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T H E A N ATO M Y O F C O R P O R AT E   L AW

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The Anatomy of Corporate Law A Comparative and Functional Approach

Third Edition REINIER KRAAKMAN JOHN ARMOUR PAU L   D AV I E S LU C A E N R I Q U E S H E N RY H A N S M A N N G E R A R D   H E RT I G K L AU S   H O P T HIDEKI KANDA M A R I A N A PA RG E N D L E R WO L F - ​G E O RG   R I N G E E DWA R D   RO C K With contributions from SOFIE COOLS and GEN GOTO

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1 Great Clarendon Street, Oxford, OX2 6DP, United Kingdom Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide. Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries 2017 © R. Kraakman, J. Armour, P. Davies, L. Enriques, H. Hansmann, G. Hertig, 2017 K. Hopt, H. Kanda, M. Pargendler, W.-​G. Ringe, and E. Rock 2017 The moral rights of the authors‌have been asserted First edition published in 2004 Third 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, 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 and you must impose this same condition on any acquirer Crown copyright material is reproduced under Class Licence 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–​19–​873963–​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.

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Acknowledgments The 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 Law School. As with prior editions, we have drawn shamelessly on our friends and colleagues 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, Tobias Tröger, 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 ETH 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, 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 in Business Law from 2001 to 2016. As ever, we thank our nearest and dearest, who may legitimately wonder why such a short book always involves so much toing and froing. The Authors

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Preface to the Third Edition As the Preface to the Second Edition observed, the Anatomy is the product of a long-​ standing collaboration. The Third Edition carries this collaboration forward into a new generation of scholars. Although the authors of the First Edition lent a hand, their role was largely advisory. We called ourselves the “supervisory board.” Most of the credit for the conceptual innovation and new research evident in this edition rightfully goes to those co-​authors who joined the Anatomy prior to the Second Edition or before the Third Edition was underway. This 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. This is not to say that the Third Edition abandons the aspirations and conceptual framework of prior editions. We remain committed to an approach to corporate law that is “international,” “functional,” “neutral,” and last but not least, “brief.” Indeed, the Third Edition is considerably improved on three of these dimensions and, against all odds, steadfastly holds the line on its commitment to brevity. The Anatomy 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 examples to fit our conceptual framework. The Second Edition added Italy to our initial set of five jurisdictions selected from a short list of developed economies: France, Germany, Japan, the UK, and the U.S. Italy was chosen not only because it fit our jurisdictional profile but also because a major scholar of Italian corporate law, Luca Enriques, joined our collaboration. John Armour, who joined the Anatomy 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 on this edition have similarly expanded our focus. Most visibly, we now include Brazil among our core jurisdictions. This may seem surprising given that prior editions relied exclusively on the legal regimes of developed economies. For the authors of the Anatomy, however, it is a considered step forward. The inclusion of a large emerging market economy—​the “B” in the so-​called 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 jurisdictional reach. And as suggested above, we are pragmatic. The decisive factor in the choice of Brazil was that Mariana Pargendler, a distinguished scholar of Brazilian corporate law, joined the Anatomy as a major contributor to the Third Edition. Although we are still constrained to referencing only a handful of jurisdictions, Professor Pargendler’s integration of Brazilian law throughout significantly adds to the international scope of the Third 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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Preface to the Third Edition

Readers of prior editions of the Anatomy can rest assured that the Third Edition follows the functional analysis of its predecessors. We begin with an effort to define “corporate 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 contracting 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. The 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 (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 Third Edition, 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, managers, employees, or creditors—​the firm’s “external constituencies.” In many cases, corporate activities 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 undertake; policies designed to prevent or redress minority and 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 Third 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 are—​used to protect or benefit its external constituencies. The Third Edition introduces other conceptual innovations that are less visible to readers but were no less energetically discussed by its authors. In particular, our chapters on creditor protection, fundamental corporate changes, and control transactions have been extensively revised and restructured. Our new author Professor Georg Ringe provided much of the energy as well as the research behind these changes, although many 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 Third Edition remains “neutral” in the sense that it does not take sides in important legal policy debates. Each of the contributors to the Anatomy has strong views about questions such as economic and social value of worker codetermination and the extent to which jurisdictions ought to target the resources and organizational capabilities of large corporations to pursue extra-​economic 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

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of the day can meet on common ground. 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. They may be less useful, however, in sharpening policy discussions among competing advocates. The 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 Third 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 points. Academic journals elsewhere may be less taxing, but my 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 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 contribution of some authors to the Third 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 of Chapter 4 in the Third Edition but also revised text in many chapters and added support to every chapter to 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. This is the first edition in which the Anatomy has featured three generations of scholars. The additions and refinement of Sofie and Gen appear in every chapter of the new Anatomy. They 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 Third Edition. Finally, our two General Editors—​John Armour and Luca Enriques—​have literally made the Third 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. 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. This edition of the Anatomy should be cited as John Armour, Luca Enriques et al., The Anatomy of Corporate Law: A Comparative and Functional Approach (3rd edn., Oxford University Press 2017). Reinier Kraakman Harvard Law School September, 2016

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Contents List of Authors  1. What Is Corporate Law?  John Armour, Henry Hansmann, Reinier Kraakman, and Mariana Pargendler 1.1 Introduction  1.2 What Is a Corporation? 

1.2.1 Legal personality  1.2.2 Limited liability  1.2.3 Transferable shares  1.2.4 Delegated management with a board structure  1.2.5 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 provisions  1.4.2 The benefits of legal rules  1.4.3 Choice of legal regime 

1.5 What Is the Goal of Corporate Law?  1.6 What Forces Shape Corporate Law? 

2. Agency Problems and Legal Strategies  John Armour, Henry Hansmann, and Reinier Kraakman 2.1 Three Agency Problems  2.2 Legal Strategies for Reducing Agency Costs  2.2.1 Rules and standards  2.2.2 Setting the terms of entry and exit  2.2.3 Trusteeship and reward  2.2.4 Selection and removal  2.2.5 Initiation and ratification  2.2.6 Ex post and ex ante 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 in Corporate Context  2.6 Systematic Differences  3. The Basic Governance Structure: The Interests of Shareholders as a Class  John Armour, Luca Enriques, Henry Hansmann, and Reinier Kraakman 3.1 Delegated Management and Corporate Boards 

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Contents 3.2 Appointment and Decision Rights  3.2.1 Appointing directors  3.2.2 Removing directors  3.2.3 Decision rights  3.2.4 Shareholder coordination 

3.3 Agent Incentives 

3.3.1 The trusteeship strategy: Independent directors 3.3.2 The reward strategy: Executive compensation 

3.4 Legal Constraints and Affiliation Rights 

3.4.1 The constraints strategy  3.4.2 Corporate governance-​related disclosure 

3.5 Explaining Jurisdictional Variation 

4. The Basic Governance Structure: Minority Shareholders and Non-​Shareholder Constituencies  Luca Enriques, Henry Hansmann, Reinier Kraakman, and Mariana Pargendler 4.1 Protecting Minority Shareholders 

4.1.1 Shareholder appointment rights and deviations from one-​share–​one-​vote  4.1.2 Minority shareholder decision rights  4.1.3 The incentive strategy: Trusteeship and equal treatment  4.1.4 Constraints and affiliation rights 

4.2 Protecting Employees 

4.2.1 Appointment and decision rights strategies  4.2.2 The incentives and constraints strategies 

4.3 Protecting External Constituencies 

4.3.1 Affiliation strategies  4.3.2 Appointment and decision rights strategies  4.3.3 The incentives and constraints strategies 

4.4 Explaining Jurisdictional Differences and Similarities  4.4.1 The law-​on-​the-​books  4.4.2 The law in practice 

5. Transactions with Creditors  John Armour, Gerard Hertig, and Hideki Kanda 5.1 Asset Partitioning and Agency Problems 

5.1.1 Asset partitioning and corporate creditors  5.1.2 Shareholder–​creditor agency problems  5.1.3 Creditor–​creditor coordination and agency problems 

5.2 Solvent Firms 

5.2.1 The affiliation strategy—​mandatory disclosure  5.2.2 The rules strategy: Legal capital 

5.3 Distressed Firms 

5.3.1 The standards strategy  5.3.2 Governance strategies 

5.4 Ownership Regimes and Creditor Protection 

5.4.1 Regulatory or contractual controls for solvent firms?  5.4.2 The role of bankruptcy law 

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Contents 6. Related-​Party Transactions  Luca Enriques, Gerard Hertig, Hideki Kanda, and Mariana Pargendler 6.1 Why Are Related-​Party Transactions Permitted at All?  6.2 Legal Strategies for Related-​Party Transactions  6.2.1 The affiliation strategy  6.2.2 Agent incentives strategies  6.2.3 The decision rights strategy: Shareholder voting  6.2.4 The rules strategy: Prohibiting conflicted transactions  6.2.5 The standards strategy: The duty of loyalty and intra-​group transactions review 

6.3 Ownership Regimes and Related-​Party Transactions 

7. Fundamental Changes  Edward Rock, Paul Davies, Hideki Kanda, Reinier Kraakman, and Wolf-​Georg Ringe 7.1 What are Fundamental Changes in the Relationship among the Participants in the Firm?  7.2 Charter Amendments  7.3 7.4

7.5 7.6 7.7

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172 174 7.2.1 The management–​shareholder conflict in charter amendments  178 7.2.2 The majority–​minority shareholder conflict in charter amendments  178 Share Issuance  180 7.3.1 The manager–​shareholder conflict  180 7.3.2 The majority–​minority conflict  181 Mergers and Divisions  183 7.4.1 The management–​shareholder conflict in mergers  185 7.4.2 The majority–​minority shareholder conflict in mergers  188 7.4.3 The protection of non-​shareholder constituencies in mergers  192 7.4.4 Corporate divisions 194 Reincorporation and Conversion  196 General Provisions on Significant Transactions  199 Explaining Differences in the Regulation of Fundamental Changes  201

8. Control Transactions  Paul Davies, Klaus Hopt, and Wolf-​Georg Ringe 8.1 Regulatory Problems in Control Transactions  8.1.1 Control transactions  8.1.2 Agency and coordination issues 

8.2 Agency Problems in Control Transactions 

8.2.1 The decision rights choice: Shareholders only or shareholders and board jointly  8.2.2 The “no frustration” rule  8.2.3 Joint decision-​making  8.2.4 Pre-​bid defensive measures 

8.3 Coordination Problems among Target Shareholders 

8.3.1 Disclosure  8.3.2 Trusteeship strategy  8.3.3 Reward (sharing) strategy  8.3.4 Exit rights: Mandatory bid rule and keeping the offer open  8.3.5 Acquisition of non-​accepting minorities 

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Contents 8.4 Specific Issues upon Acquisition from a Controlling Shareholder  231 8.4.1 Exit rights and premium-​sharing  232 8.4.2 Facilitating bids for controlled companies  234 8.5 Explaining Differences in the Regulation of Control Transaction  236 8.5.1 Differences in form and differences in substance  237 8.5.2 Different regulatory environments  238 8.5.3 Political economy considerations  239 8.5.4 Regulatory uncertainty  240

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 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 in Securities Regulation 

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10. Beyond the Anatomy  John Armour, Luca Enriques, Mariana Pargendler, and Wolf-​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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List of Authors John Armour 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 Trade 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 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 work for the UK Treasury. His most recent works include the 10th edition of Gower and Davies, Principles of Modern Company Law (Sweet & Maxwell 2016, with Sarah Worthington); and Introduction to Company Law (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 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. 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 Matteo Gatti), 15 Journal of Corporate Law Studies 55 (2015), and Disclosure and Financial Market Regulation (with Sergio Gilotta), in The Oxford Handbook of Financial Regulation (OUP 2015). He is a co-​author, together with John Armour, Paul Davies, and others, of Principles of Financial Regulation (OUP 2016). Henry 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 and nonprofit, private and public. He has been Professor or Visiting Professor at Harvard University, New York University, and the University of Pennsylvania Law Schools. Recent publications include Legal Entities as Transferable Bundles of Contracts (with Kenneth Ayotte), 111 Michigan Law Review 715 (2013), and External and Internal Asset Partitioning: Corporations and Their Subsidiaries (with Richard Squire), in Jeffrey Gordon and Georg Ringe (eds.), The Oxford Handbook of Corporate Governance (OUP 2017). He is a Fellow of the American Academy of Arts and Sciences and the European Corporate Governance Institute. Gerard Hertig is Professor of Law at ETH 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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Européennes at the University of Geneva Law School (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 of the Geneva bar. Recent publications include Decision-​Making During the Crisis: Why Did the Treasury Let Commercial Banks Fail? (with Ettore Croci and Eric Nowak), Journal of Empirical Finance (2016); Governance by Institutional Investors in a Stakeholder World, in The Oxford Handbook of Corporate Law and Governance (OUP 2017); Shadow Resolutions as a No-​No in a Sound Banking Union, with Luca Enriques, in Financial Regulation: A Transatlantic Perspective (CUP, 2015). Klaus Hopt was Director of the Max Planck Institute for Comparative and International Private Law in Hamburg, Germany. His main areas of specialization include commercial law, corporate law, banking, and securities regulation. He has been Professor of Law in Tübingen, 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. 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 Comparative Corporate Governance (CUP, 2013, with Andreas Fleckner (eds.)) and Corporate Boards in Law and Practice (OUP, 2013, with Paul Davies et al. (eds.)). Hideki Kanda is Professor of Law at Gakushuin University Law School since 2016. His main areas of specialization include commercial law, corporate law, banking regulation, and securities regulation. He was Professor of Law at the University of Tokyo 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 Corporate Law (18th edn., Kobundo, 2016, in Japanese), Comparative Corporate Governance (OUP, 1998, with Klaus Hopt et al. (eds.)), and Economics of Corporate Law (University of Tokyo Press, 1998, with Yoshiro Miwa and Noriyuki Yanagawa (eds.), in Japanese). Reinier Kraakman is the Ezra Ripley Thayer 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, corporate finances, and seminars on the theory of corporate law and comparative corporate governance. He is the author, with William T. Allen, of Commentaries and Cases in the Law of Business Corporations, 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 Virginia Law Review 313 (2014); Economic Policy and the Vicarious Liability of Firms, in Research Handbook on the Economics of Torts (Edgar Elgar, 2013); Law and the Rise of the Firm (with Henry Hansmann and Richard Squire), 119 Harvard Law Review 1333 (2006); and Property, Contract, and Verification: The Numerus Clausus Problem and the Divisibility of Rights (with Henry Hansmann), 31 Journal of Legal Studies S373 (2002). Mariana Pargendler is Professor of Law at FGV Law School in São Paulo (FGV Direito SP), where she directs the Center for 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 The Evolution of Shareholder Voting Rights: Separation of Ownership and Consumption (with Henry Hansmann), 123 Yale Law Journal 948 (2014), Politics in the Origins: The Making of Corporate Law in Nineteenth-​Century Brazil, 60 American Journal of Comparative Law 805 (2013), and State Ownership and Corporate Governance, 80 Fordham Law Review 2917 (2012).

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Wolf-​Georg Ringe is Professor of Law at the University of Hamburg where he directs the 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 Journal of Financial Regulation, 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 The Deconstruction of Equity (OUP 2016) and The Oxford Handbook of Corporate Law and Governance (OUP 2017, with Jeffrey Gordon (eds.)). Edward Rock is Professor of Law at New York University Law School and director of 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 University of Chicago Law Review 1119 (2016), Institutional Investors in Corporate Governance, in The Oxford Handbook of Corporate Law and Governance (OUP 2017), and Symbolic Corporate Governance Politics (with Marcel Kahan), 94 Boston University Law Review 1997 (2014).

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1 What Is Corporate Law? John Armour, Henry Hansmann, Reinier Kraakman, and Mariana Pargendler

1.1 Introduction What is the common structure 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 problems—​in all jurisdictions. Consider, in this regard, the basic legal characteristics of the business corporation. To anticipate our discussion below, there are five of these characteristics, most of which will be easily recognizable to anyone familiar with business affairs. They are: legal personality, limited liability, transferable shares, delegated management under a board structure, and investor ownership. These characteristics respond—​in ways we will explore—​to the economic exigencies of the large modern business enterprise. Thus, corporate law everywhere must, of necessity, provide for them. To be sure, there are other forms of business enterprise that lack one or more of these characteristics. But the remarkable fact—​and the fact that we wish to stress—​is that, in market economies, almost all 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 a principal function of corporate law is to provide business enterprises with a legal form that possesses these five core attributes. By making this form widely available and user-​friendly, corporate law enables business participants to transact easily through the medium of the corporate 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, Understanding the Japanese Keiretsu: Overlaps Between Corporation Governance and Industrial Organization, 102 Yale Law Journal 871 (1993); Bernard S. Black and John C. Coffee, Hail Britannia? Institutional Investor Behavior Under Limited Regulation, 92 Michigan Law Review 1997 (1994); Varieties of Capitalism (Peter A. Hall and David Soskice eds., 2001); Mark J. Roe, Political Determinants of Corporate Governance (2003); Corporate Governance in Context: Corporations, States, and Markets in Europe, Japan, and the US (Klaus J. Hopt et al. eds., 2005); Comparative Company Law: A Case-​Based Approach (Mathias Siems and David Cabrelli eds., 2013). The Anatomy of Corporate Law. Third 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, Henry Hansmann, Reinier Kraakman, and Mariana Pargendler, 2017. Published 2017 by Oxford University Press.

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whole.2 Nevertheless, these are the provisions that comprise the legal core of corporate law that is shared by every jurisdiction. In this chapter, we briefly explore the contracting 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, 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 forms of opportunism among different constituencies. As we outline in Section 1.2, corporate laws everywhere share core features which can be understood as serving to reduce the costs for participants of organizing their activities in 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 non-​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.” 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. The reader might object that these three types of coordination costs and agency conflicts are not uniquely “corporate.” After all, any form of jointly owned enterprise faces coordination costs and engenders conflicts among its owners, managers, and third-​ party contractors. We agree; insofar as the 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 enterprises—​ and, as a practical matter, the only form that firms with widely dispersed ownership can choose in many jurisdictions.4 In our view, this is because its particular characteristics make it uniquely effective at minimizing coordination costs. Moreover, these same features determine the particular contours of its agency problems. To take an obvious example, the fact that shareholders enjoy limited liability—​while, say, general partners in a partnership do 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 institution that has encouraged the separation of ownership from control, and so has sharpened the management–​shareholder agency problem. In this book, we explore the role of corporate law in minimizing coordination and agency problems—​and thus, making the corporate form practicable—​in the most 2  We use the term “corporation statute” to refer to the general law that governs corporations, and not to a corporation’s individual charter (or “articles of incorporation,” as that document is sometimes also called). 3  These include the costs of searching for contracting partners and negotiating and drafting 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. 4  This 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., the equity securities of so-​called “master” limited partnerships and limited liability companies may be registered for public trading.

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Introduction

3

important categories of corporate actions and decisions. More particularly, Chapters 3 to 9 address seven categories of transactions and decisions that involve the corpor­ ation, its owners, its managers, and the other parties with whom it deals. Most of these categories of firm activity 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. Taken together, the latter seven chapters of our book cover nearly all of the important problems in corporate law. In each chapter, we describe how the basic coordination costs and agency problems of the corporate form manifest themselves in a given category of corporate activity, and then explore the range of alternative legal responses that are available. We illustrate these alternative approaches with examples from the corporate laws of various prominent jurisdictions. We explore the patterns of homogeneity and heterogeneity that appear. Where there are significant differences across jurisdictions, we seek to address both the sources and the consequences of those differences. Our examples are drawn principally from a handful of major representative jurisdictions, which we label our “core jurisdictions.” These are Brazil, France, Germany, 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 cannot, in a short 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. This 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.5 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.6 Moreover, while comparative law scholarship often has a tendency to emphasize differences between jurisdictions, our approach is to highlight similarities 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 cross-​ fertilization of corporate law that has become more common in the wake of the growth of global economic activity. We realize that the term “functional,” 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 in the field of sociology—​have made it justifiably 5  Compare e.g. The Legal Basis of Corporate Governance in Publicly Held Corporations: A Comparative Approach (Arthur R. Pinto and Gustavo Visentini eds., 1998); Gunther H. Roth and Peter Kindler, The Spirit of Corporate Law (2013). 6 Other examples of this approach include John Armour et  al., Principles of Financial Regulation (2016); Gregor Bachmann et  al., Regulating the Closed Corporation (2012); Curtis Milhaupt and Katharina Pistor, Law and Capitalism (2008).

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What Is Corporate Law?

suspect. It would perhaps be more accurate to call our approach “economic” rather than “functional,” though the sometimes tendentious use of economic argumentation in legal literature to support particular (generally laissez-​faire) policy positions, as well as the tendency in economic analysis to neglect non-​pecuniary motivations or assume an unrealistic degree of rationality in human action, have also caused many scholars—​ particularly outside the U.S.—​to be as wary of “economic analysis” 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 “functional” in the sense that we organize discussion around the ways in which corporate laws respond to these problems, and the various forces that have led different jurisdictions to choose roughly similar—​though by no means always the same—​solutions to them. That 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 language and a general analytic framework with which to understand the purposes that can potentially be served by corporate law, and with which to compare and evaluate the efficacy of different legal regimes in serving those purposes.7 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 mean ignoring differences between countries’ corporate laws. Even if, as we think, corporate laws everywhere respond to similar economic problems, there may be differences in the way they do so, often reflecting local variety in the way other aspects of the system of economic production are organized.8 The basis for such differences in corporate law rules is consequently illuminated by reference to the broader economic environment. 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. To the extent that such matters impede corporate law’s ability to respond to economic exigencies, they will in time face economically motivated pressure for reform. That said, we take no strong stand here in the enduring debate on the extent to which corporate law is or should be “converging,” much less on to what it might converge.9 That is a subject on which reasonable minds (including, indeed, the authors of this book) can reasonably disagree.10 Rather, we are seeking to set out a conceptual 7  In very general terms, our approach echoes that taken by Robert Clark in his important treatise, Corporate Law (1986), and Frank Easterbrook and Daniel Fischel, in their discussion of U.S. law, The Economic Structure of Corporate Law (1991). However, our analysis differs from—​and goes 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 particular legal institutions and solutions. 8  See Section 1.6. 9 See e.g. Convergence and Persistence in Corporate Governance (Jeffrey N. Gordon and Mark J. Roe eds., 2004), Comparative Corporate Governance: A Functional and International Analysis (Andreas M. Fleckner and Klaus J. Hopt eds., 2013). 10  The views of the authors of this chapter are briefly set out in Henry Hansmann and Reinier Kraakman, The End of History for Corporate Law, 89 Georgetown Law Journal 439 (2001); Henry Hansmann and Reinier Kraakman, Reflections on the End of History for Corporate Law, in Convergence of Corporate Governance:  Promise and Prospects (Abdul Rasheed and Toru

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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 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 provides for the formation of firms with all of these characteristics. As this pattern suggests, these characteristics have strongly complementary qualities for many firms. Together, 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, in particular, those among the firm’s owners, managers, and employees—​are essentially contractual in character. This is an important insight, but it does not distinguish firms from other networks of contractual relationships. It is perhaps more accurate to describe a firm as a “nexus for contracts,” in the sense that a firm serves, fundamentally, as the common counterparty in numerous contracts with suppliers, employees, and customers, coordinating the actions of these multiple persons through exercise of its contractual rights. The 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 to engage together in joint projects. The core element of the firm as a nexus for contracts is what civil lawyers refer to as “separate patrimony.” This involves the demarcation of a pool of assets that are distinct 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. The 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 Rules Evolve? Evidence from a Cross-​Country Comparison of Shareholder, Creditor, and Worker Protection, 57 American Journal of Comparative Law 579, 619–​29 (2009); and Mariana Pargendler, Corporate Governance in Emerging Markets, in Oxford Handbook of Corporate Law and Governance (Jeffrey N. Gordon and Wolf-​Georg Ringe eds., 2017). 11  The characterization of a firm as a “nexus of contracts” originates with Michael Jensen and William Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 Journal of Financial Economics 305 (1976), building on Armen Alchian and Harold Demsetz, Production, Information Costs, and Economic Organization, 62 American Economic Review 777 (1972). 12  We use the term “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 concept of “ownership” see John Armour and Michael J. Whincop, The Proprietary Foundations of Corporate Law, 27 Oxford Journal of Legal Studies 429, 436–​48 (2007).

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What Is Corporate Law?

the rights to use the assets, to sell them, and—​of particular importance—​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. The core function of this separate patrimony has been termed “entity shielding,” to emphasize that it involves shielding the assets of the entity—​the corporation—​from the creditors of the entity’s owners.13 Entity shielding involves two relatively distinct rules of law. The 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’s owners. This rule is shared by modern legal forms for enterprise organization, including partnerships.14 The consequence of this priority rule is that a firm’s assets are, as a default rule of law,15 automatically made available for the enforcement of contractual liabilities entered into in the name of the firm.16 By thus bonding the firm’s contractual commitments, the rule makes these commitments credible. The second component of entity 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.17 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.18 In contrast to the priority rule just discussed, it is not found in some other standard legal forms for enterprise organization, such as the partnership.19 Legal entities, such as the business corporation, that are characterized by both these rules—​priority for business creditors and liquidation protection—​can therefore be thought of as having “strong-form” entity shielding, as opposed to 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. 20 13  The term “entity shielding” derives from Henry Hansmann, Reinier Kraakman, and Richard Squire, Law and the Rise of the Firm, 119 Harvard Law Review 1333 (2006). The centrality of entity shielding to organizational law is explored in Henry Hansmann and Reinier Kraakman, The Essential Role of Organizational Law, 110 Yale Law Journal 387 (2000), where this same attribute was labelled “affirmative asset partitioning.” 14  While even unregistered common law partnerships are subject to this priority rule, many civil law jurisdictions recognize a class of unregistered “partnerships” that lack this rule of priority. In effect, such partnerships are just special forms for the joint management of assets rather than distinct entities for purposes of contracting. 15  On default rules, see Section 1.4.1. 16  The effect is the same as if the firm’s owners had themselves entered into a joint contract and granted non-​recourse security over certain personal assets to the counterparty, as opposed to transferring those assets to the corporate entity, and then procuring the company to enter into the contract. 17  Hansmann and Kraakman, note 13, at 411–​13. 18  Edward B. Rock and Michael L. Wachter, Waiting for the Omelet to Set: Match-​Specific Assets and Minority Oppression in Close Corporations, 24 Journal of Corporation Law 913, 918–​20 (1999); Margaret M. Blair, Locking in Capital:  What Corporate Law Achieved for Business Organizers in the Nineteenth Century, 51 UCLA Law Review 387, 441–​9 (2003). 19 That said, it is possible in many jurisdictions to effect liquidation protection by agreement amongst the owners of a partnership. 20  While strong-form entity shielding seems essential for free tradability of 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

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What Is a Corporation?

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The benefits of these two 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. These two rules assure counterparties that their 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 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 to serve effectively as a contracting party, two other types of rules are also needed. First, there must be rules specifying to third parties the individuals who have 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 such contractual agreement—​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. The particular rules of authority governing the corpor­ ation are treated below as a separate core characteristic, “delegated management.” They 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. Corporations are subject to rules that make such suits easy to bring as a procedural matter. In particular, they eliminate any need to name, or serve notice on, the firm’s individual owners—​procedures that plagued the Anglo-​American partnership until the late nineteenth century. The outcomes achieved by each of these three types of rules—​entity shielding, authority, and 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. That 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’s other creditors.24 Rules governing the allocation shareholder liability for corporate debts: see Henry Hansmann and Reinier Kraakman, Toward Unlimited Shareholder Liability for Corporate Torts, 100 Yale Law Journal 1879 (1991); Charles R. Hickson and John D. Turner, The Trading of Unlimited Liability Bank Shares in Nineteenth-​Century Ireland: The Bagehot Hypothesis, 63 Journal of Economic History 931 (2003). 21  Kenneth Ayotte and Henry Hansmann, Legal Entities as Transferable Bundles of Contracts, 111 Michigan Law Review 715 (2013). 22  Armour and Whincop, note 12, at 441–​2. 23  Associated 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. 24  To 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 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.

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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.25 And procedures for lawsuits need to be specified by the state, whose third-​ party authority is invoked by those procedures. This need for special rules of law distinguishes 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.26 The 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 which enjoy the benefit of each of the three foregoing “foundational” rule types. Starting from the premise that the company is 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 as the corporation—​that share these three attributes. However, we should make clear that legal personality in the lawyer’s sense is not in itself an attribute that is a necessary precondition for the existence of any—​or indeed all—​of these rules,27 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,28 or the protected enjoyment of civil rights,29 we see no functional rationale that compels this.

1.2.2 Limited liability The 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’s shareholders hold in their own names. While this rule of “limited liability” was not, historically, always associated with the corporate form,30 the association

25  To 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–​7. 26  See Hansmann and Kraakman, note 13, at 407–​9. The exception is limited shareholder liability to corporate tort victims. See Section 1.2.2. 27  Thus, a common law partnership, which is commonly said by lawyers to lack legal 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; Burnes v. Pennell (1849) 2 HL Cas 497, 521; 9 ER 1181, 1191; PD 7A, para. 5A Civil Procedure Rules (UK). 28  Richard R.W. Brooks, Incorporating Race, 106 Columbia Law Review 2023 (2006). 29  See Cnty. of Santa Clara v. S. Pac. R.R. Co., 118 United States Reports 394 (1886), and, more recently, Burwell v. Hobby Lobby, 134 Supreme Court Reporter 2751 (2014). 30  For example, limited liability was not a standard feature of the English law of joint stock companies until the mid-​nineteenth century, and in California, shareholders bore unlimited personal liability for corporation obligations until 1931. See e.g. Paul L. Davies, Gower and Davies’ Principles of Modern Company Law 40–​6 (6th edn., 1997); Phillip Blumberg, Limited Liability and Corporate Groups, 11 Journal of Corporate Law 573 (1986).

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has over time become nearly universal. This evolution indicates strongly the value of limited liability as a contracting tool and financing device. Limited liability shields the firm’s owners—​the 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. This need to be “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, reducing the risk premium they will demand, and so lowers the firm’s cost of equity capital. The “owner shielding” provided by limited liability is the converse of the “entity 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. Together, 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.34 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 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 focus creditors’ monitoring efforts accordingly—​by incorporating separate subsidiaries.35 We should emphasize that, when we refer to limited liability, we mean specifically limited liability in contract—​that is, limited liability to creditors who have contractual claims on the corporation. The 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 Two Corporation Systems:  Law and Economics, 53 Virginia Law Review 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 pro rata to the number of shares held—​but without pre-​agreed limitation—​falls somewhere between this and the case of fully limited liability. Shareholders with pro rata liability can reduce their downside exposure either by holding only a small stake—​hence facilitating 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. 34  By “creditors” we mean here all persons who have a contractual claim on the firm, including employees, suppliers, and customers. 35  Of course, asset shielding through group structures can also be used to reduce transparency as to the location of assets. This concern underlies an important part of corporate law’s creditor-​oriented rules: see Chapter 5.2.1.3.

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What Is Corporate Law?

1.2.3 Transferable  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 legal entities. Transferability permits the 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.36 This in turn enhances the liquidity of shareholders’ interests and makes it easier for shareholders to construct and maintain diversified investment portfolios. Transferability of shares is the flipside of the liquidation protection that the corporation’s legal personality assures to its contractual counterparties. Precisely because counterparties can be confident that the “bundle of contracts” that constitutes the firm will be kept together, there is no need for a rule requiring owners to continue to participate. In the absence of a legal entity—​that is, if the owner contracts as sole 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, 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’s contracts by transferring the corporation’s shares. In other words, it permits the free transferability of all of a 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.37 Fully transferable shares do not necessarily mean freely tradable 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, 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 terminology, we will refer to corporations with freely tradable shares as “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

36  See Henry Hansmann, The Ownership of Enterprise 152–​5 (1996). 37  Ayotte and Hansmann, note 21. To be sure, the parties to individual contracts may—​and at times 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.

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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” 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. Transferability of shares, as we have already suggested, 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 changed. Consequently, the value of shares would be difficult for potential purchasers to judge.38 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.39 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 legal personality, limited liability, and transferable shares tend to go together, and are all features of the standard corporate form everywhere. This is in contrast to the conventional general partnership, which lacks all of these features.

1.2.4 Delegated management 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.40 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. Both aspects of this allocation are unworkable for business corpor­ ations with numerous and constantly changing owners, because of information and 38  Paul Halpern, Michael Trebilcock, and Stuart Turnbull, An Economic Analysis of Limited Liability in Corporation Law, 30 University of Toronto Law Journal 117, 136–​8 (1980). 39  Ibid. See also Chapter 9.1.1. 40  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). 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. The 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.

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coordination costs.41 Consequently, corporate law typically vests principal authority over corporate affairs in a board of directors or similar body that is periodically elected, exclusively or primarily, by the firm’s shareholders. More specifically, 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, separate from the operational managers of the corporation.42 The 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. This formal distinction between the board and 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. That separation serves as a useful check on the quality of decision-​making by hired officers.43 Second, the board of a corporation is elected—​at least in substantial part—​by the firm’s shareholders. The obvious utility of this approach is to help assure that the board remains responsive to the interests of the firm’s owners, who bear the costs and benefits of the firm’s decisions and whose interests, unlike those of other corporate constituencies, are not strongly protected by contract. This 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. Third, though largely or entirely chosen by the firm’s shareholders, the board is formally distinct from them. This separation economizes on the costs of decision-​making by avoiding the need to inform the 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. This structure—​as opposed, for example, to a structure concentrating authority in a single trustee, as in many private trusts—​facilitates mutual monitoring and checks idiosyncratic 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 board44—​the evident reason being that, for a very small corporation, most of the 41  See Clark, note 7, at 23–​4 and 801–​16; Sofie Cools, The Dividing Line Between Shareholder Democracy and Board Autonomy, 11 European Company and Financial Law Review 258, 272–​3 (2014). 42  The nature of this separation varies according to whether the board has one or two tiers. In two-​ tier boards, top corporate officers occupy the 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. 43  See Eugene Fama and Michael Jensen, Agency Problems and Residual Claims, 26 Journal of Law and Economics 327 (1983). 44  This is true not only of most statutes designed principally for private corporations, such as France’s SARL (Art. L. 223-​18 Code de commerce) and SAS (Art. L. 227-​6 Code de commerce) and Germany’s GmbH (§ 6 GmbH-​Gesetz), but also of the general corporate laws in the UK (§ 154(1) Companies Act 2006), Italy (Art. 2380–​II Civil Code), and the U.S.  state of Delaware, § 141(b) Delaware General Corporation Law.

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board’s legal functions, including its service as shareholder representative and focus of liability, can be discharged effectively by a single elected director who also serves as the firm’s principal manager.

1.2.5 Investor ownership There 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’s net earnings. The law of business corporations is principally designed to facilitate the organization of investor-​owned firms—​that is, firms in which both elements of ownership are tied to investment of equity capital in the firm. More specifically, in an investor-​owned firm, both the right to participate in control—​which generally involves voting in the election of directors and voting to approve major 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.45 There are other forms of ownership that play an important role in contemporary economies, and other bodies of organizational law—​including other bodies of corpor­ ate law—​that are specifically designed to facilitate the formation of those other types of firms.46 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 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). The facilitation of investor ownership became a feature of the corporate form only in the second half of the nineteenth century. Until then, both investor- and consumerowned firms worldwide had been routinely organized under a single corporate form.47 The subsequent specialization toward investor ownership followed from the dominant role that investor-​owned firms have come to play in 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. The 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 the firm, investors are often the most difficult to protect simply by contractual means.48 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 definitely not eliminating—​the potential for costly conflict among those who share governance of the firm.49

45  For a recently enacted rule providing for a different default (double voting rights for longer term shareholders in French listed corporations), see Chapter 4.1.1. 46  For a discussion of the varieties of forms of ownership found in 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. 47  Henry Hansmann and Mariana Pargendler, The Evolution of Shareholder Voting Rights: Separation of Ownership and Consumption, 123 Yale Law Journal 948 (2014). 48  See e.g. Oliver Williamson, Corporate Governance, 93 Yale Law Journal 1197 (1984). 49  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 Journal of Legal Analysis 35, 50–​6 (2014).

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Specialization to investor ownership is yet another respect in which the law of business corporations differs from the law of partnership. The 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 in partnerships of lawyers and other service professionals, or simply in the prototypical two-​person partnership in which one partner supplies labor and the other capital. As a consequence, the business corporation is less flexible than the partnership in terms of assigning ownership. To 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. Moreover, as the corporate form has evolved, it has achieved 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. The complex arrangements for sharing rights to earnings, assets, and control between entrepreneurs and investors in high-​tech start-​up firms are a good example.50 There has been further specialization even amongst investor-​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.51 In other instances, state-​owned 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, state ownership entails a degree of heterogeneity in the shareholder base that exceeds that of the typical investor-​owned firm, with potential for unique conflicts of interest.52 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—​to participate in either control or profit-​sharing, or both. Worker codetermination is a conspicuous example. The wisdom and means of providing for such non-​investor participation in firms that are otherwise investor-​ owned 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 as the U.S. nonprofit corporation, the civil law foundation, and the UK company limited by guarantee—​ that provide for formation of nonprofit firms. These 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 though a number of successful industrial

50  Stephen N. Kaplan and Per Strömberg, Financial Contracting Theory Meets the Real World: An Empirical Analysis of Venture Capital Contracts, 70 Review of Economic Studies 281 (2003). 51 See e.g. Jesse Finfrock and Eric L. Talley, Social Entrepreneurship and Uncorporations, 2014 Illinois Law Review 1867; Regulator of Community Interest Companies (UK), Annual Report 2013/​2014 (2014). 52  See e.g. Mariana Pargendler, Aldo Musacchio, and Sergio G. Lazzarini, In Strange Company: The Puzzle of Private Investment in State-​Controlled Firms, 46 Cornell International Law Journal 569 (2013).

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firms around the world are organized as nonprofits.53 Thus, when we use the term “corporation” 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, we will explicitly use the term “business corporation” to make specific reference to the investor-​owned company that is our principal focus.

1.3  Sources of Corporate Law All jurisdictions with well-​developed market economies have a least one core statute that establishes a basic corporate form with the five characteristics described above, and that is designed particularly to permit the formation of public corporations. Nevertheless, corporate law as we understand it here—​in functional 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. These 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 company54—​typically exhibit most of the canonical features of the corpor­ ate form. They differ from open, or “public,” companies chiefly because their shares, though generally transferable at least in principle, are presumed—​and in some cases required—​not to trade freely in a public market. Sometimes these forms also permit departure from one of our five core characteristics—​delegated management—​by permitting elimination of the board in favor of direct management by shareholders.55 The 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, which has recently been added to the forms available in the law of the U.S., Japan, and some European jurisdictions. This 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).56 Consequently, with appropriate governance provisions in the partnership agreement, it is effectively possible to create a closed corporation as a limited liability partnership.

53  On the so-​called “industrial foundations,” see Steen Thomsen and Henry Hansmann, Managerial Distance and Virtual Ownership: The Governance of Industrial Foundations, Working Paper (2013), at ssrn.com. 54  In the case of the UK private 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. 55  See note 44. 56  See Hansmann, Kraakman and Squire, note 13, at 1391–​4.

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The U.S. statutory 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.57 With appropriate charter provisions, a statutory business trust can be made equivalent to a public corporation, with the trust’s beneficiaries in the role of shareholders. The analysis we offer in this book extends to all these special and 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 There are bodies of law that, at least in some jurisdictions, are contained in statutes or case law that are separate from the core corporation statutes, and from the special and quasi-​corporation 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 of corporate law. To 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 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. Similarly, the statutory rules in many jurisdictions that require employee representation on a corporation’s board of directors—​such as, conspicuously, the German law of 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,58 and sometimes regulating sale and resale of corporate securities, mergers and acquisitions, and corpor­ ate elections. Stock exchange rules, which can regulate numerous aspects of the internal affairs of exchange-​listed firms, can also serve as an additional source of corporate law, as can other forms of self-​regulation, such as the UK’s City Code on Takeovers and Mergers.59 These supplemental sources of law are necessarily part of the overall structure of corporate law, and we shall be concerned here with all of them. 57  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. 58  A claim strongly put by Robert B. Thompson and Hillary A. Sale, Securities Fraud as Corporate Governance: Reflections upon Federalism, 56 Vanderbilt Law Review 859 (2003). 59 We term such self-​regulation a source of “law” in part because it is commonly supported, directly or indirectly, by law in the narrow sense. The self-​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 Takeover Panel was supported indirectly until 2006 by the recognition that if its rulings were not observed, formal regulation would follow. Since then, it has enjoyed

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There are many constraints imposed on companies by bodies of law designed to serve objectives that are, in general, independent of the form taken by the organizations they 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 “insolvency law,” as it is termed in some jurisdictions—​is an example. Bankruptcy effects a shift in the ownership of the firm from one group of investors to 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. Tax law also affects directly the internal governance of corporations at various points; the U.S. denial of deductibility from corporate income, for tax purposes, of executive compensation in excess of $1 million unless it is in the form of incentive pay, discussed in Chapter 3, is a clear example.60 And, beyond providing for board representation of employees, labor law in some countries—​as emphasized in Chapter 4—​involves employees or unions in the corporate decision-​making process, as in requirements that works councils or other workers’ organs be consulted prior to taking specified types of actions.

1.4  Law versus Contract in Corporate Affairs The relationships among the participants in a corporation are, to an important degree, contractual. The principal contract that binds them is the corporation’s charter (or “articles of association” or “constitution,” as it is termed in some jurisdictions). The charter sets out the basic terms of the relationship among the firm’s shareholders, and between the shareholders and the firm’s directors and other managers.61 By explicit or implicit reference, the charter can also become part of the contract between the firm and its employees or creditors. One or more shareholders’ agreements may, in addition, bind some or all of a corporation’s shareholders. At the same time, corporations are the subject of a large body of statutory law. That body of law is the principal focus of this book. Before examining the details of that law, however, we must address a fundamental—​and surprisingly 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. Those companies obtained their legal personality from partnership and trust law, and created the rest of their corporate structure—​including limited liability—​by means of contract.62 Why, then, do we today formal statutory authority (Part 28 Companies Act 2006 (UK)), and so is no longer, strictly speaking, “self-​regulatory.” 60  § 162(m) Internal Revenue Code (U.S.). 61  The charter may be supplemented by a separate set of bylaws, which commonly govern less fundamental matters and are subject to different—​generally more flexible—​amendment rules than is the charter. 62 Ron Harris, Industrializing English Law (2000); Hansmann, Kraakman, and Squire, note 13.

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have, in every advanced economy, elaborate statutes providing numerous detailed rules for the internal governance of corporations?

1.4.1 Mandatory laws 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 expli­ citly provide for something different, and laws that are mandatory, leaving parties no option but to conform to them.63 A significant part of corporate law—​more in some jurisdictions, less in others—​ consists of default provisions.64 To this extent, corporate law simply offers a standard form contract that the parties can adopt, at their option, in whole or in part. A familiar advantage of such a legally provided standard form is that it saves costs—​specifically, 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’s provision of such standard terms as default is thereby seen in economic terms as a “public good.” Default provisions can serve this function best if they are “majoritarian” in content—​that is, if they reflect the terms that the majority of well-​informed parties would themselves most commonly choose.65 Default provisions can be supplied in a variety of ways, the choice of which affects the ease and means of “contracting around” them.66 A common form of corporate law default is a statutory provision that will govern unless the parties explicitly provide an alternative. The common provision that each share carries one vote is an example. A charter clause can deviate from that default by, for instance, providing for the issuance of a class of stock carrying no voting right. Alternatively, corporate law itself sometimes specifies the rule that will govern if the default provision is not chosen—​an “either-​or” provision. An example is offered by French corporate law, which allows companies’ charters to opt for a two-​tier board structure as an alternative to the default single-​tier one.67 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). The 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.68 An extension of the binary two-​alternative-​provisions approach just described is to provide corporations with a choice among a “menu” of more than two specified rules.69 63  See generally the papers in the symposium edition entitled Contractual Freedom and Corporate Law, in 89 Columbia Law Review 1395–​774 (1989). 64  They are “defaults” in the sense that they apply (as with computer settings) “in default” of the parties stipulating something else. 65  Easterbrook and Fischel, note 7, at 34–​5. 66  The 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: An Economic Theory of Altering Rules, 121 Yale Law Journal 2032 (2012). For an empirical perspective, see Yair Listokin, What do Corporate Default Rules and Menus Do? An Empirical Examination, 6 Journal of Empirical Legal Studies 279 (2009). 67  See Art. 225-​57 Code de commerce. 68  See Lucian A. Bebchuk and Assaf Hamdani, Optimal Defaults For Corporate Law Evolution, 96 Northwestern University Law Review 489 (2002). 69  Michael Klausner, Corporations, Corporate Law, and Networks of Contracts, 81 Virginia Law Review 757, 839–​41 (1995).

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There are also important rules of corporate law that are mandatory.70 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.71 The 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.72 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. The 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.73 There 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, under a general business corporation statute, a close corporation statute, a limited liability company statute, a limited liability partnership statute, or a business trust statute—​with each statute providing a somewhat different set of mandatory and default rules. Second, even with respect to a particular type of legal entity, such as the publicly traded business corporation, the organizers of a firm may often choose among different jurisdictions’ laws. This leads us to the general issue of choice of law and the related debate about “regulatory competition” in corpor­ ation law. Before addressing that topic, however, we need to say more about the role of corporation law in general.

1.4.2 The benefits of 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. They also provide a means of accommodating, over time, developments that cannot easily be foreseen at the outset. A contract that, like a corporation’s charter, must govern complex relationships over a long period of time, is necessarily incomplete. Situations will arise for which the

70  See Jeffrey N. Gordon, The Mandatory Structure of Corporate Law, 89 Columbia Law Review 1549 (1989). 71  See Chapter 4.2.1 (codetermination) and 6.2.1 and 9.1.1 (disclosure). 72  See generally Michael J. Trebilcock, The Limits of Freedom of Contract (1993). 73  Larry E. Ribstein, Statutory Forms for Closely Held Firms:  Theories and Evidence From LLCs, 73 Washington University Law Quarterly 369 (1995); John Armour and Michael J. Whincop, An Economic Analysis of Shared Property in Partnership and Close Corporations Law, 26 Journal of Corporation Law 983 (2001).

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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. This is the gap-​filling 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.74 And the most widely used standard charter terms are often the default rules embodied in the corporation law. So, another advantage of sticking to the default provisions, rather than drafting specialized charter terms, is to benefit from the constant gap-​filling activity stimulated by the body of precedents developed as a result of other corporations that are also subject to those rules.75 This is one example of a network effect that creates an incentive to choose a common approach.76 The problem of contractual incompleteness goes beyond mere 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 statutory amendments and by judicial interpretation—​to adapt them to such changing circumstances. Consequently, by adopting a statutory default rule, a firm has a degree of assurance that the provision will not become anachronistic. If, in contrast, the firm puts in its charter a specially drafted provision in place of the statutory default, only the firm itself can amend the provision when, over time, a change is called for. This 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.77 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. The most empirically significant dimensions of selection lie in the ability of participants to select from a range of different business forms—​which we have discussed—​and of corporations to choose the jurisdiction by whose corporation law they will be governed, which is the subject to which we turn next.

74  Ian Ayres, Making A  Difference:  The Contractual Contributions of Easterbrook and Fischel, 59 University of Chicago Law Review 1391, 1403–​8 (1992). 75  Klausner, note 69, at 826–​9. 76  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, Standardization and Innovation In Corporate Contracting (or “The Economics of Boilerplate”), 83 Virginia Law Review 713 (1997). 77  See Henry Hansmann, Corporation and Contract, 8 American Law and Economics Review 1 (2006).

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1.4.3 Choice of legal regime The 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 all be provided within any given jurisdiction. As we have noted, however, there can be yet another dimension of 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 incorpor­ ated 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. That 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.78 These 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.79 The 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 thereby bring revenue to the state directly (through franchise fees) and indirectly (through increased demand for local services)—​by making that jurisdiction’s corporate law attractive. This 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.80 Whether such “regulatory competition” exists at all—​and if it does, whether it is a good thing—​has long been the subject of vigorous debate.81 Pessimists argue that it creates a “race to the bottom” in which the state 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

78  Case C-​212/​97, Centros Ltd v. Erhvervs-​og Selskabssyrelsen [1999] European Court Reports I-​1459; Case C-​208/​00, Überseering BV v. Nordic Construction Company Baumanagement GmbH (NCC) [2002] European Court Reports I-​9919; Case C-​167/​01, Kamel van Koophandel en Fabrieken voor Amsterdam v. Inspire Art Ltd [2003] European Court Reports I-​10155; Case C-​210/​ 06, Cartesio Oktató és Szolgáltató bt [2008] European Court Reports I-​9641; Case C-​378/​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 Journal of Corporate Finance 241 (2008); John Armour and Wolf-​Georg Ringe, European Company Law 1999–​2010: Renaissance and Crisis, 48 Common Market Law Review 125, 131–​43. The position as respects change of corporate law for existing companies is more complex: see ibid., 158–​69. 79  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 O.J. (L 141) 19; Case C-​341/​04 Eurofood IFSC ltd [2006] European Court Reports I-​3813; Case C-​306/​09 Re Interedil Srl [2011] European Court Reports I-​9915; Case C-​594/​14 Kornhaas v Dithmar ECLI:EU:C:2015:806. 80 See Section 1.6; Ronald J. Gilson, Henry Hansmann, and Mariana Pargendler, Corporate Chartering and Federalism: A New View, Working Paper (2015). 81 On the existential question, see e.g. Marcel Kahan and Ehud Kamar, The Myth of State Competition in Corporate Law, 55 Stanford Law Review 679 (2002); Luca Enriques, EC Company Law and the Fears of a European Delaware, 15 European Business Law Review 1259 (2004).

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top”: because the capital markets price, more or less accurately, the effects of corporate law choice, the state that wins is that whose law maximizes shareholder welfare.82 Of course, there is dispute as to what constitutes an “optimal” body of corporate law, even in theory—​a topic to which we will turn shortly. Yet an important bene­ fit associated with the existence of choice among multiple regulatory regimes is that it creates opportunities for regulatory experimentation. That 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.83 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.84 While much of the literature on regulatory competition tends to assume corporate law is a single uniform commodity, this is not always what we observe in practice.85 Finally, even if the optimal corporate law regime were uniform and known to parties, the existence of dual—​or even multiple—​regulatory regimes might be justified by reference to politics. Reform of inefficient rules may be blocked by powerful interests—​ such as those of managers, controlling shareholders, or 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 entitlements of incumbents. Both the establishment of the Novo Mercado premium listing segment in Brazil and certain EU measures such as the creation of the European Company (Societas Europaea—​SE ) can be interpreted as bypassing the political clout of interest groups in existing companies.86

1.5  What Is the Goal of Corporate Law? What is the goal of corporate law, as distinct from its immediate functions of defining a form of enterprise and containing the conflicts among the participants in this enterprise? As a normative matter, the overall objective of corporate law—​as of any branch of 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

82 The classical statements of the two polar views are William Cary, Federalism and Corporate Law:  Reflections upon Delaware, 83 Yale Law Journal 663 (1974), and Ralph Winter, State Law, Shareholder Protection and the Theory of the Corporation, 6 Journal of Legal Studies 251 (1977). For a recent review of this literature, see Roberta Romano, The Market for Corporate Law Redux, in Oxford Handbook of Law and Economics (Francesco Parisi ed., 2015). 83  See Simon Deakin, Regulatory Competition Versus Harmonization in European Company Law in Regulatory Competition and Economic Integration 190, 216–1​7 (Daniel Esty and Damien Gerardin eds., 2001). 84  See John Armour, Who Should Make Corporate Law? EC Legislation versus Regulatory Competition, 58 Current Legal Problems 369 (2005). 85  See K.J. Martin Cremers and Simone M. Sepe, The Financial Value of Corporate Law: Evidence from (Re)incorporations, Working Paper (2015), at ssrn.com; Jens Dammann and Matthias Schündeln, The Incorporation Choices of Privately Held Corporations, 27 Journal of Law, Economics, and Organization 79 (2011). 86 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, 63 Stanford Law Review 475 (2011).

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the natural environment.87 This is what economists would characterize as the pursuit of overall social welfare. At least in theory, 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 include not only managers and shareholders but also certain creditors and employees. The 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 lion’s share of corporate law 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. There 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 corpor­ ation only if they expect themselves to be better off as a result. Consequently, the corporation—​and, in particular, its shareholders, as the firm’s residual claimants88 and risk-​bearers—​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 surely ought to be—​the appropriate interpretation of statements by legal scholars and economists asserting that shareholder value is the proper object of corporate law. We should keep in mind, as well, that to say that shareholder value is the principal 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 regime as pre-​determined, but instead become actively involved in seeking to relax rules that constrain their imposition of externalities.89 Such corporate influence in the rule-​making process is clearly problematic, and to the extent 87  We speak here of maximizing the “aggregate welfare” of society more as a loose metaphor than a precise yardstick. There is no coherent way to put a number on society’s aggregate welfare, much less to maximize that number—​and particularly so when many benefits are in appreciable part non-​ pecuniary. What we are suggesting here might be put more precisely in the language of welfare economics as pursuing Kaldor-​Hicks efficiency within acceptable patterns of distribution. 88  Shareholders are a corporation’s “residual 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 been paid in full. 89  For firms in industries subject to regulation to control externalities, corporate political spending is universal: John C. Coates IV, Corporate Politics, Governance, and Value Before and After Citizens United, 9 Journal of Empirical Legal Studies 657 (2012).

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that regulation is consequently compromised, it may be appropriate for corporate law to seek to modify internal governance arrangements accordingly.90 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. 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 disclosure obligations or molding the 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, or protecting the environment.91 Although as old as corporate law itself,92 the deployment of corporate law to protect the interests of parties external to the firm has found renewed favor among law­makers 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 Shape Corporate Law? To say that the pursuit of aggregate social welfare is the appropriate goal of corporate law is not to say, of course, that the law always pursues it in the same way. The 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. These may consequently complement particular features of corporate law.93 Similarly, other features of the environment—​for example, the quality of legal 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 selection of which might be termed an “efficiency” effect on corporate law.

90 Leo E. Strine, Jr. and Nicholas Walter, Conservative Collision Course:  The Tension between Conservative Law Theory and Citizens United, 100 Cornell Law Review 335 (2015). 91  By far the most popular means to protect interests external to the firm is through 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 separating corporate from other areas of law. On the use of corporate governance to address a variety of economic and social problems, see Mariana Pargendler, The Corporate Governance Obsession, 42 Journal of Corporation Law 101 (2016). 92 See e.g. Herbert Hovenkamp, Enterprise and American Law, 1836–​1937, 63–​4 (1991); Hansmann and Pargendler, note 47, at 145. 93  For instance, an educational system that favors vocational and 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 oscillations in market conditions. Germany traditionally embodied this institutional bundle. In the U.S., by contrast, a labor regime of at-​will 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.

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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 how corporate law comes to pursue particular goals is a question of political economy—​that is, the political and economic forces that shape lawmaking.94 The 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 laws, produ­ cing 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 political effect is the phenomenon of populist reforms after a scandal or 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, which may be quite different from what will actually solve the underlying economic problems.95 The 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. 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.96 As the dust settled, it became tolerably clear—​at least to us—​that the implications of the crisis were mostly confined to the governance regimes applicable to banks and other financial institutions,97 which have an unusual degree of interconnection and propensity to contagion. Consequently, there are good functional reasons for introducing special regimes for bank governance that differ from ordinary business firms. However, some post-​crisis reforms have been more general in their scope—​which may be understood as reflecting populist political concerns triggered by the crisis.98 We touch here briefly on perhaps the most conspicuous of the various forces that help shape—​and, in turn, are shaped by—​corporate law: the pattern of corporate ownership. The nature and number of corporate shareholders differ markedly even among the most developed market economies. In recent years, the extent of these differences has lessened, but their historic and remaining contours surely leave a mark on the structure of corporate law. 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. 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, or affiliated group of shareholders, is capable of exercising control over the firm.99 Shareholdings among

94  See e.g. Mark J. Roe, Political Determinants of Corporate Governance (2003); Peter A. Gourevitch and James Shinn, Political Power and Corporate Control (2005). 95  See Pepper D. Culpepper, Quiet Politics and Business Power (2011). 96  For a discussion of the goals of corporate law, see Section 1.5. 97  See Armour and Gordon, note 49; Armour et al., note 6, ch 17. 98  See e.g. Roberta Romano, Regulating in the Dark, 1 Journal of Financial Perspectives 23 (2013). 99  Rafael La Porta, Florencio Lopez-​de-​Silanes, and Andrei Shleifer, Corporate Ownership Around the World, 54 Journal of Finance 471, 492–​3 (1999); Mara Faccio and Larry H.P. Lang, The Ultimate Ownership of Western European Corporations, 65 Journal of Financial Economics 365, 379–​80 (2002). But see Clifford G. Holderness, The Myth of Diffuse Ownership in the United States, 22 Review of Financial Studies 1377 (2009).

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major Japanese firms are also often highly dispersed,100 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.101 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,102 individuals, families, or the state.103 The types of entities by or through which non-​controlling stakes are held also differ substantially from one country to another. The 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.104 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.105 However, this pattern has changed in recent years. A secular growth in assets under management by U.S. institutional investors—​principally mutual funds and employer-​ established pension funds106—​means their ownership of stock now dwarves that of retail investors. This growth has also led U.S. institutions to invest in other stock markets around the world. Thus in the 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.107 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’ 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. The past two decades have also seen the rise of new types of institutional investor. Conspicuous among these are hedge funds and private equity funds. Hedge funds are 100  By some accounts, share ownership in Japanese publicly held corporations is more dispersed than in the U.S.: see Holderness, note 99; Julian Franks, Colin Mayer, and Hideaki Miyajima, The Ownership of Japanese Corporations in the 20th Century, 27 Review of Financial Studies 2580 (2014). 101 See Tokyo Stock Exchange, 2013 Share Ownership Survey, 4 (2014); Franks et  al., note 100, at 29–​40. For recent unwinding of cross-​shareholdings, see Gen Goto, Legally “Strong” Shareholders of Japan, 3 Michigan Journal of Private Equity and Venture Capital 125, 144–​6 (2014). 102 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 Thomsen, Convergence of Corporate Governance during the Stock Market Bubble:  Towards Anglo-​American or European Standards? in Corporate Governance and Firm Organization 297, 306–​12 (Anna Grandori ed., 2004); Wolf-​Georg Ringe, Changing Law and Ownership Patterns in Germany: Corporate Governance and the Erosion of Deutschland AG, 63 American Journal of Comparative Law 493 (2015). 103  See Alexander Aganin and Paolo Volpin, The History of Corporate Ownership in Italy, in A History of Corporate Governance Around the World (Randall K. Morck ed., 2005); Mariana Pargendler, State Ownership and Corporate Governance, 80 Fordham Law Review 2917 (2012); Aldo Musacchio and Sergio Lazzarini, Reinventing State Capitalism: Leviathan in Business, Brazil and Beyond (2014). 104  See Geof P. Stapledon, Institutional Shareholders and Corporate Governance (1996). 105  See e.g. Ralf Elsas and Jan P. Krahnen, Universal Banks and Relationships with Firms, in The German Financial System 197 (Jan P. Krahnen and Reinhard H. Schmidt eds., 2006). See also sources cited note 102. 106  Board of Governors of the Federal Reserve System, Flow of Funds Accounts in the United States: Annual Flows and Outstandings, 2005–​13, 98 (Table L.213) (2014). 107  Office for National Statistics (UK), Ownership of UK Quoted Shares, 2013 (2014).

