may sue the surviving companies for the difference between the value of the shares they previously owned and the value of those they received in exchange.¹ ¹ See Bayless Manning, Te Shareholder’s Appraisal Remedy: An Essay for Frank Coker , 72 Y L L J 223 (1962). ¹¹ § 13.02 RMB § 262 DGCL. ¹² Of courseRMBCA; thisCA; theory does not explain why appraisal rights are available when shareholders receive cash, the most liquid merger consideration possible. ¹³ See Paul G. Mahoney and Mark Mark Weinstein, Weinstein, Te Appraisal Remedy and Merger Premiums , 1 A L E E R 239 (1999) (analyz (analyzing ing 1,350 merger mergerss involvin involvingg publicly held firms from 1975–91); 1975– 91); Joel Seligman, Reappraising the Appraisal Remedy , 52 G W W L L R 829 (1984) (only ( only about abo ut 20 mergers mer gers from 1972– 1 972–81 81 resulted in appraisal proceedings). ¹ Art. 20 Tird Directive (liability of managers vis-àvis-à-vis vis their shareholders) and Art. 21 (liability of independent experts vis-àvis-à-vis vis shareholders); Art. 18 Sixth Directive (liability of managers and independent experts vis-àvis-à-vis vis shareholders). See also Matthias Habersack and Dirk Verse, E G (4th edn., 2011) para. 16-20. 16-20. ¹ § 15 Umwandlungsgesetz; Art. 25042504-IV IV Civil Code; see also Karsten Schmidt, G (4th edn., 2002); Pierre-Henri Pierre-Henri Conac, Luca Enriques, and Martin Gelter, Constraining Dominant Shareholders’ Self-Dealing: Self-Dealing: Te Legal Framework in France, Germany, and Italy , 4 E C F L R 491, 525 (2007). Te particular difficulty with the German system is that it may result in an adjustment of the terms after the merger has been carried into effect.
Fundament Fundamental al Changes 188 Indeed, the ability of individual shareholders to request the differential payment has proved so effective in Germany that it has acted as a considerable deterrent to mergers in that country.¹
7.4.2 Te majority– majority–minority minority shareholder conflict in mergers In the presence of a controlling shareholder, mergers with unconnected companies involve risks for minority shareholders that are similar to those we have seen in previous sections. Hence, many of the mechanisms that limit manager–shareholder manager–shareholder con-
flicts, for example independent assessment of the merger terms or appraisal rights, operate to protect minority shareholders against majority shareholders as well.¹ Tat is, they provide for non-controlling nonshareholders against company(or, controllers, whether protection those controllers arecontrolling management or majority shareholders of course, both). However, some of the techniques, notably shareholder approval (even on a supermajority basis) will be less effective in such a situation. But in the event of a merger with an affiliate of the controlling shareholders, such as a parent-subsidiary merger,, the conflicts of interest at the level of the subsidiary are more intense, and actumerger ally very similar to the agency problem we have focused on in i n Chapter 6: such mergers are, in fact, related party transactions. Majority–minority Majority–minority conflicts are even more acute in freeze-out freeze-out mergers, where a controlling shareholder, using the merger structure, eliminates the non-controlling non-controlling shareholders either for cash or stock.¹ Management buyouts, in which managers team up with a financial sponsor to acquire the company, company, present many of the same problems. All of our major jurisdictions strengthen the protection of minority shareholders when shareholders stand on both sides oftransactions.¹ a merger merger.. In particular, play a controlling more important role in regulating conflicted Europeanstandards jurisdictions offer minority shareholders the right to sue under a variety of protective standards. In France, for example, controlled mergers can be invalidated under the abus de doctrine,¹¹ while, in the UK the t he “unfair “unfair prejudice” remedy is at least potenmajorité doctrine,¹¹ tially available to provide an exit right for the minority at a fair price.¹¹¹ Although in the U.S. standards play a relatively small role in the regulation of most arm’s-length arm’s-length organic changes (except when the company is being sold for cash or broken up¹¹² or a merger or other transaction promises to create a new controlling shareholder where there had been none before),¹¹³ they become prominent in controlling shareholder transactions.¹¹
¹ See Section 7.4.2.3.1. ¹ Te exception are decision rights rights in the form of shareholder shareholder approval, which will be ineffective unless the requirement is for majority-ofmajority-of-thethe-minority minority approval. ¹ For a comparative perspective, see Marco Ventoruzzo, FreezeFreeze-Outs: Outs: ranscontinental Analysis and Reform Proposals , 50 V J I L 841 (2010). ¹ Se ¹ Seee Ch Chap apte terr 6. 6.2. 2.5. 5. ¹¹ Co ¹¹ Cozi zian an et al al.., not otee 39 39,, at 74 740, 0, n. 11 11.. ¹¹¹ On the “unfair prejudice” prejudice” remedy see Davies and Worthington, Worthington, note 38, ch. 20. ¹¹² Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc . 506 A R 2d 173 (Delaware 1986). ¹¹³ See e.g. Paramount Communications, Inc. v. QVC Network, Inc., Inc. , 637 A R 2d 34 (Delaware Supreme Court 1994). ¹¹ See Mahoney and Weinstein, Weinstein, note 103, 272–4; 272–4; compare Wein einberg berger er v. UOP, UOP, Inc., Inc. , 457 A R 2d. 701 (Delaware Supreme Court 1983); Kahn v. Lynch Communications Systems, Inc., Inc., 638 A R 2d 2 d 1111 (Delaware 1994). 1994 ). Robert B. Tompson, Tom pson, SqueezeSqueeze-out out Mergers and the “New” Appraisal Remedy , 62 W W U L Q Q 415 (1984). See also Chapter 6.2.2.1.
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189
7.4.2.1 When the parent parent has more than 90 percent percent In an attempt to balance the interests of minority and controlling shareholders, jurisdictions generally facilitate minority buyouts when a controlling shareholder owns more than 90 percent of a company’s shares. For example, EU law allows member states to substitute the equivalent of appraisal rights for expert assessment of the merger plans and to dispense with the need for a vote by the shareholders of the acquiring company when an acquiring corporation owns more than 90 percent of a target company—an company—an option inspired by Germany’s Konzernrecht.¹¹ More dramati-
cally, a parent company holding more than 90 percent of a subsidiary can unilater ally merge the subsidiary into itself without a shareholders meeting of the controlled company (a so-called so-called “short-form “short-form”” merger) in most U.S. jurisdictions— jurisd ictions—with with minority shareholders entitled to appraisal rights in lieu of a shareholder vote.¹¹ Japanese law is similar.¹¹
7.4.2.2 When the parent parent has less than 90 percent U.S. law also permits cash-out cash-out mergers, or or,, as they are often referred to, freeze- outs, in situations in which the controlling shareholders own less than 90 percent of a subsidiary’s shares, but at the price of providing additional minority shareholder protection beyond what would be available in an uncontrolled merger. Japanese law is, again, similar.¹¹ U.S. securities regulation requires public corporations that go private (as a result of the freeze-out freeze-out merger) to make disclosures relating to the fairness of the transaction and to any discussions disc ussions with third parties who may be interested in acquiring the company,¹¹ while in France the market regulator may require the appraisal remedy to be made available in the case of the merger of a listed subsidiary into a controlling company where it deems it i t necessary to t o protect the minority’s interests.¹² In addition, the Delaware courts generally review parent-subsidiary parent-subsidiary mergers under the rigorous “entire fairness” fairness” standard, with the burden on the controlling shareholder to prove fair price and fair process.¹²¹ However, the burden of proof is shifted to the plaintiff where the transaction was either (i) negotiated by a special committee comprised of independent directors or (ii) supplemented by approval by a majority of the minority shareholders.¹²² When both of these steps are taken, the transaction will generally be reviewed under the more deferential business judgment rule.¹²³ In establishing this framework, the case law morphs from an ex post review review standard to a de facto trusteeship strategy, strategy, as the use of independent committees is rewarded. Te law in EU jurisdictions is less clear-cut clear-cut with respect to controlled mergers and freeze-outs freezeouts involving companies in which the controlling shareholder holds less than ¹¹ See Arts. 27–9 27–9 Tird Directive. See also Volker Emmerich and Mathias Habersack, K 141–6 141–6 (10th edn., 2013). ¹¹ Se ¹¹ Seee e. e.g. g. § 25 2533 DG DGCL CL.. ¹¹ Ar ¹¹ Art. t. 78 784( 4(1) 1) Co Comp mpan anie iess Act (J (Jap apan an). ). ¹¹ In cash-out cash-out mergers (or more generally mergers in which the consideration is other than the stock of the surviving company), disclosure of additional information is required. See Arts. 182 and 184 Ordinance for Enforcement of the Companies Act. ¹¹ Rule 13e-3 13e-3 1934 Securities Exchange Act. ¹² Art. 236-6 236-6 Règlement Général de l’AMF. ¹²¹ See Chapter 6.2.2.1. ¹²² Kahn v. Lynch, note Lynch, note 114. ¹²³ Kahn v. M & F Worldwide Corp., Corp. , 88 A R 3d 635; see also In re Cox Communications, Inc. 879 Inc. 879 A R 2d 604. See Chapter 6.2.2.1. For Japan, see Wataru anaka, Going Private and the Role of Courts: A Comparison of Delaware and Japan, Japan, 3 U S L R 12 (2011).
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90 percent.¹² Te minimum requirements established by EU Directives apply to such transactions, but beyond this, EU member states have generally adopted a “neutral” approach in their national laws that, in contrast to U.S. jurisdictions, does not actively facilitate freeze-outs.¹² freeze-outs.¹² In France, a company’s charter may provide provide that its minority shareholders can be cashed out in well-defined well-defined circumstances, although the terms of such a buy-out buy-out would be subject to a Delaware-like Delaware-like fairness review by the courts.¹² Without an authorizing provision provision in the charter, charter, however however,, it does not seem that a controlling shareholder may freeze out even abusive minority shareholders.¹² By contrast, German law does recognize the right of a controlling shareholder to freeze out an
abusive minority shareholder, shareholder, but neither the German statutes nor the German courts acknowledge a general right of controlling shareholders with under 95 percent of an issuer’s shares to freeze out its minority shareholders.¹² In Italy, absent an absolute right to cash out minorities, a freeze-out freeze-out may only take place with regard to shareholders with a number of shares lower than is needed to receive one share in the resulting company.¹²
7.4.2.3 Freeze-outs Freeze-outs through non-merger non-merger techniques 7.4.2.3.1 Compulsory share sales
Many jurisdictions also provide freeze-out freeze-out (or, as they are also known, squeeze-out) squeeze-out) techniques which are not based formally on a merger transaction. As we shall see in chapter 8,¹³ under EU law an acquirer a cquirer which ends up with 90 to 95 9 5 percent of a target’s shares after a public offer is able to squeeze out the non-accepting non-accepting shareholders on the terms of the public publ ic offer (or something s omething near it)— it )—and the minority minorit y has a similar right to be bought out.95Inpercent some jurisdictions the sameviafacility is made available, whether or not the 90 or threshold is reached a public offer. In this case, fixing the price is a more sensitive matter. In France, a shareholder group holding 95 percent or more of voting rights in a listed company may eliminate the minority by making a public offer to acquire their shares, followed by a compulsory acquisition of the shares of the non-accepting non-accepting shareholders.¹³¹ Te price in the compulsory acquisition has to be approved ex ante by by the market regulator, which operates on the basis of a proposal prepared by the acquirer’s investment bank, the report of an expert commissioned by the target and its own judgment.¹³² Germany also provides a squeeze-out squeeze-out procedure at
¹² For a recent comparison, see Christian A. Krebs, FreezeFreeze-Out Out ransactions in Germany and the U.S.: A Comparative Analysis , 13 G L J 941 (2012). ¹² Regarding the German (BVGE) approach, Aug. 7, 105, 1962— 1962—1 1 BvL 16/60, 16/60, B B (BV GE)see14,Bundesverfassungsgericht, 263 [Feldmühle ]: ]: Schmidt, note at 348. ¹² Cozian et al., note 39, at 216– 216–18. 18. ¹² See Cour de Cassation Commerciale , 1996 R S 554 (freeze-out (freeze- out is prohibited unless permitted by statute or the corporation’s charter). ¹² BGH, March 20, 1995–II 1995–II ZR 205/94, 205/94, BGHZ 129, 136 [Girmes [Girmes ]. ]. ¹² See Luigi A. Bianchi, L C C R R C F 101 (2002). ¹³ See Chapter 8.3.5. If, however, however, an existing 90 percent majority mounts a bid for the company simply in order to squeeze out the minority, minority, UK scrutinizes the reason for the squeezesquee ze-out by reference to a standard akin to that applied to charter amendments to that end. See Re Bugle Press Ltd [1961] [1961] Ch 270. ¹³¹ Art. L. 433433-44 Code Monétaire et Financier; Arts. 236-3, 236- 3, 236-4, 236-4, and 237-1 237-1 Règlement Général de l’AMF. Te minority has a parallel right to be bought out (Art. L. 433- 4 Code Monétaire et Financier; Arts. 236-1 236-1 and 236-2 236-2 Règlement Général de l’AMF). ¹³² Arts. 237-2, 237-2, 261-1(II), 261-1(II), and 262-1 262-1 Règlement Général de l’AMF. See generally Viandier, note 97, at 495–8. 495–8.
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the 95 percent level for all public companies, which tracks merger rules (including the need for a report from the 95 percent shareholder and a report from a court-appointed court-appointed expert on the adequacy of the compensation).¹³³ Unlike in the French procedure, the price is not approved ex ante but but is subject to ex post challenge challenge by any individual minority shareholder before a court, whose decision will apply to all minority shareholders (Spruchverfahren). Although the challenge does not normally prevent the squeeze-out squeeze-out from being effected immediately, the post squeeze-out squeeze-out procedure can be protracted (even up to ten years), which generates a strong st rong incentive for the 95 percent shareholder sha reholder to settle the minority’s claim and an equally strong incentive for arbitrageurs to acquire the minority’s shares in order to take advantage of the court challenge.¹³
In Japan, a complex procedure using a special type of class of shares, which requires two-thirds twothirds majority vote at the shareholders’ meeting, has been used in practice to squeeze out minorities, motivated mostly by tax reasons. Japan also introduced a new procedure in 2014 that allows a shareholder holding 90 percent or more of the company’ss shares to squeeze out the minority ny’ minorit y shareholders shareholder s without a a shareholders shareholders’’ meeting.¹³ In jurisdictions (such as the UK) which lack explicit procedures for squeezing out minorities (other than post-bid), post-bid), a variety of substitute corporate procedures may be available. Te issue is whether these more general procedures provide adequate safeguards against majority opportunism when used to effect a squeeze-out. squeeze-out. Te simplest form of these non-specific non-specific squeeze-out squeeze-out mechanisms is a charter amendment requiring the minority to transfer their shares to the majority or to the company. Because the standard supermajority requirement for charter changes may seem inadequate minority protection in the squeeze-out squeeze-out situation, UK courts, under their general power to review charter amendments,¹³ have developed a requirement for a good corporate reason for even a fair-price fairprice squeeze-out, squeeze-out, in contrast with the simple requirement for good faith in respect of other changes to the charter. In Australia, Australia, from a similar doctrinal doct rinal startingstarti ng-point, point, the High Court has barred such compulsory acquisitions except in very limited circumstances.¹³
7.4.2.3.2 Other squeezesqueeze-out out techniques
A charter amendment is not, however however,, the only only,, or even the typical, way of eliminating a small minority in the absence of an explicit procedure for so doing. A reverse stock split, a sale of all the assets of the company followed by its dissolution¹³ or, in those ¹³³ §§ 327a-f 327a-f AktG. See Tomas Stohlmeier, G P L (2nd edn., 2007) 139. ¹³ Stohlmeier, note 133, at 145. Te post-bid post- bid squeeze-out squeeze-out procedure does not suffer from this defect, because of the strong presumption that the bid price is the appropriate price. See § 39a(3) WpÜG and179 Chapter 8.3.5. Act (Japan). For details, see Marco Ventoruzzo et al., C ¹³ Art. Companies C L 497 (2015). ¹³ UK courts may rely on the “unfair prejudice” prejudice” remedy, remedy, but the case law has also developed a general review standard for charter changes: i.e. the requirement that the change be effected “bona fide in the interests of the company.” company.” See note 39. Tis rather opaque formula tends to require simply that the majority act in good faith, except in cases of expropriation of shares where it has a larger impact. See Gamlestaden Fastigheter AB v. Baltic Partners Ltd [2008] [2008] 1 BCLC 468. ¹³ Gambotto v. WCP Ltd (1995) (1995) 127 A L R 417 (High Court of Australia), which seems to accept compulsory acquisition if the purpose is to protect the company from harm but not if it is to confer a benefit on it. ¹³ A procedure explicitly provided for in § 179a AktG (Germany), on a 75 percent vote of the shareholders, but in fact not taken up often in practice for a number of reasons, including the ability of the minority to delay the transaction for long periods by challenging chall enging the price for the transfer of the assets. Consequently, the more recently introduced general squeeze-out squeeze- out procedure (Section 7.4.2.3.1) is typically employed. See Stohlmeier, note 133, at 150.
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jurisdictions still attaching att aching importance to legal l egal capital, a reduction of capital, may all be used to this end. Again, since these procedures are not designed for squeeze-outs, squeeze-outs, the protection against opportunism lies mainly in the deployment of standards strategies governing the majority’s decision.¹³ Te delisting of a traded company may also operate as a squeezesqueeze-out. out. Delisting and deregistration deprive shareholders and creditors of the benefits of extended mandatory disclosure, in addition to vastly reducing the shares’ liquidity. liquidity. In light of this, exit from either regulatory structure is a fundamental change in the firm.¹ As we discuss in Chapter 9, securities regulation and stock exchange rules provide a wide variety of protections for shareholders against both managers and controlling shareholders seek-
ing to delist or to downgrade an issuer.¹¹
7.4.3 Te protection of nonnon-shareholder shareholder constituencies in mergers Several of our core jurisdictions seek to protect non-shareholder non-shareholder constituencies (creditors and/or and/or employees) in mergers and other organic changes in addition addit ion to addressing the agency problems between managers and shareholders and between controlling and minority shareholders.
7.4.3.1 Te protection of creditors creditors As we noted in Chapter 5, the t he European jurisdictions, Japan, Japan, and Brazil are generally more creditor-friendly creditor-friendly than the U.S.¹² In keeping with this tradition, these jurisdictions offer special protection to creditors when firms undergo mergers and similar organic changes. far as to grant creditors that areAlthough harmed by the merger the formalBrazilian right tolaw seekgoes its as annulment within sixty days.¹³ creditors lack the power to stop mergers in the EU or Japan, they are entitled to demand adequate safeguards when a merger puts their claims at risk.¹ Tese safeguards often extend to a requirement that their claims be secured by the surviving or emerging company or that their claims be discharged before the merger, which may act as a significant disincentive to the merger.¹ merger.¹
7.4.3.2 Te protection of employees employees Tere are two main issues here. First, to what extent do employees have a “voice” (whether through collective bargaining or legal rules providing for workforce-based workforce- based works councils or board-level representation) in the merger decision and to what ¹³ See Rock Nominees Ltd v. RCO (Holdings) plc [2004] [2004] 2 BCLC 439 (CA—UK): (CA— UK): bidder, which had fallen just short of the 90 percent threshold for a post-bid post- bid squeeze-out, squeeze-out, proposed to sell the business of the new subsidiary subsidi ary to another group company, liquidate the vendor and distribute its assets to the shareholders. Te Court of Appeal refused to regard this proposal as infringing the “unfair prejudice” standard for reviewing controllers’ decisions (see note 39) where the price obtained in the sale was “the best price reasonably obtainable.” obtainable.” It was also clear that the minority opposed the deal because it hoped to obtain a “ransom price” through a voluntary sale of its shareholding to the new parent. ¹ See Jonathan Macey Macey,, Maureen O’Hara, and David David Pompilio, Down and Out in the Stock Market: Te Law and Economics of the Delisting Process , 51 J L E 683 (2008). ¹¹ Chapter 9.1.2.7. ¹² See Chapter 5.4. ¹³³ Le ¹ Leii da dass So Soci cied edad ades es po porr Aç Açõe õess Ar Art. t. 23 232. 2. ¹ Se ¹ Seee Ar Art. t. 13 Ti Tird rd Di Dire rect ctiv ive. e. ¹ § 22 Umwandlungsgesetz (Germany) (Germany) (§ 321 AktG to similar effect); Arts. 789, 799, and 810 Companies Act (Japan).
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extent will those voice arrangements be carried over to the resulting company? Tis refers to the likely impact of the merger, either immediately or in the future, on the development of terms and conditions of employment and the availability of job and promotion opportunities. Te second issue is whether employees have the option to transfer their existing terms and conditions of employment (which, depending on the situation, may be located in a collective agreement or in an individual contract of employment), including any voice arrangements, to the corporation which results from the merger. Voice may be provided through general governance provisions relating, for example, to board-level board-level representation of employees, as discussed in Chapter 4. Or voice
may be injected through a mechanism independent of the board and applying only to certain categories of corporate decision. Here, EU law adopts a strong stance. On a transfer of a business (of which the merger is a prototypical example) the Acquired Rights Directive¹ mandates consultation on the part of both transferor t ransferor and transferee employers with the representatives of the employees (unionized or non-unionized) non-unionized) prior to the transfer of the business. Te focus of the consultation is on the implications of the merger for the employees.¹ Given the stately and public procedure of the merger (production of a merger plan, its public filing, the experts’ report, the shareholders’’ meeting), it is not normally too demanding to fit consultation with employee holders representatives into this timetable.¹ U.S. law is more cautious. Tere is no general consultation duty on transferor or transferee companies. If both merging companies are unionized, then the effects of the merger are a mandatory topic of bargaining. If one company is unionized and the other is not, the only way to implement the merger is to put the companies into separate subsidiaries because the union component has bargaining rights that can prevent any sensible integration of the operation. Te quality of the voice mechanisms after the merger will normally depend on the rules applying to the surviving or emerging company. Tis has proved to be a particular problem in cross-border cross-border mergers in the European Union, since voice requirements, especially in terms of board-level board-level representation, vary significantly from member state to member state. We We discuss this issue further in i n Section 7.5. For purely domestic mergers, mergers , the Acquired Rights Directive has a limited provision preserving the voice arrangements existing within the t he transferor after the transfer.¹ tr ansfer.¹ However However,, since in most member states stat es the provision of employee voice at enterprise or establishment level is a matter of legal requirement, the rules applicable to the surviving or emerging company will lead to the transferred business being covered by equivalent voice arrangements. U.S. law, again, preserves voice arrangements only with respect to unionized companies. When operations are transferred by merger or stock sale, both the collective bargaining agreement and the statutory duty to bargain carry forward automatically. ¹ Directive 2001/23/ 2001/23/EC, EC, Chapter III. ¹ Ibid., Art. 7 (“the (“the legal, economic and social implications of the transfer for the the employees” and “anyy measures envisaged in relation to the employees”; yet, the employer must also “an al so state “the reasons for the transfer”). In some member states, for example, France, the employee representatives have more extensive rights to review the business reasons for the transfer (Art. L. 2323- 19 Code du d u travail). ¹ However However,, for analysis of a case where the transfer of a business (not a merger) to one of two competing acquirers was significantly influenced by the consultation obligation (BMW’s disposal of a large part of its UK assets in 2000) see John Armour and Simon Deakin, Te Rover Case—Bargaining Case—Bargaining in the Shadow of UPE (2000) (2000) 29 I L L J 395. ¹ Art. 6. Tis operates only if (a) the undertaking transferred “preserves “preserves its autonomy” and (b) (b) “the “the conditions necessary for the reappointment of the representatives” after the transfer are not met.
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By contrast, when operations are transferred by a sale of assets and the rehiring of employees, the collective bargaining agreement only carries forward when the asset purchaser explicitly or constructively adopts it, while the presumption of continued majority support and related statutory duty to bargain carry over when more than 50 percent of the asset purchaser’s purchaser’s employees (in the relevant bargaining ba rgaining unit) worked for the seller.¹ As to the second point— point—protection protection of acquired rights—the rights—the “universal transmission” mechanism of the statutory merger procedure may operate so as to transfer the individual entitlements of the employees to the surviving sur viving or emerging entity.¹¹ In any event the EU Directive requires that on a transfer of a business the contracts of employment of workers employed in the transferor company are automatically transferred in
an unaltered form to the surviving or emerging entity.¹² entity.¹² It also makes the t he fact of the transfer an unacceptable ground for dismissal. Tese two rules put the burden of any subsequent lay-off lay-off compensation on the transferee employer, employer, but this can normally be allowed for in the price paid for the transferor’s business. Te more problematic rule from an economic perspective is that transferred employees employees who remain on the job also retain the pre-existing pre-existing terms and conditions of their employment. Tis makes it difficult for the transferee to integrate the transferred employees into a common structure of terms and conditions of employment for its enlarged workforce, since even changes subsequently negotiated by the transferee with the representatives of the employees are at risk of legal challenge. By contrast, the U.S. adheres to the t he common law doctrine of the t he personal nature of the contract of service¹³ and does not provide for automatic transfer of the contract of employmentt in the non-unionized employmen non-unionized area. Even in the unionized area the same approach has influenced judicial interpretation of the U.S. National Labor Relations Act. Te extent to which collectively agreed terms and conditions will be carried over to the transferee employer employer depends on the form of the transaction, as a s described above.¹
7.4.4 Corporate divisions A corporate division is the transactional inverse of a merger: it divides di vides the assets and liabilities of a single si ngle corporation into two or more surviving corporations, one of which may be the dividing corporation itself.¹ Despite logical similarities between mergers and divisions, however, jurisdictions differ on whether they are as closely regulated as mergers. Te U.S. only regulates divisions on an ad hoc basis when opportunism appears or when the corporation sells all or substantially all of its assets, and Japan regulates divisions only perfunctorily.¹ At ¹ Edward B. Rock and Michael L. Wachter Wachter,, Labor Law Successorship: A Corporate Law Approach, Approach, 92 M L R 203, 212–32 212–32 (1993). ¹¹ Tough in the UK the courts found automatic statutory transfer of employment contracts contracts to be inconsistent with the personal nature of the relationship embodied in them: see Nokes v. Doncaster Amalgamated Collieries Ltd [1940] [1940] AC 1014, HL. ¹² Directive 2001/23/ 2001/23/EC, EC, Chapter II, replacing an earlier directive of 1977. ¹³ See text accompanying note note 151. ¹ Rock and Wachter, note 150; Howard Johnson Co. v. Detroit Local Joint Executive Bd 417 U S S R 249 (1974). ¹ A corporate division is not to be confused with the creation of a subsidiary: while in the the latter it is also the case that a corporation divides into two entities, in the former case, the divided entity does not end up holding the shares in the newly formed company or issued by another company in exchange for the company’ company’ss assets. ¹ See Arts. 783, 784, 795, 796, 804, and 805 Companies Act (Japan). (Japan).
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first glance, the EU is different. Te provisions of the Sixth Company Law Directive¹ regulating divisions are a virtual mirror-image mirror-image of the Tird Directive dealing with mergers, including its provisions on minority and creditor protection. In practice, however, however, member states do not scrutinize divisions as closely as mergers, and the reach of the detailed requirements can be avoided.¹ Even where the division rules apply, European shareholders are accorded less protection than in the inverse situation of a merger. We suspect the reason lies in the functional characteristics that make corporate actions “sig “significant” nificant” in the first instance. o begin with, a division is a “smaller” transaction than most mergers, insofar as it merely restructures the existing assets and liabilities of a company instead of adding to the company’s existing assets and liabilities. In addition, and most significantly,
the risk of conflict of interests in a corporate division—or division—or at least conflict between the shareholders and managers—is managers—is lower than the parallel risk of conflict in mergers. Further,, empire dismantling is less prone to create management–shareholder Further management–shareholder conflicts than empire building. And the final period problem is less severe in a division: the managers and directors from the dividing firm usually stay on to manage at least one of the continuing firms. Apart from from shareholders, shareholders, the protectio protectionn of creditors creditors and employees employees appears appears particularly necessary in the case of corporate divisions. Te risk is that creditors’ claims will be impaired because the division of assets and liabilities (which is determined in the division contract) is not pro rata as between the receiving companies. Tus, EU law makes companies receiving assets through a division jointly and severally responsible to pre-division predivision creditors, though the liability li ability of the receiving companies other than tha n the one to which the debt was transferred may be limited to the value of the assets transferred.¹ tr ansferred.¹ Employees can also be affected by corporate divisions. For example, the assets may be transferred to an entity that seeks to avoid obligations under a collective bargaining agreement. As discussed above, under U.S. labor law law,, the rights of employees depend on the mode by which operations are transferred.¹ By contrast, the employee protection provided by EU law, as discussed in Section 7.4.3.2, turns on whether there has been a “transfer of a business” from one employer to another, a phrase which is apt to cover divisions as much as mergers and indeed sales of assets, unless they are “bare” sales of assets, so that the legal form of the transaction is less central to the application of the rules.¹¹ In Japan, the general rule is that divisions transfer debts without consent of individual creditors (though they can object and get payment or collateral¹²), but employees are given special rights to voice and generally, generally, unless they agree, their employment contracts are not transferred.¹³ ¹ Sixth Company Law Directive Directive 82/891/ 82/891/EEC, EEC, 1982 O.J. (L 378) 47. ¹ E.g. an individual transfer transfer of assets and debts falls outside the regime of divisions. ¹ Art. 12 Sixth Directive. Te joint and several liability of the transferee companies may be dispensed with entirely if, as is the case in the UK, the division requires the approval of a court (as a “scheme of arrangement”) and is dependent upon the consent of 75 percent of each class of creditor. ¹ See note 150. ¹¹ Crucially, however however,, the Directive does not cover a control shift effected by a transfer of shares, as discussed in the next chapter, because there is no change in the identity of the employer. In such a case individual and collective contractual obligations of the employer are not formally affected, whilst the consultation obligations which the directive would otherwise other wise impose are now applied under the provisions requiring employers to consult generally on matters likely to have a significant impact on their employees. See Directive 2002/ 14/ 14/EC EC establishing a general framework for informing and consulting employees in the European Community, 2002 O.J. (L 80) 29. ¹² Arts. 759(2)-(4) 759(2)-(4) and 764(2)-(4) 764(2)-(4) Companies Act. ¹³ See Act for the Succession of Employment Employment Contracts in Corporate Divisions (2000) (Japan). (Japan).
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7.5 Reincorporation and Conversion Te migration of a corporation between jurisdictions can also fundamentally transform the relationship among the participants. If the new home’s home’s corporate law is more pro-management promanagement or pro-controlling pro-controlling shareholder, such a migration can aggravate the management–shareholder management– shareholder or controlling-minority controlling-minority shareholder agency problems. If the new home’s corporate law is less protective of non-shareholder non-shareholder interests, such a migration can be a means by which shareholders and managers transfer value from non-shareholder nonshareholder constituencies to themselves. Tese problems are controlled using different tools. Consider the mechanics of corporate migration. Te easiest process is to allow com-
panies, by declaration, to change their jurisdiction of incorporation. In Canada, for example, a corporation can move its jurisdiction while preserving legal personality (i.e. all its legal rights and obligations) between provinces, upon a two-thirds two-thirds vote of shareholders, so long as the corporate body will, inter alia, remain liable to creditors in the new jurisdiction.¹ When a corporation fulfills these straightforward requirements, it ceases to be, for example, an Ontario corporation and starts to be an Alberta or federal corporation. Tis simple, direct approach is highly unusual.¹ A more common mechanism allows a corporation to migrate by merger merger.. In the U.S., for example, the mechanism commonly used to transform, say, a California corporation into a Delaware corporation is for the California corporation to merge with a newly established, wholly whol ly owned Delaware subsidiary, with the Delaware subsidiary continuing as the surviving corporation.¹ Shareholders of the California corporation typically receive the same percentage of ownership in the Delaware corporation as they previously had ina the California Elsewhere,has a scheme of arrangement—which arrangement— which requires shareholder votecorporation. and court approval—has approval— been used to effect a migration.¹ In addition, there are more complex mechanisms involving asset or stock sales that can reach the same outcome, although sometimes with different tax consequences.¹ In the common migration-bymigration-by-merger merger structure, minority shareholders and other constituencies are usually no more and no less protected than in any other merger.¹ EU law has been heavily promoting cross-border cross-border corporate mobility within Europe. Tere seem to be three avenues in place now to effect a cross-border cross-border relocation. Te first, and most uncertain way is to reincorporate to another EU jurisdiction by converting into ¹ Douglas J. Cumming and and Jeffrey G. MacIntosh, Te Rationales Underlying Reincorporation Reincorporation and Implications for Canadian Corporations , 22 I R L E 277, 279 (2002). ¹ A similar procedure is available to the European Company (see below) to move move between EU jurisdictions. Te Company Law Review Review (UK) proposed a similar procedure for British British companies to move both between the UK jurisdictions and to jurisdictions outside the UK, but the proposal was not taken up in the 2006 reforms, evidently because of reasury reasury fears of loss of tax revenues. See CLR, Final Report (2001), (2001), ch. 13 (URN 01/ 942). ¹ See e.g. Ronald J. Gilson, Globalizing Corporate Governance: Convergence of Form or Function, Function, 49 A J C C L L 329, 355 35 5 n. 90 (2001). (200 1). ¹ For an account of News News Corp’s Corp’s migration from Australia to Delaware by a scheme of arrangement, see Jennifer G. Hill, Subverting Shareholder Rights: Lessons from News Corp.’s Migration to Delaware , 63 V L R 1 (2010). ¹ For an analysis analysis of the intersection of charter competition and tax considerations, see Mitchell Mitchell Kane and Edward Rock, Corporate axation and International Charter Competition, Competition, 106 M L L R 1229 (2008). ¹ Section 7.4. Yet, Yet, this is not the case in the EU. See text accompanying notes 180–1. 180–1.
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the equivalent legal form of the destination state, relying on the case-law case-law of the European Court of Justice. Whereas the early CJEU cases concerning cross-border cross-border mobility had mostly focused on the formation stage of companies,¹ more recent jurisprudence deals with the possibility to effect midstream changes. aken together, the two recent decisions in Cartesio¹¹ and Vale ¹² ¹² suggest that a destination state is under an obligation to offer a conversion procedure for accommodating foreign companies, analogous to its local laws, and that the state of origin is under a corresponding obligation to allow the company to leave.¹³ However, this territory is still relatively relati vely uncertain and a nd awaits real- life exploration.¹ Te second strategy is to use the legal form of a Societas Europaea ,¹ ,¹ a type of panEuropean corporate entity, which expressly allows for cross-border cross-border relocation with retention of legal personality.¹ Art. 8 SE Regulation provides for an elaborate system of
protection tonegligible the benefit of minority creditors, and employees.¹ Tere is nowrights a non-negligible nonnumber of SEs, shareholders, and a substantial proportion of them have already carried out a seat transfer.¹ Te third and final route for corporate migration is to employ the European European CrossBorder Merger Directive.¹ Similar to the migration-bymigration-by-merger merger strategy used in the U.S., the migrating company may be merged onto an existing or newly formed shell company or subsidiary in the destination state.¹ But unlike in the U.S., and following
¹ See on this Wolfolf-Georg Georg Ringe, Corporate Mobility in the European Union—a Union—a Flash in the Pan? An Empirical Study Study on the Success of Lawmaking and Regulatory Regulatory Competition, Competition, 10 E C F L R 230 (2013). ¹¹ Case C-210/ C-210/06 06 Cartesio Oktató és Szolgáltató bt , [2008] ECR I-9641. I-9641. Építési(Court kft , ECLI:EU:C:2012:440. ¹² C-378/10 C-378/ 10 VALE ¹³ Case In a first decision, the OLG of Appeal) of Nuremberg Nuremberg accepted these European parameters and allowed a Portuguese company to convert to a German equivalent: OLG Nürnberg, June 19, 2013 – 12 W 520/13, 520/13, N Z G (NZG) 2014, 349. See also Kammergericht Berlin, March 21, 2016 – 22 W 64/15, 64/15, NZG 2016, 834. ¹ Tis uncertainty has led to reinforced calls for a specific EU EU instrument, dealing with crossborder shifts of the registered office. ¹ Te SE was established by two instruments in 2001: Council Regulation (EC) No No 2157/2001 2157/2001 on the Statute for a European Company (“SE Regulation”), and the accompanying Council Directive 2001/86/ 2001/ 86/EC EC of 8 October 2001 supplementing the Statute for a European company with regard to the involvement of employees (“SE Directive Directive”). ”). It can only be created by either merger, the creation of a holding company, company, creation of a joint subsidiary subsidiar y, or conversion of an existing company set up under the laws of a member state. ¹ SE Regulation, Arts. 7, 8, and 69. Te only downside is that that a reincorporation also requires requires a simultaneous shift in the location of its head office. For the argument that the requirement for the head office to be located in the state of incorporation is in conflict with the right to freedom of estabEuropean185 Company lishmentofcreated Context Freedom byoftheEstablishment European reaties reaties , 7 J see Wolf C Georg Ringe,L LTe S (2007).Statute in the ¹ See, in particular, particular, SE Regulation Art. 8(2), (3), (5), and and (7). ¹ By 2014, over 2,100 SEs were registered across the the EU, the large majority of which were based in the Czech Republic and Germany (and many of which were, in fact, shell companies). So far, we know of 79 successfully completed seat transfers under Art. 8 SE Regulation, which is only 4 percent of all SEs, but 27 percent of those SEs with more than 5 employees (289). Tis is based on data from the European rade Union Institute (http:// (http://ecdb.workerecdb.worker-participation.eu/ participation.eu/). ). ¹ Directive 2005/56/ 2005/56/EC EC of 26 October 2005 on cross-border cross-border mergers of limited liability companies, 2005 O.J. (L 310) 1 (hereinafter Cross-Border Cross-Border Merger [CBM] Directive). o some extent the CJEU jumped the gun by holding in the SEVIC case case that Germany violated (what is now) Arts. 49 and 56 FEU (freedoms of establishment and capital) by permitting the registration of domestic mergers without also permitting equivalent registration of cross-border cross- border mergers (Case C-411/ C-411/03, 03, SEVIC Systems AG [2005] [2005] ECR I-10805, I-10805, paras. 16–19). 16–19). ¹ Unlike with the SE, transfer of the the head office seems not to be required, unless it is a requirement of the national law of the new state. See John Armour and Wolf-Georg Wolf-Georg Ringe, European Company
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upon the steps of the SE framework, this Directive features a number of protection devices for shareholders, creditors, and especially employees in addition to those provided for domestic mergers. Since member states vary substantially in their national law requirements for boardlevel representation of employees, a major concern for employees is that reincorporation will be to a member state with no or less extensive requirements of this type. Both the SE framework and the CBM Directive adopt the principle that the pre-reincorporation pre-reincorporation rules will continue to apply post-reincorporation. post-reincorporation. When one or more of the companies that are merging or forming an SE are subject to employee board-level board-level influence requirements, those requirements will be carried over to the surviving or resulting company, even if the laws of the new state of incorporation would not otherwise require board-level influence.¹¹ influence.¹¹ o be sure, the safety standards for the creation of an SE and for cross-border cross-border mer-
gers underonly theifDirective are default rules, but strong defaultnegotiate rules, since they can be modified management and employee repre representatives sentatives a different solution in advance of the reincorporation.¹² Tis approach is intended to prevent crossborder mergers from undermining existing board-level board-level voice requirements but not to extend such requirements to companies not previously subject to them (e.g. in a cross-border crossborder merger of companies, none of which was previously subject to mandatory board-level boardlevel employee voice). Despite this policy, however, German companies have been over-represented over-represented in the number of SEs formed to date and seem to have been able to obtain what they regard as attractive modifications of their national employee representation systems, even if they have been unable (or, perhaps, unwilling) to avoid codetermination altogether altogether.¹³ .¹³ Beyond cross- jurisdictional jurisdictional reincorporations, firms may also choose to change the type of corporate form or abandon the corporate form altogether in favor of partial corporate forms or other organizational structures, strategy known as conversion discussed in Chapter 1, the ability to select amonga different organizational forms. As is
Law 1999– 2010: Renaissance and Crisis , 48 C M L R 125, 161 ff. (2011); Bech Bruun & Lexidale, S A C-B C- B M D, September 2013, Main Findings 23. ¹¹ Wolf-Georg Wolf-Georg Ringe, Mitbestimmungsr Ringe, Mitbestimmungsrechtliche echtliche Folgen einer SE-Sitzverlegung SE-Sitzverlegung , N Z G 931 (2006). Voice Voice provided otherwise than via board-level influence (principally via mandatory consultation of employee representatives) is subject to the rules of the jurisdiction of the resulting or emerging entity in the case of a cross-border cross- border merger and to rules modeled on the European Works Works Councils Directive (Directive 94/45/ 94/45/EC) EC) in the case of an SE. ¹² Tis summarizes a very complicated set of provisions (see Paul Davies, Workers on the Board of the European Company? , 32 I L J 75 (2003)); and the provisions themselves vary slightly according whether theforreincorporation is effected by formation of anissue SE orthrough under the CBM Directive. Tetorequirement pre-merger settlement pre-merger of the board influence negotiations with the employee representatives is likely significantly to slow down the formation of SEs. In a merger effected under the Directive the merging companies can opt for the “fall-back” “fall-back” rules on board-level representation without entering into any negotiations with the employee representatives. See on the bargaining process and content Horst Eidenmüller, Lars Hornuf, Hornuf, and Markus Reps, Contracting Employee Involvement: An Analysis of Bargaining over Employee Involvement Rules for a Societas Europaea , 12 J C L L S 201 (2012). ¹³ For example, a reduction in the the size of the board (Chapter 3.1), a more international composition of the board or a “freezing “freezing”” of the domestic level of representation (e.g. a German company about to cross the employee threshold which would trigger the move from one-third one-third to parity representation can form an SE, which will then remain subject to one-third one- third also after crossing the employee threshold). See Berndt Keller and Frank Werner, Werner, Te Establishment of the European Company: Te First Cases from an Industrial Industrial Relations Perspective , 14 E J I R 153 (2008).