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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,108 and sometimes agitate for major changes in the firms’ structure, strategy, or management. Private equity firms, in turn, are (typically) investment vehicles that acquire, at least temporarily, control, and then complete ownership of formerly public companies to effect major changes in the firms’ structure, strategy, or management.109 We have also seen the proliferation of state-​controlled institutional investors, such as sovereign wealth funds. Plausibly, differences in patterns 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,110 although subsequent studies found the results to be sensitive to the way in which “protection” is measured.111 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. To some extent, therefore, the structure of corporate law in any given country is a consequence of that country’s pattern of corporate ownership. This in turn is determined at least in part by forces exogenous to corporate law.112 It has been argued, for example, that the traditionally 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 patterns in continental Europe and Japan complemented particular patterns of industrial development.114 On this view, a controlling shareholder may, under certain circumstances, be better placed to make credible long-​term commitments to employees, which in turn may facilitate labor relations—​and hence productivity—​where the goal is to motivate workers to use existing technology, rather than to develop new technologies.115 108 Marcel Kahan and Edward B. Rock, Hedge Funds in Corporate Governance and Corporate Control, 155 University of Pennsylvania Law Review 1021 (2007); Ronald J. Gilson and Jeffrey N. Gordon, The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights, 113 Columbia Law Review 863 (2013). 109  See Brian R. Cheffins and John Armour, The Eclipse of Private Equity, 33 Delaware Journal of Corporate Law 1 (2008); Viral V. Acharya, Oliver F. Gottschalg, and Moritz Hahn, Corporate Governance and Value Creation: Evidence from Private Equity, 26 Review of Financial Studies 368 (2013). 110  For a review, see Rafael La Porta, Florencio Lopez-​de-​Silanes, and Andrei Shleifer, The Economic Consequences of Legal Origins, 46 Journal of Economic Literature 285 (2008). 111  See Sofie Cools, The Real Difference in Corporate Law Between the United States and Continental Europe: Distribution of Powers, 30 Delaware Journal of Corporate Law 697 (2005); John Armour, Simon Deakin, Prabirjit Sarkar, and Ajit Singh, Shareholder Protection and Stock Market Development: An Empirical Test of the Legal Origins Hypothesis, 2 Journal of Empirical Legal Studies 343 (2009); Holger Spamann, The “Antidirector Rights Index” Revisited, 23 Review of Financial Studies 467 (2010). 112  Brian R. Cheffins, Does Law Matter? The Separation of Ownership and Control in the United Kingdom, 30 Journal of Legal Studies 459 (2001); John C. Coffee, Jr., The Rise of Dispersed Ownership: The Roles of Law and the State in the Separation of Ownership and Control, 111 Yale Law Journal 1 (2001). 113  Mark J. Roe, Strong Managers, Weak Owners (1994). 114  See Wendy Carlin and Colin Mayer, Finance, Investment and Growth, 69 Journal of Financial Economics 191 (2003). 115  See Hall and Soskice, note 1; Barry Eichengreen, Europe’s Economy Since 1945 (2006); Colin Mayer, Firm Commitment (2013). Compare also Chapter 4.4.1.

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This 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 shaping the patterns of corporate law that we see across jurisdictions.

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2 Agency Problems and Legal Strategies John Armour, Henry Hansmann, and Reinier Kraakman

2.1  Three 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,” such as controlling shareholders and top managers, and “outsiders,” such as minority shareholders or creditors. These conflicts all have the character of what economists refer to as “agency problems” or “principal-​agent” problems. For readers unfamiliar with the jargon of economists, an “agency problem”—​in the most general sense of the term—​ arises whenever one party, termed the “principal,” relies upon actions taken by another party, termed the “agent,” which will affect the principal’s welfare. The problem lies in motivating the agent to act in the principal’s interest rather than simply in the agent’s 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”), is potentially subject to an agency problem. The 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. This 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. The 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 noted in Chapter 1, three generic agency problems arise in business firms. The 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. The problem lies in assuring

1  See Chapter 1.1. 2  We use the term “opportunism” here, following the usage of Oliver Williamson, to refer to self-​ interested behavior that involves some element of guile, deception, misrepresentation, or bad faith. See Oliver Williamson, The Economic Institutions of Capitalism 47–​9 (1985). 3 See e.g. Steven Ross, The Economic Theory of Agency:  The Principal’s Problem, 63 American Economic Review 134 (1973); Principals and Agents: The Structure of Business (John W. Pratt and Richard J. Zeckhauser eds., 1984). The Anatomy of Corporate Law. Third 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 2 © John Armour, Henry Hansmann, and Reinier Kraakman, 2017. Published 2017 by Oxford University Press.

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that the managers are responsive to the owners’ interests rather than pursuing their own personal interests. The 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,4 it appears whenever some subset of a firm’s owners can control decisions affecting the class of owners as a whole. Thus 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 creditors in bankruptcy (when creditors are the effective owners of the firm). The third agency problem involves the conflict between the firm itself—​including, particularly, its owners—​and the other parties with whom the firm contracts, such as creditors, 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—​so-​called “externalities.” 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 especially so where they have diver­ ging interests, or “heterogeneous preferences” as economists say. Multiple principals will face information and coordination costs, which will inhibit their ability to engage in collective action.5 These in turn will interact with agency problems in two ways. First, difficulties of coordinating between principals will lead them to delegate more of their decision-​making to agents.6 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.7 Coordination costs as between principals thereby exacerbate agency problems. Law can play an important role in reducing agency costs. Obvious examples are rules and procedures that enhance disclosure by agents or facilitate enforcement actions brought by principals against dishonest or negligent agents. Paradoxically, mechanisms that impose constraints on agents’ ability to exploit their principals tend to benefit agents as much as—​or even more than—​they benefit the principals. The reason is that a principal will be willing to offer greater compensation to an agent when the principal is assured of performance that is honest and of high quality. To 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 4  These 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 Journal of Economic Perspectives 117, 122–​5 (2007). 5  Classic statements of this problem are found in James M. Buchanan and Gordon Tullock, The Calculus of Consent 63–​116 (1962) and Mancur Olsen, The Logic of Collective Action (1965). 6  Frank H. Easterbrook and Daniel R. Fischel, The Economic Structure of Corporate Law 66–​7 (1991). 7  See Hideki Kanda, Debtholders and Equityholders, 21 Journal of Legal Studies 431, 440–​1, 444–​5 (1992); Henry Hansmann, The Ownership of Enterprise 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 1,8 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 is, of both principals and agents taken together.

2.2  Legal Strategies for Reducing Agency Costs In addressing agency problems, the law turns repeatedly to a basic set of strategies. We use the term “legal strategy” to mean a generic method of deploying law instrumentally in a functional 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.9 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 personality—​clearly requires special rules of law.10 The other characteristics could, in principle, be adopted by contract—​for example, through appropriate provisions in the articles of association agreed to by the firm’s owners.11 The 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 relationship, tending to constrain the agent’s behavior directly. By contrast, governance strategies seek to facilitate the principals’ control over their agent’s behavior.13 The 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 agent so as to determine the

8  See Chapter 1.5. 9  See the discussion of the various forms that rules can take in Chapter 1.3–​1.4. 10  See Chapter 1.2.1. 11  Law can, however, provide useful assistance to parties in relation to these other characteristics through the provision of “standard forms.” See Chapter 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 Metrick, Corporate Governance and Equity Prices, 118 Quarterly Journal of Economics 107 (2003); Lucian Bebchuk, Alma Cohen, and Allen Ferrell, What Matters in Corporate Governance? 22 Review of Financial Studies 783 (2009). 13 An alternative labelling would therefore be a distinction between “agent-​constraining” and “principal-​empowering” strategies.

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Table  2–​1  Legal Strategies for Protecting Principals

Ex Ante Ex Post

Agent Constraints

Affiliation Terms

Incentive Alignment

Appointment Rights

Decision Rights

Rules Standards

Entry Exit

Trusteeship Reward

Selection Removal

Initiation Veto

appropriateness of her actions, or to decide whether, and how, to take action to sanction nonperformance. High coordination costs thus render governance strategies less successful in controlling agents, and—​other things equal—​make regulatory strategies more attractive. Regulatory strategies have different preconditions for success. Most obviously, they depend for efficacy on the ability of an external authority—​a court or regulatory body—​with sufficient expertise to determine whether or not the agent complied with particular prescriptions. To be sure, governance strategies rely too on legal institutions to protect the principals’ decision-​making entitlements as respects corporate assets—​that is, their “property rights.”14 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 the principals are able to exercise them usefully—​require for effective decisions only that the principals themselves are able to observe the actions taken by the agent, for which purpose “softer” information may suffice. Table 2–​1 sets out ten legal strategies which, taken together, span the law’s principal methods of dealing with agency problems. These strategies are not limited to the corporate context; they can be deployed to protect nearly any vulnerable principal-​agent relationship. Our focus here, however, is naturally on the ways that these strategies are deployed in corporate law. At the outset, we should emphasize that the aim of this exercise is not to provide an authoritative taxonomy, but simply to 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. Moreover, their use in practice is not mutually exclusive: they may be applied, as appropriate, in combination or individually.

2.2.1 Rules and standards The most familiar pair of regulatory strategies constrains agents by commanding them not to take courses of action that would harm the interests of their 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,15 are commonly used in the 14 See Oliver D. Hart, Incomplete Contracts and the Theory of the Firm, 4 Journal of Law, Economics, and Organization 119, at 123–​5 (1988). 15  For the canonical comparison of the merits of rules and standards as regulatory techniques, see Louis Kaplow, Rules Versus Standards: An Economic Analysis, 42 Duke Law Journal 557 (1992).

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corporate context to protect a corporation’s creditors and public investors. Thus 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.16 Similarly, capital market authorities frequently promulgate detailed rules to govern takeovers and proxy voting.17 By contrast, few jurisdictions rely solely on rules for regulating complex, intra-​ corporate relations, such as, for example, 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 regulation, then, intra-​corporate topics such as insider self-​dealing tend to be governed by open standards that leave discretion for adjudicators to determine ex post whether violations have occurred.18 Standards are also used to protect creditors and public investors, but the paradigmatic examples of standards-​based regulation relate to the company’s internal affairs, as when the law requires directors to act in “good faith” or mandates that self-​dealing transactions be “entirely fair.”19 The 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 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.20 These decisions themselves then prescribe the standard to future parties, over time building up to a body of guidance.

2.2.2 Setting the terms of entry and exit A second set of regulatory strategies open to the law involve regulating the terms on which principals affiliate with agents rather than—​as with rules and standards—​ regulating the actions of agents after the principal-​agent relationship is established. The law can dictate terms of entry by, for example, requiring agents to disclose information about the likely quality of their performance before contracting with principals.21 Alternatively, the law can prescribe exit opportunities 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. The 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. Thus, it is widely accepted that public investors require some

16  See Chapter 5.2.2. 17  See e.g. Chapter 8.1.2.4 (takeovers) and Chapter 3.2.4 (proxy voting). 18  See Chapter 6.2.5. This is not to say that rules are wholly absent from such situations: some jurisdictions regulate forms of self-​dealing judged to merit particular suspicion through rules in combination with a more general standards strategy. 19  See Chapter 6.2.5. 20  In this sense, standards lie between rules (which simply require a decision-​maker to determine compliance) and another strategy that we will address below—​the trusteeship strategy, which requires a neutral decision-​maker to exercise his or her own good faith best judgment in making a corporate decision. 21  See Chapter 5.2.1 and Chapter 9.1.2. 22  See Chapter 9.1.2.

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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.24 The exit strategy, which is also pervasive in corporate law, allows principals to escape opportunistic agents. Broadly speaking, there are two kinds of exit rights. The first is the right to withdraw the value of one’s investment. The best example of such a right 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.25 As we discuss in Chapter 7,26 appraisal permits shareholders who object to a significant transaction to claim the value that their shares had prior to the disputed transaction—​thus avoiding a prospective loss if, in their view, the firm has made a value-​reducing decision. The second type of exit right is the right of transfer—​the right to sell shares—​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) by a new one that may be more effective in controlling the firm’s management. Thus, 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.27 Such a transfer of control rights, or even the threat of it, can be a highly effective device for disciplining management.28 Moreover, 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  The 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. 24  See Chapter 9.1.2.4. 25  The withdrawal right is a dominant 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. Business corporations sometimes grant similar withdrawal rights to their shareholders through special charter provisions. The most conspicuous example is provided by open-​ended investment companies, such as mutual funds in the U.S., which are frequently formed as business corporations under the general corporation statutes. The 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, Taking Exit Rights Seriously: Why Governance and Fee Litigation Don’t Work in Mutual Funds, 120 Yale Law Journal 84 (2010). 26  See Chapter 7.2.2, 7.4.1.2. 27  Many firms introduce contractual provisions which serve to restrict transfer rights, such as “poison pills”: see Bebchuk et al., note 12. Some jurisdictions impose limits on the extent to which transfer rights may be impeded. An example is the EU’s “breakthrough rule” for takeovers, implemented in a few European countries. See Chapter 8.4.2.2. 28  Viewed this way, of course, legal rules that enhance transferability serve not just as an instance of the exit strategy but, simultaneously, as an instance of the entry strategy and incentive strategy as well. The same legal device can serve multiple protective functions.

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the form of share prices.29 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.30

2.2.3 Trusteeship and reward Thus 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 relationship. We consider first incentive alignment strategies, which straddle the boundary between regulatory and governance strategies. The 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 involves a regulatory strategy, which does not define what the agent can do, but rather what she can’t do.31 This strategy assumes that, in the absence of strongly focused—​or “high-​powered”—​monetary incentives to behave opportunistically, agents will respond to the “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 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.34 In certain circumstances other agents external to the corporation may be called 29  See James Dow and Gary Gorton, Stock Market Efficiency and Economic Efficiency: Is There a Connection? 52 Journal of Finance 1087 (1997). And see Chapter 9.1.1. 30  See John Armour and Brian Cheffins, Stock Market Prices and the Market for Corporate Control, 2016 University of Illinois Law Review 101 (2016). 31  See Matthew Conaglen, Fiduciary Loyalty: Protecting the Due Performance of Non-​ Fiduciary Duties (2010). 32  We use the terms “high-​powered incentives” and “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. These 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 in the sense that they are concrete and sharply focused. See e.g. Williamson, note 2, 137–​41; Bengt Hölmstrom and Paul Milgrom, The Firm as an Incentive System, 84 American Economic Review 972 (1994). By referring to moral norms as “low-​powered” incentives we do not mean to imply that they are 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, Remuneration, Retention, and Reputation Incentives for Outside Directors, 54 Journal of Finance 2281 (2004); Eliezer M. Fich and Anil Shivdasani, Financial Fraud, Director Reputation, and Shareholder Wealth, 86 Journal of Financial Economics 306 (2007); Ronald W. Masulis and Shawn Mobbs, Independent Director Incentives: Where do Talented Directors Spend their Limited Time and Energy? 111 Journal of Financial Economics 406 (2014). 34  While auditors face reputational sanctions for failure (see e.g. Jan Barton, Who Cares About Auditor Reputation? 22 Contemporary Accounting Research 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 Cornell Law Review 269, 291–​3 (2004).

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upon to serve as trustees, as when the law requires an investment banker, a state official, or a court to approve corporate action. The second incentive strategy is the reward strategy, which—​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. The more common form of reward is a sharing rule 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.35 As a consequence of this rule, controlling shareholders—​here the “agents”—​have an incentive to maximize the returns of the firm’s minority shareholders—​here the “principals”—​at least to the extent that corporate returns are paid out as dividends. The reward mechanism less commonly the focus of corporate law is the pay-​for-​ performance regime, in which an agent, although not sharing in his principal’s returns, is nonetheless paid for successfully advancing her interests. Even though no jurisdiction imposes such a scheme on shareholders, legal rules often either facilitate or discourage high-​powered incentives of this sort.36 American law, for example, has actively encouraged incentive compensation devices such as stock option plans,37 while more skeptical jurisdictions seek to restrict their use.38 Because of the peculiarly firm-​specific (and even executive-​specific) nature of pay-​for-​performance packages, this reward strategy is typically implemented by contract. The process of writing such contracts is itself potentially susceptible to agency costs.39 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.”40 There is potential for tension between trusteeship and reward. High-​caliber agents will not adopt trusteeship roles without meaningful payment. Yet trustee compensation arrangements require careful thought, because they can generate high-​powered incentives that weaken or even overpower low-​powered incentives.41 Heavy reliance on stock options, for example, encourages risk-​taking, whereas the payment of a large fixed stipend may discourage critical engagement. Neither approach would be desirable in a trustee. The key is therefore to ensure that trustees are paid enough to make their role worth doing, but not so much as to sideline low-​powered incentives.42

35  See Chapter 4.1.3.2. On rules requiring pro rata sharing of takeover premia see Chapter 8.3.3 and 8.3.4. 36  See Chapter 3.3.2. 37  U.S. tax law has since 1993 limited the tax-​deductibility of executive compensation to a maximum of $1m per annum, except so far as payments are “performance based” (IRC §162(m)). This greatly encouraged the use of incentive compensation: see Brian J. Hall and Kevin J. Murphy, The Trouble with Stock Options, 17 Journal of Economic Perspectives 49 (2003). 38 See e.g. European Commission, Recommendation 2009/​ 3177/​ EC on Strengthening the Regime for the Remuneration of Directors of Listed Companies. 39  See Lucian Bebchuk and Jesse Fried, Pay Without Performance: The Unfulfilled Promise of Executive Compensation (2004). 40  See Chapter 3.3.2 and Chapter 6.2.3. 41  See e.g. Bruno S. Frey and Felix Oberholzer-​Gee, The Cost of Price Incentives: An Empirical Analysis of Motivation Crowding-​Out, 87 American Economic Review 746 (1997). The 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 Nature 86 (2014). 42  See e.g. 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 lower than for executives).

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37

2.2.4 Selection and removal 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 (or other man­ 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, 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 The final pair of legal strategies expands the power of principals to intervene in the firm’s management. These are decision rights, which grant principals the power to initiate or ratify management decisions. Again, it is no surprise that this set of decision rights strategies is much less prominent in corporate law than are appointment rights strategies. This 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.43

2.2.6  Ex post and ex ante strategies The bottom rows in Table 2–​1 arrange our ten legal strategies into five pairs, each with an “ex ante” and an “ex post” strategy. This presentation merely highlights the fact that half of the strategies take full effect before an agent acts, while the other half respond—​at least 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’s actions will be judged ex post. Thus, a rule might prohibit a class of self-​dealing transactions outright, while a standard might mandate that these transactions will be judged against a norm of fairness ex post.44 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.45 Turning to incentive alignment, trusteeship is an ex ante strategy in the sense that it neutralizes an agent’s adverse interests prior to her appointment by the principal, while most reward strategies are ex post in the sense that their payouts are contingent on uncertain future outcomes, and thus remain less than fully specified until after the agent acts. The appointment and removal strategies also fall into ex ante and ex post pairs. If principals can appoint their agents ex ante, they can screen for loyalty; if principals can

43  See Chapter 3.2.3. The utility, for reducing agency costs, of separating the initiation of decisions from their ratification was first emphasized by Eugene Fama and Michael Jensen, Separation of Ownership and Control, 26 Journal of Law and Economics 301 (1983). 44  Compare Chapter 6.2.4 (ex ante prohibitions) and 6.2.5 (ex post standards). 45  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 is ordinarily the case—​they might be restricted to ratifying a motion to merge offered by the board of directors.46 We do not wish, however, to overemphasize the clarity or analytic power of this categorization of legal strategies into ex ante and ex post types. One could well argue, for example, that the reward strategy should not be considered an ex post strategy but rather an ex ante strategy because, like the trusteeship 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 ex post types, since an election of directors might involve, simultaneously, the selection of new directors and the removal of old ones. We offer the ex post/​ex ante distinction only as a classification 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. The ten strategies arrayed in Table 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,47 it is an important part of the affiliation terms strategies. Most obviously, prospectus disclosure forces agents to provide prospective principals with information that helps them to decide upon which terms, if any, they wish to enter the firm as owners. To a lesser extent, periodic financial disclosure and ad hoc disclosure—​for example, of information relevant to share prices, and of the terms of related party transactions—​also permits principals to determine the extent to which they wish to remain owners, or rather exit 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 with information to bring before a court.48 In relation to governance strategies, disclosure can be used in several different, but complementary, ways. First, and most generally, mandating disclosure of the terms of the 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. Third, disclosure of those serving in trustee roles serves to bond their reputations publicly to the effective monitoring of agents. There is of course a need to ensure compliance with disclosure obligations themselves. This is a microcosm of the more general problem of securing agent compliance. 46  See Chapter 7.4. 47  See Section 2.2.2; see also Chapter 9.1.2. 48  See e.g. Simeon Djankov, Rafael La Porta, Florencio Lopes-​de-​Silanes, and Andrei Shleifer, The Law and Economics of Self-​Dealing, 88 Journal of Financial Economics 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 “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.49 The compliance issue with periodic disclosure is not so much whether it happens, but its quality, and hence a trusteeship strategy—​in the form of auditors—​is typically used to assist in assuring this. For ad hoc 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.50

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 interest, which for brevity we term agent compliance. In this regard, each strategy depends on the existence of other legal institutions—​such as courts, regulators, and procedural rules—​to secure enforcement 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 is most directly relevant as regards regulatory strategies such as rules and standards. These operate to constrain the agent’s behavior. They cannot do this credibly unless they are in fact enforced.51 This necessitates well-​functioning enforcement 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.52 Formal 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 on key issues, its success in securing agent compliance depends primarily upon the ability of principals to coordinate and act at low cost. To be sure, governance strategies rely upon background legal rules to support their 49  This mechanism is used to enforce disclosure of governance arrangements in the UK and elsewhere under so-​called “comply or explain” provisions. 50  See Utpal Bhattacharya and Hazem Daouk, The World Price of Insider Trading, 57 Journal of Finance 75 (2002); John C. Coffee, Jr., Law and the Market: The Impact of Enforcement, 156 University of Pennsylvania Law Review 229, at 263–​66 (2007). 51  This point is not new. For early recognition, see Roscoe Pound, Law in Books and Law in Action, 44 American Law Review 12 (1910); Gary Becker, Crime and Punishment: An Economic Approach, 76 Journal of Political Economy 169 (1968). 52  It is possible to talk of such interventions as an informal form of “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 Rationality in Company Law 71, at 73–​6 (John Armour and Jennifer Payne eds., 2009). 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; in particular, they rely on rules defining the decision-​making authority of the various corporate actors.53 They therefore also require legal enforcement institutions to make such delineations of authority effective. 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.54 Enforcement institutions, therefore, are of first-​order importance for regulatory strategies, but only of second-​order importance for governance strategies.

2.4.2 Initiators of enforcement Turning 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 type of enforcers—​and encourage readers to think about how matters might be affected by other dimensions along which enforcement may vary. The 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 affecting them through the actions of public officials, interested private parties, and gatekeepers.

2.4.2.1 Public enforcement By “public enforcement,” we refer to all legal and regulatory actions brought by organs of the state. This mode includes criminal and civil suits brought by public officials and agencies, as well as various ex ante 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, ran­ ging from local prosecutors’ offices to national regulatory authorities that monitor corporate actions in real time—​such as the U.S. Securities and Exchange Commission (SEC) monitoring corporate disclosures—​and have the power to intervene to prevent breaches. We also describe some self-​regulatory and quasi-​regulatory authorities, such as national stock exchanges and the UK’s Financial Reporting Council,55 as “public enforcers.” Such bodies are enforcers to the extent that they are able in practice to 53  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 governance-​ based strategies will be ineffective: see Bernard Black, Reinier Kraakman, and Anna Tarassova, Russian Privatization and Corporate Governance: What Went Wrong? 52 Stanford Law Review 1731 (2000). 54 See Alan Schwartz, Relational Contracts in the Courts:  An Analysis of Incomplete Agreements and Judicial Strategies, 21 Journal of Legal Studies 271 (1992); Edward B. Rock and Michael L. Wachter, Islands of Conscious Power: Law, Norms, and the Self-​Governing Corporation, 149 University of Pennsylvania Law Review 1619 (2001). 55  The UK’s Financial Reporting Council, through its Conduct Committee, reviews the financial statements of publicly traded companies for compliance with the law.

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compel compliance with their rules ex ante or to impose penalties for rule violations ex post, whether these penalties are reputational, contractual, or civil. Moreover, they are meaningfully described as public enforcers where their regulatory efficacy is spurred by a credible threat of state intervention, and they can be seen as public franchisees.56 Where no such credible threat exists, then such organizations are better viewed as purely private. In theory, public enforcement suffers from the limitation—​as compared with private enforcement—​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.57 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.58 In practice, public enforcement is an important modality for securing corporate agent compliance in almost all jurisdictions.59

2.4.2.2 Private 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, cooperative judges, and favorable procedural law that facilitates actions through matters as diverse as discovery rights, class actions, and legal fees.60 The 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.61 Indeed, the probability

56 The concept of “coerced self-​regulation” is developed in Ian Ayres and John Braithwaite, Responsive Regulation: Transcending the Deregulation Debate 101–​32 (1992). 57  Jonathan R. Hay and Andrei Shleifer, Private Enforcement of Public Laws:  A  Theory of Legal Reform, 88 American Economic Review 398 (1998). 58 Margaret H. Lemos and Max Minzner, For-​Profit Public Enforcement, 127 Harvard Law Review 853 (2014); Brandon L. Garrett, Too Big to Jail: How Prosecutors Compromise with Corporations (2014). 59  See e.g. Armour, note 52, at 87–​102; John Armour and Caroline Schmidt, Building Enforcement Capacity for Brazilian Corporate and Securities Law, in Public and Private Enforcement: China and the World (Robin Huang and Nico Howson eds., forthcoming 2017); Coffee, Law and the Market, note 50, at 258–​63; Howell E. Jackson and Mark J. Roe, Public and Private Enforcement of Securities Laws: Resource-​Based Evidence, 93 Journal of Financial Economics 207 (2009); Rafael La Porta, Florencio Lopes-​de-​Silanes, and Andrei Shleifer, What Works in Securities Laws? 61 Journal of Finance 1 (2006). 60  For example, enhancements across several of these dimensions have been credited with triggering a significant increase in private enforcement in Japan: Tom Ginsburg and Glenn Hoetker, The Unreluctant Litigant? An Empirical Analysis of Japan’s Turn to Litigation, 35 Journal of Legal Studies 31 (2006). 61  See e.g. 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 Journal of Empirical Legal Studies 687 (2009) (absence of UK shareholder litigation); Guido Ferrarini and Paolo Giudici, Financial Scandals and the Role of Private Enforcement: The Parmalat Case, in John Armour and Joseph A. McCahery, After Enron: Improving Corporate Law and Modernising Securities Regulation in Europe and the US 159 (2006) (lack of private enforcement in Italy); Theodore 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 2012.62 Unlike public enforcement, the modality we term private enforcement depends chiefly on the mechanism of deterrence—​namely, the imposition of penalties ex post upon the discovery of misconduct. There are few direct analogs in private enforcement to the ex ante 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.63 The 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, there is an important counterpart: private actors are of course very much involved in ex ante governance interventions to secure compliance by agents. Indeed, while 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 not observed in most of the jurisdictions we survey, in some countries—​for example, France, Italy, and Brazil—​state ownership of controlling shares in publicly traded companies is common.64 Under such circumstances, public actors—​ namely government agencies—​ take decisions regarding governance intervention.

2.4.2.3 Gatekeeper control Gatekeeper control involves the conscription of noncorporate actors, such as accountants and lawyers, in policing the conduct of corporate actors. This conscription generally involves exposing the gatekeepers to the threat of sanction for participation in corporate misbehavior, or for failure to prevent or disclose misbehavior.65 The actors so conscripted are “gatekeepers” in the sense that their participation is generally necessary, whether as a matter of practice or of 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 of Sue: The Evidence from Japan, 30 Journal of Legal Studies 351 (2001)), they are still nothing like the same level of frequency as in the U.S. 62  John Armour, Bernard Black, and Brian Cheffins, Is Delaware Losing its Cases? 9 Journal of Empirical Legal Studies 605, at 623, 627 (2012). There is, however, no mechanism for public enforcement by the state of Delaware. 63  Companies Act 2006 (UK), Part 26. 64  See Aldo Musacchio and Sérgio Lazzarini, Reinventing State Capitalism (2014). 65 See Reinier Kraakman, Gatekeepers:  The Anatomy of a Third-​Party Enforcement Strategy, 2 Journal of Law Economics and Organization 53 (1986); John C. Coffee, Jr., Gatekeepers: The Professions and Corporate Governance (2006).

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constraint (e.g. auditors refuse to issue an unqualified report) rather than through the ex post mechanism of penalizing wrongdoers. Such delegation of course creates a new agency problem between the gatekeeper and the principals. This is dealt with through the application of the basic legal strategies to the gatekeepers themselves, with chief reliance on the standards and trusteeship strategies.66

2.4.3 Penalties Enforcement by the modalities described, or indeed governance interventions, secures compliance either by introducing an ex ante requirement for approval, or imposing an ex post 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 is rather more subtle than at first might be imagined. Perhaps the most obvious form of penalty is a payment of money.67 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, it is common practice in some jurisdictions—​such as the U.S., Germany, and 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. This generally reduces the effective size of financial obligations imposed by civil liability on managers, so much so that even in jurisdictions where shareholder litigation is frequent, outside directors rarely, if ever, are required to make payments from their personal assets following a shareholder lawsuit.68 The functional rationale for this is that too-​zealous imposition of personal liability on managers might induce them to behave in a risk-​averse fashion, contrary to the wishes of diversified shareholders.69 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.70

66  See e.g. Selangor United Rubber Estates v Cradock (No 3) [1968] 1 WLR 1555 (UK Ch D); RBC Capital Markets LLC v Jervis 129 A.3d 816 (Del. 2015) (secondary liability for bankers who knowingly or dishonestly assist in boards’ breaches of duty). 67  In keeping with the broad use of the term “penalty,” we include here both compensatory and punitive—​more narrowly defined—​payments. 68  Bernard Black, Brian Cheffins, and Michael Klausner, Liability Risk for Outside Directors: A Cross-​ Border Analysis, 11 European Financial Management 153 (2005); Tom Baker and Sean J. Griffith, How the Merits Matter: Directors’ and Officers’ Insurance and Securities Settlements, 157 University of Pennsylvania Law Review 755 (2009). 69  Reinier Kraakman, Corporate Liability Strategies and the Costs of Legal Controls, 93 Yale Law Journal 957 (1984). See also Gutachten E zum 70. Deutschen Juristentag: Reform der Organhaftung? Materielles Haftungsrecht und seine Durchsetzung in Privaten und öffentlichen Unternehmen (Gregor Bachmann ed., 2014); cf. Regional Court (Landgericht) München 10.12.2013 Zeitschrift für Wirtschaftsrecht (ZIP) 2014, 570 (the Siemens/​Neubürger case). 70  Kraakman, note 69; John Armour and Jeffrey N. Gordon, Systemic Harms and Shareholder Value, 6 Journal of Legal Analysis 35 (2014). See Chapter 4.3.

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In many civil law countries, another important ex post consequence of violating company law rules is annulment of corporate decisions.71 Such orders deny the legal efficacy of corporate actions reached on the basis of a process that failed to conform to applicable rules. This 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. The 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 “criminal,” then incarceration may also be available as a penalty for individual—​although not corporate—​defendants.72 For corporate defendants in regulated industries, perhaps the most severe penalty that may be inflicted is loss of a firm’s regulatory license, which will effectively shut down its business. The threat of criminal sanctions and/​or loss of regulatory licenses can, without careful calibration of expected sanctions, easily result in over-​deterrence.73 Defendants may face a range of extra-​legal—​principally reputational—​consequences flowing from enforcement actions. For individual agents, these may include loss of jobs and greater difficulty finding other employment.74 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.75 This can greatly exceed the size of financial penalties—​indeed, no financial penalty need be imposed to trigger reputational loss, simply the credible dissemination of information about malfeasance.76 While the potential for reputational loss both makes the total effective penalty larger, it also makes it less predictable.77 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

71  See Holger Fleischer, Fehlerhafte Aufsichtsratsbeschlüsse:  Rechtsdogmatik—​Rechtsvergleichung—​ Rechtspolitik, Der Betrieb 2013, 160–​7 and 217–​24; Martin Gelter, Why do Shareholder Derivative Suits Remain Rare in Continental Europe? 37 Brooklyn Journal of International Law 843–​92 (2012). 72  Whether criminal sanctions can be used at all against legal persons is controversial. While most jurisdictions now permit this, some, such as Germany, refuse to do so. See generally Guy Stessens, Corporate Criminal Liability: A Comparative Perspective, 43 International and Comparative Law Quarterly 493 (1994). 73  See e.g. Jennifer Arlen, The Potentially Perverse Effects of Corporate Criminal Liability, 23 Journal of Legal Studies 833 (1994); Daniel R. Fischel and Alan O. Sykes, Corporate Crime, 25 Journal of Legal Studies 319 (1996). A particular concern in the EU context is competition law enforcement: see Case C-​172/​12 P, EI du Pont de Nemours v Commission [2013] European Court Reports I-​0000, ECLI: EU: C:2013:605 (parent fined for breaches of competition law by subsidiary, with fine amount calculated as a percentage of parent’s turnover). 74  See e.g. Fich and Shivdasani, note 33; Maria Correia and Michael Klausner, Are Securities Class Actions “Supplemental” to SEC Enforcement? An Empirical Analysis, Working Paper, Stanford Law School (2012). 75  See Jonathan Karpoff and John Lott, Jr., The Reputational Penalty Firms Face from Committing Criminal Fraud, 36 Journal of Law and Economics 757 (1993); Cindy Alexander, On the Nature of the Reputational Penalty for Corporate Crime: Evidence, 42 Journal of Law and Economics 489 (1999); Jonathan Karpoff, D. Scott Lee, and Gerald Martin, The Cost to Firms of Cooking the Books, 43 Journal of Financial and Quantitative Analysis 581 (2008). 76  See e.g. Benjamin L. Liebman and Curtis J. Milhaupt, Reputational Sanctions in China’s Securities Market, 108 Columbia Law Review 929 (2008). 77  See John Armour, Colin Mayer, and Andrea Polo, Regulatory Sanctions and Reputational Damage in Financial Markets, forthcoming, Journal of Financial and Quantitative Analysis (2017) (finding no correlation between size of reputational loss and financial penalty).

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performance, and does not appear to lead to reputational losses.78 This has implications for the selection of legal penalties in relation to the control of externalities.79

2.5  Legal Strategies in Corporate Context The 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, 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—​a context in which regulatory strategies 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, jurisdictions adopt a fluid mix of regulatory and governance strategies in all of the last three transactional contexts. Then, 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 law, they cover most of what is conventionally understood to be corporate law, and nearly all of the interesting and controversial issues that the subject presents today. Within each of our seven substantive chapters, our analysis proceeds functionally. 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, 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). This variation in structure responds to the greater heterogeneity of the transactions dealt with in those chapters. 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 We might expect the use of the various legal strategies for controlling agency costs, and of the associated modes of enforcement, to differ systematically across jurisdictions. 78  See Jonathan M. Karpoff, John R. Lott, Jr., and Eric W. Wehrly, The Reputational Penalties for Environmental Violations: Empirical Evidence, 48 Journal of Law and Economics 653 (2005); Armour et al., note 77. 79  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 is closely linked 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 of course the control of controlling shareholders themselves becomes more problematic. Where ownership of shares is more diffuse, however, governance mechanisms are less effective in controlling man­ agers, and there is more need for regulatory mechanisms to take the fore. Just as the choice of legal strategies for controlling agency problems is likely to complement the pattern of ownership, it will in turn be complemented by the nature 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.80 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.81 In addition, the appropriate scope of continuing disclosure obligations may vary depending on the extent to which particular legal strategies are employed.82 Thus in the U.S., where regulatory strategies are extensively used, continuing disclosure traditionally focused on self-​dealing transactions, so assisting in 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 step with a more general convergence in ownership structure we discuss in Chapter 3—​with enhancements to disclosure of related-​party transactions in the EU and of board composition and functioning in the U.S.83 The necessary extent of disclosure will also vary depending on the ownership structure. Where owners are highly coordinated, frequent disclosure may be less important as a response to managerial agency costs:84 owners are better able to discover information for themselves, and governance strategies can be used to stimulate disclosure of

80  The existence of a demand for regulatory, as opposed to governance, strategies may be expected to spur the development of regulatory expertise. Thus 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, The Efficiency of Controlling Corporate Self-​Dealing: Theory Meets Reality, 91 California Law Review 393 (2003). 81  Edward Glaeser, Simon Johnson, and Andrei Shleifer, Coase Versus the Coasians, 116 Quarterly Journal of Economics 853 (2001). 82  See e.g. para. 9 Recommendation 2005/​162/​EC on the role of non-​executive or supervisory directors of listed companies and on committees of the (supervisory) board, 2005 O.J. (L 52) 51. 83  See Chapter 3.2.4, 3.4.2, and Chapter 6.2.1.1. 84  See John Armour and Jeffrey N. Gordon, The Berle-​Means Corporation in the 21st Century, Working Paper (2008), at .

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greater information. This is not to say, 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 related party transactions—​is disseminated to minority shareholders, and that information management transmits to controllers makes its way to all owners equally​, preventing so-​called “selective disclosure.” Many such institutional differences may make little 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, 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 strategies and the exercise of governance, institutions supporting disclosure—​a strong and effective securities regulator and a sophisticated accounting profession, for example—​are always likely to make an overall difference to the success of firms in controlling agency costs.85

85  See Bernard Black, The Legal and Institutional Preconditions for Strong Securities Markets, 48 UCLA Law Review 781 (2001).

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3 The Basic Governance Structure: The Interests of Shareholders as a Class John Armour, Luca Enriques, Henry 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 constituencies. This chapter examines how the legal strategies employed in corporate governance mitigate the manager–​shareholder conflict in our core jurisdictions; Chapter 4 then explores the role of governance in safeguarding minority shareholder and non-​shareholder interests. Two of the core features of the corporate form underlie corporate governance. The 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 removed from the firm’s day-​to-​day operations and who face significant information and coordination costs.1 The second is delegated management, which is functional precisely because of shareholders’ information and coordination costs. Such delegation in turn brings with it shareholder–​manager agency costs. Corporate laws address the 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 decision rights 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 the U.S. for much of the twentieth century, appointment and decision rights are less effective, and more work is done by agent incentives, in the form of appropriately calibrated rewards for managers and a trusteeship role for non-​management directors in overseeing executives. Such strategies have been further supported by standards of conduct for directors and affiliation rights, namely disclosure rules to ensure more informed share prices and greater liquidity, which in turn make exit rights, including by tendering shares in a hostile takeover bid, more effective. Somewhere between these 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.” See Henry Hansmann, The Ownership of Enterprise 35 (1996). 2  These strategies similarly enable non-​controlling institutional shareholders in the few companies in these countries that have no dominant shareholder. The Anatomy of Corporate Law. Third 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 3 © John Armour, Luca Enriques, Henry Hansmann, and Reinier Kraakman, 2017. Published 2017 by Oxford University Press.

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commonly—​lie ownership patterns where, although controlling shareholders are not 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’ 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 key internal governance institution in each of them—​will be useful.

3.1  Delegated Management and Corporate Boards The 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 power to boards of directors. We have already seen that delegation of decision-​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 tried to make these 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 “one-​tier,” whereas in others they are “two-​tier.”4 In jurisdictions with one-​tier boards, such as the U.S., UK, and Japan, a unitary board has legal power both to manage and supervise the management of a corporation, either directly or through the board’s committees.5 By contrast, jurisdictions using 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 directors,6 which then appoint and supervise management boards that include the principal executive officers in charge of designing and implementing business strategy. Germany and Brazil mandate two-​tier boards for public corporations, while Italy and France—​as well as the EU for the European Company—​offer a choice between one and two-​tier boards.7 In theory, one-​tier boards concentrate decision-​making power in the hands of directors, because they combine the managerial and supervisory roles in one group. Thus 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, The Agency Costs of Agency Capitalism:  Activist Investors and the Revaluation of Governance Rights, 113 Columbia Law Review 863 (2013). 4  There are also intermediate board structures in other jurisdictions, such as the “Nordic” board of directors. See Per Lekvall, A Consolidated Nordic Governance Model, in The Nordic Corporate Governance Model 52, 59–​63 (Per Lekvall ed., 2014). 5  Some jurisdictions—​such as Italy, Brazil, and East Asian jurisdictions influenced by German law—​retain vestigial supervisory boards such as the “board of auditors” (Japan and Italy) or the “board of supervisors” (Brazil and China). The powers of these secondary boards, which are functionally similar to those of audit committees on a unitary board, are generally limited, especially in Japan and Italy. 6 We use “non-​ management” in the sense of non-​ participation in management. Such non-​ participation in executive decision-​making is frequently mandated for supervisory boards in two-​tier jurisdictions such as Germany. See §§ 105 and 111 IV Aktiengesetz. 7  §§ 76–​116 Aktiengesetz (Germany); Art. 138 Lei das Sociedades por Ações (Brazil); Art. L. 225–​ 57 Code de commerce (France); Art. 2380 Civil Code (Italy); Art. 38 Council Regulation (EC) No 2157/​2001 of 8 October 2001 on the Statute for a European company (SE).

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single-​tier board.8 By contrast, two-​tier jurisdictions such as Germany bar supervisory boards from making managerial decisions.9 However, board practices can blur the distinction between the two structures.10 Informal leadership coalitions can 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 boards a quasi-​supervisory flavor. Further, in jurisdictions with labor codetermination—​such as Germany, among our core countries—​a 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 board structure facilitates strong labor participation in corporate governance as full access to sensitive information and business 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 for its largest 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 members. Smaller boards are thought to be more effective in performing their monitoring role.14 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 Societas Europaea (SE), which allows for a minimum of only 12 directors.15

3.2  Appointment and Decision Rights The most basic legal strategies implied by investor ownership are appointment rights: the shareholders retain powers to appoint (and remove) members of the 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 transactions, 8  This is not universally the case. In the UK, Art. A.2.1 of the UK 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. 9  See note 6. 10  See Paul Davies and Klaus J. Hopt, Corporate Boards in Europe—​Accountability and Convergence, 61 American Journal of Comparative Law 301 (2013). 11 See Klaus J. Hopt and Patrick C. Leyens, Board Models in Europe—​Recent Developments of Internal Corporate Governance Structures in Germany, the United Kingdom, France and Italy, 1 European Company and Financial Law Review 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. 14  See e.g. David Yermack, Higher Market Valuation of Companies with a Small Board of Directors, 40 Journal of Financial Economics 185 (1996); Jeffrey L. Coles, Naveen D. Daniel, and Lalitha Naveen, Boards: Does One Size Fit All? 87 Journal of Financial Economics 329 (2008). 15  See Jochem Reichert, Experience with the SE in Germany, 4 Utrecht Law Review 22, 27–​8 (2008).

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corporate laws also grant shareholders decision rights. The 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. The 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 agency costs—​by permitting shareholders to control managers more effectively—​while at the same time it might increase shareholder–​ shareholder agency 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.16 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.17 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 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.18 Whether such activist hedge funds are in a good position to identify companies with weak strategies 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” business strategies, is one of the most disputed issues in the current corporate governance debate.19 The empirical evidence about the merits of this new corporate governance paradigm is as yet inconclusive,20 and the debate will continue on whether the new corporate governance paradigm

16  See Zohar Goshen and Richard Squire, Principal Costs: A New Theory for Corporate Law and Governance, Working Paper (2015), available at ssrn.com. 17  Bernard S. Black, Agents Watching Agents: The Promise of Institutional Investor Voice, 39 UCLA Law Review 811 (1991). 18  Marcel Kahan and Edward B. Rock, Hedge Funds in Corporate Governance and Corporate Control, 155 University of Pennsylvania Law Review 1021 (2007); Gilson and Gordon, note 3; Marco Becht, Julian R. Franks, Jeremy Grant, and Hannes F. Wagner, The Returns to Hedge Fund Activism: An International Study, 21 European Financial Management 106 (2015). 19 See e.g. Alon Brav, Wei Jiang, Frank Partnoy, and Randall Thomas, Hedge Fund Activism, Corporate Governance, and Firm Performance, 63 Journal of Finance 1729 (2008); Gilson and Gordon, note 3; April Klein and Emanuel Zur, Entrepreneurial Shareholder Activism: Hedge Funds and Other Private Investors, 64 Journal of Finance 187 (2009); Lucian A. Bebchuk, Alon Brav, and Wei Jiang, The Long-​Term Effects of Hedge Fund Activism, 115 Columbia Law Review 1085 (2015); Yvan Allaire and Francois Dauphin, The Game of “Activist” Hedge Funds: Cui Bono? Working Paper (2015), available at ssrn.com; Emiliano Catan and Marcel Kahan, The Law and Finance of Antitakeover Statutes, 68 Stanford Law Review 629 (2016). 20  For a comprehensive review see John C. Coffee, Jr. and Darius Palia, The Wolf at the Door: The Impact of Hedge Fund Activism on Corporate Governance, 1 Annals of Corporate Governance 1 (2016).

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based on activist hedge funds and institutional shareholders as arbiters of corporate strategy brings net benefits to society.21 Before analyzing individual legal strategies across jurisdictions, we should bear in mind that shareholder-​centric corporate laws are not a priori superior to board-​centric ones. Solving the trade-​off between managerial agency costs and shareholder information and coordination costs turns out to be one of the hardest challenges for corpor­ ate 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’ power to vote on the selection of directors. The impact of this power is much greater if shareholders also have the power to nominate the candidates for election. The allocation of these entitlements reflects the balance between shareholder information and coordination costs and managerial agency costs. The latter are most tightly controlled by permitting shareholders to select candidates for appointment. 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. This latter approach is common practice in most jurisdictions:  the board usually proposes a slate of nominees, which is rarely opposed at the annual shareholders’ meeting. The 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 jurisdictions permit a qualified minority (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-​or-​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 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” innovation for example (see John Armour and Luca Enriques, Financing Disruption, Working Paper (2016))—​but it is unclear whether such effects explain the pattern of activist investing. 22  In Italy the law on listed companies itself drives this outcome, by treating shareholder-​proposed slates as default. See Art. 147-​III Consolidated Act on Financial 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 documents (Art. 303 and 305 Companies Act; see also Gen Goto, Legally “Strong” Shareholders of Japan, 3 Michigan Journal of Private Equity and Venture Capital 125, 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 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.24 Finally, special rules apply to allow for minority shareholder representation on the boards of listed companies in Brazil and Italy.25 Matters are more complex in the U.S., where board elections have always been a contentious issue attracting policymakers’ attention. First of all, the statutory default in Delaware is a “plurality” voting rule, under which—​when an election is uncontested, that is, the number of candidates equals the number of directors to be elected—​any number of votes suffices to elect a nominee to a board seat.26 Following institutional investors’ dismay at reappointment of candidates for whom large numbers of votes had been “withheld,” most large companies have opted out of the default, switching to majority voting.27 Moreover, Delaware law was amended to facilitate shareholder initiatives to switch to majority voting.28 And, while plurality remains relatively common in smaller companies, their boards often yield to “withholding” campaign demands.29 Shareholders in U.S. companies have other tools to obtain representation on the board. One such tool is proxy access—​that is, placing nominees on the company’s proxy materials so all shareholders will have a choice between the board candidates and the insurgents’ ones, without any need for the latter to circulate their own proxy materials. The default in Delaware is against proxy access and federal rules regulating proxies have traditionally refrained from mandating such access. After the Dodd-​Frank Act of 2010 explicitly granted the SEC power to make rules facilitating inclusion of shareholder nominations in the corporate proxy form,30 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, 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,34 may launch a full-​blown proxy contest. In this case, the insurgent bears all the costs of soliciting their own proxies and distributing

24  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. 25  See Chapter 4.1.1. 26  See e.g. § 216(3) Delaware General Corporation Law. 27  Stephen J. Choi, Jill E. Fisch, Marcel Kahan, and Edward B. Rock, Does Majority Voting Improve Board Accountability? University of Chicago Law Review 1119 (2016). 28  See § 216(4) Delaware General Corporation Law (barring the board from revoking a stockholder bylaw requiring a majority vote for directors). 29  Marcel Kahan and Edward Rock, Symbolic Corporate Governance Politics, 94 Boston University Law Review 1997, 2011 (2014). 30  § 971, Dodd-​Frank Act (2010). 31  Business Roundtable v. Securities and Exchange Commission, 647 Federal Reporter 3d 1144. According to one study, the D.C. Circuit’s 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 Journal of Law & Economics 127 (2013). 32  § 112 Delaware General Corporation Law. 33  See e.g. Howard B. Dicker, 2016 Proxy Season: Engagement, Transparency, Proxy Access, Harvard Law School Forum on Corporate Governance and Financial Regulation, 4 February 2016, available at corpgov.law.harvard.edu. 34  See Chapter 8.2.3.

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their own materials—​that is, ballots, registration statements (subject to SEC review), and supporting materials.35 Finally, a popular tool among activists is what is known as a “short slate” proxy solicitation.36 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 proxy materials.37 A “short 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 strategy from within the board.

3.2.2 Removing directors The 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 the UK, France, Italy, Japan, and Brazil—​ accord shareholder majorities a non-​waivable right to remove directors at any time, regardless of cause or the nominal duration of their term.38 Coupled with powers to requisition a shareholders’ meeting—​for which the agenda will be circulated at the company’s 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.39 Our other jurisdictions provide weaker removal rights. German law encourages accountability to shareholders of shareholder-​elected members of the supervisory board by permitting their removal without cause, although only by a 75 percent majority.40 By contrast, shareholders may not remove the labor representatives, nor may the supervisory board remove members of the management board without cause.41 This latter rule reflects the idea that in the presence of representatives of very different constituencies, making managers (as opposed to supervisors) tightly accountable to their constituency might be counter-​productive, undermining effective day-​to-​day decision-​ making. 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; in other words, the supervisory board is entitled (and probably obliged) to remove the management board in such a situation.42 35 See e.g. Sofie Cools, The Real Difference in Corporate Law Between the United States and Continental Europe:  Distribution of Powers, 30 Delaware Journal of Corporate Law 697, 746 (2005). 36  See Coffee and Palia, note 20, at 24–​5. 37  See 17 C.F.R. §240.14a-​4(d)(4). 38  Sections 168 and 303 Companies Act 2006 (UK), Arts. L. 225-​18, 225-​75, and 225-​61 Code de commerce (France); Arts. 2367 and 2383 Civil Code (Italy) (all providing for removal within 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). 39  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 Review of Financial Studies 3093 (2010). 40  § 103 AktG (Germany). Companies’ charters may provide for a higher or lower majority (ibid.), which they rarely, if ever, do. 41  § 103 and 84(3) AktG (Germany). 42  § 84(3) AktG (Germany). In practice the management board member will not wait until the supervisory board votes on the removal, but will step down “voluntarily.”

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Many U.S. jurisdictions treat the right to remove directors without cause as a statutory default subject to reversal by a charter provision on point.43 In Delaware, however, companies may only disallow removal without cause if they choose a staggered (or “classified”) board, that is, a board where only a fraction of the members is elected each year.44 Staggered boards used to be common until the mid-​2000s. In keeping with the general trend towards greater shareholder appointment rights in the U.S., their use has been in decline for several years,45 in parallel with a heated scholarly debate over their corporate governance merits.46 Yet, Delaware indirectly cabins removal rights by denying shareholders the power to call a special shareholders’ meeting unless the company’s charter expressly so provides.47 Especially where removal without cause is not permitted, the standard 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. Among our core jurisdictions, directorial terms are the shortest (one year) in the U.S. (unless the company has a staggered board, in which case 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.48 Terms are short (two years) in Japan as well, while in Italy and Brazil they are three years.49 At the opposite end of the spectrum lie German and French corporations, which usually elect (supervisory) directors for five-​or six-​year terms respectively, the maximum that their corporation laws permit.50 Thus, removal rights generally track appointment rights:  jurisdictions with “shareholder-​centric” laws on the books—​the UK, France, Japan, Italy, and Brazil—​ provide shareholders with non-​waivable removal powers as well as robust nomination powers. Delaware—​the dominant U.S. jurisdiction—​weakens removal powers by allowing staggered boards and discouraging special shareholders’ meetings, but has an ever more commonly adopted default directorial term of one year which, together with the recent introduction of more shareholder-​friendly rules on appointment,51 have brought it broadly in line with other jurisdictions. The 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

43  See § 8.08(a) Revised Model Business Corporation Act. 44  See § 141(k) Delaware General Corporation Law. Delaware General Corporation Law requires that at least one-​third of the directors be elected annually (§141(d)) where there is a single class of voting stock. Longer terms are possible, however, where corporate charters provide for multiple classes of voting stock. 45  Marcel Kahan and Edward Rock, Embattled CEOs, 88 Texas Law Review 987, 1007–​9 (2009). 46  Compare e.g. Lucian A. Bebchuk, John C. Coates IV, and Guhan Subramanian, The Powerful Antitakeover Force of Staggered Boards: Theory, Evidence, and Policy, 54 Stanford Law Review 887 (2002) and Lucian A. Bebchuk, Alma Cohen, and Allen Ferrell, What Matters in Corporate Governance?, 22 Review of Financial Studies 783 (2009), with Martijn Cremers, Lubomir P. Litov, and Simone M. Sepe, Staggered Boards and Firm Value, Revisited, Working Paper (2014), available at ssrn.com. 47  See §§ 211(b) and 211(d) Delaware General Corporation Law. 48  UK Corporate Governance Code (2014), B.7.1. 49  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). 50  § 102 I AktG (Germany); Art. L. 225-​18 Code de commerce (France). 51  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.52

3.2.3 Decision  rights Since the corporate form seeks to facilitate delegated 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 depends on the nature of the shareholders and the coordination costs they face. Almost all jurisdictions require shareholders to approve some corporate actions, whether upon a board proposal or even a shareholder’s. Traditionally, U.S. law mandates shareholder ratification for a 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.53 For UK listed companies, the premium Listing Rules require shareholder approval of so-​called “Class 1” transactions, which exceed a threshold of significance (25 percent) measured by reference to a range of corporate valuation metrics.54 Equally important, all EU member states give shareholders the right to appoint and dismiss the auditors of listed and publicly traded companies,55 while shareholders also elect the “statutory auditors” or “supervisors” of Japanese, Italian, and Brazilian companies.56 On one dimension—​shareholder voting on executive pay—​convergence is fast approaching, on a rule that permits the shareholders’ meeting to cast a vote on man­ agers’ compensation packages. We deal with “say on pay” in Chapter 6.57 Jurisdictions also differ in the latitude of the initiation rights they grant shareholders. At one end of the spectrum, the UK and Brazil confer extensive powers on shareholders. The 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.58 Brazil does not contain a similar rule, but permits a simple majority of shareholders to make the lion’s share of business decisions beyond the very few matters that necessarily require board action.59 In addition, duly filed shareholder agreements can even bind

52  See text following note 41. 53  §§ 58 and 174 AktG (Germany); Art. L. 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 Art. 70 Schedule 3, Model Articles for Public Companies, Companies (Model Articles) Regulations 2008 No. 3229. 54  LR 10, UK Listing Rules. 55  Art. 37(1) EU Audit Directive (Directive 2006/​43/​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). 56  Ibid. See also Art. 329(1) Companies Act (Japan); Art. 2400 Civil Code (Italy); Art. 162 Lei das Sociedades por Ações (Brazil). 57  See Chapter 6.2.3. 58  See Schedule 3, Art. 4 Model Articles for Public Companies, note 53. This 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. 59  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 not counted in shareholder and board meetings.60 Elsewhere, shareholders have less extensive rights. Routine business decisions generally fall within the (management) board’s exclusive authority to “manage” the corpor­ ation.61 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 management and strategic direction, such as amendments to the corporate charter.62 By contrast, U.S.—​or at least Delaware—​law is the least 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.63 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 example is the German limited liability company (GmbH), which may become very large in capitalization and number of shareholders. The GmbH not only mandates shareholder approval of financial statements and dividends, but also authorizes the general shareholders’ meeting to instruct the company’s board (or general director) on all aspects of company policy.64 The GmbH form, then, allows 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.65 Our other core jurisdictions are similarly flexible. Finally, at the level of the individual shareholder, many jurisdictions permit derivative 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 Shareholder 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, 60  Art. 118 Lei das Sociedades por Ações. 61  E.g. § 141(a) Delaware General Corporation Law; § 76 Aktiengesetz (Germany). 62  See Dirk Zetzsche, Shareholder Interaction Preceding Shareholder Meetings of Public Corporations—​ A Six Country Comparison, 2 European Company and Financial Law Review 107, 120–​8 (2005) (France and Germany). For Italy see Art. 2367 Civil Code and Art. 126-​II Consolidated Act on Financial Intermediation. For Japan, see Goto, note 23, at 129–​31, 135–​6. 63  See Chapters 7.2 and 7.4. However, shareholders in U.S. corporations do 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. 64  §§ 37, 38, 46 GmbHG. 65  A GmbH subject to codetermination must have a two-​tier board and is subject to AG rules on the division of functions between the boards, and between boards and shareholders. Karsten Schmidt, Gesellschaftsrecht 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.66 France, Germany, Italy, and the UK allow corporations to opt for distance voting.67 As a consequence of the EU Shareholder Rights Directive, all of these jurisdictions also now permit electronic meetings and voting.68 The U.S. traditionally relied on proxy voting,69 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 “e-​proxies”).70 Finally, Brazilian law now enables distance voting and permits companies to hold live electronic meetings and voting.71 When investors hold shares in individual companies, they usually do so via institutions such as banks (in most jurisdictions) or 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 with listed companies. For this reason, when they were empowered to vote custodial shares, they generally favored the corporate nominees. This practice was once common among U.S. broker-​dealers,72 and European custodians, such as banks, played an even stronger, pro-​incumbent role in corporate governance. In Germany, for example, where supervisory boards have traditionally not engaged in partisan proxy solicitation,73 banks serving as custodians for retail investors used to vote the shares in favor of corporate nominees. This custodial exercise of voting rights was justified by reference to investors’ “implicit consent.”74 After market pressure and legal reform restricted this practice,75 voting outcomes in widely held German companies have occasionally become less predictably pro-​management.76

66  Japanese firms with 1000 or more shareholders must make this choice:  Arts. 298(1)(iii) and 298(2) Companies Act. Voting by mail is also optional for smaller companies, and voting by electronic means is optional for all Japanese companies: Art. 298(1)(iv) Companies Act. In practice most large public Japanese firms adopt voting by mail rather than proxy voting. 67  Art. L. 225-​107 Code de commerce (France); Art. 2370(4) Civil Code and Art. 127 Consolidated Act on Financial Intermediation (Italy). For 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 articles: Companies Act (UK) 2006, s 284(4). 68  Art. 8 Directive 2007/​36/​EU, 2007 O.J. (L 184) 17. 69  The NYSE mandates proxy solicitation for “operating” listed U.S. firms 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, Italy, the UK, or Japan. 70  SEC Rules 14a-​16, 14a-​17. 71  CVM Instruction No. 481 (2009), as amended by CVM Instruction No. 561 (2015). 72  Since 2009 U.S. brokerage houses have been prohibited from voting shares held as nominees (in “street name”) in directorial elections in the absence of direct instructions from beneficial owners: NYSE Rule 452. The Dodd-​Frank Act broadened the prohibition to voting on executive compensation, including say-​on-​pay (§ 957). 73  See Schmidt, note 65, at 854. 74  The shareholders could always instruct their banks as to how to vote their shares, but rarely gave explicit instructions. 75  See Wolf-​Georg Ringe, Changing Law and Ownership Patterns in Germany: Corporate Governance and the Erosion of Deutschland AG, 63 American Journal of Comparative Law 493, 506–​7 (2015). 76  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, Financial Times (Europe), 10 May 2005, at 1. For evidence of the decline in bank influence in Germany see Ringe, note 75, 522–​4. For recent anecdotal evidence of increasingly successful hedge fund activism in Germany, see Stada and Deliver, The Economist, 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.77 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.78 Institutions that invest in the market on behalf of multiple beneficiaries can aggregate control rights, thereby redu­ cing the collective action problems faced by disaggregated investors. Indeed, many institutions with financial obligations to their beneficiaries or customers—​including pension funds, mutual funds, and insurance companies—​have long been champions of shareholder interests in the UK,79 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 was historically more concerned with the risk that a faction of shareholders would gain control, to the detriment of the shareholders in general, than with managerial agency costs.80 That translated into rules that not only discouraged insurgents seeking to gain control via proxy contests, but also chilled coordination attempts among shareholders generally. Along with the advent of ubiquitous institutional investor ownership, the proxy rules restrictions on inter-​ shareholder communication were greatly relaxed in 1992.81 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,82 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’s management. They 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.83 And if, as a result, both the initial activist and other hedge funds buy shares in the target company, they need not aggregate their holdings for disclosure purposes.84 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.85 In addition, hazier definitions of “acting in concert” for mandatory bid rule purposes, especially in countries such as Germany and France, which have not

77  Ringe, note 75 at 524–​6. 78 See e.g. Paul Davies, Shareholders in the United Kingdom, Research Handbook on Shareholder Power 355, 357–​9 (Jennifer G. Hill and Randall S. Thomas eds., 2015) (UK); Edward B. Rock, Institutional Investors in Corporate Governance, in Oxford Handbook of Corporate Law and Governance (Jeffrey N. Gordon and Wolf-​Georg Ringe eds., 2017) (U.S.). 79  See Geof P. Stapledon, Institutional Shareholders and Corporate Governance (1996). 80  See e.g. John Pound, Proxy Voting and the SEC: Investor Protection Versus Market Efficiency, 29 Journal of Financial Economics 241 (1991). 81  See Regulation of Communication among Shareholders, Exchange Act Release No. 34-​31326 (1992). See SEC Rule 13d-​5 (17 C.F.R. § 240.13d-​5 (2008)). 82  See SEC Rule 13d-​5 (17 C.F.R. § 240.13d-​5 (2008)). 83  See Coffee and Palia, note 20, at 35. 84  See ibid. at 28–​42. 85  See Arts. 7–​9 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.86 Moreover, 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.87 In addition, since 2003, mutual funds have had to disclose their proxy voting policies.88 These 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 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 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. The UK, followed by Japan, took the lead in this area by adopting a ‘Stewardship Code,” which aimed to increase asset managers’ accountability as regards their exercise of ownership (mainly voting) rights.89 The Stewardship Code, however, has no mandatory component: like for Corporate Governance Codes,90 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, seem broadly shared within the industry.91 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 and/​or management and financial performance at portfolio companies.92 A cause for skepticism is that—​unlike Corporate Governance

86  See Chapter  8.3.4. The UK Takeovers Panel issued guidance on acting in concert by active shareholders. See Takeover Panel, Practice Statement No. 26. Shareholder Activism (2009) (available at www.thetakeoverpanel.org). Italy’s securities regulator (Consob) similarly clarified 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 Consob Regulation on Issuers. 87 See e.g. Robert B. Thompson, The Power of Shareholders in the United States, in Research Handbook on Shareholder Power, note 78, 441, 451. 88  SEC, Proxy Voting by Investment Advisers, Release No. IA-​2106, 68 FR 6585 (7 Feb. 2003). The 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/​EC as regards the encouragement of long-​term shareholder engagement, Directive 2013/​34/​EU as regards certain elements of the corporate governance statement and Directive 2004/​109/​EC, as approved by the European Parliament on 8 July 2015. 89  Financial Reporting Council (UK), The UK Stewardship Code (2012); Council of Experts Concerning the Japanese Version of Stewardship Code, Principles for Responsible Institutional Investors—​Japan’s Stewardship Code (2014). 90  See Chapter 3.3.1. 91  As the time of writing (June 2016), the Financial Reporting Council website lists 306 asset managers, owners, and service providers (such as proxy advisers), including Blackrock, Fidelity, Vanguard, ISS, and Glass Lewis, who have stated their commitment to the Code. See www.frc.org.uk. The Japanese Stewardship Code is a form of pure soft law, in that even Japanese institutional investors are under no obligation to comply or explain. The Financial Services Agency’s website lists 207 institutional investors who have undertaken to comply or explain as of end of May 2016. 92  A review of the empirical evidence by one of this 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 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, market forces play an important role in molding corporate agents’ behavior. They have levered upon both the low-​powered incentives of independent directors within boards tasked with a monitoring role (a trusteeship strategy), and the high-​powered incentives created by seeking to align managers’ incentives with shareholders’ interests through equity-​linked compensation (a reward strategy). The law has intervened in these two areas, sometimes to support and reinforce market practices, and sometimes to curb distortions in their use that might result from the very agency problems such practices seek to ameliorate. Trusteeship 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 strategies separately 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.93

3.3.1  The 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 the board. Because their compensation packages tend to be less sensitive than managers’ to share performance, they are free(r) from high-​powered incentives. And because they are not themselves making day-​to-​day management decisions, they can be expected to identify less with management and to be more willing to be critical.94 The board—​whether one-​tier or two-​tier—​then comprises both man­agers, whose incentives are shaped mainly by the rewards strategy,95 and non-​ executives, whose incentives are rather shaped by the trusteeship strategy.96 The 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 incentive for directors to favor the interests of the firm’s management at the expense of other constituencies. Truly independent directors are board members who are not strongly tied by high-​powered financial incentives to any of the company’s constituencies and consequently are motivated principally by ethical and reputational concerns. That is, of course, our definition of a trustee.97

93  See also end of section 3.3.1. 94  Melvin A. Eisenberg, Legal Models of Management Structure in the Modern Corporation: Officers, Directors, and Accountants, 63 California Law Review 375 (1975). 95  See Section 3.5. 96  See Ronald W. Masulis and Shawn Mobbs, Independent Director Incentives: Where Do Talented Directors Spend Their Limited Time and Energy? 111 Journal of Financial Economics 406 (2014). 97  See Chapter 2.2.2.3.