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an essential component of the flexibility that entrepreneurs enjoy to tailor the legal regime to the concrete needs of any given enterprise. However, a midstream change in the entity type is potentially more drastic than charter amendments, which typically alter discrete features of the organizational contract, and possibly as a s consequential as reincorporations: both after conversion and following migration, the outcome is a wholesale alteration in the default and mandatory rules provided by law. law. While most jurisdictions permit corporations to convert into other business forms without the need for prior dissolution, such decisions typically t ypically invite close scrutiny scrutiny.. For instance, both Delaware and Brazil in principle employ an exceptionally strong decision strategy to police conversions, which are the only corporate decisions requiring unanimous shareholder shareholder approval.¹ Yet there are ways around such rigors. Delaware permits companies to effect a change in organizational form through mergers—which mergers—which
are through comparatively morelawflexible mechanisms gers,policed as discussed in the Section 7.4. Brazilian permits companiesapplicable to opt outtoofmerthe stringent default rule through charter provision. Other jurisdictions treat changes in business form similarly to charter amendments, relying on a combination of decision strategies in the form of supermajority voting requirements and on judicial enforcement of fiduciary duties.¹ However, the precise quorum required to approve a conversion may also depend on the new entity type being selected—and on the t he nature of its differences vis-àvis-à-vis vis the business corporation. Delaware law requires the approval of a majority of the outstanding shares for a merger leading to a conversion into a limited liability company company,, but of twotwo-thirds thirds of the outstanding shares for a conversion or merger into a public benefit corporation—an corporation—an organizational form which, as the name suggests, requires the pursuit of a “public benefit” beyond profit.¹
7.6 General Provision Provisionss on Significan Significantt ransact ransactions ions Given the uncertainty about what corporate decisions are “fundamental,” it is understandable that legal systems seek to remove particular types of transaction from unilateral board control, rather than laying down general tests to identify significant transactions. Te downside of the transaction-bytransaction-by-transaction transaction approach is that it can often be side-stepped side-stepped by adopting a non-regulated non-regulated transaction that achieves the same functional goal. o be sure, in some jurisdictions, strongly enforced directors’ duties operate as powerful general standards across transactional types. Tis is particularly the case in Delaware. However, However, where a decision rights strategy is thought to be appropriate, the problem of identifying the fundamental corporate decisions and transactions is particularly acute. Both Germany the UK have developed general criteria for the identification of situations in whichand shareholder consent for a transaction is required, though in neither case as a result of legislative action.¹ In Germany the doctrine was developed ¹ DGCL § 266; Lei das Sociedades por Ações Art. 221 (requiring unanimous approval as a default rule that can be altered in the charter). ¹ E.g. Umwandlungsgesetz Umwandlungsgesetz §§ 226, 240 (Germany), and CA 2006, section 90 (UK) both specify specify,, inter alia, a 75 percent majority requirement for conversions from private to public company. ¹ DGCL § 363. See also Chapter 1.2.5. ¹ Te only exception in German law is AktG § 179a which requires requires shareholder approval where the company transfers all of its assets: see note 138. In Italy, some decisions entailing a substantial change of the company’s company’s business require shareholder approval: see Art. 2361 Civil Code (acquisition
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by the highest civil court (the Bundesgerichtshof [BGH]), despite the provision in the open company law restricting the powers of the shareholders to a list of matters and otherwise providing that “the shareholders’ shareholders’ meeting may decide on matters concerning the management of the company only if required by the management board.”¹ board.”¹ In its famous Holzmüller ¹ ¹ decision, later restricted and somewhat clarified in its Gelatine I and and II decisions,¹ decisions,¹ the BGH turned this provision on its head in the case of a spin-off spin-off of a major part of the company’s operations into a separate subsidiary. In principle, it required shareholder approval for such a restructuring on the grounds that the rights which the shareholders of the parent previously had in relation to these assets would be exercisable in future in relation to the new subsidiary by the management board of the parent alone, as the representative of the new subsidiary’s subsidiary’s only shareholder.¹¹ shareholder.¹¹ Te decision caused enormous uncertainty as to when the man-
agement had seek the approval of the shareholders restructurings. Although the to Gelatine cases cases somewhat restrict the scopeinofcorporate the doctrine, by confining it to decisions affecting a major part of the company’s company’s assets and having a highly significant impact on the practical value of the t he shareholders’ shareholders’ rights, uncertainty still exists in relation to the scope of the doctrine.¹² A more recent decision by the Frankfurt Court of Appeal confirmed that the Holzmüller principle principle does not apply to acquisitions of of major assets.¹³ In the UK, the Financial Conduct Authority’s “significant transactions” rules,¹ which apply to companies with a premium listing on the main market in London, aim at a similar objective, but do so in a more mechanical way.¹ In principle, any transaction (by the company or its subsidiary undertakings) of certain size, relative to the listed company proposing it, requires ex ante shareholder shareholder approval, unless it is within the ordinary course of the company’s company’s business or is a financing transaction not involving the acquisition assetscompany’s of the company.¹ Te requisite size is 25 percent or moreorofdisposal any oneofoffixed the listed assets, profits or gross capital of shareholdings by public companies to be approved whenever it results in a substantial change of a company’s business); Art. 2479 Civil Code (in private companies, transactions causing a substantial change in the company’s business require shareholder approval; Art. 2473 24 73 grants dissenting shareholders appraisal rights as well). ¹ AktG § 119(2). ¹ BGH, Feb. Feb. 25, 1982 – II ZR 174/ 174/80, 80, BGHZ 83,122. ¹ BGH, Apr. 26, 2004 – II ZR 155/02, 155/02, BGHZ 159, 30 (Gelatine ( Gelatine I ) and BGH, Apr. 26, 2004 – II ZR 154/02, 154/02, ZIP 2004, 1001 (Gelatine (Gelatine II ). See generally Marc Löbbe, Corporate Groups: Competences of the Shareholders’ Meeting and Minority Protection, Protection, 5 G L J 1057 (2004). ¹¹ Te threat to parent shareholders’ shareholders’ preemptive rights also played a role: role: see Section 7.3.2. Gelatine ¹² quarters As a result of thevoting cases cases it is now clear that, is required, threethree-quarters of those must consent, by analogy withwhere what shareholder is needed to approval change the constitution of the company: see Section 7.2. Under Delaware law, dropping assets into a subsidiary does not require a shareholder vote, even if they amount to all or substantially all of the assets: DGCL § 271(c). ¹³ At least where the articles of association of the company allow the management to pursue such an acquisition. See OLG Frankfurt, Dec. 7, 2010 – 5 U 29/10, 29/10, NZG 2011, 62. ¹ Listing Rules, chapter chapter 10. ¹ “Tis chapter is intended to cover cover transactions that are outside the ordinary course of the the listed company’s business and may change a security holder’s economic interest in the company’s assets or liabilities” (LR 10.1.4). ¹ LR 10.1.3. On the impact of such rules on share prices, see Marco Becht, Andrea Polo, Polo, and Stefano Rossi, Does Mandatory Shareholder Voting Prevent Bad Acquisitions? , 29 Review of Financial Studies 3035 (2016).
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or where the consideration for the transaction is 25 percent or more of value of the ordinary shares of the listed company company.¹ .¹ France does not make use of the decision rights strategy in general, although the market regulator may accord an exit right to minority shareholders under the provisions discussed above,¹ that is, when a listed company’s controllers propose to transfer or contribute all or substantially all of its assets or to “reorient the company’s business.”¹ Tis, as we have seen, is part of a set of provisions empowering the regulator to protect minority interests through the buy-out buy-out requirement where the majority propose significant legal or financial changes to the business by way of significant amendments to the company’s charter, merger of the company into its controller, disposal of all or most of its assets or a prolonged suspension of dividend payments, as well as reorientation of the business.² As such, the French approach, besides its
different remedy,and seems fall inone between thefinancial Germanthresholds one of trying to identifythea general principle thetoBritish of using for triggering minority protections, by laying down a list of circumstances in which a buy-out buy- out may be required.
7.7 Explaining Differences in the Regulation of Fundamental Changes Changes Te most striking conclusion to emerge from our review of fundamental corporate changes is how overall uniform major jurisdictions are in their distinctions between the bulk of corporate actions that are fully delegated to the board, and the handful of corporate changes in which the board’s authority is limited, by a shareholder vote requirement or direct regulation. “decisioninvolved rights” strategy seems to bechanges, the method most widely used to constrain theAproblems with fundamental and complementary strategies are more rarely in operation. In all jurisdictions, mergers, charter amendments, reincorporations, and dissolutions fall outside the scope of (complete) delegation to the board of directors, and require shareholder approval, usually with a special quorum.²¹ Despite widespread consensus about which corporate changes ought to be regulated and which ought to be left to the board, jurisdictions nonetheless differ in certain familiar respects. In general, these differences do not track the common law/civil law/civil law divide.²² Although continental European jurisdictions rely less on judicially enforced standards to regulate mergers than do the Anglo- American American jurisdictions, jurisdictions, merger transactions are atypical of the broader class of significant corporate actions. Over the entire class, France and Germany rely as heavily on standards as the U.S. or the UK. ¹ LR 10.2.2, 10.5, and 10 Annex 1. A reverse takeover (LR 10.2.3) and an indemnity (LR 10.2.4) are included in the covered transactions in certain circumstances, but the rules can be waived in restricted circumstances if the listed company is in financial difficulty (LR 10.8). ¹ Section 7.2.2. ¹ Art. 236-6 236-6 Règlement Général de l’AMF l’AMF.. See Viandier Viandier,, note 97, at 461–4. ² See Sections 7.2.2, 7.4.1.2, 7.4.2.2, and 7.4.2.3.1. ²¹ By contrast, in no jurisdiction does the investment of capital in firm projects or the incurring of debt require shareholder approval, no matter how large these transactions are. ²² Differences mostly concern the question of how much the board is in charge charge in initiating or co-deciding codeciding on the proposed fundamental change; another difference appears to be the threshold of shareholder approval (mostly simple versus super majority).
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Rather than following the common law/civil law/civil law divide, differences in the regulation of significant corporate actions among our jurisdictions appear to reflect a broader pattern of divergences in governance structures. EU law and, to some extent Japanese law, accord more attention attentio n to management– management –shareholder conflict in regulating corporate decisions than does the law of U.S. jurisdictions. In Europe, shareholder approval tends to be for a limited period of time (e.g. for authorized capital or the repurchase of shares) and is required for a wider range of decisions (e.g. reductions in legal capital) than in the U.S. In Japan, shareholders must approve large acquisitions, even when acquiring companies engage in cash-out cash-out mergers. European shareholders (except, as noted above, in Italy) may also initiate organic changes, including mergers and major restructurings, by extraordinary resolution, whereas in U.S. jurisdictions shareholders can only veto them, after such organic changes have been proposed by the board. Brazilian law stands out by permitting a mere majority
of shareholders to initiate fundamental changes, while relying on a standards strategy stra tegy to impose liability on controlling shareholders for abusive action—though action—though enforcement remains an issue. Te greater power of the general shareholders’ shareholders’ meeting to make significant corporate decisions in Europe and Brazil reflects the stronger legal position of shareholders and their lobbying power in these jurisdictions, which in turn mirrors—as mirrors—as we noted in Chapter 3—the 3—the well-known well-known differences in ownership structures.²³ In the U.S., where shares tend to be widely held and management is dominant, only the board can initiate fundamental changes. In Europe, where controlling shareholders are dominant or, as in the UK, institutional investors push the regulatory agenda, shareholders have greater power to initiate major changes. But if the U.S. provides less protection to shareholders as a class, it offers more protection to in minority shareholders. As noted boards must approve important decisions the U.S., which modestly limitsabove, the power of controlling shareholders. In addition, both the U.S. and Japan provide an exit strategy, in the form of appraisal rights, for minority shareholders who vote against mergers or (in Japan and most U.S. states) other organic transactions. U.S. jurisdictions also provide a standard of entire fairness, backed by the threat of a class action lawsuit, for significant transactions between entities controlled by a dominant shareholder. By contrast, European boards generally do not limit the power of controlling shareholders, appraisal rights are uncommon in the EU, and shareholders suing for violations of standards face significant enforcement obstacles.² In general, European jurisdictions focus their efforts on protecting minority shareholders from changes in legal capital. For example, unlike the U.S. or Japan, all major European jurisdictions grant at least default preemptive rights in case of new issues of shares. Te differences seemU.S. roughly to map extent of transactional flexibility among within jurisdictions jurisdictions:also in the and the UK,the where a variety of alternative transactional forms can be used to t o achieve the same goal, the systems are forced to adopt ex post standards standards strategies. By contrast, where transactional flexibility is more limited, more regulation can be ex ante . While France, Germany, Italy, and Japan have legislated detailed merger procedures to safeguard shareholder decision rights, the UK and U.S. rely heavily on the judiciary to screen mergers under ²³ See Chapter 3.1.1.5, 3.1.2.5, and 3.2.5. ² See Chapter 5.1.5 and 5.2.3.3.
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the aegis of a basic fairness standard, with the UK also addressing mergers in the akeover Code.² Finally, the protection of non-shareholder non-shareholder constituencies in significant corporate actions resembles that offered by corporate governance more generally. As compared with U.S. law, all our other core jurisdictions are more protective of creditors, both in general (through capital maintenance rules) and when firms embark on mergers and other organic changes. Moreover, not surprisingly, EU law provides workers with substantially more protection in mergers and other restructurings than U.S. law does.
² See Chapter 8 for discussion of the akeover Code.
8 Control ransactions Paul Davies, Klaus Hopt, and WolfWolf-Georg Ringe
8.1 Regulato Regulatory ry Problems in Contro Controll ransact ransactions ions In this chapter we consider the legal strategies for addressing the problems which arise when a person (the acquirer) attempts, through offers to the company’s shareholders,
to acquire sufficient voting shares in a company to give it control of that t hat company. company. 8.1.1 Control transactions Te core “control “control transaction” in this chapter is one between a third party (the acquirer)¹ and the company’s company’s shareholders. Of course, control may also shift as a result of a transaction between the company and and its shareholders or the investing public (as when a company issues or re-purchases re-purchases shares or engages in a statutory merger). However However,, the latter type of transactions can be analyzed in the same manner as other corporate decisions, a task we have undertaken in Chapter 7. Te absence of a corporate decision and the presence of a new actor, in the shape of the acquirer, give the agency problems of control transactions a special character warrants separate Admittedly, Admittedly , in terms of end result, which there may not be muchtreatment.² difference between a statutory merger³ and a takeover bid where the successful bidder squeezes out the nonaccepting minority. minority. Yet, Yet, in terms t erms of the legal techniques used to t o effect the control shift, there is a chasm between the two mechanisms. A merger involves corporate decisions, usually by both shareholders and the board, and often by all companies involved. Control transactions, by contrast, are effected by private contract between the acquirer and the shareholders individually. Nevertheless, at least in friendly acquisitions, the acquirer often has a free choice whether to structure its bid as a contractual offer or as a merger proposal. Tis creates the regulatory question of whether control transactions should be regulated so as to mimic the results of statutory merger regulation or instead be treated as presenting distinct regulatory issues. ¹ Of course, the acquirer may, may, and typically will, already be a shareholder of the target company, company, but it need not be and the relevant rules (other than shareholding disclosure rules) do not turn on whether it is or not. Te bidder may also be or contain the existing management of the target company (as in a management buy-out buy-out (MBO)). Tis situation generates significant agency problems for the shareholders of the target company which we address below. ² Te special character of control control transactions is also reflected reflected in the increasing number of jurisdictions which have adopted sets of rules, separate from their general company laws, to regulate them. ³ See Chapter 7.4. Where the merger is adapted to to function as a post-bid post-bid squeeze-out squeeze-out technique, the shareholder vote may be dispensed with. See Section 8.3.5. If the choice is to regulate control transactions differently, the converse question then arises. Should control transaction regulation be added to merger regulation in order to prevent transactional arbitrage? In the UK and countries which have followed its lead, control transaction rules are extended, in so far as is appropriate, to supplement regulation of mergers. (Te Panel on akeovers Te Anatomy of Corporate Law. Tird Edition. Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry Hansmann, Gerard Hertig, Klaus Hopt, Hideki Kanda, Mariana Pargendler, Wolf-Georg Ringe, and Edward Rock. Chapter 8 © Paul Davies, Klaus Hopt, and Wolf-Georg Ringe, 2017. Published 2017 by Oxford University Press.
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Control transactions may be structured in a variety of ways: private contracts with a single or a small number of important shareholders (“sale of control”); purchases of shares on the market; or a general and public offer to all the shareholders of the target company. Te public offer may be either “friendly” (i.e. supported by the management of the target company) or “hostile” (i.e. made over the heads of target management to the shareholders of the target). Of the three acquisition methods, the second and third are clearly facilitated if the target’ss shares are traded on a public market. For this reason, companies with publicly target’ traded shares are at the center of attention in this chapter. chapter. In fact, legislation specific to control transactions is usually (though not always) confined to companies whose securities are traded on public markets (or some sub-set sub-set of these, such as the top-tier top-tier markets). Not only are hostile bids difficult to organize other than in relation to publicly traded companies, but also the shareholders’ agency and coordination problems are less pronounced in companies with small numbers of shareholders. Nevertheless, control transactions are not logically confined to public companies and we will also make some
reference to non-traded non-traded companies. In jurisdictions which rely on general corporate standards, such as fiduciary duties, rather than rules specific to control transactions, to regulate the behavior of target management or the target’s target’s controlling shareholders, the application of these standards to the managements and shareholders of non-traded non-traded companies raises no difficult boundary questions. Te global takeover market has steadily grown over the past decades, with the only exceptions being after the 2001 Dotcom bubble burst and during the 2008/9 2008/9 financial crisis.¹ Te takeover market now appears to have recovered from its most recent crisis.¹¹ raditionally, the U.S. and the UK have the most active takeover markets, while takeovers are rarer in continental Europe, emerging markets, and in Japan. Empirical studies show that takeovers are usually profitable for the target shareholders,¹² whilst the share price of the bidder is frequently unaffected by the and Mergers, C (11th edn., 2013) 2013 ) § A3(b) and Appendix 7—hereafter “ “ akeover Code”). But in most jurisdictions the regulation of takeovers is confined to control shifts. Tus, Art. 2(1)(a) Directive of the European Parliament and of the Council on akeover Bids, 2004/25/ 2004/25/EC, EC, 2004 O.J. (L 142) 14 2) 12 (hereafter “ “ akeover Directive”) Directive”) excludes statutory mergers. Whether these three acquisition strategies give rise to the same regulatory problems is subject of considerable debate. See e.g. note 144. Of course, the board’s board’s decision whether to recommend an offer, offer, either at the outset or during the course of an initially hostile offer, will often be influenced by its estimate of the bidder’s bidder’s chances of succeeding with a hostile offer. And while it may be difficult to characterize a particular bid as “friendly” or “hostile,” the question of whether a particular system of rules rule s facilitates hostile bids is of enormous importance. See Section 8.2.1. Tus the akeover akeover Directive applies only to companies whose securities are traded on a “regulated market” 1(1)). In contrast, however however, UK akeover held akeover Code applies all companies which may offer their(Art. shares to the public and even ,totheclosely companies wheretothere has been something analogous to a public market in the private company’s company’s shares (akeover (akeover Code, § A3(a)). See Section 8.4.1 for a discussion of U.S. rules on sales of shares shares by controlling shareholders shareholders to looters. ¹ For recent recent analyses, see Marina Martynova Martynova and Luc Renneboog, Renneboog, Te Performance of the European Market for Corporate Control: Evidence from the Fifth akeover Wave , 17 E F M 208 (2011); Marccus Partners, E S D , section IV (2012). (201 2). ¹¹ Arash Massoudi and Ed Hammond, Hostile Bids Reach 14-Year 14-Year High, High, F , 9 June 2014, at 3. ¹² Roberta Romano, A Guide to akeovers: Teory Teory,, Evidence, and Regulation Regulation,, 9 Y J R 119, 122 (1992); Marina Martynova and Luc Renneboog, A Century of Corporate akeovers: What Have We Learned and Where Do We Stand? , 32 J B F 2148, 2153 (2008); Klaus J. Hopt, akeover Defenses in Europe: A Comparative, Teoretical and Policy Analysis , 20 C J E L L 249, 252 (2014).
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bid or may even suffer.¹³ Overall, however, takeovers to create value for both groups taken together.¹ Nevertheless, judged solely appear from the bidder’s perspective, many takeovers turn out to have been an economic misjudgment in retrospect. Tis raises the question of why takeovers happen in the first place.¹ Tat is not an issue which control transaction rules tend to address, at least not directly.¹ With due exceptions, bidder management and shareholder relations are usually left to general corporate governance rules.¹ Nevertheless, skepticism about or enthusiasm for takeover bids is reflected in takeover rules, and especially in the extent to which they facilitate hostile bids.
8.1.2 Agency and coordination coordination issues akeover regulation worldwide seeks to address two main issues: agency problems, predominantly the target company, company , and coordination a mong among the target shareholders.within Te specific shape of these problems largely problems depends on whether the
target company is controlled by a blockholder or widely held; and takeover regulation usually seeks to reflect these differences by responding to the typical or or prevailing stan standard of ownership concentration in the jurisdiction— jurisdiction—knowing, knowing, of course, that firms of all different shades of concentration exist in each of our jurisdictions.
8.1.2.1 Agency conflicts Consider agency conflicts first. Where there are no controlling shareholders in the target company, company, the main focus is on the first agency relationship, that is, the relationship between the board and the shareholders as a class. Prior to the offer de facto control of the company was probably in the hands of the target board, so that, following a takeover, control shifts from the board of the target to the acquirer. Terefore, there is a disjunction between the parties to the dealings which bring about the transfer of control (acquirer and target shareholders) and the parties to the control shift itself (acquirer and target board). It is precisely this disjunction which generates the agency issues which need to be addressed. Te control transaction may be wealth-enhancing wealth-enhancing from the target shareholders’’ point of view but threaten the jobs and perquisites of the holders t he existing senior management. Te incumbent management of the target may thus have an incentive to block such transfers by adopting a range of different “defensive measures.” Tey may seek to make the target less attractive to a potential bidder or to prevent the offer being
Acquisitions Entrenched Te Sources of Value Destruction in ¹³ Jarrad by Harford, MarkManagers Mark HumpheryHumphery, 106 Jenner Jenner, J , and Ronan F Powell,E Powell, 247 (2012). See, with further references, Klaus J. Hopt, European akeover Reform of 2012/ 2013—ime 2013—ime to Re-examine Re-examine the Mandatory Bid , 15 E B O O L R 143, 150 (2014). ¹ B. Espen Eckbo, Corporate akeovers and Economic Efficiency , 6 A R F E 51, 67 (2014). See also Martynova and Renneboog, note 12, at 2164. ¹ A number of explanations are usually put forward: first, managers may be over- optimistic, underestimating the overall costs, the likelihood of success, and the concessions that need to be made during the bidding process; secondly, the bidder management may deliberately enter into an unprofitable takeover for opportunistic reasons (“empire building”); and thirdly, the transaction may be beneficial for the entire group instead of the single bidder company. See also Hopt, note 13, at 150. ¹ Recent research suggests that a requirement of shareholder consent at the bidding company may help mitigate these problems. See Marco Becht, Andrea Polo, and Stefano Rossi, Does Mandatory Shareholder Voting Prevent Bad Acquisitions? , 29 R F S 3035 (2016). ¹ See Chapter 7.6.
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put the shareholders. stepssmay take myriad but not t he main the are: to i) placing a block ofTese the target’ target’s shares inathe handsofofforms persons likelycategories to accept a hostile bid; ii) structuring the rights of the shareholders and creditors, for example, through poison pills; and iii) placing strategic assets outside the reach of a successful bidder. Alternatively,, the transaction may not be wealth Alternatively wealth-enhancing enhancing from the shareholders’ point of view but the incumbent management may have an incentive to promote it to the shareholders, because the management stands to gain from the proposed control shift, either by reaping significant compensation for loss of office or by being part of the bidding consortium. Incumbent management may use their influence with the shareholders and their knowledge of the company to “sell “sell”” the offer to its addressees or, or, in the case of competing bids, to favor one bidder over another. another. arget firms with a controlling shareholder are not exposed to this managerial agency cost. Regulation needs to address, however, the agency relationship between the controller and the other shareholders of the target. Te controlling shareholder may seek to obtain more than its proportionate share of the current value of the
company or even impound into the sale price the value of the new controller’s future opportunistic treatment of the non-controlling non-controlling shareholders. Tis is particularly so where the target, upon acquisition, will become a member of a group of companies where business opportunities, which the target has been able to exploit in the past, may be allocated to other group members. Te law can address this thi s problem by focusing on the existing controlling cont rolling shareholder’s shareholder’s decision to sell, on the t he terms upon which the acquirer obtains the controlling block, or upon the subsequent conduct of the affairs of the target by the new controller. In the last case, reliance will be placed on the general legal strategies for constraining controlling shareholders, including group law.¹ Te first and second cases point towards legal strategies specifically addressing the control transaction, though these may take a wide variety of forms, up to and including an exit right for the minority upon a change of control, via a mandatory bid requirement.¹ By contrast, takeover rules do not often address the agency problems which arise as between the shareholders of the acquiring company company and their board in relation to the decision to acquire the target; and we shall follow that lead in this chapter. Tis issue is but an example of the general agency problems existing between shareholders (and creditors) and boards in relation to setting the corporate strategy, which have been fully analyzed in earlier chapters.² However However,, it is central to this chapter to consider the extent to which regulation purportedly designed to address the agency and coordination costs of target shareholders shareholders impacts upon the incentives for potential bidders to put forward an offer.
8.1.2.2 Coordination problems Te rules governing control transactions need also to deal with the coordination problems of the target t arget shareholders. In particular, the acquirer may seek to induce dispersed shareholders of the target to accept an offer which is less than optimal. Tere are a number of ways in which this can be done,²¹ but in essence they rely on information asymmetry, undue pressure to accept the bid, or unequal treatment of the target’s ¹ See Chapter 6.2.5.3. ¹ See Section 8.3.4. ² Se Seee Chap Chapte ters rs 3, 5, an andd 7 (a (and nd es espe peci cial ally ly Se Sect ctio ionn 7. 7.6) 6)..
²¹ Se Seee Se Sect ctio ionn 8. 8.3. 3.
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shareholders. Whe re the target company is possibly controlled a blockholder blockholder, the controlling same problem arises for Where the remaining shareholders, as by against acquirer ,and shareholder combined.
8.1.2.3 Agency problems of nonnon-shareholders shareholders Whatever Whatev er the stru structu cture re of the targ target et com company pany’’s shar shareho eholdin lding, g, age agency ncy issu issues es will also arise between the acquirer and nonnon-shareholders shareholders , especially employees. Indeed, some have argued that a substantial proportion of the gains to acquirers from takeovers are the result of wealth transfers from non-shareholder non-shareholder groups, especially the employees of the target.²² Te responses of takeover regulation to this issue can be put, broadly, into one of three classes. First, those systems which allocate to the shareholders of the target the exclusive power to approve the offer find it difficult to fit into that structure a significant mechanism for the protection of non-shareholder non-shareholder interests, other than via disclosure of information.²³ Tis strategy is heavily adopted by the akeover
Directive, but the disclosure obligation sits in a vacuum, dependent for its effective ness upon rules and institutions existing outside corporate law. In some jurisdictions such structures—usually structures—usually some form of works council—do council—do exist and may be built into the takeover process by national legislation. Te recent takeover law reform in France has strengthened information rights for target employees to the extent that the procedure may severely complicate the mechanics of the bid altogether.² Recent changes to the UK Code improved the disclosure, monitoring, and enforcement by the Panel of takeover promises (so-called (so-called “post-offer “post-offer undertakings”) that the bidder (or, exceptionally, the target) makes in the course of a bid and which are directed at non-shareholder nonshareholder concerns.² Where, however however,, the board is given a significant role in the takeover process, a second pattern can be discerned, which is to regard the survival of target management as a proxy for the furtherance of the interests of non-shareholder non-shareholder groups. Tus, in the U.S., one popular form of state antitakeover antitakeover statute (the so-called so-called “co “constituency nstituency statute”) expands the range of interests beyond the shareholders’ which management is entitled (but not bound) to take into account when responding to a takeover bid.² It is doubtful, however, however, whether, whether, by itself, relieving directors of liability liabi lity to the shareholders if they act to promote non-shareholder non-shareholder interests encourages anything more than selfinterested behavior on the part of the target board. Te greater the range of interests which directors are entitled to take into account when exercising their discretion, the more difficult it will be to demonstrate in any particular case that the standard has been breached. If this is a correct analysis, non-shareholder non-shareholder constituencies will benefit from ²² Margaret M. Blair, O C (1995); Andrei Shleifer and Lawrence H. Summers, Breach of o f rust rust in i n Hostile Hostil e akeovers akeovers , in C : : C C 33 (Alan J. Auerbach ed., 1988). ²³ Of course, non-shareholder non-shareholder interests may be protected through mechanisms existing outside company law which deal with some of the possible consequences of a control shift, e.g. mandatory consultation over lay-offs. lay-offs. See Chapter 7.4.3.2. ² Te Loi “Florange” “Florange” No. No. 2014-384 2014-384 of 29 March 2014 requires consultation over the bid itself between the CEO of the target and the works council (Code du travail, Arts. L. 2323-21 2323- 21 to L. 232324). Te board of directors cannot issue a recommendation before the works council does, which may significantly slow down the process and even discourage takeover bids. ² New Rules 19.7 and 19.8. Te background is nonnon-compliance compliance with such promises in the past. ² See e.g. § 717(b) New York York Business Corporation Law. o o the extent it applies, section 172 Companies Act 2006 (UK) is another good example.
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such rules only to the extent that their interests are aligned with those of the target board.² Te third pattern involves giving non-shareholders non-shareholders decision rights, though in practice jurisdictions only deploy this strategy in relation to employee interests. In those jurisdictions (notably Germany) Germany) in which company law is used in a significant significant way to regulate the process of contracting for labor l abor,² ,² the presence of employee representatives representatives on the supervisory board and the relative insulation of the board from the direct influence of the shareholders may enable those representatives to have a significant input into takeover-related takeover-related decisions, up to the point where control shifts are hard to achieve without the consent of the employee representatives.² Creditors, as well as employees, may stand to lose out as a result of changes in the company’s risk profile post-bid, post-bid, perhaps arising from the leveraged nature of the bid. Tose most at risk, the long-term long-term lenders, are well placed to protect themselves by contractual provisions, such as of “event “e vent risk” covenants in loans.³ Such protections may not always be fully protective the creditors, but adopting suboptimal contractual protection is normally part of the commercial bargain. Consequently, Consequently, the agency costs
of creditors are not usually addressed in control-shift control-shift rules.³¹
8.1.2.4 Te sources of rules governing governing control transactions In principle, regulation of control transactions can be addressed through rules specific to control shifts or by the application of the established principles of corporate and securities law, law, albeit in a new context. In practice, this question is largely l argely conterminous with the question of whether these rules are made by legislators or courts. All our jurisdictions utilize to some degree both types of approach, but the balance between them can vary considerably. owards one end of the spectrum stands Delaware. Here the courts have played a major role by adapting the general fiduciary standards applying to boards and controlling shareholders to the control shift context.³² akeoverakeover-specific specific law,, whether in the form of federal (Williams Act)³³ or state legislation (rules governlaw ing access to the short-form, short-form, squeeze-out squeeze-out merger),³ plays a subordinate role. ² See also Mark J. Roe, P D C G 45 (2002) (employee influence is indirect and weak, constituency statutes being made by and for managers). ² See Chapter 4.2.1. ² German law de facto opts facto opts out from the akeover Directive’s board neutrality rule by allowing defensive measures if these have been approved by the supervisory board which is codetermined in the large corporations. ³ William W. Bratton, Bond Covenants and Creditor Protection, Protection , 7 E B O O L L R 39, especially at 58– 58–62 62 (2006). ³¹ It is sometimes difficult to distinguish covenants whose aim is to protect the the lender and those which aim to protect target management (“poison debt”); in fact, both groups may have an interest in inserting provisions which make debt repayable upon a change of control. However, However, this point relates to the agency costs of the shareholders, not the creditors. ³² It has been argued that the litigation focus of U.S. takeover regulation regulation made it easier for a promanagement approach to emerge because, on the one hand, case law precedents are relatively free from interest-group interest-group influence and, on the other, the courts can decide only the cases which come before them and management (and their lawyers) are in a good position to control the flow of litigation and appear as repeat players before b efore the courts. See John Armour and David Skeel, Who Writes the Rules for Hostile akeovers, and Why?— Te Peculiar Divergences of U.S. and U.K. akeover Regulation , 95 G L L J 1727, 1793 (2007). ³³ 1968, 82 Stat. Stat. 454, codified at 15 U.S.C. U.S.C. §§ 78m(d)–(e) 78m(d)–(e) and 78n(d)– (f (f), ), adding new §§ 13(d), 13(e), and 14(d)–(f) 14(d)–(f) to the Securities Exchange Act of 1934. ³ Section 8.3.5.
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contrast,exclusion in the EU specific control shifts more important not to theBy complete of rules general rules to of corporate a ndare and securities la w). Tus,(though law). the akeover akeover Directive lays down an extensive set of rules which are confined to control shifts. Similarly, the regulation of control transfers under Brazilian law is also primarily based on specific rules.³ Japan sits somewhat between these two models.³ It has legislation specific to control shifts,³ but, on the central issue of the allocation of decision rights over the offer, court-developed courtdeveloped general standards applying to directors’ decisions are still central.³ Where regulation of control shifts is predominantly through takeovertakeover-specific specific rules, the rule-maker rule-maker is likely to create a specialized agency to apply the rules, as mandated by the akeover akeover Directive.³ Directive.³ Tis will generally be the financial markets regulator but may be a specific regulator for takeovers.
8.2 Agency Problems Problems in Control ransact ransactions ions Agency problems may arise in both widely held held and controlled target corporations: corporations: the incumbent controller is the target board in the t he former case and the blockholder in the t he
latter. In both cases, takeover regulation addresses the tensions between the “controller” latter. “controller” and the (minority) shareholders. In the following, we will first predominantly look at the case of a widely held target, and subsequently address the specific differences in a target company that is controlled by a blockholder (Section 8.4). 8.2.1 Te decision rights choice: Shareholders only or shareholders and board jointly Te central issue is whether the bidder is free to make and maintain an offer to the target shareholders without the consent of theonincumbent Te available solutions range from allocating the decision the controlmanagement. transaction exclusively to the shareholders by depriving the management of any role in the interactions between acquirer and target shareholders, to designing the control shift decision as a joint one for incumbent management and shareholders. In the former case, the shareholders’ agency problems as against the management are resolved by terminating the agency relationship for this class of decision: the principal is protected by becoming the decision-maker¹ decisionmaker¹ and free transferability of shares becomes paramount. In the latter case, both management and target shareholders must consent if the control shift is to ³ See e.g. Arts. 254- A A and 257 Lei das Sociedades por Ações. ³ On the emerging framework in Japan, see John Armour, Armour, Jack B. Jacobs, Jacobs, and Curtis J. Milhaupt, Te Evolution of Hostile akeover Regimes in Developed and Emerging Markets: An Analytical Framework , akeoverR Defences and 52 H I L J L 291 , 248 ff.(2011); 291, Hideki the H Role of Law: A Japanese Perspective , in P C LKanda, L F R 413 (Michel ison et al. eds., 2009); Masaru Hayakawa, Die Zulässigkeit von Abwehrmaßnahmen Abwehrmaßnahmen im sich entwickelnden japanischen Übernahmerecht , in F K J. H 3081 (Stefan Grundmann et al. eds., 2010). ³ See Art. 2727-22 of the Financial Instruments and Exchange Act and Section 8.3.4. ³ Section 8.2.2—coupled 8.2.2—coupled in this case with non-binding non-binding guidelines issued by the government. ³ Art. 4(1). Te former is by far the more common choice within Europe Europe but the UK and countries which follow its model usually give the supervision of takeovers to a body separate from the general financial market regulator regulator.. ¹ ypically, the shareholders determine the fate of the offer by deciding individually whether to accept the offer or not, but in some cases the shareholders’ decision may be a collective one, as where the shareholders decide in a meeting whether to approve the taking of defensive measures by the
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occur. Te acquirer to negotiate both groups. Te potential gains from the control shift mayis forced now have to be splitwith three ways (acquirer, target shareholders, target management) and, to the extent that the benefits to management of their continuing control of the target company exceed any share of the gain from the control shift which the acquirer is able or willing to allocate to them, fewer control shifts will occur occur..
8.2.2 Te “no frustr frustration” ation” rule Te UK akeover akeover Code embodies the former choice in a strong form. Since its inception in 1968 it has contained a “no frustration” principle addressed to the board of the target company. Tis provides that “during the course of an offer, or even before the date of the offer if the board of the offeree company has reason to believe that a bona fide offer might be imminent, the board must not, without the approval of the shareholders in general meeting, take any action which may result in any offer or bona fide possible offer being frustrated or in shareholders being denied the opportunity to
decide on its merits … Tis will affect, e.g. the issuance of new shares, the acquisi tion or disposal of significant assets, leveraging the capital structure or entering into substantial contracts other than in the ordinary course of business.³ Te board will, howeverr, typically remain entitled, in fact required, to give its assessment of the bid and howeve may search for an alternative bidder (the “white knight”). Te no frustration or, in EU jargon, “board neutrality” rule is an effects-based effects-based rule, not one dependent on the intentions or motives of the board. Action on the part of the incumbent management which might obstruct an offer is legitimate under this rule only if the shareholders themselves have approved it, that is, have in effect rejected the offer. Te no frustration rule r ule recognizes that effective implementation of exclusive shareholder decision-making decision-making requires rules which ensure not only that shareholders are free to accept offers which are put to them, but also that offerors are free to put offers to the shareholders. In other words, the law must provide entry rules for acquirers as well as exit rules for shareholders. Te no frustration rule is not, however, imposed by the akeover Directive; rather the choice is left to the member states. All the major continental jurisdictions make it possible for companies to avoid the “no frustration” rule (with varying degrees of flexibility). Where the “no frustration” rule is not applied, the general principles of national corporate law determine the target board’ board’ss freedom of action.
incumbent management or where the shareholders vote to remove a board that will not redeem a poison pill:21.1. Sections 8.2.2 and 8.2.3. ² Rule ³ See akeover akeover Code, Rule 21.1(b). Note that the items listed there are examples only. See e.g. Art. 9(2) and (5) akeover Directive. Jurisdictions are generally relaxed about white knights because the decision of whether to accept an offer and, if so, which one, is still ultimately left to the shareholders. Te EU-level EU-level discussion normally uses the term “board neutrality” but we prefer the term “no frustration” as more accurately indicating the scope of the rule. See Section 8.2.2.1. After the Directive was implemented across the EU, takeover takeover laws across member states were surprisingly overall less favorable to board neutrality than they had been previously. See Paul Davies, Edmund-Philipp EdmundPhilipp Schuster, and Emilie van de Walle Walle de Ghelcke, Te akeover akeover Directive Direct ive as a Protectionist Protectio nist ool? in in C L L E P 105, 10 5, 138 ff. (Ulf Bernitz and Wolf-Georg Ringe eds., 2010). Even a jurisdiction like France, which originally adopted the neutrality rule, has gone back on that choice (see Section 8.2.3.).
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It is clear in both the akeover Code and the Directive that shareholder approval means approval given during the offer period for the specific measures proposed and an d not a general authorization given in advance of any particular offer. A weaker form of the shareholder approval rule is to permit shareholder authorization of defensive measures in advance of a specific offer. Tis is a weaker form of the rule because the choice which the shareholders are making is presented to them less sharply than under a post-bid post-bid approval rule. On the other hand, rendering pre-bid pre-bid approval of post-bid post-bid defensive measures ineffective makes it more difficult for shareholders to commit themselves to handling future offers through board negotiation negotia tion with the bidder bidd er. . Pre-bid Pre-bid shareholder approval is one way of legitimizing defensive action in Germany and also in Japan. In the latter, the governmental guidelines favor pre-bid pre-bid approval of defensive action “to allow the shareholders to make appropriate investment decisions.” However, court decisions are unclear on whether pre-bid pre-bid approval will always legitimize defensive measures.¹ the scarcity hostile takeoversand, in Brazil, the law on the Nevertheless, legitimacy of defensiveGiven measures remainsofunderdeveloped therefore, uncertain. Brazil’s newly created akeover Panel, whose membership is voluntary and still small, imposes a version of the no frustration rule during a pending offer.²
8.2.2.11 No frust 8.2.2. frustration, ration, neutrality, neutrality, passivity, passivity, and competing bids Te “no frustration” rule does not require boards to be “neutral,” let alone “passive.” Tere will remain a number of situations where the target board, consistently with the rule, may take action which may significantly influence the outcome of the offer. First, incumbent management remains free to persuade shareholders to exercise their right of choice in a particular way and, indeed, in most jurisdictions the target board is required to provide the shareholders with an opinion on the offer offer.. Tis recognizes the role of the incumbent management in addressing the information asymmetry problems of the target shareholders. Tis point is well captured in the French French terminology which refers to advance authorization as approval given “à “à froid ” and authorization given after the offer as given “à “à chaud .” .” On pre-commitment pre-commitment see Chapter 7.2. For the possible use of prepre-bid bid defensive measures to this end see Section 8.2.3. Wertpapiererwerbs- und Übernahmegesetz (“WpÜG”), § 33(2). Such permission may be given for periods of up to eighteen months by resolutions requiring the approval of three-quarters three-quarters of the shareholders, though the constitution of a particular company may set more demanding rules. However,, approval may also However al so be given post-bid post-bid by the supervisory supervisor y board without shareholder approval (WpÜG § 33(1)), and so pre-bid pre-bid approval by shareholders seems unimportant in practice. See Klaus J. Hopt, Obstacles to Corporate Restructuring: Observations from a European and German Perspective , in P C L L F R 373, at 373– 373 –95 (Michel ison et al. eds., 2009). Ministry of Economy, rade and Industry (MEI) and Ministry of Justice, G R D P P E C V S’ C I, 27 May 2005, p. 2. Tese guidelines are not legally binding but seek to capture court cour t decisions and best practice. See also Corporate Value Study Group, D M L R E C, 30 June 2008. ¹ As of the time of writing, there has been no no court decision concerning a defensive measure based on the Guidelines accompanied by pre-bid pre- bid approval. However, the Supreme Court in the Bulldog Sauce case case upheld the issuance of warrants as a defensive measure that had been approved by the shareholders after the bid had been launched and acquirer was treated fairly in respect of its pre- bid holdings (if not in the same manner as the other shareholders of the target): Supreme Court of Japan, 7 August 2007, 61 Minshu 2215. See also Sadakazu Osaki, Te Bulldog Sauce akeover Defense , 10(3) N C M R 1 (2007). ² Código de Autorregulação de Aquisições e Fusões Art. 156, IX.
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Second, the management may appeal to the competition authorities to block the bid, presumably the rationale being that this is an efficient way of keeping the public authorities informed about potential competition concerns, whilst the public interest in competitive markets must trump the private interest of shareholders in accepting the offer made to them. Tird, the rule is usually understood as a negative one, not requiring incumbent management to take positive steps to facilitate an offer to the shareholders (except in some cases where a facility has already been extended to a rival bidder). Tus, the no frustration rule does not normally require the target management to give a potential bidder access to the target’s target’s books in order to formulate its offer offer.³ .³ Te first and third possibilities often give the management of the target significant negotiating power with the bidder as to the terms of the offer. Tis may explain why takeover premia are not significantly different in the UK from the U.S., despite the no frustration rule in the UK Code.
8.2.2.2 White knights and competing competing bids
Te no frustration rule does not prevent an incumbent management from seeking to enlarge the shareholders’ choice, for example, by seeking a “white knight.” Whether or not sought by the incumbent management, a competing bidder may emerge. Te wealth-enhancing wealthenhancing impact of competing bids as far as target shareholders are concerned is well established in the empirical literature. However, the cost associated with rules which facilitate competing bids is that they reduce the incentives for first offers to be made. First bidders often lose out if a competitor emerges, and in that situation the search and other costs incurred by the first bidder will be thrown away. Tis will discourage first bidders generally and so reduce the number of offers. More broadly, broadly, “any regulation that delays the consummation of a hostile [or even a friendly] bid … increases the likelihood of an auction by providing time for another bidder to enter the fray, upon the target’s solicitation or otherwise.” Tus, takeover rules ostensibly aimed at other problems may have a significant impact on the chances that an alternative offer will be forthcoming. An example is rules which require the bid to remain open for a certain minimum period of time (in order that shareholders shall not be pressurized into accepting the offer before they have had a chance to evaluate it). Another is rules requiring disclosure to the market of the beneficial ownership of shareholdings above a certain size, which may give a potential competitor advance warning that an offer for a particular target company is likely to be forthcoming. If a competitor does emerge, whether through the actions of the target management or not, its task is facilitated in those systems which permit acceptors to withdraw their acceptance of the first offer, unless it has been declared unconditional, either for any
³ Certainty about the target’s target’s income generating potential may be very important for a leveraged offeror. John C. Coates IV, IV, M&A Break Fees: Fees: U.S. Litigation vs. UK Regulation, Regulation, in R L: L : P F E L 239, 255 (Daniel P. P. Kessler ed., 2011). Frank H. Easterbrook and Daniel R. Fischel, Te Proper Role of a arget’s Management in Responding Respondi ng to a ender ender Offer Offe r , 94 H H L R R 1161 (1981). (19 81). Tis trend is reinforced by some jurisdictions’ requirement of information parity parity.. For instance, in the UK, if the target board shares information during due diligence to a preferred bidder, it must be willing to share similar information to another bidder (although not preferred) in response to specific questions (akeover (akeover Code, Rule 22). Romano, note 12, at 156. See Section 8.2.4.
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reason or if a competing offer emerges. o o the same effect are rules giving competing bidders equal treatment with the first bidder as far as information is concerned. Tere are a number of techniques which can be used to mitigate the downside to the first bidder of rules which facilitate competing bids. Where the directors of the potential target judge that it is in the shareholders’ interests that a bid be made for their company and that an offer will not be forthcoming without some protection against the emergence of a competitor competitor,, the directors of the t he target may contract not to seek a white knight or not to cooperate with one if it emerges. However, contracting not to recommend a better competing offer is normally ruled out on fiduciary duty grounds.¹ More effective from the first offeror’s point of view would be a financial commitment from the target company in the form of an “inducement fee” or “break fee,”” designed to compensate the first offeror for the costs incurred if it is defeated by a fee, rival. Such fees are common in the U.S., but have recently been severely constrained in the UK due to their potential impact upon free shareholder decision-making.² decision-making.² Tey could be used to give a substantial advantage to t o the bidder preferred by the incumbent management. Finally, the first offeror could be left free to protect itself in the market by buying shares inexpensively in advance of the publication of the offer, which shares it can sell at a profit into the competitor’s competitor’s winning offer if its own offer is not accepted.
Although prepre-bid bid purchases of shares in the target (by the offeror) do not normally fall foul of insider dealing prohibitions,³ rules requiring the public disclosure of share stakes and of economic interest in shares limit the opportunity to make cheap pre-bid pre-bid purchases of the target’s shares. Overall, in those jurisdictions which do not permit substantial inducement fees, the ability of the first bidder to protect itself against the financial consequences of a competitor’s success are limited.
8.2.3 Joint decisiondecision-making making Where management is permitted unilaterally to take effective defensive measures in relation to an offer, the process of decision-making decision-making becomes in effect a joint one involving both shareholders and management on the target company’s side. Unless the target board decides not to take defensive measures or to remove those already implemented, the offer is in practice incapable of acceptance by the shareholders. Perhaps the best Tis is the predominant rule in takeover regulations, including in the U.S. (see § 14(d)5 Securities Exchange Act and Rule 14d-7)— 14d- 7)—though though not in the UK ( (akeover akeover Code, Rule 34, allowing withdrawals only more narrowly). Te bidder may seek to avoid this rule by obtaining irrevocable acceptances outside the offer (and usually before it is made)—though made)— though the acceptor may choose to make the acceptance conditional upon no competing bidder emerging. For See note 55 analysis and Section 8.3.1. further se e Athanasios see Kouloridas, L E : : A’’ P (2008) chs. 6 and 7. A ¹ Dawson International plc v. Coats Patons plc [1990] [1990] B C L C 560 (Court of Session). ² Tey are usually in the 2–5 2–5 percent range in the U.S. Significantly, the UK Code (rule 21.2 notes) still allows break fees (up to 1 percent) in favor of a competing bidder, where the original offer was not recommended by the target board. It also allows a 1 percent fee in favor of the first bidder, if that offer is the outcome of a formal sale process initiated by the target board. Tey are allowed in Germany: see Hopt, note 12, at 276. ³ See e.g. Recital 30 to EU Market Abuse Regulation 596/2014, 596/2014, 2014 O.J. (L 173) 1. See, in the context of the shareholder activism debate, John C. Coffee, Jr., Jr., and Darius Palia, Te Wolf at the Door: Te Impact of Hedge Fund Activism on Corporate Governance , 1 A C G 1 (2016).
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known of such measures is the “poison pill” or shareholders’ rights plan, as developed in the U.S. Here, the company’s charter provides that the crossing by an acquirer of a relatively low threshold of ownership (typically, (typically, 10 or 20 percent) triggers rights for target shareholders to acquire shares in either the target or the acquirer on favorable terms, from which the acquirer itself is excluded. Te dilutive effect of the plan on the acquirer renders the acquisition of further shares in the target fruitless or impossibly expensive. Te ease with which a plan can be adopted by management of potential target companies means that even companies with no apparent defense in place can adopt one in short order, so that the distinction between pre- and post-bid post-bid defensive measures becomes meaningless. meaningless. It has also been considered to be a powerful legal technique, apparently putting the incumbent management in a position where they can “just say no” to a potential acquirer. Where the bid is acceptable, in the board’s view, it may “redeem” “redeem” the pill and thus allow the takeover take over to go ahead. Defensive measures in the U.S. rely so heavily on poison pills that separate “anti “antitakeover takeover”” statutes adopted by a number of states stat es have become largely irrelevant. i rrelevant. As we will see below below,, the standard mode of “hostile” takeover bids shifts to the proxy contest, where the bidder seeks to replace the board with one which will redeem the pill. In France the legislature in 2006 designed a shareholder rights plan (so-called (so-called “bons
Breton or, tellingly, bons patriotes ) and slotted it into the overall statutory regulation of control transactions. However, However, as is generally the case in Europe Europe,, the issuance of new shares requires shareholder approval. Initially, French law required that approval to be given post-bid post-bid (with a reciprocity-based reciprocity-based exception), in compliance with the no frustration rule. However, in 2014 (under the so-called so-called “Loi Florange”)¹ the French nofrustration no frustration rule was repealed and pre-bid pre-bid approval of plans made available (though requiring periodic renewal). Now, the scheme operates as a way for shareholders to commit to the incumbent management. French shareholders appear to have made littleterms use ofofthe possibility the anpossibility, offer.² , arguably distrusting the management before they even know Poison pills were first designed as a response to the 1980s hostile takeover wave. In many respects, they function today as a shield against contemporary activist hedge funds. Put differently, activist hedge funds may be considered, in some degree, as a market response to the dramatically increased effectiveness of defensive tactics against hostile bids resulting from poison pills. See e.g. Lucian A. Bebchuk and Allen Ferrell, Ferrell, Feder Federalism alism and Corporate Law: Te Race to Protect Managers from akeovers , 99 C L R R 1168 (1999). (1 999). See also, by the same authors, au thors, On akeover Law and Regulatory Competition, Competition, 57 B L 1047 (2002). “Te passage of time has dulled many to the incredibly powerful and novel novel device that a socalled poison pill is. Tat device has no other purpose than to give the board issuing the rights the leverage to prevent transactions it does not favor by diluting the buying proponent’s interests (even in its own corporation if the rights ‘flip-over’)”: ‘flip-over’)”: Strine V-C V-C in Hollinger Int’l v. Black , 844 A Te Law and Finance of Antitakeover Statutes , 68 S R Emiliano 2d 1022, Catan1064–5 1064– and Marcel Marc 5 (2004, el Kahan, Del. Ch.). L L R 629 (2016). See Section 8.2.3.2. See Loi No 20062006-387 387 of 31 March 2006. Given the presence of a mandatory bid rule in France, the warrants are triggered only by a general offer and, for that reason, it was unnecessary to exclude the offeror from the rights. ¹ See Arts L. 233-32 233-32 and L. 233-33 233-33 Code de commerce, as amended by the Loi “Florange” No. 2014-384 2014384 of 29 March 2014. On this reform, see Quentin Durand, Loi visant à reconquérir l’économie réelle: présentation des aspects relatifs aux offres publiques , B J B 274 (2014); Eva Mouial-Bassilana MouialBassilana and Irina Parachkévoya, Les apports de la loi Florange Florange au droit des sociétés , B J S 314 (2014); Alain Viandier, OPA, OPE, A O P, nos 2045 ff. J (5th edn., 2014). ² Durand, note 71, at 281, n. 53.
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Tis recent reform has brought France somewhat closer to the U.S. system, as it is now possible for the shareholders to issue warrants before a bid is launched or to authorize the board to issue them even when a bid has been launched, without further shareholder involvement. Te authorized board can thus negotiate with a potential bidder and equally has discretion to trigger the warrants. Nevertheless, a number of important differences persist. First, unlike U.S. poison pills, the French warrants can only be adopted or authorized by shareholder resolution and not by the board alone. Secondly, the warrants must be issued to all the shareholders, including the acquirer’s likely pre-bid pre-bid shares.³ Tirdly, the bons Breton can only be triggered when a genuine “takeover bid” has been launched. Tey will not work against creeping acquisitions. And finally, finally, the French warrants are bid-specific. bid-specific. When the bid is not successful, they automatically become void. With the removal of the nofrustration rule, incumbent management may be able to take other defensive steps, either with pre-bid pre-bid shareholder approval or without shareholder approval. In France as in other jurisdictions in this position the possibilities for unilateral defensive measures will depend upon the extent to which shareholder approval is required under general corporate law or the company’s articles. As we have seen in previous chapters, the powers of centralized management are extensive in relation to the handling of the company’s assets, but in many jurisdictions they
are more constrained where issues of shares or securities convertible into shares are concerned, because of their dilution potential for the existing shareholders. However, defensive measures which focus on the company’s company’s capital rather than t han its business assets would be more attractive to incumbent management, because they are less disruptive of the underlying business and a more powerful deterrent of the acquirer. Equally, the development of share warrants as a defensive measure in Japan was premised upon changes in general corporate law (not aimed specifically at control transactions) which expanded the board’s board’s unilateral shareshare-issuing issuing powers. Whether it is legitimate for the board to use its powers to defeat a takeover is, of course, a separate question, but without the power, the question does not even arise. Alternatively, acquirers may be discouraged through a customized version of the mandatory bid rule. Te Brazilian version of the “poison pill” originally consisted in “immutable” charter provisions imposing on acquirers of a certain percentage of the company’s stock the obligation to launch a mandatory bid to all shareholders—often shareholders—often at a large premium over the market price specified ex ante . Conceived as entrenchment devices for existing blockholders holding less than a majority of the voting capital, these provisions soon became controversial and their legality was questioned. Subsequent Subsequent revisions to the Novo Mercado, Brazil’s premium corporate governance listing segment, outlawed immutable provisions, so that a majority of shareholders can amend the charter to eliminate the mandatory bid requirement at any time.
³ Tough the shares which the bidder has agreed to acquire acquire through the bid do not count for entitlement to the warrants. See also note 70. Art. L.233-32, L.233-32, II, fourth alinéa Code de Commerce. See Matteo Gatti, Te Power to Decide on akeovers: Directors or Shareholders, What Difference Does It Make? , 20 F J C F L L 73 (2014). See especially Chapter 3.2.3 and Chapter 7. For the use of share warrants as defensive measures in Japan, see notes 50 and 51 and their accompanying text. Parecer de Orientação CVM No. No. 36 (2009). Novo Mercado Regulations Regulations Art. 3.1.2.
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8.2.3.1 Str Strategies ategies for controlling the board’s board’s powers powers to take defensive defensive measures Although the no frustration rule is not a fully fledged passivity rule, it nevertheless operates so as to put the shareholders in the driving seat as far as decision-making decision-making on the offer is concerned. Te coordination problems of target t arget shareholders as against the acquirer then become a significant concern where the no frustration principle applies. By contrast, joint decision-making decision-making strategies permit the incumbent management to negotiate on behalf of the shareholders and to take other steps in their interests, such as rejecting bids which undervalue the company. If incumbent management’s decisionmaking power is used in the shareholders’ interests, rather than to promote the selfinterest of the management, it can be argued that the outcome is superior to that achieved by lodging the decision right wholly with the shareholders. However, to achieve this result, a joint decision-rights decision-rights strategy needs to be accompanied by one or more other strategies which constrain incumbent management discretion. Tere is a range of available strategies: standards, trusteeship, removal rights, and reward strategies.
8.2.3.2 Standards
scrutiny by the courts of the exercise of the veto power by management is Ex post scrutiny available in principle, under the general law relating to directors’ duties. Te rigor of this scrutiny can vary by jurisdiction and over time. It has been argued¹ that in the 1980s the Delaware courts applied fiduciary duties to directors in such a way as to sustain refusals to redeem poison pills only where the bid was formulated abusively as against the target shareholders. Later on, court review became more accommodating of managerial interests. Te starting point was adoption of the view that decisions on the fate of a bid are in principle as much a part of the management of the company, and thus within the province of the directors, as any other part of corporate strategy.² strategy.² Te shareholders’ interests became paramount only if the incumbent management had reached a decision to sell control of the company or to dispose of its assets.³ Otherwise, the decision to maintain the existing business strategy of the company by resisting a takeover was one that the board was in principle free to take, whether or not the offer would maximize shareholder wealth in the short term. In Japan as well, in the absence of shareholder approval, the governmental guidelines and court decisions anticipate that defensive action by target management will be lawful only where it enhances “corporate value” and promotes the shareholders’ Te attractiveness of this argument depends, of course, on (a) how easily the shareholders’ shareholders’ coordination problems can be addressed if management is sidelined (Section 8.3) and (b) how much scope for negotiation is left to the incumbent board under the nofrustration no frustration rule (Section 8.2.2.1). ¹ Lucian Bebchuk, Te Case Against Ag ainst Board Boa rd Veto Veto in Corporate C orporate akeovers akeovers , 69 U C L R 973 at 1184–8 1184–8 (2002). See also R. Gilson, UNOCAL Fifteen Years Later (and What We Can Do About It), It), 26 D J C L 491 (2001). ² Paramount Communications Inc. v. ime Inc., Inc., 571 A R 2d 1140 (1989); Unocal Corp. v. Mesa Petroleum Co., Co., 493 A R 2d 946 (1985); Unitrin Inc. v. American General Corporation,, 651 A R 2d 1361 (1995). Corporation ³ Revlon Inc. v. MacAndrews & Forbes Holdings Inc .,., 506 A R 2d 173 (1986); Paramount Communications v. QVC Network , 637 A R 2d 34 (1994). In many U.S. states the managerialist approach was adopted legislatively through “constituency statutes” which, while appearing to advance the interests of stakeholders, in particular labor and regional interests, in practice operated—and operated—and were probably intended to operate—to operate—to shield management from shareholder challenge. Romano, note 12, at 171, and Section 8.1.2.3.
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interests. Consequently, defensive measures not approved by the shareholders will stand a greater chance of meeting this standard if the bid is coercive, animated by greenmail, or based on information asymmetry as between acquirer and target shareholders. Overall, there is little evidence in any jurisdiction that the courts are willing to scrutinize rigorously the discretion vested in management under the dual decisionmaking model.
8.2.3.3 Removal rights In the U.S., strong defensive measures available to target boards induced the response from acquirers, who were unwilling or unable to appease the incumbents, of relying on removal rights, that is, launching a proxy fight to seek removal of the target directors. Where the proxy fight is successful, the bidder can replace the directors with his own appointees, who will then redeem the pill. Whilst this strategy has been obstructed for a long time due to the presence of staggered boards in many U.S. corporations, the more recent years have shown a trend towards “destaggering,” which renders this strategy more attractive. Nevertheless, the need to remove the incumbents constrains the acquirer’s freedom in relation to the timing of the offer because, in Delaware, removal is practicable only at the annual general meeting.
8.2.3.4 rusteeship An additional strategy to constrain incumbent management discretion on takeoverrelated decisions is to require approval from independent directors. In Germany defensive measures proposed by the managing board need approval by the supervisory board.¹ Tis strategy heavily depends for its effectiveness on the ability of the supervisory board play isa genuinely independent Tis may be questionable in the case where thetoboard codetermined, since therole. employee representatives on the Defensive measures against a non-coercive non- coercive bid were struck down in the Livedoor case: case: okyo High Court Decision on 23 March 2005, 1899 H J 56. MEI and MoJ Guidelines, note 50, at 4– 4–5. 5. For a discussion of Livedoor and and other cases see Sôichirô Kozuka, Recent Developments in akeover Law: Changes in Business Practices Meet Decade- Old Rule , 21 Z J R 5, 12–16 12– 16 (2005). Tus, in Germany the managing board’s power to take defensive action with the consent of the shareholders and/or and/or the supervisory board will not relieve it of its duty to act in the best interests of the company. Whilst there is much academic discussion of what this limitation means, it is doubtful whether it prevents management entrenchment except in egregious cases. However, there is some evidence that the Delaware courts have done a better job with the standards strategy when it has been deployed to control managerial promotion managerial promotion of (rather than resistance to) control shifts. See Robert B. Tompson and Randall S. Tomas, Te New Look of Shareholder Litigation: Acquisition-Oriented Acquisition-Oriented Class Actions , 57 V L R 113 (2004). A board is called “staggered” “staggered” where a proportion only—normally only—normally one-third— one-third—of of the board is up for re-election re-election at each annual meeting. See Chapter 3.2.2. More than 60 percent of S&P 500 companies had a staggered board in 2002; by 2013, this number had declined to 12 percent. See Weili Ge, Lloyd anlu, and Jenny Li Zhang, Board Destaggering: Corporate Governance Out of Focus? Working Working Paper Paper (2014), at ssrn.com. On the advantages of the bid over a proxy fight see Louis Loss, Joel Seligman, and roy roy Paredes, Paredes, F F S R 562 (6th edn., 2011). 201 1). ¹ Te managing board may seek the advance advance approval of the the shareholders for defensive measures but then any exercise of the power must be approved by the supervisory board (WpÜG § 33(2)) or it may take defensive measures simply with the approval of the supervisory board (WpÜG § 33(1), last sentence). Only the last-minute last-minute amendments to § 33 in the legislative process explain this oddity. In practice, there seems little value to the management in obtaining prior approval of the shareholders.
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supervisory board will typically favor the management’s rather than the shareholders’ standpoint.² board decisions in theofU.S. to redeem not are a poison pill are typically takenEqually, by the independent members the board. Hereorthere no complications arising from codetermination but the independence of the non-executives non-executives is still an open issue. Te U.S. alternative to negotiating with the incumbents is, in reality, often a combination of removal and trusteeship strategies, since overwhelmingly the boards of U.S. public companies are composed of independent directors. Tat these combined strategies may not work out as the acquirer intended is shown by the Airgas case. case. Airgas was subject to a hostile bid by competitor Air Products, but the former’s board, relying on its poison pill, rejected the bid as too low.³ low.³ Air Products thus initiated a proxy fight and successfully installed three new independent directors in Airgas’ board. Tese newly elected directors, after taking independent advice, surprised the market by sharing the other directors’ view that the bid indeed undervalued Airgas, and became the most vociferous opponents of Air Products’ offer. offer. Tis ultimately credible result seems to have emerged from the combination of two strategies discussed here: the removal strategy—replacing strategy— replacing incumbent directors—and directors—and the trusteeship strategy—installing strategy—installing genuinely independent directors, not just representatives of the bidder, plus the use of outside advice. Another variant of, or addition to, the trusteeship strategy is the obligation on the t he
board to seek “independent advice” or a “fairness opinion” from outside the company—something pany— something which was also a factor in the Airgas case. Tis is required in the UK and France. In the U.S., fairness opinions are routinely obtained by the target board, as a consequence of the Delaware case-law law,, most importantly Smith v. Van Gorkom. More recently, both the Delaware courts and the SEC have developed detailed guidelines on what counts as an “independent” fairness opinion.
8.2.3.5 Reward strategy Under this strategy the self-interest self-interest of the incumbent management in retaining their jobs is replaced by self-interest self-interest in obtaining a financial reward which is dependent upon surrendering control of the company to the acquirer. Tis may arise because: (i) rewards under general incentive remuneration schemes for managers are triggered upon a transfer of control;¹ (ii) payments can be claimed under the
² See Hopt, note 49, at III.A.b. ³ For a fuller description, see Air Products and Chemicals, Inc. v. Airgas, Inc. Inc.,, 16 A R 3d 48 (Del. Ch. 2011). See Edward B. Rock, Institutional Investors in Corporate Governance , in O H C L L G (Jeffrey N. Gordon and Wolf-Georg Wolf-Georg Ringe eds., 2017), available at . Ibid. UK akeover akeover Code, r 3; Règlement Général de l’AMF, l’AMF, Book II, itle VI, chapters I and II. 488 A R 2d 858 (Del. 1985). For detailed references, see David Friedman, Te Regulator in Robes: Examining the SEC and the Delaware Court of Chancery’s Parallel Disclosure Regimes , 113 C L L R 1543 (2013). (201 3). Marcel Kahan and Edward B. Rock, How I Learned to Stop Worrying Worrying and Love the Pill: Adaptive Responses to akeover Law , 69 U C C L L R 871 (2002); Jeffrey N. Gordon, An American Perspectiv Perspectivee on Anti-takeover Laws in the EU: Te German Example , in R C L L E 541 (Guido Ferrarini et al. eds., 2004). ¹ E.g. because of accelerated stock options.
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management’s contracts of service;¹¹ or (iii) less often, ad hoc payments are made to the management, the acquirer or the t he target company,itinisconneccompany, tionincumbent with a successful controleither shift.by Where such payments are available, argued that the reward strategy succeeds in generating powerful incentives not to invoke the poison pill or other defensive measures.¹² However, as explained below, in many legal systems it is unacceptable or unlawful to make payments of a sufficient size to amount to a significant counter-incentive counter-incentive for the managers, at least without the consent of the shareholders. Tus, as we saw in Chapter 3, in the Mannesmann case, a payment to the CEO of a German target company after a successful takeover led to criminal charges against him for corporate waste (embezzlement). Te test developed by the top criminal court for corporate waste was a tough and objective one,¹³ and it has received strong criticism in the academic literature.¹ Tis liability can be avoided by contracting in advance for the payment of compensation for loss of office, and corporate practice has quickly adjusted, but the decision appears to have chilled the levels of contractual compensation as well. In the UK gratuitous payments as well as some contractual entitlements in connection with loss of office after a takeover require shareholder approval, in the absence of which the payments are regarded as held on trust for the shareholders who accepted the offer.¹ offer.¹ Tis remedy nicely underlines the fact that strengthening the role of incumbent management in control shifts is likely to lead to the diversion to them
of part of the control premium.¹ However, the UK rules operate in the presence of the no frustration rule. Hence, the need to incentivize directors to avoid defensive measures is arguably less important. Overall, the initial decision-rights decision-rights choice is likely to be highly significant. Whilst in some jurisdictions, notably the U.S., the deployment of additional strategies, st rategies, especially the reward strategy, may produce a result in which the outcomes of the joint decision-making sionmaking process are not significantly different (in terms of deterring value-enhancvalue-enhancing bids) from those arrived at under the nofrustration nofrustration rule, this conclusion is highly dependent upon those additional strategies being available and effective. In the absence of pro-shareholder pro-shareholder courts with effective review powers, easy removal of incumbent management or the ability to offer significant financial incentives to management to view the bid neutrally neutrally,, rejection of the no nofrustration frustration rule is likely to reduce the number of control shifts.¹ ¹¹ E.g. contractual contractual golden parachutes. ¹² Lucian Bebchuk and Jesse Fried, P W P (2004) 89–91; 89– 91; Alessio M. Pacces, R C G: L E C P (2012) ch. 3.3 (welcoming such a result on theoretical grounds as enabling a manager/entrepreneur to be compensated for idiosyncratic private benefits of control on a control shift, at a lower level of ownership of the company than she would aim for if such side-payments side- payments were not available); Governance and Merger Activity121 in the United Bengt Holmstrom Steven States: Making Senseand of the 1980sN. andKaplan, 1990s , Corporate 15 J E P (2001). ¹³ BGH 21 December 2005, N J W 2006, 522. See also Chapter 3.3.2. ¹ Gerald Spindler, Vorstandsvergütungen und Abfindungen auf dem aktien- und strafrechtlichen Prüfstand—Das Prüfstand— Das Mannesmann-Urteil Mannesmann-Urteil des BGH , ZIP-Z ZIP-Z W 349 (2006). ¹ Companies Act 2006, sections 219, 222(3), and 226C. ¹ Cf. Gordon, note 99, at 555 (“One way to understand [golden parachutes parachutes and accelerated stock options] is as a buyback by shareholders of the takeover–resistance endowment that managers were able to obtain from the legislatures and the courts during the 1980s”). ¹ See ibid. (making these points in relation to Germany, Germany, where neither easy removal of the board nor high-powered high-powered incentives to accept offers are available).
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8.2.4 Pre-bid Pre-bid defensive measures It has often been pointed out that a major limitation of the nofrustration nofrustration rule is that the requirement for shareholder approval of defensive tactics applies only once a bid is in contemplation.¹ Tis formulation of the nofrustration nofrustration rule generates powerful incentives for managements at risk of a bid to act effectively against potential offers before they materialize. Moreover, developments elsewhere in company and securities law may enhance these possibilities. For example, mandatory and rapid disclosure of the beneficial ownership of voting shares helps incumbent management by increasing the time available to them to prepare defensive steps. Most jurisdictions now have rules requiring the beneficial holders of shares in listed companies, whether acting alone or in concert, to disclose that fact to the company and the market when certain minimum levels are exceeded,¹ and increasingly economic interests in shares are brought within the disclosure obligation.¹¹ Te beneficial owner may be required to disclose not just the fact of the ownership, but also its intentions in relation to control of the company.¹¹¹ Some jurisdictions go further and give companies’ charters the power to trigger disclosure at lower levels than the lowest statutory threshold.¹¹² Following the EU’s High Level Group, we can identify six categories of pre-bid pre- bid defensive measures:¹¹³ (a) barriers to the acquisition of shares in the company (for example, ownership caps or poison pills¹¹); (b) obstacles to gaining control in the
general meeting (voting caps; multiple voting shares); (c) limits on the ability to control the board of directors (codetermination, staggered boards, special appointment rights for some shareholders); (d) arrangements preventing control of the company’ss assets ny’ asset s (lock- ups); (e) the creation creati on of financial or management problems for the acquirer as a result of the acquisition (poison debt); and (f) actions raising regulatory issues (such as engaging in defensive acquisitions creating antitrust problems if the ¹ See Paul Davies, Te Regulation of Defensive actics actics in the United Kingdom and the United States , in E : : L L P 195 (Klaus J. Hopt and Eddy Wymeersch eds., 1992). If a defense put in place pre-bid pre-bid requires action on the part of the board post-bid post-bid to be effective, it will be caught by the nofrustration nofrustration rule (e.g. post-bid, post-bid, shareholder approval is needed to issue shares which the board had previously been authorized to issue). ¹ Most national laws require regular disclosure at the 5 percent or 3 percent mark. See e.g. ransparency Directive 2004/ 109, Art. 9(1): initial disclosure at 5 percent, but member membe r states can introduce a lower threshold. See Chapter 6.2.1.1. ¹¹ See new Art. 13(1)(b) of ransparency ransparency Directive 2004/ 109/ 109/EC, EC, as revised in 2013. For the U.S., see CSX Corp v. Te Children’s Investment Fund (UK) LLP 562 562 F S 2d 511 (2008), bringing equity swaps within Securities Exchange Act 1934 § 13(d). On the policy discussion around such requirements, see Maiju Kettunen and Wolf-Georg Ringe, Disclosure Regulation of CashSettled Equity Derivatives— An IntentionsIntentions-Based Based Approach, Approach, L’ M C L Q Q 227 (2012). On creeping acquisitions, see Section 8.3.4. ¹¹¹ §this 13(d) Securities Exchange Act Exchange 1934 (U.S.); L. 233-7, 7, VII Code de 20 commerce where additional information is required at theArt. 10 L.233percent, 15 percent, percent,(France), and 25 percent levels; Wertpapierhandelsgesetz (WpHG) § 27a, only at the 10 percent level (Germany); Art. 27-23 27-23 et seq. of the Financial Instruments and Exchange Act 2006 (Japan). ( Japan). ¹¹² See Art. L. 233-7, 233-7, III Code de commerce (France) and Part 22 of the Companies Act 2006 (UK). Te European Commission proposed in 2014 to give all EU companies on top-tier top- tier markets the right to obtain disclosure of beneficial ownership at the 0.5 percent level in its suggested amendments to the (in this context, inaptly named) Shareholder Rights Directive. ¹¹³ Report of the High Level Group of Company Law Experts Issues Related to akeover akeover Bids , Brussels, January 2002, Annex 4. Some of these defensive steps could be taken, of course, course, post-bid post-bid as well. ¹¹ A poison pill may be adopted pre- or postpost-bid, bid, normally the former. However, there is still a post-bid postbid issue, namely, whether the directors redeem the pill (i.e. remove the shareholder rights plan), their unilateral power to do this being a central part of the scheme.
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hostile bid is successful).¹¹ Another effective pre-bid pre-bid defense could be change-ofcontrol in executive contracts, such as the ones recently upheld by the French Supremeclauses Court.¹¹ It would be too great an interference with the operation of centralized management to apply the no frustration rule when no bid is on the table, at least on the basis of an “effects” test.¹¹ Any commercial decision which might have the effect of deterring a future bidder for the company would then have to be approved by the shareholders. Nevertheless, one might think that the nofrustration nofrustration rule would be ineffective unless accompanied by some type of pre-bid pre-bid controls. A number of legal strategies are available. Te most general of these are the standards applied by company law to all board decision-making decisionmaking (duties of care and loyalty). Tese standards are necessarily less constraining than the no frustration rule, for the reasons just given. ypically, some form of a “primary purpose” rule is used to distinguish legitimate from illegitimate decisions taken pre-bid pre-bid which have defensive qualities as well as commercial rationales.¹¹ Such rules necessarily give management take action acti on for which there is a plausible commercial rationale,considerable even if that freedom action hastodefensive qualities of which the directors are aware and welcome, for example, an acquisition of assets which will create competition problems for a future bidder or which will put a block of shares into friendly hands.¹¹ Rules dealing with specific decisions may be more constraining, but are necessarily also of less general import. Rules on significant transactions may require shareholder
approval of certain types of pre-bid corporate action with defensive qualities.¹² We We saw above that rules on shareholder consent to capital issues have placed obstacles in the way of the t he straightforward adoption of “poison pills” in Europe.¹²¹ Here, Here, pre-bid, pre-bid, the joint decision-making decision-making process is the more pro-shareholder pro-shareholder choice, since the available alternative is not unilateral decision-making decision-making by shareholders but unilateral decisionmaking by the board. However However,, these veto rights for shareholders are generally driven by more general corporate law concerns than the control of pre-bid pre-bid defensive measures and, hence, have a somewhat adventitious impact on control shifts. Overall, management is necessarily given greater freedom to entrench itself pre-bid pre-bid than post, and the legal strategies used to t o control managerial opportunism pre-bid pre-bid are simply the general strategies used to protect the shareholders as principals and against the management as agents which are discussed elsewhere in this book.¹²² Nevertheless, Nevertheless, ¹¹ See also European Commission, Report on the Application of Directive 2004/ 25/EC 25/EC on akeover akeover Bids , 28 June 2012, COM(2012) 347, para. 14. ¹¹ Cour de cassation, decision of 26 January January 2011 (n 09-71271), 09-71271), Havas . ¹¹ Of course, the precise point at which the the line between pre- and post-periods post-periods is drawn can be the subject of some debate. Te akeover Code draws it once the board “has reason to believe that a bona fide offer might be imminent” (Rule 21.1: see Section 8.2.2), whilst the akeover Directive’s (default) no frustration make an offer (Arts. 9(2)rule andapplies 6(1)). only when the board is informed by the bidder of its decision to ¹¹ On the UK “proper “proper purpose” rule, see recently Eclairs Group Ltd v JKX Oil & Gas Plc [2015] [2015] UKSC 71. ¹¹ Even post-bid post-bid the courts may have difficulty applying the primary purpose rule rul e so as to restrain effectively self-interested self-interested defensive action. See the discussion of the Miyairi the Miyairi Valve litigation litigation in Japan by Kozuka, note 86, at 10–11. 10–11. See also Harlowe’s Nominees Pty Ltd v Woodside (Lake Entrance) Oil Co. 42 Co. 42 A L L J R R 123 (High Court of Australia) (1968). ¹² See Chapter 7 for a discussion of the extent to which significant decisions require shareholder approval. ¹²¹ See Section 8.2.3. ¹²² See Chapters 3 and and 7. Te “breakthrough “breakthrough rule” is an exception to this statement. See Section 8.4.2.2.
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in the hands of sophisticated shareholders who are able to coordinate their actions, pre-bid prebid approval requirements can be effective.¹²³
8.3 Coordinat Coordination ion Problems among arget arget Shareholders When an offer is put to the shareholders shareholders of the target company, company, they face, potentially, potentially, significant coordination problems. Tis is because the decision to accept or reject the bid is normally made by the shareholders individually, individually, rather than by way of a collective decision which binds everyone, and so there is considerable scope for a bidder to seek to divide the shareholder body. body. Tis problem arises in both controlled and widely held firms: naturally, naturally, collective action problems will be larger in a dispersed ownership scenario; but minority shareholders of a controlled target company will be subject to similar coordination obstacles, in particular in agreed (friendly) bids. both environments, coordination of (minority) shareholdersInmay be ownership mitigated to some degree the through the targetissues board’s negotiations with the potential acquirer.¹² acquirer.¹² Under the joint decision-making decision-making model, the board is in a strong position to negotiate in this way (though it may prefer to negotiate in its own interests),¹² whilst even under the nofrustration rule, the board retains non-trivial non-trivial powers to protect the shareholders’ interests, as we have seen.¹² However, if there is effective specific regulation of the shareholders’ coordination problems, there is less need for
incumbent directors to perform this role, and the risks of board entrenchment are reduced. Wee now turn to examine the legal techniques which can be deployed to reduce W target shareholders’ coordination costs. o some extent, these strategies also address the agency costs, as described above.¹² We We need to note that all these techniques have costs, in particular by reducing potential bidders’ incentives to make offers. Te main strategies deployed a mix of ex ante rules rules (mandatory disclosures) andrequirement) the trusteeship strategy; and, exarepost , a combination of the reward strategy (sharing and an exit right. 8.3.1 Disclosure Provision of up-toup-to-date, date, accurate, and relevant information can help target shareholders with both their coordination and agency problems. In particular, disclosure of information by target management reduces the force of one of the arguments in favor of the joint decision-making decision-making model, that is, that managers have information about the target’s value which the market lacks.¹² Even without regulation, information will be disclosed voluntarily in the bid process, but regulation may force disclosure of ¹²³ For the argument that this explains the absence of widespread non-voting non-voting and weighted-votweighted-voting shares in the UK, despite its strong nofrustration nofrustration rule, see Paul Davies, Shareholders in the United Kingdom,, in R H S P Kingdom P 355 (Randall Tomas and Jennifer Hill eds., 2015). ¹² Note that in a controlled target company, company, the blockholder may have direct negotiations with the bidder; alternatively, the board may be controlled by the blockholder so that the real bargaining partner would also be the blockholder. ¹² See See Sec ecttion 8.2.3.1. ¹² See Sectio ¹² ionn 8.2.2.1. ¹² See Section 8.2. ¹² Ronald J. Gilson and Reinier Kraakman, Te Mechanisms of Market Efficiency wenty Years Later: Te Hindsight Bias , in A E 57 (John Armour and Joseph A. McCahery eds., 2006), 200 6), noting, however, that target management may find it difficult to make the disclosed information credible.
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information which bidder or target would rather hide and discourage unsubstantiated andCompany unverifiable law,claims. law, of course, contains information disclosure provisions which operate independently of control transactions. How However ever,, annual financial statements are often out of date and, despite the continuing reporting obligations applied to listed companies in most jurisdictions,¹² it is likely that both the target board and the acquirer will be better informed about their respective companies than the target shareholders. Tus, it is not surprising that all jurisdictions have an elaborate set of provisions mandating disclosure by both the target board and the acquirer for the benefit of the target shareholders. It is routine to find rules requiring the disclosure of information on the nature of the offer, the financial position of the offeror and target companies, and the impact of a successful offer on the wealth of the senior management of both bidder and target. It is common to accompany the disclosure requirements requirements with an obligation to obtain and makeis facilitated available an on merits of assessments the offer. Te opinion byindependent the disclosureopinion requiremen requirements, ts, as are by independent third parties, such as securities analysts. Independent advice is particularly important in a management buy-out. buy-out. Here incumbent management appears in a dual role: as fiduciaries for the shareholders and as buyers of their shares. Equally, Equally, where a competing bid emerges, whether in an MBO context or not, rules requiring equal treatment of the bidders in terms of information provided to them by the target make it less easy for target man-
agement to further the cause of their preferred bidder. bidder. In addition, takeover regulation requires offers to be open for a certain minimum time (practice seems to coalesce around the 20-day 20-day mark) and revised offers to be kept open for somewhat shorter periods,¹³¹ in order that target shareholders and analysts can absorb the information. Te main counterargument against very generous absorption periods is the need to minimize the period during which the target’s target’s future is uncertain and, in particular, which the normal functioning of the centralized management of the target isduring disr upted.¹³² disrupted.¹³² In addition, mandatory minimum offer periods increase the opportunities for defensive measures by the target board or the emergence of a white knight, imposing a cost on acquirers and, possibly, upon shareholders of potential targets through the chilling effect upon potential bidders.¹³³ In ¹² See Chapter 9.1.2.5. ¹³ In jurisdictions without takeover-specific takeover- specific regulation on the matter, it may be possible to leave the issue to general corporate law, notably the rules on self-dealing self- dealing transactions. See Werner F. Ebke, Te Regulation of Management Buyouts in American Law: A European Perspective , in E : L P, note 108, 304–6— 304– 6—though though it should be noted that the transaction here is technically one between the director (or associated person) and the shareholders, not the company. In the case of MBOs of close companies common law jurisdictions may deal with the grosser information disparities by imposing a duty (see on the information to Z the shareholders as an element of their fiduciary duties e.g.directors Colemantov.disclose Myers [1977] [1977] 2 N L R 225, NZCA). See also note 55. ¹³¹ Te Williams Act (note 33) in the the U.S. was motivated in particular by the the desire to control “Saturday night specials” i.e. offers to which the shareholders had an unreasonably short time to respond, the term being apparently used originally to refer to inexpensive hand-guns hand- guns popular for use on Saturday nights. ¹³² Designed to reduce the period the company is “in play,” play,” recent changes to the UK akeover akeover Code limit the freedom of acquirers to let it be known that they might make a bid but without manifesting a firm intention to do so: Rule 2.6, inserted 2011 (the “put up or shut up” rule). Tis provision seeks to remove uncertainty around market rumors or potential bid announcements and thus to improve the situation of target shareholders as against “virtual bids.” ¹³³ See Section 8.2.2.2 for a discussion of competing bids and and the passivity rule.
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efficient securities markets, moreover, moreover, new information is rapidly impounded into the t he share price, and so it is likely that the main practical practi cal effect of the minimum periods is to allow new information to be generated and to facilitate competing bids rather than to promote understanding of the information disclosed.
8.3.2 ruste rusteeship eship strateg strategy y arget shareholders face the risk that the incumbent management will exaggerate the unattractive features of a hostile bid and do the opposite with a friendly one. As we have seen immediately above, an ex ante common common response is to require the incumbent management to obtain “competent independent advice” on the merits of the offer (usually from an investment bank) and to make it known to the shareholders. Tis is partly a disclosure of information strategy and partly a trusteeship strategy: the investment bank does not take the decision but it provides an assessment of the offer, the accuracy of which hassuch reputational consequences forsubject the bank. Particularly sensitive items of information, as profit forecasts, may be to third-party thirdparty assessment. Where there is an MBO, the directors involved in the bidding team may be excluded from those responsible for giving the target’s view of the offer, thus allocating that responsibility to the non-conflicted non-conflicted directors of the target.¹³ Ex post liability liability rules may add something to the ex ante incentives incentives to be accurate.