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All of our core jurisdictions now recognize a class of “independent” 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,98 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.99 In addition, the Sarbanes-​Oxley Act of 2002 (“SOX”) mandated wholly independent audit committees; eight years later, the Dodd-​Frank Act mandated wholly independent compensation committees.100 Similarly, the SOX-​inspired EU Audit Directive requires publicly traded companies to have audit committees with a majority of independent directors, including an independent chair.101 Other than that, our EU jurisdictions promote independent directors mainly through soft law, in the form of “corporate governance codes.” These 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 guidelines. Instead, they have an obligation to report annually whether they comply with code provisions and, if they do not comply, the reasons for their noncompliance—​a so-​called “comply or explain” obligation.102 This 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.103 The 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,104 who should also fill the audit and remuneration committees as well as a majority of the nomination committee.105 France, Germany, and Italy follow the same direction, although they are less whole-​hearted in their embrace of independence. The French code distinguishes between widely held companies (recommending independence for half of the board) and companies with a controlling shareholder (recommending

98  In particular, Delaware courts have repeatedly emphasised the importance of independence as a criterion for review of conflicted transactions or litigation decisions. See Chapter 6.2.2.1. 99 See Rules 303A.01 (listed companies must have a majority of independent directors) and 303A.04–​05 (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) (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. 100  SOX, § 301; Dodd-​Frank Act of 2010, § 952. 101 Art. 39(1) Directive 2006/​43/​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. 1, 2. 102  See e.g. LR 9.8.6 UK Listing Rules; for Germany, § 161 AktG. 103 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 Regulation, Working Paper (2014), available at ssrn. com. See also Alain Pietrancosta, Enforcement of Corporate Governance Codes: A Legal Perspective, in Festschrift für Klaus J. Hopt 1, 1109, 1130 (Stefan Grundmann et al. eds., 2010). 104  UK Corporate Governance Code (2014), Provisions B.1.2. 105  Ibid., Provisions B.2.1, C.3.1, and D.2.1.

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independence for one-​third),106 while the German and Italian codes only recommend an “adequate number” of independent directors/​members of the supervisory board, leaving broad discretion to individual companies.107 The 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,108 France and Italy a remuneration committee, and Germany, with France, a nomination committee.109 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.110 As a response to criticisms of the traditional system of insider-​dominated boards coupled with a nominally independent but weak board of statutory auditors,111 the Japanese Companies Act permitted companies to adopt a U.S.-​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. This and a recommendation, in the Corporate Governance Code of 2015,114 to appoint two independent directors, has triggered a rapid increase in the number of listed companies appointing one or two independent directors.115 Nevertheless, it remains infrequent for Japanese companies to appoint any more independent directors.116

106  French Corporate Governance Code, Principle 9.2. 107 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). 108  On EU requirements for an audit committee see note 158. 109  See French Corporate Governance Code, Principle 15 and 17; Recommendation 5.3 German Corporate Governance Code; Arts. 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 Developments of Internal Corporate Governance Structures in Germany, the United Kingdom, France, and Italy, 1 European Company and Financial Law Review 135, 141 (2004). 110  Novo Mercado Regulations Art. 4.3; Level 2 Regulations Art. 5.3. 111  See note 5. 112  See Ronald J. Gilson and Curtis J. Milhaupt, Choice As Regulatory Reform: The Case of Japanese Corporate Governance, 53 American Journal of Comparative Law 343, 349 (2005); Amon Chizema and Yoshikatsu Shinozawa, The “Company with Committees”: Change or Continuity in Japanese Corporate Governance?, 49 Journal of Management Studies 77 (2012). 113  As of July 2014, only 58 out of 3414 (or 1.7 percent of ) listed companies at the Tokyo Stock Exchange took the form of a company with three committees. See Tokyo Stock Exchange, TSE-​ Listed Companies White Paper on Corporate Governance 2015, at 15 (available at http://​www. jpx.co.jp/​english/​equities/​listing/​cg/​02.html). 114 The Council of Experts Concerning the Corporate Governance Code, Japan’s Corporate Governance Code [Final Proposal] (2015). 115  For details and analysis of the recent reforms in Japan, see Gen Goto, Manabu Matsunaka, and Souichirou Kozuka, Japan’s Gradual Reception of Independent Directors: An Empirical and Political-​ Economic Analysis, in Independent Directors in Asia (Harald Baum et al. eds.) (forthcoming). The ratio of companies listed in the First Section of the Tokyo Stock Exchange (the 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 Tokyo Stock Exchange, Inc., Appointment of Outside Directors by TSE-​Listed Companies [Final Report] (29 July 2015), available at http://​www.jpx.co.jp/​english/​listing/​stocks/​ind-​executive/​index.html. 116  Ibid. As of July 2015, the ratio of companies listed in the 1st Section of Tokyo Stock 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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Trustee-​like directors are thus increasingly considered to be a key element of 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 shareholder interests).117 In EU jurisdictions with concentrated ownership structures and Brazil, truly independent directors are more likely to be seen as champions of minority shareholders or non-​shareholder constituencies. Put differently, trustee-​like directors can be seen as a wide-​spectrum prophylactic. They are potentially valuable for treating all agency problems (as well as externalities), but not exclusively dedicated to treating any.118 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.119 Moreover, independent directors come at a price, as there is inevitably a tradeoff between a director’s independence and her knowledge about the company.120 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 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, the aspects of board structure that affect performance vary by country

117  See e.g. Ronald J. Gilson and Reinier Kraakman, Reinventing the Outside Director: An Agenda for Institutional Investors, 43 Stanford Law Review 863 (1991); Jonathan R. Macey, Corporate Governance: Promises Kept, Promises Broken 90–​2 (2008). 118  On the use of independent directors to tackle a variety of agency and non-​agency problems over time, see Mariana Pargendler, The Corporate Governance Obsession, 42 Journal of Corporation Law 101 (2016). 119  See Wolf-​Georg Ringe, Independent Directors:  After the Crisis, 14 European Business Organization Law Review 401 (2013); Arcot and Bruno, note 103. See also Chapter 4.1.3.1 and Chapter 6.2.2.1. 120  For discussion of trade​offs between independence and information on the board see Arnoud W.A. Boot and Jonathan R. Macey, Monitoring Corporate Performance: The Role of Objectivity, Proximity, and Adaptability in Corporate Governance, 89 Cornell Law Review 356 (2003). Cf. Jeffrey N. Gordon, The Rise of Independent Directors in the United States, 1950–​2005: Of Shareholders Value and Stock Market Prices, 59 Stanford Law Review 1465, at 1541–​63 (2007) (increasingly informed share prices in the U.S. facilitate monitoring by independent directors); Enrichetta Ravina and Paola Sapienza, What do Independent Directors Know? Evidence From Their Trading, 23 Review of Financial Studies 962 (2008) (independent directors do almost as well as insiders in trading company stock, suggesting no lack of information). 121  See e.g. Jacob de Haan and Razvan Vlahu, Corporate Governance of Banks: A Survey, 30 Journal of Economic Surveys 228 (2016). 122  See e.g. Art. 91(1) Council Directive 2013/​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. The overall composition of the management body shall reflect an adequately broad range of experiences.” For 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, The Role of Boards of Directors in Corporate Governance: A Conceptual Framework and Survey, 48 Journal of Economic Literature 58 (2010).

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as much as by firm.124 Finally, no matter what definition the law or corporate governance codes provide of independence, whether directors labeled as “independent” will act as such depends on a congeries of factors, such as personal character and the actual remoteness of insiders from the appointment process, which are formidably difficult to measure.

3.3.2 The reward strategy: Executive compensation The 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.125 The theory is that optimally structured pay packages can align the interests of managers with those of shareholders as a class. The reality is that managerial rewards can—​depending on their terms—​be as much a strategy for controlling agency costs as a symptom of them. In addition, if alignment of managers’ and 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” value of their investment policies and business strategies, such as in sectors where innovation is more relevant and harder to understand.126 Corporate law generally does not stipulate rewards directly, but regulates how companies can compensate their managers in order to advance the interests of the firm. The most important reward for managers of publicly traded firms today is equity-​based compensation, which comes in many forms—​namely, stock options, restricted stock, and stock appreciation 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 has traditionally accorded shareholders the weakest decision rights amongst our core jurisdictions—​has embraced high-​powered equity incentives most comprehensively. Although Delaware courts initially regarded stock options with suspicion,127 they soon made their peace, aided by the wide discretion U.S. firms enjoy to issue rights and repurchase shares.128 Moreover, a 1994 change in U.S. tax law129 gave options an enormous (if unintentional) boost by barring corporations from expensing executive compensation in excess of $1 million per year that was not tied to firm performance.130 For the rewards strategy to operate effectively, compensation must be appropriately calibrated. The U.S. has long relied on disclosure to avoid excessive or incentive-​ distorting compensation. Nevertheless, objections of miscalibration have repeatedly been voiced, with some cause.131 As hinted in previous sections, the Dodd-​Frank Act 124 Bernard S. Black, Antonio Gledson de Carvalho, and Érica Gorga, What Matters and for Which Firms for Corporate Governance in Emerging Markets? Evidence from Brazil (and other BRIKC Countries), 18 Journal of Corporate Finance 934 (2012). 125  Marcel Kahan and Edward Rock, How I Learned to Stop Worrying and Love the Pill: Adaptive Responses to Takeover Law, 69 University of Chicago Law Review 871 (2002). 126  See text preceding note 21. 127  See e.g. Krebs v. California Eastern Airways, 90 Atlantic Reporter 2d 562 (Del. Ch. 1952). 128  E.g. § 157 Delaware General Corporation Law. 129  Internal Revenue Code § 162(m). 130  See John C. Coffee, A Theory of Corporate Scandals: Why the USA and Europe Differ, 21 Oxford Review of Economic Policy 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 same time, it mandated the introduction of shareholder decision rights in relation to executive compensation, by providing for an advisory “say on pay” vote.133 Our other core jurisdictions have relied less heavily on the rewards strategy. Thus, 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, meaning that there has been less need for the reward strategy.134 In Japan, while recent policy discussions suggest increased favor for the reward 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.135 And in other jurisdictions, the common presence of a controlling shareholder is associated with significantly lower CEO compensation,136 presumably because the controlling shareholder can rely on his own decision rights both to ensure good performance from managers and to curb excessive pay. These 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. This 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 President137 with the criminal prosecution of Josef Ackermann, at the time Deutsche Bank’s CEO and a Mannesmann AG 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 takeover battle.138 The 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. In Mannesmann, the payments at issue were gratuitous (ex post bonuses granted by Ackermann and one other member of the 132  Dodd-​Frank Act of 2010, § 952. The SOX had previously introduced modest controls on executive compensation: see §§ 304 (mandating disgorgement of CEO/​CFO incentive compensation received following a financial misstatement); 402 (banning corporate loans to senior executives to use for exercising options). 133  Dodd-​Frank Act of 2010, § 951. 134  See Martin J. Conyon and Kevin J. Murphy, The Prince and the Pauper? CEO Pay in the United States and United Kingdom, 110 Economic Journal 467 (2002). The greater performance-​sensitivity in the U.S. means executives there bear more firm-​specific risk, which pushes upward the size of overall awards: Martin J. Conyon, John E. Core, and Wayne R. Guay, Are U.S. CEOs Paid More than U.K. CEOs? Inferences from Risk-​Adjusted Pay, 24 Review of Financial Studies 402 (2011). 135 See Robert J. Jackson, Jr. and Curtis J. Milhaupt, Corporate Governance and Executive Compensation: Evidence from Japan, 2014 Columbia Business Law Journal 111. 136  See Martin J. Conyon et al., The Executive Compensation Controversy: A Transatlantic Analysis 55, Working Paper (2011); Marcos Barbosa Pinto and Ricardo Pereira Câmara Leal, Ownership Concentration, Top Management and Board Compensation, 17 Revista de Administração Contemporânea 304 (2013) (finding a negative correlation between the levels of ownership concentration and executive compensation in Brazil). 137  In re Walt Disney Co. Derivative Litigation, 906 Atlantic Reporter 2d 27 (Del. 2006). 138  See e.g. Curtis J. Milhaupt and Katharina Pistor, Law and Capitalism 69–​86 (2008).

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compensation committee), but made with the full approval of Vodafone—​which, by the time of the payout, held 98.66 percent of Mannesmann’s shares. Despite these factual differences, the differing outcomes of the two cases are revealing. The Delaware court deployed the business judgment rule to exonerate Eisner 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.139 From the perspective of Delaware 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.140 Delaware has long permitted disinterested boards to reward departing executives with compensation in excess of their contractual entitlements.141 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 golden parachute.142 While the U.S.  has traditionally constrained managerial pay less than elsewhere, signs of convergence are emerging. As we have noted, the U.S. has now introduced 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.143

3.4  Legal Constraints and 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 share prices.144 And, of course, 139  BGH, Decision of 21 December 2005, 3 StR 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. 140  See Franklin A. Gevurtz, Disney in a Comparative Light, 55 American Journal of Comparative Law 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 as a former Mannesmann officer. 141 See Zupnick v. Goizueta, 698 Atlantic Reporter 2d 384 (Del. Ch. 1997) (upholding options granted for past services at the end of tenure) and Blish v. Thompson Automatic Arms Corporation, Del. Supr., 64 Atlantic Reporter 2d 581 (1948) (retroactive compensation is not made without consideration where an implied contract is shown to exist or where the amount awarded is not unreasonable in view of the services rendered). 142  The Mannesmann decision is thought to be wrong by a clear majority of German commentators. The Mannesmann court remanded the case to the lower instance that was courageous enough to drop the criminal case. The 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. 143  Francesca 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, Germany Overtakes UK in Corporate Executive Pay Stakes, Financial Times, 5 January 2015. On the recent legal reform of managerial compensation in Germany see Chapter 6.2.2.1. 144  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 Chapter 8. By contrast, exit rights by means of withdrawal of one’s investment in the firm are made available 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 The constraints strategy Both hard-​edged rules and fiduciary standards would seem to be of little use, if not counterproductive, to protect the interests of shareholders. After all, shareholders who can appoint and remove managers should have no need to hobble managerial discretion with legal 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 duty on corporate directors and officers to take reasonable care in the exercise of their offices—​the duty of care. This duty is a non-​trivial component of the 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 requirements, will implicitly force directors to exercise due care in a number of situations, lest their disclosures prove wanting.145 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.146 This is why courts in all jurisdictions display at least some deference to corporate directors’ decision-​making. At the very least, most of them will refrain from second-​guessing business decisions on their merits.147 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. This is the case in continental Europe, where some jurisdictions explicitly articulate a duty to make well-​informed decisions.148 For example, under the German law on public corporations, management board 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 145  See Robert B. Thompson and Hillary A. Sale, Securities Fraud as Corporate Governance: Reflections upon Federalism, 56 Vanderbilt Law Review 859 (2003). 146  See e.g. Holger Spamann, Monetary Liability for Breach of the Duty of Care? 18–​19, Harvard Law School John M. Olin Center Discussion Paper No. 835 (2015) (available at ssrn.com); see also Re Barings plc (No 5) [2000]1 Butterworths Company Law Reports 523 at 536 (rejecting analogy with medical malpractice and declining admissibility of expert evidence). 147  Even in 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. Puchniak and Masafumi Nakahigashi, Comment, in Business Law in Japan—​Cases and Comments (Moritz Bälz et al. eds., 2012). 148  Art. 2381 Civil Code (Italy); § 93 AktG (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, 953 Revista dos Tribunais 51 (2015).

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judgment rule” in that jurisdiction but the exculpatory reach of which the case law has restricted.149 A post-​crisis surge in liability suits (and criminal prosecutions) against directors, especially at banks, is testing the wisdom of granting courts such wide-​ranging discretion in reviewing business decisions.150 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 the (ubiquitously exercised) power to introduce charter provisions waiving directors’ liability for good faith breaches of duty151 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.152 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 by amendment of the company’s articles of association.153 However, these have been combined with procedural obstacles to enforcement such that, outside bankruptcy, directors are rarely sued.154 The law’s deference to corporate decision-​making has two main justifications. The 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. The 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 with higher expected returns.155 Ultimately, shareholders may stand to lose more from such “defensive management” than they stand to gain from deterring occasional negligence.156

149  § 93 AktG (Germany). See Klaus J. Hopt and Markus Roth, Sorgfaltspflicht und Verantwortlichkeit der Vorstandsmitglieder, in Aktiengesetz, Grosskommentar (Heribert Hirte et  al. eds., 5th edn., 2015), § 93 comments 61–​131; Klaus J. Hopt, Die Verantwortlichkeit von Vorstand und Aufsichtsrat, Zeitschrift für Wirtschaftsrecht 2013, 1793. 150  Klaus J. Hopt, Responsibility of Banks and Their Directors, Including Liability and Enforcement, in Functional or Dysfunctional—​The Law as a Cure? 159 (Lars Gorton, Jan Kleineman, and Hans Wibom eds., 2014). 151  DGCL § 102(b)(7). 152 See Bernard Black, Brian Cheffins, and Michael Klausner, Outside Director Liability, 58 Stanford Law Review 1055 (2006). 153  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, Gazette du Palais, 12 May 2015, No. 132, 19. 154  Practically no shareholder lawsuits are launched 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 Journal of Empirical Legal Studies 687 (2009)). This 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). The 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. 155  See e.g. Gagliardi v. Trifoods International, Inc. 683 Atlantic Reporter 2d 1049 at 1052–​3 (Del. Ch. 1996). 156  In the U.S., the rare cases in which courts hold directors personally liable for gross negligence in decision-​making tend to involve unusual circumstances, such as a merger or sale of the entire company

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The general duty of care applies—​as far as it 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 plays into corporate governance and serves in part to protect shareholder interests. For example, case law in Delaware and the UK holds that the duty of care extends to creating “information and reporting systems” that can allow the board to assess corporate compliance with applicable laws.157 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.158 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’ internal financial control.159 Such provisions are mainly enforced by outside auditor attestation.160

3.4.2 Corporate governance-​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 least for publicly traded companies. The 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. That is the focus of Chapter 9. There is considerable convergence in disclosure obligations, including on aspects of continuing or the onset of insolvency. See Chapter 5.3.1.1. Moreover, even in these cases, the courts often hint at something more than negligence—​bad faith or a conflict of interest that is difficult to prove—​as the real basis for liability. The famous Delaware example is Smith v. Van Gorkom, 488 Atlantic Reporter 2d 858 (Del. 1985), in which the Delaware Supreme Court clearly believed 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. 157 See In re Caremark Int’l Inc. Derivative Litigation, 698 Atlantic Reporter 2d. 959 (Del. Ch. 1996), reaffirmed by the Del. Supreme Court in In re Citigroup Inc. S’holder Derivative Litig., 964 Atlantic Reporter 2d 106 (Del. Ch. 2009). Breach of this duty entails that the corporation had in place no information and reporting system whatsoever or that directors knew of its inadequacy. German law is less deferential. See LG München, decision of 10 December 2013 (5 HKO 1387/​10—​ Neubürger), ZIP 2014, 570 (management board member held liable for having failed to implement a comprehensive compliance system to detect unlawful activities). The UK adopts a straightforward negligence standard:  see Re Barings plc (No.5), note 146, especially at 486–​9, and Companies Act 2006 s 174. 158  See FSA Disclosure Rules and Transparency Rules DTR 7.1 (UK); § 91(2) AktG (Germany); Art. L. 225–​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-​13(1), 404(2), and 416(1) of the Companies Act, and Arts. 24-​4-​4(1) and 193-​2(2) of the Financial Instruments and Exchange Act. The EU directive on statutory audits (Directive 2006/​43/​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’s] internal quality control and risk management systems and, where applicable, its internal audit, regarding the financial reporting of the audited entity.” Art. 39(6)(c). 159  SOX § 404. See Art. 24-​4-​4 Financial Instruments and Exchange Act (Japan). In the EU, the directive on company reporting (Art. 20(1)(c) Directive 2013/​34/​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.” 160  SOX § 404(b). Art. 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 in the accounting system.” Art. 11(2)(j) Regulation (EU) 537/​2014, 2014 O.J. (L 158) 77.

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disclosure that are 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.161 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.162 In particular, by making stock prices more informative, mandatory disclosure makes hostile takeovers less risky. Arguably, the comprehensive nature of U.S. proxy statements, and the large potential liability that 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 is particularly common in Germany, where courts take such matters very seriously, both in publicly traded and privately held companies.163

3.5  Explaining Jurisdictional Variation A review of major jurisdictions 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 jurisdictions also rely on mandatory disclosure to enlist the market as a monitor of the performance of public companies and aid disaggregated shareholders in exercising their appointment, decision, and exit rights. Despite these global similarities, 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-​on-​the-​books, whether hard or soft, only imperfectly reflects each 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 the least empowering for shareholders vis-​à-​vis managers in publicly traded companies, we

161  For ownership and compensation disclosure requirements, see Chapter 6.2.1.1. U.S. Regulation S-​K, 17 C.F.R. Part 229 Item 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 Table. Disclosure of voting agreements is also required by the EC Takeover Bids Directive (Art. 10 Directive 2004/​25/​EC, 2004 O.J. (L 142) 12). For board structure, see European Commission, Recommendation 2014/​208/​EU on the Quality of Corporate Governance Reporting, 2014 O.J. (L 109) 43. 162  See generally John Armour, Enforcement Strategies in UK Corporate Governance:  A  Roadmap and Empirical Assessment, in Rationality in Company Law 71, at 102–​4 (John Armour and Jennifer Payne eds., 2009); Gordon, note 120. 163  See e.g. Ulrick Noack and Dirk Zetzsche, Corporate Governance Reform in Germany: The Second Decade, 15 European Business Law Review 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, the similarities end there. In the UK, the corporate governance environment fully accords with the shareholder-​ friendly 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.164 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.165 This ownership structure largely neutralizes the 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 shareholders should have company laws that empower shareholders as a class. This is exactly what the law does in France, Italy, and especially Brazil. Each accords shareholders significant rights, such as the non-​waivable minority rights to initiate a shareholders’ meeting, to initiate a resolution to amend 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. That, in turn, helps make such companies a rarity, because strong shareholder power makes dispersed ownership companies more prone to hostile takeovers. The 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 governance is a three-​party game that revolves around more than the interests of shareholders and managers. In Italy, France, and Brazil, the third party is the state, which is simultaneously an intrusive regulator, a major shareholder,166 and a defender of “national champions,” in which it may or may not hold an equity stake.167 In France there is a well-​travelled career track between elite state bureaucracies and the corporate

164  See text accompanying note 79. 165  See e.g. Julian Franks, Colin Mayer, Paolo Volpin, and Hannes F. Wagner, The Life Cycle of Family Ownership: International Evidence, 25 Review of Financial Studies 1675 (2012) (controlled ownership structures appear stable over time in our core jurisdictions). 166  See Mariana Pargendler, State Ownership and Corporate Governance, 80 Fordham Law Review 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). 167  A good example is the French state’s failed attempt to prevent General Electric from taking over 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, transport, telecommunications, and public health sectors (Decree No. 2014-​479 of 14 May 2014). The 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, New York Times, 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.168 In Brazil, not only is the state the controlling shareholder in numerous listed firms, but the main institutional investors in the country—​the pension funds of state-​owned enterprises and the development bank—​are themselves under government control.169 The role of the state in corporate governance reinforces both shareholder-​friendly governance law and concentrated ownership in these jurisdictions—​though strengthening the power of the state as a controlling shareholder does not necessarily serve the interests of minority shareholders.170 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, well-​ connected blockholders can be an economic asset for firms in a politicized environment, to the extent that these “owners” have more legitimacy and resources to protect their companies from political intervention than mere managers backed by dispersed shareholders could muster.171 Thus, an interventionist state, concentrated ownership, and shareholder-​friendly law may be mutually reinforcing, especially when the state holds large blocks of stock in its own right.172 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 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.173 In contrast to Italy, France, and Brazil, the third actor in German corporate governance is not the state but labor. As discussed further in Chapter 4, German law provides for quasi-​parity codetermination, in which employees and union representatives fill half of the seats on the supervisory boards of large firms.174 Of 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 German shareholders than the state’s interests might have with those of blockholders in France and Italy, especially at a time when their governments are experiencing public budgets constraints, which make

168  See e.g. William Lazonick, Corporate Governance, Innovative Enterprise and Economic Development, 49–​56 (2006) (describing the elite education and civil service experience of typical French CEOs). 169  See e.g. Mariana Pargendler, Governing State Capitalism:  The Case of Brazil, in Regulating the Visible Hand? The Institutional Implications of Chinese State Capitalism 377, 385–​8 (Benjamin Liebman and Curtis J. Milhaupt eds., 2015). 170  See Pargendler, note 166. 171  This observation tracks Mark 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 Harvard Law Review 460 (2006). 172  See generally, Pargendler, note 169; Ben Ross Schneider, Hierarchical Capitalism in Latin America (2013); Aldo Musacchio and Sergio G. Lazzarini, Leviathan in Business: Varieties of State Capitalism and Their Implications for Economic Performance (2014). 173  Perhaps 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. 174  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 suspect (and we are not the first to do so175) that the net effect of Germany’s closely divided supervisory board is to enhance the power of top managers—​ that is, of the management 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.176 U.S. corporate law is harder to encapsulate. While Delaware law has traditionally been viewed as board-​centric, the shift toward shareholder empowerment that has taken place in the last couple of decades177 has occurred with very little change in state law and only in part due to federal law reforms. In other words, 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 corpor­ ate law than in the past. Finally, Japanese corporate law also has a plausible claim to 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 corporate law and the reality of Japanese corporate governance appears to be larger than in any other core jurisdiction. Japan is a dispersed-​shareholder jurisdiction, like the U.S. and UK,178 but its shareholders are weak, and its managers are strong, even compared to the U.S. 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 War II, a statutory law derived from early—​and shareholder-​friendly—​German law, the role of the state in mobilizing Japanese recovery after the war, a strong reliance on debt rather than equity financing, and the continuous increase in Japanese share prices for four decades after the war.179 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) that cement business relationships and insulate top managers from challenge. These business-​to-​business holdings are numerous but generally not

175  See Katharina Pistor, Codetermination: A Sociopolitical Model with Governance Externalities in Employees and Corporate Governance 171 (Margaret M. Blair and Mark J. Roe eds., 1999). 176  It can hardly be otherwise if Germany’s 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 the company’s shareholder nominees to the supervisory board. See note 11. 177  See e.g. Edward B. Rock, Adapting to the New Shareholder-​Centric Reality, 161 University of Pennsylvania Law Review 1907, 1917–​26 (2013). 178  One recent study finds that listed companies in the UK and Japan have the most dispersed ownership structures in the world, while the U.S. trails some distance behind. See Clifford G. Holderness, The Myth of Diffuse Ownership in the United States, 22 Review of Financial Studies 1377 (2009). 179  See Masahiko Aoki, Toward an Economic Model of the Japanese Firm, 28 Journal of Economic Literature 1 (1990); Ronald J. Gilson and Mark J. Roe, Understanding the Japanese Keiretsu: Overlaps Between Corporate Governance and Industrial Organization, 102 Yale Law Journal 871 (1993); Steven Kaplan, Top Executive Rewards and Firm Performance: A Comparison of Japan and the U.S., 102 Journal of Political Economy 510 (1994).

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large, and they are frequently not even reciprocal. But the important point is that they are stable and management-​friendly.180 In prior decades these “captive” shareholders accounted for a much higher percentage of the outstanding shares of Japanese listed companies than they do today, when they represent around one-​third of outstanding shares—​only slightly more than the share percentage held by foreign investors in Japanese firms.181 While U.S.-​style hedge fund activism against Japanese companies in the 2000s has been largely unsuccessful, mostly because of cross-​shareholdings,182 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.183 At the same time, once cross-​shareholdings are unwound, the legislator may deem existing Japanese corporate law too 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 opportunism vis-​à-​vis the shareholder class—​is paramount only in diffuse shareholding jurisdictions such as the U.S. and UK. The 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:184 the same global good governance recipe of independent directors and independent committees somehow responds effectively to the various agency problems: not only the problem of managerial opportunism, but also the conflict between majority shareholders on one hand, and minority shareholders or 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 empower Japanese shareholders and reinforce shareholder dominance in the UK, while it traditionally served to justify allocating power to the board rather than shareholders in the U.S. The 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.185

180  See Julian Franks, Colin Mayer, and Hideaki Miyajima, The Ownership of Japanese Corporations in the 20th Century, 27 Review of Financial Studies 2580 (2014). We take no position on the continuing debate about the importance of the Keiretsu, or networks of companies bound by cross shareholding and relations with a “main bank.” Compare Curtis Milhaupt and Mark D. West, Economic Organizations and Corporate Governance in Japan: The Impact of Formal and Informal Rules (2004) with J. Mark Ramseyer and Yoshiro Miwa, The Fable of the Keiretsu, Urban Legends of the Japanese Economy, ch. 2 (2006). 181  As of 1986, manager-​friendly business companies, banks, and insurance companies together held more than 60 percent of market capitalization. This ratio fell to slightly 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, however, that this unwinding of cross-​shareholding relationships is taking place mostly in large public companies and less in small and medium-​sized listed ones. See Goto, note 23, at 144–​6. 182  See Goto, note 23, at 140–​4. Whether U.S.-​style hedge fund activists will come back to Japan making the most of its shareholder-​friendly law remains to be seen. 183  An example of such attitude by the government is the adoption of the Stewardship Code and the Corporate Governance Code. See notes 89 and 114. 184  See Section 3.3.1. 185  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: Convergence of Form or Function, 49 American Journal of Comparative Law 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, 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 governance information, do significantly worse in their cross-​border interventions than in their domestic engagements.186

186  Becht et al., note 18.

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4 The Basic Governance Structure: Minority Shareholders and Non-​Shareholder Constituencies Luca Enriques, Henry Hansmann, Reinier Kraakman, and Mariana Pargendler

The corporate governance system principally supports the interests of shareholders as a class. Nevertheless, corporate law can—​and to some degree must—​also address the agency conflicts jeopardizing the interests of minority shareholder and non-​ shareholder contractual constituencies. And herein lies the rub. To mitigate either the minority shareholder or the 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 at the hands of controlling shareholders. In this chapter, we first address the protection of minority shareholders, and then turn to governance arrangements that protect the firm’s employees—​the principal non-​ shareholder constituency to enjoy such protections as a matter of right in some jurisdictions. 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 The final part of this chapter explores how the legal strategies of corporate law can also be directed to serve the interests of non-​contractual stakeholders.

4.1  Protecting Minority Shareholders It is well-​documented by empirical research that dominant shareholders enjoy “private benefits of control”—​that is, disproportionate returns—​often at the expense of minority shareholders.2 These 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 Tatiana Nenova, The Value of Corporate Voting Rights and Control: A Cross-​Country Analysis, 68 Journal of Financial Economics 325, 336 (2003) (employing share price differentials for dual class firms to calculate private benefits); Alexander Dyck and Luigi Zingales, Private Benefits of Control: An International Comparison, 59 Journal of Finance 537, 551 (2004) (employing control premia in sales of control blocks to calculate private benefits). The Anatomy of Corporate Law. Third 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 shares in the same companies. Both measures are often assumed to be rough indicators of the extent of minority shareholder expropriation.3 The 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-​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 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 sometimes do—​require the appointment of minority directors for individual firms. The 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.4 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.5 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, as well as cumulative voting at the request of shareholders representing at least 10 percent of voting capital.6 However, 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,7 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;8 and in Germany, commentators dispute whether cumulative voting is permissible at all in public corporations.9 In the 3  See note 136 and accompanying text. 4 For example, Art. 78 Russian 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. 5  Art. 147-​3 Consolidated Act on Financial Intermediation (requiring that at least one director be elected by minority shareholders). 6  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 firms). 7  Art. 342 Companies Act. 8  At the turn of the twentieth century, cumulative voting was common in the U.S. See e.g. Jeffrey N. Gordon, Institutions as Relational Investors: A New Look at Cumulative Voting, 94 Columbia Law Review 124 (1994); cf. §§ 708(a) and 301.5(a) California Corporation Code (respectively mandating cumulative voting and authorizing opt-​out from cumulative voting for listed companies). 9  See Mathias Siems, Convergence in Shareholder Law 172 (2008). Even though 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. Their appointment is initially subject to separate approval by all shareholders and minority shareholders. If such approval is not obtained, then the shareholder majority can determine the election after a “cooling-​off” period, between 90 and 120 days later.10 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 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 between cash-​flow and voting rights may impair a company’s ability to raise further equity finance and secure profitable investment opportunities.11 Consequently, our jurisdictions often contemplate adjustments to shareholder appointment and 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 deviations from the one-​share–​one-​vote norm to let dominant shareholders enhance their control over the corporation. These mechanisms include 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 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-​vote that increase the power of controlling shareholders: both countries ban shares with multiple Convergence, 61 American Journal of Comparative Law 301 (2013) (noting that cumulative voting has failed to gain much traction in Europe). 10  UK Listing Rules, 9.2.2E and 9.2.2F. 11  See e.g. Kristian Rydkvist, Dual-​class Shares: A Review, 8 Oxford Review of Economic Policy 45 (1992). 12  Most jurisdictions forbid subsidiaries from voting the shares of their parent companies:  Art. L. 233–​31 Code de commerce (France); Art. 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 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 relationship. See Shearman & Sterling, LLP, Proportionality Between Ownership and Control in EU Listed Companies: Comparative Legal Study 17 (2007) at http://​www.ecgi.de/​osov/​final_​report.php. 13  A less traditional example of separating control rights from cash-​flow rights is 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 T.C. Hu and Bernard Black, The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership, 79 Southern California Law Review 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 Ringe, The Deconstruction of Equity 162–​99 (2016).

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votes and cap the issuance of non-​voting or limited-​voting preference shares to 50 percent of outstanding shares.14 In Brazil, where dual-​class firms were historically common, non-​voting shares are prohibited outright in the Novo Mercado, the premium corporate governance segment of the São Paulo Stock Exchange.15 Even these jurisdictions, however, do not regulate pyramidal ownership structures (where company A owns a majority of the voting shares of company B, which in turn owns a majority of the voting shares of company C, and so on),16 which have identical effects to dual-​class shares in separating cash flow and voting rights.17 The U.S., by contrast, goes furthest in banning or discouraging the use of pyramidal structures through holding company regulations and the taxation of inter-​corporate distributions.18 Similarly, some European jurisdictions permit the issuance of 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.19 This mechanism had long been available in France on an opt-​in basis, but in 2014, as part of an openly protectionist law on takeovers, it became the default rule for listed companies. Unless such companies opt out, their shares spawn double voting rights after two years in the same hands.20 Although such “tenure voting” systems are usually justified as protecting the interests of long-​term over short-​term shareholders,21 they tend also to embed the power of controlling shareholders relative to outside investors. The 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 Stock

14  See §§ 12 II and 139 II Aktiengesetz AktG (Germany); and Arts. 15, § 2o, and 110, § 2o, Lei das Sociedades por Ações (Brazil). In Brazil, however, companies have recently circumvented the ban on multi-​voting stock by adopting a functionally equivalent dual-​class structure where the public float carries economic rights that are a multiple of those granted to insiders. Brazil’s Securities Commission (CVM) blessed this structure in the Azul case in 2013. France caps the issue of non-​voting shares by listed companies at 25 percent of all outstanding shares. Arts. L. 228–​11 to L. 228–​20 Code de commerce. In 2014, Italy partially repealed the ban on multiple voting shares: it now allows 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. The 50 percent cap on 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 and limited voting shares: Arts. 108(1)(iii) and 115 Companies Act. 15  For a discussion, see 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, 63 Stanford Law Review 475, 489–​90 (2011). 16  As a result, pyramidal firms have emerged in Brazil’s Novo Mercado, as elsewhere. 17  See e.g. Lucian A. Bebchuk, Reinier Kraakman, and George Triantis, Pyramids, Cross-​Ownership, and Dual Class Equity: The Mechanisms and Agency Costs of Separating Control from Cash-​Flow Rights, in Concentrated Corporate Ownership 445 (Randall K. Morck ed., 2000). 18  See Steven A. Bank and Brian R. Cheffins, The Corporate Pyramid Fable, 84 Business History Review 435 (2010); Eugene Kandel, Konstantin Kosenko, Randall Morck, and Yishay Yafeh, The Great Pyramids of America:  A  Revised History of US Business Groups, Corporate Ownership and Regulation, 1930–​1950, NBER Working Paper No w19691 (2015). 19  Art. 129-​V Consolidated Act on Financial Intermediation, as amended in 2014. This mechanism may actually serve to enhance the power of the state as shareholder. 20  Art. L.  225-​123 Code de commerce, as amended by Loi. No. 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 Tokyo Stock Exchange, Securities

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Exchange (NYSE) listing rules banned deviations from proportional voting for most of the twentieth century, dual-​class shares have recently enjoyed something of a renaissance in media and hi-​tech corporations.23 The U.S. has even attracted high profile dual-​class companies from abroad: for instance, Chinese e-​commerce giant Alibaba opted to go public on the NYSE after being unable to list on the Hong Kong Stock Exchange, which still adheres to a strict one-​share–​one-​vote rule. In the UK, where institutional investors had successfully discouraged dual-class shares altogether,24 the Premium market segment is now exclusively for companies listing classes of shares with proportionate voting rights.25 Thus, although legal support for a one-​share–​one-​vote norm is limited, all our core jurisdictions restrict some ways of leveraging 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 the best known technique of this sort is “vote capping,” that is, imposing a ceiling on the control rights of large shareholders and correlatively inflating the voting power of small shareholders. For example, a stipulation that no shareholder may cast more than 5 percent of the votes reallocates 75 percent of the control rights that a 20 percent shareholder would otherwise exercise to shareholders with stakes of less than 5 percent. Except for Germany and Japan,26 all our core jurisdictions permit publicly traded corporations to opt into voting caps by charter provision. Today, however, the real motivation for voting caps is more likely to be the deterrence of takeovers than the protection of minority investors. They are more commonly adopted where no controlling block exists, to dissuade the building of one, rather than to constrain the voting power of an existing block-​holder. Voting caps survive today chiefly in France and, to a lesser extent, in Italy and Brazil.27

Listing Regulations, Rule 601(1)(xvii) and Enforcement Rules for Securities Listing Regulations, Rule 601(4)(xiv) (prohibiting unreasonable ex post restrictions on shareholder voting rights). 23 Prominent examples include News Corporation, Google (now Alphabet), Facebook, and LinkedIn, where the use of “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. 24  See Julian Franks, Colin Mayer, and Stefano Rossi, Spending Less Time with the Family:  The Decline of Family Ownership in the United Kingdom, in A History of Corporate Governance Around the World 581, 604 (Randall K. Morck ed., 2005). 25  UK Listing Rule 7.2.1A, Premium Listing Principle 4. 26  Voting caps were banned for German publicly traded (listed) companies in 1998. See § 134 I Aktiengesetz (AktG) (as amended by KonTraG). Still, there was one important exception: Volkswagen AG, which is regulated by a special law, was subject to a 20 percent voting cap. The 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 Treaty (now Art. 63 TFEU); see Case C-​112/​05, Commission v. Germany, Judgment of 23 October 2007, European Court Reports [2007] I‐8995. Japan adopts the rule of 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). 27  For France see Art. L. 225-​125 Code de commerce; Art. 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, voting caps were common in the nineteenth century in the U.S., Europe, and Brazil. See Mariana Pargendler and Henry Hansmann, A New View of Shareholder Voting in the Nineteenth Century, 55 Business History 585 (2013).

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4.1.2 Minority shareholder decision rights As in the case of appointment rights, the law 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 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 against whom the corporation may have a cause of action.28 Granting decision rights to a majority of minority shareholders is also an effective governance strategy. For this reason, corporate laws sometimes impose a majority-​of-​the-​minority approval requirement on transactions between controlling shareholders and their corporations.29 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.30 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 jurisdictions use decision rights to protect large blocks of minority shares against expropriation effected via major transactions such as mergers. Several 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 prevent a “bare” majority from trumping the will of a “near” 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 The 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 The incentive strategy: Trusteeship and equal treatment The 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 prophylactic, suitable for treating both the agency problems of minority shareholders and those of shareholders as a class. The second mode of protecting minority shareholders is strong enforcement of the equal treatment norm, particularly with respect to distribution and voting rights. This norm applies to both closely held and publicly traded firms, and blurs into an aspect of the constraints strategy: a fiduciary duty of loyalty to the corporation that implicitly extends towards minority shareholders and perhaps other corporate constituencies as well.

28  See Chapter 3.2.3 and Chapter 6.2.5.4. 29  See Chapter 6.2.3 and Chapter 7.4.2.3. 30  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 are common in Brazil, for example.

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4.1.3.1 The trusteeship strategy and independent directors The addition of independent directors to the board is a popular device, not only as a solution to shareholder–​manager agency problems,34 but also for protecting minority shareholders and non-​shareholder constituencies. Lawmakers implicitly assume that independent directors—​motivated by “low-​powered incentives”—​namely, morality, professionalism, and personal reputation—​will stand up to controlling shareholders in the interest of the enterprise as a whole,35 including its minority shareholders and, to varying degrees, its 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. This was the core principle of the Netherlands’ old “structure regime,”36 under which the boards of some large companies became self-​ appointing 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 opportunism. This pattern is common in venture capital-​backed firms.37 In our core jurisdictions, however, most “independent” directors are neither self-​ appointing nor rigorously screened for independence by savvy investors. Instead, director “independence” typically means at most financial and familial independence from controlling shareholders (as well as from the company and its top corporate officers).38 A director qualifies as independent under such a definition even if she is vetted and approved by the company’s controlling shareholder—​and even if she has social ties to the controller—​as long as she has no close family or financial ties, such as an employment position or a consulting relationship, with the controller. A conventional example is that an officer of an unrelated, 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 (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 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.39 Alternatively, shareholders may be barred from directly making any decisions

34  See Chapter 3.3.1. 35 For a critical assessment, see Wolf-​Georg Ringe, Independent Directors:  After the Crisis, 14 European Business Organization Law Review 401 (2013). 36  See e.g. Edo Groenewald, Corporate Governance in the Netherlands: From the Verdam Report of 1964 to the Tabaksblat Code of 2003, 6 European Business Organization Law Review 291 (2005). 37  See Jesse M. Fried and Mira Ganor, Agency Costs of Venture Capitalist Control in Startups, 81 New York University Law Review 967, 988 (2006). 38  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, American Journal of Comparative Law (forthcoming). 39  See § 251 (b) Delaware General Corporation Law; Chapter 3.4; Art. 2367 Civil Code (Italy).

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about the company’s business without the board’s invitation, as under German law.40 These 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 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.41 Nevertheless, U.S. case law provides anecdotal evidence that independent boards or committees can make a difference in cash-​out mergers,42 or when controlling shareholders egregiously overreach.43

4.1.3.2 The equal treatment norm The equal treatment of shares (and shareholders) of the same class is a fundamental norm of corporate 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. To the extent that it effectively binds the controlling shareholder, it motivates her to act in the interests of shareholders as a class, which includes the interests of minority shareholders. As with all abstract norms, however, its functioning is subject to at least two important qualifications. The first concerns the range of corporate decisions or shareholder actions that trigger this norm. The 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.44 Our core jurisdictions differ with respect to these qualifications of the equal treatment norm. In general, civil law jurisdictions—​and particularly those that have been 40  § 119 II AktG (shareholders may 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 so-​ called Holzmüller doctrine). 41  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 Table:  Independent Directors in Family-​Influenced Public Companies, 33 Journal of Corporation Law 819 (2008). 42  See Chapter 7.4.2. 43  An example is the Hollinger case, in which 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 Atlantic Reporter 2d 1022 (Del. Ch. 2004). The 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. 44  For an instructive U.S. example on the point, compare Donahue v. Rodd Electrotype Co., 328 North Eastern Reporter 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 North Eastern Reporter 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 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.45 By contrast, the common law jurisdictions—​the U.S.  and 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 standards such as the controlling shareholder’s duty to act fairly vis-​à-​vis minority shareholders.46 These 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 makes American-​style poison pills more difficult to implement in jurisdictions that discourage companies from distinguishing among shareholders in awarding benefits, including stock purchase rights.47 Indeed, it is arguable that the law in the U.S.—​or at least Delaware—​accords the widest latitude for unequal treatment of identical shares among 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 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 shareholders. Another area in 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 as Germany, France, Italy, and Brazil—​provide for special regulation in this area, permitting judicial evaluation of intra-​group transactions in aggregate.48 Equal treatment is thus interpreted as applying not to individual transactions, but to aggregates of transactions. To conclude, the reach of the equality norm varies greatly, both within and between jurisdictions. However, all our jurisdictions rely on this device, in at least some circumstances, to align the incentives of controlling and minority shareholders.

45  § 53a Aktiengesetz (Germany) and Art. 109(1) Companies Act (Japan). There is also a gray area in German law when it comes to the preferential provision of information to blockholders vis-​à-​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/​EU, 2012 O.J. (L 315) 74; Art. 3(1)(a) Directive 2004/​25/​EC, 2004 O.J. (L 345) 64; Art. 17(1) Directive 2004/​ 109/​EC, 2004 O.J. (L 390) 38; Art. 4 Directive 2007/​36/​EC, 2007 O.J. (L 184) 17. 46 Under Delaware law, equal treatment of minority shareholders determines whether a given transaction is conceived as 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, 280 Atlantic Reporter 2d 717 (Del 1971). On the treatment of related-​party transactions by controlling shareholders, see Chapter 6.2.2 and 6.2.5. 47  Given Japan’s strong statutory provision enshrining the equal treatment norm, the evolving Japanese case law on warrant-​based takeover defenses is particularly interesting in this regard. See Bull-​dog Sauce v. Steel Partners, Minshu 61–​5-​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. 48  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 rights We group together the remaining strategies for protecting minority shareholders because there is less to say about them in a chapter devoted to the governance system. Legal constraints—​principally in the form of standards such as the duty of loyalty, the oppression standard, and abuse of majority voting—​are widely used to 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, in effect, that controlling shareholders cannot accept unauthorized distributions from the corporate treasury at the expense of the firm’s minority shareholders. We examine these 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 transaction nor a fundamental change.49 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. To the extent that disclosure, as a condition for entering and trading in the public markets, reveals controlling shareholder structures and conflicted transactions, market prices may bring home to controllers the costs of their opportunism.50 Moreover, mandatory disclosure provides the information necessary to protect minority shareholders through other mechanisms, such as voting or litigation.51 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 shares, and even then, usually at a price that already reflects the controlling shareholder’s abuses.52 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 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;53 or the mandatory bid rule triggered by a sale of control and sell-​out rights in Europe and Brazil.54

49  For instance, in some jurisdictions a minority 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’s distributions to shareholders take the form of employee or director compensation. 50  See Chapter 6.2.1.1. 51  See Chapter 9.1.2.3. 52  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 a controlling shareholder. See Alex Edmans, Blockholders and Corporate Governance, 6 Annual Review of Financial Economics 23 (2014) (reviewing the use of exit by blockholders as a governance device). 53  See Chapter 7.2.2 and 7.4.1.2. 54  See Chapter 8.3.4.

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4.2  Protecting Employees In addition to protecting minority shareholders, the corporate governance system extends important protections to non-​shareholder constituencies in a contractual relationship with the corporation. Corporate law in all jurisdictions provides specialized protections to corporate creditors, which we consider separately in Chapter 5. Here we focus principally on the governance protections accorded to employees. As contractual counterparties to the corporation, employees may deserve the protection of corporate law insofar as they are particularly susceptible to exploitation by the 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 investments that workers may make in their employer’s business, such as by learning to use the firm’s technology or relocating to a remote region where a particular facility is located.55 When these investments are firm-​specific (in the sense that they are useful only in the context of this employment), a profit-​seeking corporation may subsequently exploit an employee’s lack of outside options to “hold up” the employee.56 This could be done by renegotiating the employment contract to transfer surplus from the worker to the firm, for example by decreasing wages and benefits, or worsening working conditions. To 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 investments to begin with, thus ultimately harming profits.57 Our core jurisdictions differ profoundly in the extent to which they rely on corpor­ ate law for the protection of employees. 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 employees in a different way: labor unions in the U.S. have pushed for a rule requiring companies to disclose the “pay ratio” between the CEO and the median worker, a figure that might arguably help their bargaining position in wage negotiations.58 Finally, a recent legal change in the UK also purports to rely on corporate law as a substitute for the labor law protections by permitting the elimination of various labor rights for “employee shareholders” having received a grant of at least £2,000 in company stock.59 55  Moreover, employees may also have firm-​specific financial investments in the form of unfunded defined-​benefit pension obligations, which are more common in Germany and Japan. See Martin Gelter, The Pension System and the Rise of Shareholder Primacy, 43 Seton Hall Law Review 909, 966 (2013). 56 See generally Margaret M. Blair, Ownership and Control:  Rethinking Corporate Governance for the Twenty-​first Century (1995); Paul L. Davies, Efficiency Arguments for the Collective Representation of Workers: A Sketch, in The Autonomy of Labour Law 367 (Alan Bogg et al. eds., 2015). 57 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 Team Production Theory of Corporate Law, 85 Virginia Law Review 247 (1999); Martin Gelter, The Dark Side of Shareholder Influence: Managerial Autonomy and Stakeholder Orientation in Comparative Corporate Governance, 50 Harvard International Law Journal 129 (2009). 58  On the “pay ratio” rule, see Section 4.3.1. 59  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, however, an implausible substitute:  an undiversified position only compounds workers’ vulnerability to firm-​specific risks and opportunism.

4.2.1 Appointment and decision rights strategies The widespread introduction of 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 employee-​ appointed directors in at least some large companies,60 although our core jurisdictions are not fully representative in this respect. The U.S., UK, 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 of the board.61 France requires some employee board representation for listed companies in which employees own more than 3 percent of the shares.62 Since 2013, large companies must also stipulate in their articles of association that one or two directors will be appointed as employee representatives.63 However, in the majority of French companies (with over 50 employees) employees may only select two (sometimes four) non-​voting representatives to attend board meetings.64 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 labor-​ related matters.65 By contrast, German law establishes “quasi-​ parity codetermination,” in which employee directors comprise half the members of supervisory boards in German companies with over 2,000 (German-​based) employees.66 Just as importantly, some of these labor directors must be union nominees, who generally come from outside the enterprise.67 Moreover, only German-​based employees and German trade unions have a right to appoint labor directors—​though such differential treatment of foreign employees has recently become questionable under EU law.68 Although shareholders and workers appoint equal numbers of directors to the supervisory boards of large German companies (as the term “quasi-​parity” denotes), this does not mean that they share power equally as a formal legal matter, since the supervisory board’s

60  The only EU countries that have not 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.worker-​participation.eu/​. 61 This is the case for instance in Austria, Denmark, Luxembourg, and Hungary. See Aline Conchon, Board-​level Employee Representation Rights in Europe:  Facts and Trends, European Trade Union Institute Report No. 121 (2011), www.etui.org. 62  Arts. L. 225-​23 and L. 225-​71 Code de commerce (for a one-​tier board and a supervisory board respectively). 63  Arts. L.  225-​27-​1 and L.  225-​79-​2 Code de commerce (for one-​tier boards and supervisory boards respectively), introduced by Loi No. 2013-​504 of 14 June 2013. 64  Art. L. 432-​6 Code du travail. 65  Lei 12.353, de 28 de dezembro de 2010 (Braz.). 66  §§ 1 and 7 Mitbestimmungsgesetz. German companies with between 500 and 2,000 employees must grant one-​third of their board seats to employees. §§ 1 and 4 Drittelbeteiligungsgesetz. 67  In the largest companies seven members are elected by employees and three are appointed by trade unions. § 7 II Mitbestimmungsgesetz. 68 See Kammergericht, decision of 16 October 2015, 14 W 89/​ 15, Zeitschrift für Wirtschaftsrecht 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 vote in a second round of balloting in case of deadlock.69 Nevertheless, employee representatives retain considerable power, formally through a statutory right to veto nominees to the management board,70 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,” who often has close ties with unions and employees.71 Thus, 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. This 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, owing to the presence of independent board members.72 With the exception of Germany, whose laws permit works councils to co-​decide (with management) on a number of employee-​sensitive matters,73 corporate laws never confer direct 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.74 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.75

4.2.2 The 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 do not

69  § 29 II Mitbestimmungsgesetz. 70  Election to the management board is by a two-​thirds majority vote of the supervisory board (§ 31 II Mitbestimmungsgesetz). If there is no two-​thirds majority for a candidate, lengthy proceedings are instituted which finally award the tie-​breaking vote in a simple majority vote to the chairman of the supervisory board. 71  § 33 Mitbestimmungsgesetz. (Germany). 72  See Chapter 3.3.1. 73  §§ 87 et seq. Betriebsverfassungsgesetz (Germany). 74  See European Works Council Directive (Recast Directive 2009/​38/​EC, 2009 O.J. (L 122) 28); Art. 4 General Framework Directive (Directive 2002/​14/​EC, 2002 O.J. (L 80) 29); Art. 2 Collective Redundancies Directive (Council Directive 98/​59/​ EC, 1998 O.J. (L 224)  16); Art. 7 Sale of Undertakings Directive (Council Directive 2001/​23/​EC, 2001 O.J. (L 82) 16). 75  Works councils can provide a better framework for 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, The Contribution of Work Representation to Solving the Governance Structure Problem, 8 Journal of Management and Governance 129 (2004). See also Davies, note 56.

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require—​directors to consider the interests of employees and other non-​shareholder constituencies in making important decisions, especially in the context of a hostile takeover.76 Unlike minority shareholders, non-​shareholder contractual constituencies do not—​ and usually cannot—​enjoy the protection of the equal sharing norm. Employees, lenders, and suppliers generally receive the bulk of their compensation as fixed payments rather than volatile claims on the net income of the firm as a whole. Where employees invest in developing firm-​specific human capital, such fixed payments may be the firm’s dominant 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.77 Yet share ownership entails different, and less satisfactory, consequences for employees than for outside investors with diversified portfolios. For employees, ownership of their firm’s shares increases the already large—​and largely undiversified—​firm-​ specific 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 generally remain a minority, without significant governance rights. Nevertheless, the grant of stock options to lower-​level employees is surprisingly frequent in practice, especially in high-​tech industries: stock options can help alleviate financing and capital constraints facing the firm, as well as promote retention and the sorting of optimistic employees.78 Finally, the constraints strategy for protecting employees is largely embodied in dedicated 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.79 Otherwise, the laws that permit or mandate corporate directors to have regard to non-​shareholder constituencies typically encompass the interests of employees as well.80 Nevertheless, these other corporate law constraints for protecting non-​shareholder constituencies are usually toothless or narrowly targeted, as discussed further below.