8.3.3 Reward (sharing) strategy A notable feature of laws aimed at solving solving target shareholders shareholders’’ coordination problems is their adoption of the equal treatment rule—though rule—though this principle can be implemented with varying degrees of rigor. Te principle stands in the way of acquirers that wish to put pressure on target shareholders to accept the offer, by promising some (normally those whomaking accepton early) than others.¹³ In general,alone systems place decision-making decisionthe better bid interms the hands of the shareholders havewhich developed the equality principle more fully than those which have adopted the model of joint decision-making. decisionmaking. All systems recognize the equal treatment principle to some degree. It can be applied, first, within the offer (i.e. that the offer addressees receive the same terms¹³); second, as between those who accept the offer and those who sell their shares to the offeror outside the offer, whether before or after a formal offer is launched; and, third, t hird, as between those who sell their shares to an acquirer as part of a controlcontrol-building building acquisition and those who are left as shareholders in the company. In this third case, implementation of the equality principle goes beyond a sharing strategy and involves providing an exit right for the target shareholders. Te first level of equality is recognized in all our jurisdictions. Tus, “front-end “front-end loaded” offers are ruled out; and prior acceptors receive the higher price if the offer is later increased. However, However, instead of formulating differential general offers, the acquirer may seek to offer some target shareholders (in particular, a blockholder) preferential terms by obtaining their shares outside the offer offer.. One solution is to prohibit purchases outside the offer, though this rule can be sensibly applied only to purchases during ¹³ UK akeover akeover Code, Rule 25.2 (notes 4 and 5). ¹³ Paul Davies, Te Notion of Equality in European akeover Regulation, Regulation, in E G L L 9 (Jennifer Payne ed., 2002). ¹³ Or equivalent terms, where the offer covers covers more than one class of share.
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or close to the offer period.¹³ An alternative strategy is to require the offer consideration to be raised to the level of the out-ofout-of-bid bid purchases.¹³ Where such purchases are permitted during the offer period, the imposition of a sharing rule seems universal. Some jurisdictions go further and impose a sharing rule triggered by recent pre-bid pre-bid purchases.¹³ A pre-bid pre-bid sharing rule gains considerable importance where the target company is controlled by a blockholder blockholder,, since the consequence is that the takeover premium paid to the blockholder effectively has be shared with all other minority shareholders, if the acquirer launches a general offer soon after the acquisition of the block. Many jurisdictions in fact mandate such an offer, as we shall see in the next section.
8.3.4 Exit rights: Mandatory bid rule and keeping the offer open open Te strongest, and most controversial, expression of the sharing principle is the requirement that the acquirer of shares make a general offer to the other shareholders once it has acquired sufficient shares (whether on or off market) to obtain control of the target. Control is usually defined as holding 30 percent (or one-third) one-third) of the voting shares in the company.¹ company.¹ Tis is the mandatory bid rule.¹¹ It is a particularly parti cularly demanding rule if, as is common, it requires that the offer be at the highest price paid for the controlling shares¹² and that shareholders be given the t he option of taking cash.¹³ Here the law, in imposing a duty on the acquirer to make a general offer, provides the shareholders with a right to exit the company and at an attractive price. Te mandatory bid rule does not simply structure an offer the acquirer wishes in principle to make, but requires
a bid in a situation where the acquirer might prefer not to make one at all. Such a requirement might be defended on two grounds. First, the absence of a mandatory bid rule would permit the acquirer to put pressure on those to whom offers are made during the control acquisition process to accept those offers, for fear that any later offer will be at a lower level or not materialize at all. Where the offer is valuedecreasing or its impact on the target is just unclear, use of the mandatory bid rule to ¹³ See e.g. in France France Art. 231231-41 41 Règlement Général de l’AMF, l’AMF, which prohibits market purchases pu rchases of the target shares during the offer period in share exchange offers because of the risk of market manipulation, with an exception for share repurchase programs (Viandier, note 71, at 367). In cash bids, the bidder bid der is not allowed to acquire securities of the target during the “pre-offer” period, i.e. the period between publication of the terms of the offer and the formal offer, if the terms had to be published earlier due to rumors in the market (Art. 231-38, 231- 38, II Règlement Général de l’AMF). ¹³ Again, French French law provides an example: where the bidder acquires securities of the target during the offer period at a higher price, the offer price will be revised accordingly (Art. 231- 39 Règlement Général de l’AMF). ¹³ Rules 6 and 11 UK akeover akeover Code (but requiring cash only where the pre-bid pre-bid purchases for cash reach 10 percent of the class in question over the previous 12 months); WpÜG § 31 and WpÜG Angebotsverordnung § 4 (Germany) (requiring cash at the 5 percent level but only where that percentage was acquired for cash in the six months prior to the bid). Te akeover Directive does not require sharing in this situation. ¹ Tat is most common within the EU. See Commission’s Commission’s Report on the Implementation of the Directive on akeover Bids (SEC(2007) 268, February 2007), annex 2. For alternative approaches worldwide, see Umakanth Varottil, Comparative akeover Regulation and the Concept of ‘Control’ , S J L S 208 (2015). (2015 ). ¹¹ Te additional issues arising when a mandatory bid rule is imposed upon an acquirer who obtains the control block from an existing controlling shareholder are discussed Section 8.4 and 8.4.2. ¹² Te akeover akeover Directive, Art. 5(4), imposes a highest price rule, subject to the power of the supervisory body to allow dispensations from this requirement in defined cases. But see the system in Brazil, Section 8.4.2.1. ¹³ Te akeover akeover Directive permits the mandatory bid to consist of “liquid securities” but some member states (e.g. UK akeover Code rule 9.5) require the offer to be in cash or accompanied by a cash alternative.
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remove pressure to tender thus addresses a significant coordination issue of the shareremove holders as against the acquirer. Where the bid is value-increasing value-increasing for target company shareholders, it can be argued that providing the non-accepting non-accepting shareholders with an exit right is not necessary. However, it may be difficult for the rule-maker rule-maker to identify ex which category the offer falls into, so that the choice is between applying or not ante which applying the mandatory bid rule across the board. Moreover, though the offer may be value-increasing value-increasing for the target company’s shareholders as a whole, the non-controlling non-controlling shareholders may not obtain in the future their pro rata share of that value, for example because of the extraction of private benefits of control by the acquirer. Tat leads to the second rationale for the mandatory bid rule. Permitting Pe rmitting the acquisition acquis ition of control over the whole of the company’s company’s assets by purchasing only a proportion of the company’s shares encourages transfers of control to those likely to exploit the private benefits of corporate control. On this view, the mandatory bid rule constitutes a preemptive strike against majority oppression of minority shareholders by providing minority shareholders with an exit right at the point of acquisition of control.¹ It assumes that general corporate law is not fully adequate to police the behavior of controllers.¹ On this rationale, the mandatory bid rule should be accompanied by a prohibition on partial general offers, even where, through a pro rata acceptance rule, all target shareholders are treated equally. By extension, one would expect to find a rule requiring comparable offers to be made for all classes of equity shares in the target, whether those classes carry voting rights or not.¹ Mandatory bid rules are now quite widespread. Te akeover akeover Directive requires EU mem-
ber states to impose a mandatory bid rule (whilst leaving a number of crucial features of the rule, including the triggering percentage, to be determined at national level).¹ However, the mandatory bid rule is not part of U.S. federal law nor the law of Delaware, where shareholders’ coordination problems are dealt with by empowering target management.¹ While popular among lawmakers and investors, the mandatory bid rule runs the risk of reducing the number of control transactions which First,for thepotential implicit prohibition on partial bids makes control transactions moreoccur. expensive bidders: either the bidder offers for the whole of the voting share capital and, often, at a high price¹ or it does not offer for control at all.¹ Secondly, the mandatory bid
¹ Te balance between this effect and its discouragement of efficient efficient transfers of control is disputed. See Lucian Bebchuk, Efficient and Inefficient Sales of Corporate Co rporate Control , 109 Q J E 854 (1994); Marcel Kahan, Sales of Corporate Control , 9 J L, E O 368 (1993). More recently Edmund-Philipp Edmund-Philipp Schuster, Te Mandatory Bid Rule: Efficient, After All ?, ?, 76 M L L R 529 (2013). ¹ It constitutes, in the the concept developed by German law, law, an example of Konzerneingangskontrolle (regulation of group entry ). ). See Alessio M. Pacces, note 102, at ch. 7.4.5, arguing for reliance on fiduciary duties to control future diversionary private benefits of control rather than a mandatory bid rule. But cf. Caroline Bolle, A C O O M M B R B, F, G U K 279–80 279– 80 (2008), suggesting that the mandatory bid is more effective. ¹ Te UK akeover akeover Code contains both such rules: see rules 14 (offers where more than one class of equity share) and 36 (partial offers). ¹ Art. 5 akeover akeover Directive. See note 140 and accompanying text. ¹ In any event partial bids are in fact rare rare in the U.S., due to the pervasiveness of poison pills. ¹ See note 142. Te UK and France France also require that a takeover bid be conditional upon reaching reaching at least 50 percent of the shares, which also discourages low-ball low- ball offers. See Luca Enriques and Matteo Gatti, Creeping Acquisitions in Europe: Enabling Companies to be Better Safe than Sorry , 15 J C L L S 55, 78 (2015). ¹ See e.g. Clas Bergström, Peter Peter Högfeldt, and Johan Molin, Molin, Te Optimality of the Mandatory Bid , 13 J L, L, E O 433 (1997); Stefano Rossi and Paolo Volpin, Volpin,
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rule may also require the bidder to offer a cash alternative when otherwise it would have been free to make a wholly paper offer. Tirdly, Tirdly, the rules fixing the price at which the acquirer must offer for the outstanding shares may expose the acquirer to adverse movements moveme nts in the t he market between the acquisition of de facto control and the making of a full offer. Te chilling effect of the rule is particularly parti cularly intense where there is a controlling shareholder, shareholder, but it occurs also where the acquirer builds up a controlling stake by acquisitions from non-controlling non-controlling shareholders.¹¹ Some, but by no means all, takeover regimes have responded to these concerns. A somewhat common common technique is not to extend extend the rationale underlying the mandatory bid rule to a complete prohibition of partial general offers.¹² Switzerland goes further and permits shareholders of potential target companies to choose between the protection of the mandatory bid rule in its full form or modifying it to encourage changes of control. Te Swiss regulation permits the shareholders to raise the triggering percentage from one-third one-third (the default setting) to up to 49 percent or to disapply the rule entirely.¹³ Mandatory bid rules tend to be complex, partly because of the need to close obvious loopholes. Tus, the rule will usually apply to those “acting in concert” to acquire shares,¹ not just to single acquirers, but the notion of a “concert party” is not selfevident.¹ It may also be possible to circumvent the rule by using derivatives that provide on their face fac e only an economic interest int erest in shares, or through thro ugh a “creeping takeover,” takeover,” i.e. small acquisitions of shares spread out over a period of time, frequently exploiting loopholes in public disclosure or takeover t akeover laws.¹ Additional complexity is generated where it is thought necessary to subordinate
the policy behind the mandatory bid bi d rule to more highly valued objectives, for example, where the threshold is exceeded in the course of rescuing a failing company. Te Cross-Country Determinants of Mergers and Acquisitions , 74 J F E 277 Cross-Country (2004), showing that takeover premia are higher in countries with strong shareholder protection, especially those with mandatory bid rules. ¹¹ On the other hand, the mandatory bid rule discourages acquisitions driven by the prospect of private benefits of control, in the form of diversion of corporate assets and opportunities to the controller,, because it creates a risk to the acquirer that it will end up controller u p with all or nearly all of the shares and no one to expropriate. ¹² Italy permits partial bids for at least 60 percent of the shares, provided that a majority of shareholders other than the offeror and connected persons approves the offer and the offeror has not acquired more than 1 percent of the shares over the preceding 12 months. (Legislative Decree No. 58 of 24 February 1998 (as amended) Art. 107). Japan, by contrast, permits general offers to acquire up to twoto two-thirds thirds of the shares via a tender offer to all shareholders or market purchases (Arts. 27-2(1), 27-2(1), 27-2(5) 272(5) and 27-13(4) 27-13(4) of the Financial Instruments and Exchange Act; Arts. 8(5)(iii) and 14-214-2-22 of the Order for Enforcement of the Financial Instruments and Exchange Act). See omotaka Fujita, Te akeover akeover Regulation in Japan Japan:: Peculiar Developments in the Mandatory Offer Rule , 3 U S L R 24 (2011). ¹³ Börsengesetz (Switzerland), Arts. 22(2) and 32(1). Tese provisions provisions must be contained in the company’ss charter. otal company’ otal disapplication can be decided upon upo n only before listing. ¹ akeover Directive, Art. 5. Tere is a considerable danger that the acting in concert extension will chill shareholder activism, a development which policymakers policymakers may or may not welcome. welcome . Contrast the Risk Limitation Act 2008 in Germany (discussed by Hopt, note 49, at III.B) with the akeover Code, note 2 to Rule 9.1. ¹ Leading to proposals for greater harmonization harmonization with the EU: see European Securities Markets Markets Expert Group, Preliminary Views on the Definition of Acting in Concert between the ransparency Directive and the akeover Bids Directive , November 2008. See more specifically Chapter 3.2.4. ¹ Enriques and Gatti, note 149. Te UK akeover akeover Code is unusual in applying the mandatory bid rule to any acquisition acqui sition of voting shares by a shareholder holding between 30 and 50 percent of the voting shares. After the Loi Florange (note 71), French law comes close to this: Art. L. 433-3, 433- 3, I Code Monétaire et Financier.
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akeover Directive allows national authorities to identify specific situations in which the rule may be set aside. Member States have made ample use of this flexibility. Te European Commission perceives these various derogations as a risk to the European level playing field,¹ but they may have the advantage of allowing a llowing for value-enhancing value-enhancing control shifts where they otherwise would not be made. In addition to the mandatory bid bi d rule, a minor form of the exit right can be found in the obligation imposed in some jurisdictions on an offeror to keep the offer open for acceptance, even after the acquirer has obtained the level of acceptances it sought.¹ Tis enables a shareholder, whose first preference is to reject the offer but who thinks the share price will suffer if the acquirer obtains control, to maintain the position of non-acceptance nonacceptance until it is clear that the acquirer has obtained control and to exit at that point under the offer terms.¹ Tis problem may be acute in a controlled company, where minority shareholders may not know whether the blockholder will accept the offer. Tis option is more effective than the often provided right to “sell out” to an acquirer who obtains a high proportion of the shares,¹ because it operates at a t whatever level the acquirer declares the offer “unconditional as to acceptances. acceptances.”” 8.3.5 Acquisition of nonnon-accepting accepting minorities Te absence of a binding corporate decision in a control transaction may confer holdup powers on the shareholders who do not accept the offer, despite the fact that the majority of the shareholder base has chosen to do so, in an attempt to extract better terms from the offeror. Failure to accept may also result from simple apathy or from
an assessment that the new controller will run the company well so that staying in the company is the attractive option. Most jurisdictions provide, in one way or another, for the squeeze-out squeeze-out of minorities on the terms accepted by the majority, usually, however, only where a very high proportion of the shareholders have accepted the offer. Teless right squeeze-out squeeze-out minorities initial fixing of the off leveltheof table the offer at thantoacquirer’s expected gainsfacilitates from thethe acquisition by taking the options of remaining in the company or exiting at a price higher than the offer price. It thus encourages bids.¹¹ In most jurisdictions, minority hold-ups hold-ups or incentives not to tender are directly addressed by takeover-specific takeover-specific rules¹² which give the acquirer compulsory purchase ¹ See Commission Report, note 115, para. 17; European Company Law Experts, Te Application of the akeover Bids Directive—Response Directive—Response to the European Commission’s Report (November 2013), section 3. ¹ See e.g. UK akeover Code, rule 31.4 (but qualified by Rule 33.2); WpÜG, § 16(2) (Germany), both adopting a two-week two-week period. In Italy, Italy, a similar rule applies, appl ies, but limited to tender offers off ers launched by someone already holding a stake higher than 30 percent, or by management. Art. 40-II, 40-II, Consob Regulation on Issuers. ¹ Lucian A. Bebchuk, Pressure to ender: An Analysis and a Proposed Remedy , 12 D J C L L 911 (1987). See however however Guhan Subramanian, Subramanian, A A New New akeover Defense Defense Mechanism: Using an Equal reatment reatment Agreement as an Alternative to the Poison Pill , 23 D J C C L L 375, 387 (1998). ¹ Art. 16 akeover akeover Directive. Directive. See Section 8.3.5. ¹¹ Mike Burkart and Fausto Fausto Panunzi, Mandatory Panunzi, Mandatory Bids, Squeeze-Outs Squeeze- Outs and Similar ransactions , in R C L E, note 99, at 753–6. 753– 6. ¹² Some jurisdictions have both types of rule. In Germany the introduction introduction of the squeeze-out squeeze-out power specific to control shifts was important precisely because of its presumption that the bid price is fair (WpÜG § 39a(3)), in contrast to endless opportunities to challenge the price under the general merger procedure (AktG § 327b). Under both specific and general squeeze-out squeeze-out mechanisms the courts are likely to be worried if the threshold is (to be) reached as a result of a bid by an already controlling
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powers over the non-accepting non-accepting minority.¹³ Te Delaware version is the “two-step “two-step merger,” that is, a tender offer for the shares followed by a short-form short-form merger of the new subsidiary with the acquirer (i.e. without a shareholder vote), taking advantage of the fact that Delaware law has a general provision allowing squeeze-out squeeze-out mergers at the 90 percent level.¹ Te importance of the short-form short-form squeeze-out squeeze-out to acquirers is reflected in its extension in 2013 to acquirers with less than 90 percent after the first step but nevertheless enough votes to obtain shareholder approval for merger (normally a majority of the issued shares).¹ Unlike the earlier procedure, the 2013 reform is takeover-specific, takeover-specific, ie. the first-step first-step general offer is now a mandatory element of the procedure.¹ In many countries the right of the offeror at above the 90 percent level to acquire minority shares compulsorily is “balanced” by the right of minorities to be bought out at that level (“sell out”), a right which, again, may or may not be tied to a preceding takeover offer.¹ Functionally, the two are very different. A squeeze-out squeeze-out right promotes offers whilst a right to be bought out reduces the pressure on target shareholders to tender, tender, though that objective is in fact better achieved by rules requiring the bid to be kept open for a period after it has become unconditional.¹
8.4 Specific Issues upon Acquisition from a Controlling Sharehold Shareholder er Where there is a controlling shareholder or shareholding group the allocation al location of the
decision on the offer as between the shareholders alone and shareholders and target board jointly loses much of its significance, for, on either basis, the controlling shareholder is likely to determine whether the control shift occurs.¹ However, the shareholder–board holder– board agency issues are here replaced by minority–majority minority–majority agency problems. shareholder. See Re Bugle Press [1961] shareholder. [1961] Ch 279, CA (UK) and Re Pure Resources Inc .,., 808 A R 2d 421 (Del. Ch. 2002)—both 2002)— both in effect requiring the acquirer to show the offer to be fair. ¹³ Art. 15 akeover akeover Directive requires Member States to provide provide such a mechanism, provided that the offeror reaches at least 90 percent of the shares as an outcome of the bid. ¹ DGCL § 253. And see Chapter 7.4.2. ¹ Although the acquirer would win the shareholder vote, a vote is expensive for the newly acquired target because of the need to comply with proxy solicitation rules. ¹ DGCL §251(h). Other conditions reinforce reinforce this orientation. Te first step must be a tender offer for all the shares with voting rights in a merger, the merger must follow as soon as possible after the conclusion of the tender offer, the offer consideration must be that contained in the merger proposal, the procedure is open only to third-party third-party acquirers (i.e. not existing controllers) and the target management must consent (i.e. “friendly” takeovers only). ¹ Both types of rule are discussed in greater detail in Forum Europaeum Corporate Group Group Law, Law, Corporate Group Law for Europe , 1 E B O L R 165, 226 ff. (2000). TeSection akeover akeover Directive requires a squeezesqueeze-out outa and a sell-out sell-outstake right. ¹ See 8.3.4. An offeror mayboth be satisfied with controlling stak e short of the 90 percent level and thus not be subject to the sell-out sell- out right, whereas the “keep it open” requirement applies at whatever level the acquirer declares the bid to be unconditional. ¹ Tis depends, of course, on the board being immediately responsive to the wishes of the majority. If it is not, even a majority holder may not be able to assert its will. For a striking example see Hollinger Int’l v. Black , 844 A R 2d 1022 (2004, Del. Ch.), where the Delaware Court of Chancery upheld the power of the board of a subsidiary to adopt a poison pill in order to block a transfer by the controller of the parent of his shareholding in the parent to a third party. Tis case involved egregious facts. In particular, the controller of the parent was in breach of contractual and fiduciary duties (as a director of the subsidiary) sub sidiary) in engaging in the transfer transfer,, and the transferee was aware of the facts giving rise to the breaches of o f duty. duty. See also Chapter C hapter 4.1.3.1.
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Since minority–majority minority–majority conflicts are not unique to control transactions, it is possible to leave their resolution to the standard company law techniques analyzed in previous chapters. However, laws dealing with control shifts have tended to generate more demanding obligations for controlling shareholders which arise only in this context. Tere are two central issues. First, are the selling controlling shareholder and the t he acquirer free to agree the terms of sale of the controlling block without offering the non-controlling noncontrolling shareholders either a part of the control premium or an opportunity to exit the company? Second, may the controlling shareholder, by refusing to dispose of its shares, prevent the control shift from occurring?
8.4.1 Exit rights and premium-sharing In dealing with sales of control blocks, the central question is whether the law imposes a sharing rule. Tis question may be approached either from the side of the selling controlling shareholder (i.e., by imposing a duty on the seller to share the control premium with the non-selling non-selling minority: sharing of the consideration), or, from the side of the acquirer (i.e., by imposing a duty upon the purchaser of the controlling block to offer to buy the non-controlling non-controlling shares at the same price as that obtained by the controlling shareholder: sharing of both the consideration and the exit opportunity). Looking first at obligations attached atta ched to the selling controlling shareholder, some jurisdictions in the U.S. have used fiduciary standards to impose a sharing rule.¹ However, However, despite some academic argument to the contrary,¹¹ U.S. courts have not adopted a general equality principle which might have led them to generate an unqualified right for non-controlling noncontrolling shareholders to share in the control premium. Te law is probably best
stated from the opposite starting point: “a controlling shareholder has the same right to dispose of voting equity securities as any other shareholder, shareholder, including … for a price that is not made proportionally available to other shareholders,” shareholders,” but subject to a requireme requirement nt for fair dealing.¹² Provided self-dealing self-dealing is effectively controlled, permitting sales at a premium price would give both seller and acquirer an appropriate reward for their extra monitoring costs.¹³ Despite this, purchases of control from blockholders bl ockholders disjunct from the buy-out buy-out of minorities are rare in the U.S., possibly because private benefits of control are low and finance to acquire 100 percent of the shares is generally available. As far as duties on the acquirer are concerned, many of the sharing rules discussed in Section 8.3 will operate in favor of minority shareholders against a shareholder purchasing a controlling block, for example, the rules determining the level of the consideration.¹ Consequently, an acquirer that wishes to obtain an equity stake in the target beyond that which the purchase of the controlling block will provide may find it ¹ As in looting cases: see Gerdes v. Reynolds , 28 N Y S R 2nd Series 622 (1941); or where the sale can be identified as involving the alienation of something belonging to Perlman v. 781 Feldman Feldman, all , 219 F R 2d Series 173 (1955); (1955 ); Brown v. Halbert , 76 shareholders: C R (1969). ¹¹ William Andrews, Te Stockholder’s Right to Equal Opportunity in the Sale of Shares , 78 H L L R 505 (1965). For an incisive general discussion of this area see Robert Clark, C L 478–98 478–98 (1986). ¹² American Law Institute, P P C C G § 5.16. ¹³ For the argument that in general general the controlling shareholder should be free to transfer control, whether directly or indirectly, for the reason given in the text, see Ronald J. Gilson and Jeffrey N. Gordon, Controlling Controlling Shareholders , 152 U P L R 785, 793–6, 793– 6, 811–16 811–16 (2003). ¹ Section 8.3.3. In most cases these rules can be avoided if the the acquirer is prepared to wait long enough before launching an offer for full control.
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difficult to offer a sufficiently high price to the controlling shareholder to secure those shares if the rules require the subsequent public offer to reflect the price paid outside or prior to bid. Te greatest however, the question of whether thethe mandatory bid rulecontroversy, should be applied to arevolves transferaround of a controlling position, so as to require the acquirer to make a public offer, offer, where it would otherwise not wish to do so, and on the same terms as those accepted by the controlling seller. It can be argued that there is a vital difference between purchasing control from a blockholder and acquiring it from the market in a widely held company, company, because in the former case the minority is no worse off after the control shift than it was previously. However How ever,, such a view ignores the risks which the control shift generates for the minority. Te acquirer, even if it does not intend to loot the company, may embark upon a different and less successful strategy; may be less respectful of the minority’s interests and rights; or may just simply use the acquired control to implement a group strategy at the expense of the new group member company and its minority shareholders.¹ As noted above in relation to acquisitions of control, it is very difficult to establish ex ante whether the minority shareholders will be disadvantaged by the sale of the controlling block, so that the regulatory choice is between reliance on general corporate law to protect the minority against unfairness in the future and giving the minority an exit right at the time of the control shift. Nevertheless, Neverthele ss, the costs of the mandatory exit right are potentially much greater in a situation of a control block sale than for acquisitions of control from dispersed shareholders. Te acquirer no longer has the option of sticking with the control block it has purchased at a price acceptable to the seller seller.. Under the mandatory bid rule it must now offer that price to the non-controlling non-controlling shareholders as well. It may well face the situa-
tion that it cannot pay the existing controller the price it wants to consent to the deal (reflecting private benefits of control) without overpaying for the company as a whole. If private benefits of control are high, the disincentive effect of a mandatory sharing of bid premiums will be significant.¹ Fewer control shifts will occur occur,, even where the acquirer intends to increase the operational efficiencies of the target. In countries where controlling shareholders are common, common, this may be seen as a strong objection to the mandatory bid rule.¹ Te adverse impact of the mandatory bid rule is further enhanced if it applies to indirect acquisitions of control.¹ On the other hand, the ¹ Tese are, of course, the arguments in favor of the mandatory bid rule, even where where the seller is not a controlling shareholder. See Section 8.3.4. ¹ John C. Coffee, Regulating the Market for Corporate Control , 84 C L R 1145, 1282–99 (1984); Bebchuk, note 144. 1282– ¹ See Luca Enriques, Te Mandatory Bid Rule in the Proposed EC akeover akeover Directive: Directi ve: Harmonization Harmonizati on as Rent-Seeking? Rent-Seeking? in in R C L L E, note 99, 99 , at 785. See further Pacces, note 102, at 335–7, 335–7, arguing for the abandonment of the mandatory bid rule and for permitting the acquirer of the controlling block to make a post-acquisition bid at the higher of the pre- and postpost-acquisition acquisition market bid price the target’s further consequence of our analysis is that a harmonized mandatory ruleof across the EUshares. will inAfact produce very different impacts depending on the level of private benefits of control. ¹ Sometimes referred to as the “chain principle,” i.e., a person acquiring control of company A, which itself holds a controlling block in company B; or a company using its own subsidiary A to acquire control in company B. Must the acquirer make a general offer to the outside shareholders of company B? Perhaps reflecting the British penchant for wholly owned subsidiaries, the akeover akeover Code starts from the presumption that an offer is not required (Rule 9.1, Note 8); German law, as befits its commitment to group law, starts from the opposite presumption but allows the supervisory authority to dispense with the obligation if the assets of the subsidiary are less than 20 percent of the assets of the parent (WpÜG §§ 35, 37 and WpÜG- Angebotsverordnung Angebotsverordnung § 9(2) no. 3). See also similarly simil arly,, for Italy,, Art. 45 Consob Regulation on Issuers, as amended. Italy
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mandatory bid rule will discourage transfers to acquirers who intend simply to extract higher benefits of control than the existing controller: the exit right at a premium ensures that there will be no minority for the new controller to exploit.
8.4.2 Facilitating bids for controlled companies Te existence of controlling blocks of shareholders in public companies clearly constitutes a structural barrier to control shifts, if the controllers are unwilling to relinquish their position. However, there is not much company law can do about such barriers: “[c]oncentrated “[c]oncentrated patterns of ownership represent … simply the existing condition of the economic environment. environment.”¹ ”¹ Nevertheless, there are two avenues through which lawmakers can facilitate bids in a controlled shareholder environment. First, they may create exemptions from or impose a weaker version of the mandatory bid rule, so that its adverse impact on control shifts is diluted. Secondly, Secondly, they may neutralize “technical” “technical” barriers to control shifts such as control-reinforcing mechanisms.
8.4.2.1 Weakening the mandatory bid rule We have seen that the mandatory bid rule has a chilling effect on control shifts, irre We spective of whether the target has dispersed or concentrated ownership. Given that the existence of a controlling shareholder in the target serves as a deterring factor itself, lawmakers may be tempted to consider the two elements together as excessive and thus attempt to weaken the impact of the mandatory bid rule. r ule. Seen in this light, the various exceptions, exemptions, and limitations of the mandatory bid rule thus may be there
for a perfectly rational reason: a weak version of the mandatory bid rule may be more functional for a system of concentrated ownership. ownership. An example of weaker weaker versions of the mandatory bid rule are the so-called so-called “partial” sharing rules that are in force in China and India.¹ Tus, in China, a mandatory bid needs only be for a minimum of 5 percent of the outstanding shares, which naturally dilutes its effect.¹¹ Similarly, Similarly, the Indian version of the rule requires any acquirer exceeding 25 percent of the voting rights in the target company to make a mandatory mandator y tender offer for at least 26 percent of the shares of the target company.¹² company.¹² Another version is the Brazilian requirement that a mandatory bid be made to all common shareholders, but only at 80 percent of the price paid to the controlling shareholder¹³—an shareholder¹³—an implicit recognition of the exceptionally high private benefits that controlling shareholders enjoy in that country country.¹ .¹ Moreover Moreover,, the fact that the mandatory mandator y bid rule by law only applies to voting shares significantly reduces its scope given the high incidence of ¹ Ronald J. Gilson, Te Political Ecolog Ecol ogyy of akeovers in in E :: L P, note 108, at 67, discussing the difference between “structural” and “technical” “technical” barriers to takeovers. ¹ Armour, Jacobs, and Milhaupt, at 274of ff. ¹¹ Measures for the Administra Administration tion ofnote the 36, akeover Listed Companies Companies (China (China Securities Regulatory Commission, 27 August 2008, revised), art. 25, available at www.lawinfochina.com/ www.lawinfochina.com/display. display. aspx?lib=law&id=7043&CGid=.. See Chao Xi, Te Political Economy of akeover Regulation: What aspx?lib=law&id=7043&CGid= Does the Mandatory Bid Rule in China ell ell us? , J B L L 142 (2015). (20 15). ¹² Securities Exchange Board of India (Substantial Acquisition of Shares and akeovers) Regulations 2011. See Umakanth Varottil, Te Nature of the Market for Corporate Control in India , Working W orking Paper Paper (2015), at ssrn.com ssrn.com.. ¹³ Art. 254- A A Lei das Sociedades por Ações. However, However, the Novo Mercado, Mercado, Brazil’s Brazil’s premium corporate governance listing segment, requires a mandatory bid rule at the same price paid to controlling shareholders. Art. 8.1 Novo Mercado Regulations. ¹ See Chapter 4.4.2.1.
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non-voting preferred shares in Brazil’ non-voting Brazil’ss capital market.¹ All three jurisdictions provide examples of a cautious legal transplant: accepting the mandatory bid bi d rule as worldwide best practice, but adjusting to theofspecific regulatory environment in place. All three regimes thus avoid the costlyit effect a full sharing rule.¹ A different different strategy would be an “optional” “optional” mandatory mandatory bid rule.¹ As As we saw above, above, Swiss law serves as an example by permitting shareholders to modify or remove the rule in their charters.¹ Potential target shareholders can thus deliberately facilitate control changes in their company. Other jurisdictions achieve a similar outcome in a much less l ess transparent way. way. Even though EU member states all provide for a fully fledged mandatory bid rule as required by the Directive, the laws’ lacunae and lax enforcement in some of them¹ may also be understood as functional to the purpose of mitigating the mandatory bid bi d rule’s rule’s chilling effects. For instance, German law—intentionally law—intentionally or not—allows not—allows for circumventions of the mandatory bid rule where the bidder acquires economic rather than legal interests in shares, or where a “creeping takeover” is combined with a voluntary bid at a deliberately lowofprice.¹ In light these considerations, some commentators have even argued that takeover regulation should rather be “unbiased” instead of prescriptive, and let decision-makers decision-makers on the individual company level decide on their level of control contestability.¹¹ Others caution against too far-reaching far-reaching flexibility, citing potential real-life real-life problems in controlled companies and asking whether the market will adequately price in the choices made by individual companies.¹²
8.4.2.2 Addressing technical elements: Te breakthrough rule
echnical barriers to takeovers may be susceptible to regulation through corporate law. Te breakthrough rule (BR), which EU member states may impose or at least make available to companies on an opt-in basis,¹³ constitutes an example of a legislative attempt to address technical barriers to control shifts. Te BR aims to prevent boards and controlling shareholders from structuring the rights of shareholders pre-bid pre-bid in such a way as to deter bids. Subject to the payment of compensation, it removes some restrictions on shareholders shareholders’’ transfer and voting rights once a bid is made, whether the restrictions are found in the company’s charter or in contracts among shareholders (to which contracts the company may or may not be party).¹ Such restrictions are not permitted to operate during the offer period. More importantly, they are ineffective, and multiple voting shares will be reduced to one ¹ Art. 254- A A Lei das Sociedades por Ações. Te regulations of the Level 2 listing segment of the São Paulo Stock Exchange however impose a mandatory bid rule with respect to both voting and non-voting nonvoting preferred shareholders at the same price paid to the controlling shareholder. Art. 8.1 Level 2 Regulations. ¹ Armour, Jacobs, and Milhaupt, note 36, at 274 ff. ¹ See Luca Enriques, Ronald J. Gilson, and Alessio M. Pacces, Te Case for an Unbiased akeover Law (with an Application to the European Union), Union), 4 H B L R 85 (2014). ¹ Se ¹ Seee Sec ecti tion on 8. 8.3. 3.4. 4. ¹ Se ¹ Seee Enr nriq ique uess an andd Gat attti, not otee 14 149, 9, at 76 76––9. ¹ Teodor Baums, Low Balling, Creeping in und deutsches Übernahmerecht , ZIP – Z F W W 2374 (2010). ¹¹ Enriques, Gilson, and Pacces, Pacces, note 187. ¹² See Hopt, note 13, at 156– 156–7; 7; Johannes W. Fedderke and Marco Ventoruzzo, Te Biases of an “Unbiased” Optional akeovers Regime: Te Mandatory Bid Treshold as a Reverse Drawbridge , available at ssrn.com ssrn.com.. ¹³³ Art ¹ rtss. 11 and 12 akeover Directive. ¹ Art rt.. 11.
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vote per share, at any shareholder meeting called to approve a pprove defensive measures measures under the no frustration rule¹ and at at the first general meeting called by a bidder who has obtained 75 percent of the voting shares. At this “extraordinary right” of shareholders in relation to the appointment and meeting removal any of directors shall not apply either.¹ either .¹ Te overall aim of the BR is to render contestable the control of companies where control has been created through (some) forms of departure from the notion of “one share one vote” or by shareholder agreements. Te break-through break-through of voting restrictions during the offer period might be thought to be necessary to make the no frustration rule work effectively. Te post-acquisition post-acquisition break-through breakthrough is potentially more significant and gives the successful bidder an opportunity to translate its higher-thanhigher-than-7575-percent percent stake into control of the company by placing its nominees on the board and by amending the company’s company’s constitution so that its voting power reflects its economic interest in the company company.. Te optional BR has been an a n unsuccessful experiment, since si nce only a few, small member states have chosen to make it mandatory. Further, the BR is nowhere the default rule no company of in two member statesexplains where itwhy is optional appears tostates haveopted optedfor intoa it.¹and A combination elements so few member mandatory BR. On the one hand, the BR does not catch simple controlling positions where the one-share, one-share, one-vote one-vote rule is observed, so that the majority of controlling positions within European companies were not affected by it; on the other, the BR does not catch some departures from the one-share one-share one-vote one-vote principle, such as pyramids:¹ these two circumstances together were enough to generate aggressive—and aggressive—and successful—lobbying successful— lobbying by those that a mandatory BR would have caught. Te reason why no companies have opted into the BR is even simpler: an opt-in opt-in at company level requires a supermajority vote of the shareholders in most cases, and controlling share-
holders, still possessing their thei r technical advantages, have weak incentives to vote in favor.
8.5 Explaining Differences in the Regulation of Control ransaction Wee have analyzed W analyzed control shift regulation regulation along three three dimensions, focusing focusing mainly on two: the location of decision-making decision-making on the offer and the protection of target shareholders (especially non-controlling non-controlling shareholders) against opportunism on the part of the acquirer (or acquirer plus controlling shareholder). Te minor dimension was the responsiveness responsivene ss of the regulation to non-shareholder non-shareholder constituencies. wo immediate conclusions can be drawn from our analysis. Te first and negative conclusion is that none of the systems puts the goal of maximizing the number ¹ Section 8.2.2. ¹ Tus rights of codetermination (see Section 8.1.2.3) are not affected because these are are normally not shareholder rights of appointment and will be contained in legislation rather than the company’s company’s articles. ¹ See Commission’s Commission’s Report on the Implementation of the Directive on akeover akeover Bids, note 140, at 7–8. 7–8. ¹ See John C. Coate Coatess IV, IV, Te Proposed ‘Break-Trough’ ‘Break-Trough’ Rule-Ownership, akeovers and EU Law: How Contestable Should EU Corporations Be? , in R C L E, note 99, 677, 683–4 683–4 (summarizing data suggesting that only a maximum of 4 percent of public firms in the EU would be affected, and arguing that the controlling shareholders in some of those might be able to avoid the impact of the BR by increasing their holdings of cash- flow rights or moving to equivalent equi valent structures not caught by the BR, such as pyramid structures and/ or cross-holdings). crossholdings).
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of control shifts at the center of their regulatory structures. Te maximum number of takeovers is likely to be generated by a system which enjoins upon target management aand rulewhich of passivity relation the to actual or threatened takeovers dimension) gives thein acquirer maximum freedom to structure(the its first bid (the second dimension), whilst (non-)shareholder (non-)shareholder interests are ignored. None of our jurisdictions conforms to this pattern: the regulation of agency and coordination issues in takeovers ta keovers is a better, if more complex, explanation of the goals and effects of national regulatory systems than the maximization of the number of bids. Second, the overall characterization of a system requires that attention be paid to both the major dimensions of regulation.¹ A system which rigorously controls defensive tactics on the part of management may nevertheless still chill takeovers by, say, strict insistence upon equality of treatment of the target shareholders by the acquirer or the prohibition of partial bids. Indeed, it is probably no accident that those systems which, historically, most clearly favor shareholder decision-making decision-making in bid contexts (UK and France—the France—the latter now only doubtfully in this category) also have the most developed rulesDeprived against acquirer opportunism, addressing intra-shareholder intra-shareholder coordination problems. of the protection of centralized management, the target shareholders need explicit regulatory intervention as against acquirers, but that intervention— notably the mandatory bid rule—may rule—may also protect indirectly incumbent management. A system system configu configured red in this this way may both both make make it difficult difficult for for incumbent incumbent managem management ent to entrench themselves against tender offers which do emerge and reduce the incidence of such offers. Which effect is predominant in practice is an empirical question.²
8.5.1 Differences in form and differences in substance Te most sensitive question in relation to control transactions is whether they can be
implemented over the opposition of the incumbent board. So, the crucial dividing line appears to lie between those systems which place the decision on the control transaction wholly inand thethehands shareholders boardofathe vetotarget right.shareholders and those which give both target However, there are reasons for thinking that this division may be an oversimplification. First, a jurisdiction following the joint decision model may develop adaptive mechanisms which, to a greater or lesser extent, reproduce the effects of an allocation wholly to the shareholders of the target ta rget company. company. Te U.S. demonstrates the t he possibilities for a development of this kind.²¹ Tus, Armour and Skeel have observed that, whilst the proportion of hostile bids in the U.S. is smaller than in the UK,²² which allocates the decision entirely to the shareholders, the overall level of control shifts is not much different.²³ In other words, a combination of legal strategies and
¹ See also Sanford J. Grossman Grossman and Oliver Hart, An Hart, An Analysis of the Principal-Agent Problem, Problem, 51 E 7 (1983). ² Martynova and Renneboog, note 12, table 2, show that in the 1990s European merger wave 58 percent of all hostile takeovers within Europe involved UK or Irish targets, as did 68 percent of all tender offers (hostile or friendly), whilst the premium paid for UK targets exceeded that paid for continental targets (at 235). ²¹ See Section 8.2.3.1. ²² Armour and Skeel, note 32, table 1; see also Coates, note note 54, 253 (7 percent hostile bids in the UK versus 3 percent in the U.S.). ²³ Armour and Skeel, note 32, at 1741. Whether the two systems are functionally absolutely equivalent is not clear (see ibid. at 1742–3, 1742– 3, arguing that the U.S. system has costs which the straightforward adoption of a no frustration rule avoids).
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institutional facts may permit the shareholders to reap the benefits of joint decisionmaking over control shifts (shareholders overcome their coordination problems by using management to negotiate with management the bidder onentrenchment). their behalf) without incurring the costs of this arrangement (notably Where those Where legal strategies are not available or the institutional facts do not obtain, however, however, the initial allocation of the decision right will indeed be crucial. cr ucial.
8.5.2 Different regulatory environments Ownership structure, industry structure, and complementarities already in place matter for the design of functional legal rules. Strategic choices will certainly also play a role.² Tus, we might expect countries with concentrated ownership structures to be less reliant on takeovers as a corporate governance device, since managerial monitoring is arguably performed by corporate blockholders. Tese countries—actually countries—actually the overwhelming majority of all laws.² jurisdictions worldwide²— worldwide²—might might befor lessthein reluctance “need” to deploy pro-bidders pro-bidders takeovers Tis could be an explanation of some continental European countries to support a mandatory board neutrality rule in the akeover Directive.² Japan with its closely knit network of cross-shareholdings cross-shareholdings is also an example of a system where tools of external corporate governance other than hostile takeovers have prevailed historically—though historically—though cross-shareholdings cross-shareholdings have weakened in recent years.² Likewise, we could hypothesize that different designs of a takeover ta keover framework framework may be more appropriate for different types of industry. A growing literature discusses the “varieties of capitalism” capitalism” and how they impact on legal rules.² Tus, it could be argued a rgued that industries with certain types of productive technology need to make long-term long-term
commitments to employees as a quid pro quo for the employees’ investment in firmspecific human capital or acceptance of flexible working. In such a scenario, takeovers might be perceived as disruptive totowards such longcommitment and likely l ikely to produce a “breach of trust” by the acquirer theterm existing employees.²¹ Finally,, the design of appropriate rules seems to be naturally influenced by the preFinally existing body of laws and tools. In other words, complementarities and path dependencies are important factors for the design of laws. For example, they may explain a lot of the peculiar UK/U.S. UK/U.S. divide described above. Te UK system of company law has always been strongly shareholder-centered— shareholder-centered—the the board’s powers derive from the company’s charter, not the legislation, and the charter is, formally, wholly under ² Guido Ferrarini Ferrarini and Geoffrey Miller, Miller, A Simple Teory of akeover Regulation Regulation in the United United States States and Europe , 42 C I I L J 301 (2009). See also Hopt, note 12, at 259. ² Marco Becht Becht and Colin Mayer, Mayer, Introduction Introduction,, in C C C C E (Fabrizio Barca and Marco Becht eds., 2001). ² It could be argued that that these countries should better focus on rules that address intraintra-shareholder shareholder agency costs directly, directly, such as related party transactions. See Chapter 6. ² See Section 8.2.2. ² Joseph Lee, Critical Exposition of Japanese akeover Law in an International Context , Working Paper (2016), at ssrn.com ssrn.com.. ² See V V C: I I F C A A (Peter A. Hall and David Soskice, eds., 2001); Wendy Carlin and Colin Mayer, How Do Financial Systems Affect Economic Performance ?,?, in C G: E P 137 (Xavier Vives ed., 2000). ²¹ Shleifer and Summers, note note 22; Paul Paul Davies, Efficiency Arguments for the Collective Representation of Workers , in A L L (Alan Bogg et e t al. eds., 2015).
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the control of the shareholders;²¹¹ directors can be removed at any time by ordinary shareholder vote. U.S. law has traditionally been more protective of the prerogatives of centralized management, whilst preserving the ultimate control of the shareholders.²¹² Hence, allocating decision-making on control shifts wholly to the shareholders fitted well with established patterns of UK corporate governance, whilst in the U.S. board influence over control shifts was established in a more convoluted and, perhaps, less stable way, way, but one doctrinally consistent with its managerial orientation.²¹³ In a similar vein, jurisdictions might choose to promote alternative elements of corporate governance as substitutes for an active takeover market.²¹ It should be noted, however, that such alternative improvements will rarely be sufficient: the threat of a hostile bid usually remains “the most effective corporate governance mechanism.”²¹ Another important complementarity complementarity to consider is the regulatory framework addressaddressing shareholder engagement. Over recent years, various policy initiatives have sought to promote active shareholder participation in corporate affairs. It has been pointed out that some elements of takeover regulation—most regulation—most importantly, importantly, the mandatory bid rule conjunction withshareholder the conceptengagement.²¹ of “acting in concert”—may concert”—may run against the policyingoal of promoting
8.5.3 Political economy economy considerations Divergences in takeover takeover regulation may also be explained by different political choices and perceptions in different jurisdictions. Chief amongst the driving factors here is a potential backlash against a perceived sale of strategic firms into foreign hands. akeovers can make newspaper headlines—and headlines—and broad-scale broad-scale takeovers of companies by, in particular, foreign acquirers have the potential of being used for protectionist counteractions. Tis is even more likely during times of economic crisis, as the recent global financial crisis has demonstrated.²¹ For example, Italy—briefly Italy—briefly during the financial
crisis—and more recently France opted out of the board neutrality rule contained crisis—and in the EU akeover Directive.²¹ Even the traditionally takeover-friendly takeover-friendly UK saw a fierce political debate after the 2009 takeover of iconic chocolate maker Cadbury by American food giant Kraft.²¹ ²¹¹ See Chapter 7.2. ²¹² See Chapter 3.5. ²¹³ Armour and Skeel, note 32, at 1767– 1767–8, 8, point out that the traditional doctrinal pro-shareholder pro- shareholder orientation of British corporate law was reinforced by the rise of institutional shareholding during the precise period that modern takeover regulation was being developed in the UK, i.e. in the 1960s, whereas this coincidence did not occur in the U.S. Equally, one might speculate that, if managerial stock option plans were to become a less significant si gnificant part of compensation in the U.S., then U.S. institutional investors might begin to agitate for shareholder-friendly shareholder-friendly control-shift control-shift regulation. ²¹ Paul Davies and Klaus J. Hopt, Corporate Boards in Europe— Accountability and Convergence , 61 A J C C L L 301 (2013). ²¹ Jonathan Macey, Macey, C G: G: P K, P B 10, 118 ff. (2008). On the market of corporate control and the pros and cons of the nofrustration nofrustration rule see Hopt, note 12, at 261–8. 261–8. ²¹ See ESMA, Information on Shareholder Cooperation and Acting in Concert under the akeover Bids Directive , ESMA/2013/ ESMA/2013/1642 1642 (12 November 2013); Martin Winner, Active Shareholders and European akeover Regulation, Regulation, 12 E C F L L R 364 (2014). See also Chapter 3.2.4. ²¹ See a number of contributions in C L L E P (Ulf Bernitz and Wolf-Georg Wolf-Georg Ringe eds., 2010). ²¹ See Sections 8.2.2 and 8.2.3.2. ²¹ Some even called for the adoption of a specific “Cadbury’s “Cadbury’s Law” to better protect British British firms from foreign takeovers. See Wolf-Georg Wolf-Georg Ringe, Deviations from Ownership-Control Ownership-Control Proportionality— Economic Protectionism Revisited , in C L L E P, note 217, at 235.
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In many emerging markets, takeovers are generally very rare, mostly because of severe ownership concentration in the hands of families and the state, but also due to regulatory hurdles in those (rare) countries where ownership is a little more dispersed, such as India.²² But even in developed Western economies, politicians may fall prey to the perceived need to “protect” the local economy from foreign bidders. A case in point is France, where policymakers of all parties regularly act or intervene to create or protect “national champions.” champions.” Law and politics may frequently blend into each other. Consider the example of the 2014 acquisition of French industry champion Alstom by U.S. conglomerate General Electric (GE). Despite the fact that the French government government was not a shareholder in Alstom, and despite there being no legal requirement to do so, it was clear as a matter of fact that GE had to (and did) negotiate directly with the Elysée Palace before it was eventually “allowed” “allowed” to proceed with the bid. In the course of this takeover, takeover, the French government additionally adopted a legislative decree, protecting local key industries by an official government veto on control shifts.²²¹ In all jurisdictions such policies are common for sensitive industries, for example to shield the Apart local from defense from foreign influence.²²² theindustry perceived perceived need to protect strategic industries, industries, the reasons for public public uproar are frequently the impact that takeovers have on the workforce. It is true that takeovers frequently lead to redundancies—though redundancies—though restructurings are not unique to takeovers. And it is no wonder that trade unions are amongst the most vociferous groups protesting against takeovers. Public attitudes are severely tested t ested where—as for example in the above-mentioned Cadbury/Kraft Cadbury/Kraft transaction—previous transaction—previous promises to keep employment are broken after completion of the takeover. Ultimately,, then, this relates back to the many agency conflicts that control transacUltimately tions generate, in particular for non-shareholder non-shareholder groups.²²³ In those countries where company law is used to address company–employee company–employee agency issues as a matter of general practice via employee or union representation on the board (namely, Germany),
a control shift effected simply by means of a transaction between the acquirer and the target shareholders, thus by-passing by-passing organ which embodies the principle of employee representation, is likelythetocorporate be regarded with suspicion. Conversely, the freedom of management to take defensive measures may be seen as a proxy for the protection of the interests of employees and, possibly, other stakeholders.
8.5.4 Regulatory uncertainty Tere is an important qualification to all the arguments made above. None of the various factors that may shed light on particular regulatory choices can explain them ²² Armour, Jacobs, and Milhaupt, note 36, at 273 ff.; Érica Gorga, Gorga, Changing the Par Paradigm adigm of Stock Ownership from Concentrated owards Dispersed Ownership? Evidence from Brazil and Consequences for Emerging Countries , 29 N J I L B 439, 445 (2009); Mariana Pargendler, Pargendler, Corporate Governance in Emerging Markets , in O H C L L G (Jeffrey N. Gordon and Wolf-Georg Wolf-Georg Ringe eds., 2017). ²²¹ Hugh Carnegy, Michael Stothard, and Elizabeth Rigby, French “Nuclear Weapon” against akeovers Sparks Blast from Cable , F , , 16 May 2014, p. 1. ²²² Germany revised revi sed its Foreign rade Act ( Außenwirtschaftsgesetz Außenwirtschaftsgesetz ) in 2008, establishing a review process for investments from outside the EEA if a company takes a stake in a German company of more than 25 percent. See Hopt, note 49, at 384 ff. Similarly, the U.S. review process for foreign investments—undertaken investments— undertaken by the Committee on Foreign Investments in the United States (CFIUS)— was amended in 2007/8 2007/8 to accommodate concerns that the process in its previous form had been ineffective and too lenient. ²²³ See Section 8.1.2.3.
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in their entirety, and most importantly, lawmakers face severe uncertainty as to the prevailing regulatory problem that they need to solve. For example, in relation to t o ownership structure, we know that the average size of the largest block varies from jurisdiction to jurisdiction,²² so that in jurisdictions with medium-sized medium-sized average blocks, hostile takeovers may be difficult, but not ruled out entirely. Further, consider the impact of changes over time: for example, there t here is evidence, in important jurisdictions, of a weakening of the grip of blockholders over the years.²² Finally, even in jurisdictions dominated by large blockholders, shareholdings in particular companies atypically may be dispersed. Tus, there are very few jurisdictions in which hostile takeovers are fully ruled out on shareholder structure grounds. More importantly, over the last few decades the hostile bid has become a significant event in a number of jurisdictions where previously it was virtually unknown. unknown.²² ²² Lastly, the desire of rule-makers rule-makers to fit takeover rules into the existing parameters of corporate law will explain much of the responses in these situations. All those uncertainties and conflicting interests will become even more acute in heterogeneous, federal systems (such as the EU), where a common pattern is not observable. Tus, it is fair to say that regulators are somewhat “agnostic” when it comes to choosing an appropriate takeover regime for their specific needs: even if we optimistically imagine that lawmakers seriously seek to optimize their takeover framework in the public interest by designing functional rules that fit to the assumed real-life real-life business realities, they can never be sure that these assumptions hold true (i) for all business entities that they seek to regulate, (ii) across different industries, and (iii) over time. Tis agnosticism has two consequences. First, lawmakers will try to encapsulate the “typical” situation relevant for their jurisdiction by, for example, assuming that companies controlled by a blockholder are the “typical” (as distinguished from ubiquitous) situation they need to address. Secondly, Secondly, regulators faced with continued uncertainty and conflicting pieces of real-life real-life evidence will plainly be unsure on how
to determine the optimal regime and so respond to other policy arguments. Tis is the point political considerations, efforts, andEU regulatory fall, onto fertile where grounds. A good illustration is lobbying the adoption of the akeovercapture akeover Directive Directive, with the European Commission pushing for a pro-takeover pro-takeover response as an important tool for promoting an integrated “sin “single gle market” within the Union,²² whilst some member states (and the Europe European an Parliament) responded to current popular fears of globalization and its impact.²² With the abandonment of the no frustration rule r ule and the BR ²² Becht and Mayer, Mayer, note 205, table 1.1, reporting that in the late 1990s the median size of the largest voting block in listed companies varied from 57 percent in Germany to 20 percent in France. ²² For Germany, see Wolf-Georg Wolf-Georg Ringe, Changing Law and Ownership Patterns in Germany: Corporate Governance and the Erosion of Deutschland AG , 63 A J C L 493 (2015). For Japan, see Japan Exchange Group, 2015 SO S (2016), at . >. ²² Julian Franks Franks et al., Te Life Cycle of Family Ownership: International Evidence, 25 Evidence, 25 R F S 1675 (2012), report in appendix A1 that the average number of listed companies which of in anGermany; unsolicited1.1 bidpercent expressed as a percentage of all in listed companies between 2001–66were 2001– was the 0.9target percent in Italy; and 0.7 percent France. Te UK figure was 3.3 percent. Te same general trend can be found in Japan, as the litigation it has generated attests: see note 51. ²² For which policy there was considerable empirical support. See, for example, Marina Marina Martynova and Luc Renneboog, Mergers Renneboog, Mergers and Acquisitions in Europe , in A C F A P 13, 20 (Luc Renneboog ed., 2006), stating that the European merger boom of the 1990s “boiled down to business expansion in order to address the challenges of the European market.” market.” ²² See Klaus J. Hopt, Observations on European Politics, Protectionism, and the Financial Crisis , in C L E P 13, 20–1 20– 1 (Ulf Bernitz and Wolf-Georg Wolf-Georg Ringe eds., 2010).
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as mandatory rules at EU level,²² protectionists may be said to have had the better of the argument with pro-integration pro-integration forces. Tis trend was repeated in the process of transposing the Directive, where, overall, there was a more protectionist approach on the part of the member states than had obtained previously.²³ previously.²³ Te sobering bottom line is that takeover regulation is a mixture of political interests, strategic consequences, lobbying efforts, and the external pressure of capital markets. At best, regulators will attempt to capture the “most typical” agency conflicts and coordination problems they need to address and ensure that they update their approach as and when real-life real-life changes occur. As strict oneone-sizesize-fitsfits-all all regulation rarely truly reflects business realities, takeover rules that allow for exceptions and/or and/or discretionary decisions would seem to be welfare-improving, welfare-improving, but there is no guarantee that the choices so provided are exercised in a way consistent with social welfare.²³¹
²² Section 8.2.2 and 8.4.2.2.
²³ Davies et al., note 46.
²³¹ Section 8.4.2.
9 Corporate Law and Securities Markets Luca Enriques, Gerard Hertig, Reinier Kraakman, and Edward Rock
Corporations are formidable tools for raising finance from the public. Te core features of corporate law set out in Chapter 1, especially limited liability and transferability of shares, make corporations highly effective for this purpose. Yet, as we have seen throughout this book, raising external capital exacerbates the agency problems described in Chapter 2. A broad shareholder (or debtholder) base entails higher information and coordination costs and more pervasive information asymmetries, which agents (managers, dominant shareholders, shareholders shareholders as a class) can exploit to pursue their own interests to the detriment of principals (shareholders, minority shareholders, and holders of debt instruments). Historically, the idea that providers of external capital—that capital—that is, (individual) investors—needed tors— needed protection from the risk of fraudulent or opportunistic behavior on the part of issuers and their agents was at the root of special rules dealing with (a) the process of selling securities (shares, bonds, debentures) to the public, (b) the status of companies with securities traded in “public” “public” or “se “securities” curities” markets,¹ markets,¹ and (c) the process of exiting from such a status.² From a more functional perspective, this body of rules, commonly referred to as “securities “sec urities law” or “se “securities curities regulation,” regulation,” supports corporations in their efforts to raise
external capital in the t he face of the familiar agency a gency problems.³ Te broad thrust of securities law is concerned with affiliation strategies—the strategies—the entry and exit of investors to and from the body of shareholders—primarily shareholders—primarily by increasing the quantity, quality, and reliability of corporate disclosures. Securities laws also provide enforcement mechanisms capable of bypassing the collective action problems faced by dispersed investors. o o the extent that these measures increase investors’ expected returns, firms that issue securities to the public (“issuers”) should enjoy a lower cost of capital. Tis chapter provides a necessarily brief and partial overview of the regulatory framework for securities markets in our core jurisdictions. Our treatment is partial for two reasons. First, securities law regulates not only issuers, but also public markets as a form of infrastructure providing liquidity services to investors and traders. Such ¹ By “public,” “public,” or “securities,” “securities,” markets we refer to organized capital markets that trade standardized financial instruments (securities) and are generally investors. AlthoughinEU law between parlance refers instead to “financial instruments,” and thereaccessible are sometotechnical differences scope these and the U.S. conception of “securities, “securities,”” the terms broadly overlap. Cf. Louis Loss, Joel Seligman, and roy Paredes, F S R 353–457 353–457 (6th edn., 2011) (U.S.); Niamh Moloney, Moloney, EU S F M R 84–5 84–5 (3rd edn., 2014) (EU). Wee generically refer to securities throughout the text. W ² See Joel Seligman, Te Historical Need for a Mandatory Corporate Co rporate Disclosure System, System, 9 J C L 1 (1983). ³ As highlighted in Chapters 1 and 4, securities laws are sometimes used for social purposes which are hard to square with the idea of reducing the cost of capital for issuers or even of protecting investors. See Chapters 1.5 and 4.3.1. Te Anatomy of Corporate Law. Tird Edition. Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry Hansmann, Gerard Hertig, Klaus Hopt, Hideki Kanda, Mariana Pargendler, Pargendler, Wolf-Georg Wolf-Georg Ringe, and Edward Rock. Chapter 9 © Luca Enriques, Gerard Hertig, Reinier Kraakman, and Edward Rock, 2017. Published 2017 by Oxford University Press.
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public market regulation includes rules about margin requirements for investors, the registration and conduct of broker-dealers, broker-dealers, and the structure and operations of stock exchanges and other market infrastructure institutions. Given the book’s book’s focus on corporations, we do not address market regulations of this sort here, but rather focus on the legal strategies directly addressing issuers and their agents. Te second reason for limited coverage of securities regulation at this point is that Chapters 3 to 8 have, in the course of the treatment of their various topics, already analyzed a nalyzed a number of provisions that are formally classed as securities regulation.
9.1 Securities Regulation Regulation and Legal Strategies Strategies Te legal strategies used to enhance securities markets are based on affiliation terms. More precisely, precisely, compliance with securities laws is i s a condition for entering, remaining in, and exiting the public markets, even if entry or exit may not be entirely voluntary. Tat said, it is convenient to group the legal strategies employed in the service ser vice of public traded markets into four categories. Te first is the paradigmatic exemplar of the entry strategy: mandatory disclosure in all of its dimensions, including the prescription of accounting methods. Te second category is an exit strategy: here, it takes the form of rules and regulations that a company has to comply with in order to cease to be treated as an issuer and therefore subject subject to securities regulation. Te third and fourth categories include governance and regulatory regulatory strategies contingent on participating par ticipating in the public markets. But before we describe how our core jurisdictions deploy these legal strategies, let us briefly illustrate the functions of securities regulation. 9.1.1 Why securities regulation?
Te most immediate goal of the securities law provisions we focus on in this chapter is to provide market participants with a better disclosure environment. When When supported by an active market where traders compete to realize gains from new information, a well-functioning wellfunctioning disclosure system increases the “informativeness” of market prices, often referred to as the market’s “informational efficiency.” Furthermore, effective sanctions for misleading statements increase the veracity of disclosures, meaning investors can rely on them more safely. In tandem with a prohibition on insider trading, more informative prices mean that potential buyers and sellers have less to fear that, by trading, they will lose money to counterparties who know more about the issuer’ issuer’ss prospects than is i s already reflected in the market price. Terefore, participation in securities markets will be broader, with a positive effect on market liquidity—that liquidity—that is, the ability of investors to sell their securities easily and rapidly with little l ittle or no impact on price. For an introduction to this area of regulation see John Armour, Daniel Awrey Awrey,, Paul Davies, Luca Enriques, Jeffrey Gordon, Colin Mayer Mayer,, and Jennifer Payne, P F R, 143–59 143– 59 (2016). See e.g. e.g. Chapter Chapter 6.2.1.1. See Ronald J. Gilson and Reinier Reinier H. Kraakman, Te Mechanisms of Market Efficiency , 70 V L R 549 (1984); see also Armour et al., note 4, ch. 5. See Section 9.1.3.2. In the absence of a prohibition prohibition on insider trading, new information can become impounded in stock prices without disclosure, through outsiders drawing inferences from the trading behavior of
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Market liquidity is important for a number of reasons. First of all, the prospect of a liquid market is relevant to primary markets—that markets—that is, where issuers first offer their securities to the public. If potential buyers can expect to be investing in liquid shares, they will be willing to pay a higher price (reflecting a lower liquidity discount, if any). Ultimately, issuers’ cost of capital will be lower. Second, as discussed in Chapters 2, 3, and 8, liquid securities markets affect corporate governance in various ways: liquid shares facilitate the use of equity-based equity-based compensation for managers and serve as an alternative currency for takeovers. Almost all thus agree that a system which allows information to be speedily incorporated into prices is desirable. Although some argue that less liquidity would reduce the incentives for trading with a very short time horizon and would therefore push investors to take a longer view, reducing the amount of available information would be an indirect, seemingly costly, costly, and possibly ineffective, way of attaining that goal.¹ A different different question question altogether altogether is whether mandatory disclosure, disclosure, via informationally efficient securities prices, can also be relied on to enhance allocative efficiency—that efficiency— that is, to ensure that scarce capital is channeled toward the most promising investment projects. Te link between informational and allocative efficiency would be as follows: informationally efficient prices also incorporate the estimates about issuers’ profprofitability that skilled analysts and traders t raders elaborate from publicly available information. Te greater the available information, the more accurate such estimates. Within the firm, independent directors focused on shareholder wealth and managers with equitybased compensation packages may thus use stock price reactions as guidance for corporate strategy.¹¹ Provided outsiders’ estimates of a company’s expected profitability are more precise than a biased insider’s, insider’s, the efficiency of corporate asset allocation will be improved.¹² Whether this is really the case is highly debatable and the correct answer may well vary market by market, industry by industry, and company by company. For instance, it may be harder for outsiders to come up with better estimates than insiders in highly innovative industries where uncertainty is extreme and the trajectory of entire
new markets is impossible to understand, let alone objectively predict.
9.1.2 Affiliation terms strategies All of our core jurisdictions make compliance with extensive mandatory disclosure regimes a condition of issuers’ access to public trading markets. In addition, they insiders: Henry G Manne, I S M (1966). However, this not only reduces liquidity for the reasons discussed in the text, but also makes it more difficult for outsiders to determine why the price has moved, meaning that although the price may react quickly to new events, the level at which it settles would be less grounded on analysis: Zohar Goshen and Gideon Parchomovsky, Te Essential Role of Securities Regulation, Regulation, 55 D L J 711 (2006). Te history of U.S. stock markets, which shifted from an insider-driven to a disclosuredi sclosure-driven driven system during the twentieth century, century, provides some support for this view: see John Armour and Brian Cheffins, Stock Market Prices Prices and the Market for for Corporate Control Control , 2016 U I L R 101. See Chapters 2.2.1.2, 3.5, and 8.1.1. ¹ See e.g. Robert C. Pozen Pozen and Mark J. Roe, Roe, Tose Short-Sighted Short-Sighted Attacks on Quarterly Earnings (2015), corpgov.law.harvard.edu corpgov.law.harvard.edu.. ¹¹ James Dow and Gary Gorton, Stock Market Efficiency and Economic Efficiency: Is Tere a Connection? 52 J F 1087 (1997); Jeffrey N. Gordon, Te Rise of Independent Directors in the United States, 1950– 2005: Of Shareholder Value and Stock Stock Market Prices , 59 S S L L R 1465 (2007). ¹² Cf. Luca Enriques, Ronald Ronald J. Gilson, and Alessio M. Pacces, Pacces, Te Case for an Unbiased akeover Law (with an Application to the European Union), Union), 4 H B L R 85, 93–5 93–5 (2014). ¹³ See John Armour and Luca Enriques, Financing Disruption, Disruption, Working Paper (2016).
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restrict firms’ freedom to exit such markets, thereby strengthening their commitment to high disclosure standards and to a liquid market for their securities.¹ But why must policymakers impose such such requirements? Why can we not expect issuers to provide market participants with all the information they need to make accurate assessments about the value of securities?
9.1.2.1 Te underproduction of information information Te case for mandatory disclosure disclosure assumes that firms will not disclose sufficient, or sufficiently comparable, information unless they are required to do so. Several theoretical arguments support this view.¹ First, there are the familiar agency problems within corporations. Corporate insiders often prefer to suppress bad news: managers may do so to obtain higher compensation or to retain their jobs; shareholders may gain from silence by selling their shares at a higher price, or by having their companies raise additional additi onal capital more cheaply. cheaply. Biased disclosure raises the cost of capital across the board and distorts dist orts its allocation allocat ion when real-world real-world market conditions prevent companies from signaling signal ing their true value. ying ying mandatory disclosure di sclosure to legal liability helps assure the market about the absence of bias in a company’s disclosures and the credibility of its commitments to continue honest disclosure in the future.¹ A second justification for mandatory disclosure is that, even apart from internal agency problems, the private benefits of disclosure to issuers may be less than its social benefits to market participants. Sensitive disclosures might damage any given firm in the market, while having the same disclosures delivered by all firms might generate a net benefit for shareholders holding a diversified portfolio. Put differently, diversified investors care less about individual firms than about the informational effects on the market as a whole. Arguably, disclosure disclosure is justified provided it leads to increased aggregate returns and lower price volatility across the market.¹ Finally, a third justification for mandatory disclosure is the value of standardization
of substance, format, and quality. At bottom, this solves a coordination problemand among firms. Standardization through mandatory disclosure improves comparability, thus increases the value of information to its users. Although firms have surmounted this collective action a ction problem probl em in the t he past— for example, through accounting accounti ng and stock exchange rules—mandatory rules—mandatory disclosure may accelerate the standardization process.
9.1.2.2 Te empirical evidence Despite the foregoing arguments, legal scholars have long debated how far issuers should be given discretion over disclosure to public markets.¹ Recent empirical ¹ See Edward B. Rock, Securities Regulation as Lobster rap: A Credible Commitment Teory of Mandatory Disclosure , 23 C LseeR R 675 (2002). (20 02). ¹ For a more comprehensive review review LucaEnriques and Sergio Gilotta, Disclosure and Financial Market Regulation, Regulation, in O H F R 511 (Niamh Moloney, Eilis Ferran, and Jennifer Payne eds., 2015). ¹ John C. Coffee, Te Future as History: Te Prospects for Global Convergence in Corporate Governance and its Implications , 93 N U L R 641 (1999). ¹ See e.g. Frank Frank H. Easterbrook and Daniel R. Fischel, Fischel, Mandatory Mandatory Disclosure and and the Protection of Investors , 70 V L R 669 (1984). ¹ See e.g. Roberta Romano, A C F S R (2002); Merritt B. Fox, Retaining Mandatory Securities Disclosure: Why Issuer Choice Is Not Investor Empowerment , 85 V L R 1335 (1999).
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literature supports the conventional view that publicly traded firms under-report under-report information—and information— and especially negative information—if disclosure is not mandated. While early studies of the U.S. mandatory mandator y disclosure regime suggested otherwise, at least for exchange-traded exchangetradedstudies companies, suffered from ofserious methodological weaknesses.¹ More recent providethey stronger evidence benefits. One reports that large U.S. firms trading on over-theover-the-counter counter markets realized highly significant positive abnormal returns when they were first made subject to continuous mandatory disclosure requirements in 1964.² Another study finds that mandatory disclosure is associated with a dramatic reduction in the volatility of stock returns.²¹ Moreover, non-U.S. nonU.S. studies point in the same direction, with several cross- jurisdictional jurisdictional comparisons identifying benefits of mandating disclosure.²² For example, one study concluded that more extensive disclosure requirements, coupled with stricter enforcement mechanisms, significantly lowered the cost of equity capital.²³ Another found that stricter securities laws within the EU, coupled with effective enforcement, were associated with improved liquidity.² Note, however, that empirical studies providing evidence of benefits (in terms of higher liquidity and lower cost of capital) do not measure mandatory disclosure’s direct and indirect costs , some of which are impossible to quantify.² Notwithstanding that, there is widespread support for the proposition that mandatory disclosure improves social welfare. oday, the debate is not so much on whether mandatory disclosure is justified as on on how broad its scope scope should should be (both in terms of addressees and contents) and how effective enforcement can be ensured in different institutional contexts.²
9.1.2.3 Te benefits of information Mandatory disclosure serves the principal, though not exclusive, purpose of enhancing price informativeness. Te familiar yet remarkable fact is that in modern markets the disparate traders—savvy traders—savvy stock pickers, arbitrageurs, algo-traders, algo-traders, short sellers,
and others— others—impound impound new information price extremely rapidly . As allows hinted,comthis not only enhances liquidity by attractinginto uninformed traders,rapidly. but also panies to use market prices as benchmarks of performance, to guide investment decisions, acquire other companies, and better compensate managers.² Similarly, ¹ See Christian Leuz and Peter D. Wysocki, Te Economics of Disclosure and Financial Reporting Regulation: Evidence and Suggestions for Future Research, Research, 54 J A R 525 (2016) (providing a rich survey of the theoretical and empirical literature). ² See Michael Greenstone, Paul Oyer, and Annette Vissing- Jorgensen, Jorgensen, Mandated Disclosure, Stock Returns and the 1964 Securities Acts Amendments , 121 Q Q J E 399 (2006). ²¹ See Allen Ferrell, Mandated Disclosure and Stock Returns: Evidence from the OverOver-thethe-Counter Counter Market , 36 J L S 213 (2007). ²² See Allen Ferrell, Ferrell, Te Case for Mandatory Disclosure in Securities Regulation Around the World World , 2 B B J B L 81, 88–99 88– 99 (2007) for a review. International Differences in the Cost ofR Equity Capital: Do Legal ²³ Luzi Hail and Christian Leuz,Matter? Institutions and Securities Regulation 44 J 44 A 485 (2006). ² Hans B. Christensen, Luzi Hail, and Christian Leuz, Capital- Market Market Effects of Securities Regulation: Prior Conditions, Implementation, and Enforcement , 29 R F S 2885 (2016). ² See e.g. ibid., at 2916. ² See Benjamin E. Hermalin and Michael S. Weisbach, Information Disclosure and Corporate Governance , 67 J F 195 (2012); Leuz and Wysocki, note 19. ² See Anat R. Admati and Paul Paul Pfleiderer, Forcing Firms to alk: Financial Disclosure Regulation and Externalities , 13 R F S 479 (2000); Ronald A. Dye, Mandatory versus Voluntary Disclosure: Te Cases of Real and Financial Externalities , 65 A R 1 (1990).
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lenders and other financial intermediaries make use of corporate disclosure to reduce monitoring costs and engage in profitable signaling.² In short, issuers, sophisticated traders, and public investors alike rely on well-informed well-informed public market prices. But mandatory public securities markets waysfor that beyond its positive disclosure impact on supports pricing. Disclosure also greases the in wheels t heextend the other legal strategies of corporate law.² law.² On the governance side, informed shareholders can better exercise their decision and appointment rights. Tus, the requirement in most of our jurisdictions that public issuers disclose the individual rather than the aggregate compensation of senior managers is almost certainly intended to counter a perceived agency problem rather than to enhance informational efficiency.³ On the regulatory side, information crucially affects the enforcement of rules and standards. o take an obvious example, shareholders might never detect dubious related-party related-party transactions if companies were not required to disclose them. Te enforcement role of mandatory disclosure is particularly clear in the U.S. As noted before,³¹ issuers must report transactions with insiders involving sums as low as $120,000—an $120,000—an amount that is seldom material to most issuers’ share prices but might well help identify any inclination by insiders to breach their duty of loyalty loyalty..
9.1.2.4 Te scope of disclosure disclosure requirements requirements All jurisdictions impose disclosure duties on companies with securities traded on domestic public trading markets and, notwithstanding academic policy proposals,³² none of them allows issuers unfettered discretion in the t he choice of their own disclosure regimes.³³ Jurisdictions differ, however, in the quantity and content of information that they require companies to disclose. More precisely, precisely, disclosure regimes can be distinguished along two dimensions: (1) the range of transactions and issuers that trigger disclosure obligations, and (2) the breadth of information requirements. Consider first the mandatory disclosure threshold for securities offerings. All of our core jurisdictions adjust the level of required disclosure—from disclosure—from minimal to extensive—
according to the number and presumed sophistication of the investors to whom the securities are sold and the amount of the offering, in an effort to balance the costs and benefits of disclosure. While details vary across jurisdictions, all distinguish between private and public offerings of securities on the one hand, and sophisticated and unsophisticated investors on the other. Few, if any, rules apply to private (or smaller) offers and to offers made to sophisticated investors, the definition of private (and smaller) offers and of sophisticated investors being broadly similar across jurisdictions, especially after the U.S. relaxed its ² See Anjan V. Takor, An Exploration of Competitive Signaling Equilibria with “Tird Party Party”” Information Production, Production, 37 J F 717 (1982); im S. Campbell and William A. Kracaw, Information Production, Market Signaling, and the Teory of Financial Intermediation, Intermediation , 35 J F F 863 (1980). ² See Chapter 2.4. ³ See generally Paul G. Mahoney, Mandatory Disclosure as a Solution to Agency Problems , 62 U C L R 1047, 1080 (1995). ³¹ See Chapter 6.2.1.1. ³² See, e.g. Stephen J. Choi and Andrew . Guzman, Portable Reciprocity: Rethinking the International Reach of Securities Regulation, Regulation, 71 S C L R 903 (1998); Romano, A, note 18. ³³ Cf. Luca Enriques Enriqu es and obias obias H. röger, röger, Issuer Choice in Europe , 67 C L L J 521, 529–33 529–33 (2008) (highlighting the limited scope of regulatory arbitrage for issuers of shares as opposed to debt issuers i ssuers within the European Union).
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rules for primary offers with the JOBS Act of 2012. However, EU jurisdictions have traditionally been much less concerned than the U.S. or Japan with avoiding resales to the public of securities issued on the basis of a prospectus exemption.³ exemption.³ disIn contrast to the regulation new varies issues more of securities, of continuing Te requirements requirements for public of issuers among the our scope core jurisdictions. closure EU requirements are narrow in scope: they have traditionally extended only to firms traded on regulated markets.³ Some of them, however, are now broader, reflecting the new trading environment in which exchanges compete with more lightly regulated providers of liquidity services: on-going on-going mandatory disclosure of material information³ has been extended to issuers having approved (or requested admission to) trading of their securities on a multilateral trading facility facility.³ .³ By contrast, as a matter of EU law, even a share offering successfully targeting many investors by a large firm does not trigger continuing disclosure obligations.³ Brazil also limits continuing disclosure obligations to firms that trade on regulated markets, but defines regulated markets broadly to encompass both formal exchanges and over-theover-the-counter counter markets.³ Disclosure requirements requirements in other non-EU non-EU jurisdictions are broader broader.. In Japan, public
companies subject continuing include notover-theonlythe-counter issuers of exchangelisted securities, buttoalso i ssuers ofdisclosure issuers securitiesduties registered with overcounter markets, issuers that have previously filed disclosure documents for issuance of securities with the regulator under the relevant statute, and companies that have had 1000 or more shareholders on the last day of any of the last five business years. Te U.S. requirements are similar to Japan’s.¹
9.1.2.5 Te contents contents of of disclosure disclosure Te content of mandatory disclosure, like its scope, is broadly similar across jurisdictions. Te registration statement or prospectus that accompanies new public issues of securities must describe them and the issuer in detail, as well as the intended use of the proceeds from their issuance. It must also include a comprehensive set of financial
³ See Moloney, Moloney, note 1, at 95– 95–6. 6. Japanese law tries to restrict resale of the securities issued by private placement to the general public by not extending the private placement exemption to securities that are likely to be resold: Art. 2(3)(ii)(a), (b)(2), and (c) Financial Instruments and Exchange Act; Arts. 1-4, 14, 1-51-5-2, 2, and 1-7 1-7 Cabinet Order for Implementation of Financial Instruments and Exchange Act. ³ Tat is still currently the case with periodic and ownership disclosures: see Art. 1 ransparency ransparency Directive. Art. 4(1)(21) Markets in Financial Instruments Directive, 2014 O.J. (L 173) 349, defines defi nes a “regulated market” as a multilateral system, which brings together or facilitates the bringing together of multiple third-party third-party buying and selling interests in financial instruments according to its rules and/ or systems, and which is authorized au thorized as such and functions regularly in accordance with the applicable rules set out in the Directive itself. ³ See Chapter 9.1.2.5. ³ Art. 17 Market Abuse Regulation, 2014 O.J. (L 173) 1. A “multilateral “multilateral trading facility” is a multilateral system, which brings together multiple third-party third-party buying and selling interests in financial instruments, in accordance with non-discretionary non- discretionary rules and in accordance with the applicable rules set out in the Markets in Financial Instruments Directive (Art. 4(1)(22)). ³ Italy is the only main EU jurisdiction where some of the “ad hoc” and periodic disclosure requirements also apply to such an issuer. See Art. 116 Consolidated Act on Financial Intermediation, in connection with Art. 2-2 2-2 Consob Regulation on Issuers. ³ Art. 22 Lei 6.385, de 7 de dezembro de 1976 (Brazil); Arts. 1º and 13 CVM Instruction No. No. 480 (2009); Art. 1º CVM Instruction No. 461 (2007). Art. 24(1) Financial Instruments and Exchange Act; Arts. 3 and 3-6(4) Cabinet Order for the Enforcement of the Financial Instruments and Exchange Act. ¹ §§ 12(g) and 15(d) 1934 Securities Exchange Act and Rule 12g- 1.
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statements prepared in accordance with applicable accounting standards, and extensively describe the nature and performance of an issuer’ issuer’ss business and the identity of its management and large shareholders. Notwithstanding these commonalities, however however, , our core jurisdictions differconsider in their commitment to disclosure as a tool to support securities markets. o see why, that information subject to disclosure falls into one of four categories. Te first is a basic description of the company, ranging from an inventory of its assets to an accurate statement of its current financial position and past cash flows. Tis is the hard, “benchmark”” data that would allow an investor to value the firm as a going concern if “benchmark the future were exactly like the past. All jurisdictions require substantial substantial disclosure of such hard data. However However,, jurisdictions still differ with respect to the detail they require, as accounting methods have yet to be fully harmonized or implemented in uniform ways.² In addition, the U.S. and the EU now differ with respect to quarterly reporting. While U.S. securities regulation mandates quarterly reports, which are a key feature of the U.S. disclosure system, they are no longer mandatory in the EU,³ on the basis that they are costly for small and medium sizediscourage firms to produce andinvestment.” that they are a re said to “encourage short-term short-term performance and long-term long-term A second category of disclosure disclosure mandated in some jurisdictions encompasses encompasses “soft, “soft,”” “projective,” or “forward-looking” “forward-looking” information. Tis includes management’s predictions about likely price changes in each of the multiple markets in which the firm operates (such as product, supply, supply, capital, and labor markets), as well as management’s best estimates of likely changes in demand for the firm firm’’s products, including any new products or cost-saving cost-saving technologies that the firm plans to introduce. Investors may use this “scenario” information better to estimate future changes in a firm’s cash flows. Such information is thus critical for valuing firms with conventional financial methodologies such as discounted cash-flow cash-flow analysis. Despite the importance of projective data, forward-looking forward-looking information accounts for only a tiny fraction of mandated disclosure in our core jurisdictions.
Te U.S. pioneered the reporting of forward requiring that reports contain a “Management Discussion andlooking Analysisinformation of FinancialbyCondition and Results of Operations” (“MD&A”), and encouraging (but not requiring) companies to disclose forward-looking forward-looking financial projections by shielding such projections from securities litigation. Japan followed suit by introducing MD&A reporting in 2003. Te EU also mandates the disclosure of soft and projective information, but in a very ver y ² See Section 9.1.2.6. ³ See Art. 1(5) Directive Directive 2013/50/ 2013/50/EU, EU, 2013 O.J. (L 294) 13). Member states may still impose quarterly reports so long as, in short, they deem it necessary: ibid., Art. 1(2)(b). Ibid., preamble (4). See e.g. Vivien Beattie, Bill McInnes, and Stella Fearnley, A Methodology for Analysing and Evaluating Narratives Narratives in Annual Reports: A Comprehensive Descriptive Profile and Metrics for Disclosure Quality Attributes , 28 A F 205, 213 (2004). Regulation S-K, S-K, Item 303. Since 1980, the MD&A report has to include an extensive discussion of “known trends or uncertainties” that might have a favorable or unfavorable impact on future financial performance. 1933 Securities Act, Rule 175 (adopted in 1979). Cabinet Office Ordinance on Disclosure of Corporate Affairs, Form 2 (Precautions for Recording (36)) and Form 3-2 3-2 (Precautions for Recording (16)) (as amended in 2014). Brazil introduced MD&A-style MD&A-style reporting in 2009, but the scope of required forward-looking forward-looking information is comparatively circumscribed. Te disclosure of estimates and projections remains optional. Art. 22 and items 10 and 11 of Annex 24 CVM Instruction No. 480 (2009).