4.3  Protecting External Constituencies Corporate laws everywhere focus primarily on the relationships between the corpor­ ation and its contractual 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. 76  See Chapter 8.1.2.3. For a trustee-​like analysis of the U.S. board, see Blair and Stout, note 57. 77  There 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, The Ownership of Enterprise 87 (1996). France mandates both extensive information and limited employee profit-​sharing rights in all firms with more than 50 workers. See Arts. L. 2322-​1, 2323-​6 to 2323-​23-​60, 3322-​2, 3324-​1 and 3324-​10 Code du travail. 78  See e.g. John E. Core and Wayne R. Guay, Stock Option Plans for Non-​executive Employees, 61 Journal of Financial Economics 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 Theories, 76 Journal of Financial Economics 99 (2005) (attributing the widespread use of stock options to sorting and retention goals, rather than incentives). 79  See Chapter 7.4.3.2. 80  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. The recent scandal involving German car manufacturer Volkswagen—​which designed its cars’ software to cheat emissions tests—​illustrates this concern. The company’s relentless pursuit of growth, which initially benefited both shareholders and workers, encouraged managerial choices that clearly conflicted with the wider interests of 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 enterprise, the social harms it engenders are correspondingly large-​scale. Moreover, limited liability—​an essential feature of the corporate form—​serves to compound the problem, by permitting shareholders to bear only a fraction of the costs their companies’ activities cause for third parties.81 And precisely because they cannot protect themselves through contract, the corporation’s non-​contractual stakeholders have a greater need for legal protection than do its contractual constituencies. The crucial question is not whether the corporation’s non-​contractual stakeholders deserve legal protection of some sort—​they clearly 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 constraints strategy—​to promote interests extraneous to the corporate form is, almost by definition, not corporate law, but the application to corporations—​as legal persons—​of norms from other fields of law. On occasion, 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 to regulators’ information gaps or to successful industry lobbying—​more direct regulatory responses to externalities and other social problems are not feasible.82 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. The 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.83 In fact, the historical and contemporary uses of corporate law to protect non-​contractual stakeholders are too numerous to describe in full.84 It is worth noting, however, that in recent years—​and in particular, in the wake of the recent financial 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.

81  See Chapter 1.2.2 and Chapter 5.1.2.3. 82  See Mariana Pargendler, The Corporate Governance Obsession, 42 Journal of Corporation Law 101 (2016). 83  Henry Hansmann and Mariana Pargendler, The Evolution of Shareholder Voting Rights: Separation of Ownership and Consumption, 123 Yale Law Journal 948 (2014). 84  This is particularly conspicuous with respect to takeover regulation, which is often shaped by the interests of labor, local communities, and the national economy. For examples, see Chapter 8.

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Before proceeding, one caveat is necessary. Most attempts to protect external interests—​from gender equality in the boardroom to the reduction of systemic risk and the protection of human rights—​can be, and have been, rationalized in terms of promoting long-​term shareholder value. Nevertheless, while the long-​term interests of shareholders may at times coincide with those of society at large, perfect alignment in all circumstances is implausible. In 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 The 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.85 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 (and, to a lesser extent, voting) decisions by shareholders as a class. In recent years, however, there has been a rise in the use of “non-​financial” or “social” disclosure requirements.86 These 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 Act of 2010 requires publicly traded companies to disclose their use of conflict minerals from the Democratic Republic of the Congo—​a rule intended ultimately to discourage the use of such minerals and thereby alleviate the humanitarian crisis in the region.87 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. The Dodd-​Frank Act also includes a provision mandating disclosure of the ratio of CEO compensation to that of their company’s median employee. This 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.88 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 high threshold that is not met in most Japanese companies.89 85  See Chapter 3.4.2 and Chapter 9. 86  See e.g. Donald C. Langevoort and Robert B. Thompson, “Publicness” in Contemporary Securities Regulation after the JOBS Act, 101 Georgetown Law Journal 337 (2013). 87  The D.C. Circuit has found that the portion of such a rule requiring a company to report that its products have not been found to be “DRC conflict free” violates freedom of speech under the U.S. Constitution: Nat’l Ass’n of Mfrs. v. SEC, 2014 Westlaw 1408274 (D.C. Cir., Apr. 14, 2014). 88 See Robert J. Jackson, Jr. and Curtis J. Milhaupt, Corporate Governance and Executive Compensation: Evidence from Japan, 2014 Columbia Business Law Review 111, 129. 89 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. The 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.90 Moreover, a 2014 directive mandates disclosure of non-​financial information in management reports, including the company’s policy and performance with respect to “environmental, social and employee matters, respect for human rights, anti-​ corruption and bribery matters.”91 These 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. The goal is 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 Tokyo Stock Exchange requires companies to describe how they respect the interests of various stakeholders in their governance reports. Whether disclosure is an appropriate means to accomplish these ambitious goals remains an open question, which we consider further below.

4.3.2 Appointment and decision rights strategies The 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),92 none of our core jurisdictions confers general appointment rights on non-​shareholder constituencies other than employees. The only exception is the appointment rights conferred by certain “golden shares”—​such as France’s action spécifique—​which permit governments to appoint board representatives in privatized firms.93 Yet most jurisdictions have director qualification requirements that constrain shareholders’ 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.94 More recently, Germany, Italy, and France and other countries have instituted mandatory minimum quotas on corporate boards,95 and Japan has concurrently introduced voluntary targets. Gender quotas are best viewed as a constraint on the exercise of

90  See Arts. 41–​8 Directive 2013/​34/​EU, 2013 O.J. (L 182) 19. “Extractive industries” encompass the exploration and extraction of minerals, oil, natural gas deposits, or other materials. The disclosure provisions also apply to firms engaged in logging activity in primary forests (Art. 41). 91  Directive 2014/​95/​EU, 2014 O.J. (L 330) 4, which inserted Art. 19A to Directive 2013/​34/​EU. 92  See e.g. Ralph Nader, Mark Green, and Joel Seligman, Taming the Giant Corporation 125 (1976) (advocating the presence of an informed representative on the board for each public concern, such as environmental matters, consumer interests, compliance, among others). 93  Art. 31-​1 Ordonnance No. 2014-​948 of 20 August 2014, inserted by Loi No. 2015-​990 of 6 August 2015. 94  Section 8 of the Clayton Act (U.S.); § 100 section 2 No. 3 AktG (Germany); Art. 36, Decree-​ Law 6 December 2011, No. 201 (Italy). 95 Aktiengesetz § 96(2) (30  percent of supervisory board seats for the largest companies with employee board representation); Arts. 225-​18-​1 and 225-​69-​1 Code de commerce (in force, respectively, as of 1 January 2017 and 2020); Art. 147-​III Consolidated Act on Financial Intermediation (Italy) (one-​third of board seats). The 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. The empirical literature does not evidence any clear link between board diversity and corporate performance.96 While a similar absence of evidence has not stopped independent directors being promoted as a means of securing shareholders’ interests,97 a likely alternative motivation for these new quota requirements is the political desire to promote gender fairness. Perhaps also, they may seek to further the interests of non-​ shareholder constituencies, as some studies suggest that female directors exhibit different preferences from male directors with respect to risk-​taking and the protection of stakeholders.98 Decision rights are also occasionally used to protect the interests of non-​ shareholder constituencies. This 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. These first emerged in the UK during privatizations in the 1980s, and then spread to Brazil, France, Germany, and Italy.99 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 shares can be “shareholders” in name only—​they are not necessarily investors in, or beneficial owners of, the firm.100 The rationale for awarding such outsize decision rights to governments is presumably to protect the public interest at large.101 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.102 Despite waves of

96  See e.g. Deborah H. Rhode and Amanda Packel, Diversity on Boards: How Much Difference Does Difference Make? 39 Delaware Journal of Corporate Law 363 (2014) (reviewing the empirical literature on female participation on boards and concluding that “the relationship between diversity and financial performance has not been convincingly established”); Renee B. Adams, Women on Boards: The Superheroes of Tomorrow?, ECGI Finance WP No 466/​2016 (2016) (similar). 97  See Chapter 3.2. 98  See e.g. George R. Franke, Deborah F. Crown, and Deborah F. Spake, Gender Differences in Ethical Perceptions of Business Practices, 82 Journal of Applied Psychology 920 (1997) (women more likely than men to perceive certain business practices unethical); Renée B. Adams and Daniel Ferreira, Women in the Boardroom and Their Impact on Governance and Performance, 94 Journal of Financial Economics 291 (2009) (diverse boards devote more effort to monitoring); David A. Matsa and Amalia R. Miller, A Female Style in Corporate Leadership? Evidence from Quotas, 5 American Economic Journal: Applied Economics 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 (banks with more women directors no less prone to risk-​taking). 99  However, golden shares have been successfully challenged in the EU as an impediment to the free movement of capital. See e.g. Wolf-​Georg Ringe, Company Law and Free Movement of Capital, 69 Cambridge Law Journal 378 (2010). 100 Whether golden shares entitle governments to cash-​flow rights varies by jurisdiction. Even where they do, the associated decision rights are disproportionately powerful. 101  However, corporate income taxation makes the government a residual claimant of sorts in all firms in a way that serves to align the interests of the government with those of shareholders. Indeed, a high rate of tax compliance is associated with lower private benefits of control. See Dyck and Zingales, note 2. 102  Bernardo Bortolotti and Mara Faccio, Government Control of Privatized Firms, 22 Review of Financial Studies 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, Leviathan in Business, Brazil and Beyond (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, Italy, and Brazil.103 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 enterprises (SOEs) are usually subject to the same corporate law regime applicable to private firms, which generally affords the state as controlling shareholder wide discretion to pursue public goals.104 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.105 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. The basic premise is that the rise in institutional investors pursuing indexing strategies entailing 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.106 The expansion of shareholder rights following the 2008 financial crisis—​as exemplified by the rise of “say on pay” around the globe—​is at least partly premised on this assumption.107

4.3.3 The incentives and constraints strategies As discussed above, the widespread use of the constraints strategy to protect the interests of external constituencies is usually thought to happen beyond the perimeter of “corporate law.” There 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 enforcement 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 other than shareholders—​an expression of the standards strategy. The corporate laws of many jurisdictions provide that directors owe their duty of loyalty to the company rather than to any of its constituencies.108 Such a duty is most naturally understood as an exhortation to maximize the net aggregate returns (pecuniary and non-​pecuniary) of all corporate constituencies.

103  See Mariana Pargendler, State Ownership and Corporate Governance, 80 Fordham Law Review 2917 (2012). 104  Marcel Kahan and Edward Rock, When the Government is the Controlling Shareholder, 89 Texas Law Review 1293 (2011); Mariana Pargendler, Governing State Capitalism:  The Case of Brazil, in Chinese State Capitalism and Institutional Change:  Domestic and Global Implications 385 (Curtis J. Milhaupt and Benjamin Liebman eds., 2015). 105  Art. 4º § 1º Lei 10.303, de 30 de junho de 2016 (Braz.). 106  See e.g. Robert A. G. Monks and Nell Minow, Watching the Watchers 121 (1996); James P. Hawley and Andrew T. Williams, The Rise of Fiduciary Capitalism (2000); Gelter, The Pension System, note 55. 107  The same idea has inspired recent proposals to employ 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 Journal of Legal Analysis 35 (2014) (suggesting diversified shareholders would act “as a proxy for society” in enforcing such liability). 108  E.g. Germany: §§ 76 I and 93 I 2 AktG; 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 constituencies such as employees, in order to maximize the aggregate private welfare of all corporate constituencies.109 In practice, however, courts are not well-​placed to determine which policies maximize aggregate private welfare. This explains why, even where it is spelt out, a duty to pursue the corporation’s interest (in this broad sense) is unenforceable. Even fair-​ minded directors are unlikely to know how best to distribute surplus among multiple corporate constituencies. Thus, 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] members as a whole, and in doing so [to] have regard (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.”110 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 in the best interests of the company, “subject to the exigencies of public good and the social function of enterprise”; controlling shareholders, in turn, have duties and responsibilities towards “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 non-​ shareholder constituencies with quite such ambition as the new regime introduced by India’s Companies Act of 2013. This 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 in local areas—​or to explain their reasons for noncompliance. The Indian statute’s definition of “corporate social responsibility” is particularly broad, encompassing not only social objectives closely related to the firms’ primary activities, but also general humanitarian goals such as the eradication of extreme hunger and poverty, reducing child mortality, and combating various diseases.113 Unsurprisingly, given its ambition, the effectiveness of this regime remains very much open to question. Yet 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.114 Legal systems may also encourage corpor­ ate charitable contributions through various tax deductions. And even in the United States, where fiduciary duties to shareholders are formally perhaps the strongest,115

109  Note that maximizing the private welfare of all of the 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 hired because the high wages of current employees limit firm expansion. 110  § 172 Companies Act 2006 (UK). 111  Arts. 164 and 116 Lei das Sociedades por Ações. 112  See Chapter 8.5. 113  Companies Act 2013 (India), Art. 135 and Schedule VII. 114 See e.g. § 122(9) Delaware General Corporation Law; Art. 154, § 4º Lei das Sociedades por Ações. 115  The most famous articulation of 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 constituencies so long as the decision is framed in terms of promoting long-​term shareholder value.116 Corporate law may also indirectly protect 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.117 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.118 In practice, however, this duty is principally read to protect the creditors of closely held corporations.119 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 even shareholders—​for violations of law.120 All of our core jurisdictions occasionally deviate from the general rule that only the corporation—​as a distinct legal 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 law, environmental law, labor law, antitrust law, and financial regulation.121 These include both direct sanctions for intentional or reckless 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 the “broad-​spectrum prophylactic” previously 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 such ambiguity with respect to the function served by independent directors—​the protection of shareholders as a class, of minority shareholders, of 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 Atlantic Reporter 3d 1, 33 (Del. Ch. 2010) (“Promoting, protecting, or pursuing non-​stockholder considerations must lead at some point to value for stockholders”). 116  Einer Elhauge, Sacrificing Corporate Profits in the Public Interest, 80 New  York University Law Review 733 (2005) (business judgment rule deference entails significant managerial discretion to sacrifice profits in the public interest). 117  Claire Hill and Brett McDonnell, Reconsidering Board Oversight Duties after the Financial Crisis, University of Illinois Law Review 859, 866–​7 (2013). 118  Art. 429(1) Companies Act (Japan); Art. 2395 Civil Code (Italy); Art. L. 225-​251 Code de commerce (France). 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., Droit des sociétés 179 (28th edn., 2015). 119  See Chapter 5.3.1.1. 120  See Reinier H. Kraakman, Corporate Liability Strategies and the Costs of Legal Controls, 93 Yale Law Journal 857 (1984). 121 See e.g. Klaus J. Hopt and Markus Roth, Sorgfaltspflicht und Verantwortlichkeit der Vorstandsmitglieder, in Aktiengesetz: Grosskommentar (Heribert Hirte et al. eds., 5th edn., 2015), § 93 comments 656 et seq (discussing controversial imposition of personal liability on corporate directors in Germany for product liability cases). 122 See e.g. Victor Brudney, The Independent Director—​Heavenly City or Potemkin Village? 95 Harvard Law Review 597, 597 (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”).

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stakeholders—​has in fact facilitated political consensus and contributed to the spread of this mechanism in our core jurisdictions over time.123 The reward strategy has also been increasingly deployed to protect the interests of non-​shareholder constituencies. Rather than attempting to tie executive remuneration to benefits conferred by the corporation on society as a whole—​which would clearly be 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 returns, compensation packages in financial institutions contributed to the system’s collapse by encouraging managers to take risks that were excessive from a social standpoint.124 In systemically important financial institutions, the interests of undiversified shareholders conflict with those of society as a 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, given the countervailing advantages of equity-​based compensation, none of our core jurisdictions has completely banned its use in financial institutions, though the EU has capped the variable component at twice fixed pay.125 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, most reforms in this area took the form of decision strategies, as in the global spread of the “say on pay” rule,126 of trusteeship strategies, as in the most stringent independence requirements for members of compensation committees imposed in the U.S,127 and of affiliation strategies, as in the greater disclosure requirements in the U.S. and Japan.128

4.4  Explaining Jurisdictional Differences and Similarities As with our discussion of the primary manager–​ 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 The law-​on-​the-​books The 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, provide an indication of which countries go furthest to protect employees through corporate law.

123  Pargendler, note 82. 124  See e.g. Lucian A. Bebchuk and Holger Spamann, Regulating Bankers’ Pay, 98 Georgetown Law Journal 247 (2010). 125  Art. 94(1)(g) Capital Requirements Directive IV, 2013 O.J. (L 176) 338. The 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., Principles of Financial Regulation 380–​8 (2016). Moreover, the supervisory board members of most large German firms no longer receive stock options, though their fixed salary has increased considerably. 126  See Section 4.3.2 and Chapter 6.2.3. 127  See Chapter 3.3.1. 128  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 minority-​ elected board members, to protect minority shareholders. Elsewhere the long-​term trend is in the opposite direction—​ namely, away from minority empowerment through devices such as cumulative voting and strong supermajority voting rules.129 Why do so few jurisdictions mandate minority-​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.130 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. This 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 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, 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 in light of the growing collaboration between hedge funds and traditional institutional investors.133 What, then, of other legal strategies for protecting minority investors? Among our core jurisdictions the U.S., followed by the UK, appears to rely most extensively on independent directors (in publicly traded companies), even more so after the Sarbanes-​ Oxley and 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 in a particular firm (or in other firms with controlling shareholders). The U.S., however, complements the trusteeship strategy with the strongest mandatory disclosure system of all our core jurisdictions.134

129  See Chapter 3.2.1 and Chapter 4.1.1. 130  See e.g. Gordon, note 8, at 167 (discussing traditional critiques of cumulative voting). 131 Institutional investors nominate around one-​third of the minority-​appointed directors in companies voluntarily providing such information. See Assonime, Corporate Governance in Italy:  Compliance with the CG Code and Directors’ remuneration (Year 2012) 62–​70 (2013), at http://​www.assonime.it. 132  See Mark J. Roe, Strong Managers, Weak Owners: The Political Roots of American Corporate Finance 273 (1994). 133 See Kobi Kastiel, Against All Odds:  Shareholder Activism in Controlled Companies, 2016 Columbia Business Law Review 60. 134  See Chapter 6.2.1.1 and Chapter 9.

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Alternatively, consider the equal treatment norm as a minority safeguard. Here, Japan—​followed by continental European jurisdictions and Brazil—​is the country with the most stringent standards, at least on-​the-​books. The UK also gives substance to the equal treatment norm in the form of preemption rights and minority-​protective takeover rules, while Delaware appears to rely on it the least. Put differently, all we know from reviewing the law-​on-​the-​books is that jurisdictions pursue different strategies to protect minority interests. How well these strategies work in practice is a totally different story. When it comes to governance strategies that protect labor’s interest, Germany’s system of quasi-​parity codetermination, coupled with works council co-​decision rights, clearly stands out.135 France follows, a considerable distance behind 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.136 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.137 The 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.138 Conversely, different jurisdictions embrace a variety of strategies with respect to the protection of external constituencies, making it difficult to establish a clear pecking order. The use of the affiliation strategy through mandatory disclosure of non-​financial information is currently most extensive in EU countries, and least so in Brazil. Whether explicitly or implicitly, all jurisdictions require or at least permit the board to take into account the interests of non-​shareholder constituencies.139 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, if only de facto, to promote a broader set of interests.140

4.4.2 The law in practice As we argue above, the law-​on-​the-​books provides an imperfect measure of the protection accorded to corporate constituencies. This is particularly the case for minority shareholders. 135  For reviews of the empirical literature on these mechanisms, see John T. Addison and Claus Schnabel, Worker Directors: A German Product that Did Not Export, 50 Industrial Relations 354, 354 (2011); Davies, note 56. 136  See Rebecca Gumbrell-​McCormick and Richard Hyman, Embedded Collectivism? Workplace Representation in France and Germany, 37 Industrial Relations Journal 473, 482 (2006). 137  See e.g. Juan C. Botero, Simeon Djankov, Rafael La Porta, Florencio Lopez-​de-​Silanes, and Andrei Shleifer, The Regulation of Labor, 119 Quarterly Journal of Economics 1339 (2004) (France’s labor law is most restrictive among our jurisdictions). 138 Gelter, The Dark Side, note 57. But see Mark J. Roe, Political Preconditions to Separating Ownership from Control, 53 Stanford Law Review 539 (2000) (for the different view that social democracies induce concentrated ownership in order to counterbalance the influence of labor in firm management). 139  See notes 111–​12 and accompanying text. 140  See Chapter 3.4. See also Christopher M. Bruner, Corporate Governance in the Common Law World 105 (2013).

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4.4.2.1 Minority shareholders Two 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, through moderately larger in Germany (approximately 10 percent), very large in Italy (30 percent or more) and France (28  percent), to extraordinarily large (65  percent) in Brazil.141 Thus, to the extent that private benefits of control measure the severity of the 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-​on-​the-​books.142 Moreover, these variations followed a clear pattern. The 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. This 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 of control are relatively small. Whenever private benefits of control are sufficiently large, dispersed ownership becomes inherently unstable, since a potential raider would have much to gain from acquiring a controlling block and expropriating the remaining minority.143 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)144 and the reduction of the wedge between ownership and control in others (Italy),145 cast doubt on the continued accuracy of these earlier measurements of private benefits of control. Strikingly, there are no cross-​country studies that update the earlier estimates of private benefits of 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 not necessarily a solution—​to the mistreatment of minority shareholders. Moreover, it indicates that the strong equal treatment norms found in civil law jurisdictions did not necessarily protect minority shareholders, nor did a relatively low percentage of 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 141  The two papers are Nenova, note 2, at 336 (employing share price 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’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. 142 But see Sofie Cools, The Real Difference in Corporate Law Between the United States and Continental Europe: Distribution of Powers, 30 Delaware Journal of Corporate Law 697, 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). 143  See e.g. Lucian Bebchuk and Mark Roe, A Theory of Path Dependence in Corporate Ownership and Governance, 52 Stanford Law Review 127 (1999). 144  Érica Gorga, Changing the Paradigm of Stock Ownership from Concentrated Towards Dispersed Ownership? Evidence from Brazil and Consequences for Emerging Countries, 29 Northwestern Journal of International Law and Business 439 (2009). 145  Massimo Belcredi and Luca Enriques, in Research Handbook on Shareholder Power 383, 385 (Jennifer G. Hill and Randall S. Thomas eds., 2015).

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generally manifested low levels of private benefits despite concentrated ownership structures.146 What, then, predicts the efficacy of minority shareholder protections and, by implication, the extent of private benefits of control? The literature suggests that many disparate factors matter, including legal rules, the general business culture, and even the competitiveness of the product markets.147 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.148 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 Takeover Panel. Large institutional investors are normally 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,149 and taxation of intra-​corporate distributions150 are all indications of the comparative weakness of controlling shareholders under U.S. law. Delaware courts also take a tougher stance toward self-​dealing by controlling shareholders than by officers and directors.151 Finally, shareholder class actions and enforcement by the SEC are, respectively, very common and increasingly severe. The 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.152 By contrast, in jurisdictions such as France, Italy, and Brazil, where large shareholders control most listed companies, one assumes that controlling shareholders are a potent political influence. The fact that the state is a major shareholder in many companies in these countries—​and is often a member of the controlling coalition in the companies in which it holds a non-​controlling stake—​further compounds the influence of 146 See Ronald J. Gilson, Controlling Shareholders and Corporate Governance:  Complicating the Comparative Taxonomy, 119 Harvard Law Review 1641 (2006). 147  See Dyck and Zingales, note 2. 148  See also Bebchuk and Roe, note 143. 149 Roe, Strong Managers, Weak Owners, note 132, at 98. 150  Randall Morck and Bernard Yeung, Dividend Taxation and Corporate Governance, 19 Journal of Economic Perspectives 163 (2005). 151  See Chapter 6.2.5. 152  Note, 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 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 despite friendly shareholder support, managers gain an interest in discriminating among shareholders in order to facilitate warrant or 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 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.153

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 quasi-​ parity codetermination and co-​decision rights. The question then becomes: how effective is co​determination 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.154 There 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.155 But in addition to this, labor directors may also play an important informational role, at least in theory. Mutually wasteful bargaining behavior such as strikes and lock-​outs result in part from distrust between firms and employees.156 By credibly informing employees, labor directors might limit such costly bargaining behavior. Likewise, by revealing the firm’s intentions, labor directors 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, with some empirical support in the literature, argues that codetermination can provide German supervisory boards with “valuable first-​hand operational knowledge” that improves board decision-​making and increases firm value in the subset of firms in which the need for intra-​firm coordination is greatest.157 Yet there is also evidence that quasi-​parity codetermination in larger German firms reduces firm value158—​and still other, non-​comparable, studies finding that codetermination increases employee productivity or firm profitability.159 153  See Chapter 3.3.1, and Sections 4.1.1 and 4.1.3.1. 154  See Chapter 3.5. 155  E. Han Kim, Ernst Maug, and Christoph Schneider, Labor Representation in Governance as an Insurance Mechanism, Working Paper (2016), at ssrn.com (skilled workers in German firms with quasi-​parity codetermination receive wages that are 3.5 percent lower in exchange for protection against layoffs). 156 See R.B. Freeman and E.P. Lazear, An Economic Analysis of Works Councils, in Works Councils:  Consultation, Representation and Cooperation in Industrial Relations 27 (J. Roger and W. Streek eds., 1995). See generally John Kennan and Robert Wilson, Bargaining with Incomplete Information, 31 Journal of Economic Literature 45 (1993). 157 Larry Fauver and Michael E. Fuerst, Does Good Corporate Governance Include Employee Representation? Evidence from German Corporate Boards, 82 Journal of Financial Economics 673, 679 (2006). 158  See ibid. at 698–​701; Gary Gorton and Frank A. Schmid, Capital, Labor, and the Firm: A Study of German Codetermination, 2 Journal of the European Economic Association 863 (2004). 159  For a useful if partisan review, see Simon Renaud, Dynamic Efficiency of Supervisory Board Codetermination in Germany, 21 Labour 689 (2007). Renaud’s strongly positive findings about the effects of 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 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 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 codetermination once it has been introduced? Although commentators have offered speculative economic answers to these questions,160 the empirical literature again remains sparse. There 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 is a highly imperfect way of making decisions in the presence of such conflicts. Majority decision-​making by a divided board risks opportunistic outcomes that diminish the value of the firm as a whole,161 and is also likely to make for a costly and cumbersome decision-​making process.162 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.163 Indeed, managers may withhold information from boards with the acquiescence of shareholders to limit leaks to employees and competitors.164 Strong labor may benefit managers, just as strong managers have proven to be loyal protectors of labor’s interests in large Japanese companies, even without a regime of codetermination.165

160  See e.g. 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). 161  Perhaps for this reason, the double voting right of the chairman of the supervisory board of co​determined corporations in Germany is very rarely used (its use is thought to undermine labor relations). 162  It is nearly always the case that, in any given firm (whether investor-​, employee-​, customer-​, or supplier-​owned), the group of persons sharing ownership is remarkable for its homogeneity of interest. Even within 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 firms it is rare for both managerial and line 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 and 91–​2. This suggests that the appointment strategy is not easily adapted to resolve significant conflicts of interest. 163  But see Fauver and Fuerst, note 157 (in some instances employee board representation may increase supervisory boards’ monitoring capacity and thereby reduce agency costs). 164  See Katharina Pistor, Co-​Determination in Germany: A Socio Political Model with Governance Externalities, in Employees and Corporate Governance 163, 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 separately prior to board meetings (a practice that the German Corporate Governance Code, in the one and only provision addressing codetermination, endorses) and always present a common front in formal meetings of the supervisory board. The common practice of for­ cing 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). 165  See Masahiko Aoki, Toward an Economic Model of the Japanese Firm, 28 Journal of Economic Literature 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 codetermination, the empirical literature is, as hinted, surprisingly mixed. Certainly large German firms survive and even flourish under the quasi-​parity regime of employee representation, and it seems intuitively likely that codetermination has contributed to the heavy orientation of the 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 codetermination.

4.4.2.3 External constituencies Evaluating the correlation between formal law and the actual protection of non-​contractual constituencies is exceedingly difficult. The interests of different stakeholders might conflict with one another, and measuring the impact of various strategies on overall social welfare is simply impossible. Moreover, the desirability of using corporate law to protect non-​contractual constituencies hinges not only on its ability to protect stakeholders, but also on how it fares compared with regulation by other fields of law. As a result, any normative assessment of existing approaches to corporate law in different jurisdictions will be tentative at best. There 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 constituencies, they are usually unenforceable by those constituencies. Not only are there procedural constraints to enforceability (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 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. Yet the effects of state ownership on overall social welfare are dubious, especially when regulatory alternatives are taken into account.166 More recently, policymakers have hoped that institutional investors, as “universal owners” exposed to the entire market, will act as stewards of the public good.167 The new 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 166 See e.g. World Bank, Bureaucrats in Business: The Economics and Politics of Government Ownership (1995) (finding that state-​owned factories pollute more than private factories); Andrei Shleifer, State Versus Private Ownership, 34 Journal of Economic Perspectives 133 (1998) (arguing that social goals are usually best addressed by government contracting and regulation). 167  See e.g. European Commission, Green Paper: The EU Corporate Governance Framework (2011); http://​ec.europa.eu; John Kay, The Kay Review of UK Equity Markets and Long-​Term Decision Making: Final Report 74 (2012) (“institutional investors acting in the best interest of their clients should consider the environmental and social impact of companies’ 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”).

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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.168 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 the boundaries.169 Nevertheless, there 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 to deflect more fundamental regulatory reforms, remains an open question.170 There is, however, reason to be skeptical about the ability of corporate law to significantly tackle concerns which reach far beyond the agency problems that form its core competency.

168  Edward B. Rock, Institutional Investors in Corporate Governance, in Oxford Handbook of Corporate Law and Governance (Jeffrey N. Gordon and Wolf-​Georg Ringe eds., 2016). 169  John Armour, Colin Mayer, and Andrea Polo, Regulatory Sanctions and Reputational Damage in Financial Markets, Working Paper (2015), at ssrn.com. 170  Pargendler, note 82.

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5 Transactions with Creditors John Armour, Gerard Hertig, and Hideki Kanda

In Chapter 1, we saw that two of the core structural characteristics of the business corporation—​legal personality and limited liability—​involve partitioning pools of assets, both to and from creditors’ claims. As we explained, these facilitate contracting and investment by making certain which assets will—​and will not—​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’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 This 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 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. Consequently, every corporate law includes some provisions protecting corporate creditors. By serving to reduce agency costs, these measures help lower the cost of raising debt finance,3 and of using the corporate form as a vehicle for contracting. Of course, the general law of debtor-​creditor relations will apply to such transactions. We focus here on legal strategies specifically directed at creditors of corporate debtors, commonly justified as responding to particular problems stemming from the partitioning of corporate assets. This chapter considers the way in which the features of the corpor­ ate 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 Tirole, The Theory of Corporate Finance 389–​ 95 (2006); Patrick Bolton, Corporate Finance, Incomplete Contracts, and Corporate Control, 30 Journal of Law, Economics & Organization 164 (2014); On “ownership” for these purposes, see Chapter 1.2.5. 3 Stronger creditors’ rights are associated with increased credit availability:  see e.g. Rainer Haselmann, Katharina Pistor, and Vikrant Vig, How Law Affects Lending, 23 Review of Financial Studies 549 (2010). This is especially so given effective debt enforcement: Simeon Djankov, Oliver Hart, Caralee McLiesh, and Andrei Shleifer, Debt Enforcement Around the World, 116 Journal of Political Economy 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 Secured Transactions Law, Economic Impact and Reform 1 (Frederique Dahan ed., 2015). The Anatomy of Corporate Law. Third 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, 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. There 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. They now raise more through markets, and less from banks.4 This 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 and Agency Problems 5.1.1 Asset partitioning and corporate creditors We saw in Chapter  1 that the asset partitioning function of corporate law has two aspects. First, entity shielding—​a consequence of legal personality—​which ensures that the claims of corporate creditors have priority over shareholders (and their creditors) to the company’s asset pool. This makes credible the firm’s pledge to make its assets available for its creditors. Secondly, limited liability (or “owner 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’s creditors. As creditors’ recourse is limited to corporate assets, lenders need only evaluate and monitor these assets, lowering their overall costs. The limitation also facilitates specialization by creditors, because those with expertise in evaluating and monitoring assets of the type owned by the firm will—​all other things equal—​be able to offer cheaper credit. The cost savings from matching creditors’ monitoring capabilities with the assets to which they have recourse also provides a rationale for corporate group structures. That 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 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.5 This 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 information-​ gathering, but also undermines their incentives to monitor the assets of the entity in question.6 This 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, 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 was common in many securitization deals prior to the financial crisis—​such creditors are offered additional rights of recourse (known as a “credit enhancement”) from the originating company and/​or a third party. 4  An exception is the U.S., for which market-​based debt finance has long been more significant. 5  Creditors of the parent company are said to be “structurally subordinated” because their only claim to the subsidiary’s assets is via the parent company’s shareholding. 6  See Richard Squire, The Case for Symmetry in Creditors’ Rights, 118 Yale Law Journal 806 (2009).

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5.1.2 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.7 Most basically, the shareholders may siphon assets out of the corporate pool in favor of themselves. This 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 their claims. Second, creditors’ interests may be harmed by an increase in the riskiness—​that is, the volatility—​of the firm’s business, in particular through “asset substitution.”8 Here shareholders do not take the firm’s assets for themselves, but rather sell assets used in low-​risk business activities to pay for the acquisition of assets used in high-​risk business activities.9 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 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.10 To make things worse, such a substitution may be attractive to shareholders even if it reduces the overall value of the firm’s assets: that is, the shareholders may prefer a larger slice of a smaller overall pie.11 A third way in which shareholders may benefit at creditors’ expense is by increasing the firm’s overall borrowing. If the “new” creditors end up sharing the firm’s assets with the “old” creditors in the event of failure, this reduces the expected recoveries of the old creditors should the firm default. This benefits the shareholders by enabling them, in effect, to have the benefit of finance from the old creditors on terms which, in light 7  For a classic account, see Robert C. Clark, The Duties of the Corporate Debtor to its Creditors, 90 Harvard Law Review 505, 506–​17 (1977). 8  See Michael C. Jensen and William H. Meckling, Theory of the Firm:  Managerial Behavior, Agency Costs and Ownership Structure, 3 Journal of Financial Economics 305, 334–​7 (1976); Dan Galai and Ronald W. Masulis, The Option Pricing Model and the Risk Factor of Stock, 3 Journal of Financial Economics 53 (1976). 9  However, empirical evidence regarding the significance of asset substitution (or risk-​shifting) is mixed:  see Gregor Andrade and Steven Kaplan, How Costly is Financial (not Economic) Distress? Evidence from Highly Leveraged Transactions that Became Distressed, 53 Journal of Finance 1443 (1998); Assaf Eisdorfer, Empirical Evidence of Risk Shifting in Financially Distressed Firms, 63 Journal of Finance 609 (2008); Pablo Hernández, Paul Povel, and Giogo Sertsios, Does Risk Shifting Really Happen? Results from an Experiment, Working Paper (2014). 10  The 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  The phenomenon of firms investing in business projects that a rational investor would reject as yielding too low a rate of return is sometimes referred to as “overinvestment.” The inverse problem—​ referred to as “underinvestment”—​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 Journal of Financial Economics 147 (1977).

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of the addition of the new creditors, now look too favorable. This effect is sometimes referred to as “debt dilution.”12 The 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, and which, without such a subsidy, they would decline to fund.13 The intensity of the shareholder–​creditor agency problem will be influenced by managerial risk aversion and shareholder control over firm 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 their reputations if the firm becomes financially distressed.14 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, 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 at creditors’ expense. Control transactions can affect creditors adversely along several of these dimensions at once—​a phenomenon known as “event risk.” A leveraged management buyout, for example, may jointly increase the firm’s debt load, change the direction of its business and tightly tie managers to shareholder returns through significant personal stockholdings.15 Shareholder–​creditor conflicts have the potential to reduce the overall value of the firm’s assets.16 Thus 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.17 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’s ability to engage in activities that might conflict with creditors’ interests—​such as payments of dividends to shareholders, significant asset transactions, or increases in borrowing.18 Creditors may also take security interests in corporate assets, which restrict the scope

12  See e.g. Alan Schwartz, A Theory of Loan Priorities, 18 Journal of Legal Studies 209 (1989). 13 A  version of this conflict involves granting contingent debt obligations—​such as personal guarantees—​for which liability is correlated with the firm’s insolvency risk. These 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 Harvard Law Review 1151 (2010). 14  E.g. managers of U.S.  firms undergoing debt restructurings frequently lose their jobs:  Edith Hotchkiss, Post-​Bankruptcy Performance and Management Turnover, 50 Journal of Finance 21 (1995); Kenneth M. Ayotte and Edward R. Morrison, Creditor Control and Conflict in Chapter 11, 1 Journal of Legal Analysis 511 (2009). 15  See Paul Asquith and Thierry A. Wizman, Event Risk, Covenants, and Bondholder Returns in Leveraged Buyouts, 27 Journal of Financial Economics 195 (1990); Sudheer Chava, Dmitry Livdan, and Amiyatosh Purnanandam, Do Shareholder Rights Affect the Cost of Bank Loans? 22 Review of Financial Studies 2973 (2009) (takeover defenses, reducing event risk, associated with lower costs of credit). 16  See e.g. Jensen and Meckling, note 8. 17  Clifford W. Smith, Jr. and Jerold B. Warner, On Financial Contracting:  An Analysis of Bond Covenants, 7 Journal of Financial Economics 117 (1979); Michael H. Bradley and Michael R. Roberts, The Structure and Pricing of Corporate Debt Covenants, 5 Quarterly Journal of Finance 1 (2015). 18 See Smith and Warner, note 17; William W. Bratton, Bond Covenants and Creditor Protection:  Economics and Law, Theory and Practice, Substance and Process, 7 European Business Organization Law Review 39 (2006). In addition to these non-​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,19 and prevent the creditor from being diluted.20 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 of control over the debtor’s activities.22 As creditors and firms frequently expend resources in writing covenants or 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. This general reliance on contract, rather than legal provisions, calls for explanation. We believe three factors are particularly salient. First, there is a risk of 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 The appropriate balance is likely to vary depending on the firm’s business model,24 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.25 Second, creditors’ interests in the firm—​their time and risk horizons—​are likely to be much more heterogeneous than those of shareholders.26 As a result, the provision commonly agree to a range of so-​called financial covenants:  promises to maintain a certain level of financial health. These 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, 25 Review of Financial Studies 1713 (2012). 19  Clifford W. Smith, Jr. and Jerold B. Warner, Bankruptcy, Secured Debt, and Optimal Capital Structure: Comment, 34 Journal of Finance 247 (1979). For overviews of the literature on secured credit, see Barry E. Adler, Secured Credit Contracts, in The New Palgrave Dictionary of Economics and the Law, Vol. 3, 405 (Peter Newman ed., 1998); Jean Tirole, note 2, 164–​70, 251–​4; Efraim Benmelech and Nittai K. Bergman, Collateral Pricing, 91 Journal of Financial Economics 339 (2009). 20  Dilution can also be restricted in the lending agreement (with a “negative pledge”), but a security interest is self-​enforcing in its protection of the creditor’s priority: Alan Schwartz, Priority Contracts and Priority in Bankruptcy, 82 Cornell Law Review 1396 (1996). 21  See Kenneth Ayotte and Stav Gaon, Asset-​Backed Securities:  Costs and Benefits of “Bankruptcy Remoteness”, 24 Review of Financial Studies 1299 (2011); Douglas G. Baird and Anthony Casey, No Exit? Withdrawal Rights and the Law of Corporate Reorganizations, 113 Columbia Law Review 1 (2013). 22 See Ronald J. Daniels and George G. Triantis, The Role of Debt in Interactive Corporate Governance, 83 California Law Review 1073 (1995); Douglas G. Baird and Robert K. Rasmussen, Private Debt and the Missing Lever of Corporate Governance, 154 University of Pennsylvania Law Review 1209 (2006). 23  Viral V. Acharya and Krishnamurthy V. Subramanian, Bankruptcy Codes and Innovation, 22 Review of Financial Studies 4949 (2009); Greg Nini, David C. Smith, and Amir Sufi, Creditor Control Rights and Firm Investment Policy, 92 Journal of Financial Economics 400 (2009); Viral V. Acharya, Yakov Amihud, and Lubimor Litov, Creditor Rights and Corporate Risk-​Taking, 102 Journal of Financial Economics 150 (2011). 24  See e.g. Efraim Benmelech and Nittai K. Bergman, Vintage Capital and Creditor Protection, 99 Journal of Financial Economics 308 (2011). 25  See Paul Brockman and Emre Unlu, Dividend Policy, Creditor Rights, and the Agency Costs of Debt, 92 Journal of Financial Economics 276 (2009); Darius P. Miller and Natalia Reisel, Do Country-​Level Investor Protections Affect Security-​Level Contract Design? Evidence from Foreign Bond Covenants, 25 Review of Financial Studies 408 (2012). 26  Hideki Kanda, Debtholders and Equityholders, 21 Journal of Legal Studies 431, 440–​1, 444–​5 (1992); Marcel Kahan, The Qualified Case Against Mandatory Terms in Bonds, 89 Northwestern University Law Review 565, 609–​10 (1995).

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of standard-​form “terms” to protect creditors may be at once over-​protective of some creditors and under-​protective of others. And third, the appropriate content of creditor-​protective restrictions may change over time, making it necessary to renegotiate them. The ease of renegotiation (and hence the appropriate initial tightness of the restrictions) will depend on creditors’ coordination and information 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.27 Restrictions seeking to govern relations with all of a firm’s creditors would create significant renegotiation problems unless they are set at a very lax level at the outset—​so much so, that in most cases it would not be worth doing at all.28 However, in three particular instances—​which we now consider—​it appears that these general conditions do not hold, and consequently the benefits of corporate law responding to shareholder–​ creditor agency problems relations plausibly outweigh their costs.

5.1.2.1 The vicinity of insolvency All our jurisdictions specifically deal with shareholder–​creditor agency problems in relation to corporations that are financially distressed—​that is, “in the vicinity of insolvency.” The incentives for shareholders or managers to engage in value-​decreasing 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.29 A common theme in these restrictions is for the law to seek to encourage managers of distressed corporations—​who are, by and large, well-​placed to assess the firm’s financial 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.30 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 of shareholder loans in bankruptcy, and “piercing the corporate veil.” Moreover, third parties may be recruited as monitors 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.

27  Thus bond agreements commonly have fewer (and weaker) 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 Journal of Corporate Finance 201 (2003). 28  John Armour, Legal Capital: An Outdated Concept?, 7 European Business Organization Law Review 5, 21–​2 (2006). 29  However, this may be a little simplistic, as the effects of such provisions will be taken into account in ex ante decision-​making. Excessive sanctions in financial distress may dull risk-​taking in solvent firms: see Michelle J. White, The Costs of Corporate Bankruptcy: A U.S.-​European Comparison, in Corporate Bankruptcy: Legal and Economic Perspectives, 467 (Jagdeep S. Bhandari and Lawrence A. Weiss eds., 1996); Acharya and Subramanian, note 23. 30 See e.g. UNCITRAL, Legislative Guide on Insolvency Law, Part Four:  Directors’ Obligations in the Period Approaching Insolvency (2013).

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5.1.2.2 Groups Corporate groups are 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 risk to creditors best placed to evaluate and monitor particular assets. However, groups also give 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 with the complexity of their structure—​for opaque transfers of assets and creation of intra-​group liabilities that have the 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 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. These problems are compounded by the fact that identifying corporate groups itself is sometimes difficult. “Control” over group members—​a necessary prerequisite of groups—​is hard to define;33 voting agreements that create control blocks often go undisclosed; and simple rules based on a putative controller’s voting rights can be misleading.34

5.1.2.3 Externalities So-​called “non-​adjusting” 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 a particular challenge.35 Most obviously, this group includes victims of corporate torts and the state in right of regulatory claims.36 In

31  See Simon Johnson, Rafael La Porta, Florencio Lopez-​De-​Silanes, and Andrei Shleifer, Tunneling, 90 American Economic Review, Papers and Proceedings 22 (2000); Vladimir Atanasov, Bernard Black, and Conrad Ciccotello, Unbundling and Measuring Tunneling, 2014 University of Illinois Law Review 1697 (2014). The issue of minority shareholder protection is addressed in Chapters 6 and 7. 32  See Jaap Winter et al., Report of the High Level Expert Group of Company Law Experts on A Modern Regulatory Framework for Company Law in Europe (2002), 94–​9; Richard Squire, Strategic Liability in the Corporate Group, 78 University of Chicago Law Review 605 (2011). 33  See e.g. Art. 22 Directive 2013/​34/​EU, 2013 O.J. (L 182) 19 (articulating seven different tests for “control” for the purposes of parent/​subsidiary status); Art. 2(13)–​(14) Regulation (EU) 2015/​ 848, 2015 O.J. (L 141) 19. 34  E.g. control of a closely held company might require 51 percent of its voting rights, while control of a publicly held company might only require 10–​20 percent of its voting rights. 35  For a taxonomy of such claimants, see Lucian A. Bebchuk and Jesse M. Fried, The Uneasy Case for the Priority of Secured Claims in Bankruptcy, 105 Yale Law Journal 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 do not adjust the terms on which they lend, they nevertheless adjust the amount of credit extended according to the riskiness of the borrower: see Mitchell A. Petersen and Raghuram J. Rajan, Trade Credit: Theories and Evidence, 10 Review of Financial Studies 661, 678–​9 (1997). 36  Although the state is able to adjust the intensity of enforcement: see e.g. Katharina Pistor, Who Tolls the Bells for Firms? Tales from Transition Economies, 46 Columbia Journal of Transnational Law 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, when limited liability shields the assets of those controlling, and profiting from, the company’s activities, tort law’s economic function is undermined.37 This is especially the case when shareholders undercapitalize, or shift assets out of, risky operating companies precisely in order to minimize their potential tort liability.38 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 creditors might be given priority over other creditors in insolvency proceedings.39 Alternatively, shareholders might be held liable for excess tort liability, either on a pro rata basis in every case of tort liability, or to the full extent of damages in cases in which shareholders control risky activities directly.40 Yet effective protection to non-​adjusting creditors is rare in our core jurisdictions, although Brazil perhaps goes furthest in this regard: unlimited shareholder liability through veil-​ piercing is the norm whenever corporate assets are insufficient to compensate the damages caused to workers, consumers, and the environment.41 One regulatory strategy that is adopted in a number of jurisdictions—​although not strictly speaking part of corporate law—​is to require firms pursuing hazardous activities to carry 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. These requirements are often supplemented by legislation providing that, on the insolvency of the tortfeasor, entitlement to payment by the liability insurer is automatically transferred to the victim. However, 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.

5.1.3 Creditor–​creditor coordination and agency problems The 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 the case of a company, its shareholders—​and their creditors. To 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. The 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. The 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

37  See Steven Shavell, Foundations of the Economic Analysis of Law, 230–​2 (2004). 38  Empirical studies of firms operating in hazardous industries suggest that this occurs:  see Al H. Ringleb and Steven N. Wiggins, Liability and Large-​Scale, Long-​Term Hazards, 98 Journal of Political Economy 574 (1990). 39  David W. Leebron, Limited Liability, Torts Victims, and Creditors, 91 Columbia Law Review 1565 (1991). 40 For a pro rata approach, see Henry Hansmann and Reinier Kraakman, Toward Unlimited Shareholder Liability for Corporate Torts, 100 Yale Law Journal 1879 (1991); for a control approach, see Nina A. Mendelson, A Control-​Based Approach to Shareholder Liability, 102 Columbia Law Review 1203 (2002). 41  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 Fim da Responsabilidade Limitada no Brasil (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.42 An unpaid creditor may seek a court order enforcing its claim against the 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 its credit obligations, then its creditors have the option, between them, to become owners of all its assets.43 However, the creditors will then face a coordination problem. If each acts individually to enforce, this will very quickly result in the break-​up of the firm’s business. 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 less-​ than-​complete payout in a restructuring. Resolving these problems is bankruptcy law’s core function.44 As indicated, all our jurisdictions give creditors the right to trigger bankruptcy proceedings against firms that are insolvent.45 This 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.46 First, the staying of creditors’ individual claims means that the firm’s assets are subject to strong-​form 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.47 Second, creditors have limited liability for the firm’s post-​bankruptcy debts, which facilitates continuation of the firm’s business if appropriate.48 Third, creditors’ claims are usually freely transferable in bankruptcy, as are those of shareholders in the solvent firm.49 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, 42  See George G. Triantis, The Interplay Between Liquidation and Reorganization in Bankruptcy: The Role of Screens, Gatekeepers, and Guillotines, 16 International Review of Law and Economics 101 (1996); Douglas G. Baird and Robert K. Rasmussen, Control Rights, Property Rights and the Conceptual Foundations of Corporate Reorganizations, 87 Virginia Law Review 921 (2001); Robert K. Rasmussen, Secured Debts, Control Rights and Options, 25 Cardozo Law Review 1935 (2004). 43  We assume, as can normally be observed in practice, that equity is wiped out in firms that default generally on their obligations. 44  Thomas H. Jackson, The Logic and Limits of Bankruptcy Law 7–​19 (1986). 45  There are a variety of definitions of insolvency, but two criteria predominate: a debtor is insolvent when its liabilities exceed its assets (“balance-​sheet test,” or “overindebtedness”); or when it is durably unable to pay its debts as they fall due (“cash-​flow test” or “commercial” insolvency). 46  Here we use the term “owners” in the functional sense articulated in Chapter  1, namely the group entitled to control the firm’s assets (see Chapter 1.2.5). The extent to which bankruptcy transfers such control from shareholders to creditors varies across jurisdictions (see Section 5.3.2). 47 This is an important functional difference from bankruptcy laws applicable to individuals, which often do not provide for such effective entity shielding, at least against secured creditors. 48  The 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 of the debtor’s assets. 49  See Victoria Ivashina, Benjamin Iverson, and David C. Smith, The Ownership and Trading of Debt Claims in Chapter 11 Restructurings, 119 Journal of Financial Economics 316 (2016); Wei Jiang, Kai Li, and Wei Wang, Hedge Funds and Chapter 11, 67 Journal of Finance 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.50 Of course, creditors often would rather not have a distressed firm actually go into “formal” bankruptcy proceedings. This is because a firm’s bankruptcy calls its future into question, with the consequence that its suppliers and customers downgrade their expectations about its commitment to performance—​which, in turn reduces the value that can be obtained by selling the firm’s assets. Hence it is common for firms to seek, and creditors to agree to, a course of action that avoids formal bankruptcy, but yields similar outcomes. This might take the form of a “workout”—​a reorganization in the shadow of bankruptcy proceedings—if creditors are supportive of the firm’s management and business model. Alternatively, it might take the form of a sale—​liquidation—​of the firm’s business, “pre-​packaged” before the start of formal proceedings. Inter-​creditor coordination and agency costs mean that the chances of achieving a workout or “pre-​pack” reduce with the number, and heterogeneity, of creditors involved in renegotiation,51 making bankruptcy law’s role correspondingly more important.52 While creditors have significant influence over the selection between bankruptcy procedures (for example, by agreeing to “pre-​packaged” restructuring plans), few, if any, jurisdictions permit firms to contract with their creditors to use a particular procedure,53 and none permits firms to design their own.54 This approach can be supported on similar grounds to the availability of a number of different organizational forms for legal entities, each with mandatory features.55 A limited menu of such bankruptcy procedures can generate a body of judicial precedent regarding their interpretation. This in turn renders them more valuable to future parties, because there is greater certainty as to the court’s approach. Consequently, at a step before that, it influences how much creditors will be willing to lend in the first place.56 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

50  See e.g. UNCITRAL, Legislative Guide on Insolvency Law 26–​31 (2004). 51  See e.g. Stuart C. Gilson, Kose John, and Larry L.P. Lang, Troubled Debt Restructurings:  An Empirical Study of Private Reorganization of Firms in Default, 27 Journal of Financial Economics 315, 354 (1990); Paul Asquith, Robert Gertner, and David Scharfstein, Anatomy of Financial Distress:  An Examination of Junk-​Bond Issuers, 109 Quarterly Journal of Economics 625, 655 (1994); Antje Brunner and Jan Pieter Krahnan, Multiple Lenders and Corporate Distress: Evidence on Debt Restructuring, 75 Review of Economic Studies 415 (2008). 52  Claims trading by activist investors can also help to concentrate debt structure and lower coordination costs: see Ivashina et al., note 49. 53  The UK formerly permitted firms to grant a secured creditor the right to enforce against the entirety of their assets, through a procedure known as “receivership.” This was, however, abolished for most firms by the Enterprise Act 2002. See John Armour and Sandra Frisby, Rethinking Receivership, 21 Oxford Journal of Legal Studies 73 (2001). 54  For “bankruptcy 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 Contract Theory Approach to Bankruptcy, 107 Yale Law Journal 1807 (1998); Stanley D. Longhofer and Stephen R. Peters, Protection for Whom? Creditor Conflict and Bankruptcy, 6 American Law and Economics Review 249 (2004). However, parties remain free to partition assets across subsidiaries, which permits them to tailor the scope of the pool of assets which will be subject to bankruptcy: see Baird and Casey, note 21. 55  See Chapter 1.3.1 and 1.4.1. 56  See Oliver Hart, Firms, Contracts, and Financial Structure (1995); Alan Schwartz, A Normative Theory of Business Bankruptcy, 91 Virginia Law Review 1199 (2005).

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parties from agreeing on bankruptcy procedures that benefit them at the expense of non-​adjusting creditors.57 We now turn to the legal strategies deployed by our jurisdictions to respond to these problems. We look first at the (modest) control of shareholder–​creditor agency problems in firms that are solvent, and second, the (intensive) control of such problems, and also creditor–​creditor coordination and agency problems, in insolvent firms.

5.2  Solvent Firms To the extent that corporate law seeks to control shareholder–​creditor agency problems in solvent firms, it does so through ex ante strategies: affiliation and rules.58 The affiliation strategy, as we shall see, is primarily geared towards credit raised from markets, whereas the rules strategy is more appropriate for bank-​based debt finance.

5.2.1 The affiliation strategy—​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 security interests (whereby payment is expedited through enforcement against particular assets).59 Corporate law facilitates these transactions by requiring companies to disclose certain basic information. Most 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.60 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.61 Beyond this common core of obligations, there are differences regarding mandatory disclosure to creditors—​which increasingly depend on the type of company, rather than the jurisdiction of incorporation. Mandatory disclosure obligations are likely to be more beneficial for creditors supplying finance by way of markets than for bank lenders.62 Banks generally make relatively large investments in borrower companies, and so have incentives to engage in screening and monitoring of debtors. To 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 competitors. This is the

57  See generally Lucian Ayre Bebchuk, and Jesse M. Fried, The Uneasy Case for the Priority of Secured Claims in Bankruptcy, 105 Yale Law Journal 857, 882–​91 (1996). 58  This is because the very event that triggers the operation of ex post strategies in this context is the firm’s lack of solvency. 59  See e.g. Robert E. Scott, The Truth about Secured Financing, 82 Cornell Law Review 1436 (1997). 60 See Jonathan R. Macey, The Limited Liability Company:  Lessons for Corporate Law, 73 Washington University Law Quarterly 433, 439–​40 (1995). 61  See e.g. Arts. 2–​3 Directive 2009/​101/​EC, 2009 O.J. (L 258) 11 (EU); Revised Model Business Corporation Act § 2.02(a) (U.S.); Art. 32, II, a Lei 8.934 of 1984 (Brazil); Art. 911(3) Companies Act (Japan). 62  The question of whether disclosure needs to be mandatory, as opposed to voluntary, is discussed in Chapter 9.1.2.

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model of “relationship 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. 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 markets, for two important reasons. First, such investors typically each supply a much smaller proportion of the borrower’s 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 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.63 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.64 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.65 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.66

5.2.1.2 Publicly traded corporations Disclosure by publicly traded companies is extensively regulated in all our jurisdictions.67 Under U.S.  securities law, a company issuing publicly traded securities—​ including bonds—​must disclose all material information bearing on the value of the issue and the issuer’s financial condition in a registration statement filed with the SEC.68 EU initial disclosure requirements have become increasingly similar to U.S. requirements.69 There has also been considerable convergence as regards financial statements. U.S. publicly traded firms must periodically file financial statements that are prepared 63  See Alicia M. Robb and David T. Robinson, The Capital Structure Decisions of New Firms, 27 Review of Financial Studies 153 (2014). 64  See William J. Carney, The Production of Corporate Law, 71 Southern California Law Review 715, 761 (1998). 65  See Art. 2(1)(f ) Directive 2009/​101/​EC (“First Company Law Directive (Recast)”), 2009 O.J. (L 258) 11 and Accounting Directive 2013/​14/​EU, 2013 O.J. (L 182) 19 (EU); Arts. 176 and 289 Lei das Sociedades por Ações (Brazil); Art. 440 Companies Act (Japan). 66  See e.g. Art. 14 Accounting Directive (EU: applying a graduated scale such that the 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). 67  See also Chapter 9.1.2.5. 68  Securities Act 1933 §§ 5–​7. 69  See Prospectus Directive 2003/​71/​EC, 2003 O.J. (L 345)  64; Transparency Directive 2004/​ 109/​EC, 2004 O.J. (L 390) 38, both as amended by Directive 2010/​73/​EU.

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in accordance with U.S. GAAP.70 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 are closer to the Anglo-​American tradition of financial reporting—​to their consolidated financial statements.71 Publicly traded firms in Brazil must also follow IFRS.72 Japan too has undertaken disclosure and accounting reforms, which have rendered Japanese GAAP closer to IFRS, and has increasingly encouraged the voluntary adoption of IFRS by Japanese firms.73 On the other hand, as we shall see in Chapter 9, there remain real differences in the intensity of enforcement of these disclosure obligations.74

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.75 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.76 In addition, real differences remain when it comes to 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.77 Moreover, while most jurisdictions require public companies to disclose intra-​ group 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 “formal” contractual groups,78 the German Konzernrecht merely obligates controlled firms to provide creditors with an audited summary of the extensive report—​termed the Abhängigkeitsbericht or “dependence” report—​that these companies must deliver to their supervisory board.79

70  See e.g. Securities Exchange Act 1934, § 13; Sarbanes-​Oxley Act, §§ 401, 409; Regulation S-​X. See also Chapter 9.1.2.6. 71  Regulation 1606/​2002 on the Application of International Accounting Standards (The “IAS Regulation”), 2002 O.J. (L 243) 1. See Chapter 9.1.2.6. 72  CVM Instruction No. 457 of 2010, Art. 1º. 73  See Accounting Standards Board of Japan and IASB, Agreement on Initiatives to Accelerate the Convergence of Accounting Standards (8 August 2007); IFRS, IFRS Application Around the World—​ Jurisdictional Profile: Japan (2014). 74  See Chapter 9.2. 75  See Section 5.1.2.2. 76  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, 8 (2014); European Commission, State of Play on Convergence Between IFRS and Third Country GAAP, Staff Working Paper SEC(2011) 991 final. 77  Arts. 22–​3 Accounting Directive (EU); Art. 275 Lei das Sociedades por Ações (Brazil; such formal groups are however rare in Brazilian corporate practice). 78  So-​called formal groups are those listed as such in the trade register as having entered into a “control agreement”: see §§ 291, 294 Aktiengesetz. Although the exact numbers are uncertain, only a minority of German corporate groups are thought to have opted for this formal structure: see Volker Emmerich and Mathias Habersack, Konzernrecht 198 (10th edn., 2013). See also Section 5.3.1.2. Compare Art. 2497–​II Civil Code (Italy), under which a controlled company must disclose the effect of the controlling entity’s dominance on its management and results. 79  See § 312 Aktiengesetz; Uwe Hüffer and Jens Koch, Aktiengesetz (12th edn., 2016), § 312 para 38. See also Chapter 6.2.1.1 (disclosure requirements for related-​party transactions).