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generic (and therefore not particularly prescriptive) way. As a matter of practice, larger issuers have since long voluntarily offered more forward-looking information than was strictly required. required. Te U.S., then, has been leader disclosure of soft and future-oriented futureoriented information, the volume of the which has in in requiring fact increased in recent years.¹ Despite a lack of similarly strong requirements, an increase in volume can also be observed in other core jurisdi jur isdictio ctions ns as well. well.² ² A thir thirdd cate category gory of mand mandatory atory disc disclosu losure re rel relates ates dire directly ctly to go govern vernance ance issu issues es and agency problems. As we have seen in previous chapters, this category includes information informat ion about top management compensation, as well as information about the corporate value that finds its way to insiders and controlling shareholders.³ It also includes information that is ancillary to informed voting by shareholders, an area which is highly litigationintensive in Germany, where courts take voting-related voting-related disclosures very seriously, and well-developed, welldeveloped, thanks to federal regulation of proxy voting and best practices, respectively in the U.S. and the UK. Finally, a fourth category of mandatory disclosure is “event-related” “event-related” disclosure— that “material” or “priceprice sensitive sensitive” ” information the on issuer likelyand to haveis, annew impact on the market of securities. Here, about the U.S., the that one ishand, European and Brazilian regulations, on the other, follow two very different approaches. In the U.S., there is no obligation to disclose new information per se, unless it falls within one of the many pre-identified pre-identified mandated disclosure items, or unless the company has in the past made a public statement that the new event now makes misleading, in which case, according to some courts, a duty to update exists. With a view to curbing insider trading and fostering equal access to information for all market participants, EU and Brazilian laws instead require the immediate disclosure of any new price sensitive information.
market Arts. report 4(2)(c) “principal and 5(4) risksransparency and ransparency uncertainties Directive that they merely face” require on a yearly that firms and half-yearly halftraded yearly on abasis. regulated
See Gary K. Meek, Clare B. Roberts, Roberts, and Sidney J. Gray, Gray, Factors Influencing Voluntary Annual Report Disclosures by U.S., U.K. and Continental European Multinational Corporations , 26 J I I B S 555, 558 (1995). ¹ See Marilyn F. F. Johnson, Ron Kasznik, and Karen K. Nelson, Te Impact of Securities Litigation Reform on the Disclosure of Forward-Looking Forward- Looking Information by High echnology Firms , 39 J A R 297 (2001) (finding a significant increase in both the frequency of firms issuing forecasts and the mean number of forecasts issued following the adoption of the safe harbor rule). ² See e.g. for the UK, Paul L. Davies and Sarah Worthington, Worthington, G D D P M C L 774–5 774–5 (9th edn., 2012). In Japan, it has been be en customary for listed corporations to disclose their earnings forecast for the next term. See http:// http://www.jpx.co.jp/ www.jpx.co.jp/equities/ equities/listedlisted-co/ co/ format/forecast/ format/ forecast/index.html index.html (in (in Japanese). ³ See Chapter 6.2.1.1. See e.g. Ulrick Noack and Dirk Zetzsche, Zetzsche, Corporate Governance Reform in Germany: Te Second Decade , 15 E B L L R 1033, 1044 (2005). See Loss et al., note 1, 700– 700–811; 811; Davies and Worthington, note 52, 406–9. 406–9. Insider rading, rading, Selective Select ive Disclosure, Disclos ure, and Prompt Disclosure: A Comparative See, 22 e.g.U e.g. Marc I. Steinberg, Steinberg,Insider Analysis P P J I E L L 635, 657– 657–88 (2001). See Form 88-K K (17 CFR 249.308). 10b-5 , See Donald C. Langevoort and G. G. Mitu Gulati, Gulati, Te Muddled Duty to Disclose under Rule 10b-5 57 V L R 1639, 1664–71 1664–71 (2004). See Art. 17 Market Abuse Regulation; Art. 157, § 4º Lei das Sociedades por Ações; Art. 22, § 1º, VI Lei 6.385, de 7 de dezembro de 1976; Art. 2 CVM Instruction 358 (2002) (Brazil). o be sure, U.S. stock exchanges impose a similar obligation, but they seldom enforce it. See Steinberg, note 56, at 657. Japanese law lies somewhere in-between, in-between, as it itemizes information to be disclosed,
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However,, the difference in practical outcomes of the two regimes may not be as great as it However looks. On the one hand, the granular and ever-expanding ever-expanding itemized disclosure requireme requirements nts in the U.S. combine with propro-disclosure disclosure practices (both to avoid the risks of liability under the “duty to update” doctrine and to avoid the wrath of analysts) to ensure that U.S. issuers make public plenty of “ad hoc” information without waiting for the next periodic disclosure. On the other hand, a standard—as in the EU and a nd Brazil—that Brazil—that relies on information having the character of “price-sensitivity” “price-sensitivity” leaves scope for discretion in deciding when a piece of information is ripe for disclosure (it must be “o “off a pr preci ecise se nature” nature” in the EU¹) and material (what does it mean that it “may have have a meaningful impact on share prices” under Brazilian law?). In addition, in both the EU and in Brazil, disclosure may be delayed if it would prejudice a “legitimate interest” of the company.² Tat said, the European Court of Justice has so far interpreted the concept of “inside information information”” broadly, broadly, and lawmakers followed the Court’s lead in reforming the market abuse relevant disclosure rules in 2014.³ Even an “intermediate step in a protracted process,” such as the commenceme commencement nt of merger negotiations, is to be disclosed if it is itself of a precise nature and price sensitive.
9.1.2.6 Accounting methods Financial reporting regimes—the regimes—the provision of information about a firm’s past and current financial position—have position—have evolved from two very different models. One, the “continental European” model, originated in seventeenth century France with the goals of protecting creditors and facilitating the taxation of firms. Te other, the “Anglo- American” American” model, developed in the UK during the nineteenth century with the goal of enhancing the ability of equity holders to monitor their investments. Put differently,, the interests differently i nterests of creditors, insiders, and the state strongly st rongly influenced a continental European model of accounting, while the interests of equity holders informed the Anglo- American American accounting model. model. Tese disparate interests point toward different valuation methods. raditionally, valuation has looked either to historical cost, which captures the conservative thrust of continental accounting, or to “fair market value,” which tracks the interests of equity
holders. With due exceptions and qualifications, both accounting methods report like U.S. law, but also requires disclosure of any event e vent with an impact higher than pre-set pre-set quantitative thresholds (Art. 24-5 24-5 Financial Instruments and Exchange Act and Art. 19 Cabinet Office Ordinance on Disclosure of Corporate Affairs). See James D. Cox, Robert W. W. Hillman, and Donald C. Langevoort, S R: R: C M 728 (7th edn., 2013); Steinberg, note 56, at 659. ¹ Although the Court of Justice of the European Union interpreted the term “precise” “precise” broadly, broadly, holding that information can be precise even if it is impossible to tell whether it will impact prices upwards or downwards. See Case C-628/13, Lafonta v. AMF ECLI:EU:C:2015:162. ECLI:EU:C:2015:162. ² Art. 157, § 5º Lei das Sociedades por Ações and Art. 6 CVM Instruction 358 (2002); Art. 17(4)(a) Market Abuse Regulation (to be sure, Art. 17(4)(b) makes this exemption’s scope narrower by adding that delay is not permitted if it is likely to mislead the public). ³ SeeAbuse CaseRegulation. C-19/11 C-19/ 11 Geltl v Daimler ECLI:EU:C:2012:397; recitals (16) and (17) and Art. 7 Market Art. 7(3) Market Abuse Abuse Regulation. See Bruce Mackenzie et al., I I A I I F R S S 3–4 3– 4 (2014). Indeed, even today the U.S. and UK distinguish between financial and tax accounting, accounting, while most European jurisdictions employ the same accounting method for both tax and financial reporting purposes. See e.g. Martin Gelter and Zehra G. Kavame Eroglu, Whose rojan Horse? Te Dynamics of Resistance against IFRS , 36 U P J I L 89, 144–55 (2014). 144–
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assets on the balance sheet at the lower of historical cost or market value. However, traditional continental accounting makes much broader use of historical cost, which yields easily verifiable data but also allows firms to defer profit recognition over time (which in turn may help conceal worsened performance), and, in inflationary periods, undervalues non-financial non-financial assets. By contrast, the fair value approach relies on current market prices as its metric (especially for financial assets), and is therefore more likely to correlate with the stock market valuation of firms. However, if financial assets lack an active market, fair value accounting requires that they be marked to a model of what their market value “should” be—a be—a highly discretionary exercise which may well lead to inconsistent, if not misleading, results. Moreover, fair value accounting increases the volatility of financial reporting and may not reflect the going-concern value of firm-specific firm-specific assets.¹ Indeed, the financial crisis has dramatically highlighted the propro-cyclical cyclical effects of marking assets to market when market prices are purportedly “distr “distressed, essed,”” and therefore below the normal-times normal-times hold-tohold-to-maturity maturity value of complex financial assets.² Nevertheless the divergence between the Continental and Anglo- American American approaches should exaggerated. As indicated above, both models havetoward alwaysaccounting used historical costnot to be value non-financial non-financial assets.³ In addition, accountants are conservative by profession, which should discourage them from overvaluing financial assets under fair value accounting. Finally, EU harmonization, coupled with the growing importance of global capital markets, has prompted continental European jurisdictions to accept a wider role for fair value, especially with the EU’ss endorsement of International Financial Reporting Standards, which draw heavily EU’ from the U.S./UK U.S./UK approach. Even Germany, which had traditionally favored a “precautionary approach” (Vorsichtsprinzip) to the valuation of balance-sheet items, edged toward accepting the fair value model before the financial crisis erupted. As a result, financial reporting methodologies converged throughout the 1990s and the 2000s. See Joanne M. Flood, I I A G G A A P 978–81 978–81 (2014). See Alexander Bleck and Xuewen Liu, Market ranspar ransparency ency and the Accounting Regime , 45
J A A R R 229 (2007) (historical costs give give management a veil veil under which they can potentially mask a firm’s true economic performance). ”Fair value” value” is defined as the price for which an asset or a liability can be exchanged between willing and knowledgeable parties in an arm’s arm’s length transaction. Note that empirical evidence on the share price relevance of fair value accounting is mixed. See e.g. Jochen Zimmermann and Jörg-Richard Jörg-Richard Werner, W erner, Fair Value Accounting under IAS/IFRS: IAS/IFRS: Concepts, Reasons, Criticisms , in I A 127 (Greg (Greg N. Gregoriou and Mahamed Mahamed Gaber eds., 2006). See FAS 157: for the Financial Accounting Accounting Standards Board, a fair value measurement is based on market data reporting (observable inputs) and, to the extent market data is unavailable, on the best be st information available (unobservable inputs). ¹ See Guillaume Plantin, Haresh Sapra, and Hyun Song Shin, Marking Marking-toto- Market: Market: Pan Panacea acea or Pandora’s Box , 46 J A R 435 (2008) (marking to market is especially problematic when assets are long-lived, illiquid, and senior). ² See Franklin Allen and Elena Carletti, Mark Mark-toto- Market Market Accounting and Liquidity Pricing , 45 J A E 358 (2008); International Monetary Fund, Global Financial Stability Report 58–66 Plantin 58–66 (2008). et al., note 71. See also International ³ See e.g. Janice Loftus, Loftus, A A Fair Go to Fair Fair Value , in Gregoriou and Gaber, note 69, at 41. See e.g. Sugata Roychowdhuroy Roychowdhuroy and Ross L. Watts, Watts, Asymmetric Asymmetric imeliness imeliness of Earnings, Marketto-Book toBook and Conservatism in Financial Earnings , 44 J A E 2 (2007). See Gelter and Kavame Eroglu, Eroglu, note 66, 148. See Werner F. Ebke, Rechnungslegung und Publizität in europarechtlicher und rechtsvergleichender Sicht , in I R U? 67 (Werner F. F. Ebke, Claus Luttermann, and Stanley Siegel eds., 2007).
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Since the crisis, however, criticism of fair value accounting has increased and Germany has backtracked from the idea of imposing it, leaving companies a free choice on the matter. At the same time, U.S. securities regulators have also backtracked from the idea of allowing U.S. companies to use International Financial Reporting Standards (IFRS), which would have greatly enhanced international convergence. All in all, the extent to which accounts accounts drawn up according according to IFRS are comparable to U.S. Generally Accepted Accounting Principles (GAAP) accounts is still limited and varies with a number of factors, including industry, industry, legal origins, and enforcemen enforcementt intensity. And even similar accounting methods do not necessarily imply uniform accounting practices. Institutional differences in ownership regimes and regulatory structures will remain a source of divergence.¹ For example, U.S. GAAP are said to rely on detailed rules to reduce the risk of shareholder litigation alleging faulty accounting—aa concern that is much less salient elsewhere.² Conversely, accounting— Conversely, jurisdictions with low litigation risk, such as European ones, have embraced the principle-oriented principle-oriented IFRS, which leave more room for managerial discretion. Ironically, Ironically, flexibility may help explain the global popularity of IFRS, even though flexibility reduces the comparability of financial statements between and within IFRS jurisdictions.³ But comparability across or within jurisdictions can also be difficult under rule-oriented rule-oriented accounting systems, insofar as rules cannot anticipate all cases and must be supplemented by standards anyway.
9.1.2.7 Protecting exit rights: making making commitments credible Te impact of securities regulation on market behavior would be negligible if issuers could engage in transactions allowing them to escape the regime while retaining a broad shareholder base. In other words, easy exit would encourage firms to bait and switch—to switch—to attract investors with the implicit promise of full disclosure and high liquidity,, and then “go dark” liquidity dark” by abandoning their status as public companies. But buyers would discount that possibility and refuse to pay the “premium premium”” otherwise associa ssociated with securities regulation. Tat is the reason why all jurisdictions have rules in
place that make it harder for issuers to free themselves of such a regime: in other words, restrictive exit rules are a key component of securities regulation. Tis is, howeve howeverr, an area of considerable divergence across jurisdictions. Some of them establish objective criteria for allowing companies to cease complying with public reporting obligations. Sometimes, these criteria are quantitative. For example, U.S., Italian, and Japanese securities laws cease to require disclosures when
See Gelter and Kavame Eroglu, note 66, 159–63. 159–63. See Bilanzrechtsmodernisierungsgesetz Bilanzrechtsmodernisierungsgesetz (BilMoG) (BilMoG) (2009). See Gelter and Kavame Eroglu, note 66, 103–4. 103–4. See Mary E. E. Barth et al., Are al., Are IFRSIFRS-Based Based and US GAAP-Based GAAP-Based Accounting Amounts Comparable?
54¹J A Hope, E (2012). and Hervé Stolowy, Differences Between Yuan Ding, Ole-Christian Ole-Christian Tomas68Jeanjean, Domestic Accounting Standards and IAS: Measuremen Measurement,t, Determinants and Implications , 26 J A P P P 26 (2007). ² See e.g. Gelter and Kavame Eroglu, note 66, 124. ³ See Christopher Nobes and Robert Parker Parker,, C C I A A ch. 7 (12th edn., 2012). See William W. Bratton, Enron, Sarbanes-Oxley Sarbanes-Oxley and Accounting: Rules Versus Principles Versus Rents , 48 V L R 1023 (2003). See Rock, Rock, note 14.
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the number of a company’s company’s shareholders drops below given thresholds. By contrast, in other European jurisdictions and Brazil, disclosure requirements cease to apply as soon as an issuer’s securities are no longer admitted to trading on a regulated market (or trading facility). Public companies that are exchange-listed must also comply with the rules governing voluntary delisting. In many jurisdictions, the law specifically empowers supervisory authorities to oppose delisting applications when it is in the interests of investors to do so or laws are violated. Tis public law la w approach reinforces the effectiveness effectiveness of delisting-related delistingrelated company law requireme requirements, nts, which some jurisdictions deploy. deploy. So, for instance, the NYSE requires a board resolution and notice, while the Main Market of the London Stock Exchange requires supermajority shareholder approval.¹ After lengthy debate, Germany now places the delisting decision in the hands of corporate corporate management,² but imposes an exit right for (minority) shareholders at a fair price.³ Brazil displays the strictest regime: public companies wishing to go private must launch a mandatory bid at a “fair price” to the remaining public shareholders, as well as obtain either the acceptance of the bid or the express consent to deregistration from shareholders comprising two-thirds two-thirds of the company’s free float. While the exact rules are more complex, that is the case when the number of a U.S. issuer’s shareholders falls below 300 (or, in the case of banks, 1200) or, in Japan, an issuer’s issuer’s legal capital drops below 500 million yen. See §§ 12(g)(4) and 15(d) 1934 19 34 Securities Exchange Act (U.S.) and Art. 24(1) Financial Instruments and Exchange Act and Art. 3–6(1) 3–6(1) Cabinet Order for the Enforcement of the Financial Instruments and Exchange Act (Japan). ( Japan). In Italy, Italy, crossing the relevant thresholds downwards allows companies to go dark, i.e. to stop complying with “ad hoc” and periodic reporting obligations; other disclosure obligations cease to apply when securities are no longer traded on a regulated market or trading facility, as in the rest of Europe. See e.g. Moloney, Moloney, note 1, at 133– 133–4. 4. Delisting may also be involuntary, involuntary, for failure to meet listing standards or rule violations. See Shinhua Liu, Te Impact of Involuntary Foreign Delistings: An Empirical Analysis , 10 J E M 22 (2005) (identifying 103 foreign firm delistings from U.S. markets between 1990 and 2003, 20 03, 100 being threshold-related and three due to failure to meet other non-numerical non- numerical standards). See Art. 64 Consolidated Law on Financial Intermediation (Italy); Börsengesetz § 39(2) (Germany). Japanese law is unclear: although Art. 127 of FIEA grants the JFSA the power to order re-listing relisting when the stock exchange delists deli sts shares of a corporation “in violation of the exchange rules,”
there is no provision in the okyo okyo Stock Exchange listing rules spelling out the conditions for voluntary delisting. Te practice of the okyo Stock Exchange, however, is said to be restrictive: corporations that have been permitted to delist voluntarily were those that were also cross-listed cross- listed on other exchange(s). NYSE Listed Company Manual § 806.00. It should be noted that previously it was far more difficult to delist, with the longstanding rule requiring a vote of two-thirds two- thirds of the shareholders in favor and not more than 10 percent against. Rock, note 14, at 683. Te change to a rule permitting easier exit was in response to pressure from foreign private issuers who wished to leave the NYSE in the wake of Sarbanes-Oxley. Sarbanes-Oxley. ¹ FCA Listing Listing Rule Rule 5.2.5. ² Te Frosta decision decision (BGH, Oct. 8, 2013—II 2013—II ZB 26/12, 26/12, NJW 2014, 146) thus reversed the earlier Macrotron earlier Macrotron decision decision (BGH, Nov. 25, 2002—II 2002— II ZR 133/01, 133/01, BGHZ 153, 47), which required shareholder approval. Tis exit right was reinstalled in late in response to commonly perceived in minority³protection following Frosta (note 93).2015 Revised § 39 Börsengesetz now requiresgaps an exit right at the weighted average market price of the previous six months. For details, see Walter Bayer, Delisting: Korrektur der Frosta-Rechtsprechung Frosta-Rechtsprechung durch den Gesetzgeber , N Z G 1169 (2015). Art. 4º, § 4º Lei das Sociedades por Ações; Art. 16 CVM Instruction No. 361 (2002). If the controlling shareholder or the company succeeds in acquiring more than two-thirds two-thirds of any given class of shares, CVM regulations require the offer to remain open to the remaining shareholders for three months at the same price—a price—a mechanism that effectively reduces the pressure to tender. Art. 10, § 2 CVM Instruction No. 361 (2002).
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9.1.3 Governance and regulatory strategies In addition to mandating disclosure, lawmakers and stock exchanges also impose “quality” restrictions on companies’ access to securities markets and restrictions on market participants’ trading. Bothwhich are meant to curb behavior, as misleading statements or price manipulation, may alienate investors fromsuch securities markets and thereby hinder market liquidity.
9.1.3.1 Quality controls In general terms, the rationale for quality controls relies on two premises. First, that fraud perpetrated at a publicly traded firm, unlike at a closely held one, may have a market-wide marketwide impact: that is, it may raise the cost of capital for all companies in the market. Te second premise is that better governance reduces the risk of fraud. Quality controls can take the form of minimum corporate governance requirements, trusteeship intervention and entry restrictions based on proxies for the prospective issuer’s quality.. Such controls can be public (when they are the product of laws, regulations, or quality public agents’ decisions) or semi-private: semi-private: the latter is the case with stock exchangedevised listing or admission to trading requirements. 9.1.3.1.1 Governance strategies
In prior chapters, we have provided examples of corporate governance quality standards, such as board independence, the three-committee three-committee structure, supermajority requirements, requirem ents, and so on, that policymakers (and stock exchanges) impose on publicly traded companies. Here, we briefly focus on a variation of the trusteeship strategy, the screening by regulators or stock exchanges of companies eligible for public trading. When the screening is performed by a public authority authority,, this is known as “merit regulation.” Many U.S. states permit state regulators to refuse approval of an issue of securities that fails to conform to certain guidelines or appears—to appears—to the officials—to officials—to be particularly without economic merit. In practice, most securities offerings are nowrisky exempt fromoffsetting state regulators’ review. EU law also allows listing authorities (which may be securities regulators as well as
stock exchanges) to screen applications for exchange listings in the interest of protecting the investing public. Tus, the UK’s Financial Financial Services Servi ces and Markets Act 2000 authorizes the UK Listing Authority to refuse a listing application that it considers consi ders detrimental to the Of course, quality controls also exist that are purely private, such as when the intermediary setting up a non-regulated non-regulated market (e.g. a multilateral trading facility that does not require regulators’ approval of its admission to trading rules) provides for specific quality requirements: think of Italy’s Alternative Investment Market or Euronext’s Alternext, both specializing in small and medium enterprises, but still providing for some minimal initial liquidity thresholds. See Borsa Italiana, AIM I/M I/ M A A C: R C 33 (2016) (20 16) (available at ); only -privatesee because they are subject en/listings/ to securities regulators’ approval: can both informally make their approval of listing rules conditional upon the inclusion of further requirements and reject attempts at getting rid of existing quality controls. It is therefore hard to tell to what extent listing rules are really a form of self-regulation self- regulation or rather public regulations in disguise. See Chapters 3.1, 3.2., 3.3, 3.4, 6.2.3, and 7.3.1. Section 18, Securities Act Act 1933, as amended (15 U.S. Code § 77r). See Art. 11 Consolidated Admission and Reporting Directive, Directive, 2001 O.J. (L 184) 1, applicable to “official” listed segments.
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interests of investors.¹ Similarly, the Italian authority may oppose exchange listings that, based on its own information, would be against its supervisory goal of ensuring “market transparency,, the orderly conduct transparency cond uct of trading trad ing and investor invest or protection.”¹¹ However, However, qualitycontrol provisions have fallen fall en from favor among European policymakers as well: the t he powers we have described are seldom, if ever, used.¹² 9.1.3.1.2 Quality checks upon entering public markets
In addition to investor protections based on mandatory mandator y disclosure for securities offerings and merit regulation, our core jurisdictions provide for minimum quality rules, whether self-regulatory self-regulatory or public, to screen issuers entering the public market. “Official” or “first-tier” “first-tier” markets typically mandate a minimum size for corporate issuers (whether in terms of assets or market capitalization), a minimum float and a minimum number of securities holders in order to ensure quality mainly in terms of sufficient liquidity. Some of them also screen prospective listed companies based on past profitability, which is, intuitively, quite a rough indicator of quality. For example, for its so-called so-called first section, the okyo Stock Exchange requires at least 20,000 unit shares, billioncalculated yen in market 2,200 shareholders, and a impose high minimum pre-tax pretax 4profit over capitalization, a two-year two-year period.¹³ Other exchanges similar, although mostly less rigorous, requirements.¹ requirements.¹
9.1.3.2 Market manipulation (securities fraud) and insider trading restrictions Finally, our jurisdictions use regulatory strategies (rules and standards) to Finally, t o curb abusive practices on securities markets. In particular, particular, all of them ban the dissemination of false or misleading statements about an issuer, whether by the issuer itself or by third parties¹ (known as market manipulation in Europe, and securities fraud in the t he U.S.),¹ and provide for some restrictions on trades by those who are in possession of inside information about an issuer (insider trading).
Financial Services and and Markets Act 2000 (UK) section 75(5). ¹¹ Art. 64 Consolidated Law on Financial Financial Intermediation (Italy). (Italy). ¹² See also Moloney, Moloney, note 1, 171– 171–2. 2. In Brazil, quality controls are similarly exceptional; they only apply when a company is constituted by public subscription, a practice that is effectively unheard of in modern business practice: Art. 82, § 2º Lei das Sociedades por Ações. ¹³ okyo Stock Exchange, Securities Listing Regulations, Rule 308. ¹ For NYSE’s NYSE’s requirements, which are based on prepre-tax tax corporate income ($10 million in the aggregate for the previous three years) or, failing that, on a “V “Valuation/ aluation/Revenue est” est” or an “Assets and Equity est, est,”” see New York York Stock Exchange Listed Company Manual Section 102.01. For a company listing in connection with an IPO, the NYSE also requires a minimum of 400 shareholders with 100 shares each and a float of at least 1.1 million publicly held hel d shares with a value of $40 million. European listing rules require a minimum float of usually 25 percent of the subscribed capital (e.g. for France, Rule 6702/1 6702/1 Euronext Rulebook, Harmonised Rules), a minimum (and usually waivable) foreseeable market capitalization (e.g. SpA) €40 million in Italy, of Art. 2.2.2 Listing Rules for the markets set up and managed by Borsa Italiana and a minimum three years of prior business (e.g. for Germany and the UK, see § 3 Börsenzulassungsverordnung; § 6.1.7 Listing Rules). Te São Paulo Stock Exchange requires a minimum free float of 25 percent in its premium corporate governance listing segments, but otherwise imposes no limitations in terms of firm size, number of shareholders, or profitability. ¹ Similarly, trading techniques that are aimed to move market prices so as to profit from the artificial change in price thus obtained are prohibited (so-called (so- called trade-based trade-based manipulation). ¹ See Art. 1 Market Abuse Regulation, 2014 O.J. (L 173) 1 (EU); 17 C.F.R. C.F.R. § 240.10b-5 240.10b-5 (U.S.); CVM Instruction No. 8 (1979) (Brazil); Arts. 158– 9 Financial Instruments and Exchange Act (Japan). ( Japan).
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Te rationale for bans on market manipulation is intuitive: securities markets would be more akin to casinos if issuers were free to lie about themselves or third parties could spread lies about issuers with impunity. In fact, such bans adapt the inveterate common or private law on fraud to the specific features of securities markets, with the main purpose of easing enforcement and deterring such forms of misbehavior. In so doing, the bans reinforce the credibility of individual issuers’ disclosures and thereby contribute to lowering their cost of capital. Only slightly less intuitive is why jurisdictions should prevent those in possession of insider information from trading on it. We We have already seen in Chapter 6 that one rationale is to protect corporations from expropriation by their insiders: a manager who trades on inside information pertaining to the company is effectively misappropriating a valuable asset of the firm.¹ However How ever,, most of our jurisdictions have moved away from the idea that t hat insider tradtrad ing presupposes the misappropriation of a corporate asset (or, similarly, the violation of a fiduciary duty). Rather, Rather, the explicit underlying rationale has more to do with the concept of market egalitarianism—that is, the idea that those who trade in securities on a public market should be able to rely on the fact that they are informationally on an equal footing with all other traders, because those with inside information are barred from trading. Tis rationale has made its way into European legislation and case law and is reflected in a broad-sweeping broad-sweeping ban on trading by any person possessing insider information, irrespective of that person person’’s relationship with the company and how the information was acquired.¹ It has traditionally also been advocated by the U.S. SEC, yet so far without success.¹ An economically economically better grounded justification for a broad-scope broad-scope insider trading ban is that it is beneficial to market liquidity: in markets where liquidity is ensured by market makers, the perception that they may systemically trade with insiders with superior information would lead them to increase bid-ask bid-ask spreads.¹¹ Similarly, in markets where participants trade with each other via brokers, the ban will reassure informed traders that their investments in acquiring, processing, and acting upon new information about issuers may be rewarded: like market makers, if informed traders had to compete with insiders in the trading of securities, they would systematically lose. ¹¹¹
9.2 Securities Law Enforcement As hinted in the introduction to this chapter, a key component of an effective securities law regime is an enforcement apparatus making up for the serious collective action problems affecting investors in public markets. Our core jurisdictions rely on all of the enforcement modalities outlined in Chapter 2—namely, 2—namely, public and private enforcement and gatekeeper control—for control—for this purpose.¹¹² Yet Yet jurisdictions differ dramatically ¹ See Chapter 6.2.4. ¹ See Art. 8 and Preamble 24, Market Abuse Regulation. See also ECJ, Case C-45/ C-45/08 08 Spector Photo Group [2009] Group [2009] E.C.R. I-12073. I-12073. For the scope of insider trading prohibitions in the U.S., Brazil, and Japan see Chapter 6.2.4. Newman, 733 F ¹ See Dirks v SEC , 103 S C R 3255 (1983); U.S. v. Newman, R 3d 438 (2d Cir. 2014). ¹¹ See Chapter 6.2.4. ¹¹¹ See Zohar Goshen and Gideon Parchomovsky, On Insider rading, Markets and “Negative” Property Rights in Information Information 87 87 V L R 1230 (2001). ¹¹² See Chapter 2.3.2.
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in the mix of enforcement modes they employ, employ, as well as in the severity and intensity of enforcement.
9.2.1 Public enforcement Public enforcement is initiated by government actors (usually, in this context, securities regulators and public prosecutors) or private institutions with quasi-governmental quasi-governmental powers such as self-regulatory self-regulatory bodies and stock exchanges.¹¹³ All of our major jurisdictions devote significant resources to public enforcement of securities laws. wo resource-based resource-based measures provide a rough indication of the intensity of enforcement by market regulatory authorities in our major jurisdictions. Looking at public enforcement staff relative to population, the UK and the U.S. stand out: these two jurisdictions devote at least three times the staff to public securities enforcement (adjusted for population) as any one of our remaining five jurisdictions.¹¹ Enforcement budgets adjusted adjusted for GDP yield much the same result, with the budgets of the UK and U.S. exceeding those of Brazil, France, Germany, and Japan by ratios of three or four.¹¹ Despite the similarity in inputs, the balance between formal and informal public enforcement outputs in the U.S. and the UK differs significantly. Historically, U.S. administrative and criminal authorities bring many more formal enforcement enforcement actions than their UK counterparts. UK authorities have traditionally appeared to accomplish much informally, by raising their eyebrow or by engaging with issuers without pursuing cases against them.¹¹ In the wake of the crisis, however, even the UK has been putting considerably more weight on formal public enforcement.¹¹ Tese results do not include many aspects of public enforcement, such as criminal prosecutions and enforcement undertaken by exchanges. But here, too, the U.S. public enforcement machinery seems to have more firepower, having imposed “real” prison sentences on top executives or dominant shareholders in high profile cases such as Enron, WorldCom WorldCom,, and yco yco International Internat ional and, a nd, more recently recent ly,, on a number of o f investment managers and corporate directors for insider trading.¹¹ European jurisdictions
¹¹³ For a more elaborated definition of public enforcement, see Chapter 2.3.2.1. Of course, one
could equally qualify self-regulatory self-regulatory bodies and stock exchanges as private enforcers, due to their hybrid nature. ¹¹ Howell E. Jackson and Mark J. Roe, Public and Private Enforcement of Securities Regulation: Resource-Based ResourceBased Evidence , 93 J F E 207, able 2 (2009), also showing that, by comparison, France, Italy, Germany, and Japan have roughly the same population-adjusted population-adjusted enforcement staff; data are from the mid-2000s. mid- 2000s. Brazil has the lowest population-adjusted population- adjusted enforcement staff of our core jurisdictions. Note that the evidence consolidates issuer behavior and market trading enforcement. ¹¹ Ibid. (note that the data is not adjusted for per capita market capitalization). Te exception is Italy,, where the enforcement budget is closer to U.S.–UK levels, but staffing remains far below them. Italy ¹¹ See Jackson and Roe, note 114, 235; John Armour, Enforcement Strategies in UK Corporate Governance: A Roadmap and Empirical Assessment , in R C L: E H D D. P 71, 87–92 87– 92 (John Armour and Jennifer Payne eds., 2009). ¹¹ See Eilís Ferran and Look Chan Ho, P C C F L L 413 (2nd edn., 2014). See also Brooke Masters, Don Don’t’t Hold Your Breath Waiting Waiting for a esco Fraud Case Cas e , F F , 1–2 1–2 November November 2014 (London), at 16 (reporting a handful of cases of public enforcement against issuers’ fraudulent disclosures, their mixed judicial outcome and one important reason why they are harder to win than in the U.S., i.e. the difficulty of “cut[ting] co-operation co- operation deals with lower level conspirators”). ¹¹ See e.g. ebsy Paul, Friends with Benefits: Analyzing the Implications of United States v. Newman for the Future Future of Insider rading , 5 A U B L L R 109, 124 (2015). (20 15).
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and Brazil are more lenient when it comes to punishing securities fraud,¹¹ while in Japan, public enforcemen enforcementt relies mainly (and increasingly) on administrative fines. Moreover, as discussed in Chapter 6, higher levels of U.S. private enforcement go hand-inhandin-hand hand with higher levels of public enforcement.¹² Vibrant private litigation prompts enforcers to be more acti veenforcers.¹²¹ active themselves while, conversely, conversely, private litigation feedspublic on evidence gathered by public
9.2.2 Private enforcement Te chief private enforcement mechanism for investor protection consists of investor lawsuits for damages, brought chiefly against issuing companies. Less frequently, the defendants are audit firms and other public “speakers,” such as financial analysts and their employers, whose credibility can materially influence market prices. Te law in all of our major jurisdictions imposes negligence-based liability when it mandates the disclosure of specific information in prospectuses.¹²² In the U.S. and the UK, however,, the law employs the more lenient standard for liability of “knowing misconduct” ever (knowing or reckless reckless misconduct in the UK) in the case of violations violat ions of on-going on-going and periodic disclosure requireme requirements.¹²³ nts.¹²³ Despite the more lenient standards of liability, liability, reliance on private enforcement (i.e. securities litigation) is much greater in the U.S.:¹² the securities class action based on the “fraud on the market” theory is one of the most important mechanisms for enforcing mandatory disclosure requirements, notwithstanding past U.S. Congress efforts to cabin it.¹² Te fraud on the market theory facilitates securities fraud class actions by relieving plaintiffs from the burden of proving that they relied on the false or misleading information when they made their investment decisions: there is a presumption that the market share price at which they traded reflected all available material information, including the false statement, and was therefore distorted by it. In other words, plaintiffs may rely on the integrity of the price formation process on (presumptively well-functioning) well-functioning) securities markets.¹² ¹¹ See e.g. for France, Nicolas Rontchevsky Rontchevsky,, L’harmonisation des sanctions pénales , B J B 139, 1 March 2012, n° 3. ¹² See Chapter 6.2.5.4.
¹²¹ See James D. Cox, Randall S. Tomas, and Lynn Bai, Tere Are Plaintiffs and … Tere Are Plaintiffs: An Empirical Analysis of Securities Class Action Settlements , 61 V L R 355 (2008) (finding that private suits with parallel SEC actions settle for significantly more than private suits without such proceedings). ¹²² For the U.S., see e.g. §§ 11 and 12(a)(2) Securities Act 1933; for the UK, § 90 Financial Services and Market Act 2000; for France, Germany, and Italy, see P- K 9, 125–7 125–7 (Klaus J. Hopt and Hans-Christoph Voigt eds., 2005). On Japan see text accompanying notes 128–9. 128–9. ¹²³ See Hopt and Voigt, note 122, 9, 125–6 125– 6 (contrasting this approach with that adopted in European jurisdictions, with Germany lying in between, in that it requires knowledge or gross negligence). For the UK, see FSMA section 90A and Schedule 10A; see also Final Report, Davies Review of Issuer Liability (2007, (2007, at hmhm-treasury.gov.uk treasury.gov.uk ) (outlining the rationale for the looser standard). ¹² Between 1997 and 2014, around 200 securities fraud cases seeking class-action status have been filed every year in federal fed eral courts, with numbers somewhat some what lower than that in the most recent years: see the data provided by Stanford Law School, Securities Class Action Clearing House, at www.securities. stanford.edu.. 2014 was the year with the lowest total dollar value of approved settlements during the stanford.edu period, due to below-average below-average filing rates and increasing dismissal rates. ¹² See e.g. John C. Coffee, Jr., Jr., E L: L: I R, F, F, F 64–85 64–85 (2015). ¹² See Basic Inc. v. Levinson, Levinson, 485 U S R 224 (1988), and, more recently, Halliburton Co. v. Erica P. John Fund Inc., Inc. , 134 S C R 2398 (2014).
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Securities class actions are typically brought by a specialized “plaintiff’s law firm” in the wake of an SEC investigation, a financial reporting restatement or merely the disclosure of bad news unanticipated unanticipat ed by the market. Like bounty hunters in the Old West, West, a law firm that settles a securities class action (a very frequent occurrence) earns lucrative attorney’s fees.¹² Whatt to Wha is pec peculia is that settlement settlemen t agr agreem eements ents virtually virtua lly never requi re managers manage and directors payuliar forrthe damages: the money invariably comes fromrequire the issuers’ (or rsrather their D&O insurers’) coffers.¹² In other words, shareholders as a whole pay for the loss that a subset of them (those trading shares in the period when incomplete or false information distorted the market price) suffered from managers’ misstatements or omissions. Unsurprisingly, the effectiveness in terms of both costs and fraud deterrence of such an arrangement is the subject of a lively debate in the U.S.¹² One argument in support of this system is that, by providing a sort of insurance against the risk of misrepresentations for those who trade, it enhances stock market liquidity.. Further, liquidity Further, while managers do not pay securities class action damages from their own pockets, they still stand to lose from securities litigation: not only is their compensation heavily linked to the stock price (which should negatively reflect the damages paid and the legal fees), but they will often have to give testimony and otherwise be distracted from the main business running their corporations. In suits addition, there are reputational concerns: directors ofof companies that face shareholder a ppear appear to suffer modest but discernible negative impacts on their future career prospects.¹³ prospects.¹³ Ex ante , these concerns should prompt them to ensure that compliance with securities regulation is taken seriously in their firm. A final argument in support of a system that makes issuers pay for securities fraud is that, in its absence, managers would commit fraud (also) in their principals’ interest, because, as a class, current shareholders gain from inflated prices.¹³¹ Whether that is i s convincing depends on one’s views on how aligned the interests of managers of U.S. corporations are with those of shareholders. In addition, an implicit assumption of this argument is that current shareholders would would heavily discount the negative impact on the company’s credibility, and ultimately on the stock price, of the—however the—however less than certain—exposure certain—exposure of the company’s fraud.¹³² Outside the U.S., procedural rules and the less favorable law governing attorneys’ fees make private lawsuits for monetary damages a much less frequently used tool for enforcing the mandatory disclosure regimes.¹³³ Te incidence of private
¹² See e.g. Michael Klausner, Persona Personall Liability of Officers in U.S. Securities Class Actions , 9 J C L L S 349 (2009). (2 009). See also Chapter 6.2.5.4 (discussing shareholder lawsuits). l awsuits). ¹² See e.g. John John C. Coffee Jr., Jr., Reforming the Securities Class Action: An Essay on Deterrence and Its Implementation,, 106 C L R Implementation R 1534 (2006). (20 06). ¹² See e.g. William Willi am W. W. Bratton, and Michael L. Wachter, Wachter, Te Political Economy of Fraud on the Market , 160 U P P L R 69 (2011). ¹³ See e.g. Eliezer M. Fich and Anil Shivdasani, Financial Fraud, Director Reputation, and Shareholder Wealth, Wealth, 86 J F E 306 (2007); Maria Correia and Michael Klausner, Are Securities Class Actions “Supplemental” to SEC Enforcement? An Empirical Analysis , Working W orking Paper, Paper, Stanford Stanford Law School (2014). ¹³¹ For this line of argument, see James C. Spindler, Vicarious Liability for Bad Corporate Governance:: Are We Governance We Wrong Wrong About Rule 10b-5? 10b- 5? 13 13 A L E R 359 (2011). ¹³² See William . Allen and Reinier Kraakman, C C L B O O ch. 14 (5th edn., e dn., forthcoming). See also text preceding note 147. ¹³³ For a recent overview of collective action mechanisms in Europe, see Martin Gelter, Riskshifting Trough Issuer Liability and Corporate Monitoring , 13 E B O O L L R 497, 529–32 529–32 (2013). See also Érica Gorga, Te Impact of the Financial Crisis on Nonfinancial Firms: Te Case of Brazilian Corporations and the “Double Circularity” Problem in ransnational Securities Litigation, Litigation, 16 I L L 131 (2015).
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lawsuits relating to disclosure violations is modest but increasing in Brazil, France, and Germany,¹³ steadily low in Italy,¹³ and, perhaps surprisingly, extremely rare in the UK.¹³ Japan has become an exception since the mid-2000s: mid- 2000s: the introduction of strict liability for issuers in 2004 sparked a mini-boom mini-boom in litigation.¹³ Tat led to a changeJapan in the law tentoyears later when, with the of curbing litigation, retreated a negligence standard for purpose issuer liability in thesecurities secondary market.¹³ Whether litigation against issuers will deflate as intended is too early to tell. Te U.S. is much less of an outlier when it i t comes to private enforcement vis-àvis negligent gatekeepers. As indicated in Chapter 5,¹³ expansion of auditor liability lia bility,, especially in the U.S., prompted both courts and legislatures to seek to rein in this form of litigation.¹ Generally speaking, enforcement against gatekeepers has been limited to situations in which public investors could reasonably be expected to rely on the certification or information that gatekeepers provide.¹¹ provide.¹¹ Te law also acts as a prop to market discipline (itself, broadly speaking, a form of private enforcement¹²): mandatory disclosure facilitates the t he reputational sanctioning of publicly traded firms that deviate from “best practices” and other non-binding non-binding qualityquality-control control Tat is the“co case fororEU jurisdictions’ of best practices, whichrecommendations. are backed by a mandatory “comply mply explain” rule.¹³codes As discussed in Chapter 3, these codes establish much of the governance structure of European listed companies, including board composition and committee structure.¹ In theory at least, the “comply or explain” requirement encourages firms to adopt recommended practices unless they have good reasons for not doing so. In case of unjustified non-compliance, noncompliance, they face the risk of a penalty in the form of a lower share price.¹ Although some U.S. disclosure requiremen requirements ts come come close,¹ close,¹ the U.S., Brazil, and Japan Japan generally rely less on this mechanism. Finally, the market’s reaction may amplify the effect of securities law enforcement (in a way, also a form of indirect private enforcement): in fact, both for the U.S. and
¹³ See Tierry Bonneau and France Drummond, Drummond, D M F No. No. 528 (3rd. ed. 2010); Hopt and Voigt, Voigt, note 122, 99– 9 9–103 103 and 140. ¹³ See Andrea Perrone Perrone and Stefano Valente, Valente, Against Against All Odds: Investor Protection in Italy and the Role of Courts , 13 E B O O L R 31 (2012). ¹³ See Armour, Armour, note 116.
¹³ Gen Goto, Growing Growing Securities Litigation against Issuers in Japan— Japan—Its Its Background and Reality, Working W orking Paper Paper (2016), available at ssrn.com. ¹³ Te burden of proving non-negligence non- negligence is on the defendant (Art.21-2(2) (Art.21-2(2) FIEA). Japan has, however, kept strict liability for primary market disclosures (Art. 18 FIEA). ¹³ See Chapter 5.2.1.4. ¹ See Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., N.A. , 511 U S R 164 (1994) (no aiding and abetting liability under Rule 10b-5); 10b- 5); European Commission, Recommendation of 5 June 2008 concerning the limitation of the civil liability of statutory auditors and audit firms, 2008 O.J. (L 162) 39. ¹¹ See, for the the U.S., U.S., Stoneridge Investment Partners LLC v. Scientific Atlanta Inc. and Motorola Inc ., Inc ., 128 S C R 761 (2008); for the UK, Caparo v Dickman, Dickman, [1990] 2 AC 605. ¹² See Armour, Armour noteListing 116. Rules 9.8.6; for Germany, § 161 AktG; for France, Arts. 225–37, ¹³ See, for the ,UK, 225–37, al. 7 and L. 225-68, 225-68, al. 8 Code de commerce; for Italy, Art. 123-II 123-II Consolidated Act on Financial Intermediation. ¹ See Chapter 3.3.2. ¹ See also Armour, note 116, 102– 102–9. 9. ¹ See Chapter 3.3.1. For the the U.S., see e.g. § 972 Dodd Frank Frank Act (requiring companies to to explain whether and why the same person serves as the CEO C EO and the Chair of the board positions or different individuals do).