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5.2.1.4 The role of gatekeepers The quality of mandated disclosures can be enhanced through verification by trusted third parties, or “gatekeepers.”80 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.81 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.82 All major jurisdictions require publicly traded companies to use outside auditors to verify their financial statements. Moreover, many of our jurisdictions require professional audits for larger closely held companies.83 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. This aspect of gatekeeping is reinforced in all our jurisdictions by licensing requirements, the setting of operational standards and ex post liability for auditors and CRAs, which together provide a framework for dealing with gatekeeper “failure.”84 Auditors must ensure that a 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.85 Although auditors disclaim any duties beyond verifying financial statements, they are increasingly pressed to accept a broader scope of responsibility.86 The 1990s saw a number of legislative moves to rein in auditor liability,87 only to be rolled back during the outcry following Enron, Parmalat, and other accounting scandals in the early 2000s.88 Then again the implosion of Arthur Andersen after its Enron-​related criminal investigation highlighted the dangers of tampering with auditor reputation and provided further impetus for limiting auditor liability.89

80  See Chapter 2.4.2.3. 81  See Simeon Djankov, Caralee McLiesh, and Andrei Shleifer, Private Credit in 129 Countries, 84 Journal of Financial Economics 299 (2007). 82  See Arnoud W.A. Boot, Todd T. Milbourn, and Anjolein Schmeits, Credit Ratings as Coordination Mechanisms, 19 Review of Financial Studies 80 (2006). 83  See Art. 34 Accounting Directive (EU); Art. 328 Companies Act (Japan); Art. 3º Lei 11.638 of 2007 (Brazil). 84  See John Armour et al., Principles of Financial Regulation ch. 6 (2016). 85  See Chapter 6.2.1.1. 86  See John C. Coffee, Jr., Gatekeepers:  The Professions and Corporate Governance, at 168 (2006); Paul L. Davies and Sarah Worthington, Gower and Davies’ Principles of Modern Company Law 847–​53 (9th edn., 2012). 87  See, for the U.S., John C. Coffee, What Caused Enron? A Capsule Social and Economic History of the 1990s, 89 Cornell Law Review 269 (2004); for Japan, Arts. 34-​2-​2 et seq. Certified Public Accountant Act (revised, 2007); for France, Art. L. 822-​18 Code de commerce (three-​year limitation period); for Italy, Art. 164 Testo Unico della Finanza; for the UK, Limited Liability Partnership Act 2000. 88  See §§ 101–​9 Sarbanes-​Oxley Act 2001 (U.S.); Commission Communication COM(2003) 286, Reinforcing the Statutory Audit in the EU, 2003 O.J. (C 236) 2; Directive 2006/​43/​EC on statutory audits of annual accounts and consolidated accounts, 2006 O.J. (L 157) 87. 89  See e.g. Commission Recommendation concerning the limitation of the civil liability of statutory auditors and audit firms, 2008 O.J. (L 162) 39 (EU); 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 services by audit firms, and mandatory rotation of audit partners.90 The EU has recently gone further by mandating rotation of publicly traded companies’ audit firms every ten years.91 While there is some evidence that mandatory partner rotation helps reduce the incidence of accounting restatements,92 audit firm rotation is difficult to implement in a concentrated market for auditors, given the prohibitions on non-​audit services, and the evidence for its efficacy is rather more questionable.93 Similarly, the failure of CRAs to rate mortgage-​based financial products effectively in the 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,94 they are also subject to conflicts of interest, because their ratings are generally paid for by the issuer.95 Hence, regulation introducing measures such as licensing requirements, liability for gross negligence, transparency in rating methodology, and/​or seeking to foster competition in the sector, has been introduced in all our jurisdictions.96 A particular problem for the efficacy of CRAs as gatekeepers has been the use, in prudential regulation applicable to institutional investors, of minimum rating requirements as a precondition for investment in an asset class. To the extent that investors use ratings simply to satisfy regulatory conditions, as opposed to relying on their information content, demand for CRAs’ services need not be reduced by poor quality.97 To counter this problem, lawmakers around the world have sought to reduce such mandated reliance on credit ratings by institutional investors.98

J. Hopt, Patrick C. Leyens, Markus Roth, and Reinhard Zimmermann, Auditors’ Liability and its Impact on the European Financial Markets, 67 Cambridge Law Journal 62 (2008). 90  Sarbanes-​Oxley Act of 2002, §§ 201, 202 (U.S.: rotation after 5 years); Arts. 22 and 42 Directive 2006/​43/​EC on statutory audits, 2006 O.J. (L 157) 87, as amended by Directive 2014/​56/​EU, 2014 O.J. (L 158) 196 (EU: rotation after 7 years). 91  Art. 17 Regulation (EU) No 537/​2014 on specific requirements regarding statutory audit of public-​interest entities, 2014 O.J. (L 158) 77. 92  Henry Laurion, Alastair Lawrence, and James Ryans, U.S. Audit Partner Rotations, Working Paper, Berkeley Haas School of Business (2015). 93  See e.g. Mara Cameran, Giulia Negri, and Angela K. Pettinicchio, The Audit Mandatory Rotation Rule: The State of the Art, 3(2) Journal of Financial Perspectives (2015). Brazil also has a 5-​year audit firm rotation requirement, although no partner rotation rule: ibid. 94  See Amir Sufi, The Real Effect of Debt Certification: Evidence from the Introduction of Bank Loan Ratings, 22 Review of Financial Studies 1659 (2009). 95 See Lawrence J. White, Markets: The Credit Rating Agencies, 24 Journal of Economic Perspectives 211 (2010); John M. Griffin and Dragon Y. Tang, Did Credit Rating Agencies Make Unbiased Assumptions on CDOs?, 101 American Economic Review: Papers & Proceedings 125 (2011). 96 See Regulation (EC) No 1060/​2009 on Credit Rating Agencies, 2009 O.J. (L 302)  1, as amended by Regulation (EC) No 462/​2013, 2013 O.J. (L 146) 1 (EU); Dodd-​Frank Act of 2010, §§931–​939H (U.S.); CVM Instruction No. 521 of 2012 (Brazil); Art. 38(iii), Arts. 66-​27–​Art. 66-​49 Financial Instruments and Exchange Act (Japan) (the Japanese regulation does not impose liability on CRAs). 97 See Christian C. Opp, Marcus M. Opp, and Milton Harris, Rating Agencies in the Face of Regulation, 108 Journal of Financial Economics 46 (2013). 98  See e.g. SEC (U.S.), Report on Review of Reliance on Credit Rating 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 Paper (2014).

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5.2.2╇The 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. The most important rules traditionally relate to “legal capital.”99 These 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,100 the law’s provision of such standardized terms is most functional when creditors are (relatively) homogeneous, and can coordinate (relatively) easily: in other words, when banks are the primary lenders. This 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 member states may set higher thresholds if they wish.101 Although this number is large by the standards of our other jurisdictions, which require nothing at all,102 it appears small compared to the actual capital 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.103 Moreover, all of our core jurisdictions now permit incorporation of a private company without any minimum capital requirement.104 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

99╇ In “par value” jurisdictions, legal capital is at least the aggregate nominal (“par”) value of issued shares (typically lower than the issue price), and may be extended to the entire issue price (so-╉called “share premium”). In jurisdictions permitting “no par” shares, legal capital is initially set by a company’s organizers at any amount up to the issue price of a company’s shares. 100╇Section 5.1.2. 101╇ See Art. 6 Directive 2012/╉30/EU (“Second Company Law Directive (Recast)”), 2012 O.J. (L 315) 74 (applicable to AG, SA, SpA, plc, etc). 102╇ On the U.S., see Bayless Manning and James J. Hanks, Legal Capital (4th edn., 2013). Japan abolished minimum capital requirements in its Companies Act of 2005. Similarly, Brazil imposes no minimum capital requirement. 103╇KPMG, Feasibility Study on an Alternative to the Capital Maintenance Regime Established by the Second Company Law Directive 77/╉91/╉EEC of 13 December 1976 and an Examination of the Impact on Profit Distribution of the New EU-╉Accounting Regime: Main Report (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. 104╇See Reiner Braun, Horst Eidenmüller, Andreas Engert, and Lars Hornuf, Does Charter Competition Foster Entrepreneurship? A  Difference-╉in-╉Difference Approach to European Company Law Reforms, 51 Journal of Common Market Studies 399 (2013). Italy was the last of our core jurisdictions to permit incorporation without minimum initial capital, making the change in 2013: see Art. 2463-╉II Civil Code (Italy). Proposals for a European 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 Private Limited Liability Companies, 2014/╉ 0120 (COD).

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Europe has been associated with an increase in entrepreneurship.105 Nevertheless, most entrepreneurs appear to invest some capital in newly formed firms, even in the absence of minimum capital rules.106 This finding is hard to interpret: it may indicate that the presence of capital is a rough-​and-​ready proxy for the “seriousness” of entrepreneurs, by showing that they commit a non-​trivial amount of money to their project;107 or it may simply reflect a desire to avoid potential liability for trading while insolvent.108

5.2.2.2 Distribution restrictions Company laws generally restrict distributions to shareholders—​including dividends and share repurchases—​in order to prevent asset dilution.109 Although these distribution restrictions vary across jurisdictions, the most common is on the payment of dividends which impair the company’s legal capital—​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.110 Rules restricting distributions can be viewed as an “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 their capital investment in the firm. From a debtor perspective, such an “opt-​in” has the advantage that when there are multiple 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

105 See John Armour and Douglas J. Cumming, Bankruptcy Law and Entrepreneurship, 10 American Law and Economics Review 303 (2008); Braun et al., note 104. 106  See Marco Becht, Colin Mayer, and Hannes F. Wagner, Where Do Firms Incorporate? Deregulation and the Cost of Entry, 14 Journal of Corporate Finance 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). 107 See John Hudson, The Limited Liability Company:  Success, Failure and Future, 161 Royal Bank of Scotland Review 26 (1989); Horst Eidenmüller, Barbara Grunewald, and Ulrich Noack, Minimum Capital and the System of Legal Capital, in Legal Capital in Europe, 1, 25–​7 (Marcus Lutter ed., 2006). 108  See Section 5.3.1. 109  See text to note 7. 110  For an overview of a variety of dividend restriction rules, see Brian R. Cheffins, Company Law: Theory, Structure and Operation 534–​5 (1997); Holger Fleischer, Disguised Distributions and Capital Maintenance in European Company Law, in Lutter, note 107, 94. 111 Wolfgang Schön, The Future of Legal Capital, 5 European Business Organization Law Review 429, 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, The Place for Creditor Protection on the Agenda for Modernisation of Company Law in the European Union, 3 European Company and Financial Law Review 178, 196 (2006). 112 See Yaxuan Xi and John Wald, State Laws and Debt Covenants, 51 Journal of Law & Economics 179 (2008) (firms in U.S.  states with “tighter” dividend restrictions in company law have less debt covenants in their borrowing agreements). But see also Edward B. Rock, Adapting to the New Shareholder-​Centric Reality, 161 University of Pennsylvania Law Review 1907, 1984–​6 (2012) (questioning these results by pointing out that there are no meaningful differences in dividend restrictions between states). 113  See Kanda, note 26, 440; Kahan, note 26, 609–​10.

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The 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.”114 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 legal capital—​and hence the level at which the distribution restriction is set—​without creditor consent.115 By contrast, our other jurisdictions require any reduction in legal capital to be preceded by adequate protection—​for example, a third party guarantee or veto rights—​for existing creditors.116 The efficacy of distribution restrictions also depends upon accounting methodology. While conservative accounting provides less information about the ongoing 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.117 Hence, the increasing reliance on “marking-​to-​market” in U.S. GAAP may be one of the reasons for the declining use of profit distribution covenants by U.S. publicly traded corporations.118 This, in turn, calls into question the continued utility of legal capital restrictions following the move to IFRS accounting by many listed European firms.119

5.2.2.3 Loss of capital In some jurisdictions—​particularly in Europe, but not in the 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 legal capital.120 Several European jurisdictions have adopted 114  On the UK, see Progress Property Co Ltd v Moorgarth Group Ltd [2010] UKSC 55; on Germany, see Fleischer, note 110; on the U.S., see e.g. Rock, note 112, at 1953–​6 (Delaware). For Brazil, see Art. 177, § 1º, VI Criminal Code (distribution of “fictional” dividends is a crime). There is no such extension in France and Italy: see Pierre-​Henri Conac, Luca Enriques, and Martin Gelter, Constraining Dominant Shareholders’ Self-​Dealing: The Legal Framework in France, Germany, and Italy, 4 European Company and Financial Law Review 491 (2007). 115  However, there is a residual constraint that dividends of such magnitude that they “diminish the company’s ability to pay its debts” will be held unlawful: in re Int’l Radiator Co., 92 Atlantic Reporter 255, 255 (Del. Cl., 1914). Moreover, fraudulent conveyance law restricts dividend payments by insolvent companies: see Section 5.3.1.3. 116 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). These rules are sometimes called “capital maintenance” rules in the EU and “capital unchangeability” rules in Japan. 117  See Bernhard Pellens and Thorsten Sellhorn, Creditor Protection through IFRS Reporting and Solvency Tests, in Lutter, note 107, 365; see also Schön, note 111. 118  See Joy Begley and R. Freedman, The Changing Role of Accounting Numbers in Public Lending Agreements, 18 Accounting Horizons 81 (2004); Christoph Kuhner, The Future of Creditor Protection through Capital Maintenance Rules in European Company Law—​An Economic Perspective, in Lutter, note 107, 341. 119  Ferran, note 111, 200–​15. See also Section 5.2.1.2. 120  See Art. 19 Second Company Law Directive (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, 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, the company must be put into liquidation should its net assets fall below half its legal capital (France) or, jointly, below 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 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.124 To 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 such costs can be avoided by a re­negotiation, the more heterogeneous the firm’s creditors, the less likely this will be to succeed.125

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, the creditors may have appointment rights as respects the firm’s “crisis manager” and generally have decision rights as respects its plan. These are complemented by other strategies, principally standards and trusteeship. Their application covers two phases: first, the period of transition into bankruptcy, and second the bankruptcy procedure itself.126 The relevant strategies deal largely—​but not exclusively—​with shareholder–​creditor conflicts in the first phase and creditor–​creditor conflicts in the second. The understanding that these strategies will be employed ex post necessarily influences private contracting

121  This is a balance-​sheet test, not a cash-​flow test. See note 45. 122  See Art. L.  224-​2 Code de commerce (France); Arts. 2447 and 2482–​3 Civil Code (Italy). However, Art. 182-​ VI Legge Fallimentare disapplies the obligation if the company files for reorganization. 123  §§ 15a and 19 Insolvenzordnung (Germany). However, there is an exclusion for companies which have negative net assets (“overindebtedness”), but for which the probability of continued operation is otherwise “highly likely” (§ 19(2) Insolvenzordnung). 124  See Lorenzo Stanghellini, Directors’ Duties and the Optimal Timing of Insolvency: A Reassessment of the “Recapitalize or Liquidate” Rule, in Il Diritto delle Società Oggi. Innovazioni e Persistenze 731 (Paolo Benazzo, Mario Cera, and Sergio Patriarca eds., 2011). 125  Moreover, a “guillotine” rule may simply result in (some) creditors being forced to accept less of the restructuring surplus in any renegotiation. In the out-​of-​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 at the expense of other creditors: see Alessandro Penati and Luigi Zingales, Efficiency and Distribution in Financial Restructuring: The Case of the Ferruzzi Group, Working Paper (1997), at http://​faculty.chicagobooth.edu. 126  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 of determining debt structure, and later in any renegotiation.

5.3.1 The 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 standard on persons associated with a distressed company. The ex post nature of the standards strategy means that it tends only to be employed if something has gone wrong in a lending 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” creditors. 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 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 negligence or fraud to creditors when the company is, or is nearly, insolvent.127 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”) imposes liability for negligently worsening the financial position of the insolvent 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 is likely to be facilitated if the duties are owed directly to individual creditors, and reduced for duties owed only to the company, which will be unlikely to be enforced unless the company enters bankruptcy proceedings.128 The appropriate intensity of such director liability depends on the ownership structure and/​or governance of the debtor firm.129 Shareholder–​creditor agency problems are likely to be most pronounced in firms where managers’ and shareholders’ interests are closely aligned, that is, where 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’

127  See also Chapter 3.4.1. 128  However, some jurisdictions (e.g. Delaware) permit creditors of an insolvent company to launch a derivative action: see Quadrant Structured Products Co. Ltd. v. Vertin, 115 Atlantic Reporter 3d 535 (Del. Ch., 2015). 129  See text to note 14.

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interests may over-​deter directors, resulting in less risk-​taking than would be optimal.130 Directorial liability may therefore be expected to be most useful where shareholders’ and managers’ interests are aligned. Among our jurisdictions, the lowest-​intensity standard for directorial liability to creditors is employed in the U.S. That is consistent with its long history of both dispersed ownership and managerial autonomy.131 Most U.S. states 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 There was flirtation in some states with a direct tortious claim against directors for “deepening 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.134 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 liability for directors who approved or oversaw it.135 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.136 This includes directors’ duty of care.137 The UK also imposes additional negligence-​based liability on directors for “wrongful trading,” if they fail to take reasonable care in protecting creditors’ interests once insolvency proceedings have become inevitable.138 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,139 but in some jurisdictions—​such as France and Italy—​directors can potentially be held liable simply for failing to take action following serious loss of capital.140 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

130  See also Cheffins, note 110, 537–​48; Henry T.C. Hu and Jay Lawrence Westbrook, Abolition of the Corporate Duty to Creditors, 107 Columbia Law Review 1321 (2007). 131  See e.g. Mark J. Roe, Strong Managers, Weak Owners: The Political Roots of American Corporate Finance (1994). 132  North American Catholic Education Programming Foundation v.  Gheewalla, 930 Atlantic Reporter 2d 92, 98–​102 (Del., 2007); Quadrant Structured Products, note 128. 133  See e.g. Official Committee of Unsecured Creditors v. R.F. Laffertey & Co, 267 Federal Reporter 3d 340 (3d. Circuit, 2001) (Pennsylvania). 134  Trenwick America Litigation Trust v.  Ernst & Young LLP, 906 Atlantic Reporter 2d 168, 204–​7 (Delaware Chancery, 2006). 135  Delaware General Corporation Law §174. Significantly, this negligence-​based liability is not excluded by a waiver of directors’ general duty of care under §102(b)(7). 136  West Mercia Safetywear Ltd v. Dodd [1989] 4 Butterworths Company Law Cases 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. 137  Roberts v Frohlich [2011] EWHC 257 (Ch), [2011] 2 Butterworths Company Law Cases 625. 138  Insolvency Act 1986 §§ 214, 246ZA (UK). There is also negligence-​based liability for directors who permit the company to pay an unlawful distribution: Bairstow v Queens Moat House plc [2001] EWCA Civ 712. 139  See for France, L. 225–​251 Code de commerce, as well as the much feared Art. L. 651-​2 Code de commerce (insuffisance d’actifs)—​see also text to note 155; for Germany, § 43 GmbH-​Gesetz, §§ 93 and 116 Aktiengesetz; for Italy, Art. 2394 and 2394-​II Civil Code. 140  On loss of capital, see Section 5.2.2.3. On liability, see note 151 (Germany and Italy); Art. L. 651–​2 Code de commerce (France).

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is solvent.141 Although this liability is rarely imposed on directors of publicly traded firms, it is frequently litigated in the case of closely held companies.142 The Japanese Supreme Court has also developed an oversight liability doctrine, under which non-​ executive 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,143 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 not formally change in the vicinity of insolvency.144 This, of course, does not rule out the imposition of liability if managers harm the company (and, 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 conduct (including breaches of accounting rules or fiduciary duties) by banning them from being involved in the management of a company.145 This is a further way to increase the intensity of deterrence, especially when civil liability has limited deterrence value due to directors’ wealth constraints.146 In the UK, for example, any possible misconduct must be investigated in corporate bankruptcy, with a view to initiating possible disqualification proceedings.147 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.148 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. 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. The scope of criminal provisions is much more specific in continental Europe and Brazil.149 In France, directors who act opportunistically in the vicinity of insolvency face up to five years

141  Art. 429 Companies Act. Although most suits under this 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. 142  Over a hundred cases have been published in the second half of the twentieth 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 Kinyu Shoji Hanrei 42. For the most comprehensive survey, see Kazushi Yoshihara, Commentaries to Art. 429, in Commentaries of the Companies Act, Vol.9, at 337–​419 (Shinsaku Iwahara ed., 2014) (in Japanese). 143  See Arts. 425–​7 Companies Act (Japan). 144  Arts. 153 et seq. Lei das Sociedades por Ações (Brazil). 145  See Art. L. 653-​8 Code de commerce (France); Arts. 216–​17 and 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 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). 146  Text to note 129. 147  Company Directors Disqualification Act 1986, § 7.  Since 2015, these proceedings can also impose compensation orders: ibid., §§ 15A–​15C. 148 See Insolvency Service, Enforcement Outcomes April to June 2015, Table 1; John Armour, Enforcement Strategies in UK Company Law: A Roadmap and Empirical Assessment, in Rationality in Company Law 71 (John Armour and Jennifer Payne eds., 2009). 149  See Arts. 168 et seq. Lei 11.101 of 2005.

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imprisonment.150 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, to avoid the worsening of the financial position of the company (Italy).151

5.3.1.2 Shareholders All jurisdictions offer doctrinal tools for holding shareholders liable for the debts of insolvent corporations, although the use of these tools is generally restricted to controlling or managing shareholders who “abuse” the corporate form.152 The three principal tools are the doctrine of de facto or shadow directors, equitable subordination, and “piercing the corporate veil.”153 In addition, some jurisdictions apply enhanced standards to corporate groups. The doctrine of de facto or shadow directors154 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).155 Versions of this doctrine are also applied in our other jurisdictions, apart from the U.S. and Brazil.156 The UK distinguishes between the case of solvent and insolvent subsidiaries: a parent company will expressly not 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.157 A second form of shareholder liability involves the subordination of debt claims brought by controlling shareholders against the estates of their bankrupt companies.158

150  Arts. L. 654-​1 to L. 654-​3 Code de commerce. 151 For Germany, see § 401 Aktiengesetz and § 84 GmbH, as well as Heribert Hirte, Kapitalgesellschaftsrecht 135–​6 (5th edn., 2006) (providing an overview of leading German cases). For Italy see Corte di Cassazione, Sez. V penale, 9 October 2014, No. 8863 (criminal liability if failure to take action leads to, or worsens, the company’s financial distress). France recently abolished criminal provisions of a similar content (former Arts. L. 241-​6, 1° and. L. 242-​29, 1° Code de commerce, as repealed by Loi No. 2012-​387 of 22 March 2012). 152  In Brazil, however, where veil-​piercing is broadly applied, minority shareholders are routinely held liable for labor obligations. 153  Actions might also be brought against shareholders in many jurisdictions to challenge distributions by virtue of the breach of distribution rules discussed in Section 5.2.2.2 or using fraudulent conveyance or actio pauliana powers: see Section 5.3.1.3. To the extent that the liability is negligence-​ based, it takes on the quality of a standard, although it depends for efficacy on the underlying rules restricting distributions. 154  In some jurisdictions, such as the UK, shadow directors are said to influence directors secretly, as distinguished from de facto directors who act openly as directors but are not (see e.g. Re Hydrodan (Corby) Ltd [1994] Butterworths Company Law Cases 161). We use the terms interchangeably. 155 Art. L.  651-​2 Code de commerce. See André Jacquemont, Droit des Entreprises en Difficulté, 605–​9 (8th edn., 2013). 156  See, for Germany, Bundesgerichtshof Zivilsachen 104, 44; for Italy, Corte di Cassazione, 14 September 1999, No. 9795, 27 Giurisprudenza Commerciale II 167 (2000); for Japan, Art. 429 Companies Act; for the UK, §§ 250–​1 Companies Act 2006; Secretary of State for Trade and Industry v. Deverell [2001] Chancery Division 340, 354–​5. 157  Compare Companies Act 2006 (UK) §251(3); Insolvency Act 1986 (UK) §251. 158  See generally Martin Gelter and Juerg Roth, Subordination of Shareholder Loans from a Legal and Economic Perspective, 5 Journal for Institutional Comparisons 40 (2007). Technically, subordination is a recharacterization of the shareholder’s claim from debt to equity, but the result is functionally similar to liability.

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In some jurisdictions (Germany and Brazil), major shareholders’ loans are automatically subordinated,159 whereas in other jurisdictions (Italy and the U.S.) this depends on the circumstances or conduct of the shareholder.160 The rationale is to deter over­ investment 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.161 Perhaps reflecting these difficulties, this doctrine is not applied in France or the UK.162 Finally, all our jurisdictions permit courts to “pierce the corporate veil” in extreme circumstances; that is, to 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.163 The exception to this is Brazil, where veil-​piercing is common. In no jurisdiction has veil-​piercing been directed against publicly traded companies or—​apart from in Brazil—​passive (non-​controlling) shareholders, and most successful cases involve fraud: that is, blatant misrepresentation or ex post opportunism by shareholders.164 Thus, U.S. jurisdictions permit veil-​piercing when (1) controlling shareholders disregard the integrity of their companies by failing to observe formalities, intermingling personal and company assets, or failing to capitalize the company adequately—​and (2)  there is an element of fraud or “injustice,” as when shareholders have clearly behaved opportunistically. Japan and most EU jurisdictions apply the veil-​piercing doctrine similarly, as does Brazil for adjusting creditors.165 In France, for example, insolvency procedures can be extended to shareholders that disregard the integrity of their companies (action en confusion de patrimoine).166 Brazil is unique among our jurisdictions in permitting veil-​piercing in the absence of fraud or abuse, for the benefit of certain non-​ adjusting creditors—​notably workers, consumers, and victims of environmental harm.167 159  See, for Germany, §§ 39 (subordination of loans by shareholder with >10 percent equity capital) and 135 (avoidance of repayments of such loans within one year of insolvency) Insolvenzordnung; Dirk A. Verse, Shareholder Loans in Corporate Insolvency—​A New Approach to an Old Problem, 9 German Law Journal 1109 (2008); for Brazil, Art. 83, VIII Lei 11.101 of 2005 (automatic subordination of shareholder loans). 160  Taylor v. Standard Gas and Electronic Corporation, 306 United States Reports 307 (1939); Pepper v.  Litton, 308 United States Reports 295 (1939) (U.S.:  where shareholder has “behaved inequitably”); For Italy, Art. 2467 (close companies) and Art. 2497-​II (within groups) Civil Code (where firm’s financial condition would have required an equity contribution rather than a loan). 161  See Martin Gelter, The Subordination of Shareholder Loans in Bankruptcy, 26 International Review of Law & Economics 478 (2006). 162  See, for France, Maurice Cozian et al., Droit des Sociétés 152 (28th edn., 2015); for the UK, Salomon v. A. Salomon & Co Ltd [1897] Appeal Cases 22. 163  See e.g. Prest v Petrodel Resources Ltd [2013] UKSC 34 (UK); Stephen M. Bainbridge, Abolishing Veil Piercing, 26 Journal of Corporation Law 479 (2001) (U.S.). 164 See for the U.S.: Peter B. Oh, Veil-​Piercing, 89 Texas Law Review 81 (2010); John H. Matheson, Why Courts Pierce: An Empirical Study of Piercing the Corporate Veil, 7 Berkeley Business Law Journal 1 (2010); for Germany: Uwe Hüffer and Jens Koch, Aktiengesetz (12th edn., 2016), § 1 paras 15–​33: Durchgriffslehre; for the UK: Davies and Worthington, note 86, 217–​22; for Brazil: Meyerhof Salama, note 41. In Japan, veil-​piercing is a frequently litigated issue since its first application by Supreme Court Judgment 27 February 1969, 23 Minshu 511. 165  Although German courts discuss policy considerations in veil-​piercing analyses, this has few practical implications: see Friedrich Kübler and Heinz-​Dieter Assmann, Gesellschaftrecht § 23 I  2 (6th edn., 2006). For Brazil, see Art. 50 Civil Code; for Japan, see Marco Ventoruzzo et  al., Comparative Corporate Law 175–​8 (2015). 166  Arts. L. 621–​2 (sauvegarde), L. 631–​7 (redressement judiciaire) and L. 641–​1 (liquidation judiciaire) Code de commerce (France). 167  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 for all—​with the result that 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 doctrines are also occasionally used to protect the creditors of corpor­ ate groups. In the U.S., the doctrine of “substantive consolidation” gives bankruptcy courts the power to put assets and liabilities of two related corporations into a single pool.168 Brazilian courts also have—​and very liberally employ—​this power.169 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.170 Veil-​piercing is, if anything, less common within groups of companies than it is between companies and controlling shareholders who are individuals.171 That said, a special set of creditor protection standards covers groups of companies in some jurisdictions. The German Konzernrecht provides the most elaborate example of such a law, attempting to balance the interests of groups as a whole with those of the creditors and minority shareholders of their individual members.172 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.173 Should this fail to happen, creditors of the subsidiary may challenge its indemnification claim or sue the parent’s directors for damages.174 If a controlling company has not entered into a control agreement (i.e. in a de facto group), it must compensate any subsidiaries that it causes to act contrary to those subsidiaries’ own interests.175 Should the parent fail to do so, creditors of the subsidiary may sue the parent for damages.176 168  See e.g. In Re Augie/​Restivio Baking Co, 860 Federal Reporter 2d 506 (2d Cir. 1988). See also Irit Mevorach, The Appropriate Treatment of Corporate Groups in Insolvency, 8 European Business Organization Law Review 179 (2007). 169  See e.g. In re Rede Energia S.A., Case No. 14-​10078 (SCC) (Bankr S.D.N.Y., 2014) (unsuccessfully arguing that Brazil’s liberal use of substantive consolidation violates U.S. public policy). 170  See Douglas G. Baird, The Elements of Bankruptcy 158–​66 (5th edn., 2010). 171  In the U.S., Oh, note 164, at 130–​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 Trabalho), though judicial decisions have extended a similar treatment to individual controlling shareholders. 172 See Emmerich and Habersack, note 78; for a comparative perspective, see Klaus J. Hopt, Groups of Companies: A Comparative Study of the Economics, Law, and Regulation of Corporate Groups, in The Oxford Handbook of Corporate Law and Governance (Jeffrey N. Gordon and Wolf-​ Georg Ringe eds., 2017). 173  See § 302 Aktiengesetz. For the distinction between contractual and de facto groups, see § 18 Aktiengesetz. 174  See §§ 302 and 309 Aktiengesetz (subsidiary is an AG); Emmerich and Habersack, note 78, 566–​7 (subsidiary is a GmbH). 175  See § 311 Aktiengesetz (subsidiary is an AG). Emmerich and Habersack, note 78, 535 (subsidiary is a GmbH). The same approach has been adopted in Italy: see Art. 2497 Civil Code. 176 See § 317 Aktiengesetz; Bundesgerichtshof Zivilsachen 149, 10 (Bremer Vulkan) and Bundesgerichtshof Zivilsachen 173, 246 (Trihotel ).

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German law’s focus on protecting the interests of the individual entity contrasts with the 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.177 The French focus on the “enterprise” has been perceived as having the advantage of reflecting a more functional approach,178 while the indemnification requirements of Konzernrecht seem more protective of a given subsidiary’s creditors. However, French courts take serious consideration of creditor interests when applying the equitable cooperation doctrine,179 whereas German courts have recently adopted a more balanced doctrine of “solvency threatening” parent intervention (Existenzvernichtungshaftung) for closely held firms.180 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.181

5.3.1.3 Creditors and other third parties The 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-​à-​vis the others, and in many cases, both. The 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 the debtor’s bankruptcy, and that they are required to return the benefits they received. These results are brought about under doctrines deriving from the actio pauliana in continental Europe and Brazil, fraudulent conveyance in the U.S. and Japan, and “undervalue transactions” in the UK.182 The standards strategy recruits third parties as gatekeepers by making them wary of desperate transactions entered into by a distressed debtor, whose shareholders may be engaging in asset substitution.183 The gatekeeper will only be able to rely on the transaction if they 177 This is the holding of the well-​known Rozenblum case (Cour de Cassation (Ch. Crim.) 4 February 1985, 1985 Revue des Sociétés 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, section 2.2 (2016). 178 See e.g. Report of the Reflection Group on the Future of EU Company Law (2011), 59–​65. 179  See Marie-​Emma Boursier, Le Fait Justificatif de Groupe dans l’Abus de Biens Sociaux:  Entre Efficacité et Clandestinité, 125 Revue des Sociétés 273 (2005); Report of the Reflection Group, note 178, at 63. 180 See note 176; Mathias Habersack, Trihotel—​Das Ende der Debatte?, 37 Zeitschrift für Unternehmens-​und Gesellschaftsrecht 533 (2008); Hüffer and Koch, note 164, § 1 paras. 21–​33. 181  See note 154 and text thereto. 182  See Arts. 130, 168, and 172, Lei 11.101 of 2005 (Brazil); Arts. L. 632-​1 and L. 632-​2 Code de commerce (France); § 129 Insolvenzordnung (Germany); Art. 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); §§ 238, 241, 423–​5 Insolvency Act 1986 (UK). 183 See Douglas G. Baird and Thomas H. Jackson, Fraudulent Conveyance Law and Its Proper Domain, 38 Vanderbilt Law Review 829 (1985); John Armour, Transactions at an Undervalue, in Vulnerable Transactions in Corporate Insolvency 46–​7 (John Armour and Howard N. Bennett eds., 2003).

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can show they were in “good faith,”184 or more specifically, that there were reasonable grounds for believing, at the time, that it would benefit the debtor’s business.185 The 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 creditors such as banks may be made liable as de facto directors or, if an animus societatis can be established, as partners of the insolvent firm. In some jurisdictions, such as the UK, liability attaches to any person knowingly carrying on a company’s business with the intent to defraud creditors, whereas in others, like Italy or the U.S., there is no shortage of doctrines that impose liability upon lenders who deal with insolvent firms.186 There is a real risk, however, of over-​deterrence: 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.187 Another application of the standards strategy against “insider” creditors concerns so-​called “preferential” transactions—​resulting in a particular creditor being placed in a better position than the others in the debtor’s bankruptcy. In continental European jurisdictions and Brazil, the actio pauliana may also be used to challenge such transactions,188 the principal requirement being that the creditor benefiting from it has acted in bad faith, which is presumed in some instances.189 Similarly, in Japan, the benefiting creditor must have been aware of the debtor’s insolvency.190 In the U.S. and UK, by contrast, there is no need to demonstrate any knowledge or bad faith on the part of the creditor, although the UK requires that the debtor have had some desire to favor the creditor, and the U.S. only permits transactions to be set aside up to 90 days before bankruptcy.191 The 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.192

5.3.2 Governance strategies 5.3.2.1 Appointment rights All our jurisdictions give creditors power to initiate a change in the control of the assets of a financially distressed company by triggering bankruptcy proceedings. A  single 184  See § 8(a) Uniform Fraudulent Transfer Act (U.S.) (but primary transferees have no good faith defense under Bankruptcy Code, 11 U.S. Code § 548); Art. 67 Legge Fallimentare (Italy). 185  See § 238(5) Insolvency Act 1986 (UK). 186  See, for the UK, § 213 Insolvency Act 1986; Morris v Bank of India [2005] 2 Butterworths Company Law Cases 328; for Italy, see Corte di Cassazione, 28 March 2006, No. 7029, Diritto Fallimentare II/​630 (2006) (de facto director); for the U.S., Lynn M. LoPucki and Christopher R. Mirick, Strategies for Creditors in Bankruptcy Proceedings (6th edn., 2014). 187 See for France, Cozian et  al., note 162, at 161; for Germany, § 826 BGB (“Insolvenzverschleppung”); for Italy, Corte di Cassazione SU, 28 March 2006, No. 7028, 2007 Diritto della Banca e del Mercato Finanziario 149; for the UK, see Davies and Worthington, note 86, 232–​3; for the U.S. Baird and Rasmussen, note 22. 188  See sources cited in note 182. 189 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). 190  Art. 162 Bankruptcy Act (Japan). 191  § 239 Insolvency Act 1986 (UK); Bankruptcy Code, 11 U.S. Code § 547 (U.S. The “look-​ back” period extends to one year for insiders). 192  Alan Schwartz, A Normative Theory of Business Bankruptcy, 91 Virginia Law Review 1199, 1224–​31 (2005).

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creditor can generally exercise this power by demonstrating that the debtor is insolvent in the “cash-​flow” sense—​that is, unable to pay debts as they fall due.193 The U.S., however, requires that three creditors bring a petition together.194 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.195 In most of our jurisdictions, a consequence of transition to bankruptcy is removal of the board from effective control of corporate assets, and its replacement with, or supervision by, an “administrator” or “crisis manager” to whom operational managers are accountable.196 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,197 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.198 An alternative to appointing a crisis manager is to permit the incumbent managers to remain in situ.199 This economizes on costs associated with getting an outsider up to speed with running the business, and capitalizes on any firm-​specific human capital the managers may possess. In this case, the trusteeship strategy—​in the form of court oversight—​is relied upon even more heavily to control shareholder–​creditor agency costs. “Reorganization” or “rescue” proceedings on this pattern have become more common in our core jurisdictions. For example, in reorganization proceedings under Chapter 11 of the U.S. Bankruptcy Code, board members continue in office and maintain their powers to control the company’s assets, albeit with their fiduciary duties now owed to the creditors.200 Creditors may apply to the court to appoint a trustee to take over control, or to switch the proceedings into Chapter 7—​where a trustee in bankruptcy is appointed by creditors as crisis manager.201 Japan, France, Germany, and Brazil have adopted more modest versions of the U.S. approach. In Germany, courts must allow boards to remain in control of corpor­ ate assets—​under the surveillance of a custodian—​unless there is evidence that this

193  See Arts. L. 631-​1 Code de commerce (redressement judiciaire) and L. 640-​1 and 640-​5 (liquidation judiciare) (France); § 14(1) Insolvenzordnung (Germany); Arts. 5 et seq. Legge Fallimentare (Italy); § 123(1)(e) Insolvency Act 1986 (UK); Arts. 15 and 16 Bankruptcy Act (Japan); Art. 94, I and 97, IV Lei 11.101 of 2005 (Brazil). 194  Bankruptcy Code, 11 U.S. Code §§ 303(b)(1). 195  See § 18 Insolvenzordnung (Germany); Art. L. 620–​1 Code de commerce (France: procédure de sauvegarde); Art. 160 Legge Fallimentare (Italy: concordato 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); compare Bankruptcy Code, 11 U.S. Code § 301(a) (U.S.: voluntary petition—​no requirement that debtor be financially distressed). 196  See Arts. L. 622-​1 (procédure de sauvegarde), L. 631-​9 (redressement judiciaire) and L. 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). 197  See § 56 Insolvenzordnung (Germany); Insolvency Act 1986 § 139 and Schedule B1 ¶ 14 (UK); Bankruptcy Code, 11 U.S. Code § 702 (U.S.). 198  See Arts. L.  621-​4 (procédure de sauvegarde), L.  631-​9 (redressement judiciaire) and L.  641-​ 1 (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). 199  See European Commission, Recommendation of 12 March 2004 on a new approach to business failure and insolvency, C(2014) 1500 final (the “Restructuring Recommendation”), ¶ 6. 200  Bankruptcy Code, 11 U.S. Code § 1107 (U.S.). See note 132 and text thereto. 201  Ibid., §§ 1104, 1112.

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will disadvantage creditors.202 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.203 Managers also retain their posts in reorganization proceedings in Brazil, unless they engage in proscribed conduct or the reorganization plan provides otherwise.204 And in the UK, an administrator may elect to keep the incumbent management in post, subject to his oversight.205 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.206 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. This involves agreeing a prospective restructuring or sale, which is then executed through a “pre-​packaged” insolvency process. The crisis manager’s formal appointment lasts long enough only for her to execute the agreed sale on behalf of the company. This saves both on the destruction of goodwill that occurs during formal proceedings and on the appointment costs of crisis managers.207 Such “pre-​packaged” bankruptcies have long been common in the U.S. and UK,208 and following recent reforms to facilitate their use, are growing in popularity in other jurisdictions as well.209

5.3.2.2 Decision rights In most jurisdictions, a proposal for “exit” from bankruptcy proceedings—​whether by a sale or closure of the business or a restructuring of its balance sheet—​is initiated by the crisis manager, subject to veto rights from creditors.

202  § 270 Insolvenzordnung (Germany). If this has the unanimous support of the initial creditors’ committee, then it is deemed to be beneficial to the creditors: ibid., § 270(3). 203  See Arts. 38 and 64 et seq. Civil Rehabilitation Act 1999 (simple general reorganization proceedings) and Art. 67 Corporate Reorganization Act 1952 (more formal proceedings for joint-​stock companies, amended in 2002 to introduce debtor-​in-​possession schemes) (Japan); Arts. L. 621-​4 (sauvegarde) and L. 631-​9 (redressement judiciaire) Code de commerce (France) (firms with less than 20 employees or turnover below €3,000,000: Art. R. 621-​11 Code de commerce). 204  Arts. 50 IV-​V and 64 Lei 11.101 of 2005. 205  Insolvency Act 1986 (UK) Sch B1, ¶¶ 59-​61. 206  Arts. 167 (concordato preventivo) and 27 (fallimento), Legge Fallimentare. 207  See John Armour, The Rise of the “Pre-​Pack”: Corporate Restructuring in the UK and Proposals for Reform, in Restructuring in Troubled Times: Director and Creditor Perspectives (Robert P. Austin and Fady J.G. Aoun eds., 2012), 43, 58–​60. 208  See e.g. Elizabeth Tashjian, Ronald C. Lease, and John J. McConnell, An Empirical Analysis of Prepackaged Bankruptcies, 40 Journal of Financial Economics 135 (1996) (U.S.); Sandra Frisby, A Preliminary Analysis of Pre-​Packaged Administrations (2007); Andrea Polo, Secured Creditor Control in Bankruptcy: Costs and Conflict (2012), at ssrn.com (UK). 209  See e.g. § 270b Insolvenzordnung (Germany, from 2012); Art. L. 611-​7 Code de commerce, as amended by Decree No. 2014-​326 (France). Italy allows out-​of-​court pre-​packs which are binding only to consenting creditors; a majority rule applies, however, to financial creditors: Art. 182-​II and 182-​VII Legge Fallimentare (Italy) (however, pre-​packs using “Chapter-​11”-​style reorganizations, a broad equivalent of which had been introduced in 2005, are no longer available: Art. 163-​II Legge Fallimentare, as amended in 2015). These developments were encouraged at EU level by the Restructuring Recommendation (note 199), ¶ 7. See generally Horst Eidenmüller and Kristin van Zwieten, Restructuring the European Business Enterprise:  The EU Commission Recommendation on a New Approach to Business Failure and Insolvency, 16 European Business Organization Law Review 625 (2015).

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However, exceptions include France, Italy, and the U.S., where for debtors entering “reorganization” proceedings, the restructuring plan in the first instance is proposed by the debtor.210 The 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.214 The resulting plans have consequently become more favorable to creditors over time.215 Deciding upon a plan for exiting bankruptcy also runs into problems of inter-​ creditor conflicts.216 Creditors who are in a junior class that is “out of the 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”—​that is, the assets are more than enough to pay them 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’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 either creditors who will recover in full or, in some jurisdictions, by junior creditors who are “out of the money” under the plan.217 Where the bankruptcy proceedings are “pre-​packaged”—​as we have seen, an increasingly common phenomenon218—​any necessary agreements to secure approval are obtained in advance—​including, where appropriate, a creditor vote. The agreements reached must be congruent with the decision rights available in formal proceedings, otherwise parties will have an incentive to trigger formal proceedings instead.

210  In France and Italy, this occurs in sauvegarde proceedings (Art. L. 626-​2 Code de commerce) and in concordato 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 majority of each committee of creditors: Arts. L. 626-​30-​2 and 626-​31 (sauvegarde) and L. 631-​19 (redressement judiciaire) Code de commerce, as amended in 2014. However, for corporations with less than 150 employees and turnover of less than €20m, the court retains discretion regarding the outcome of proceedings: Arts. L. 626-​9, L. 626-​34-​1, L. 631-​19, and R. 626-​52 Code de commerce. 212  Creditors holding at least 10 percent of the debtor’s debt may also propose a plan in concordato preventivo (Art. 163, as amended in 2015). 213  Bankruptcy Code, 11 U.S. Code § 1121. This may be extended by the court to 180 days. 214  David A. Skeel, Jr., Creditors’ Ball: The “New” New Corporate Governance in Chapter 11, 152 University of Pennsylvania Law Review 917 (2003). 215  See Ayotte and Morrison, note 14; Barry E. Adler, Vedran Capkun, and Lawrence A. Weiss, Value Destruction in the New Era of Chapter 11, 29 Journal of Law, Economics and Organization 461 (2013). 216  See Philippe Aghion, Oliver Hart, and John Moore, The Economics of Bankruptcy Reform, 8 Journal of Law, Economics, and Organization 523 (1992). 217 See §§ 237 Insolvenzordnung (Germany); Arts. 127 and 177 Legge Fallimentare (Italy); Schedule B1 ¶ 52 Insolvency Act 1986 (UK); Bankruptcy Code, 11 U.S. Code §§ 1126(f )–​(g) (U.S.). Compare Arts. L. 626-​30-​2 and L. 626-​32 Code de commerce (France) (vote of all creditors not being paid in full, but subject to court decision); Art. 45, § 3º Lei 11.101 of 2005 (Brazil). 218  See Section 5.3.2.1.

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5.3.2.3 Incentive strategies The 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. There seem to be two reasons for this. The first reflects basic differences in the payoffs to creditors and shareholders. The 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 fixed by their contracts.219 Instead, creditors are more concerned about the possibility of losses—​hence a reward strategy, which relies upon offering participation in upsides, does not seem an obvious fit.220 The second reason stems from the problems of inter-​creditor agency costs that arise once a firm moves under the control of its creditors. Because the value of a firm’s assets is uncertain and 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. There are two principal types of trusteeship in relation to bankrupt firms. The 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 The second significant trusteeship role in the governance of bankrupt firms is the oversight role of courts. Courts’ role is principally to act as arbiters between the many different classes of claimant in an insolvency proceeding. The more fundamental the potential conflict, the greater the role for court oversight qua trustee. France still relies perhaps most heavily on courts, entrusting 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 in France for large firms—​are not primarily responsible for making the decision how to exit formal proceedings.223 Rather, they confirm significant decisions and resolve questions and disputes arising between different classes of claimant. They also oversee decisions to sell assets.224

219  Compensation structures may, however, mitigate the asset substitution problem. See James Brander and Michel Poitevin, Managerial Compensation and the Agency Problem, 13 Managerial and Decision Economics 55 (1992); Kose John and Teresa John, Top-​Management Compensation and Capital Structure, 48 Journal of Finance 949 (1993). 220  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 Review of Finance 75 (2011); Chenyang Wei and David Yermack, Investor Reactions to CEOs’ Inside Debt Incentives, 24 Review of Financial Studies 3813 (2011). 221  On the analogy of a “trust,” see Ayerst v C&K Construction Ltd [1976] Appeal Cases 167, 176–​80. 222  See note 211 and text thereto. 223  See e.g. for Germany, § 248 Insolvenzordnung (confirmation of plan); for Japan, Patrick Shea and Kaori Miyake, Insolvency-​Related Reorganization Procedures in Japan: The Four Cornerstones, 14 University of California at Los Angeles Pacific Basin Law Review 243 (1996) (applicable to Chapter 11-​type procedures only); for the UK, Insolvency Act 1986 Schedule B1 ¶¶ 63, 68 (administrator may apply to court for directions), 70–​3 (court to authorize sale of assets subject to security), 76–​9 (extension or termination of administration proceedings); for 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 (judicial confirmation of plan despite the lack of approval by all class of creditors). 224  See e.g. Bankruptcy Code, 11 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 courts lack the high-​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.225

5.4  Ownership Regimes and Creditor Protection Corporate law in every jurisdiction supplements debtor-​creditor law in facilitating transactions between corporations and their creditors. All our jurisdictions, 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 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 variations is to describe countries’ legal regimes as being “debtor-​friendly” or “creditor-​friendly,” according to the extent to which they facilitate or restrict creditor enforcement against a financially distressed debtor.226 Thus, the U.S., and to a lesser extent, Japanese, approaches are said to be debtor-​ friendly; the UK and, to a lesser extent, German approaches are said to be creditor-​ friendly. However, the existence of different classes of creditors suggests that a binary division into pro-​creditor pro-​debtor may be too simplistic. For example, is the presence of an automatic stay of secured creditors’ claims in bankruptcy proceedings “creditor friendly”? The 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,227 this account is called into question not only by the framework similarities across jurisdictions that we document in this chapter, but also the considerable micro-​level variation in creditor rights within the civil and common law families.228 As indicated in Chapter 1, legal strategies appear to be significantly related to ownership structures, although perhaps less directly in relation to creditor rights than when it comes to the basic governance structure. Some systems’ concentration of debt finance in the hands of banks has both efficiency and distributional consequences for creditor rights, which mirror those we have seen vis-​à-​vis share ownership structure in Chapters  3 and 4.  Concentrated debt claims lower creditors’ coordination costs, 225  See Edward R. Morrison, Bankruptcy Decision Making:  An Empirical Study of Continuation Bias in Small-​Business Bankruptcies, 50 Journal of Law and Economics 381 (2007); Régis Blazy, Bertrand Chopard, Agnès Fimayer, and Jean-​Daniel Guigou, Employment Preservation vs. Creditors’ Repayment Under Bankruptcy Law:  The French Dilemma? 31 International Review of Law & Economics 126 (2011). 226  See e.g. Julian R. Franks, Kjell G. Nyborg, and Walter N. Torous, A Comparison of U.S., UK, and German Insolvency Codes, 25 Financial Management 86 (1996); Sefa Franken, Creditor-​ and Debtor-​Oriented Corporate Bankruptcy Regimes Revisited, 5 European Business Organization Law Review 645 (2004). 227  See Djankov et al., Private Credit, note 81. 228  See Erik Berglöf, Howard Rosenthal, and Ernst-​Ludwig von Thadden, The Formation of Legal Institutions for Bankruptcy: A Comparative Study of Legislative History, Working Paper (2001), at vwl. uni-​mannheim.de; John Armour, Simon Deakin, Priya Lele, and Mathias Siems, How Do Legal Rules Evolve? Evidence from a Cross-​Country Comparison of Shareholder, Creditor and Worker Protection, 57 American Journal of Comparative Law 579, 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.229 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 for solvent 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 accounting principles and legal capital rules. The U.S.  has taken the opposite approach, having adopted market-​oriented disclosure requirements 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. The traditional approach of German—​and to a lesser extent, Italian—​law complements a typical capital structure in which firms’ debt finance is largely raised from banks. If debt is “concentrated”—​both at the firm and country level—​in the hands of these institutions, this makes creditor co​ordination relatively straightforward. In turn, this facilitates both monitoring and—​where necessary—​renegotiation. Under these circumstances, the drawbacks of standard terms are minimized,230 but their potential benefits remain. More generally, because concentrated debt facilitates creditors’ response to shareholder–​creditor agency costs, it complements concentrated share ownership, which otherwise tends to increase these costs.231 In the U.S., by contrast, banking 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 co​ordination costs, and reducing the advantages of one-​size-​fits-​all standard terms. Consequently, creditors derived few benefits from firms’ adherence to such provisions, but debtors still bore their costs. This 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 banks) allows for a more relaxed approach to the mandating of standard terms. While the UK and Japan, like the U.S., have relatively dispersed share 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. This has been associated with a greater use of mandatory standard terms than in the U.S.

229  See Luca Enriques and Jonathan R. Macey, Creditors Versus Capital Formation: The Case Against the European Legal Capital Rules, 86 Cornell Law Review 1165, 1202–​3 (2001); see also Bruce G. Carruthers and Terence C. Halliday, Rescuing Business: The Making of Corporate Bankruptcy Law in England and the United States (1998). 230  Discussed in text to notes 23–​8. 231  See John Armour, Brian R. Cheffins, and David A. Skeel, Corporate Ownership Structure and the Evolution of Bankruptcy Law: Lessons from the United Kingdom, 55 Vanderbilt Law Review 1699 (2002); Jan Mahrt-​Smith, The Interaction of Capital Structure and Ownership Structure, 78 Journal of Business 787 (2005). 232  Roe, note 131, at 54–​9. 233 See e.g. Brian R. Cheffins, Corporate Ownership and Control:  British Business Transformed (2008).

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However, as we saw in Chapters  1 and 3, patterns of share ownership are shifting in many jurisdictions. The gradual fragmentation of share ownership in large German companies—​because it increases shareholders’ coordination costs—​will tend to reduce concerns about 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 agency costs.234 Yet on the analysis above, the implications of changes in share ownership for corporate law’s protection of creditors depends on the structure 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.235 Indeed, the change in debt finance has been at least as significant as the changes in share ownership.236 This shift appears to have been accelerated by the aftermath of the financial crisis, which saw tightening of capital controls—​and consequent reduction in credit supply—​at many banks.237 As a response to this reduction, the European Commission is launching a battery of policy proposals, known as the “Capital Markets Union,” designed to deepen capital market finance for both debt and equity.238 Increased creditor heterogeneity and coordination costs make the standard “creditor terms” less useful, and more likely to cause hindrance. Thus, it seems broadly functional that strongly pro-​creditor European measures such as minimum capital, historic cost accounting, and vigorous pro-​creditor duties for directors should have been slightly relaxed in recent years. However, the inverse development—​that is, growth of bank financing at the expense of debt markets—​has not occurred in the U.S. As a consequence, while more concentrated shareholders may increase shareholder–​creditor agency costs, the ability of creditors to coordinate so as to make effective use of “creditor terms” still remains low. This 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 The 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 “workout.”239 However, as the dispersion of creditors increases, so does the difficulty of achieving a private solution, and it becomes increasingly valuable to have

234  Rock, note 112. 235  See e.g. Deutsche Bank, Corporate Bond Issuance in Europe: Where Do We Stand and Where Are We Heading? 31 January 2013. 236  The majority of large European firms are still not widely held: see Julian Franks, Colin Mayer, Paolo Volpin, and Hannes Wagner, The Life Cycle of Family Ownership:  International Evidence, 25 Review of Financial Studies 1675, 1689 (2012) (37  percent of largest 1,000 firms in each of France, Germany, and Italy widely held; 74 percent in the UK). 237  See e.g. Fiorella De Fiore and Harald Uhlig, Corporate Debt Structure and the Financial Crisis, ECB Working Paper No 1759 (2015). 238  European Commission, Action Plan on Building a Capital Market Union, COM(2015) 468 final (2015). 239  In such a milieu, the absence of any governance strategies in bankruptcy law geared towards the continuation—​as opposed to the closure—​of a distressed firm can actually serve to increase the chances of a successful workout. The 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.240 As we have seen, Chapter  11 of the U.S. Bankruptcy Code gives managers of distressed companies discretion to orchestrate a 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 more on bonds and less on bank debt—​than was the case in other jurisdictions.241 This corresponded with an environment in which banks were fragmented, and consequently posed no real opposition to the passage of the “manager-​friendly” bankruptcy code in 1978.242 The 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.243 This has corresponded to a strong, concentrated, banking sector, with relatively low use of bonds, as opposed to bank, finance.244 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 creditors unwilling to negotiate ex post. Bankruptcy has, in this environment, tended to be reserved for more severe failures—​an outcome reflecting the interests of both the debtor’s institutional owners and its banks.245 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, but with greater state involvement. However, these 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 led by hedge 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.246 240 See Viral V. Acharya, Rangarajan K. Sundaram, and Kose John, Cross-​Country Variations in Capital Structures: The Role of Bankruptcy Codes, 20 Journal of Financial Intermediation 25 (2011). 241  See e.g. Jenny Corbett and Tim Jenkinson, How is Investment Financed? A Study of Germany, Japan, the United Kingdom and the United States, 65 (Suppl.) Manchester School 69, 74–​5, 80–​1, 85 (1997); William R. Emmons and Frank A. Schmid, Corporate Governance and Corporate Performance, in Corporate Governance and Globalization 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”). 242  See Roe, note 131; on banks’ weak opposition to the 1978 Act, see Carruthers and Halliday, note 229, at 166–​94; David A. Skeel, Jr., Debt’s Dominion 180–​3 (2001). 243  See Armour and Frisby, note 53. 244  See Peter Brierley and Gertjan Vleighe, Corporate Workouts, the London Approach and Financial Stability, 7 Financial Stability Review 168, 175 (1999). 245  See Stijn Claessens and Leora F. Klapper, Bankruptcy Around the World:  Explanations of Its Relative Use, 7 American Law and Economics Review 253, 262 (2005) (U.S.  bankruptcy rate—​proportion of firms filing for bankruptcy 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 percent, and Japan 0.22 percent). 246  See e.g. Mehnaz Safavian and Siddharth Sharma, When Do Creditor Rights Work?, 35 Journal of Comparative Economics 484, 500–​2, 506–​7 (2007); Kenneth Ayotte and Hayong Yun, Matching Bankruptcy Laws to Legal Environments, 25 Journal of Law, Economics & Organization 2 (2009); Mark J. Roe and Federico Cenzi Venezze, A Capital Market, Corporate Law Approach to Creditor Conduct, 112 Michigan Law Review 59 (2013).

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6 Related-​Party Transactions 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 shareholders. This chapter centers upon a straightforward technique for value diversion: related-​ party 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 and managerial compensation—​and transactions in which related parties may appropriate value belonging to the corporation—​the taking of corporate opportunities and trading in the company’s shares.1 In traditional 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. 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, are unavoidable for companies and thus less suspect. Nevertheless, as hinted at in Chapter 3, there is an obvious risk of collusion among senior managers 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.4 Similarly, when trading in the

1  See Robert C. Clark, Corporate Law 141–​5 (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, Pay Without Performance 25–​7 (2004). 3  See e.g. Jacob Kastiel, Executive Compensation in Controlled Companies, 90 Indiana Law Journal 1131 (2015). 4  A famous example is the personal acquisition of Pepsi-​Cola by the executive of another beverage company. See Guth v. Loft, Inc., 5 Atlantic Reporter 2d 503 (Delaware Supreme Court 1939). The Anatomy of Corporate Law. Third 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 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 corporate information (so-​called 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 transactions fall under the broader category of “tunneling,”5 which covers all forms of misappropriation of value (assets, cash flows, or the company’s equity itself ) by corporate insiders.6 We deal with other, more specialized forms of tunneling in later chapters, including tunneling associated with significant corporate actions, such as parent-​subsidiary mergers and freeze-​outs of minority shareholders (Chapter 7), the extraction of private benefits in connection with control transactions (Chapter  8), and misappropriation arising from securities fraud other than insider trading (Chapter 9).

6.1  Why Are Related-​Party Transactions Permitted at All? As a threshold matter, we must ask why related-​party transactions are permitted at all, given their vulnerability to abuse by corporate insiders. Consider first traditional 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 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 the profitability of the corporate opportunity—​better than an unrelated but distrustful 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 shares. Equally important, per se prohibitions of related-​party transactions may not accomplish much. They are unlikely to reduce the incentives to engage in one-​shot expropriations of firm assets (“steal-​and-​run transactions”), these being in any event unlawful under general private or criminal law. They are arguably unnecessary for more modest forms of abusive 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 transactions would just push insiders into using other tunneling techniques. 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 5  See Simon Johnson, Rafael La Porta, Florencio Lopez-​de-​Silanes, and Andrei Shleifer, Tunneling, 90(2) American Economic Review 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).” 6 See Vladimir Atanasov, Bernard Black, and Conrad S. Ciccotello, Law and Tunneling, 37 Journal of Corporation Law 1 (2011).

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corporate theft.7 This explains why jurisdictions permit related-​party transactions even when conflicts of interests are especially acute because of the dispersion of shareholder ownership or the use of control-​enhancing mechanisms, such as pyramids and dual class shares.8

6.2  Legal Strategies for Related-​Party Transactions All jurisdictions, however, subject related-​party transactions to legal constraints.9 Corporate laws resort to a wide range of legal strategies to constrain 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 transactions.10

6.2.1 The affiliation strategy 6.2.1.1 Mandatory disclosure Mandatory disclosure that alerts shareholders and the market to related-​party transactions is an intuitively effective control against expropriation by managers or controlling shareholders. The 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’ independence, as they will act more assertively if they know the 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, compensation contracts, or trading in shares, although one can think of situations in which beneficial related-​party transactions would only be entered into if they could be kept confidential. At the same time, mandatory disclosure may lead to over-​enforcement:  enforcement actors will be more likely to challenge even legitimate 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’s legality.12

7  See Luca Enriques, Related Party Transactions: Policy Options and Real-​World Challenges (with a Critique of the European Commission Proposal), 16 European Business Organization Law Review 1, 14 (2015). 8  See Chapter 4.1.1. 9  See Zohar Goshen, The Efficiency of Controlling Corporate Self-​Dealing: Theory Meets Reality, 91 California Law Review 393 (2003). 10  For instance, shareholders dissatisfied with executive compensation decisions often withhold support from members of compensation committees. 11  See e.g. Bernard S. Black, The Core Fiduciary Duties of Outside Directors, 2001 Asia Business Law Review 3, 10. 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 transactions, managerial compensation, and trading in the company’s shares, the regulatory intensity varies. Let us start with 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 These 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.”14 U.S. Generally Accepted Accounting Principles (“‘U.S.-​GAAP”) complement this requirement by imposing annual disclosure of all “material” transactions between the company and its officers, directors, or controlling shareholders.15 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 transactions. Under International Financial Reporting Standards (IFRS),16 EU listed companies have to disclose annually any transaction with directors, senior executives, and controlling shareholders.17 Similarly to the U.S., however, non-​“material” transactions can be omitted.18 In addition, similar transactions can be disclosed in aggregate form.19 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 related-​ party transactions that have not been concluded under “normal” market conditions.20 Some member states impose further disclosure requirements. Single firm accounting standards are converging towards IFRS in many of them.21 In addition, UK listed companies must circulate a form (circular) prior to entering into material related-​party transactions.22 Italy, like Brazil,23 requires listed firms to disclose large related-​party transactions within seven days.24 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. 14  SEC Regulation S-​K, Item 404 (applying more precisely to any shareholder with more than 5 percent of any class of the voting securities). 15  See Statement of Financial Accounting Standards (SFAS) 57, Related Party Disclosure. 16  Regulation 1606/​2002 on the Application of International Accounting Standards, 2002 O.J. (L 243) 1. 17  See International Accounting Standard (IAS) 24 (part of the International Financial Reporting Standards). Art. 5(4) Transparency Directive (Directive 2004/​109/​EC, 2004 O.J. (L 390) 38) provides for half-​yearly disclosure of “major related parties transactions.” 18  See IAS 1, para. 31 (“An entity need not provide a specific disclosure required by an IFRS if the information is not material”). 19  IAS 24, para. 24. 20  Arts. 17(1)(r) and 28 Directive 2013/​34/​EU, 2013 O.J. (L 182) 19. It is up to member states to decide whether disclosure can be limited to transactions that have not been concluded under “normal” market conditions. The 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 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/​EU. 21 See European Commission, Report on the Operation of IAS Regulation 1606/​2002 COM (2008) 215 Final (2008), at www.ec.europa.eu. 22  See Listing Rules, section 11.1.7 (non-​routine transactions, other than smaller ones, by listed firms); §§ 188–​226 Companies Act 2006 (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. 24  See Art. 5 Commissione Nazionale per le Società e la Borsa (Consob) Regulation on Related Party Transactions (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,25 statutory corporate law goes little further than the EU requires even in the context of corpor­ate groups: while parent companies must disclose the share of their profits and losses that is attributable to their subsidiaries taken as a whole,26 Konzernrecht limits the information rights of minority shareholders in these subsidiaries to an audited summary of the legally required annual report on intra-​group transactions (Abhängigkeitsbericht).27 In Japan, all companies are required to disclose details of their transactions with directors, officers, or third parties acting on their behest.28 Japanese accounting regulations complement these disclosure mandates by requiring companies to list material transactions with controlling shareholders.29 Jurisdictions have also broadly converged in requiring disclosure of individual managers’ 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.30 European Union rules are more lenient, because IFRS impose annual disclosure of aggregate 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 jurisdictions remuneration disclosure practices are closing the gap with traditionally more detailed U.S. and UK ones.33 Japan has recently reformed its 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/​EC as regards the encouragement of long-​term shareholder engagement, Directive 2013/​34/​EU as regards certain elements of the corporate governance statement and Directive 2004/​109/​EC (hereinafter, the Proposed Directive), would similarly impose ad hoc disclosure of larger related-​party transactions. 25  See section 5.5.3 Corporate Governance Code. Likewise, the management board has to inform the supervisory board about its own conflicts of interest. See section 4.3.4, ibid. 26  § 307(2) Handelsgesetzbuch (HGB). 27  § 312(1) and (3) Aktiengesetz (AktG). The annual report mentioned in the text, itself not available to shareholders or the public, has to comprise all of the intra-​group transactions and is subject to the company auditor’s control. See also Chapter 5.2.1.3. 28  Art. 118(v) Ministerial Ordinance for the Enforcement of the Companies Act, Arts. 98(1)(xv) and 112 Ministerial Ordinance for the Accounting of Companies. 29  Accounting Standards Board of Japan (ASBJ), Disclosure of Related Party Transactions (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. 30  SEC Regulation 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, 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/​EC and 2005/​162/​EC as regards the regime for the remuneration of directors of listed companies, 2009 O.J. (L 120) 28 (EU); Art. L. 225-​102-​1 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 Consob Regulation on Issuers (Italy); sections 420–​1 Companies Act 2006 (UK). 33  See Roberto Barontini et al., Directors Remunerations Before and After the Crisis: Measuring the Impact of reforms in Europe, in Board and Shareholders in European Listed Companies 251, 276–​9 (Massimo Belcredi and Guido Ferrarini eds., 2013).

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limited to executives earning ¥100 million or more a year.34 This 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 threshold.35 Brazilian 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, though some executives have challenged the latter mandate as an unconstitutional violation of their fundamental right to privacy and personal security.36 Individualized compensation disclosure may actually have unintended consequences. Because prospective CEOs insist on 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.37 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. The U.S., Italy, and Japan require officers, directors, and large shareholders (typically above 10 percent) of a listed company to disclose transactions in the company’s shares.38 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.39 There has thus been substantial convergence in the treatment of related-​party transactions in listed companies and that trend is likely to continue in coming years. Many jurisdictions are subjecting their major firms to IFRS and regulators everywhere are tightening their supervision of the reporting of insider trades. Even more importantly, auditors around the world are tightening their scrutiny of transactions that may reflect asset diversion or profit manipulation. To begin with, the International Standards on Auditing, a set of non-​binding principles on how to conduct audits issued by the International Federation of Accountants, require auditors to pay special attention to related-​party transactions.40 In addition, many jurisdictions have adopted statutory provisions that strengthen precisely this mandate.41 And the growing use of firm-​wide auditing standards by Big Four 34 Cabinet Office Ordinance on Disclosure of Corporate Affairs, Form 2 (Precautions for Recording (57)d) and Form 3 (Precautions for Recording (37)). 35 See Robert J. Jackson, Jr. and Curtis J. Milhaupt, Corporate Governance and Executive Compensation: Evidence from Japan, Columbia Business Law Review 111, 156 (2014). 36 Most companies have however complied with these regulations. See Mariana Pargendler, Corporate Governance in Emerging Markets, in Oxford Handbook of Corporate Law and Governance (Jeffrey N. Gordon and Wolf-​Georg Ringe eds., 2017). 37  For a theoretical model, see Rachel M. Hayes and Scott Schaefer, CEO Pay and the Lake Wobegon Effect, 94 Journal of Financial Economics 280 (2009). 38 § 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). 39  In the EU, see, for managers, Art. 19 Market Abuse Regulation 596/​2014, 2014 O.J. (L 173) 1; for shareholders, Art. 9 Transparency Directive 2004/​109/​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, 50 percent and 2/​3, or 75 percent 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). 40  See International Standard on Auditing 550. 41  Art. 149-​50 Consolidated Act on Financial Intermediation; Art. 2391-​II Civil Code (Italy); § 313 AktG (Germany; and see also Section 5.2.1.3); Art. L. 225-​40 Code de commerce (France); Art. 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.42 When it comes to ex post 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, 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 their shares in a U.S. stock market, thus bonding to more stringent securities laws.43 Nevertheless, the limited extraterritor­ ial effects of U.S.  securities laws mean that investors who acquire shares of cross-​ listed firms outside of the U.S. may be left without a remedy in case of disclosure violations.44 The law on the books and in action is less comparable for non-​listed companies. While U.S. law does not impose mandatory disclosure requirements on non-​public companies, they tend to reveal related-​party transactions through voluntary compliance with U.S. GAAP.45 In Europe, Brazil, and Japan, on the other hand, it is difficult to tell whether larger non-​listed firms disclose material self-​dealing transactions and unclear whether smaller firms voluntarily reveal such information, especially in countries with a single set of accounts for corporate and tax law purposes.46 As an aid to private enforcement against abusive related-​party transactions, 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 ones.47 These court-​appointed experts are a means for shareholders to obtain information needed to challenge unfair self-​dealing. This 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. But while this information-​ gathering mechanism is of increasing importance in France and Germany, it seems less effective elsewhere.48 On the other hand, U.S. law not only is favorable to plaintiffs 42  See Yasuyuki Fuchita, Financial Gatekeepers in Japan, in Financial Gatekeepers, Can they Protect Investors? 13, 23–​9 (Yasuyuki Fuchita and Robert E. Litan eds., 2006); John C. Coffee Jr., Gatekeepers: The Professions and Corporate Governance 89–​93 (2006). 43  For a review of the literature on dual listing and the “bonding hypothesis,” see Olga Dodd, Why Do Firms Cross-​list Their Shares on Foreign Exchanges? A Review of Cross-​Listing Theories and Empirical Evidence, 5 Review of Behavioral Finance 77 (2013). 44 See Érica Gorga, The Impact of the Financial Crisis on Nonfinancial Firms:  The Case of Brazilian Corporations and the “Double Circularity” Problem in Transnational Securities Litigation, 16 Theoretical Inquiries in Law 131 (2015). After the U.S. Supreme Court decision in Morrison v. National Australia Bank, 561 United States Reports 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-​à-​vis domestic investors. 45  See American Institute of Certified Public Accountants, Private Company Financial Reporting Task Force Report 8 (2005) (many private companies prepare their financial statements in accordance with U.S. GAAP). 46  See Chapter 5.2.1.1. 47  See e.g. § 142 AktG (Germany). 48  See, for France, Maurice Cozian et al., Droit des sociétés 249 (28th edn., 2015) (high number of petitions to designate an expert de gestion); for Germany, Gerald Spindler, in Aktiengesetz Kommentar (Karsten Schmidt and Marcus Lutter eds., 3rd edn., 2015) § 142 para 7 (same). Compare, for the UK, Paul L. Davies and Sarah Worthington, Gower and Davies Principles of

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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.”49 Japanese law grants both of these rights (designation of special auditor and inspection of company’s books and records) to shareholders holding 3 percent or more of shares or voting rights.50 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.”51

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, most of our major jurisdictions give the minority a right to force a corporate dissolution.52 This exit strategy, however, is limited to closely held companies and, even in that context, actual dissolution is rare: courts tend to protect the going-​concern value of companies by encouraging or requiring their controllers to buy out minority shareholders.53 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 as a response to the procedural and evidentiary hurdles generally plaguing plaintiffs.54 In practice, then, minority 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. Modern Corporate Law 673 (9th edn., 2012); for Italy, Luca Enriques, Scelte Pubbliche e Interessi Particolari nella Riforma del Diritto Societario, 2005 Mercato Concorrenza Regole 145, 170 (the 2003 corporate law reform emasculated a similar protection tool). For a comparative law discussion, see Forum Europaeum Corporate Group Law, Corporate Group Law for Europe, 1 European Business Organization Law Review 165, 207–​17 (2000). 49  Delaware GCL § 220; for more details, see William T. Allen, Reinier Kraakman, and Guhan Subramanian, Commentaries and Cases on the Law of Business Organization 167–​8 (4th edn., 2012). 50  Arts. 358 and 433 Companies Act (Japan). 51  Art. 105 Lei das Sociedades por Ações. 52  Art. 1844-​7 Code Civil (France); § 61 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); section 122(1)(g) Insolvency Act 1986 (UK); § 14.30(2) RMBCA; § 40 Model Statutory Close Corporation Supplement (U.S.). No such right exists under Italian law. 53 See, for France, Cozian et al., note 48, at 274–​5 (courts do not grant dissolution lightly); for Germany, Detlef Kleindiek, § 61 No. 8, in GmbH-​Gesetz Kommentar (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 (the unfair prejudice remedy has crowded out winding-​up petitions). 54  The mere allegation of a breach of affectio societatis (the will to be part of a common organization) seems to suffice. See e.g. STJ, ERESP 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 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 4.55 In some European countries, minority shareholders are also protected by 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 “disguised” or “hidden” and, therefore, unlawful distributions,56 but rarely are such cases litigated outside bankruptcy. Most jurisdictions, however, enlist the board to review at least some conflicted transactions, which we can categorize as a trusteeship strategy at least wherever boards are independent or the law disqualifies non-​independent directors from deciding on the transaction.

6.2.2.1 Letting the board decide One way to screen related-​party transactions is to require internal decision-​makers with no interest in the matter, or even better, independent from the related party, to approve the transaction. Most commonly, this means requiring the board to resolve on the transaction without the vote of the interested 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 transactions will likely be approved and thereby, in some jurisdictions, insulated from outside attack;57 third, disinterested directors may well raise questions at least about suspect related-​party transactions. The 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 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. The involvement of boards in the approval of related-​party transactions can come in many shapes. In increasing order of prophylactic potential, jurisdictions may, first of all, require that the board to be informed about related-​party transactions58—​ which amounts to implicitly subjecting them to a weak form of board authorization or ratification. Second, they may require or strongly encourage explicit board approval of at least some related-​party transactions. Third, they may require board approval and require the related party, its affiliates or more generally interested directors to abstain from voting. Finally, it may grant a veto power or exclusive decision-​ making power to independent directors or a committee exclusively only comprised of them.

55  See Chapter 4.1.3.2. 56  See Holger Fleischer, Disguised Distributions and Capital Maintenance in European Company Law, in Legal Capital in Europe 94 (Marcus Lutter ed., 2006). 57  See Robert B. Thompson and Randall S. Thomas, The Public and Private Faces of Derivative Law Suits, 57 Vanderbilt Law Review 1747, 1787 (2004). 58  See Corporate Governance Code § 4.3.4 (Germany); Art. 2391 Civil Code (Italy); section 177 Companies Act 2006 (UK).

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Whether explicitly or implicitly, all jurisdictions impose, or strongly encourage, some form of board approval of at least some self-​dealing transactions.59 For instance, under UK law, listed companies’ boards de facto approve all related-​party transactions that have to be submitted to a shareholder vote,60 but for non-​listed companies such approval is limited to a subset of them, namely substantial property transactions and credit transactions with directors.61 By contrast, French and Japanese laws mandate disinterested board authorization for all non-​routine transactions between a company and its directors, general managers or, in the case of France, major shareholders.62 In Italy, in turn, additional rules applying to listed companies heavily rely on independent directors. They require that a committee of independent directors provides its own advice on the related-​party transaction, which the board then has to vote on: the advice is 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.63 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 merger.64 Similarly, the best practice of obtaining approval by an independent special committee is also gaining ground in Japan in the context of freeze-​out and M&A transactions involving controlling shareholders.65 Although U.S. jurisdictions stop short of mandating board approval of managerial self-​dealing, they strongly encourage it. State law creates incentives for interested managers to seek board approval by according transactions that are authorized (or ratified) by the board business judgment rule protection.66 Board approval also plays a crucial

59  Italian law mandates board approval merely for self-​dealing transactions in which directors otherwise having the authority to decide on them are self-​interested. Art. 2391 Civil Code. German requirements mainly apply to lending to, and significant services provided by, supervisory board 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 ZR 48/​11 (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 “important” transactions with persons they are close to. Brazilian law only requires board approval (as an alternative to shareholder approval) for corporate loans to directors and officers, and for the use of company assets or services. Art. 154, § 2°, b Lei das Sociedades por Ações. 60  See Chapter 6.2.3. 61  See sections 188–​226 Companies Act 2006 (also covering payments for loss of office and longterm service contracts). 62  For France, see Arts. L. 225-​38 (one-​tier board) and L. 225-​86 (two-​tier board) Code de commerce (also applicable to third parties acting for directors or general managers) and Arts. L. 225-​39 and L. 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, Les conflits d’intérêts dans la société anonyme 120 (2nd edn., 2004). For Japan, see Arts. 356(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, 656 Hanrei Jiho 85. 63  Arts. 7–​8 Consob Regulation on Related Party Transactions. 64  CVM Advisory Opinion No. 35 (2008). 65  See Chapter 7.4.1.2. 66 See § 8.31 Model Business Corporation Act; Flieger v.  Lawrence, 361 Atlantic Reporter 2d 218 (Delaware Supreme Court 1976); Kahn v. Lynch Communications Systems, Incorporated, 638 Atlantic Reporter 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” 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.67 But while this may be de facto necessary to pass the “entire fairness” test applied by Delaware courts,68 it may not be sufficient, as Delaware courts tend to look at a wider range of facts.69 In the context of going-​private mergers with controlling shareholders, recent case law appears to have strengthened Delaware 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-​functioning special committee of the board and by a majority of minority shareholders.70 It is, 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.71 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 post-​financial crisis reforms.72 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.73 At the same time, judges tend to defer to boards’ decision-​making on compensation matters even more than for other related-​party transactions. Board approval of executive compensation is unlikely to be successfully questioned in the U.S., which otherwise strictly

67  See Allen et al., note 49, at 323; Kahn v. Lynch Communications Systems, note 66; Weinberger v. UOP, Inc., 457 Atlantic Reporter 2d 701 (Delaware Supreme Court 1983). 68  See Chapter 6.2.5.2. 69  On the intricacies of Delaware case law on procedural fairness in parent-​subsidiary transactions, see William J. Carney and George B. Shepherd, The Mystery of Delaware Law’s Continuing Success, 2009 University of Illinois Law Review 1. 70  Kahn v. M & F Worldwide Corp., 88 Atlantic Reporter 3d 635 (Delaware Supreme Court 2014). 71  See § 8.11 Model Business Corporation Act (U.S.); § 87 AktG (Germany); Art. 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 Table 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, L. 225-​46, L. 225-​63, L. 225-​83, and L. 225-​84 Code de commerce (France). Brazil is again distinctive in this regard, as its shareholder-​centric model of corporate governance has long attributed the determination of aggregate executive compensation to shareholders. Art. 152 Lei das Sociedades por Ações. 72 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 Oxford Handbook of Corporate Law and Governance, note 36. 73  See Chapter 3.3.

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polices related-​party transactions.74 And even in 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.75 Things 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.”76 Finally, jurisdictions increasingly encourage their managers to obtain board approval 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.77 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 sociaux or violation of the duty of loyalty) in France.78

6.2.3 The decision rights strategy: Shareholder voting As an alternative or complement to disinterested board approval of related-​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 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.79 No jurisdiction mandates across-​the-​board shareholder approval for related-​party transactions, not even with controlling shareholders. This is because doing so might be excessively cumbersome, especially for companies that are integrated into groups, where such transactions can be very frequent. 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, the decision will be made by a minority that may well lack information or hold out opportunistically.

74  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. Templeton, 114 Atlantic Reporter 3d 563 (Del. Ch. 2015). See also Chapter 3.3.2 for an account of the deployment of the business judgment rule in the Disney case. 75  § 87 AktG (supervisory board approval for compensation of executives that are members of the Vorstand). See also Chapter 3.3.2 for an account of the (quite unusual) Mannesmann case. 76 § 87 AktG. See also Klaus. J. Hopt, Conflict of Interest Secrecy and Insider Information of Directors—​A Comparative Analysis, 10 European Company and Financial Law Review 167, 181 (2013) (noting that the reform is plagued by “many doctrinal and practical difficulties”). 77  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). 78  See, for Germany, Thomas E. Abeltshauser, Leitungshaftung im Kapitalgesellschaftsrecht 373 (1998); Art. 2391(5) Civil Code (Italy); Art. 155 Lei das Sociedades por Ações (Brazil); for France, see Cozian et al., note 48, at 164, 186, and 373 (causing the loss of a profit opportunity is potentially abusive). 79  See Chapter 1.2.4.

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“Majority of the minority” shareholder approval is a well-​established institution in the U.S. and UK,80 two jurisdictions in which large companies 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 and M&A transactions with controlling shareholders, as a result of Delaware influence.81 In Brazil, the question of whether a conflicted controlling shareholder can vote to approve a related-​party transaction is controversial and remains unsettled.82 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 of executive compensation to shareholder approval.83 All jurisdictions also grant shareholders a binding (in the UK, Japan, and Brazil) or advisory vote on executive compensation packages (a regime known as “say on pay”).84 Moreover, U.S. stock exchanges require a shareholder vote on all equity compensation plans whereas some states mandate shareholder approval of stock option plans.85 In the EU, most member states have adopted rules on prior shareholder approval of share-​based incentive schemes (Germany, Italy, and the UK being the most demanding by mandating such a vote without limitations).86 Beyond the realm of executive compensation, the UK, followed by France, appears to be most inclined to give shareholders a say on related-​party transactions. The UK mandates ex ante shareholder approval for large non-​routine transactions with directors and large shareholders of listed companies.87 If controlled companies that have a premium listing fail to comply with the terms of the required “relationship agreement” with its controlling shareholders, ex ante approval by minority shareholders will be required for any transaction with the controlling shareholder.88 For other companies, the Companies Act requires shareholder approval of some transactions with directors, in particular substantial property transactions and credit transactions.89 French

80  On Delaware law see e.g. Leo E. Strine, Jr., The Delaware Way: How We Do Corporate Law and Some of the New Challenges We (and Europe) Face, 30 Delaware Journal of Corporate Law 673, 678 (2005). 81  See Mori, Hamada, and Matsumoto, M&A-​ho Taikei [Comprehensive Analysis of M&A Laws of Japan] 761–​6 (2015) (in Japanese). 82  The 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 mergers. Art. 264 Lei das Sociedades por Ações. 83  See §§ 113 and 120(4) AktG (Germany); Arts. L 225-​45, L. 225-​53, L. 225-​63, and L. 225-​ 83 Code de commerce (France); Arts. 2389 Civil Code and 114–​II Consolidated Act on Financial Intermediation (Italy); Art. 361(1) Companies Act (Japan). 84  In Japan and Brazil, however, shareholders must only approve aggregate (rather than individual) executive compensation packages. The 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). 85 See § 303A.08 New  York Stock Exchange Listing Rules; Jeffrey N. Gordon, Executive Compensation:  If There’s a Problem, What’s the Remedy? The Case for “Compensation Discussion and Analysis”, 30 Journal of Corporation Law 675, 699 (2005). Moreover, Section 162(m) of the Internal Revenue Code conditions the tax deductibility of performance-​based compensation on shareholder approval of the material terms of the compensation plan. 86 See Commission Staff Working Document, Report on the application of the Commission Recommendation on directors’ remuneration (2007) 1022. 87  See Davies and Worthington, note 48, 580–​1. 88  See Listing Rules, section 11.1.1. The relationship agreement with the controlling shareholder must contain certain “independence provisions,” including the requirement that related-​party transactions be conducted at arm’s length and on normal commercial terms and the controlling shareholder do not circumvent the listing rules. Listing Rules, section 6.1.4D R. 89  See note 61.

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statutory law requires shareholder ratification of all non-​routine self-​dealing transactions entered into during the prior financial year.90 While the French approach seems stringent and encompassing, in practice it may not prove as effective as UK law. As in the UK for listed companies, it leaves corporate decision-​makers with wide discretion in deciding whether a transaction is non-​routine and, thus, needs to be approved by shareholders.91 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 transactions before they become effective, but only express their (precatory) dissatisfaction ex post.92 Other jurisdictions are less insistent on shareholder approval. Italy, for instance, only requires shareholder approval when a director of a publicly traded corporation wants to sit on the board of a competing corporation.93

6.2.4 The rules strategy: Prohibiting conflicted transactions Sweeping prohibitions of related-​party transactions were once common in company law. Today, 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.94 Only France and the U.S. currently prohibit loans between a company and one of its directors. The French prohibition has a long tradition.95 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.96 As a response to Enron and other scandals, Congress prohibited public companies from making personal loans to executives.97 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, prohibitions tend to focus on transactions between managers 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’s non-​compete rule for top executives in closely held companies.98 Of course,

90  Arts. L.  225-​40 (one-​tier board) and 225-​88 (two-​tier board) Code de commerce (France). Conflicted shareholders or managers are forbidden from voting their shares to approve their own transactions—​the outcome being nullified if they are found to have voted. 91  See Schmidt, note 62, at 117–​21 (criticizing the French regime because it grants insiders too much discretion). 92  The practical effect of a shareholder vote rejecting a properly board-​approved transaction is virtually nil. See Luca Enriques, The Law on Company Directors’ Self-​Dealing: A Comparative Analysis, 2 International and Comparative Corporate Law Journal 297, 327–​8 (2000). 93  Art. 2390 Civil Code (Italy). See also text preceding note 63. 94  Of course, specific rules on conflicted transactions, usually not banning them outright, exist for certain industries, such as banking. 95  See Arts. L. 225-​43 and L. 225-​91 Code de commerce (France). 96  See Bebchuk and Fried, note 2, at 112–​17. 97  § 402 Sarbanes-​Oxley Act. 98  See Peter Hommelhoff and Detlef Kleindiek No. 20 Anhang § 6 in Bayer et al., note 53. By contrast, the supervisory boards of German public companies may allow top managers to 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 this reason, most jurisdictions deal with competition issues through other legal strategies. “Insider trading” is a third—​and much more important—​class of transactions that jurisdictions typically subject to restrictions. To be sure, insider trading is not strictly speaking a related-​party transaction like the others examined in this chapter, for at 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 insider trading laws, anyone who otherwise knows that they are in possession of material non-​public information:99 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. That 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 information are misappropriating information that belongs to the corporation for their own benefit. There are two sorts of rules against trading by insiders: prophylactic restrictions on short-​term trading and direct bans on trading on material inside information. The most important prophylactic rules are restrictions on “short swing” (within less than six months) purchase-​and-​sale or sale-​and-​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.100 These rules effectively prohibit short-​term trading by allocating the resulting profits (or losses avoided) to the corporate treasury, on the theory that these gains are likely to derive from non-​public corporate information. The UK adopts similar restrictions in their listing requirements for the same purpose.101 Still more significantly, all major jurisdictions now impose some kind of ban on insiders’ trading on the basis of non-​public 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.102 The 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 information.103 The U.S., by contrast, bars trading by insiders who possess non-​public 99  See notes 102–​4 and accompanying text. 100  See § 16(b) 1934 Securities Exchange Act (U.S.); Art. 164 Financial Instruments and Exchange Act (Japan). 101  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 nature (§ 8(b)). 102  For the EU, see Art. 8 Market Abuse Regulation 596/​2014. For an interpretation of the meaning of “use” of inside information in the EU context, see ECJ, Case C-​45/​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). In Brazil, however, criminal penalties only apply to persons who are under a legal duty to keep the information confidential. Art. 27-​D Lei 6.385, de 7 de dezembro de 1976 (Brazil), and Art. 13 CVM Instruction No. 358 (2002). 103  Art. 166 Financial Instruments and Exchange Act (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.104 Although all jurisdictions mandate stiff civil, administrative, and/​or criminal sanctions for illegal insider trading (e.g. disgorgement of profits, treble damages, other civil penalties, and prison sentences),105 the U.S. has traditionally mounted a much larger enforcement effort than other jurisdictions.106 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 more limited public enforcement resources.107 The divergence in enforcement approaches might well increase in the future. While prosecutions of insider trading in the U.S. have intensified in recent years, the European Court of Human Rights has held that the structure 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.108 Why are (selective) bans the strategy of choice for insider trading? The reason must be that potential benefits are much less visible, and therefore less plausible, than those resulting from self-​dealing transactions. Mutually 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. To date, lawmakers remain unpersuaded that trading based on undisclosed information might sometimes have similar benefits. Some academics have argued that lawmakers underestimate the advantages it has as an efficient form of incentive compensation or as a superior channel of non-​public information into share prices.109 Other scholars, however, have questioned the informational benefits

104  However, the specific contours of insider trading liability in the U.S. remain fuzzy. For a discussion see John C. Coffee Jr., Introduction: Mapping the Future of Insider Trading Law, 2013 Columbia Business Law Review 281. 105  For the U.S., see Louis Loss, Joel Seligman, and Troy Paredes, Fundamentals of Securities Regulation 1412–​19 (6th edn., 2011) (also discussing special sanctions such as disgorgement, civil penalties, and bounty provisions); for France, see Daniel Ohl, Droit des sociétés cotées 351 (3rd edn., 2008) (criminal sanctions and administrative fines); for Germany, Rolf Sethe, Insiderrecht No. 13-​17, in Heinz-​Dieter Assmann and Rolf A. Schütze, Handbuch des Kapitalanlagerechts (4th edn., 2015) (criminal sanctions and disgorgement of profits); for the UK, see Davies and Worthington, note 48, 1167–​71 (criminal sanctions, administrative fines, disgorgement of profits). 106  The U.S. has historically had a very high number of public and private enforcement 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 (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 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/​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 Trading X-​Ray in the Brazilian Securities Commission (CVM) 2002–​2014, Working Paper (2015), ssrn.com. 107  See Chapter 9.2.1. 108  Grande Stevens et autres c. Italie (App No. 18640/​10, 18647/​10, 18663/​10, 18668/​10) (2014) ECHR 4 March 2014. 109  See e.g. Henry G. Manne, Insider Trading and the Stock Market (1966); Dennis W. Carlton and Daniel R. Fischel, The Regulation of Insider Trading, 35 Stanford Law Review 857

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of trading based upon non-​public information and provided evidence that it may have a negative impact on market liquidity by increasing bid-​ask spreads.110 A recent review of the literature on the effects of insider trading laws has described the existing evidence as inconclusive.111

6.2.5 The standards strategy: The duty of loyalty and intra-​group transactions review If nowadays rules are rarely used to regulate conflicted transactions, standards are pervasive. All jurisdictions impose standards—​which we group under the umbrella phrase “duty of loyalty”—​to control related-​party conflicts and limit the risk of asset or information diversion. In essence, the duty of loyalty is a fairness standard which requires judges to determine ex post whether shareholders—​as a class or as a minority—​are worse off as an outcome of the related-​party transaction. Duty-​of-​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 transactions are unlawful and it is for the courts to determine unfairness after the fact. The 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 either obtains deal terms comparable to those it would have obtained in a transaction with a non-​related party or negotiates with the related party following procedural steps that mimic those that are typical of an arm’s length transaction. For other courts, like 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.114

(1983). See also the empirical study by Nihat Aktas, Eric de Bodt, and Hervé Van Oppens, Legal Insider Trading and Market Efficiency, 32 Journal of Banking and Finance 1379 (2008). 110 Reinier Kraakman, The Legal Theory of Insider Trading Regulation in the United States, in European Insider Dealing 39 (Klaus J. Hopt and Eddy Wymeersch eds., 1991); Zohar Goshen and Gideon Parchomovsky, On Insider Trading, Markets, and “Negative” Property Rights in Information, 87 Virginia Law Review 1229 (2001); Raymond P.H. Fishe and Michel A. Robe, The Impact of Illegal Insider Trading in Dealer and Specialist Markets, 71 Journal of Financial Economics 461 (2004). 111  Utpal Bhattacharya, Insider Trading Controversies: A Literature Review, 6 Annual Review of Financial Economics 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 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) criminal courts, and countries where civil law courts dealing mainly with corporate law cases, like Delaware’s, hear breach of fiduciary duty cases. 114  See Davies and Worthington, note 48, at 561: if there is a conflict of interest of the type covered by self-​dealing law, British courts will find a breach of duty on the part of the director, even if the transaction is fair. But if, as it is usually the case, specific rules apply on related-​party transactions and there has been no violation thereof, judges will not look into the fairness of the transaction. See ibid., at 569. As an outcome, it is rare for British courts to engage in standard-​based review of related-​party 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 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).115 Other jurisdictions usually allocate the burden of proving unfairness of 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 encouraged—​screening of related-​party transactions. Thus, the standards strategy frequently operates in conjunction with the trusteeship strategy. Jurisdictions differ, however, in the extent to which the standards strategy functions independently of other strategies. The 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 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.116 European, Japanese, and Brazilian courts, by contrast, seldom question the “fairness” of conflicted transactions and even 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. The liability risk is highest in U.S. jurisdictions. Courts apply tough standards—​the “entire fairness” test (in Delaware) and the “utmost good faith and loyalty” test (in some other states)—​to self-​dealing by controlling shareholders, even when such transactions have been preapproved by independent directors—​ although Delaware has recently applied business judgment review when the trusteeship strategy is combined with a decision rights strategy in the form of a “majority of the minority” vote.117 European jurisdictions, Brazil, and Japan are not as strict. The European approach reflects a general reluctance to hold controlling shareholders liable so long as they are not directly involved in the company’s management. But when controlling shareholders assume actual control, European jurisdictions become more demanding. Controlling shareholders who actively intervene in corporate affairs 115  See e.g. Allen et al., note 49, at 289–​92, 308–​9. 116 See Edward B. Rock, Saints and Sinners:  How Does Delaware Corporate Law Work? 44 UCLA Law Review 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 Texas Law Review 1385 (2006). Indemnification provisions and insurance protection make the liability risk even lower. See Chapter 3.4.1. 117  See note 70 and accompanying 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 French abus de biens sociaux provisions.118

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 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 the parent and other affiliates, are fair as a whole.119 This implies that a successful challenge of an individual transaction harming a subsidiary will become more difficult, because the defendants will win, if they persuade the judge that that the damage from the individual transaction is offset once the overall management of the group is taken into account. The 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 to follow group interests rather than their own individual ones.120 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.124 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.125 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.126 Nowadays, improvements

118  Art. L. 246-​2 Code de commerce. In Germany, AG shareholders using their influence on the company to instruct supervisory or management board members 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). 119  For the argument that focusing on each single transaction to prevent controlling shareholders’ abuse, as most jurisdictions (and especially Delaware) do, may lead to inefficient allocation of control rights by systematically disfavoring control by business partners, see Jens Dammann, Corporate Ostracism: Freezing-​Out Controlling Shareholders, 33 Journal of Corporation Law 681 (2008). 120  On the difference between contractual and de facto groups under German law, see Chapter 5.2.1.3 and 5.3.1.2. 121  See § 302 AktG. Similarly, in Brazil, 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, where de facto corporate groups are common, all related-​party transactions between affiliates must, at least in theory, be “strictly fair” or subject to the payment of adequate compensation. Art. 276 Lei das Sociedades por Ações. 123  §§ 142 II, 315 and 317 AktG. See also Chapter 6.2.1.1. 124  The main tests are whether parent-​subsidiary transactions are at arm’s length and whether the subsidiary’s directors have otherwise exceeded their business discretion. Uwe Hüffer and Jens Koch, Aktiengesetz, § 311 AktG No. 31-​36 (11th edn., 2014). 125  See Jochen Vetter, in Schmidt and Lutter, note 48, § 311 paras. 8–​9 (for AGs); Tobias H. Troeger, Corporate Groups, Working Paper (2014), at ssrn.com. 126  See Forum Europaeum Corporate Group Law, Corporate Group Law for Europe, 1 European Business Organization Law Review 165, 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.127 Italy’s approach to corporate groups is less articulate than 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 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 of the overall results of the parent’s management and co-​ordination activity.”128 French case law allows for even more flexibility:129 parent companies may instruct their subsidiaries to sacrifice their own interests for those of the corpor­ ate group without incurring criminal liability for abuse of corporate assets.130 The 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 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 transactions do not pose a threat to the company’s solvency.131

6.2.5.4 Enforcement In its core 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 the merits of business choices that are tainted by self-​interest.133 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 fee awards, and the absence of the “loser pays” rule have concurred to support a specialized and highly active plaintiff’s 127  See Vetter, note 125, para. 8. 128  Art. 2497 Civil Code. See Corte di Cassazione, 24 August 2004, No. 16707, Giurisprudenza commerciale 2005/​II, 40. 129  See Klaus J. Hopt, Groups of Companies, in Oxford Handbook of Corporate Law and Governance, note 36. 130 (1985) Revue des Sociétés 648 (Cour de Cassation); see also Cozian et al., note 48, at 792. 131  See Marie-​Emma Boursier, Le Fait Justificatif de Groupe dans l’Abus de Biens Sociaux:  Entre Efficacité et Clandestinité, 2005 Revue des Sociétés 273. 132  See also Klaus J. Hopt, Common Principles of Corporate Governance in Europe, in The Coming Together of the Common Law and the Civil Law 105, 109 (Basil S. Markesinis ed., 2000). 133  Cf. Luca Enriques, Do Corporate Law Judges Matter? Some Evidence from Milan, 3 European Business Organization Law Review 765, 795–​801 (2002) (contrasting Delaware judges’ judicial style with Italian courts’ reluctance to second-​guess solvent companies’ business decisions, even when tainted by conflicts of interest).

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bar.134 In addition to that, federal securities regulation complements state-​level private enforcement of director and dominant shareholder duties, ensuring that the critical facts are available to plaintiffs.135 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 by both managers and controlling shareholders, especially in Germany, Italy, and Brazil. As a result, in Germany, private litigation is mostly limited to transactions which have to be approved by the shareholders’ meeting (e.g. mergers and recapitalizations) and takes the form of challenges to the validity of the meeting resolution (usually for incomplete disclosure) or the price for the appraisal remedy.136 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.137 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.138 A peculiar case is France, where certain forms of self-​dealing amounting to a vaguely defined “abuse of corporate assets” (abus de biens sociaux) face a non-​trivial risk of criminal sanctions. Prosecutions for abus de biens sociaux, most often upon minority shareholders’ petitions, are common, making it the most prosecuted corporate crime in France.139 So, enforcement there is privately initiated, but then is exclusively in public hands. 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.140 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 transactions and has been particularly 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.141

134  See e.g. Martin Gelter, Why Do Shareholder Derivative Suits Remain Rare in Continental Europe? 37 Brooklyn Journal of International Law 843 (2012). 135  See Sections 6.2.1.1 and 6.2.4. 136  See Pierre-​Henri Conac, Luca Enriques, and Martin Gelter, Constraining Dominant Shareholders’ Self-​Dealing: The Legal Framework in France, Germany, and Italy, 4 European Company & Financial Law Review 491, 513–​14 and 526 (2007). See also Chapter 7.4.1. 137  See Dan W. Puchniak and Masafumi Nakahigashi, Japan’s Love for Derivative Actions: Irrational Behavior and Non-​Economic Motives as Rational Explanations for Shareholder Litigation, 45 Vanderbilt Journal of Transnational Law 1 (2012). 138  See Mark D. West, Why Shareholders Sue:  The Evidence from Japan, 30 Journal of Legal Studies 351, 378 (2001). 139  See Art. L. 242-​6 Code de commerce (jail up to 5 years, fine up to €375,000). Paul Le Cannu and Bruno Dondero, Droit des sociétés 536 (6th edn., 2015). 140  Art. 11 Lei 6.385, de 7 de dezembro de 1976 (Brazil) (authorizing the Commission to impose various sanctions, including fines, for violations of the Corporations Law as well as of securities regulations). 141  See Consob, Relazione per l’anno 2014 26, 194–​7, and 262 (2015); Consob, Relazione per l’anno 2013 274–​5 (2015) (both available at www.consob.it).

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6.3  Ownership Regimes and Related-​Party Transactions 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, with or without counting related-parties’ votes) are commonly used. Yet, a closer look at substantive rules and the consideration of differences in the intensity 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 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. Following scandals in the early 2000s, 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 transactions. The question is of course how well-​grounded reliance on independent directors can be in a country where, with the exception of one minority-​elected director,142 the 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.143 The likelihood of 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 related-​ party transactions,144 which led to a Council and European Parliament proposal allowing member states to retain the status quo.145 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 transactions. The vote, however, takes place once a year and ultimately may not affect 142  See Chapter 4.1.1. 143  German scholars frequently point out that the equivalent minority protection in Germany would be achieved in three ways: (1) the supervisory 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 of shareholders, and shareholders’ fiduciary duties addresses specific suspicious transactions with shareholders generally. See Holger Fleischer, Related Party Transactions bei börsennotierten Gesellschaften: Deutsches Aktien(konzern)recht und Europäische Reformvorschläge, Betriebs-​Berater 2691 (2014). Nevertheless, even the cumulative impact of these measures does not appear to catch all situations that may present problems of minority protection. 144  See e.g. Jochen Vetter, Regelungsbedarf für Related Party Transactions? 179 Zeitschrift für das gesamte Handelsrecht und Wirtschaftsrecht 273 (2015). 145  See note 147.

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a transaction’s validity or directors’ liability other than to insulate the transaction from judicial review in case of a favorable vote. Further, in all three countries special, more lenient rules or doctrines on intra-​group transactions apply. Brazilian law is probably even more lax in policing related-​party transactions involving either controlling shareholders or managers: trusteeship and decisions strategies are used only sparingly, while enforcement problems hamper the efficacy of disclosure mandates and duty of loyalty standards. This, perhaps, can help explain why Brazil has had uniquely high levels of private benefits of control,146 and, more speculatively, why its courts have been so liberal in granting requests for partial dissolution by minority shareholders in closely held corporations. The situation is quite different in the other countries. The 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 transactions in listed companies.147 In the U.S., courts do not shy away from imposing liability on managers for self-​ dealing 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 U.S. when it comes to related-​ party 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 mechanisms employed to police 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’ meeting resolutions (which may approve related-​party transactions like parent-​subsidiary mergers) or to obtain judicial review of the appraisal 146  See Chapter 4.4.2.1. 147  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 or board approval (with safeguards to prevent the related party from influencing the outcome of the board vote).

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price. Disgruntled shareholders in a French company having engaged in a 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 efforts is borne by securities regulators via both formal and informal actions. Finally, in the UK, enforcement is more informal and governance-​based than elsewhere as far as publicly traded companies are concerned, chiefly relying upon institutional investors’ pressure.148 This model, however, has recently been tested at East Asian companies listed in the UK.149 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. The differences we have highlighted so far reflect the by now 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.150 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, 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.151 In the case of the UK, the rigor of the related-​party regime for listed companies reflects the political influence of strong institutional investors. In France, in turn, the emphasis on ex post 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, so to speak, “from a distance,” i.e. reducing the risk of collusion between directors and top managers). That may also help explain why French requirements for shareholder ratification are perfunctory: they provide a focal point for shareholders’ attention and allow, as the case may be, for the exercise of more effective powers, including removal, vis-​à-​vis unfaithful directors and managers. The relevant role of the state as a controlling shareholder may also explain the controller-​friendly regime applicable to related-​party transactions in Brazil.152

148  With respect to closed companies see Chapter 6.2.5.4. 149  See Roger Barker and Iris H.Y. Chiu, Protecting Minority Shareholders in Blockholder-​Controlled Companies: Evaluating the UK’s Enhanced Listing Regime in Comparison with Investor Protection Regimes in New York and Hong Kong, 10 Capital Markets Law Journal 98, 104–​5 (2014). 150  See Chapter 1.6. 151  This does not necessarily translate into high, let alone uniform, level of tunneling across jurisdictions. We have in fact seen 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. 152  See Mariana Pargendler, State Ownership and Corporate Governance, 80 Fordham Law Review 2917 (2012).

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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. Those involved in the functioning of the enforcement system (such as the bar, securities regulators, and judges themselves) may be well-​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. The 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 the evidence unearthed.153 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 ownership structures are not static—​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 transactions. What is puzzling is that, despite an even stronger trend toward dispersed and institutional ownership,154 no similar reform efforts have gained momentum in Germany. An optimistic answer would be that the smaller size of private benefits in that country compared to Brazil and Italy155 is evidence that 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.156 But once again, path dependence and interest group dynamics may provide an equally plausible explanation. The law of corporate groups, by accommodating the frequent use of intra-​ group transactions, reinforces group-​based organizational structures. Their operation would be more burdensome under the set of rules prevailing elsewhere, which raise the costs of individual related-​party transactions.157 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.

153 See James D. Cox, Randall S. Thomas, and Dana Kiku, SEC Enforcement Heuristics:  An Empirical Enquiry, 53 Duke Law Journal 737, 761 (2003). 154  Wolf-​Georg Ringe, Changing Law and Ownership Patterns in Germany: Corporate Governance and the Erosion of Deutschland AG, 63 American Journal of Comparative Law 493 (2015). 155 See Chapter 4.4.2.1.   156 See note 143.   157  See Dammann, note 119.

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7 Fundamental Changes Edward Rock, Paul Davies, Hideki Kanda, Reinier Kraakman, and 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.” The 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 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 mandatory legal rules,1 most commentators agree that there is a stronger case for legislative interference in midstream situations.2 As initial investors reasonably anticipate later opportunistic changes, they would discount for this risk at the stage of their investment decision. To 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 This assessment is consistent with the limited extent of private ordering: several studies suggest that contractual freedom is rarely exercised in corporate law and that default arrangements and mandatory rules matter.4

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 University of Pennsylvania Law Review 713, 740 (2003); Bernard S. Black, Is Corporate Law Trivial? A Political and Economic Analysis, 84 Northwestern University Law Review 542, 571–​2 (1990). See also Jeffrey N. Gordon, The Mandatory Structure of Corporate Law, 89 Columbia Law Review 1549, 1563 (1989). 2  On the distinction between formation stage and midstream changes see e.g. Gordon, note 1, at 1593; Lucian A. Bebchuk, The Debate on Contractual Freedom in Corporate Law, 89 Columbia Law Review 1395, 1401 (1989). 3  Gordon, note 1, at 1593. 4  Yair Listokin, What Do Corporate Default Rules and Menus Do? An Empirical Examination, 6 Journal of Empirical Legal Studies 279 (2009); Henry Hansmann, Corporation and Contract, 8 American Law and Economics Review 1 (2006). For the specific case of IPOs see John C. Coates IV, Explaining Variation in Takeover Defenses: Blame the Lawyers, 89 California Law Review 1301, 1357 (2001); Robert Daines and Michael Klausner, Do IPO Charters Maximize Firm Value? Antitakeover The Anatomy of Corporate Law. Third 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 of this problem along two dimensions. First, there is disagreement on which situations require a statutory protection mechanism: put differently, which changes are so “fundamental” that they should trigger legal interference? 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, double-​majority or supermajority requirements for the effectiveness of the change, majority-​of-​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. The functionality of a particular jurisdiction’s approach might depend—​again—​on the prevailing agency conflict that it seeks to address. As we shall see, some of the fundamental changes that we discuss in this chapter will be more salient in a certain ownership environment than in another. The 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 are the norm.5 These jurisdictions are more likely to require a supermajority or a majority-​of-​the-​minority consent. To complicate matters further, fundamental changes do not only concern shareholder or minority shareholder expropriation. To 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. To 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 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 power in the corporate form, but this rule does not extend to decisions that have the potential of fundamentally rea­llocating power among the firm’s participants.6 No jurisdiction, for example, authorizes the board of directors to amend the company’s charter in a material way or to effect unilaterally a merger that alters the company’s risk and return profile. The board’s 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 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 conflicts of interest between the company and its directors or controlling shareholders.7

Provisions in IPOs, 17 Journal of Law, Economics & Organization 83, 95 (2001). For an overall assessment, see Michael Klausner, Fact and Fiction in Corporate Governance, 65 Stanford Law Review 1325, 1346 et seq. (2013). 5  See Chapter 6.2.3. 6  See Chapter 3.4. 7  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. Although there is no single set of characteristics that marks the limits of the board’s power to decide unilaterally, either across jurisdictions or within them, there are some general tendencies. Corporate law seldom limits board discretion unless 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 for directors, even if this conflict does not qualify as a related-​party transaction; or (3) they involve general, non-​firm specific, investment-​ like judgments that shareholders are arguably equipped to make for themselves. Although these three characteristics largely describe the limitations on board discretion, jurisdictions inevitably diverge to some extent in how they select and regulate “fundamental changes.” That is because they 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 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 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. The 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. To 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 other words, the higher transaction costs associated with a shareholders’ meeting (as compared to a board meeting) are justified when agency costs are potentially high.8 In addition, shareholders’ meetings are more likely to be effective if the stakes are large enough to overcome shareholders’ information and coordination problems.9 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. The second key characteristic of corporate actions that is often associated with constraints on board discretion is a risk of self-​interested decision-​making by the board. Low-​powered conflicts of interest frequently dog major transactions, even without signs of flagrant 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, their acquiring companies.10 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 conflicts of interest can seriously harm shareholders, and are thus a focus of regulation.

8  Sofie Cools, The Dividing Line Between Shareholder Democracy and Board Autonomy: Inherent Conflicts of Interest as Normative Criterion, 11 European Company and Financial Law Review 258, 273–​5 (2014). 9  Edward B. Rock, Institutional Investors in Corporate Governance, in Oxford Handbook of Corporate Law and Governance (Jeffrey N. Gordon and Wolf-​Georg Ringe eds., 2017). 10  See Ronald J. Gilson and Reinier Kraakman, What Triggers Revlon?, 25 Wake Forest Law Review 37 (1990). 11  Cools, note 8, at 275–​8.

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Finally, a third characteristic often associated with transformative corporate actions that are subject to special rules is that they are such as not to require a firm-​specific judgment, but rather one that resembles a decision on how to allocate portfolio money. Hence, shareholders’ comparative disadvantage in decision-​making vis-​à-​vis the company’s management will be lower, despite the inevitable information asymmetries, than for typical business decisions. For instance, 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. 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 company. In the latter case, specific knowledge, among many other things, about whether the R&D department has the right mix of human resources 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 and asset sales, re​incorporations, and conversions. As we shall see, many of these corporate-​level 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 restructuring. Given this, and the fact that the legal strategies used to protect minority shareholders in corporate-​level freeze-​outs often track those used in shareholder-​level restructurings, we extend our discussion to cover freeze-​out (or squeeze-​out) transactions more generally.12 Interestingly, despite the vulnerability of minority shareholders in freeze-​out transactions, none of our core jurisdictions prohibits controllers from taking public corpor­ ations private, or parent companies from forcing the sale of minority shares in their subsidiaries. The 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 intra-​ group 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. Third, controlling shareholders may be less inclined to invest additional capital in positive net present-​value projects if they are forced to share their returns with minorities.14 Finally, in many jurisdictions going-​private transactions eliminate the costs of being a public company, such as preparing disclosure documents and the opportunity costs of disclosing information of value to the firm’s competitors.

7.2  Charter Amendments Although many of the relationships among participants in the firm are structured by contract, including contracts with creditors and shareholder agreements, corporate law 12  However, we postpone full discussion of post-​public offer squeeze-​outs until Chapter 8. 13  See Chapter 4.1.3.2. 14 This rationale for freeze-​outs requires additional assumptions to be plausible. Imagine, for example, a 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.15 Like other constitutions, corpor­ ate 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.16 The most pervasive regulatory strategy employed is that of an ex post decision right: shareholders are called to ratify the charter amendment. As we saw in Chapter 2, this is a typical strategy for regulating fundamental changes: the regular distribution 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.17 However, such decision rights come in different variations across jurisdictions: under Delaware law, for example, a charter amendment must be proposed by the board and ratified by a majority of the outstanding stock.18 By contrast, in European jurisdictions and in Japan, the charter can normally be amended by a supermajority shareholder vote, and without board initiative.19 The 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 charter—​an option that is particularly valuable since our core jurisdictions allow any charter provision not in conflict with the law. By means of charter provisions, shareholders can make credible pre-​commitments. For example, under the Delaware approach, dispersed shareholders who approve an antitakeover provision in the charter—​such as a classified 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.20 Under the supermajority shareholder approval mechanism, shareholders bond themselves to consider (large) minority interests. The 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,

15  Marcel Kahan and Edward Rock, Corporate Constitutionalism: Antitakeover Charter Provisions as Precommitment, 152 University of Pennsylvania Law Review 473 (2003). 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 the internal structure and rules of the organization. See note 32 and accompanying text. 16  Although jurisdictions disagree on the mandatory scope of corporate charters, see text accompanying notes 28–33. 17  See Chapter 2.2.2.2. 18  Delaware General Corporation Law (hereafter DGCL) § 242. 19  UK Companies Act 2006, section 21; France: Art. L. 225-​96 Code de commerce; Germany: AktG § 119(1) no 5; Italy: Art. 2365 Civil Code; Japan: Art. 466 Companies Act. These 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 decision-​making. Of course, in practice most proposals for charter amendments originate from the board. 20  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 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, and the charter amendment regime is thus one which formally excludes management from the decision on whether to amend the charter. In a system with concentrated holdings, by contrast, a bilateral 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 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 standards strategy that imposes liability on controlling shareholders for charter amendments that are “not in the interest of the company” and that “seek to harm” minority shareholders, workers, and bondholders—​a standard that is arguably overly demanding to be effective in constraining abuse.24 Combined with a prohibition on supermajority approval requirements in publicly traded corporations’ charters,25 this regime in practice reduces the ability of controlling shareholders to make credible pre-​ commitments 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 upon approval by a majority. Ultimately, the great advantage of entrenchment in the charter is that it operates more smoothly, by automatically binding new shareholders, than an extra-​charter agreement. However, because many jurisdictions do not require the disclosure of shareholder agreements, at least if the company is not listed, that may be perceived as a countervailing advantage.26 Of course, a shareholder agreement to which only some

21  Of course management entrenchment can be constrained in other ways. See Chapter 8.2.3.1. 22  See e.g. Companies Act 2006, section 22 (UK). The 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. 24  Art. 117, § 1º, c ibid. 25  Art. 136 ibid. 26  Italy is an example of a jurisdiction mandating disclosure of shareholder agreements. See e.g. Vincenzo V. Chionna, La pubblicità dei patti parasociali (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. 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” capital structures in which some shares have more votes than others, where permitted,27 may be required to appear in the charter; similarly, where permitted, limitations on directorial liability.28 The more prescriptive a jurisdiction is about the mandatory contents of corporate charters, the more important is the amendment procedure. Whilst some jurisdictions specify only a few rudimentary issues that charters need to address, and leave the remainder to the company’s discretion, the German concept of Satzungsstrenge (“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.29 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. This 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 share capital in a significant 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. The extent to which such terms constrain the board in the issuance of shares depends, however, on a larger set of rules. Thus, 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 at least statutory default rules requiring shareholder authorization of share issues or pre​emption rights.30 Another example of divergence is the structure 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 contrast, in the U.S., such provisions are typically included in the “bylaws”—​the rules for the day-​to-​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

27  See Chapter 4.1.1. 28  DGCL § 102(b)(7); Arts. 426 and 427 Companies Act (Japan). 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). The 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. 29  AktG § 23(5). 30  Share issuance rules are discussed in Section 7.3. 31  The charter must specify the number of supervisory board seats for German AGs if it is to comprise more than the mandatory minimum (§ 95 AktG). For the French SA, the charter only sets a maximum number of seats within the range (3–​18) allowed by law (Art. L. 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. specify a number, set a range, or leave the decision to another 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-​to-​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. These differences in mandatory content are of decreasing importance, 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.33

7.2.1 The management–​shareholder conflict in charter amendments Charter provisions can be used to entrench management vis-​à-​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).34 The decision rights strategy is used to control management–​shareholder agency costs: any midstream charter change must be approved by shareholder vote.

7.2.2 The majority–​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 a separate class of shareholders must be approved by a majority of that class voting together.35 Such a “reinforced” decision right strategy is particularly important for preferred shareholders, who often lack voting rights and who rely in consequence on the charter, and the rules governing its amendment, to protect their interests. Such protection, however, must be carefully drafted to actually fulfil its purpose.36 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.37 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). Thus, 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. This 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 bylaw. See Chapter 3.2.1 and 3.2.3. 33  See Chapter 3.3.2. 34  See Chapter 3.1.3. 35  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). 36  William Bratton, Venture Capital on the Downside: Preferred Stock and Corporate Control, 100 Michigan Law Review 891, 922–​39 (2002); William Bratton and Michael L. Wachter, A Theory of Preferred Stock, 161 University of Pennsylvania Law Review 1815, 1831 ff. (2013). 37  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.38 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 charter changes, whether involving class rights or not, but these standards are rarely invoked successfully.39 However, a more common protection is the exit right strategy, mostly in the form of an appraisal right.40 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 rights or limiting voting rights).41 Charter provisions can also be used to solidify control by a controlling shareholder. A dual-​class capital structure (either high voting and low voting, or voting and non-​ voting, stock), which must be in the charter to be valid, will allow shareholders with a minority of the cash-​flow rights to retain control.42 As such, it is a powerful entrenchment device. Having been banned by the New York Stock Exchange (NYSE) listing rules for the most part of the twentieth century, it has seen somewhat of a renaissance in both media and IT corporations lately.43 Midstream introductions of dual-​class structures are frequently understood as efforts by would-​be controlling shareholders (often current managers) to exploit non-​controlling shareholders’ collective action problems to induce them to approve 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 recapitalizations.44 Although the SEC rule was ultimately held to be beyond its regulatory authority,45 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 non-​ controlling shareholders.46 38 See Paul Davies and Sarah Worthington, Gower And Davies’ Principles Of Modern Company Law (9th edn., 2012), paras. 19-​32 to 19-​37. 39 E.g. abus de majorité in France (see Maurice Cozian, Alain Viandier, and Florence Deboissy, Droit des Sociétés 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.” This 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]. 40  See Chapter 2.2.1.2. 41  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 Revised Model Business Corporation Act (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 offer, on terms agreed with the AMF, for the minority shares. Art. L. 433-​4 Code Monétaire et Financier; Art. 236-​6 Règlement Général de l’AMF. 42  See also Chapter 4.1.1. 43  Recent examples are the New York Times, 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. 44  Voting Rights Listing Standards, Release No. 34-​25891, 53 Fed. Reg. 26376 (1988). 45  Business Roundtable v. SEC, 905 Federal Reporter 2d 406 (D.C. Cir. 1990). 46  See Tokyo Stock Exchange, Listing System Improvement FY2008, 27 May 2008.

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In Europe, dual-​class recapitalizations are controversial although generally permitted;47 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 or governance rights attached, mandatory rules of corporate law, derived from the Second Directive, require shareholder consent to any particular exercise of the power and also require pre-​ emptive rights to be given to the existing shareholders in the case of the issue of equity shares for cash.48 Consequently, dual-​class recapitalizations have been handled not through specific rules implementing the proportionality principle but rather through the general rules on charter amendments.49

7.3  Share Issuance Transactions 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, provide an exit to an advantaged shareholder, and injure creditors.50 Most jurisdictions again use predominantly a decision-​rights approach to address these issues.