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the UK there is evidence of significant reputational penalties that markets impose on firms that have been the t he target of public enforcement actions.¹
9.2.3 Gatekeeper control Gatekeeper control has traditionally been an important mechanism to ensure compliance with securities regulation and accounting standards. Whether voluntarily or in compliance with mandatory legal requirements, issuers acquire reputation intermediaries’ services to make their disclosures more credible. Tis is the case with audit services, ser vices, whereby an outside team of specialized professionals, usually from a well-established well- established firm, provides its own judgment on whether disclosures are in line with applicable regulations and standards. It is also the case for investment banks acting as underwriters in an IPO transaction: they similarly undertake due diligence to make sure that a company’s prospectus is in line with legal requirements. It is further the case for issuers’ law firms: their advice and assisass istance on securities law may further reinforce reinforc e the investing public’ publi c’ss perception of an issuer’s compliance with applicable laws. Finally, in some markets an investment bank actsthe as astock “sponsor” for atogiven company is therefore underwith an obligation vis-àvisà-vis vis exchange ensure that theand company complies its listing obligations.¹ In screening financial information and a nd issuers’ behavior more generally, generally, auditors, investment bankers, securities law firms, and sponsors enhance issuers’ trustworthiness by implicitly pledging their reputational capital, which they may have accumulated over many years and many clients.¹ However, reputational capital is not immutable or unperishable, especially when a firm, as opposed to an individual, is entrusted with it.¹ While in theory no gatekeeper as a collective entity should be willing to squander its reputational capital to favor an individual client of its, agency costs can be high within such an entity as well (i.e. between the audit firm partner receiving credit or compensation for work done for the issuer client, and the rest of the firm), leading to more gatekeeper failures than theory might predict by treating the gatekeeper as a unitary economic agent.¹¹ Failures to spot, and react to, t o, patently unlawful and outright fraudulent behavior do periodically catch the public opinion opinion’’s and policymakers’ attention, such as in the infamous cases of Arthur Andersen with Enron in the U.S. or an affiliate of Grant Tornton (a middle-tier middle- tier audit firm) with Parmalat in Italy.
Parmalat in Italy. What is impossible to tell is whether, whether, despite such failures, gatekeepers gatekeepers nevertheless play an overall positive role in reducing the risk of fraud and securities law violations. In fact, there is no way to know how often and to what degree gatekeepers successfully
¹ Jonathan M. Karpoff, D. Scott Lee, and Gerald Gerald S. Martin, Te Cost to Firms of Cooking the Books , 43 J F Q A 581 (2008); John Armour, Colin Mayer, and Andrea Polo, Regulatory Sanctions and Reputational Damage in Financial Markets , J ¹ F Q (2017). See e.g. UK Listing Rules, §A 8. ¹ See Reinier Kraakman, Gatekeepers: Te Anatomy of a Tird-Pa Party rty Enforcement Strategy , 2 J L L, , E, O 53 (1986); John C. Coffee, Coff ee, G: P C G (2006). ¹ See Reinier Reinier H. Kraakman, Corporate Legal Strategies Strategies and the Costs of Legal Controls , 93 Y L J 892–3 892–3 (1984). ¹¹ For an illustration, see Jonathan Jonathan R. Macey, Macey, Efficient Capital Markets, Corporate Disclosure, and Enron,, 89 C L R 394, 408–10 Enron 408–10 (2003).
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prevent issuers from misbehaving. However, the fact that markets relied on gatekeeper control before laws forced issuers to hire them,¹² suggests that their services are valued by market participants. As noted, securities laws have often assimilated assimilat ed such market practices by making it a requirement for issuers to hirefailures, gatekeepers. same time,the andlaw especially in the wake of spectacular gatekeeper in all At ourthe jurisdictions has regulated gatekeepers in order to ensure the quality of their services—and, services—and, indirectly, the quality of market information. Reasonable minds can differ on whether making the use of their services mandatory and providing for barriers to entry and uniform quality standards, thereby reducing competition, has in fact improved gatekeeper control effectiveness, or conversely undermined it, and whether suitable reforms could be enacted to improve the quality of gatekeeper control.¹³
9.3 Convergence and Persistence in Securities Securities Regulation Regulation Issuers in all our major jurisdictions are subject to mandatory mandator y disclosure and the other securities law requirements we have briefly surveyed in this chapter. Such rules apply as soon—and soon—and for as long—as long—as a publicly traded company offers securities to the public, lists on a particular public market or crosses certain thresholds (such as a minimum number of investors). Significant differences remain, of course, in the extent of mandatory disclosure. As we noted earlier, however, the disclosure gap between the U.S., where modern securities regulation originated, and the UK, with its long tradition of an investor-friendly investor-friendly environment, on the one hand, and civil law jurisdictions, on the other,, has narrowed. Te most notable differences concern enforcement. other Te unique feature of U.S. enforcement is that private lawsuits for damages are of roughly equal importance to civil and criminal actions brought by public actors. For better or worse, other jurisdictions lack a fully effective class action device to threaten issuers with massive monetary damages for misrepresentations or omissions in public disclosures. As far as private enforcement is concerned, these other jurisdictions rely chiefly on listing requirements and best practices, backed by the reputational sanction implicit in negative share price reactions. Te public enforcement of securities law breaks down in a slightly different way. Te U.S. and UK invest more resources in the public enforcement of investment protection than our remaining core jurisdictions; but U.S. authorities put the emphasis on for-
mal enforcement while their UK counterparts have traditionally operated much more informally, possibly reflecting the fact that for a considerable time direct investment in shares by U.S. retail investors was much higher than in the UK.¹ Brazil, France, Germany, Italy, and Japan have broadly similar public enforcement capacity and do not have a strong record of punishing securities fraud via criminal sanctions. Unsurprisingly, the intensity of securities law enforcement seems roughly to correspond to the size and maturity of national capital markets.¹ Where Where capital markets are large and highly developed, as in the U.S. and the UK, securities law in action ¹² See e.g. Paul G. Mahoney, Mahoney, W W C: C : W W S S R F 80 (2015 (2015).). ¹³ Compare Macey, D C R 253–75 253–75 (2013), with Coffee, G, G , note 149, at 333–56. 333– 56. ¹ See e.g. John C. Coffee, Jr. Jr. and Hillary A. Sale, Redesigning the SEC: Does the reasury Have a Better Idea? 95 95 V L R 707, 727–9 727–9 (2009). ¹ See also Rafael La Porta, Florencio Lopez-deLopez- de-Silanes, Silanes, and Andrei Schleifer, Te Economic Consequences of Legal Origins , 46 J E L 285 (2008).
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appears to be more effective than in jurisdictions, such as Brazil, France, Germany and Italy, where equity markets are smaller. Tis correlation, while not perfect, seems robust. Te most straightforward explanation is that, in jurisdictions with more developed capital markets, ensuring that they function well yields larger economic and political benefits. Correspondingly, Correspondingly, in such jurisdictions there will be higher demand for securities laws by well-organized interest groups, such as institutional instit utional investors, investment banks, stock exchanges, gatekeepers, and securities lawyers.¹ Consistently with this view,, increasing equity ownership by (domestic and foreign) institutional investors and view the maturing of capital markets have pushed substantive disclosure requirements in Brazil, Europe, and Japan closer to those of the U.S. and the UK. Consider also that politicians politi cians will be especially receptive to demand for more aggressive securities laws in the wake of financial crises or salient corporate scandals, which is in fact precisely when new, new, more stringent securities laws are most often enacted.¹ Where capital capita l markets are already wellwell-developed developed and therefore more central to the political discourse, the public reaction to crises—and crises—and associated demand for stricter laws—will laws— will be stronger. Mediated by effective interest groups—such groups—such as the plaintiff bar in theintense. U.S.—Hence, U.S.—and and policy entrepreneurs, willgreater correspondingly be more other things beingpoliticians’ equal, one reaction can expect post-crisis ratcheting-up ratchetingup of securities laws in countries with well-developed well-developed capital markets than in ones where capital markets are less important for the economy. economy. Finally,, differences in securities Finally securiti es law regimes may again mirror mi rror differences in ownership structures and the ensuing interest group dynamics. Concentrated ownership systems will have powerful controlling shareholders with little interest in better securities laws: the publicly traded companies they control do not usually plan to raise further equity, and controlling shareholders risk no displacement via a hostile takeover. Hence, they are quite indifferent to price informativeness, stock market price movements, and volatility more generally general ly.. In addition, rules that tha t contribute to exposing the value of the companies under their stewardship (and the private benefits they may extract from them) may negatively affect their reputation. Tus, because they generally to lose than toagainst gain from rules law thatreforms. would better nies’ value,stand theymore will tend to lobby securities Strongreflect labor,compawhich often goes hand in hand with strong ownership, also has reason to oppose strong securities laws:¹ if such laws are successful in increasing the size and importance of capital markets for an economy¹ and in fostering higher, direct or indirect, retail
investor participation in equity markets, an equity culture will be likelier to spread within the political system and to erode the pro-labor pro-labor hegemony which may otherwise pervade it.¹ In dispersed ownership regimes, on the other hand, managers may be less averse to broader disclosure mandates, at least so long as the enforcement system is designed so as to spare them from any serious risk of personal liability. Consider, first, that a
¹ See generally Franklin Allen and Douglas Douglas Gale, C F F S (2000). ¹ See e.g. Roberta Romano, Te Sarbanes-Oxley Sarbanes-Oxley Act and the Making of Quack Corporate Governance , 114 Y L J 1521 (2005). (2 005). ¹ See generally Mark J. Roe, P P D C C G (2003). ¹ See Andrei Shleifer Shleifer and Daniel Wolfenzon, Investor Protection and Equity Markets , 66 J F E 3 (2002). ¹ See e.g. Marco Pagano and Paolo Volpin, Volpin, Te Political Economy of Finance , 17 O R E P 502, 504–10 504–10 (2001).
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well-functioning system of broad-scope well-functioning broad-scope disclosure reduces the risk that markets draw negative implications from silence: because analysts may find a competitor’s competitor’s silence to be informative also of another firm’ firm’s prospects (no matter whether the latter voluntarily discloses positive information), imposing detailed disclosure on all will lower the risk that individual shares suffer from other firms’ voluntary disclosure choices. More generally,, managers tend to be optimistic about their firms erally firms’’ prospects. Tey may thus not oppose a system that allows for prices to more accurately reflect available (and supposedly positive) information, even though such a system also makes their displacement likelier if the information flow happens to be negative. Similarly, Similarly, more informationally efficient markets can better signal (again, optimistic) managers’ quality to investors and therefore (supposedly) (supposedly) strengthen those managers’ position in the market for managerial talent. Once again, ownership structures and political economy dynamics provide an explanation for persistent divergences in securities laws and for trends t rends towards greater similarity. Convergence in the law on the books in the last two decades has not yet been followed by a comparable degree of convergence in enforcement intensity. intensity. A time lag between law enactment and effective enforcement is to be expected in an area that requires In serious human capital on theunrelated part of both private and securipublic players. addition, features thatinvestments are almost totally to corporate ties laws, such as the interest group dynamics within the market for legal services and, more generally, the legal and economic elites’ views of what is “proper” in terms of enforcementt efforts,¹¹ may be at play in ways that make convergence in enforcement enforcemen enforcement less likely than convergence in the law on the books.
¹¹ See generally Curtis J. Milhaupt and Katharina Pistor, L L C C ch. 10 (2008).
10 Beyond the Anatomy John Armour Armour,, Luca Enriques, Enriques, Mariana Mariana Pargendler Pargendler,, and Wolf-Georg Wolf-Georg Ringe
A short book deserves a short conclusion. Te Te preceding chapters survey the corporate laws of our core jurisdictions in areas ranging from the basic governance structure to securities markets. Te laws are presented in terms of a handful of legal strategies that all jurisdictions deploy. Tese strategies are used to address the agency problems inherent in corporations: the conflicts between managers and shareholders, between minority and controlling non-shareholder constituencies and shareholders as a class.shareholders, and between non-shareholder Wee do not summarize the contents of earlier chapters here. Rather, we focus more W explicitly on the boundaries of what the book explains. We reflect first on methodological tradeoffs: what our analytic approach can explain and what it cannot. Ten, we consider the limits of the book’s coverage, in terms of the jurisdictions, organizational forms, and time period surveyed. In so doing, we speculatively peer “beyond” the anatomy of corporate law.
10.1 Beyond the Analysis Our analytic starting point has been that corporate law can most usefully be understood in terms its functions . Te motivating conceit thattothese functions areexigensimilar the world over.ofBusiness organization everywhere givesisrise similar economic cies; in responding to these, corporate laws everywhere share the same core elements. Large business organizations everywhere must overcome agency and coordination costs, and as we show, show, much of corporate law can be understood as a response to these common economic problems. A great strength of this approach is that it emphasizes
the underlying similarities between corporate laws. Tis is in contrast to most works on comparative law, which focus on differences. di fferences. However, as we move beyond the core elements set out in Chapter 1, there are of course also differences across various systems of corporate law. law. We We mainly explain such differences as functional responses to variation in the configuration of typical agency and coordination problems within business organizations, themselves determined by differences in other aspects of the corporate environment, including, most notably, ownership structure.¹ ¹ o be sure, the book’ b ook’ss brevity and the scope of its subject-matter subject-matter necessitate application of the theoretical framework at a very high level of generality. For example, our discussion of ownership structure seeks to present “ideal types” reflecting general patterns in our core countries. Both the construction of these ideal ide al types and their application appl ication on an “average” “average” basis to particular par ticular countries abstract from more granular differences in ownership structure both across and within countries. Te Anatomy of Corporate Law. Tird Edition. Reinier Kraakman, John Armour, Paul Davies, Luca Enriques, Henry Hansmann, Gerard Hertig, Klaus Hopt, Hideki Kanda, Mariana Pargendler, Pargendler, Wolf-Georg Wolf-Georg Ringe, and Edward Rock. Chapter 10 © John Armour, Luca Enriques, Mariana Pargendler, and Wolf-Georg Ringe, 2017. Published 2017 by Oxford University Press.
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Te book’s account demonstrates the power of a few relatively simple theoretical components to explain patterns in corporate laws. Of course, there are limits to its analytic power. power. Not all differences in national corporate laws are a re explicable by reference to differences in the functions they perform. A complementary tradition in comparative scholarship emphasizes political differences as a source of variation in laws. Tese can yield different outcomes in corporate law from those predicted by a functional approach, where interest groups, or populism, divert the political process from the pursuit of social welfare. And at a higher level of generality, generality, corporate law also reflects a synthesis of our societal values. Tat is, corporate law responds to more than economic needs alone, being also a function of culture, historical contingencies, and other constraints on lawmakers’ ability to design and implement optimal institutions. It is not always easy to disentangle the effects of politics from functional considerations. ake, for instance, the global fashion for independent directors. While this may be explained in functional terms as an application of the trusteeship strategy in response to agency costs, alternative explanations include national political dynamics, blockholder lobbying, and regulation-driven biases at the level of the institutional investors who promote this practice across the board. Where multiple theoretical accounts point in the same direction, their relative importance is hard to gauge. Where there are overlapping explanations, our account reflects a methodological hierarchy. We rely first on a functional account, as far as this is capable of explaining matters, and turn to political and other accounts only when the analytic traction of the functional account is exhausted. We prioritize the functional approach because it has many advantages in terms of simplicity and tractability tracta bility.. And more fundamentally, fundamentally, it yields a common analytic framework that is independent of the internal categorizations of any legal system—a system—a huge advantage for comparative work.
10.2 Beyond the Scope Te scope of this book book’’s subject matter, while broad, is not unlimited. One such limit is jurisdictional: the sakeAnother of brevity anis and d readability, readability , the analysis restricted a number of key legalfor systems. limit typological, as we limit isour study to t otothe legal form of the business corporation, explicitly excluding other forms of organization. Tis third edition has expanded our jurisdictional scope by adding Brazil to the selection of core countries. In doing so, we go beyond the prior focus on mature market economies to include the corporate law system of a large emerging market. Yet
other prominent emerging market jurisdictions, such as China and India, remain conspicuously absent. Aside from the interest in restricting the number of jurisdictions to ensure readability, readability, our only real justification for their omission is a pragmatic reflection of the limitations in our own expertise. Neverthele Nevertheless, ss, our hope is that the book’s book’s conceptual framework will also be useful in analyzing the laws of jurisdictions that we do not directly examine. Indeed, the inclusion of Brazil offers an interesting test case for the explanatory reach of the book’s basicuseful framework. the one to hand, is little doubt Te that vast our analytical tools remain when On transposed this there different context. majority of Brazilian corporate law fits squarely within the legal strategies identified in Chapter 2, and our framework sheds critical light on the particular choices observed. For example, we saw in Chapter 7 that while other core jurisdictions rely on trusteeship and decision rights strategies to govern fundamental corporate changes, Brazil stands out by policing them primarily through regulatory strategies taking the form
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of open-ended open-ended standards—a standards—a mechanism that relies heavily on courts as enforcement institutions. Tis approach seems problematic given perceived weaknesses of courts in emerging markets.² Yet on the other hand, the addition of Brazil calls into question the extent to which the core features of the corporate form identified in Chapter 1 are universal, or simply reflect developed market economies. For instance, the role of the corporate form in providing asset partitioning through entity shielding and limited liability is particularly fragile in Brazil, precisely because courts—the courts—the arbiters of the partitioning—are partitioning—are willing to permit deviations both through dissolution and veilpiercing. And perhaps more fundamentally, the prevalence of state share ownership means that, quite apart from subtle divergences in the content of corporate law, law, there may be fundamental differences as to the very structure of the corporate form.³ Wee leave to future enquiry reflection on the extent to which these W t hese differences di fferences are specific to Brazil, or generalize across emerging markets. As we have seen, developed market economies use a variety of legal strategies to address the central problems posed by the corporate form. Legal regimes may plausibly be even more heterogeneous in emerging markets, where the institutional environment is especially dynamic and extralegal constraints typically play a greater role. A second limitation of scope concerns concerns the very definition of the corporate form form that is the object of our study. study. Tere has been a noticeable trend towards greater organizational choice, with respect not only to certain pre-packaged organizational forms but also to the basic elements and governance structure of any particular type of entity. Te U.S. experience with limited liability companies (LLCs) and business trusts, which are increasingly common in business practice, illustrates this approach of enabling the parties to replicate the essential features of the corporate form (or some of them) by contract. Insofar as these entities contain the five basic elements of the corporate form, they qualify as “de facto” corporations for our purposes. Even if these organizational forms lack one or more of the key elements of the corporate form, our framework can shed light on the agency problems generated by the remaining characteristics and how the law addresses them. Nevertheless, a more granular examination of the particular problems posed by different partial corporate forms remains outside the scope of the present analysis.
10.3 Beyond the Pr Present esent Our approach throughout the book is ahistorical: the analysis is limited to legal regimes currently in effect. In focusing on contemporary outcomes, we have eschewed analyz-
ing broad trends in the evolution of corporate law over time. Tis, too, is principally for pragmatic reasons. It means, however, that the analysis understates the impact of history and path dependence in shaping the legal l egal institutions that we presently observe. Nevertheless, Neverthele ss, this new edition comes at a time when a fundamental rethink of corporate laws is under way in many countries, partly as a reaction to corporate scandals and the alleged failure of corporate governance at financial institutions in the runup the global financial crisis. Many aspects of these changes are contentious, theirto implications are as yet incompletely understood. Consequently, the extentand to which they reflect an evolution in the configuration of agency problems, as opposed to to ² See Chapter 2.3.1. ³ See Mariana Pargendler, How Universal Is the Corporate Form? Reflections on the Dwindling of Corporate Attributes in Brazil , Working Paper (2016).
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populist or other political concerns, remains unclear, unclear, as does the extent to which they may be expected to persist. A recurring theme in many recent corporate law la w reforms is a desire to t o increase the protection available to investors, especially shareholders. Tis takes shape in the rollout of three particular legal strategies. First, the affiliation strategy, strategy, through a continued appetite for ever-broader ever-broader disclosure requirements. Second, a growing enhancement of shareholders’’ decision rights, as illustrated by the spread of “say on pay” votes around shareholders the world. Tird, continued use and refinement of the trusteeship tr usteeship strategy in the form of independent directors and disinterested board approval. At a very high level of generality, generality, these developments might be seen as tracking the considerable convergence in national ownership structures we note throughout the book. Tis assimilation of ownership regimes has occurred in part through an increase in controlled firms in jurisdictions traditionally boasting dispersed ownership, and the gradual emergence of widely held firms in jurisdictions typically characterized by concentrated ownership. Yet, perhaps more importantly, our core jurisdictions have also witnessed a noticeable rise in firms subject to various blockholders—typically blockholders—typically large and often international institutional investors—but no controlling shareholder. shareholder. However, However, a closer look at the evolution of share ownership suggests it would be unwise to take for granted that corporate law’s law’s current investorinvestor-oriented oriented convergence will persist. Institutions such as BlackRock, the world’s largest financial institution, are global players in the market for asset management services and own substantial stakes in numerous companies in our core jurisdictions. Tis development is arguably itself becoming an important source of international convergence in corporate law. Global institutional investors have generated pressure for the international adoption of the governance practices prevailing in developed (typically UK and U.S.) markets. Tis may, however, result in a convergence that is more formal than functional, if “investor-oriented” tororiented” strategies are applied beyond the extent justified by the type of agency problems they address. Yet, growing familiarity with foreign environments may lead to more nuanced views about the local relevance of different governance governance strategies. In addition, the fact that in jurisdictions other than the U.S. investors are increasingly foreign may hinder their effectiveness as an interest group and hence reduce the chances that investor-oriented investor-oriented laws are enacted. Another important consequence of the ubiquity of global institutional investors is that the major shareholders in publicly traded corporations are increasingly organizations in their own right. Tis injects a second layer of agency costs beneath the level of the publicly traded company, as between asset managers exercising the shareholders’ rights and their end-beneficiaries. end-beneficiaries. Many institutional investors are not organized as
corporations, which may call into question the applicability of our framework to asset managers directly. Yet, looking more closely, financial regulation already mitigates (or may further mitigate) this second tier of agency problems through many of the same strategies applied to publicly traded companies themselves. A different question is how corporate law should respond to the consequences of these “agency costs of agency capitalism” on the corporations in which institutions Tis echoes the observation in Section 10.1 about overlapping overlapping explanatory accounts. Bernard S. Black, Agents Black, Agents Watching Watching Agents: Te Promise of Institutional Investor Voice Voice , 39 UCLA L R 811 (1991); Ronald J. Gilson and Jeffrey N. Gordon, Te Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights , 113 C L R 863 (2013). Tis echoes the point made in Section 10.2 concerning the the scope of our enquiry. enquiry.
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invest. Te answer depends on how these agency costs actually manifest themselves—a highly debated issue on which the current evidence is, as yet, inconclusive. Depending on the configuration, such agency costs may lead asset managers not to pursue shareholder rights as assiduously as they might; conversely, they may cause asset managers to pursue such rights too vigorously in the pursuit of short-term short-term performance targets. Which of these problems is thought to dominate has implications for how far the “investor-oriented” “investororiented” model of corporate law continues to be appropriate. Moreover, global institutional investors are not the only large blockholders in evidence across our core jurisdictions. State ownership, once discounted as destined for extinction, seems remarkably resilient in many countries around the world. Not only do governments continue to hold majority and minority stakes in large domestic corporations, but sovereign wealth funds have become relevant players in equity markets. Tis influences corporate law in two ways. First, the interests of the state as a shareholder may continue to play a role in the political economy of corporate law reforms. Second, the very content of “optimal” corporate law may be different when the interi nterests of shareholders are highly heterogeneous, which is usually the case in the presence of state ownership ownership.. Consistently with these observations, there appear to be some signs of backlash against the ubiquitous focus on shareholder voting rights, independent directors, and enhanced disclosure requirements. After years of gradual convergence towards the idea of proportional voting (“ (“oneone-share, one-vote”) one-vote”) in continental Europe, both France and Italy have enacted reforms permitting greater divergence between voting rights and cash-flow cashflow rights through tenure voting schemes, while iconic Silicon Valley Valley firms such as Facebook, following in Google’s Google’s footsteps, have gone public with a voting structure allowing founders to retain voting control with low cash-flow cash-flow rights. Following decades of expansion, the emphasis on independent directors may also have peaked. Scholars have increasingly come to question the effectiveness of this mechanism, especially in countries where most companies have controlling shareholders. Finally, even disclosure obligations have come under attack, as there is growing criticism that the system of quarterly reporting of financial results promotes a shortterm orientation in corporate management. Another current issue concerns the goals of corporate law law.. One broadly accepted view,, which we articulate in Chapter 1, is that corporate law should seek to maximize view shareholder value, because this ordinarily tends to serve the broader goal of advancing social welfare. Yet Yet for this to be true, regulatory measures must be used to impose the social costs of corporate activities onto the firm’s bottom line where affected parties cannot bargain with the firm. Te financial crisis of 2007–9 2007–9 underscored both the
significance of the systemic risk externalities created by large financial firms and the inability of regulators to tackle this problem. Te perceived limitations of existing regulatory regimes in dealing with issues such as human rights, inequality, and environmental protection have likewise led activists to focus on the structure of corporate law itself. Consequently, Consequently, as we discuss in Chapter 4, a number of corporate law reforms have developed with the interests of external stakeholders in mind. Tere is reason to be skeptical, however, about the ability of corporate law to solve challenges that span far beyond its core mandate of facilitating the operation of a For example, according to some, hedge fund activism can help mitigate the agency problems plaguing mutual funds. However, for this mechanism to work, the corporate law system has to be amenable to hedge fund activism by, for instance, permitting hedge funds to profit from undisclosed acquisitions of shares in the market before launching a campaign.
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business enterprise. Te emerging scholarly consensus following the financial crisis is that concerns about externalities should at most affect the t he corporate law regime applicable to large financial institutions, or possibly systemically relevant enterprises more generally. While this view seems moderate in circumscribing changes in governance arrangements to a particular industry or risk profile, it is more fundamental in supporting a departure from legal regime generalnature applicability in favor ofbusiness a more tailored corporate lawa uniform regime based on the ofspecific of a company’s features. Whether Whether a similar trend of regulatory differentiation may in the future come to encompass other industries remains to be seen. Looking further into the future, it may be that technological change will prompt evolution in the basic structure of corporate enterprise. Tis could have a wide range of possible impacts on the configuration of agency costs. For example, increases in the relative value of the human capital of employees may dictate greater alignment of their interests with those of investors; or growth in the relative value of intangible corporate assets could increase asymmetries of information—and consequently agency costs— between managers and others. Yet Yet changes such as these, which are driven by particular par ticular business models, seem unlikely to trigger a need for wholesale corporate law reform. Rather, they might be met by customization of the corporate form to the firm’s particular challenges, as occurs in the t he technology and financial sectors already already.. Moreover, Moreover, parallel technological developments in fields such as process authentication and automated decision-making decision-making may come to reduce internal agency costs considerably. considerably. None of us has a crystal ball to predict the future. But a remarkable feature of corporate law is that, despite constant innovations in business practices and frequent legal changes, many of its central challenges have been remarkably persistent, periodically reemerging over time. While we cannot foresee the policy outcomes, we can say that this book’s theoretical framework, building upon the key elements of the corporate form and the strategies used to address agency problems in the corporate enterprise, will continue to be relevant as new questions emerge and old ones resurface.
Index References such as ‘178–9’ ‘178–9’ indicate (not necessarily continuous) discussion of a topic across a range of pages. the whole of workpoint is about law’, use of this others whichBecause occur throughout) as this an entry has ‘corporate been restricted. Please lookterm under(and the certain appropriate detailed entries. Wherever Wherever possible in the case of topics with many references, these have either been divided into sub-topics sub-topics or only the most significant discussions of o f the topic are listed. accountants, see auditors accountants, auditors accounting, see also auditors; accounting, also auditors; GAAP; gatekeepers; IFRS conflicted transactions 148 conservative 126, 252– 252–3 3 continental 252–3 252–3 methods 244, 250, 250, 252, 254 standards 120–2, 120–2, 148, 250, 254, 263 true and fair view 126, 252– 252–4 4 accounts 25–6, accounts 25–6, 102, 107, 114, 151, 156, 163, 209, 254, 268
asset managers managers 52, 60– 60–2, 2, 270–1 270–1 assets 5– assets 5–9, 9, 11, 109–13, 109–13, 115–18, 115–18, 133, 135–6, 135–6, 191–2, 191– 2, 194–6, 194–6, 199–201, 199–201, 253; see also also divisions; mergers; related party transactions corporate, see corporate corporate assets dilution 111, 125 partitioning 9, 110, 269 personal 6, 9, 43, 111 111 sales 96, 145, 145, 174, 194– 194–5 5 substitution 111, 113– 113–14, 14, 134
acquisitions acquisitions 185–6, 185– 6, 31, 199– 199–200, 200,235, 207– 207–8, 8, 212, 222, 227, 229– 229–31, 233, 240– 240–1; 1; see also control also control transactions compulsory 190–1 190–1 actio pauliana 134–5; 134–5; see also insolvency also insolvency activist hedge funds funds 52–3, 52–3, 59–60, 59–60, 155, 216, 271 affiliation strategies strategies 32–3, 32–3, 38, 49, 68–72, 68–72, 88, 94–5, 94– 5, 100, 102, 119–20, 119–20, 124, 127, 147– 52, 244–5; 244–5; see also entry also entry strategy; exit agency conflicts 2, 79, 106, 106, 172, 207, 240 costs 29, 44, 47, 52– 52–3, 3, 55, 106, 109, 263, 268, 270–2 270–2 managerial 46, 52– 52–3, 3, 60, 79, 81, 208 reduction 30–8 30–8 problems 2–5, 2–5, 29–47, 29–47, 76, 108–9, 108–9, 115–17, 115–17, 184–5, 184– 5, 207–8, 207–8, 211, 243, 269–70 269–70 and legal strategies 30 majority–minority majority– minority shareholder 2, 79 79 manager–shareholder manager– shareholder 2, 208, 208, 211 minority–majority 105, 231 non-shareholder nonshareholder 79, 209 shareholder 2, 37, 43, 43, 100, 186 shareholder-creditor shareholdercreditor 111–16, 111–16, 119, 128 shareholder-non shareholdernon shareholder 2, 79
audit committees63–4, committees 50,4,71 independence 63– 99, 178 auditors 35, 39, 43, 57, 71, 122–3, auditors 122–3, 150, 263; see also gatekeepers also gatekeepers liability 122–3, 122–3, 151, 262 special 151–2, 151–2, 163 authority 7– 7–8, 8, 11–12, 11–12, 16, 37, 40, 85, 154–5, 154– 5, 177, 181, 264 bad faith faith 29, 67, 71, 135 balance sheet(s) sheet(s) 105, 125, 137, 148, 253 test 117, 127 bankruptcy, see insolvency bankruptcy, insolvency banks 25–6, banks 25–6, 59, 65, 70, 95–6, 95–6, 100, 119–20, 119–20, 124, 135, 140–3 140–3 best practices practices 63, 76, 105, 154, 178, 213, 235, 251, 262, 264 bidders 83, 205– bidders 205–6, 6, 208–9, 208–9, 211, 213–17, 213–17, 219–20, 223–5, 223–5, 227–9, 227–9, 235–6, 235–6, 238 potential 35, 207– 207–8, 8, 217, 224–5, 224–5, 228 bids 39, 73, 178, 190, bids 190, 205–10, 205–10, 212–28, 212–28, 230– 1, 233–7, 233–7, 240, 255 competing 208, 213– 213–15, 15, 225–6 225–6 hostile 45, 72– 72–3, 3, 206–10, 206–10, 213, 216, 220, 223, 226, 237–9, 237–9, 241 mandatory 207, 217, 227– 227–8, 8, 230, 234, 255
agent incentives incentives 35, 49, 62– 62–8, 8, 139–40, 139–40, 147, 153–6; 153– 6; see also rewards; also rewards; trusteeship agents 7– agents 7–8, 8, 29–33, 29–33, 35–40, 35–40, 42–3, 42–3, 46, 65, 139, 223, 243–4 243–4 aggregate welfare welfare 22–4, 22–4, 31, 98, 135 analysts, see financial analysts, financial analysts antifraud provisions provisions 151, 161, 167, 253; see also disclosure also disclosure anti-takeover anti-takeover defenses, see control defenses, control transactions appointment rights rights 37–8, 37–8, 51, 53, 55–6, 55–6, 59, 64, 72–3, 72–3, 80–1, 80–1, 84, 90, 95–6, 95–6, 101, 103, 105, 135–7, 135–7, 139, 185, 236 appraisal rights 34, 37, 88, 165, 167– 167–8, 8, 176–7, 179, 186–9, 186–9, 200, 202
bilateral veto veto 175–6 175–6 blockholders 73–4, blockholders 73–4, 87–8, 87–8, 207, 209, 211, 224, 226–7, 226– 7, 230, 233, 241 blocks 26, 153, 158, 183, 186, 207–8, blocks 207–8, 214, 223, 227, 231 controlling controlli ng 79, 83, 85, 103, 208, 232–4 232–4 boards of directors directors 10–13, 10–13, 50–1, 50–1, 53–8, 53–8, 85–6, 85–6, 153– 153–5, 5, 175– 8, 180–2, 180– 2, 201–2, 201– 2, 207–13, 207– 13, 216–24; 216– 24;175–8, see also agency, also agency, problems; appointment rights; control transactions; delegated management; judicial review approval 85, 153, 206 committees 46, 51, 63– 63–4, 4, 80, 84, 86, 137–8, 137–8, 153, 155, 178