7.3.1 The manager–​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.51 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 requirements 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 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.52 But there are exceptions: U.S. listing requirements require a shareholder vote when a new 47  See Arman Khachaturyan, Trapped in Delusions: Democracy, Fairness and the One-​Share-​One-​Vote Rule in the European Union, 8 European Business Organization Law Review 335 (2007); Mike Burkart and Samuel Lee, One Share-​One Vote: The Theory, 12 Review of Finance 1 (2008); Renée Adams and Daniel Ferreira, One Share-​One Vote: The Empirical Evidence, 12 Review of Finance 51 (2008); Wolf-​ Georg Ringe, Deviations from Ownership-​ Control Proportionality—​ Economic Protectionism Revisited, in Company Law and Economic Protectionism 209 (Ulf Bernitz and Wolf-​ Georg Ringe eds., 2010). 48  See Section 7.3. 49  The European Commission rejected proposals to make the 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. 50  Note, too, that some of these adjustments to capital are also organic changes, since they require material amendments to company charters. 51  See Section 7.1. 52  Grimes v. Alteon, 804 Atlantic Reporter 2d 256 (Del. 2002). Frequently, the charter’s limitation on authorized shares will be illusory. When a charter contains an authorized but unissued series

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issue of shares is large enough to shift voting control over a listed company, unless the new issue takes the form of an offering to dispersed public shareholders.53 In Japan, since 2014, the law requires shareholder 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.54 By contrast, EU jurisdictions have a stronger tradition of putting new share issues to the vote of shareholders, although the company’s charter or the shareholders in general meeting may delegate that decision to the board, for periods of up to five years.55 This 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.56 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.57 By contrast, most U.S. jurisdictions allow companies relatively broad flexibility with their legal capital without seeking shareholder approval58—​an approach that reflects the U.S.  view of legal capital as a vestigial concept rather than a meaningful trigger for shareholder decision rights.59 Japan falls somewhere in the middle. While the minimum capital requirement 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.60

7.3.2 The majority–​minority conflict Although all shareholders risk dilution from new equity and corporate distributions, minority shareholders face the largest risk because they are often not 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. This occurred in the bailout of AIG. Steven M. Davidoff and David T. Zaring, Regulation by Deal:  The Government’s Response to the Financial Crisis, 61 Administrative Law Review 463 (2009). The power conferred on the board by authorized but unissued preferred stock also provides the foundation for the board’s power to issue “poison pill” shareholder rights plans without shareholder approval. See Chapter 8.2.3. 53 See § 312.03(c) NYSE Listed Company Manual and §§ 712, 713 American Stock Exchange Company Guide. The qualifications of these requirements in the U.S. make clear that they are directed at control transfers rather than at dilution. 54  Art. 206-​2 Companies Act. The new requirement may not be enough to prevent managerial entrenchment. In such a case, shareholders can seek for a court’s injunction of the issuance of stock asserting that it is “significantly unfair,” a remedy that courts have granted when the primary purpose of the issuance is to preserve the control of management. Art. 210(ii) Companies Act. 55  Art. 29 Second Directive (now 2012/​30/​EU). On this point see Vanessa Edwards, EC Company Law 77–​8 (1999). Member states may determine the majority required for such shareholder author­ ization 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 vote in favor of giving boards authorization to issue more than one-​third of the existing share capital (and in any event no more than two-​thirds) only on the basis that the whole board should stand for 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 Rights, December 2008. 56  See Chapter 8.2.3. 57  See Art. 34 Second Directive. 58  § 244 DGCL (the reduction of the legal capital can be made by a decision of the board of directors). 59  On the very limited role of legal capital in the U.S., see Chapter 5.2.2. 60  Arts. 309(2)(ix) and 447(1) Companies Act.

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shareholder decision rights. Instead, minority shareholders must depend on other legal strategies for protection, such as sharing norms, rules, and standards. Preemptive rights are a paradigmatic example of the sharing strategy. By allowing existing shareholders to purchase new shares pro rata 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. Jurisdictions differ in their approaches to preemptive rights. The U.S. and Japan only enforce preemptive rights that are enshrined in company charters (opt-​in).61 Brazil grants them as the statutory default, as do all European jurisdictions, due to requirements in the Second Directive.62 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.63 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 narrowly identifying the situations in which they will routinely vote in favor of disapplication resolutions put forward by listed companies.64 In 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.65 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.66 Despite this hurdle, corporate practice has found its ways to comply with the requirement, and time-​limited delegation to the board plus the waiver of preemptive rights appear common practice today.67 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.68 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.69 This became visibly apparent during the 2008/​9 financial crisis, where speedy 61  See § 6.30 RMBCA. Japan does recognize them for closely held firms, see Art.199(2) and 309(2) (v) Companies Act (two-​thirds majority necessary for excluding pre​emptive rights). 62  For Europe, see Art. 33 Second Directive (shareholders must be offered shares on a 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). 63  Second Directive, Arts. 29(2) and 33(4) and (5). 64  Preemption Group, Disapplying Pre-​Emption Rights: A Statement of Principles (March 2015): no more than 5 percent of the issued common shares in any year or more than 7.5 percent over a rolling period of three years. 65  Cozian et al., note 39, at 475–​7. 66  This is true for either the shareholder resolution waiving the rights or the board decision, where authorized. See Bundesgerichtshof (BGH), March 13, 1978 –​II ZR 142/​76, BGHZ 71, 40, 46 [Kali + Salz]; BGH, June 23, 1997 –​II ZR 132/​93, BGHZ 136, 133, 139 [Siemens/​Nold]. The insistence on preemptive rights appears to have been a major driver for the Holzmüller case, requiring shareholder approval for the transfer of major assets to a subsidiary. See Section 7.6. The 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). 67  Rüdiger Veil, Commentary on § 202, para 2, in Aktiengesetz Kommentar (Karsten Schmidt and Marcus Lutter eds., 3rd edn., 2015). 68  Art. 172 Lei das Sociedades por Ações. 69  In particular, the shares of the company making the rights issue may come under pressure from short-​sellers, 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.

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execution of decisions to raise fresh capital proved to be paramount.70 They also limit management’s ability to issue blocks of shares with significant voting power. These 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.71 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, 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 of preemptive rights, they may file a petition al­leging “unfair prejudice” and seeking a right to be bought out at a fair price.72 Japan and Brazil combine the standards and the decision-​rights strategy here. In Japan, shareholders in 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.73 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.74 The European preemption rules apply only to share issues for cash. In 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 non-​ cash consideration in public companies.75

7.4  Mergers and Divisions A merger can revolutionize the relationships among the participants in the firm. Mergers 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”).76 In the process, a shareholder’s ownership stake can be diluted, transformed, or, in some jurisdictions, cashed out.77 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 no antitakeover protections can wake up a shareholder in 70  See e.g. Kate Burgess, Pre-​emption: Knowing Your Rights is a Serious Issue, Financial Times, 3 February 2010 (reporting on the difficulties HBOS met with 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, Report of the Rights Issue Review Group, November 2008. 71  See Robert C. Clark, Corporate Law 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. Hamilton, The Law of Corporations 196 (5th edn., 2000)) and especially at companies raising funds from venture capitalists (see e.g. George G. Triantis, Financial Contract Design in the World of Venture Capital, 68 University of Chicago Law Review 305, 312 (2001)). 72  On unfair prejudice see note 39. 73  Arts. 199(2), 201(1), 309(2)(v) Companies Act (Japan). 74  Art. 170 § 1º Lei das Sociedades por Ações. 75  Art. 10 Second Directive, somewhat relaxed by Art. 11, introduced in 2006. 76  Therein lies the difference to the takeover; see Chapter 8.1. 77  In a so-​called cash-​out merger, shareholders in one of the two merged companies have no choice but to accept cash in exchange for their shares.

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a company that is effectively takeover-​proof. A shareholder in a privately held company can end up a shareholder of a publicly held company or vice versa. The overwhelming problems, however, are related to price, that is, typically 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), many mergers exhibit the functional characteristics of fundamental changes: they are large; they often give rise to agency problems;78 and they involve investment-​like decisions. These problems are predominantly addressed by a decision rights strategy. Thus, most jurisdictions require supermajority shareholder authorization for a merger or consolidation. In the EU, the Third Company Law Directive sets a minimum approval requirement of at least two-​thirds of the votes at the shareholders’ meeting (or, as an alternative, one half of outstanding shares).79 Some member states impose even higher voting thresholds. For example, Germany and the UK80 require 75 percent of voting shareholders to approve a merger, while France and Japan require at least a two-​ thirds majority of voting shares with a minimum quorum of one fourth and one-​third of the outstanding shares, respectively.81 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.82 These shareholder ratification requirements ordinarily apply to both (or all) participants in a merger or consolidation.83 The fact that shareholders of acquiring companies

78  The 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 Takeovers: In the Eyes of the Beholder? 55 Journal of Finance 2599 (2000). 79  Art. 7 Third Company Law Directive 2011/​35/​EU, 2011 O.J. (L 110) 1, applicable to domestic mergers of public companies. This 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. 80 The UK is 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 creditors and the company, whether or not another company is involved in the scheme. It was originally designed (in the nineteenth century) for the adjustment of creditors’ rights in insolvency. If the scheme is used to effect a merger or division, it may attract the additional regulation of Part  27, implementing the Third 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, Schemes of Arrangement: Theory, Structure and Operation (2014). 81  § 65 Umwandlungsgesetz (unless the charter sets a higher threshold) (Germany); ss. 899 and 907 of Companies Act 2006 (UK); Arts. L. 236-​2 and L. 225-​96 Code de commerce (France). For Japan, see Arts. 783, 795, 804, 309(2)(xii) Companies Act. Similarly, Italy requires a two-​thirds majority of shares representing at least one-​fifth of the outstanding capital for listed companies (SPA) (in non-​listed public companies, a simple majority of the voting shares may, however, approve the merger) (Arts. 2368-​2369 Civil Code). 82  Art. 136 Lei das Sociedades por Ações (Brazil); § 251(c) 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. 83  Jurisdictions allowing for 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).

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must often authorize mergers (even if there is no alteration of their charters) suggests that corporate law is less concerned with formal legal identity 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 relations is the fact that some jurisdictions do not 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.84 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 The management–​shareholder conflict in mergers The two principal management–​shareholder agency conflicts that potentially arise in mergers are: (a) management’s self-​interested refusal to agree to a merger that shareholders support; and (b) self-​interested attempts by management to build empires or to negotiate their future job status or compensation with an acquiring company at the expense of their shareholders.85 Because these agency problems primarily arise in dispersed ownership structures, we focus here mostly on the U.S., the UK, and Japan.86

7.4.1.1 Managerial “entrenchment” What is to be done when managers resist a merger proposal which shareholders would like to accept? How can a system distinguish between resistance that is driven by a sincere, well-​founded belief that a merger is not in the interests of shareholders from resistance that is driven by self-​interest? In a board-​centered system such as the U.S., managerial entrenchment is addressed through a combination of a trusteeship strategy (boards dominated by independent directors) combined with a rewards strategy (high-​ powered incentive compensation for managers triggered by a change in control) and an appointment rights strategy (although boards may veto a merger proposal, shareholders can vote in a new slate of directors). The 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.87 Yet, there are practical difficulties in convening the shareholders’ meeting without the cooperation of the board.88 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 Takeover Code’s ban on frustrating action to neutralize any negative action the target management might take against the tender offer without shareholder approval.89

84  See § 251(f ) DGCL (Delaware) (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). 85  A third conflict arises in management buyouts when managers, with a financial sponsor, seek to acquire the company from the public shareholders. It is discussed in Section 7.4.2, in the context of freeze-​outs. 86  For majority–minority shareholder conflict see Section 7.4.2. 87  See Chapter 3.2.2. 88  For the difficulties an acquirer has in using the UK-​style merger against a hostile target see Re Savoy Hotel Ltd [1981] Ch 351, discussed in Davies and Worthington, note 38, para. 29-​5. 89  These issues are discussed more fully in Chapter 8 in the context of control shifts. See Chapter 8.2.

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7.4.1.2 Managerial nest-​feathering A second manager–​shareholder agency problem arises where managers, in negotiating a merger agreement, put their own interests—​in building an empire through acquisitions or in securing employment with the surviving firm—​ahead of shareholders’. Here, interestingly, the strategies adopted by different jurisdictions are rather similar. First, the shareholder approval requirement90 gives shareholders a means of challenging a merger driven by managerialism. 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.91 Secondly, with the purpose of improving the quality of shareholder decision-​ making, 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.92 In Japan, when the proposed merger is one with the company’s controlling shareholder, the stock exchanges require a third party to analyze whether it is fair to the shareholders.93 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,94 which shareholders can peruse before they vote. Third, the U.S.  and Japan also protect shareholders through an exit strategy—​the appraisal 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.95 Brazil and Italy provide for a similar remedy, which however applies more selectively.96 Although EU law does not require appraisal in the event of a merger as such, 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 some mergers.97 Appraisal may be made available expressly where the merger involves a change in legal form or some other unusual restriction on shareholders’ rights.98 As a side benefit, the appraisal remedy also protects shareholders as a class by making unpopular decisions more expensive for the company to pursue.99 The cost of these protections is that this same remedy may harm shareholders if 90  note 81. 91  For examples, see Marcel Kahan and Edward Rock, Hedge Funds in Corporate Governance and Corporate Control, 155 University of Pennsylvania Law Review 1021 (2007). 92  Art. 10 Third Directive (requiring third-​party reports on the fairness of merger terms, though the holders of voting securities in the company can waive this requirement on the basis of unanimity). 93  Tokyo Stock Exchange, Securities Listing Rules, Art. 441-​2. 94  See e.g. Smith v.  Van Gorkom, 488 Atlantic Reporter 2d 858 (Delaware Supreme Court 1985) (sale of a company without valuation report and with little deliberation is grossly negligent despite premium price). 95 On the appraisal remedy under Japanese law, see Alan K. Koh, Appraising Japan’s Appraisal Remedy, 62 American Journal of Comparative Law 417 (2014). 96  Dissenting shareholders in Brazil may seek appraisal only if their 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 non-​ listed one: Civil Code, Arts. 2505-​IV (closed companies) and 2437-​V (listed into non-​listed company). 97  See text attached to note 41 and Alain Viandier, OPA, OPE et Autres Offres Publiques 460–​1 (5th edn., 2014). 98  See Art. 236-​5 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). 99  See Hideki Kanda and Saul Levmore, The Appraisal Remedy and the Goals of Corporate Law, 32 UCLA Law Review 429 (1985).

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the need for cash to satisfy appraisal demands scuttles transactions that would otherwise increase the company’s value.100 The scope of the appraisal remedy varies widely among U.S. states and the non-​ U.S.  jurisdictions that offer this exit right. In practice, however, cumbersome procedures, 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 Delaware and RMBCA jurisdictions, further limit appraisal rights by introducing a so-​called “stock market exception” to their availability in corporate mergers.101 Under this “exception,” shareholders do not receive appraisal rights if the merger consideration consists of stock in a widely traded company rather than cash, debt, or closely held equity—​apparently on the theory either that appraisal rights ought to protect the liquidity rather than the 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.102 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.103 These difficulties may explain why most European jurisdictions have never turned to the exit strategy—​appraisal 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) and on the trusteeship strategy as well, to the extent that EU law requires valuation by independent experts who are liable to shareholders for their misconduct.104 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. This 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.105

100  See Bayless Manning, The Shareholder’s Appraisal Remedy: An Essay for Frank Coker, 72 Yale Law Journal 223 (1962). 101  § 13.02 RMBCA; § 262 DGCL. 102  Of course this theory does not explain why appraisal rights are available when shareholders receive cash, the most liquid merger consideration possible. 103  See Paul G. Mahoney and Mark Weinstein, The Appraisal Remedy and Merger Premiums, 1 American Law and Economics Review 239 (1999) (analyzing 1,350 mergers involving publicly held firms from 1975–​91); Joel Seligman, Reappraising the Appraisal Remedy, 52 George Washington Law Review 829 (1984) (only about 20 mergers from 1972–​81 resulted in appraisal proceedings). 104  Art. 20 Third Directive (liability of managers vis-​à-​vis their shareholders) and Art. 21 (liability of independent experts vis-​à-​vis shareholders); Art. 18 Sixth Directive (liability of managers and independent experts vis-​à-​vis shareholders). See also Matthias Habersack and Dirk Verse, Europäisches Gesellschaftsrecht (4th edn., 2011) para. 16-​20. 105 § 15 Umwandlungsgesetz; Art. 2504-​ IV Civil Code; see also Karsten Schmidt, Gesellschaftsrecht 390 (4th edn., 2002); Pierre-​Henri Conac, Luca Enriques, and Martin Gelter, Constraining Dominant Shareholders’ Self-​Dealing: The Legal Framework in France, Germany, and Italy, 4 European Company and Financial Law Review 491, 525 (2007). The 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.

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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.106

7.4.2 The majority–​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 conflicts, for example independent assessment of the merger terms or appraisal rights, operate to protect minority shareholders against majority shareholders as well.107 That is, they provide protection for non-​controlling shareholders against company controllers, whether those controllers are management or majority shareholders (or, 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 actually very similar to the agency problem we have focused on in Chapter 6: such mergers are, in fact, related party transactions. Majority–​minority conflicts are even more acute in freeze-​out mergers, where a controlling shareholder, using the merger structure, eliminates the non-​controlling shareholders either for cash or stock.108 Management buyouts, in which managers team up with a financial sponsor to acquire the company, present many of the same problems. All of our major jurisdictions strengthen the protection of minority shareholders when controlling shareholders stand on both sides of a merger. In particular, standards play a more important role in regulating conflicted transactions.109 European 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 majorité doctrine,110 while, in the UK the “unfair prejudice” remedy is at least potentially 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 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.114

106  See Section 7.4.2.3.1. 107  The exception are decision rights in the form of shareholder approval, which will be ineffective unless the requirement is for majority-​of-​the-​minority approval. 108  For a comparative perspective, see Marco Ventoruzzo, Freeze-​Outs:  Transcontinental Analysis and Reform Proposals, 50 Virginia Journal of International Law 841 (2010). 109  See Chapter 6.2.5. 110  Cozian et al., note 39, at 740, n. 11. 111  On the “unfair prejudice” remedy see Davies and Worthington, note 38, ch. 20. 112  Revlon, Inc. v.  MacAndrews & Forbes Holdings, Inc. 506 Atlantic Reporter 2d 173 (Delaware 1986). 113  See e.g. Paramount Communications, Inc. v. QVC Network, Inc., 637 Atlantic Reporter 2d 34 (Delaware Supreme Court 1994). 114  See Mahoney and Weinstein, note 103, 272–​4; compare Weinberger v. UOP, Inc., 457 Atlantic Reporter 2d. 701 (Delaware Supreme Court 1983); Kahn v. Lynch Communications Systems, Inc., 638 Atlantic Reporter 2d 1111 (Delaware 1994). Robert B. Thompson, Squeeze-​out Mergers and the “New” Appraisal Remedy, 62 Washington University Law Quarterly 415 (1984). See also Chapter 6.2.2.1.

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7.4.2.1 When the parent has more than 90 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 option inspired by Germany’s Konzernrecht.115 More dramatically, a parent company holding more than 90 percent of a subsidiary can unilaterally merge the subsidiary into itself without a shareholders meeting of the controlled company (a so-​called “short-​form” merger) in most U.S. jurisdictions—​with minority shareholders entitled to appraisal rights in lieu of a shareholder vote.116 Japanese law is similar.117

7.4.2.2 When the parent has less than 90 percent U.S. law also permits cash-​out mergers, 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.118 U.S. securities regulation requires public corporations that go private (as a result of the freeze-​out merger) to make disclosures relating to the fairness of the transaction and to any discussions with third parties who may be interested in acquiring the company,119 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 necessary to protect the minority’s interests.120 In addition, the Delaware courts generally review parent-​subsidiary mergers under the rigorous “entire 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 standard to a de facto trusteeship strategy, as the use of independent committees is rewarded. The law in EU jurisdictions is less clear-​cut with respect to controlled mergers and freeze-​outs involving companies in which the controlling shareholder holds less than 115 See Arts. 27–​ 9 Third Directive. See also Volker Emmerich and Mathias Habersack, Konzernrecht 141–​6 (10th edn., 2013). 116  See e.g. § 253 DGCL. 117  Art. 784(1) Companies Act (Japan). 118  In 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. 119  Rule 13e-​3 1934 Securities Exchange Act. 120  Art. 236-​6 Règlement Général de l’AMF. 121  See Chapter 6.2.2.1. 122  Kahn v. Lynch, note 114. 123  Kahn v.  M & F Worldwide Corp., 88 Atlantic Reporter 3d 635; see also In re Cox Communications, Inc. 879 Atlantic Reporter 2d 604. See Chapter 6.2.2.1. For Japan, see Wataru Tanaka, Going Private and the Role of Courts: A Comparison of Delaware and Japan, 3 University of Tokyo Soft Law Review 12 (2011).

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90 percent.124 The 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.125 In France, a company’s charter may provide that its minority shareholders can be cashed out in well-​defined circumstances, although the terms of such a buy-​out would be subject to a Delaware-​like fairness review by the courts.126 Without an authorizing provision in the charter, however, it does not seem that a controlling shareholder may freeze out even abusive minority shareholders.127 By contrast, German law does recognize the right of a controlling shareholder to freeze out an abusive minority 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.128 In Italy, absent an absolute right to cash out minorities, a 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.129

7.4.2.3 Freeze-​outs through non-​merger techniques 7.4.2.3.1  Compulsory share sales Many jurisdictions also provide freeze-​out (or, as they are also known, squeeze-​out) techniques which are not based formally on a merger transaction. As we shall see in ­chapter 8,130 under EU law an acquirer which ends up with 90 to 95 percent of a target’s shares after a public offer is able to squeeze out the non-​accepting shareholders on the terms of the public offer (or something near it)—​and the minority has a similar right to be bought out. In some jurisdictions the same facility is made available, whether or not the 90 or 95 percent threshold is reached via 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 shareholders.131 The price in the compulsory acquisition has to be approved ex ante 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 procedure at

124  For a recent comparison, see Christian A. Krebs, Freeze-​Out Transactions in Germany and the U.S.: A Comparative Analysis, 13 German Law Journal 941 (2012). 125  Regarding the German approach, see Bundesverfassungsgericht, Aug. 7, 1962—​1 BvL 16/​60, Bundesverfassungsgericht (BVerfGE) 14, 263 [Feldmühle]: Schmidt, note 105, at 348. 126  Cozian et al., note 39, at 216–​18. 127 See Cour de Cassation Commerciale, 1996 Revue des Sociétés 554 (freeze-​out is prohibited unless permitted by statute or the corporation’s charter). 128  BGH, March 20, 1995–​II ZR 205/​94, BGHZ 129, 136 [Girmes]. 129  See Luigi A. Bianchi, La Congruità del Rapporto di Cambio nella Fusione 101 (2002). 130  See Chapter 8.3.5. If, however, an existing 90 percent majority mounts a bid for the company simply in order to squeeze out the minority, UK scrutinizes the reason for the squeeze-​out by reference to a standard akin to that applied to charter amendments to that end. See Re Bugle Press Ltd [1961] Ch 270. 131  Art. L. 433-​4 Code Monétaire et Financier; Arts. 236-​3, 236-​4, and 237-​1 Règlement Général de l’AMF. The minority has a parallel right to be bought out (Art. L.  433-​4 Code Monétaire et Financier; Arts. 236-​1 and 236-​2 Règlement Général de l’AMF). 132  Arts. 237-​2, 261-​1(II), and 262-​1 Règlement Général de l’AMF. See generally Viandier, note 97, at 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 expert on the adequacy of the compensation).133 Unlike in the French procedure, the price is not approved ex ante but is subject to ex post 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 from being effected immediately, the post squeeze-​out procedure can be protracted (even up to ten years), which generates a strong incentive for the 95 percent shareholder 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.134 In Japan, a complex procedure using a special type of class of shares, which requires two-​thirds 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’s shares to squeeze out the minority shareholders without a shareholders’ meeting.135 In jurisdictions (such as the UK) which lack explicit procedures for squeezing out minorities (other than post-​bid), a variety of substitute corporate procedures may be available. The issue is whether these more general procedures provide adequate safeguards against majority opportunism when used to effect a squeeze-​out. The simplest form of these non-​specific 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 situation, UK courts, under their general power to review charter amendments,136 have developed a requirement for a good corporate reason for even a fair-​price squeeze-​out, in contrast with the simple requirement for good faith in respect of other changes to the charter. In Australia, from a similar doctrinal starting-​point, the High Court has barred such compulsory acquisitions except in very limited circumstances.137

7.4.2.3.2  Other squeeze-​out techniques A charter amendment is not, however, the 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 dissolution138 or, in those 133 §§ 327a-​ f AktG. See Thomas Stohlmeier, German Public Takeover Law (2nd edn., 2007) 139. 134  Stohlmeier, note 133, at 145. The post-​bid 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 and Chapter 8.3.5. 135 Art. 179 Companies Act (Japan). For details, see Marco Ventoruzzo et  al., Comparative Corporate Law 497 (2015). 136  UK courts may rely on the “unfair prejudice” 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.” See note 39. This 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] 1 BCLC 468. 137  Gambotto v. WCP Ltd (1995) 127 Australian Law Reports 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. 138  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 the price for the transfer of the assets. Consequently, the more recently introduced general 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 importance to legal capital, a reduction of capital, may all be used to this end. Again, since these procedures are not designed for squeeze-​outs, the protection against opportunism lies mainly in the deployment of standards strategies governing the majority’s decision.139 The delisting of a traded company may also operate as a squeeze-​out. Delisting and deregistration deprive shareholders and creditors of the benefits of extended mandatory disclosure, in addition to vastly reducing the shares’ liquidity. In light of this, exit from either regulatory structure is a fundamental change in the firm.140 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 seeking to delist or to downgrade an issuer.141

7.4.3 The protection of non-​shareholder constituencies in mergers Several of our core jurisdictions seek to protect non-​shareholder constituencies (creditors and/​or employees) in mergers and other organic changes in addition to addressing the agency problems between managers and shareholders and between controlling and minority shareholders.

7.4.3.1 The protection of creditors As we noted in Chapter 5, the European jurisdictions, Japan, and Brazil are generally more creditor-​friendly than the U.S.142 In keeping with this tradition, these jurisdictions offer special protection to creditors when firms undergo mergers and similar organic changes. Brazilian law goes as far as to grant creditors that are harmed by the merger the formal right to seek its annulment within sixty days.143 Although 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.144 These 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.145

7.4.3.2 The protection of employees There 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 works councils or board-​level representation) in the merger decision and to what 139 See Rock Nominees Ltd v. RCO (Holdings) plc [2004] 2 BCLC 439 (CA—​UK): bidder, which had fallen just short of the 90 percent threshold for a post-​bid squeeze-​out, proposed to sell the business of the new subsidiary to another group company, liquidate the vendor and distribute its assets to the shareholders. The 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.” 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. 140  See Jonathan Macey, Maureen O’Hara, and David Pompilio, Down and Out in the Stock Market: The Law and Economics of the Delisting Process, 51 Journal of Law & Economics 683 (2008). 141 Chapter 9.1.2.7. 142  See Chapter 5.4. 143  Lei das Sociedades por Ações Art. 232. 144  See Art. 13 Third Directive. 145  § 22 Umwandlungsgesetz (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? This 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. The 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 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 Directive146 mandates consultation on the part of both transferor and transferee employers with the representatives of the employees (unionized or non-​unionized) prior to the transfer of the business. The focus of the consultation is on the implications of the merger for the employees.147 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 representatives into this timetable.148 U.S. law is more cautious. There 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. The quality of the voice mechanisms after the merger will normally depend on the rules applying to the surviving or emerging company. This has proved to be a particular problem in cross-​border mergers in the European Union, since voice requirements, especially in terms of board-​level representation, vary significantly from member state to member state. We discuss this issue further in Section 7.5. For purely domestic mergers, the Acquired Rights Directive has a limited provision preserving the voice arrangements existing within the transferor after the transfer.149 However, since in most member states 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.

146  Directive 2001/​23/​EC, Chapter III. 147  Ibid., Art. 7 (“the legal, economic and social implications of the transfer for the employees” and “any measures envisaged in relation to the employees”; yet, the employer must also 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 travail). 148  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, The Rover Case—​Bargaining in the Shadow of TUPE (2000) 29 Industrial Law Journal 395. 149  Art. 6. This operates only if (a) the undertaking transferred “preserves its autonomy” and (b) “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 employees (in the relevant bargaining unit) worked for the seller.150 As to the second point—​protection of acquired 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 or emerging entity.151 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.152 It also makes the fact of the transfer an unacceptable ground for dismissal. These two rules put the burden of any subsequent lay-​off compensation on the transferee employer, but this can normally be allowed for in the price paid for the transferor’s business. The more problematic rule from an economic perspective is that transferred employees who remain on the job also retain the pre-​existing terms and conditions of their employment. This 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 common law doctrine of the personal nature of the contract of service153 and does not provide for automatic transfer of the contract of employment in the non-​unionized area. Even in the unionized area the same approach has influenced judicial interpretation of the U.S. National Labor Relations Act. The extent to which collectively agreed terms and conditions will be carried over to the transferee employer depends on the form of the transaction, as described above.154

7.4.4  Corporate divisions A corporate division is the transactional inverse of a merger: it divides the assets and liabilities of a single corporation into two or more surviving corporations, one of which may be the dividing corporation itself.155 Despite logical similarities between mergers and divisions, however, jurisdictions differ on whether they are as closely regulated as mergers. The 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.156 At 150  Edward B. Rock and Michael L. Wachter, Labor Law Successorship: A Corporate Law Approach, 92 Michigan Law Review 203, 212–​32 (1993). 151  Though in the UK the courts found automatic statutory transfer of employment contracts to be inconsistent with the personal nature of the relationship embodied in them: see Nokes v. Doncaster Amalgamated Collieries Ltd [1940] AC 1014, HL. 152  Directive 2001/​23/​EC, Chapter II, replacing an earlier directive of 1977. 153  See text accompanying note 151. 154 Rock and Wachter, note 150; Howard Johnson Co. v.  Detroit Local Joint Executive Bd 417 United States Reports 249 (1974). 155  A corporate division is not to be confused with the creation of a subsidiary: while in 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’s assets. 156  See Arts. 783, 784, 795, 796, 804, and 805 Companies Act (Japan).

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first glance, the EU is different. The provisions of the Sixth Company Law Directive157 regulating divisions are a virtual mirror-​image of the Third Directive dealing with mer­ gers, including its provisions on minority and creditor protection. In practice, however, member states do not scrutinize divisions as closely as mergers, and the reach of the detailed requirements can be avoided.158 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 “significant” in the first instance. To 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 at least conflict between the shareholders and managers—​is lower than the parallel risk of conflict in mergers. Further, empire dismantling is less prone to create 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 shareholders, the protection of creditors and employees appears particularly necessary in the case of corporate divisions. The 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. Thus, EU law makes companies receiving assets through a division jointly and severally responsible to pre-​division creditors, though the liability of the receiving companies other than the one to which the debt was transferred may be limited to the value of the assets transferred.159 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, the rights of employees depend on the mode by which operations are transferred.160 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.161 In Japan, the general rule is that divisions transfer debts without consent of individual creditors (though they can object and get payment or collateral162), but employees are given special rights to voice and generally, unless they agree, their employment contracts are not transferred.163 157  Sixth Company Law Directive 82/​891/​EEC, 1982 O.J. (L 378) 47. 158  E.g. an individual transfer of assets and debts falls outside the regime of divisions. 159  Art. 12 Sixth Directive. The 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. 160  See note 150. 161  Crucially, 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 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/​EC establishing a general framework for informing and consulting employees in the European Community, 2002 O.J. (L 80) 29. 162  Arts. 759(2)-​(4) and 764(2)-​(4) Companies Act. 163  See Act for the Succession of Employment Contracts in Corporate Divisions (2000) (Japan).

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7.5  Reincorporation and Conversion The migration of a corporation between jurisdictions can also fundamentally transform the relationship among the participants. If the new home’s corporate law is more pro-​management or pro-​controlling shareholder, such a migration can aggravate the management–​shareholder or controlling-​minority shareholder agency problems. If the new home’s corporate law is less protective of non-​shareholder interests, such a migration can be a means by which shareholders and managers transfer value from non-​shareholder constituencies to themselves. These problems are controlled using different tools. Consider the mechanics of corporate migration. The easiest process is to allow companies, 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 vote of shareholders, so long as the corporate body will, inter alia, remain liable to creditors in the new jurisdiction.164 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. This simple, direct approach is highly unusual.165 A more common mechanism allows a corporation to migrate by 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 owned Delaware subsidiary, with the Delaware subsidiary continuing as the surviving corporation.166 Shareholders of the California corporation typically receive the same percentage of ownership in the Delaware corporation as they previously had in the California corporation. Elsewhere, a scheme of arrangement—​which requires a shareholder vote and court approval—​has been used to effect a migration.167 In addition, there are more complex mechanisms involving asset or stock sales that can reach the same outcome, although sometimes with different tax consequences.168 In the common migration-​by-​merger structure, minority shareholders and other constituencies are usually no more and no less protected than in any other merger.169 EU law has been heavily promoting cross-​border corporate mobility within Europe. There seem to be three avenues in place now to effect a cross-​border relocation. The first, and most uncertain way is to reincorporate to another EU jurisdiction by converting into 164  Douglas J. Cumming and Jeffrey G. MacIntosh, The Rationales Underlying Reincorporation and Implications for Canadian Corporations, 22 International Review of Law & Economics 277, 279 (2002). 165  A similar procedure is available to the European Company (see below) to move between EU jurisdictions. The Company Law Review (UK) proposed a similar procedure for 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 Treasury fears of loss of tax revenues. See CLR, Final Report (2001), ch. 13 (URN 01/​942). 166  See e.g. Ronald J. Gilson, Globalizing Corporate Governance: Convergence of Form or Function, 49 American Journal of Comparative Law 329, 355 n. 90 (2001). 167  For an account of News 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 Vanderbilt Law Review 1 (2010). 168  For an analysis of the intersection of charter competition and tax considerations, see Mitchell Kane and Edward Rock, Corporate Taxation and International Charter Competition, 106 Michigan Law Review 1229 (2008). 169  Section 7.4. Yet, this is not the case in the EU. See text accompanying notes 180–​1.

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the equivalent legal form of the destination state, relying on the case-​law of the European Court of Justice. Whereas the early CJEU cases concerning cross-​border mobility had mostly focused on the formation stage of companies,170 more recent jurisprudence deals with the possibility to effect midstream changes. Taken together, the two recent decisions in Cartesio171 and Vale172 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.173 However, this territory is still relatively uncertain and awaits real-​life exploration.174 The second strategy is to use the legal form of a Societas Europaea,175 a type of pan-​ European corporate entity, which expressly allows for cross-​border relocation with retention of legal personality.176 Art. 8 SE Regulation provides for an elaborate system of protection rights to the benefit of minority shareholders, creditors, and employees.177 There is now a non-​negligible number of SEs, and a substantial proportion of them have already carried out a seat transfer.178 The third and final route for corporate migration is to employ the European Cross-​ Border Merger Directive.179 Similar to the migration-​by-​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.180 But unlike in the U.S., and following

170  See on this Wolf-​Georg Ringe, Corporate Mobility in the European Union—​a Flash in the Pan? An Empirical Study on the Success of Lawmaking and Regulatory Competition, 10 European Company & Financial Law Review 230 (2013). 171  Case C-​210/​06 Cartesio Oktató és Szolgáltató bt, [2008] ECR I-​9641. 172  Case C-​378/​10 VALE Építési kft, ECLI:EU:C:2012:440. 173  In a first decision, the OLG (Court of Appeal) of 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, Neue Zeitschrift für Gesellschaftsrecht (NZG) 2014, 349. See also Kammergericht Berlin, March 21, 2016 –​22 W 64/​15, NZG 2016, 834. 174  This uncertainty has led to reinforced calls for a specific EU instrument, dealing with cross-​ border shifts of the registered office. 175  The SE was established by two instruments in 2001: Council Regulation (EC) No 2157/​2001 on the Statute for a European Company (“SE Regulation”), and the accompanying Council Directive 2001/​86/​EC of 8 October 2001 supplementing the Statute for a European company with regard to the involvement of employees (“SE Directive”). It can only be created by either merger, the creation of a holding company, creation of a joint subsidiary, or conversion of an existing company set up under the laws of a member state. 176  SE Regulation, Arts. 7, 8, and 69. The only downside is that a reincorporation also 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 establishment created by the European Treaties see Wolf-​Georg Ringe, The European Company Statute in the Context of Freedom of Establishment, 7 Journal of Corporate Law Studies 185 (2007). 177  See, in particular, SE Regulation Art. 8(2), (3), (5), and (7). 178  By 2014, over 2,100 SEs were registered across 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). This is based on data from the European Trade Union Institute (http://​ecdb.worker-​participation.eu/​). 179  Directive 2005/​56/​EC of 26 October 2005 on cross-​border mergers of limited liability companies, 2005 O.J. (L 310)  1 (hereinafter Cross-​Border Merger [CBM] Directive). To some extent the CJEU jumped the gun by holding in the SEVIC case that Germany violated (what is now) Arts. 49 and 56 TFEU (freedoms of establishment and capital) by permitting the registration of domestic mergers without also permitting equivalent registration of cross-​border mergers (Case C-​411/​03, SEVIC Systems AG [2005] ECR I-​10805, paras. 16–​19). 180  Unlike with the SE, transfer of 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 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 rules will continue to apply post-​reincorporation. When one or more of the companies that are merging or forming an SE are subject to employee 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.181 To be sure, the safety standards for the creation of an SE and for cross-​border mer­ gers under the Directive are default rules, but strong default rules, since they can be modified only if management and employee representatives negotiate a different solution in advance of the reincorporation.182 This approach is intended to prevent cross-​ border mergers from undermining existing board-​level voice requirements but not to extend such requirements to companies not previously subject to them (e.g. in a cross-​border merger of companies, none of which was previously subject to mandatory board-​level employee voice). Despite this policy, however, German companies have been 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.183 Beyond cross-​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, a strategy known as conversion. As discussed in Chapter 1, the ability to select among different organizational forms is

Law 1999–​2010:  Renaissance and Crisis, 48 Common Market Law Review 125, 161 ff. (2011); Bech Bruun & Lexidale, Study on the Application of the Cross-​Border Mergers Directive, September 2013, Main Findings 23. 181  Wolf-​Georg Ringe, Mitbestimmungsrechtliche Folgen einer SE-​Sitzverlegung, Neue Zeitschrift für Gesellschaftsrecht 931 (2006). 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 merger and to rules modeled on the European Works Councils Directive (Directive 94/​45/​EC) in the case of an SE. 182  This summarizes a very complicated set of provisions (see Paul Davies, Workers on the Board of the European Company?, 32 Industrial Law Journal 75 (2003)); and the provisions themselves vary slightly according to whether the reincorporation is effected by formation of an SE or under the CBM Directive. The requirement for pre-​merger settlement of the board influence issue through 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” 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, and Markus Reps, Contracting Employee Involvement: An Analysis of Bargaining over Employee Involvement Rules for a Societas Europaea, 12 Journal of Corporate Law Studies 201 (2012). 183  For example, a reduction in the size of the board (Chapter 3.1), a more international composition of the board or a “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 to parity representation can form an SE, which will then remain subject to one-​third also after crossing the employee threshold). See Berndt Keller and Frank Werner, The Establishment of the European Company: The First Cases from an Industrial Relations Perspective, 14 European Journal of Industrial Relations 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 consequential as reincorporations: both after conversion and following migration, the outcome is a wholesale alteration in the default and mandatory rules provided by law. While most jurisdictions permit corporations to convert into other business forms without the need for prior dissolution, such decisions typically invite close 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 approval.184 Yet there are ways around such rigors. Delaware permits companies to effect a change in organizational form through mergers—​which are policed through the comparatively more flexible mechanisms applicable to mer­ gers, as discussed in Section 7.4. Brazilian law permits companies to opt out of the 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.185 However, the precise quorum required to approve a conversion may also depend on the new entity type being selected—​and on the nature of its differences vis-​à-​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, but of two-​thirds of the outstanding shares for a conversion or merger into a public benefit corporation—​an organizational form which, as the name suggests, requires the pursuit of a “public benefit” beyond profit.186

7.6  General Provisions on Significant Transactions 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. The downside of the transaction-​by-​transaction approach is that it can often be side-​stepped by adopting a non-​regulated transaction that achieves the same functional goal. To be sure, in some jurisdictions, strongly enforced directors’ duties operate as powerful general standards across transactional types. This is particularly the case in Delaware. 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 and the UK have developed general criteria for the identification of situations in which shareholder consent for a transaction is required, though in neither case as a result of legislative action.187 In Germany the doctrine was developed 184  DGCL § 266; Lei das Sociedades por Ações Art. 221 (requiring unanimous approval as a default rule that can be altered in the charter). 185  E.g. Umwandlungsgesetz §§ 226, 240 (Germany), and CA 2006, section 90 (UK) both specify, inter alia, a 75 percent majority requirement for conversions from private to public company. 186  DGCL § 363. See also Chapter 1.2.5. 187  The only exception in German law is AktG § 179a which 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 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’ meeting may decide on matters concerning the management of the company only if required by the management board.”188 In its famous Holzmüller189 decision, later restricted and somewhat clarified in its Gelatine I and II decisions,190 the BGH turned this provision on its head in the case of a 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 only shareholder.191 The decision caused enormous uncertainty as to when the management had to seek the approval of the shareholders in corporate restructurings. Although the Gelatine cases somewhat restrict the scope of the doctrine, by confining it to decisions affecting a major part of the company’s assets and having a highly significant impact on the practical value of the shareholders’ rights, uncertainty still exists in relation to the scope of the doctrine.192 A more recent decision by the Frankfurt Court of Appeal confirmed that the Holzmüller principle does not apply to acquisitions of major assets.193 In the UK, the Financial Conduct Authority’s “significant transactions” rules,194 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.195 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 approval, unless it is within the ordinary course of the company’s business or is a financing transaction not involving the acquisition or disposal of fixed assets of the company.196 The requisite size is 25 percent or more of any one of the listed company’s 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 grants dissenting shareholders appraisal rights as well). 188  AktG § 119(2). 189  BGH, Feb. 25, 1982 –​II ZR 174/​80, BGHZ 83,122. 190  BGH, Apr. 26, 2004 –​II ZR 155/​02, BGHZ 159, 30 (Gelatine I ) and BGH, Apr. 26, 2004 –​II ZR 154/​02, ZIP 2004, 1001 (Gelatine II ). See generally Marc Löbbe, Corporate Groups: Competences of the Shareholders’ Meeting and Minority Protection, 5 German Law Journal 1057 (2004). 191  The threat to parent shareholders’ preemptive rights also played a role: see Section 7.3.2. 192  As a result of the Gelatine cases it is now clear that, where shareholder approval is required, three-​quarters of those voting must consent, by analogy with what is needed to 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). 193  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, NZG 2011, 62. 194  Listing Rules, c­ hapter 10. 195  “This chapter is intended to cover transactions that are outside the ordinary course of 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). 196  LR 10.1.3. On the impact of such rules on share prices, see Marco Becht, Andrea 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.197 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,198 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.”199 This, as we have seen, is part of a set of provisions empowering the regulator to protect minority interests through the 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.200 As such, the French approach, besides its different remedy, seems to fall in between the German one of trying to identify a general principle and the British one of using financial thresholds for triggering the minority protections, by laying down a list of circumstances in which a buy-​out may be required.

7.7  Explaining Differences in the Regulation of Fundamental Changes The 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. A “decision rights” strategy seems to be the method most widely used to constrain the problems involved with fundamental changes, 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.201 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 divide.202 Although continental European jurisdictions rely less on judicially enforced standards to regulate mergers than do the Anglo-​American 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. 197  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). 198 Section 7.2.2. 199  Art. 236-​6 Règlement Général de l’AMF. See Viandier, note 97, at 461–​4. 200  See Sections 7.2.2, 7.4.1.2, 7.4.2.2, and 7.4.2.3.1. 201  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. 202  Differences mostly concern the question of how much the board is in charge in initiating or co-​deciding 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 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 to 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 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 to impose liability on controlling shareholders for abusive action—​though enforcement remains an issue. The greater power of the general 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 we noted in Chapter 3—​the well-​known differences in ownership structures.203 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 minority shareholders. As noted above, boards must approve important decisions in the U.S., which modestly limits 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.204 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. The differences among jurisdictions also seem roughly to map the extent of transactional flexibility within jurisdictions: in the U.S. and the UK, where a variety of alternative transactional forms can be used to achieve the same goal, the systems are forced to adopt ex post 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

203  See Chapter 3.1.1.5, 3.1.2.5, and 3.2.5. 204  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 Takeover Code.205 Finally, the protection of 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.

205  See Chapter 8 for discussion of the Takeover Code.

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8 Control Transactions Paul Davies, Klaus Hopt, and Wolf-​Georg Ringe

8.1  Regulatory Problems in Control Transactions 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 company.

8.1.1 Control transactions The core “control transaction” in this chapter is one between a third party (the acquirer)1 and the company’s shareholders. Of course, control may also shift as a result of a transaction between the company and its shareholders or the investing public (as when a company issues or re-​purchases shares or engages in a statutory merger). 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. The 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 which warrants separate treatment.2 Admittedly, in terms of end result, there may not be much difference between a statutory merger3 and a takeover bid where the successful bidder squeezes out the non-​ accepting minority. Yet, in terms of the legal techniques used to effect the control shift, there is a chasm between the two mechanisms. A merger involves corporate decisions, usually by both shareholders and the board,4 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. This 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.5 1  Of course, the acquirer may, and typically will, already be a shareholder of the target company, but it need not be and the relevant rules (other than shareholding disclosure rules) do not turn on whether it is or not. The bidder may also be or contain the existing management of the target company (as in a management buy-​out (MBO)). This situation generates significant agency problems for the shareholders of the target company which we address below. 2  The special character of control transactions is also 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. 4  Where the merger is adapted to function as a post-​bid squeeze-​out technique, the shareholder vote may be dispensed with. See Section 8.3.5. 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. (The Panel on Takeovers The Anatomy of Corporate Law. Third 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.6 The 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).7 Of the three acquisition methods, the second and third are clearly facilitated if the target’s shares are traded on a public market. For this reason, companies with publicly traded shares are at the center of attention in this 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 of these, such as the top-​tier markets).8 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 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 controlling shareholders, the application of these standards to the managements and shareholders of non-​traded companies raises no difficult boundary questions.9 The 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 financial crisis.10 The takeover market now appears to have recovered from its most recent crisis.11 Traditionally, 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, The Takeover Code (11th edn., 2013) § A3(b) and Appendix 7—​hereafter “Takeover Code”). But in most jurisdictions the regulation of takeovers is confined to control shifts. Thus, Art. 2(1)(a) Directive of the European Parliament and of the Council on Takeover Bids, 2004/​25/​EC, 2004 O.J. (L 142) 12 (hereafter “Takeover Directive”) excludes statutory mergers. 6  Whether these three acquisition strategies give rise to the same regulatory problems is subject of considerable debate. See e.g. note 144. 7  Of course, the board’s decision whether to recommend an 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 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 facilitates hostile bids is of enormous importance. See Section 8.2.1. 8  Thus the Takeover Directive applies only to companies whose securities are traded on a “regulated market” (Art. 1(1)). In contrast, however, the UK Takeover Code applies to all companies which may offer their shares to the public and even to closely held companies where there has been something analogous to a public market in the private company’s shares (Takeover Code, § A3(a)). 9  See Section 8.4.1 for a discussion of U.S. rules on sales of shares by controlling shareholders to looters. 10  For recent analyses, see Marina Martynova and Luc Renneboog, The Performance of the European Market for Corporate Control:  Evidence from the Fifth Takeover Wave, 17 European Financial Management 208 (2011); Marccus Partners, External Study on the application of the Directive on takeover bids, section IV (2012). 11  Arash Massoudi and Ed Hammond, Hostile Bids Reach 14-​Year High, Financial Times, 9 June 2014, at 3. 12 Roberta Romano, A Guide to Takeovers:  Theory, Evidence, and Regulation, 9 Yale Journal on Regulation 119, 122 (1992); Marina Martynova and Luc Renneboog, A Century of Corporate Takeovers:  What Have We Learned and Where Do We Stand?, 32 Journal of Banking & Finance 2148, 2153 (2008); Klaus J. Hopt, Takeover Defenses in Europe: A Comparative, Theoretical and Policy Analysis, 20 Columbia Journal of European Law 249, 252 (2014).

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bid or may even suffer.13 Overall, however, takeovers appear to create value for both groups taken together.14 Nevertheless, judged solely from the bidder’s perspective, many takeovers turn out to have been an economic misjudgment in retrospect. This raises the question of why takeovers happen in the first place.15 That is not an issue which control transaction rules tend to address, at least not directly.16 With due exceptions, bidder management and shareholder relations are usually left to general corporate governance rules.17 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 issues Takeover regulation worldwide seeks to address two main issues:  agency problems, predominantly within the target company, and coordination problems among the target shareholders. The specific shape of these problems largely 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 prevailing standard of ownership concentration in the jurisdiction—​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, 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. Therefore, 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. The control transaction may be wealth-​enhancing from the target shareholders’ point of view but threaten the jobs and perquisites of the existing senior management. The incumbent management of the target may thus have an incentive to block such transfers by adopting a range of different “defensive measures.” They may seek to make the target less attractive to a potential bidder or to prevent the offer being

13  Jarrad Harford, Mark Humphery-​Jenner, and Ronan Powell, The Sources of Value Destruction in Acquisitions by Entrenched Managers, 106 Journal of Financial Economics 247 (2012). See, with further references, Klaus J. Hopt, European Takeover Reform of 2012/​2013—​Time to Re-​examine the Mandatory Bid, 15 European Business Organization Law Review 143, 150 (2014). 14  B. Espen Eckbo, Corporate Takeovers and Economic Efficiency, 6 Annual Review of Financial Economics 51, 67 (2014). See also Martynova and Renneboog, note 12, at 2164. 15  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. 16  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 Review of Financial Studies 3035 (2016). 17  See Chapter 7.6.

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put to the shareholders. These steps may take a myriad of forms but the main categories are: i) placing a block of the target’s shares in the hands of persons not likely 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-​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” the offer to its addressees or, in the case of competing bids, to favor one bidder over another. Target 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. The 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 shareholders. This 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. The law can address this problem by focusing on the existing controlling shareholder’s decision to sell, on the 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.18 The 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.19 By contrast, takeover rules do not often address the agency problems which arise as between the shareholders of the acquiring company and their board in relation to the decision to acquire the target; and we shall follow that lead in this chapter. This 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.20 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 impacts upon the incentives for potential bidders to put forward an offer.

8.1.2.2 Coordination problems The rules governing control transactions need also to deal with the coordination problems of the target shareholders. In particular, the acquirer may seek to induce dispersed shareholders of the target to accept an offer which is less than optimal. There 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 18  See Chapter 6.2.5.3. 19  See Section 8.3.4. 20  See Chapters 3, 5, and 7 (and especially Section 7.6).

21  See Section 8.3.

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shareholders. Where the target company is controlled by a blockholder, the same problem arises for the remaining shareholders, possibly as against acquirer and controlling shareholder combined.

8.1.2.3 Agency problems of non-​shareholders Whatever the structure of the target company’s shareholding, agency issues will also arise between the acquirer and non-​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 groups, especially the employees of the target.22 The 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 interests, other than via disclosure of information.23 This strategy is heavily adopted by the Takeover Directive, but the disclosure obligation sits in a vacuum, dependent for its effectiveness upon rules and institutions existing outside corporate law. In some jurisdictions such structures—​usually some form of works council—​do exist and may be built into the takeover process by national legislation. The 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.24 Recent changes to the UK Code improved the disclosure, monitoring, and enforcement by the Panel of takeover promises (so-​called “post-​offer undertakings”) that the bidder (or, exceptionally, the target) makes in the course of a bid and which are directed at non-​shareholder concerns.25 Where, 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 groups. Thus, in the U.S., one popular form of state anti​takeover statute (the so-​called “constituency 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.26 It is doubtful, however, whether, by itself, relieving directors of liability to the shareholders if they act to promote non-​shareholder interests encourages anything more than self-​ interested behavior on the part of the target board. The 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 constituencies will benefit from

22 Margaret M. Blair, Ownership and Control (1995); Andrei Shleifer and Lawrence H. Summers, Breach of Trust in Hostile Takeovers, in Corporate Takeovers: Causes and Consequences 33 (Alan J. Auerbach ed., 1988). 23  Of course, 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. See Chapter 7.4.3.2. 24  The Loi “Florange” No. 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 to L. 2323-​ 24). The board of directors cannot issue a recommendation before the works council does, which may significantly slow down the process and even discourage takeover bids. 25  New Rules 19.7 and 19.8. The background is non-​compliance with such promises in the past. 26  See e.g. § 717(b) New York Business Corporation Law. To 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.27 The third pattern involves giving non-​shareholders decision rights, though in practice jurisdictions only deploy this strategy in relation to employee interests. In those jurisdictions (notably Germany) in which company law is used in a significant way to regulate the process of contracting for labor,28 the presence of employee 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 decisions, up to the point where control shifts are hard to achieve without the consent of the employee representatives.29 Creditors, as well as employees, may stand to lose out as a result of changes in the company’s risk profile post-​bid, perhaps arising from the leveraged nature of the bid. Those most at risk, the long-​term lenders, are well placed to protect themselves by contractual provisions, such as “event risk” covenants in loans.30 Such protections may not always be fully protective of the creditors, but adopting sub-​optimal contractual protection is normally part of the commercial bargain. Consequently, the agency costs of creditors are not usually addressed in control-​shift rules.31

8.1.2.4 The sources of rules 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, albeit in a new context. In practice, this question is largely 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. Towards 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 Takeover-​specific law, whether in the form of federal (Williams Act)33 or state legislation (rules governing access to the short-​form, squeeze-​out merger),34 plays a subordinate role.

27 See also Mark J. Roe, Political Determinants of Corporate Governance 45 (2002) (employee influence is indirect and weak, constituency statutes being made by and for managers). 28  See Chapter 4.2.1. 29  German law de facto opts out from the Takeover 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. 30 William W. Bratton, Bond Covenants and Creditor Protection, 7 European Business Orga­nization Law Review 39, especially at 58–​62 (2006). 31  It is sometimes difficult to distinguish covenants whose aim is to protect 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, 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 made it easier for a pro-​ management approach to emerge because, on the one hand, case law precedents are relatively free from 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 the courts. See John Armour and David Skeel, Who Writes the Rules for Hostile Takeovers, and Why?—​The Peculiar Divergences of U.S. and U.K. Takeover Regulation, 95 Georgetown Law Journal 1727, 1793 (2007). 33  1968, 82 Stat. 454, codified at 15 U.S.C. §§ 78m(d)–​(e) and 78n(d)–​(f ), adding new §§ 13(d), 13(e), and 14(d)–​(f ) to the Securities Exchange Act of 1934. 34 Section 8.3.5.

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By contrast, in the EU rules specific to control shifts are more important (though not to the complete exclusion of general rules of corporate and securities law). Thus, the Takeover 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.35 Japan sits somewhat between these two models.36 It has legislation specific to control shifts,37 but, on the central issue of the allocation of decision rights over the offer, court-​developed general standards applying to directors’ decisions are still central.38 Where regulation of control shifts is predominantly through takeover-​specific rules, the rule-​maker is likely to create a specialized agency to apply the rules, as mandated by the Takeover Directive.39 This will generally be the financial markets regulator but may be a specific regulator for takeovers.40

8.2  Agency Problems in Control Transactions Agency problems may arise in both widely held and controlled target corporations: the incumbent controller is the target board in the former case and the blockholder in the latter. In both cases, takeover regulation addresses the tensions between the “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 The decision rights choice: Shareholders only or shareholders and board jointly The central issue is whether the bidder is free to make and maintain an offer to the target shareholders without the consent of the incumbent management. The available solutions range from allocating the decision on the control 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-​maker41 and free transferability of shares becomes paramount. In the latter case, both management and target shareholders must consent if the control shift is to 35  See e.g. Arts. 254-​A and 257 Lei das Sociedades por Ações. 36  On the emerging framework in Japan, see John Armour, Jack B. Jacobs, and Curtis J. Milhaupt, The Evolution of Hostile Takeover Regimes in Developed and Emerging Markets: An Analytical Framework, 52 Harvard International Law Journal 291, 248 ff. (2011); Hideki Kanda, Takeover Defences and the Role of Law: A Japanese Perspective, in Perspectives in Company Law and Financial Regulation 413 (Michel Tison et al. eds., 2009); Masaru Hayakawa, Die Zulässigkeit von Abwehrmaßnahmen im sich entwickelnden japanischen Übernahmerecht, in Festschrift für Klaus J. Hopt 3081 (Stefan Grundmann et al. eds., 2010). 37  See Art. 27-​2 of the Financial Instruments and Exchange Act and Section 8.3.4. 38  Section 8.2.2—​coupled in this case with non-​binding guidelines issued by the government. 39 Art. 4(1). 40  The former is by far the more common choice within 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. 41  Typically, 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. The acquirer is forced to negotiate with both groups. The potential gains from the control shift may now have to be split 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.

8.2.2 The “no frustration” rule The UK Takeover 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. This 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 … ”42 This will affect, e.g. the issuance of new shares, the acquisition or disposal of significant assets, leveraging the capital structure or entering into substantial contracts other than in the ordinary course of business.43 The board will, however, typically remain entitled, in fact required, to give its assessment of the bid and may search for an alternative bidder (the “white knight”).44 The no frustration or, in EU jargon, “board neutrality” rule45 is an 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. The no frustration rule recognizes that effective implementation of exclusive shareholder 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. The no frustration rule is not, however, imposed by the Takeover 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).46 Where the “no frustration” rule is not applied, the general principles of national corporate law determine the target board’s freedom of action.

incumbent management or where the shareholders vote to remove a board that will not redeem a poison pill: Sections 8.2.2 and 8.2.3. 42 Rule 21.1. 43  See Takeover Code, Rule 21.1(b). Note that the items listed there are examples only. 44  See e.g. Art. 9(2) and (5)  Takeover 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. 45  The 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. 46  After the Directive was implemented across the EU, takeover laws across member states were surprisingly overall less favorable to board neutrality than they had been previously. See Paul Davies, Edmund-​Philipp Schuster, and Emilie van de Walle de Ghelcke, The Takeover Directive as a Protectionist Tool? in Company Law and Economic Protectionism 105, 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 Takeover Code and the Directive that shareholder approval means approval given during the offer period for the specific measures proposed and 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. This 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 approval rule.47 On the other hand, rendering pre-​bid approval of post-​bid defensive measures ineffective makes it more difficult for shareholders to commit themselves to handling future offers through board negotiation with the bidder.48 Pre-​bid shareholder approval is one way of legitimizing defensive action in Germany49 and also in Japan. In the latter, the governmental guidelines favor pre-​bid approval of defensive action “to allow the shareholders to make appropriate investment decisions.”50 However, court decisions are unclear on whether pre-​bid approval will always legitimize defensive measures.51 Given the scarcity of hostile takeovers in Brazil, the law on the legitimacy of defensive measures remains underdeveloped and, therefore, uncertain. Nevertheless, Brazil’s newly created Takeover Panel, whose membership is voluntary and still small, imposes a version of the no frustration rule during a pending offer.52

8.2.2.1 No frustration, neutrality, passivity, and competing bids The “no frustration” rule does not require boards to be “neutral,” let alone “passive.” There 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. This recognizes the role of the incumbent management in addressing the information asymmetry problems of the target shareholders. 47  This point is well captured in the French terminology which refers to advance authorization as approval given “à froid” and authorization given after the offer as given “à chaud.” 48  On pre-​commitment see Chapter 7.2. For the possible use of pre-​bid defensive measures to this end see Section 8.2.3. 49 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 of the shareholders, though the constitution of a particular company may set more demanding rules. However, approval may also be given post-​bid by the supervisory board without shareholder approval (WpÜG § 33(1)), and so 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 Perspectives in Company Law and Financial Regulation 373, at 373–​95 (Michel Tison et al. eds., 2009). 50 Ministry of Economy, Trade and Industry (METI) and Ministry of Justice, Guidelines Regarding Takeover Defense for the Purposes of Protection and Enhancement of Corporate Value and Shareholders’ Common Interests, 27 May 2005, p. 2. These guidelines are not legally binding but seek to capture court decisions and best practice. See also Corporate Value Study Group, Takeover Defense Measures in Light of Recent Environmental Changes, 30 June 2008. 51  As of the time of writing, there has been no court decision concerning a defensive measure based on the Guidelines accompanied by pre-​bid approval. However, the Supreme Court in the Bulldog Sauce 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, The Bulldog Sauce Takeover Defense, 10(3) Nomura Capital Markets Review 1 (2007). 52  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. Third, 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). Thus, the no frustration rule does not normally require the target management to give a potential bidder access to the target’s books in order to formulate its offer.53 The first and third possibilities often give the management of the target significant negotiating power with the bidder as to the terms of the offer. This 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.54

8.2.2.2 White knights and competing bids The 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. The wealth-​enhancing 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. This will discourage first bidders generally and so reduce the number of offers.55 More 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.”56 Thus, 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.57 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

53  Certainty about the target’s income generating potential may be very important for a leveraged offeror. 54  John C. Coates IV, M&A Break Fees: U.S. Litigation vs. UK Regulation, in Regulation versus Litigation: Perspectives From Economics and Law 239, 255 (Daniel P. Kessler ed., 2011). 55 Frank H. Easterbrook and Daniel R. Fischel, The Proper Role of a Target’s Management in Responding to a Tender Offer, 94 Harvard Law Review 1161 (1981). This trend is reinforced by some jurisdictions’ requirement of information 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 (Takeover Code, Rule 22). 56  Romano, note 12, at 156. 57  See Section 8.2.4.