274 boards of directors (Cont.) de facto or facto or shadow directors 114, 128, 131, 133–5, 133– 5, 163 director disqualification 129 director independence independence 85, 153, 153, 220 director liability 69– 69–70, 70, 85, 128, 162–3 162–3 fiduciary 69–70, 70, 84, 129, 155, 162, 164,duties 218 69– independent directors 62– 62–7, 7, 76–7, 76–7, 80–1, 80–1, 84–6, 84–6, 99, 101, 153–5, 153–5, 166–8, 166–8, 219–20, 219–20, 270–1 270–1 and insolvency 127– 127–30 30 limits on board authority authority 84 management boards 50– 50–1, 1, 55, 57, 59, 69, 71, 75, 91, 154, 200 one-tier onetier 50, 90, 90, 154, 154, 158 powers 172–3, 172–3, 181, 218, 238 removal of directors directors 55– 55–6, 6, 75, 136–7, 136–7, 218–19 218–19 self-selecting selfselecting 85 and shareholder shareholder interests 84 staggered boards boards 56, 176, 219, 222 structure 1, 5, 5, 11– 11–12, 46, 65, 72, 177–8 177–8 supervisory boards 50– 50–1, 1, 54–5, 54–5, 63–4, 63–4, 74–5, 74–5, 90–1, 105–6, 105–6, 154, 156, 210, 219–20 219–20 two-tier twotier boards boards 12, 18, 18, 50–51, 50–51, 58, 154, 157–8 157–8 bondholders 112, 114, 176 bondholders bons Breton Breton 216–17 216–17 Brazil 53–7, Brazil 53–7, 73–4, 73–4, 80–4, 80–4, 101–5, 101–5, 119–24, 130–9, 130– 9, 150–2, 150–2, 165–9, 165–9, 249–52, 249–52, 268–9 268–9 Break-Trough BreakTrough Rule Rule 223, 235– 235–6, 6, 241 business judgment rule rule 68–70, 68–70, 87, 154, 156, 167; see also duty also duty of care; fiduciary duties capital, see legal capital, legal capital capital markets, and issuer regulation regulation 149 cash flow(s) flow(s) 111, 136, 146, 250 rights 81–2, 81–2, 96, 179–80, 179–80, 236, 271 test 117, 127 centralized management, see delegated management, delegated management CEOs (Chief Executive Officers) Officers) 50, 56, 67– 67–8, 8, 71, 89, 94, 139, 149, 167, 209 charter amendmen amendments ts 20, 37, 57– 57–8, 8, 72–3, 72–3, 84, 126, 174–80, 174–80, 190–1, 190–1, 199, 201 class approval approval requirements requirements 178 court review 179 decision-making rights rights in relation relation to 174 majority–minority shareholder conflict
Index closely held firms, and widely held firms firms 11, 147, 151 codetermination 14, 16, 19, 51, 58, 74–5, codetermination 74–5, 90–1, 105–7, 105–7, 220, 222 and takeovers takeovers 220, 222 tie-breaking tiebreaking vote 91 collective action issues issues 30, 45– 45–6, 6, 58, 60, 101, 106, 171, 179, 243, 246; see also also enforcement common law/civil law/civil law 164, 201– 201–2 2 community interest corporations corporations 14 comparative law 3– 3–5, 5, 51, 59, 64, 68, 76, 81, 85, 239, 241 compensation 30–1, compensation 30–1, 36, 63, 66–8, 66–8, 92, 94, 149–50, 149– 50, 155–7, 155–7, 163, 165; see also also managers; rewards, strategy; say on pay aggregate 149–50, 149–50, 248 approval 68, 156 committees 63–4, 63–4, 67–8, 67–8, 100, 147, 155 disclosure 71, 94, 149– 149–50 50 equity-based equitybased 62, 66, 100, 157, 157, 245 loans as 158 competing bids bids 208, 213– 213–15, 15, 225–6 225–6 compliance 32–3, compliance 32–3, 38–44, 38–44, 61, 63, 99, 101, 162, 244–5, 244–5, 261, 263; see also also enforcement; social norms compulsory acquisitions acquisitions 190–1 190–1 compulsory share sales sales 190–1 190–1 concentrated ownership ownership 53, 65, 74, 85, 102– 102–4, 4, 129, 234, 238, 265, 270 conflicted transactions transactions 63, 88, 153, 156, 158, 161–2, 161– 2, 164; see also control also control transactions; related party transactions fiduciary duties 88, 131– 131–4 4 liability 133, 162– 162–3 3 subordination of debt debt 131 consolidations, see mergers consolidations, mergers constituencies 12, 51, 53, 55, 62, 84–5, constituencies 84–5, 97–8, 97–8, 100, 102, 171–2 171–2 contractual 23–4, 23–4, 79, 92–3, 92–3, 99 external 92–5, 92–5, 97, 99–100, 99–100, 102, 107 non-shareholder nonshareholder 79–80, 79–80, 82, 84, 86, 88, 90, 92, 96, 98–100, 98–100, 102 constraints strategy 31, 69, 71, 84, 88, 91– 91–3, 3, 97, 99; see also rules; also rules; standards consumers 13, 30, 93– consumers 93–5, 5, 115–16, 115–16, 132 continental accounting 252–3 252–3 contracts 5– contracts 5–12, 12, 17–20, 17–20, 30–1, 30–1, 35–6, 35–6, 67–8, 67–8, 85–6, 85– 6, 113, 118–19, 118–19, 174, 235; see also also
in 178–80 178–80 management–shareholder management– shareholder conflict in 178 charters 16–20, charters 16–20, 56, 72–3, 72–3, 80, 175–83, 175–83, 185–6, 185–6, 190–1, 190– 1, 216–17, 216–17, 235, 238 Chief Executive Officers, Officers, see CEOs CEOs China 41, 50, 50, 234, 234, 268 choice of law 19, 21– 21–2; 2; see also regulatory also regulatory competition civil law jurisdictions jurisdictions 6, 86, 103, 164, 264 civil liability 43, 68, 130, 146, 163 class actions actions 41, 44, 151, 167, 202, 260–1, 260–1, 264; see also enforcement also enforcement closed corporations, corporations, see corporate corporate form, closed/ private corporation
corporate law, law, and contracts; creditors employment 89, 194– 194–5 5 contractual constituencies constituencies 23–4, 23–4, 79, 92–3, 92–3, 99 contractual counterparties counterparties 2, 10, 10, 79, 79, 89, 92, 109 control 13–15, control 13–15, 27, 81, 102–4, 102–4, 115, 135–6, 135–6, 178–81, 178– 81, 218–23, 218–23, 227–30, 227–30, 232–4 232–4 blocks 45, 79, 103, 103, 115, 227, 232– 232–3 3 private benefits benefits of 79, 103– 103–4, 167–8, 167–8, 221, 228–9, 228– 9, 232–3 232–3 rights 11, 31, 34, 34, 47, 60, 66, 81, 83, 117, 141 shifts 184–5, 184–5, 195, 205–12, 205–12, 219, 221, 223, 230–5, 237–40 237–40
Index
275
control transactions transactions 45, 112, 146, 205–43; 205–43; see also bidders; also bidders; hostile bids/takeovers bids/takeovers agency issues 207– 207–9, 9, 211–24, 211–24, 231 board role in 211 competing bids 214 coordination problems 208– 208–9 9 among target target shareholders shareholders 224– 224–31 31 decision rights 211– 211–12 12 defensive measures 207, 210– 210–11, 11, 213, 215–19, 221–3, 221–3, 225, 236, 240 post-bid postbid 213, 216 pre-bid prebid 213, 215, 215, 219, 222– 222–4 4 differences in regulation regulation 236– 236–42 42 disclosure 224 issues on acquisition from controlling shareholder 231–6 231–6 joint decision-making decision-making 215–21 215–21 mandatory bid 208, 227, 233 233 no frustration rule 213, 236 236 poison pills 208, 212, 212, 216– 216–18, 18, 220–3, 220–3, 228, 230–1 230– 1 sources of rules rules 210– 210–11 11 standards 218–19 218–19
special and partial 15, 198, 198, 269 corporate governance governance 3– 3–5, 5, 24–7, 24–7, 49–52, 49–52, 58–61, 58–61, 63–9, 63– 9, 71–6, 71–6, 88–90, 88–90, 104–8, 104–8, 149–51, 149–51, 238–41 238–41 codes 61, 63–6 corporate groups, groups, see groups groups of companies corporate law, law, see also Introductory also Introductory Note and contracts 17– 17–21 21 commonalities 3–4 3–4 creditor friendliness 141 definition 1–27 1–27 forces shaping 24– 24–8 8 goal 22–5, 22–5, 29, 186, 271 and insolvency law 17 and labor law 17, 91 corporate opportunity 145, 156; see also related also related party transactions corporate ownership, 25– ownership, 25–7, 7, 82, 103; see also also ownership costs, see agency, costs, agency, costs; coordination costs, transaction costs counterparties 2, 6– counterparties 6–7, 7, 10, 44, 79, 89, 92, 109, 159, 173 courts 38–40, courts 38–40, 69–72, 69–72, 132–3, 132–3, 135–40, 135–40, 152–3, 152–3,
takeover regulation 210, 174, 225 188, 208, 211, controllers controllers 85–6, 88, 152, 85–6, 228–9, 228– 9, 231, 233–4 233–4 controlling blocks blocks 79, 83, 85, 103, 208, 232–4 232–4 controlling shareholde shareholders rs 79–82, 79–82, 84–8, 84–8, 103–5, 103–5, 145–9, 145– 9, 153–7, 153–7, 162–3, 162–3, 165–8, 165–8, 188–90, 188–90, 206–10, 206– 10, 231–6; 231–6; see also controllers also controllers convergence 51, 57, 68, 71, 76, 81, 120–1, convergence 120–1, 150, 264–6, 264–6, 270 conversion 174, 196– conversion 196–9 9 coordination 2, 49, 51– coordination 51–2, 2, 60, 101, 114, 224 costs 2, 12, 30– 30–2, 2, 49, 52–3, 52–3, 57, 66, 80, 128, 140, 142, 208 problems 117–18, 117–18, 173, 206–8, 206–8, 218, 224–9, 224–9, 238, 242, 246, 267 shareholders 52, 58– 58–62 62 core jurisdictions jurisdictions 49–50, 49–50, 62–3, 62–3, 65–7, 65–7, 71–3, 71–3, 85–7, 85– 7, 95–104, 95–104, 174–6, 174–6, 248–51, 248–51, 257–9, 257–9, 270–1 270– 1 corporate assets assets 8, 32, 40, 43, 68, 109–12, 109–12, 116–17, 116– 17, 136, 139, 229; see also assets also assets abuse 161, 164– 164–5, 5, 168 corporate charters, charters, see charters charters corporate constituencies, constituencies, see constituencies constituencies corporate control, control, see control control
161–4, 161– 167– 167–8, 8, 189–92, 189– 92, 210, 251–2 251–2 CRAs, CRAs, see credit 4, credit rating agencies credit bureaus bureaus 122; see also gatekeepers also gatekeepers credit rating agencies agencies 122–3 122–3 creditor ownership ownership 109 creditor–creditor creditor– creditor coordination coordination 116–19 116–19 creditors 2– creditors 2–3, 3, 5–9, 5–9, 14–17, 14–17, 23, 29–31, 29–31, 109–43, 109–43, 172, 192, 195–8, 195–8, 210 contractual covenants covenants 119, 125, 125, 143 and directors’ directors’ fiduciary duties 127– 127–8 8 and distressed distressed firms firms 127– 127–40 40 and limited liability 2 and mergers 192 non-adjusting nonadjusting 115–16, 115–16, 119, 132 personal 6–7, 6–7, 9, 117 protection 2, 45, 112– 112–13, 13, 125–6, 125–6, 140–1, 140–1, 143, 192, 195, 210 secured 117–18, 117–18, 140 security 112, 119 and solvent solvent firms 119– 119–27 27 transactions with 140– 140–3 3 criminal liability 44, 68, 130– 130–1, 1, 164 criminal sanctions sanctions 44, 131, 160, 163, 165, 264 crisis managers managers 117, 127, 136– 136–9 9 cross-border crossborder relocation relocation 196–7 196–7 cross-shareholdings crossshareholdings 26, 75– 75–6, 6, 81, 238
corporate distributions distributions 36, 55, 58, 84, 86 7, 103–4, 103– 4, 112, 115, 125–6, 125–6, 181 corporate divisions, divisions, see divisions divisions corporate form form 1– 1–3, 3, 8–17, 8–17, 19, 37, 49–50, 49–50, 93, 124, 198, 269, 272 basic characteristics 1 closed/private closed/ private corporation corporation 3, 11, 14– 14–15 15 function 1 insolvent firms 117 nonprofit firms 14 open/public open/ public corporation 11 and other other forms 13– 13–16 16 piercing the corporate veil 114, 116, 116, 131–4, 131– 4, 269
cumulative voting 80 1, 101 damages 99, 116, 129, 133, 160– damages 160–1, 1, 163–5, 163–5, 246, 260–1, 260–1, 264 debt(s) 111–13, debt(s) 111–13, 117, 119, 122, 126, 131, 136, 139, 141–3, 141–3, 195 renegotiation 113–14, 113–14, 118, 127–8, 127–8, 141 debt finance finance 109–10, 109–10, 112, 119–20, 119–20, 140–3 140–3 debtors 111–12, debtors 111–12, 117, 119–20, 119–20, 127–8, 127–8, 133–6, 133–6, 138, 141, 143 decision-making decisionmaking 12, 69– 69–70, 70, 105–6, 105–6, 173–5, 173–5, 212, 215, 223–4, 223–4, 226, 236–7, 236–7, 239 joint 221, 223–4 223–4 power 50, 153, 172, 218
276
Index
decision rights rights 37–8, 37–8, 49, 51–3, 51–3, 57–9, 57–9, 81, 84, 95–6, 95– 6, 137–8, 137–8, 166–7, 166–7, 175–6; 175–6; see also also delegated management; shareholder(s) minority shareholders 84 strategy 37, 40, 84– 84–5, 5, 90, 155–8, 155–8, 162, 184, 187, 199, 201 default, see insolvency default, insolvency default provisions provisions 6, 18, 20– 20–1, 1, 124, 126 defensive measures, measures, see control control transactions, defensive measures Delaware 54, 56, Delaware 56, 68, 84– 84–7, 7, 154–7, 154–7, 161–4, 161–4, 175–9, 175– 9, 184–9, 184–9, 196, 199–200 199–200 delegated management 1, 5, 7, 11– 11–13, 13, 15, 37, 49–52, 49– 52, 86, 117, 156; see also boards also boards of directors; decision rights centralized management management 5, 217, 223, 223, 225, 237, 239 delisting 192 derivative action action 162–4; 162–4; see also enforcement also enforcement directors, see boards directors, boards of directors disclosure 38–9, disclosure 38–9, 46–7, 46–7, 94–5, 94–5, 119–21, 119–21, 148–51, 148– 51, 167, 222, 244, 246–52, 246–52, 254, 260–1 260– 1
electronic meetings meetings 59 electronic voting 59 empirical evidence evidence 18, 52, 61, 105, 111, 246–7 246–7 employees 5, 17, 22– employees 22–4, 4, 95, 100, 104–6, 104–6, 192–5, 192– 5, 197–8, 197–8, 209–10, 209–10, 238; see also also codetermination appointment and decision rights strategies 90–1 and control control transactions 209– 209–10 10 incentives and constraints strategies 91– 91–2 2 information 91 jurisdictional differences differences and similarities 105–7 105–7 and mergers 193 protection 89–92 89–92 representatives/representation representatives/ representation 16, 90– 90–1, 1, 193, 198, 210, 219 employmentt contracts employmen contracts 89, 194– 194–5 5 enforcement 38–45, 38–45, 104, 128, 160–1, 164–6, 168–9, 168– 9, 247–9, 247–9, 258–9, 258–9, 261–2, 261–2, 264 antifraud provisions provisions 128, 130, 130, 151 collective action 46, 261
mandatory 37–9, 37–8, 8,251, 68, 71–2, 71– 2, 7, 88,264 119–20, 119–20, 147, 244–9, 244– 256– 256–7, periodic 39, 166, 166, 249, 252, 260 260 requirements requiremen ts 69, 71– 71–2, 2, 100, 104, 121, 147–8, 147– 8, 222, 225, 247–9, 247–9, 255; see also also accounting benefits and costs 247 conflicted transactions 147– 147–51 51 as entry entry strategy 33, 88 function 38, 45 material information 120 policies 38–9 38–9 public registers 119 rationale 38, 247 scope 47 selective 47, 251 discretion 29, 33, 66– discretion 66–7, 7, 70, 158, 180, 217, 219, 246, 248 dispersed ownership ownership 2, 24, 27, 63, 73, 75, 103, 129, 185, 240 dispersed sharehold shareholders ers 58, 74– 74–5, 5, 80, 128, 175, 181, 208, 233 dissolution 96, 126, 152, 191, 201, 269 dissolution partial 152, 167 distressed firms firms 127, 129, 131– 131–3, 3, 135, 137, 139 and creditors 127– 127–40 40 distributions, see corporate distributions, corporate distributions
directorial liability 128– 128–30 30 148 disclosure requireme requirements nts 46, 148 discovery 41, 151 gatekeeper control 42, 121– 121–4 4 initiators 40–3 40–3 insider trading 39 intensity 115, 121, 169, 169, 254, 259, 259, 266 modes of 42, 151 private 41–2, 41–2, 70, 128, 130, 160, 165, 167, 169, 258, 260–4 260–4 public 40–2, 40–2, 130, 147, 151, 169, 259–60, 259–60, 263–4 263– 4 rules and standards standards 39, 46, 160, 164 standing to sue 128– 128–9 9 entity shielding 6– 6–7, 7, 9, 110–111, 110–111, 113, 116– 17, 269; see also assets, also assets, partitioning liquidation protection 6 priority rule 6 strong form 6, 15, 15, 117 weak form 6 entrenchment 175–6, 175–6, 180–1, 180–1, 185 entry strategy 33–4, 33–4, 37, 244, 256 equal treatment 36, 84, 86– 86–8, 8, 102, 104, 215, 225 equity-based/ equitybased/linked linked compensation compensation 62, 66, 100, 157, 245 European company, company, see Societas Societas Europaea
divergence 1, 25, 76, 140, 202, 210, divergence 210, 253–4, 253–4, 266, 269, 271 dividends, see corporate dividends, corporate distributions divisions 58, 98, 174, 183–5, divisions 183–5, 187, 189, 191, 193–5, 193– 5, 237 dominant shareholders shareholders 49, 73– 73–4, 4, 79, 81, 86,
ex ante strategies strategies 37–8, 37–8, 119 ex post strategies strategies 36–8, 36–8, 119, 218 executive compensation, compensation, see compensation compensation executives, see managers executives, managers exit 33–4, 33–4, 37–8, 37–8, 88, 179–80, 179–80, 187–8, 187–8, 226–8, 226–8, 230, 232–4, 232–4, 243–4, 243–4, 254–5 254–5
164, 166–rights 166–7, 7, 169, 202, double voting rights 13, 82,243 106 duty of care care 69–71, 69–71, 129; see also also fiduciary duties duty of loyalty 68, 84, 88, 97, 129, 156, 161–2, 164, 183, 248; see also also fiduciary duties
compulsory buyout exit strategy buy-out 34–5, 34– 5, 37,232 88, 152–3, 152–3, 186–7, 186–7, 202, 244 mandatory bid 208 rights 34, 69, 72, 166, 187– 187–8, 8, 224, 226–8, 226–8, 230, 232–4, 232–4, 254–5 254–5 external constituencies constituencies 92–100, 92–100, 102
Index appointment and decision rights strategies 95–7 95–7 incentives and constraints strategies 97– 97–100 100 jurisdictional differences differences and similarities 107–8 107–8 externalities 23, 30, 43, 45, 65, 93, 115, 247, 272 externalities fair price price 183, 188– 188–9, 9, 255 fair value value 253–4 253–4 fairness 37, 94, fairness 94, 148, 148, 161–4, 161–4, 172, 180, 186–7, 189, 202; see also fiduciary also fiduciary duties; judicial review fiduciary duties duties 97–9, 97–9, 130–1, 130–1, 136, 161, 165–6, 215, 218, 225, 228, 231 auditors 122 directors and managers managers 69– 69–71, 71, 84, 92, 128–9, 155, 161–2, 161–2, 164, 206 shareholders 131, 206 third parties 134– 134–5 5 fiduciary standards standards 69, 210, 232 financial analysts analysts 147, 260 financial crisis crisis 24–5, 24–5, 97, 99–100, 99–100, 122–4, 122–4, 142, 181–2, 181– 2, 239, 241, 253, 271–2 271–2 financial distress distress 114,insolvency 118, 128, 131; see also also distressed firms; financial intermediaries intermediaries 58–9, 58–9, 80, 82, 143, 150, 157, 248–9, 248–9, 255, 257, 262 France 55–60, 55–60, 73–5, 73–5, 102–4, 102–4, 125–7, 125–7, 129–32, 129–32, 134–9, 134– 9, 149–52, 149–52, 154–8, 154–8, 163–6, 163–6, 186–90 186–90 fraud 128, 132, 256, 258, 260– 260–1 1 risk 256, 263 securities 16, 69, 146, 146, 151, 167, 257, 260–1, 260–1, 264 fraudulent conveyance conveyance 134 freeze-outs freezeouts 146, 174, 185, 188–90; 188–90; see also also squeeze-outs squeezeouts functional approach approach 3, 134, 268 fundamental changes changes 72, 88, 171– 171–203 203 definition 172–4 172–4 explanation of differences differences 201– 201–3 3 GAAP (Generally Accepted Accounting Principles) 121, 126, 148, 151, 253– Principles) 253–4; 4; see also accounting; also accounting; IFRS gatekeepers 40, 42– gatekeepers 42–3, 3, 117, 122–4, 122–4, 134, 151, 186, 256, 262–5 262–5 control 42, 258, 263– 263–4 4 gender quotas quotas 95–6 95–6 general meetings, meetings, see shareholders’ shareholders’ meetings Generally Accepted Accounting Principles, Principles,
277 strategies 31–2, 31–2, 35, 38–40, 38–40, 44–6, 44–6, 49, 93, 135, 140, 142–3, 142–3, 256; see also also appointment rights; decision rights; rewards; trusteeship groups of companies companies 16–17, 16–17, 52, 87–8, 87–8, 109–10, 115, 121, 131–4, 131–4, 138–9, 138–9, 163–4, 163–4, 207–8; 207– 8; see also intraalso intra-group group transactions; parent companies; pyramidal ownership structures; subsidiaries accounting 148 approval of conflicted conflicted transactions 87 piercing the corporate veil 133 regulation of 87, 133– 133–4, 4, 162–4 162–4 subsidiary indemnification indemnification 87, 133– 133–4, 4, 163 hedge funds funds 26–7, 26–7, 52, 55, 60, 101, 108, 117, 143, 186; see also investors also investors activist 52–3, 52–3, 59–60, 59–60, 155, 216, 271; see also also investors, activist high-powered highpowered incentives incentives 35–6, 35–6, 62, 221 hostile bids/takeovers bids/takeovers 45, 72– 72–3, 3, 206–10, 206–10, 213, 216, 220, 223, 226, 237–9, 237–9, 241 human rights rights 24, 93– 93–5, 5, 160, 271 IAS (International Accounting Standard) Standard) 121, 148–9, 148– 9, 254 IFRS (International Financial Reporting Standards) 121, 126, 148– Standards) 148–50, 50, 252–4; 252–4; see also accounting; also accounting; GAAP; IAS incentive strategy 34–5, 34–5, 84, 86, 93, 139–40, 139–40, 153; see also managers; also managers; rewards; trusteeship incentives 62, 86– incentives 86–7, 7, 91–2, 91–2, 110–14, 110–14, 117, 119–20, 128, 154–5, 154–5, 207–8, 207–8, 221–2 221–2 alignment 32, 35, 37 high-powered highpowered 35–6, 35–6, 62, 221 incumbent management 137, 207– 207–8, 8, 211–22, 211–22, 225–6, 225– 6, 237 independent directors directors 62–7, 62–7, 76–7, 76–7, 84–6, 84–6, 99, 101, 153–5, 153–5, 162, 166–8, 166–8, 219–20, 219–20, 270–1; see also boards also boards of directors information 32–4, information 32–4, 38–40, 38–40, 46–7, 46–7, 49–50, 49–50, 52–3, 52–3, 159–61, 159– 61, 224–6, 224–6, 245–8, 245–8, 250–2, 250–2, 257–8; 257–8; see also disclosure also disclosure asymmetry 52, 123, 171, 208, 219 benefits 248 sensitive 51, 60, 101, 159, 251 underproduction 246 initiation of decisions decisions 37 insider trading 29, 31, 65– 65–6, 6, 146, 150–1, 150–1, 158–61, 158– 61, 244–5, 244–5, 248, 251–2, 251–2, 257–9; 257–9; see
see GAAP GAAP Germany 50–1, 50–1, 54–60, 54–60, 68–72, 68–72, 105–6, 131–2, 134–9, 134– 9, 141–3, 141–3, 149–53, 149–53, 155–8, 155–8, 163–7 163–7 courts 132, 134, 154, 154, 190 190 law 55–6, 55–6, 71, 74–5, 74–5, 86–7, 86–7, 121, 163, 226, 228, 233, 235 going private goldenprivate shares 192, shares 95–6,255 95–6, 102, 107 good faith faith 33, 70, 98, 135, 147, 179, 191 governance 38–9, governance 38–9, 46–7, 46–7, 49, 79, 103, 105, 108, 127–8, 127– 8, 177, 244 interests of shareholders as a class 49– 49–77 77 rights 27, 50, 52, 70, 94, 180, 270
also related-party transactions also related-party insolvency 30, 70– 70–1, 1, 113–19, 113–19, 126–40, 126–40, 143, 152–3, 152– 3, 166, 184; see also creditors; also creditors; restructurings and boards 114, 138 and corporate law 17 crisis manager manager 117, 136– 136–7 7 divergence in protecting creditors 140 filing 127, 136 fraudulent conveyance 134 liquidation 118 pre-packaged prepackaged bankruptcy 117– 117–18 18 reorganization 117–18 117–18
278
Index
insolvency (Cont.) role of courts 138, 140 140 subordination of debt debt 131 veto rights 138 vicinity of 114, 130, 130, 134 134 workout 142 institutional investors investors 26, 49– 49–50, 50, 53–5, 53–5, 60–61, 73–5, 73– 5, 101, 104, 107–8, 107–8, 265, 270–271 270–271 portfolio shares 60– 60–1 1 insurance 43, 105, 114, 116, 261 insurance insurgents 53–5 insurgents 53–5 interest groups groups 22, 27, 169, 268, 268, 270 dynamics 4, 25, 25, 168– 168–9, 9, 265–6 265–6 International Accounting Standard, Standard, see IAS IAS International Financial Reporting Standards, Standards, see accounting; accounting; GAAP; IFRS intra-group intragroup transactions transactions 87, 121, 149, 161, 164, 167, 169 investments 10, 13, 88– investments 88–9, 9, 109, 111, 120, 123, 238, 240, 252 investor ownership ownership 1, 13– 13–15, 15, 49–51, 49–51, 106; see also ownership also ownership investor protection protection 60, 257, 260, 262, 265
in corporate context 45 systematic differences across jurisdictions 45– 45–7 7 liability, see auditors; liability, auditors; boards of directors; controlling shareholders; criminal liability; limited liability; shareholder(s), personal liability; third parties
disclosure investors investors 13–14, 13–256 14, 59, 76–7, 76–7, 120, 151, 243–4, 243–4, 248–50, 248– 50, 254–5, 254–5, 257–8, 257–8, 270; see also also institutional investors activist 27, 50, 77, 101, 118, 270; 270; see also also activist hedge funds foreign 76 institutional 26, 49– 49–50, 50, 53–5, 53–5, 60–1, 60–1, 73–5, 73–5, 101, 104, 107–8, 107–8, 265, 270–1 270–1 issuers 97, 120– issuers 120–1, 1, 123, 230, 233, 243–6, 243–6, 248–9, 248– 9, 251–2, 251–2, 254–5, 254–5, 257–9, 257–9, 261–4; 261–4; see also investor also investor protection public 97, 248– 248–9 9 Italy 50–1, 50–1, 53–9, 53–9, 73–5, 73–5, 80–3, 80–3, 95–7, 95–7, 101–5, 101–5, 129–39, 129– 39, 148–50, 148–50, 152–8, 152–8, 163–6 163–6
75, 91,agency 154, 200 managerial costs 46, 52– costs 52–3, 3, 60, 79, 81, 208 managers 62, 65– managers 65–7, 7, 72–5, 72–5, 145–7, 145–7, 158–9, 158–9, 164–9, 164– 9, 184–6, 184–6, 245–7, 245–7, 261, 265–6; 265–6; see also also agency problems; boards of directors conflicted transactions 145– 145–6, 6, 153, 162; see also insider also insider trading mandatory bid rule rule 88, 216– 216–17, 17, 227–30, 227–30, 233–5, 237, 239 mandatory disclosure disclosure 37–8, 37–8, 68, 71–2, 71–2, 88, 119–24, 119– 24, 147, 244–9, 244–9, 251, 256–7, 256–7, 264; see also disclosure, also disclosure, requiremen requirements ts mandatory law/rules law/rules 18–20, 18–20, 106, 118, 171, 180, 199; see also rules also rules markets 87–8, markets 87–8, 119, 227, 233–5, 233–5, 243–6, 243–6, 255–6, 258–9, 258–9, 263–4, 263–4, 266, 270–1 270–1 public 10, 15, 45, 71, 88, 148–9, 148–9, 206, 243–4, 246, 257–8 257–8 securities, see securities, securities, markets mergers 37–8, mergers 37–8, 69–70, 69–70, 84, 171–2, 171–2, 174, 183–9, 183–9, 192–9, 192– 9, 201–3, 201–3, 205–6, 205–6, 231; see also control also control transactions; parent-subsidiary parent-subsidiary mergers appraisal rights 186– 186–7 7 creditor protection 192 employee protection 192– 192–4 4 majority–minority majority– minority shareholder conflict 188–92 188–92
Japan 55–9, Japan 55–9, 75–6, 75–6, 94–5, 94–5, 119–24, 119–24, 129–32, 129–32, 134–7, 134– 7, 149–52, 149–52, 154–7, 154–7, 177–86, 177–86, 249–51 249–51 joint decision-making decision-making 221, 223– 223–4 4 judicial review 167, 172, 182 board decisions 70, 155 labor directors directors 74–5, 74–5, 90, 105–6 105–6 labor law 17, 92, 99, 133, 133, 195 law and finance studies studies 27 lawmakers 24–5, lawmakers 24–5, 80, 84–5, 84–5, 160, 168, 228, 234, 241, 252, 256 law-onlawon-thethe-books books 72, 100, 102– 102–3 3
limited liability 1– 1–2, 2, 5–6, 5–6, 8–9, 8–9, 11, 15–17, 15–17, 93, 109–10, 109– 10, 116–17, 116–17, 243, 269; see also assets, also assets, partitioning liquidity 7, 10, 159, 161, 186– 186–7, 7, 243–5, 243–5, 247, 249, 254, 256–8 256–8 listed companies companies 53–4, 53–4, 63–4, 63–4, 73–6, 73–6, 80–2, 80–2, 104, 148–51, 148–51, 154–9, 154–9, 166–9, 166–9, 178–82, 178–82, 241 litigation, see enforcement; private litigation litigation, shareholder 41, 43, 70, 72, 130, 164– 164–5, 168, 219, 254, 261 management incumbent 137, 207– 207–8, 8, 211–22, 211–22, 225–6, 225–6, 237 target 185, 206, 209– 209–10, 10, 212, 214, 218, 224–5, 224– 5, 228, 231, 237 management boards boards 50–1, 50–1, 55, 57, 59, 69, 71,
legal capital capital 13–14, 13–14, 110–11, 110–11, 124–7, 124–7, 129, 174, 177–82, 177– 82, 201–2, 201–2, 243, 245–7, 245–7, 255–6 255–6 authorized 180, 182, 202 increase 87 maintenance 125, 128 minimum 124 1, 5– legal personality 5–11, 11, 17, 31, 109–10, 109–10, 133, 197 legal strategies strategies 29–32, 29–32, 36–40, 36–40, 42–6, 42–6, 49–50, 49–50, 71, 109–10, 109–10, 147, 237–8, 237–8, 244–58, 244–58, 267–9; 267–9; see also agency also agency problems; governance, governance, strategies; regulatory strategies
management– shareholder conflict 185– management–shareholder 185–8 8 protection of non-shareholder non-shareholder constituencies 192–4 192–4 shareholder approval 84, 184 184 third party evaluation evaluation 186 merit regulation 256–7 regulation 256–7 minorities viii, 94 minority shareholder(s) shareholder(s) 29–31, 29–31, 79–92, 79–92, 98–106, 98–106, 151–3, 151– 3, 163–5, 163–5, 167–8, 167–8, 171–9, 181–3, 187–92, 187– 92, 195, 201–2, 201–2, 208, 230–234; see also also agency problems; controlling shareholders; exit; groups of companies; shareholder(s)
Index appointment rights 80– 80–3 3 approval 84, 156 constraints and affiliation rights 88 corporate distributions 87, 152 and corporate groups 87, 164 164 decision rights 84 governance protection 79, 84 jurisdictional difference differences similarities 100–5s and 100–5 oppression 88, 152 protection 79–88 79–88 remedies 151–2 151–2 misappropriation 146, 158, 258; see also misappropriation also related-party transactions misconduct 42–4, 42–4, 130, 187 mutual funds funds 26, 34, 60– 60–1, 1, 271 nest-feathering 186 nest-feathering New York York Stock Exchange, Exchange, see NYSE NYSE nexus of contracts contracts 5 no frustration rule rule 212–14, 212–14, 216–18, 216–18, 221–4, 236–7, 236– 7, 239, 241; see also control also control transactions non-listed nonlisted companies companies 82, 151, 154, 184, 186 nonprofit corporations corporations 12, 14– 14–15, non-sharehol nonshareholder der constituencies constituencies 15, 79–85 79–80, 80, 82, 84–6, 84– 6, 88–90, 88–90, 92, 94–6, 94–6, 98–100, 98–100, 102, 104, 106; see also constituencies also constituencies NYSE (New York Stock Exchange) Exchange) 59, 63, 82–3, 99, 179, 181, 255, 257 officers 7, 12, 62– officers 62–3, 3, 85, 99, 146, 148–50, 148–50, 154–5, 154– 5, 159, 162; see also managers also managers one-share– oneshare–oneone- vote, vote, deviations from from 80–1, 80–1, 83; see also double also double voting rights one-tier onetier boards boards 50, 90, 154, 158 open corporations, corporations, see corporate corporate form opportunism 2, 27, 29, 31, 76, 88, 90, 192, opportunism 207–8, 207– 8, 221–3 221–3 organic changes changes 180, 184, 186, 188, 192, 202–3; 202– 3; see also charter also charter amendments; divisions; mergers oversight liability 99, 130 owners 2– owners 2–3, 3, 5–10, 5–10, 12, 14, 29–30, 29–30, 38, 46–7, 46–7, 59, 109, 116–17 116–17 ownership 10–11, ownership 10–11, 13–14, 13–14, 24–7, 24–7, 46, 60–1, 60–1, 81, 92–3, 92–3, 102–4, 102–4, 141–3, 141–3, 221–2; 221–2; see also also creditor ownership; investor ownership and agency agency problems 49 concentrated 53, 65, 74, 85, 102– 102–4, 4, 129, 234, 238, 265, 270 and corporate corporate law 141
279 parent-subsidiary mergers parent-subsidiary mergers 146, 154, 157, 167, 188 partnerships 2, 6, 10– partnerships 10–11, 11, 14, 17 path dependence dependence 24, 103, 169, 269 pay for performance performance 68, 92, 155, 157, 237; see also compensation; also compensation; rewards, strategy penalties 39, 41– penalties 41–5, 5, 68, 159–60, 159–60, 262 performance performance 29–6,30, 29–30, 33,250 35–6, 44–5, 35–6, 44–5, 62–3, 62–3, 65, 72, 95–6, 95– 247, periodic disclosures disclosures 39, 166, 249, 252, 260 personality, legal, legal, see legal legal personality piercing the corporate veil, veil, see veil-piercing veil-piercing poison pills pills 208, 212, 216– 216–17, 17, 220–3, 220–3, 228, 230–1; 230– 1; see also control also control transactions political economy 25, 39, 75, 109, 116, 234, 239, 265, 271; see also interest also interest groups; ownership potential bidders bidders 35, 207– 207–8, 8, 217, 224–5, 224–5, 228 power(s)boards power(s)boar ds of directors directors 172–3, 172–3, 181, 218, 238 shareholder 60–1, 60–1, 73–4, 73–4, 103, 224 preemptive rights rights 87, 102, 177, 180, 182– 182–3, 3, 200, 202 principals 29–40, principals 29–40, 42–3, 42–3, 46, 139, 175, 223, 243, 261 private benefits of control control 79, 103– 103–4, 4, 167–8, 167–8, 221, 228–9, 228–9, 232–3 232–3 private companies/corporations companies/corporations 10, 12, 15, 124, 151, 200; see also corporate also corporate form private litigation litigation 165, 169, 260 privatizations 95–7 privatizations 95–7 profitability 105, 146, 245, 257 profits 13, 23, 35, 120, 149, 159–60, profits 159–60, 199–200, 215, 257, 271 proportionality 81, 180, 239 proxy advisers advisers 61 proxy voting 33, 53– 53–6, 6, 58–61, 58–61, 66, 72, 209, 216, 219–20, 219–20, 231, 240; see also also shareholder voting public benefit 14, 93, 199 public companies/corporations companies/corporations 27, 53, 57– 57–8, 8, 121, 126, 183–4, 183–4, 186, 191, 199–200, 199–200, 254–5; 254– 5; see also corporate also corporate form public interest 40, 96– 96–7, 7, 99, 214, 241 public issuers, issuers, see issuers issuers public markets markets 10, 15, 45, 71, 88, 148–9, 148–9, 206, 243–4, 243– 4, 246, 257–8 257–8 publicly traded firms firms 40, 42, 53, 55–7, 55–7, 70–2, 70–2, 94, 120, 122–3, 122–3, 130, 132 delisting 192 disclosure 71, 147, 147, 151, 256
and disclosure 46– 46–7 7 dispersed 2, 24, 27, 63, 73, 75, 103, 129, 185, 240 and enforcement 46 and legal legal strategies 46
listing requirements requirements 59, 80 pyramids 147 and unlisted unlisted firms 84, 146 146 pyramidal ownership structures structures 81–2 81–2
state 14, 26, 42, 73, 96– 96–7, 107, 168, 2711, structures 25– 25–6, 6, 28, 46, 7, 72– 72–4, 4, 76, 140– 140–1, 169, 238, 241, 265–7 265–7
qualified majorities majorities 181– minorities 181–2 minorities 53 2 quality controls controls 71, 256– 256–7 7
parent companies companies 81, 110, 131, 134, 149, 163–4, 163– 4, 174, 189; see also groups also groups of companies; subsidiaries
ratification, see decision ratification, decision rights regulation 21–4, regulation 21–4, 60–1, 60–1, 123, 148, 181–2, 181–2, 197, 206, 208, 224–5, 224–5, 234–7 234–7
280
Index
regulators 22, 39– regulators 39–40, 40, 93, 150, 201, 211, 220, 241–2, 241– 2, 249, 256 regulatory competition competition 19, 21– 21–2, 2, 197, 216 regulatory strategies strategies 31–3, 31–3, 35, 38–40, 38–40, 45–7, 45–7, 49, 116, 140, 179, 244, 256–7; 256–7; see also also entry strategy; exit; rules; standards reincorporation 196–9, reincorporation 196–9, 201
authorized capital 180 majority–minority majority– minority conflict 181– 181–3 3 manager–shareholder manager– shareholder conflict 180– 180–1 1 shareholder(s), see also Introductory shareholder(s), also Introductory Note; agency problems; controlling shareholders; delegated management; exit; minority shareholder(s); ownership structures; share-
relatedrelated-party party transactions transactions 38,238, 46–7, 46– 7, 69,see87–8, 87– 8, 121, 145– 145–71, 71, 173, 188, 248; also also insider trading; self dealing; tunneling abusive 147, 151, 158 corporate opportunities 155 definition 145 duty of loyalty loyalty (fairness) 156, 161– 161–2, 2, 164 legal strategies for 147– 147–65 65 and ownership ownership regimes regimes 166– 166–9 9 prohibition 161 reasons for permitting permitting 146– 146–7 7 relocation, cross-border cross-border 196–7 196–7 removal rights rights 55–6, 55–6, 75, 136–7, 136–7, 218–19 218–19 removal remov al strategies strategies 37, 220 remuneration committees, committees, see compensation, compensation, committees reorganization 117–18, reorganization 117–18, 127, 136–8 136–8 reputation 35, 38, 44– reputation 44–5, 5, 63, 112, 119, 122, 162, 263, 265 restructurings 114, 117, 127, 137, 200, 203, restructurings 240; see also insolvency also insolvency retail investors investors 26, 59, 62, 101, 101, 264 rewards 35–6, rewards 35–6, 39, 62, 66, 68, 120, 139, 220, 226; see also compensation; also compensation; managers strategy 36–8, 36–8, 62, 66–7, 66–7, 92, 100, 139–40, 139–40, 218, 220–1, 220–1, 224, 226–7 226–7 risk taking 111, 129 rules 4– rules 4–9, 9, 16–24, 16–24, 29–34, 29–34, 54–61, 54–61, 124–8, 124–8, 157–62, 177–80, 177–80, 205–15, 205–15, 221–34, 221–34, 254–7; see also mandatory also mandatory law/rules benefits of legal rules 19– 19–20 20 strategy 33, 119, 124, 128, 128, 158–61, 158–61, 223
holder voting agreements 17, 57, 80, 101, 174, 176–7, 176–7, 236 approval 57–8, 57–8, 147, 154–8, 154–8, 172, 180–1, 180–1, 184–8, 184– 8, 199–202, 199–202, 213, 216–18, 216–18, 221–3 221–3 as a class 49 collective action issues issues 30 controlling 79–82, 79–82, 84–8, 84–8, 103–5, 103–5, 145–9, 145–9, 153–7, 153– 7, 162–3, 162–3, 165–8, 165–8, 188–90, 188–90, 206–10, 206– 10, 231–6 231–6 derivative action 164 dispersed 58, 74– 74–5, 5, 80, 128, 175, 181, 208, 233 dominant 49, 73– 73–4, 4, 79, 81, 86, 164, 166– 166–7, 7, 169, 202, 243 engagement 60–1, 60–1, 149, 239 equal treatment 84, 226 friendliness 76 interests as a class 49– 49–77 77 jurisdictional variation explained explained 72– 72–7 7 liability 6–8, 6–8, 43, 86, 116, 131, 162–3 162–3 litigation 41, 43, 70, 72, 130, 164– 164–5, 168, 219, 254, 261 majorityy 57, 72, 76, 79, 81, 172, 176, 186, majorit 188, 202 minority 79–81, 79–81, 83–9, 83–9, 91–2, 91–2, 99–105, 99–105, 151–3, 151– 3, 163–5, 163–5, 171–4, 171–4, 181–3, 181–3, 187–92, 187– 92, 201–2 201–2 personal assets assets 6, 9, 43, 111 personal creditors 6– 6–7, 7, 9, 117 personal liability 8, 43, 99, 99, 162, 265 265 ratification 37, 57, 68, 158, 168, 184 rights 57–8, 57–8, 66–7, 66–7, 74, 97, 102, 112, 166, 172, 177, 181–2 181–2
say on pay 36, 57, 67– 67–8, 8, 97, 157, 270 secured creditors creditors 117–18, 117–18, 140 securities 6– securities 6–7, 7, 9, 110, 206, 227, 243–6, 243–6, 248–9, 251, 255–6, 255–6, 258 fraud 16, 69, 146, 146, 151, 167, 257, 260–1, 260–1, 264 law enforcement 258– 258–64 64 laws 16, 41, 120, 148, 151, 210–11, 210–11, 222, 243–4, 243– 4, 259, 263–6 263–6 convergence and persistence persistence 264– 264–6 6 litigation 151, 250, 260– 260–2 2 markets 11, 159, 226, 243– 243–67; 67; see also also
target 206–8, 206–8, 211–14, 211–14, 216, 218–19, 218–19, 224–9, 224–9, 231, 235–7, 235–7, 240 shareholderr activism shareholde activism 52, 55, 60– 60–1, 1, 101, 178, 229; see also activist also activist hedge funds; investors, activist shareholder value value 13, 23– 23–4, 4, 43, 65, 94, 97, 99, 245 shareholderr voting 33, 57, 59– shareholde 59–60, 60, 83–4, 83–4, 154, 156–8, 156– 8, 180–1, 180–1, 184–5, 184–5, 196, 231; see also also shareholders’’ meetings shareholders cumulative voting 80 double voting voting rights 13, 82, 106
markets, public regulation regulatio n 41, 151, 160, 165, 189, 192, 219, 243–59, 243– 59, 261, 263–5 263–5 security interests interests 112–13, 112–13, 119, 143 selective disclosure disclosure 47, 251 self dealing 33, 37, 145– 145–6, 6, 148, 151, 154, 158, 160–161, 160– 161, 167, 174; see also related-party also related-party transactions sensitive information information 51, 60, 101, 159, 251 shadow directors directors 114, 128, 131, 133–4, 133–4, 163 share issuance issuance 171, 174, 177, 180–3 180–3
proportional voting 80 proxy voting 33, 53– 53–6, 6, 58–61, 58–61, 66, 72, 209, 216, 219–20, 219–20, 231, 240 rights 59, 61, 81– 81–4, 4, 103, 115, 150, 152, 178–80, 178– 80, 234–5, 234–5, 271 super-majority supermajority 84 voting by mail 72 shareholder–creditor shareholder– creditor agency costs costs 115, 136, 141–2 141–2 shareholder–creditor shareholder– creditor agency problems problems 111–16, 119, 128
Index
281
shareholders, coordination shareholders, coordination 52, 58– 58–62 62 shareholders’ meetings, meetings, 50, 53– 53–9, 9, 83–4, 83–4, 131, 156, 173, 179, 184–7, 184–7, 181, 191, 193, 200, 202–12, 202–12, 222, 236; see also also shareholder voting special 55–6 55–6 shares, see corporate distributions; transferable shares,
target sharehol shareholders ders 206–8, 206–8, 211–14, 211–14, 216, 218–19, 224–9, 224–9, 231, 235–7, 235–7, 240 tax law 17, 36, 66, 92, 99 tender offers, offers, see control control transactions terms of entry and exit 33–5, 33–5, 37 third parties parties 7, 9, 11, 11, 19, 22, 22, 98–9, 98–9, 108, 110, 134, 257–8 257–8
shares dual class 79, 81– 81–3, 3, 103, 147, 177, 179 golden 95–6, 95–6, 102, 107 repurchase 66, 87, 87, 125– 125–6, 180, 202 transferability 10–11, 10–11, 34, 88, 211, 243 significant corporate actions actions 146, 173– 173–4, 4, 200–3 200– 3 significant transactions transactions 34, 45, 167, 199–202, 199– 202, 223 social norms norms 36 social welfare welfare 23–5, 23–5, 31, 98, 107, 242, 247, 271 Societas Europaea 12, 22, 50– 50–1, 1, 58, 64, 125–6, 153, 156, 187, 196–8 196–8 SOEs, see state-owned SOEs, state-owned enterprises solvent firms, and creditors creditors 119–27 119–27 sources of corporate law 15–17 15–17 special auditors auditors 151–2, 151–2, 163 squeeze-outs squeezeouts 174, 188, 190– 190–2, 2, 205, 210, 230– 1; see also freezealso freeze-outs outs staggered boards boards 56, 176, 219, 222 standards accounting 120–2, 120–2, 148, 250, 254, 263 in corporate governance 69, 87– 87–8, 161 fiduciary 69, 210, 232 standards strategy strategy 33, 128, 128, 134–5, 134–5, 161–5, 161–5, 176, 183, 192, 202, 218–19, 218–19, 222–3 222–3 state capitalism capitalism 74, 96– 96–7 7 state-owned stateowned enterprises enterprises 14, 74, 74, 97, 107 state ownership ownership 14, 26, 42, 73, 96– 96–7, 7, 107, 168, 271 subsidiaries 133–4, subsidiaries 133–4, 149, 163–4, 163–4, 174, 188–9, 188–9, 192–4, 192– 4, 197, 200, 231, 233; see also groups also groups
liability 134– torts torts 7– 7–8, 8, 134–5 115–516 115–16 transaction costs costs 2, 113, 125, 138, 146, 173 transactions 45, 114– transactions 114–16, 16, 134–6, 134–6, 145, 147–51, 147– 51, 153–63, 153–63, 165–7, 165–7, 184–5, 184–5, 189–91, 189–91, 199–201 199– 201 control, see control control transactions with creditors 140– 140–143 143 related-party, relatedparty, see related-party related-party transactions significant 34, 45, 167, 199– 199–202, 202, 223 undervalue, see undervalue undervalue transactions transferable shares shares 1, 3, 5, 10–11, 10–11, 13 trustees 12, 35– trustees 35–6, 6, 62, 65, 86, 91, 136, 139, 153, 167 trusteeship 35–7, trusteeship 35–7, 49–50, 49–50, 62–3, 62–3, 66, 136, 139, 147, 155, 166–7, 166–7, 218–19 218–19 strategy 35, 38– 38–9, 9, 62, 85–6, 85–6, 99–101, 99–101, 139–40, 153–4, 153–4, 162, 185–7, 185–7, 220 tunneling 146, 166– 166–9; 9; see also related-party also related-party transactions two-tier twotier boards boards 18, 51, 157
of companies supermajority requirements requiremen ts 56, 84, 172, 175–8, 181, 183–4, 183–4, 191, 236, 255–6 255–6 supervisory boards boards 50–1, 50–1, 54–5, 54–5, 63–4, 63–4, 74–5, 74–5, 90–1, 90– 1, 105–6, 105–6, 154, 156, 210, 219–20 219– 20 takeovers 33–4, takeovers 33–4, 82–3, 82–3, 175, 183–4, 183–4, 205–7, 205–7, 211, 215–19, 215–19, 221, 234–5, 234–5, 237–40; 237–40; see also bids; also bids; control transactions; mergers target companies companies 205–7, 205–7, 209, 211–12, 211–12, 215–16, 221, 224–5, 224–5, 227, 229, 234, 237
UK 55–7, 55–7, 59–61, 59–61, 73–6, 73–6, 129–32, 129–32, 134–43, 134–43, 155–60, 155– 60, 181–5, 181–5, 220–31, 220–31, 259–60, 259–60, 262–5 262–5 undervalue transactions transactions 126, 134, 218, 253 United Kingdom, Kingdom, see UK UK United States, States, see U.S. U.S. unlimited liability 7, 9, 116 U.S. 54–61, U.S. 54–61, 63–8, 63–8, 70–6, 70–6, 82–7, 82–7, 120–6, 129–43, 148–52, 148–52, 154–62, 154–62, 179–90, 179–90, 247–65 247– 65 veil-piercing veilpiercing 114, 116, 131– 131–4, 4, 269 veto shareholder veto 36, 73, 73, 155, 155,voting 175–6, 185, 202, 237; see also 175–6, also bilateral 175–6 175–6 rights 30, 80, 126, 137– 137–8, 8, 153, 218, 223 vicinity of insolvency 114, 130, 134; see also also distressed firms voluntary liquidations liquidations 199 voting, see shareholder voting, shareholder voting white knights knights 212, 214– 214–15, 15, 225 worker codetermination, codetermination, see codetermination codetermination workouts 118, 135, 142; see also insolvency workouts also insolvency
target management 185, 206, 209– 209–10, 10, 212, 214, 218, 224–5, 224–5, 228, 231, 237
works councils councils 17, 91, 102, 105, 192, 209
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