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reason or if a competing offer emerges.58 To the same effect are rules giving competing bidders equal treatment with the first bidder as far as information is concerned.59 There are a number of techniques which can be used to mitigate the downside to the first bidder of rules which facilitate competing bids.60 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, the directors of the 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.61 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 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.62 They could be used to give a substantial advantage to 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 winning offer if its own offer is not accepted. Although pre-​bid purchases of shares in the target (by the offeror) do not normally fall foul of insider dealing prohibitions,63 rules requiring the public disclosure of share stakes and of economic interest in shares limit the opportunity to make cheap pre-​bid purchases of the target’s shares.64 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 decision-​making Where management is permitted unilaterally to take effective defensive measures in relation to an offer, the process of 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 58 This is the predominant rule in takeover regulations, including in the U.S. (see § 14(d)5 Securities Exchange Act and Rule 14d-​7)—​though not in the UK (Takeover Code, Rule 34, allowing withdrawals only more narrowly). The bidder may seek to avoid this rule by obtaining irrevocable acceptances outside the offer (and usually before it is made)—​though the acceptor may choose to make the acceptance conditional upon no competing bidder emerging. 59  See note 55 and Section 8.3.1. 60  For further analysis see Athanasios Kouloridas, The Law and Economics of Takeovers: an Acquirer’s Perspective (2008) chs. 6 and 7. 61  Dawson International plc v. Coats Patons plc [1990] Butterworths Company Law Cases 560 (Court of Session). 62  They are usually in the 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. They are allowed in Germany: see Hopt, note 12, at 276. 63  See e.g. Recital 30 to EU Market Abuse Regulation 596/​2014, 2014 O.J. (L 173) 1. 64  See, in the context of the shareholder activism debate, John C. Coffee, Jr., and Darius Palia, The Wolf at the Door:  The Impact of Hedge Fund Activism on Corporate Governance, 1 Annals of Corporate Governance 1 (2016).

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known of such measures is the “poison pill” or shareholders’ rights plan, as developed in the U.S.65 Here, the company’s charter provides that the crossing by an acquirer of a relatively low threshold of ownership (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.66 The dilutive effect of the plan on the acquirer renders the acquisition of further shares in the target fruitless or impossibly expensive. The 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 defensive measures becomes 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.67 Where the bid is acceptable, in the board’s view, it may “redeem” the pill and thus allow the takeover to go ahead. Defensive measures in the U.S. rely so heavily on poison pills that separate “anti​takeover” statutes adopted by a number of states have become largely irrelevant.68 As we will see 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.69 In France the legislature in 2006 designed a shareholder rights plan (so-​called “bons Breton” or, tellingly, “bons patriotes”)70 and slotted it into the overall statutory regulation of control transactions. However, as is generally the case in Europe, the issuance of new shares requires shareholder approval. Initially, French law required that approval to be given post-​bid (with a reciprocity-​based exception), in compliance with the no frustration rule. However, in 2014 (under the so-​called “Loi Florange”)71 the French no​frustration rule was repealed and 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 little use of the possibility, arguably distrusting the management before they even know the terms of an offer.72

65 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. 66  See e.g. Lucian A. Bebchuk and Allen Ferrell, Federalism and Corporate Law: The Race to Protect Managers from Takeovers, 99 Columbia Law Review 1168 (1999). See also, by the same authors, On Takeover Law and Regulatory Competition, 57 Business Lawyer 1047 (2002). 67   “The passage of time has dulled many to the incredibly powerful and novel device that a so-​ called poison pill is. That 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’)”: Strine V-​C in Hollinger Int’l v. Black, 844 Atlantic Reporter 2d 1022, 1064–​5 (2004, Del. Ch.). 68  Emiliano Catan and Marcel Kahan, The Law and Finance of Antitakeover Statutes, 68 Stanford Law Review 629 (2016). 69  See Section 8.2.3.2. 70  See Loi No 2006-​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. 71  See Arts L. 233-​32 and L. 233-​33 Code de commerce, as amended by the Loi “Florange” No. 2014-​384 of 29 March 2014. On this reform, see Quentin Durand, Loi visant à reconquérir l’économie réelle: présentation des aspects relatifs aux offres publiques, Bulletin Joly Bourse 274 (2014); Eva Mouial-​Bassilana and Irina Parachkévoya, Les apports de la loi Florange au droit des sociétés, Bulletin Joly Sociétés 314 (2014); Alain Viandier, OPA, OPE, et Autres Offres Publiques, nos 2045 ff. (5th edn., 2014). 72  Durand, note 71, at 281, n. 53.

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This 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. The 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 shares.73 Thirdly, the bons Breton can only be triggered when a genuine “takeover bid” has been launched. They will not work against creeping acquisitions. And finally, the French warrants are bid-​specific. When the bid is not successful, they automatically become void.74 With the removal of the no​frustration rule, incumbent management may be able to take other defensive steps, either with 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.75 As we have seen in previous chapters,76 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 capital rather than 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 unilateral share-​issuing powers.77 Whether it is legitimate for the board to use its powers to defeat a takeover is, of course, a separ­ ate 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. The 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 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.78 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.79

73  Though the shares which the bidder has agreed to acquire through the bid do not count for entitlement to the warrants. See also note 70. 74  Art. L.233-​32, II, fourth alinéa Code de Commerce. 75  See Matteo Gatti, The Power to Decide on Takeovers: Directors or Shareholders, What Difference Does It Make?, 20 Fordham Journal of Corporate & Financial Law 73 (2014). 76  See especially Chapter 3.2.3 and Chapter 7. 77  For the use of share warrants as defensive measures in Japan, see notes 50 and 51 and their accompanying text. 78  Parecer de Orientação CVM No. 36 (2009). 79  Novo Mercado Regulations Art. 3.1.2.

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8.2.3.1 Strategies for controlling the board’s powers to take 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 on the offer is concerned. The coordination problems of target shareholders as against the acquirer then become a significant concern where the no frustration principle applies. By contrast, joint 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 decision-​ making power is used in the shareholders’ interests, rather than to promote the self-​ interest of the management, it can be argued that the outcome is superior to that achieved by lodging the decision right wholly with the shareholders.80 However, to achieve this result, a joint decision-​rights strategy needs to be accompanied by one or more other strategies which constrain incumbent management discretion. There is a range of available strategies:  standards, trusteeship, removal rights, and reward strategies.

8.2.3.2 Standards Ex post scrutiny by the courts of the exercise of the veto power by management is available in principle, under the general law relating to directors’ duties. The rigor of this scrutiny can vary by jurisdiction and over time. It has been argued81 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. The 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.82 The 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.83 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.84 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’

80  The attractiveness of this argument depends, of course, on (a) how easily the 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 no​frustration rule (Section 8.2.2.1). 81  Lucian Bebchuk, The Case Against Board Veto in Corporate Takeovers, 69 University of Chicago Law Review 973 at 1184–​8 (2002). See also R. Gilson, UNOCAL Fifteen Years Later (and What We Can Do About It), 26 Delaware Journal of Corporate Law 491 (2001). 82  Paramount Communications Inc. v. Time Inc., 571 Atlantic Reporter 2d 1140 (1989); Unocal Corp. v. Mesa Petroleum Co., 493 Atlantic Reporter 2d 946 (1985); Unitrin Inc. v. American General Corporation, 651 Atlantic Reporter 2d 1361 (1995). 83  Revlon Inc. v.  MacAndrews & Forbes Holdings Inc., 506 Atlantic Reporter 2d 173 (1986); Paramount Communications v. QVC Network, 637 Atlantic Reporter 2d 34 (1994). 84  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 were probably intended to operate—​to shield management from shareholder challenge. Romano, note 12, at 171, and Section 8.1.2.3.

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interests.85 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.86 Overall, there is little evidence in any jurisdiction that the courts are willing to scrutinize rigorously the discretion vested in management under the dual decision-​ making model.87

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 boards88 in many U.S. corporations, the more recent years have shown a trend towards “destaggering,”89 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.90

8.2.3.4 Trusteeship An additional strategy to constrain incumbent management discretion on takeover-​ related decisions is to require approval from independent directors. In Germany defensive measures proposed by the managing board need approval by the super­ visory board.91 This strategy heavily depends for its effectiveness on the ability of the supervisory board to play a genuinely independent role. This may be questionable in the case where the board is codetermined, since the employee representatives on the 85  Defensive measures against a non-​coercive bid were struck down in the Livedoor case: Tokyo High Court Decision on 23 March 2005, 1899 Hanrei Jiho 56. 86  METI and MoJ Guidelines, note 50, at 4–​5. For a discussion of Livedoor and other cases see Sôichirô Kozuka, Recent Developments in Takeover Law: Changes in Business Practices Meet Decade-​Old Rule, 21 Zeitschrift für Japanisches Recht 5, 12–​16 (2005). 87  Thus, in Germany the managing board’s power to take defensive action with the consent of the shareholders 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 of (rather than resistance to) control shifts. See Robert B. Thompson and Randall S. Thomas, The New Look of Shareholder Litigation: Acquisition-​Oriented Class Actions, 57 Vanderbilt Law Review 113 (2004). 88  A board is called “staggered” where a proportion only—​normally one-​third—​of the board is up for re-​election at each annual meeting. See Chapter 3.2.2. 89 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 Tanlu, and Jenny Li Zhang, Board Destaggering: Corporate Governance Out of Focus? Working Paper (2014), at ssrn.com. 90  On the advantages of the bid over a proxy fight see Louis Loss, Joel Seligman, and Troy Paredes, Fundamentals of Securities Regulation 562 (6th edn., 2011). 91  The managing board may seek the advance approval of 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 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.92 Equally, board decisions in the U.S. to redeem or not a poison pill are typically taken by the independent members of the board. Here there are no complications arising from codetermination but the independence of the non-​executives is still an open issue. The 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. That these combined strategies may not work out as the acquirer intended is shown by the Airgas 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.93 Air Products thus initiated a proxy fight and successfully installed three new independent directors in Airgas’ board. These 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. This ultimately credible result seems to have emerged from the combination of two strategies discussed here: the removal strategy—​ replacing incumbent directors—​ and the trusteeship strategy—​ installing genuinely independent directors, not just representatives of the bidder, plus the use of outside advice.94 Another variant of, or addition to, the trusteeship strategy is the obligation on the board to seek “independent advice” or a “fairness opinion” from outside the company—​something which was also a factor in the Airgas case.95 This is required in the UK and France.96 In the U.S., fairness opinions are routinely obtained by the target board, as a consequence of the Delaware case-​law, most importantly Smith v. Van Gorkom.97 More recently, both the Delaware courts and the SEC have developed detailed guidelines on what counts as an “independent” fairness opinion.98

8.2.3.5 Reward strategy Under this strategy the self-​ interest of the incumbent management in retaining their jobs is replaced by self-​interest in obtaining a financial reward which is dependent upon surrendering control of the company to the acquirer.99 This may arise because:  (i)  rewards under general incentive remuneration schemes for managers are triggered upon a transfer of control;100 (ii) payments can be claimed under the

92  See Hopt, note 49, at III.A.b. 93 For a fuller description, see Air Products and Chemicals, Inc. v.  Airgas, Inc., 16 Atlantic Reporter 3d 48 (Del. Ch. 2011). 94  See Edward B. Rock, Institutional Investors in Corporate Governance, in Oxford Handbook of Corporate Law and Governance (Jeffrey N. Gordon and Wolf-​Georg Ringe eds., 2017), available at . 95 Ibid. 96  UK Takeover Code, r 3; Règlement Général de l’AMF, Book II, Title VI, chapters I and II. 97 488 Atlantic Reporter 2d 858 (Del. 1985). 98  For detailed references, see David Friedman, The Regulator in Robes: Examining the SEC and the Delaware Court of Chancery’s Parallel Disclosure Regimes, 113 Columbia Law Review 1543 (2013). 99  Marcel Kahan and Edward B. Rock, How I Learned to Stop Worrying and Love the Pill: Adaptive Responses to Takeover Law, 69 University of Chicago Law Review 871 (2002); Jeffrey N. Gordon, An American Perspective on Anti-​takeover Laws in the EU:  The German Example, in Reforming Company and Takeover Law in Europe 541 (Guido Ferrarini et al. eds., 2004). 100  E.g. because of accelerated stock options.

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management’s contracts of service;101 or (iii) less often, ad hoc payments are made to the incumbent management, either by the acquirer or the target company, in connection with a successful control shift. Where such payments are available, it is argued that the reward strategy succeeds in generating powerful incentives not to invoke the poison pill or other defensive measures.102 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 for the managers, at least without the consent of the shareholders. Thus, 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). The test developed by the top criminal court for corporate waste was a tough and objective one,103 and it has received strong criticism in the academic literature.104 This 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.105 This 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.106 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 choice is likely to be highly significant. Whilst in some jurisdictions, notably the U.S., the deployment of additional strategies, especially the reward strategy, may produce a result in which the outcomes of the joint decision-​making process are not significantly different (in terms of deterring value-​enhancing bids) from those arrived at under the no​frustration rule, this conclusion is highly dependent upon those additional strategies being available and effective. In the absence of 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, rejection of the no​frustration rule is likely to reduce the number of control shifts.107 101  E.g. contractual golden parachutes. 102 Lucian Bebchuk and Jesse Fried, Pay Without Performance (2004) 89–​91; Alessio M. Pacces, Rethinking Corporate Governance:  The Law and Economics of Control Powers (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 were not available); Bengt Holmstrom and Steven N. Kaplan, Corporate Governance and Merger Activity in the United States: Making Sense of the 1980s and 1990s, 15 Journal of Economic Perspectives 121 (2001). 103 BGH 21 December 2005, Neue Juristische Wochenschrift 2006, 522. See also Chapter 3.3.2. 104 Gerald Spindler, Vorstandsvergütungen und Abfindungen auf dem aktien-​und strafrechtlichen Prüfstand—​ Das Mannesmann-​ Urteil des BGH, ZIP-​Zeitschrift für Wirtschaftsrecht 349 (2006). 105  Companies Act 2006, sections 219, 222(3), and 226C. 106  Cf. Gordon, note 99, at 555 (“One way to understand [golden 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”). 107  See ibid. (making these points in relation to Germany, where neither easy removal of the board nor high-​powered incentives to accept offers are available).

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8.2.4 Pre-​bid defensive measures It has often been pointed out that a major limitation of the no​frustration rule is that the requirement for shareholder approval of defensive tactics applies only once a bid is in contemplation.108 This formulation of the no​frustration 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,109 and increasingly economic interests in shares are brought within the disclosure obligation.110 The 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 defensive measures:113 (a) barriers to the acquisition of shares in the company (for example, ownership caps or poison pills114); (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’s assets (lock-​ups); (e) the creation 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

108  See Paul Davies, The Regulation of Defensive Tactics in the United Kingdom and the United States, in European Takeovers: Law and Practice 195 (Klaus J. Hopt and Eddy Wymeersch eds., 1992). If a defense put in place pre-​bid requires action on the part of the board post-​bid to be effective, it will be caught by the no​frustration rule (e.g. post-​bid, shareholder approval is needed to issue shares which the board had previously been authorized to issue). 109 Most national laws require regular disclosure at the 5  percent or 3  percent mark. See e.g. Transparency Directive 2004/​109, Art. 9(1): initial disclosure at 5 percent, but member states can introduce a lower threshold. See Chapter 6.2.1.1. 110  See new Art. 13(1)(b) of Transparency Directive 2004/​109/​EC, as revised in 2013. For the U.S., see CSX Corp v. The Children’s Investment Fund (UK) LLP 562 Federal Supplement 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 Cash-​ Settled Equity Derivatives—​An Intentions-​Based Approach, Lloyd’s Maritime & Commercial Law Quarterly 227 (2012). On creeping acquisitions, see Section 8.3.4. 111  § 13(d) Securities Exchange Act 1934 (U.S.); Art. L.233-​7, VII Code de commerce (France), where this additional information is required at the 10 percent, 15 percent, 20 percent, and 25 percent levels; Wertpapierhandelsgesetz (WpHG) § 27a, only at the 10 percent level (Germany); Art. 27-​23 et seq. of the Financial Instruments and Exchange Act 2006 (Japan). 112  See Art. L. 233-​7, III Code de commerce (France) and Part 22 of the Companies Act 2006 (UK). The European Commission proposed in 2014 to give all EU companies on 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 Takeover Bids, Brussels, January 2002, Annex 4. Some of these defensive steps could be taken, of course, post-​bid as well. 114  A poison pill may be adopted pre-​or post-​bid, normally the former. However, there is still a post-​bid 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).115 Another effective pre-​bid defense could be change-​of-​ control clauses in executive contracts, such as the ones recently upheld by the French Supreme Court.116 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.117 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 no​frustration rule would be ineffective unless accompanied by some type of pre-​bid controls. A number of legal strategies are available. The most general of these are the standards applied by company law to all board decision-​making (duties of care and loyalty). These standards are necessarily less constraining than the no frustration rule, for the reasons just given. Typically, some form of a “primary purpose” rule is used to distinguish legitimate from illegitimate decisions taken pre-​bid which have defensive qualities as well as commercial rationales.118 Such rules necessarily give management considerable freedom to take action for which there is a plausible commercial rationale, even if that action has defensive 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.119 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.120 We saw above that rules on shareholder consent to capital issues have placed obstacles in the way of the straightforward adoption of “poison pills” in Europe.121 Here, pre-​bid, the joint decision-​making process is the more pro-​shareholder choice, since the available alternative is not unilateral decision-​making by shareholders but unilateral decision-​ making by the board. However, these veto rights for shareholders are generally driven by more general corporate law concerns than the control of 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 than post, and the legal strategies used to control managerial opportunism 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, 115  See also European Commission, Report on the Application of Directive 2004/​25/​EC on Takeover Bids, 28 June 2012, COM(2012) 347, para. 14. 116  Cour de cassation, decision of 26 January 2011 (no 09-​71271), Havas. 117  Of course, the precise point at which the line between pre-​and post-​periods is drawn can be the subject of some debate. The Takeover 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 Takeover Directive’s (default) no frustration rule applies only when the board is informed by the bidder of its decision to make an offer (Arts. 9(2) and 6(1)). 118  On the UK “proper purpose” rule, see recently Eclairs Group Ltd v JKX Oil & Gas Plc [2015] UKSC 71. 119  Even post-​bid the courts may have difficulty applying the primary purpose rule so as to restrain effectively self-​interested defensive action. See the discussion of the Miyairi Valve litigation in Japan by Kozuka, note 86, at 10–​11. See also Harlowe’s Nominees Pty Ltd v Woodside (Lake Entrance) Oil Co. 42 Australian Law Journal Reports 123 (High Court of Australia) (1968). 120  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 7. The “break​through 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 approval requirements can be effective.123

8.3  Coordination Problems among Target Shareholders When an offer is put to the shareholders of the target company, they face, potentially, significant coordination problems. This is because the decision to accept or reject the bid is normally made by the shareholders 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. This problem arises in both controlled and widely held firms: 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. In both ownership environments, the coordination issues of (minority) shareholders may be mitigated to some degree through the target board’s negotiations with the potential acquirer.124 Under the joint 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),125 whilst even under the nofrustration rule, the board retains non-​trivial powers to protect the shareholders’ interests, as we have seen.126 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. We now turn to examine the legal techniques which can be deployed to reduce target shareholders’ coordination costs. To some extent, these strategies also address the agency costs, as described above.127 We need to note that all these techniques have costs, in particular by reducing potential bidders’ incentives to make offers. The main strategies deployed are a mix of ex ante rules (mandatory disclosures) and the trusteeship strategy; and, ex post, a combination of the reward strategy (sharing requirement) and an exit right.

8.3.1 Disclosure Provision of up-​to-​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 model, that is, that managers have information about the target’s value which the market lacks.128 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 and weighted-​voting shares in the UK, despite its strong no​frustration rule, see Paul Davies, Shareholders in the United Kingdom, in Research Handbook on Shareholder Power 355 (Randall Thomas and Jennifer Hill eds., 2015). 124  Note that in a controlled target 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. 125  See Section 8.2.3.1. 126  See Section 8.2.2.1. 127  See Section 8.2. 128 Ronald J. Gilson and Reinier Kraakman, The Mechanisms of Market Efficiency Twenty Years Later: The Hindsight Bias, in After Enron 57 (John Armour and Joseph A. McCahery eds., 2006), 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 and unverifiable claims. Company law, of course, contains information disclosure provisions which operate independently of control transactions. However, annual financial statements are often out of date and, despite the continuing reporting obligations applied to listed companies in most jurisdictions,129 it is likely that both the target board and the acquirer will be better informed about their respective companies than the target shareholders. Thus, 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 with an obligation to obtain and make available an independent opinion on merits of the offer. The independent opinion is facilitated by the disclosure requirements, as are assessments by third parties, such as securities analysts. Independent advice is particularly important in a management buy-​out. Here incumbent management appears in a dual role: as fiduciaries for the shareholders and as buyers of their shares. 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 management to further the cause of their preferred bidder.130 In addition, takeover regulation requires offers to be open for a certain minimum time (practice seems to coalesce around the 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. The main counterargument against very generous absorption periods is the need to minimize the period during which the target’s future is uncertain and, in particular, during which the normal functioning of the centralized management of the target is 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

129  See Chapter 9.1.2.5. 130 In jurisdictions without takeover-​specific regulation on the matter, it may be possible to leave the issue to general corporate law, notably the rules on self-​dealing transactions. See Werner F. Ebke, The Regulation of Management Buyouts in American Law: A European Perspective, in European Takeovers: Law and Practice, note 108, 304–​6—​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 on the directors to disclose information to the shareholders as an element of their fiduciary duties (see e.g. Coleman v. Myers [1977] 2 New Zealand Law Reports 225, NZCA). See also note 55. 131  The Williams Act (note 33) in the U.S. was motivated in particular by 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 popular for use on Saturday nights. 132  Designed to reduce the period the company is “in play,” recent changes to the UK Takeover 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). This 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 the passivity rule.

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efficient securities markets, moreover, new information is rapidly impounded into the share price, and so it is likely that the main practical 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 Trusteeship strategy Target 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 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. This 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 has reputational consequences for the bank. Particularly sensitive items of information, such as profit forecasts, may be subject to third-​party 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 directors of the target.134 Ex post liability rules may add something to the ex ante incentives to be accurate.

8.3.3 Reward (sharing) strategy A notable feature of laws aimed at solving target shareholders’ coordination problems is their adoption of the equal treatment rule—​though this principle can be implemented with varying degrees of rigor. The principle stands in the way of acquirers that wish to put pressure on target shareholders to accept the offer, by promising some (normally those who accept early) better terms than others.135 In general, systems which place decision-​making on the bid in the hands of the shareholders alone have developed the equality principle more fully than those which have adopted the model of joint decision-​making. 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 terms136); 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, as between those who sell their shares to an acquirer as part of a control-​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. The first level of equality is recognized in all our jurisdictions. Thus, “front-​end loaded” offers are ruled out; and prior acceptors receive the higher price if the offer is later increased. 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. One solution is to prohibit purchases outside the offer, though this rule can be sensibly applied only to purchases during 134  UK Takeover Code, Rule 25.2 (notes 4 and 5). 135  Paul Davies, The Notion of Equality in European Takeover Regulation, in Takeovers in English and German Law 9 (Jennifer Payne ed., 2002). 136  Or equivalent terms, where the offer covers more than one class of share.

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or close to the offer period.137 An alternative strategy is to require the offer consideration to be raised to the level of the out-​of-​bid purchases.138 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 purchases.139 A pre-​bid sharing rule gains considerable importance where the target company is controlled by a 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 The 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) of the voting shares in the company.140 This is the mandatory bid rule.141 It is a particularly demanding rule if, as is common, it requires that the offer be at the highest price paid for the controlling shares142 and that shareholders be given the option of taking cash.143 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. The 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 value-​ decreasing or its impact on the target is just unclear, use of the mandatory bid rule to 137  See e.g. in France Art. 231-​41 Règlement Général de l’AMF, which prohibits market purchases 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 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, II Règlement Général de l’AMF). 138  Again, 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). 139  Rules 6 and 11 UK Takeover Code (but requiring cash only where the 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). The Takeover Directive does not require sharing in this situation. 140  That is most common within the EU. See Commission’s Report on the Implementation of the Directive on Takeover Bids (SEC(2007) 268, February 2007), annex 2. For alternative approaches worldwide, see Umakanth Varottil, Comparative Takeover Regulation and the Concept of ‘Control’, Singapore Journal of Legal Studies 208 (2015). 141  The 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. 142  The Takeover 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. 143  The Takeover Directive permits the mandatory bid to consist of “liquid securities” but some member states (e.g. UK Takeover 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 shareholders as against the acquirer. Where the bid is value-​increasing for target company shareholders, it can be argued that providing the non-​accepting shareholders with an exit right is not necessary. However, it may be difficult for the rule-​maker to identify ex ante which category the offer falls into, so that the choice is between applying or not applying the mandatory bid rule across the board. Moreover, though the offer may be value-​increasing for the target company’s shareholders as a whole, the 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. That leads to the second rationale for the mandatory bid rule. Permitting the acquisition of control over the whole of the 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.144 It assumes that general corporate law is not fully adequate to police the behavior of controllers.145 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.146 Mandatory bid rules are now quite widespread. The Takeover Directive requires EU member 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).147 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.148 While popular among lawmakers and investors, the mandatory bid rule runs the risk of reducing the number of control transactions which occur. First, the implicit prohibition on partial bids makes control transactions more expensive for potential bidders: either the bidder offers for the whole of the voting share capital and, often, at a high price149 or it does not offer for control at all.150 Secondly, the mandatory bid

144  The balance between this effect and its discouragement of efficient transfers of control is disputed. See Lucian Bebchuk, Efficient and Inefficient Sales of Corporate Control, 109 Quarterly Journal of Economics 854 (1994); Marcel Kahan, Sales of Corporate Control, 9 Journal of Law, Economics and Organization 368 (1993). More recently Edmund-​Philipp Schuster, The Mandatory Bid Rule: Efficient, After All?, 76 Modern Law Review 529 (2013). 145  It constitutes, in the concept developed by German 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 Comparative Overview of the Mandatory Bid Rule in Belgium, France, Germany and the United Kingdom 279–​80 (2008), suggesting that the mandatory bid is more effective. 146  The UK Takeover Code contains both such rules: see rules 14 (offers where more than one class of equity share) and 36 (partial offers). 147  Art. 5 Takeover Directive. See note 140 and accompanying text. 148  In any event partial bids are in fact rare in the U.S., due to the pervasiveness of poison pills. 149  See note 142. The UK and France also require that a takeover bid be conditional upon reaching at least 50 percent of the shares, which also discourages low-​ball offers. See Luca Enriques and Matteo Gatti, Creeping Acquisitions in Europe: Enabling Companies to be Better Safe than Sorry, 15 Journal of Corporate Law Studies 55, 78 (2015). 150  See e.g. Clas Bergström, Peter Högfeldt, and Johan Molin, The Optimality of the Mandatory Bid, 13 Journal of Law, Economics & Organization 433 (1997); Stefano Rossi and Paolo 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. Thirdly, the rules fixing the price at which the acquirer must offer for the outstanding shares may expose the acquirer to adverse movements in the market between the acquisition of de facto control and the making of a full offer. The chilling effect of the rule is particularly intense where there is a controlling shareholder, but it occurs also where the acquirer builds up a controlling stake by acquisitions from non-​controlling shareholders.151 Some, but by no means all, takeover regimes have responded to these concerns. A somewhat common technique is not to extend the rationale underlying the mandatory bid rule to a complete prohibition of partial general offers.152 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. The Swiss regulation permits the shareholders to raise the triggering percentage from one-​third (the default setting) to up to 49 percent or to disapply the rule entirely.153 Mandatory bid rules tend to be complex, partly because of the need to close obvious loopholes. Thus, the rule will usually apply to those “acting in concert” to acquire shares,154 not just to single acquirers, but the notion of a “concert party” is not self-​ evident.155 It may also be possible to circumvent the rule by using derivatives that provide on their face only an economic interest in shares, or through a “creeping takeover,” i.e. small acquisitions of shares spread out over a period of time, frequently exploiting loopholes in public disclosure or takeover laws.156 Additional complexity is generated where it is thought necessary to subordinate the policy behind the mandatory bid rule to more highly valued objectives, for example, where the threshold is exceeded in the course of rescuing a failing company. The Cross-​Country Determinants of Mergers and Acquisitions, 74 Journal of Financial Economics 277 (2004), showing that takeover premia are higher in countries with strong shareholder protection, especially those with mandatory bid rules. 151  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 with all or nearly all of the shares and no one to expropriate. 152  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 two-​thirds of the shares via a tender offer to all shareholders or market purchases (Arts. 27-​2(1), 27-​2(5) and 27-​13(4) of the Financial Instruments and Exchange Act; Arts. 8(5)(iii) and 14-​2-​2 of the Order for Enforcement of the Financial Instruments and Exchange Act). See Tomotaka Fujita, The Takeover Regulation in Japan: Peculiar Developments in the Mandatory Offer Rule, 3 UT Soft Law Review 24 (2011). 153  Börsengesetz (Switzerland), Arts. 22(2) and 32(1). These provisions must be contained in the company’s charter. Total disapplication can be decided upon only before listing. 154  Takeover Directive, Art. 5. There is a considerable danger that the acting in concert extension will chill shareholder activism, a development which policy​makers may or may not welcome. Contrast the Risk Limitation Act 2008 in Germany (discussed by Hopt, note 49, at III.B) with the Takeover Code, note 2 to Rule 9.1. 155  Leading to proposals for greater harmonization with the EU: see European Securities Markets Expert Group, Preliminary Views on the Definition of Acting in Concert between the Transparency Directive and the Takeover Bids Directive, November 2008. See more specifically Chapter 3.2.4. 156  Enriques and Gatti, note 149. The UK Takeover Code is unusual in applying the mandatory bid rule to any acquisition 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, I Code Monétaire et Financier.

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Takeover 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. The European Commission perceives these various derogations as a risk to the European level playing field,157 but they may have the advantage of allowing for value-​enhancing control shifts where they otherwise would not be made. In addition to the mandatory bid 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.158 This 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 until it is clear that the acquirer has obtained control and to exit at that point under the offer terms.159 This problem may be acute in a controlled company, where minority shareholders may not know whether the blockholder will accept the offer. This option is more effective than the often provided right to “sell out” to an acquirer who obtains a high proportion of the shares,160 because it operates at whatever level the acquirer declares the offer “unconditional as to acceptances.”

8.3.5 Acquisition of non-​accepting minorities The absence of a binding corporate decision in a control transaction may confer hold-​ up 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 of minorities on the terms accepted by the majority, usually, however, only where a very high proportion of the shareholders have accepted the offer. The right to squeeze-​out minorities facilitates the initial fixing of the level of the offer at less than acquirer’s expected gains from the acquisition by taking off the table the options of remaining in the company or exiting at a price higher than the offer price. It thus encourages bids.161 In most jurisdictions, minority hold-​ups or incentives not to tender are directly addressed by takeover-​specific rules162 which give the acquirer compulsory purchase 157  See Commission Report, note 115, para. 17; European Company Law Experts, The Application of the Takeover Bids Directive—​Response to the European Commission’s Report (November 2013), section 3. 158  See e.g. UK Takeover Code, rule 31.4 (but qualified by Rule 33.2); WpÜG, § 16(2) (Germany), both adopting a two-​week period. In Italy, a similar rule applies, but limited to tender offers launched by someone already holding a stake higher than 30 percent, or by management. Art. 40-​II, Consob Regulation on Issuers. 159 Lucian A. Bebchuk, Pressure to Tender:  An Analysis and a Proposed Remedy, 12 Delaware Journal of Corporate Law 911 (1987). See however Guhan Subramanian, A New Takeover Defense Mechanism:  Using an Equal Treatment Agreement as an Alternative to the Poison Pill, 23 Delaware Journal of Corporate Law 375, 387 (1998). 160  Art. 16 Takeover Directive. See Section 8.3.5. 161  Mike Burkart and Fausto Panunzi, Mandatory Bids, Squeeze-​Outs and Similar Transactions, in Reforming Company and Takeover Law in Europe, note 99, at 753–​6. 162  Some jurisdictions have both types of rule. In Germany the introduction of the 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 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 minority.163 The Delaware version is the “two-​step merger,” that is, a tender offer for the shares followed by a 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 mergers at the 90 percent level.164 The importance of the short-​form 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).165 Unlike the earlier procedure, the 2013 reform is takeover-​specific, ie. the first-​step general offer is now a mandatory element of the procedure.166 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.167 Functionally, the two are very different. A  squeeze-​out right promotes offers whilst a right to be bought out reduces the pressure on target shareholders to 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.168

8.4  Specific Issues upon Acquisition from a Controlling Shareholder Where there is a controlling shareholder or shareholding group the allocation 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.169 However, the shareholder–​board agency issues are here replaced by minority–​majority agency problems. shareholder. See Re Bugle Press [1961] Ch 279, CA (UK) and Re Pure Resources Inc., 808 Atlantic Reporter 2d 421 (Del. Ch. 2002)—​both in effect requiring the acquirer to show the offer to be fair. 163  Art. 15 Takeover Directive requires Member States to provide such a mechanism, provided that the offeror reaches at least 90 percent of the shares as an outcome of the bid. 164  DGCL § 253. And see Chapter 7.4.2. 165 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. 166  DGCL §251(h). Other conditions reinforce this orientation. The 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 acquirers (i.e. not existing controllers) and the target management must consent (i.e. “friendly” takeovers only). 167  Both types of rule are discussed in greater detail in Forum Europaeum Corporate Group Law, Corporate Group Law for Europe, 1 European Business Organization Law Review 165, 226 ff. (2000). The Takeover Directive requires both a squeeze-​out and a sell-​out right. 168  See Section 8.3.4. An offeror may be satisfied with a controlling stake short of the 90 percent level and thus not be subject to the sell-​out right, whereas the “keep it open” requirement applies at whatever level the acquirer declares the bid to be unconditional. 169  This 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 Atlantic Reporter 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. This 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) in engaging in the transfer, and the transferee was aware of the facts giving rise to the breaches of duty. See also Chapter 4.1.3.1.

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Since 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. There are two central issues. First, are the selling controlling shareholder and the acquirer free to agree the terms of sale of the controlling block without offering the non-​controlling 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. This 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 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 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 to the selling controlling shareholder, some jurisdictions in the U.S. have used fiduciary standards to impose a sharing rule.170 However, despite some academic argument to the contrary,171 U.S. courts have not adopted a general equality principle which might have led them to generate an unqualified right for non-​controlling shareholders to share in the control premium. The 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, including … for a price that is not made proportionally available to other shareholders,” but subject to a requirement for fair dealing.172 Provided 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.173 Despite this, purchases of control from blockholders disjunct from the 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.174 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 170  As in looting cases: see Gerdes v. Reynolds, 28 New York Supplement Reporter 2nd Series 622 (1941); or where the sale can be identified as involving the alienation of something belonging to all shareholders: Perlman v. Feldman, 219 Federal Reporter 2d Series 173 (1955); Brown v. Halbert, 76 California Reporter 781 (1969). 171  William Andrews, The Stockholder’s Right to Equal Opportunity in the Sale of Shares, 78 Harvard Law Review 505 (1965). For an incisive general discussion of this area see Robert Clark, Corporate Law 478–​98 (1986). 172  American Law Institute, Principles of Corporate Governance § 5.16. 173  For the argument that in 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 University of Pennsylvania Law Review 785, 793–​6, 811–1​6 (2003). 174  Section 8.3.3. In most cases these rules can be avoided if 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 the bid. The greatest controversy, however, revolves around the question of whether the mandatory bid rule should be applied to a transfer of a controlling position, so as to require the acquirer to make a public 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, because in the former case the minority is no worse off after the control shift than it was previously. However, such a view ignores the risks which the control shift generates for the minority. The 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.175 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, 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. The acquirer no longer has the option of sticking with the control block it has purchased at a price acceptable to the seller. Under the mandatory bid rule it must now offer that price to the non-​controlling shareholders as well. It may well face the situation 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.176 Fewer control shifts will occur, even where the acquirer intends to increase the operational efficiencies of the target. In countries where controlling shareholders are common, this may be seen as a strong objection to the mandatory bid rule.177 The adverse impact of the mandatory bid rule is further enhanced if it applies to indirect acquisitions of control.178 On the other hand, the

175  These are, of course, the arguments in favor of the mandatory bid rule, even where the seller is not a controlling shareholder. See Section 8.3.4. 176  John C. Coffee, Regulating the Market for Corporate Control, 84 Columbia Law Review 1145, 1282–​9 (1984); Bebchuk, note 144. 177  See Luca Enriques, The Mandatory Bid Rule in the Proposed EC Takeover Directive: Harmonization as Rent-​Seeking? in Reforming Company and Takeover Law in Europe, note 99, at 785. See further Pacces, note 102, at 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 post-​acquisition market price of the target’s shares. A further consequence of our analysis is that a harmonized mandatory bid rule across the EU will in fact produce very different impacts depending on the level of private benefits of control. 178  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 Takeover 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 § 9(2) no. 3). See also similarly, for Italy, Art. 45 Consob Regulation on Issuers, as amended.

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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 The 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 patterns of ownership represent … simply the existing condition of the economic environment.”179 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, they may neutralize “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, irrespective 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. 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. An example of weaker versions of the mandatory bid rule are the so-​called “partial” sharing rules that are in force in China and India.180 Thus, in China, a mandatory bid needs only be for a minimum of 5 percent of the outstanding shares, which naturally dilutes its effect.181 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 tender offer for at least 26 percent of the shares of the target company.182 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 shareholder183—​an implicit recognition of the exceptionally high private benefits that controlling shareholders enjoy in that country.184 Moreover, the fact that the mandatory bid rule by law only applies to voting shares significantly reduces its scope given the high incidence of 179  Ronald J. Gilson, The Political Ecology of Takeovers in European Takeovers: Law and Practice, note 108, at 67, discussing the difference between “structural” and “technical” barriers to takeovers. 180  Armour, Jacobs, and Milhaupt, note 36, at 274 ff. 181  Measures for the Administration of the Takeover of Listed Companies (China Securities Regulatory Commission, 27 August 2008, revised), art. 25, available at www.lawinfochina.com/​display. aspx?lib=law&id=7043&CGid=. See Chao Xi, The Political Economy of Takeover Regulation: What Does the Mandatory Bid Rule in China Tell us?, Journal of Business Law 142 (2015). 182 Securities Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations 2011. See Umakanth Varottil, The Nature of the Market for Corporate Control in India, Working Paper (2015), at ssrn.com. 183  Art. 254-​A Lei das Sociedades por Ações. However, the Novo Mercado, 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. 184  See Chapter 4.4.2.1.

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non-​voting preferred shares in Brazil’s capital market.185 All three jurisdictions provide examples of a cautious legal transplant: accepting the mandatory bid rule as worldwide best practice, but adjusting it to the specific regulatory environment in place. All three regimes thus avoid the costly effect of a full sharing rule.186 A different strategy would be an “optional” mandatory bid rule.187 As we saw above, Swiss law serves as an example by permitting shareholders to modify or remove the rule in their charters.188 Potential target shareholders can thus deliberately facilitate control changes in their company. Other jurisdictions achieve a similar outcome in a much less transparent 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 them189 may also be understood as functional to the purpose of mitigating the mandatory bid rule’s chilling effects. For instance, German law—​intentionally or 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 low price.190 In light of these considerations, some commentators have even argued that takeover regulation should rather be “unbiased” instead of prescriptive, and let decision-​makers on the individual company level decide on their level of control contestability.191 Others caution against too far-​reaching flexibility, citing potential real-​life problems in controlled companies and asking whether the market will adequately price in the choices made by individual companies.192

8.4.2.2  Addressing technical elements: The breakthrough rule Technical barriers to takeovers may be susceptible to regulation through corporate law. The breakthrough rule (BTR), which EU member states may impose or at least make available to companies on an opt-​in basis,193 constitutes an example of a legislative attempt to address technical barriers to control shifts. The BTR aims to prevent boards and controlling shareholders from structuring the rights of shareholders pre-​bid in such a way as to deter bids. Subject to the payment of compensation, it removes some restrictions on 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).194 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 185  Art. 254-​A Lei das Sociedades por Ações. The 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 preferred shareholders at the same price paid to the controlling shareholder. Art. 8.1 Level 2 Regulations. 186  Armour, Jacobs, and Milhaupt, note 36, at 274 ff. 187  See Luca Enriques, Ronald J. Gilson, and Alessio M. Pacces, The Case for an Unbiased Takeover Law (with an Application to the European Union), 4 Harvard Business Law Review 85 (2014). 188  See Section 8.3.4. 189  See Enriques and Gatti, note 149, at 76–​9. 190  Theodor Baums, Low Balling, Creeping in und deutsches Übernahmerecht, ZIP –​Zeitschrift Für Wirtschaftsrecht 2374 (2010). 191  Enriques, Gilson, and Pacces, note 187. 192  See Hopt, note 13, at 156–​7; Johannes W. Fedderke and Marco Ventoruzzo, The Biases of an “Unbiased” Optional Takeovers Regime: The Mandatory Bid Threshold as a Reverse Drawbridge, available at ssrn.com. 193  Arts. 11 and 12 Takeover Directive. 194 Art. 11.

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vote per share, at any shareholder meeting called to approve defensive measures under the no frustration rule195 and at the first general meeting called by a bidder who has obtained 75 percent of the voting shares. At this meeting any “extraordinary right” of shareholders in relation to the appointment and removal of directors shall not apply either.196 The overall aim of the BTR 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. The break-​through of voting restrictions during the offer period might be thought to be necessary to make the no frustration rule work effectively. The post-​acquisition break-​through is potentially more significant and gives the successful bidder an opportunity to translate its higher-​than-​75-​percent stake into control of the company by placing its nominees on the board and by amending the company’s constitution so that its voting power reflects its economic interest in the company. The optional BTR has been an unsuccessful experiment, since only a few, small member states have chosen to make it mandatory. Further, the BTR is nowhere the default rule and no company in member states where it is optional appears to have opted into it.197 A combination of two elements explains why so few member states opted for a mandatory BTR. On the one hand, the BTR does not catch simple controlling positions where the one-​share, one-​vote rule is observed, so that the majority of controlling positions within European companies were not affected by it; on the other, the BTR does not catch some departures from the one-​share one-​vote principle, such as pyramids:198 these two circumstances together were enough to generate aggressive—​and successful—​lobbying by those that a mandatory BTR would have caught. The reason why no companies have opted into the BTR is even simpler: an opt-​in at company level requires a supermajority vote of the shareholders in most cases, and controlling shareholders, still possessing their technical advantages, have weak incentives to vote in favor.

8.5  Explaining Differences in the Regulation of Control Transaction We have analyzed control shift regulation along three dimensions, focusing mainly on two: the location of decision-​making on the offer and the protection of target shareholders (especially non-​controlling shareholders) against opportunism on the part of the acquirer (or acquirer plus controlling shareholder). The minor dimension was the responsiveness of the regulation to non-​shareholder constituencies. Two immediate conclusions can be drawn from our analysis. The first and negative conclusion is that none of the systems puts the goal of maximizing the number 195 Section 8.2.2. 196  Thus rights of codetermination (see Section 8.1.2.3) are not affected because these are normally not shareholder rights of appointment and will be contained in legislation rather than the company’s articles. 197  See Commission’s Report on the Implementation of the Directive on Takeover Bids, note 140, at 7–​8. 198  See John C. Coates IV, The Proposed ‘Break-​Through’ Rule-Ownership, Takeovers and EU Law: How Contestable Should EU Corporations Be?, in Reforming Company and Takeover Law in Europe, note 99, 677, 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 BTR by increasing their holdings of cash-​flow rights or moving to equivalent structures not caught by the BTR, such as pyramid structures and/​or cross-​holdings).

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of control shifts at the center of their regulatory structures. The maximum number of takeovers is likely to be generated by a system which enjoins upon target management a rule of passivity in relation to actual or threatened takeovers (the first dimension) and which gives the acquirer the maximum freedom to structure its bid (the second dimension), whilst (non-​)shareholder interests are ignored. None of our jurisdictions conforms to this pattern: the regulation of agency and coordination issues in takeovers 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.199 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 in bid contexts (UK and France—​the latter now only doubtfully in this category) also have the most developed rules against acquirer opportunism, addressing intra-​shareholder coordination problems. Deprived 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 also protect indirectly incumbent management. A system configured in this way may both make it difficult for incumbent management 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.200

8.5.1 Differences in form and differences in substance The 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 in the hands of the target shareholders and those which give both target shareholders and the board a veto right. However, there are reasons for thinking that this division may be an over-​ simplification. 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 company. The U.S. demonstrates the possibilities for a development of this kind.201 Thus, Armour and Skeel have observed that, whilst the proportion of hostile bids in the U.S. is smaller than in the UK,202 which allocates the decision entirely to the shareholders, the overall level of control shifts is not much different.203 In other words, a combination of legal strategies and

199  See also Sanford J. Grossman and Oliver Hart, An Analysis of the Principal-​Agent Problem, 51 Econometrica 7 (1983). 200  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). 201  See Section 8.2.3.1. 202  Armour and Skeel, note 32, table 1; see also Coates, note 54, 253 (7 percent hostile bids in the UK versus 3 percent in the U.S.). 203  Armour and Skeel, note 32, at 1741. Whether the two systems are functionally absolutely equivalent is not clear (see ibid. at 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 decision-​ making over control shifts (shareholders overcome their coordination problems by using management to negotiate with the bidder on their behalf ) without incurring the costs of this arrangement (notably management entrenchment). Where those legal strategies are not available or the institutional facts do not obtain, however, the initial allocation of the decision right will indeed be crucial.

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.204 Thus, 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. These countries—​actually the overwhelming majority of all jurisdictions worldwide205—​might be less in “need” to deploy pro-​bidders takeovers laws.206 This could be an explanation for the reluctance of some continental European countries to support a mandatory board neutrality rule in the Takeover Directive.207 Japan with its closely knit network of cross-​shareholdings is also an example of a system where tools of external corporate governance other than hostile takeovers have prevailed historically—​though cross-​shareholdings have weakened in recent years.208 Likewise, we could hypothesize that different designs of a takeover framework may be more appropriate for different types of industry. A growing literature discusses the “varieties of capitalism” and how they impact on legal rules.209 Thus, it could be argued that industries with certain types of productive technology need to make long-​term commitments to employees as a quid pro quo for the employees’ investment in firm-​ specific human capital or acceptance of flexible working. In such a scenario, takeovers might be perceived as disruptive to such long-​term commitment and likely to produce a “breach of trust” by the acquirer towards the existing employees.210 Finally, the design of appropriate rules seems to be naturally influenced by the pre-​ 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.  divide described above. The UK system of company law has always been strongly shareholder-​centered—​the board’s powers derive from the company’s charter, not the legislation, and the charter is, formally, wholly under 204  Guido Ferrarini and Geoffrey Miller, A Simple Theory of Takeover Regulation in the United States and Europe, 42 Cornell International Law Journal 301 (2009). See also Hopt, note 12, at 259. 205  Marco Becht and Colin Mayer, Introduction, in The Control of Corporate Europe (Fabrizio Barca and Marco Becht eds., 2001). 206  It could be argued that these countries should better focus on rules that address intra-​shareholder agency costs directly, such as related party transactions. See Chapter 6. 207  See Section 8.2.2. 208  Joseph Lee, Critical Exposition of Japanese Takeover Law in an International Context, Working Paper (2016), at ssrn.com. 209 See Varieties of Capitalism: The Institutional Foundations of Comparative Advantage (Peter A. Hall and David Soskice, eds., 2001); Wendy Carlin and Colin Mayer, How Do Financial Systems Affect Economic Performance?, in Corporate Governance: Theoretical and Empirical Perspectives 137 (Xavier Vives ed., 2000). 210  Shleifer and Summers, note 22; Paul Davies, Efficiency Arguments for the Collective Representation of Workers, in The Autonomy of Labour Law (Alan Bogg et 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, 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.214 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.”215 Another important complementarity to consider is the regulatory framework addressing 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 importantly, the mandatory bid rule in conjunction with the concept of “acting in concert”—​may run against the policy goal of promoting shareholder engagement.216

8.5.3 Political economy considerations Divergences in 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. Takeovers can make newspaper headlines—​and broad-​scale takeovers of companies by, in particular, foreign acquirers have the potential of being used for protectionist counteractions. This is even more likely during times of economic crisis, as the recent global financial crisis has demonstrated.217 For example, Italy—​briefly during the financial crisis—​and more recently France opted out of the board neutrality rule contained in the EU Takeover Directive.218 Even the traditionally takeover-​friendly UK saw a fierce political debate after the 2009 takeover of iconic chocolate maker Cadbury by American food giant Kraft.219 211  See Chapter 7.2. 212  See Chapter 3.5. 213  Armour and Skeel, note 32, at 1767–​8, point out that the traditional doctrinal 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 part of compensation in the U.S., then U.S. institutional investors might begin to agitate for shareholder-​friendly control-​shift regulation. 214  Paul Davies and Klaus J. Hopt, Corporate Boards in Europe—​Accountability and Convergence, 61 American Journal of Comparative Law 301 (2013). 215  Jonathan Macey, Corporate Governance: Promises Kept, Promises Broken 10, 118 ff. (2008). On the market of corporate control and the pros and cons of the no​frustration rule see Hopt, note 12, at 261–​8. 216  See ESMA, Information on Shareholder Cooperation and Acting in Concert under the Takeover Bids Directive, ESMA/​2013/​1642 (12 November 2013); Martin Winner, Active Shareholders and European Takeover Regulation, 12 European Company and Financial Law Review 364 (2014). See also Chapter 3.2.4. 217  See a number of contributions in Company Law and Economic Protectionism (Ulf Bernitz and Wolf-​Georg Ringe eds., 2010). 218  See Sections 8.2.2 and 8.2.3.2. 219  Some even called for the adoption of a specific “Cadbury’s Law” to better protect British firms from foreign takeovers. See Wolf-​Georg Ringe, Deviations from Ownership-​Control Proportionality—​ Economic Protectionism Revisited, in Company Law and Economic Protectionism, 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.220 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.” 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 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” to proceed with the bid. In the course of this 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 local defense industry from foreign influence.222 Apart from the perceived need to protect strategic industries, the reasons for public uproar are frequently the impact that takeovers have on the workforce. It is true that takeovers frequently lead to 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 where—​as for example in the above-mentioned Cadbury/​Kraft 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 transactions generate, in particular for non-​shareholder groups.223 In those countries where company law is used to address 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 the corporate organ which embodies the principle of employee representation, is likely to 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 There 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 220  Armour, Jacobs, and Milhaupt, note 36, at 273 ff.; Érica Gorga, Changing the Paradigm of Stock Ownership from Concentrated Towards Dispersed Ownership? Evidence from Brazil and Consequences for Emerging Countries, 29 Northwestern Journal of International Law & Business 439, 445 (2009); Mariana Pargendler, Corporate Governance in Emerging Markets, in Oxford Handbook of Corporate Law and Governance (Jeffrey N. Gordon and Wolf-​Georg Ringe eds., 2017). 221 Hugh Carnegy, Michael Stothard, and Elizabeth Rigby, French “Nuclear Weapon” against Takeovers Sparks Blast from Cable, Financial Times, 16 May 2014, p. 1. 222  Germany revised its Foreign Trade Act (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 by the Committee on Foreign Investments in the United States (CFIUS)—​ was amended in 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 ownership structure, we know that the average size of the largest block varies from jurisdiction to jurisdiction,224 so that in jurisdictions with 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 is evidence, in important jurisdictions, of a weakening of the grip of blockholders over the years.225 Finally, even in jurisdictions dominated by large blockholders, shareholdings in particular companies atypically may be dispersed. Thus, 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.226 Lastly, the desire of 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. Thus, 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 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. This 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, regulators faced with continued uncertainty and conflicting pieces of real-​life evidence will plainly be unsure on how to determine the optimal regime and so respond to other policy arguments. This is the point where political considerations, lobbying efforts, and regulatory capture fall onto fertile grounds. A good illustration is the adoption of the EU Takeover Directive, with the European Commission pushing for a pro-​takeover response as an important tool for promoting an integrated “single market” within the Union,227 whilst some member states (and the European Parliament) responded to current popular fears of globalization and its impact.228 With the abandonment of the no frustration rule and the BTR 224  Becht and 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. 225 For Germany, see Wolf-​Georg Ringe, Changing Law and Ownership Patterns in Germany: Corporate Governance and the Erosion of Deutschland AG, 63 American Journal of Comparative Law 493 (2015). For Japan, see Japan Exchange Group, 2015 ShareOwnership Survey (2016), at . 226  Julian Franks et al., The Life Cycle of Family Ownership: International Evidence, 25 Review of Financial Studies 1675 (2012), report in appendix A1 that the average number of listed companies which were the target of an unsolicited bid expressed as a percentage of all listed companies between 2001–​6 was 0.9 percent in Germany; 1.1 percent in Italy; and 0.7 percent in France. The UK figure was 3.3 percent. The same general trend can be found in Japan, as the litigation it has generated attests: see note 51. 227  For which policy there was considerable empirical support. See, for example, Marina Martynova and Luc Renneboog, Mergers and Acquisitions in Europe, in Advances in Corporate Finance and Asset Pricing 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.” 228 See Klaus J. Hopt, Observations on European Politics, Protectionism, and the Financial Crisis, in Company Law and Economic Protectionism 13, 20–​1 (Ulf Bernitz and Wolf-​Georg Ringe eds., 2010).

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as mandatory rules at EU level,229 protectionists may be said to have had the better of the argument with pro-​integration forces. This 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.230 The 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 changes occur. As strict one-​size-​fits-​all regulation rarely truly reflects business realities, takeover rules that allow for exceptions and/​or discretionary decisions would seem to be welfare-​improving, but there is no guarantee that the choices so provided are exercised in a way consistent with social welfare.231

229  Section 8.2.2 and 8.4.2.2.    230  Davies et al., note 46.    231 Section 8.4.2.

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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. The 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 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 is, (individual) investors—​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” or “securities” 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 law” or “securities regulation,” supports corporations in their efforts to raise external capital in the face of the familiar agency problems.3 The broad thrust of securities law is concerned with affiliation strategies—​the entry and exit of investors to and from the body of 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. To the extent that these measures increase investors’ expected returns, firms that issue securities to the public (“issuers”) should enjoy a lower cost of capital. This 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,” or “securities,” markets we refer to organized capital markets that trade standardized financial instruments (securities) and are generally accessible to investors. Although EU law parlance refers instead to “financial instruments,” and there are some technical differences in scope between these and the U.S. conception of “securities,” the terms broadly overlap. Cf. Louis Loss, Joel Seligman, and Troy Paredes, Fundamentals of Securities Regulation 353–​457 (6th edn., 2011) (U.S.); Niamh Moloney, EU Securities and Financial Markets Regulation 84–​5 (3rd edn., 2014) (EU). We generically refer to securities throughout the text. 2  See Joel Seligman, The Historical Need for a Mandatory Corporate Disclosure System, 9 Journal of Corporation Law 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. The Anatomy of Corporate Law. Third 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 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, and the structure and operations of stock exchanges and other market infrastructure institutions. Given the book’s focus on corporations, we do not address market regulations of this sort here,4 but rather focus on the legal strategies directly addressing issuers and their agents. The 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 number of provisions that are formally classed as securities regulation.5

9.1  Securities Regulation and Legal Strategies The legal strategies used to enhance securities markets are based on affiliation terms. More precisely, compliance with securities laws is a condition for entering, remaining in, and exiting the public markets, even if entry or exit may not be entirely voluntary. That said, it is convenient to group the legal strategies employed in the service of public traded markets into four categories. The first is the paradigmatic exemplar of the entry strategy: mandatory disclosure in all of its dimensions, including the prescription of accounting methods. The 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 to securities regulation. The third and fourth categories include governance and regulatory strategies contingent on participating 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? The 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 supported by an active market where traders compete to realize gains from new information, a well-​functioning disclosure system increases the “informativeness” of market prices, often referred to as the market’s “informational efficiency.”6 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,7 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’s prospects than is already reflected in the market price. Therefore, participation in securities markets will be broader, with a positive effect on market liquidity—​that is, the ability of investors to sell their securities easily and rapidly with little or no impact on price.8 4  For an introduction to this area of regulation see John Armour, Daniel Awrey, Paul Davies, Luca Enriques, Jeffrey Gordon, Colin Mayer, and Jennifer Payne, Principles of Financial Regulation, 143–​59 (2016). 5  See e.g. Chapter 6.2.1.1. 6  See Ronald J. Gilson and Reinier H. Kraakman, The Mechanisms of Market Efficiency, 70 Virginia Law Review 549 (1984); see also Armour et al., note 4, ch. 5. 7  See Section 9.1.3.2. 8  In the absence of a 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 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 compensation for managers and serve as an alternative currency for takeovers.9 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, and possibly ineffective, way of attaining that goal.10 A different question altogether is whether mandatory disclosure, via informationally efficient securities prices, can also be relied on to enhance allocative efficiency—​that is, to ensure that scarce capital is channeled toward the most promising investment projects. The link between informational and allocative efficiency would be as follows: informationally efficient prices also incorporate the estimates about issuers’ profitability that skilled analysts and traders elaborate from publicly available information. The greater the available information, the more accurate such estimates. Within the firm, independent directors focused on shareholder wealth and managers with equity-​ based compensation packages may thus use stock price reactions as guidance for corpor­ ate strategy.11 Provided outsiders’ estimates of a company’s expected profitability are more precise than a biased 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.13

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, Insider Trading and the Stock Market (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, The Essential Role of Securities Regulation, 55 Duke Law Journal 711 (2006). The history of U.S. stock markets, which shifted from an insider-​driven to a disclosure-​driven system during the twentieth century, provides some support for this view: see John Armour and Brian Cheffins, Stock Market Prices and the Market for Corporate Control, 2016 University of Illinois Law Review 101. 9  See Chapters 2.2.1.2, 3.5, and 8.1.1. 10  See e.g. Robert C. Pozen and Mark J. Roe, Those Short-​Sighted Attacks on Quarterly Earnings (2015), corpgov.law.harvard.edu. 11 James Dow and Gary Gorton, Stock Market Efficiency and Economic Efficiency:  Is There a Connection? 52 Journal of Finance 1087 (1997); Jeffrey N. Gordon, The Rise of Independent Directors in the United States, 1950–​2005: Of Shareholder Value and Stock Market Prices, 59 Stanford Law Review 1465 (2007). 12  Cf. Luca Enriques, Ronald J. Gilson, and Alessio M. Pacces, The Case for an Unbiased Takeover Law (with an Application to the European Union), 4 Harvard Business Law Review 85, 93–​5 (2014). 13  See John Armour and Luca Enriques, Financing 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.14 But why must policymakers impose 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 The underproduction of information The case for mandatory 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.15 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 capital more cheaply. Biased disclosure raises the cost of capital across the board and distorts its allocation when real-​world market conditions prevent companies from signaling their true value. Tying mandatory disclosure 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.16 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 is justified provided it leads to increased aggregate returns and lower price volatility across the market.17 Finally, a third justification for mandatory disclosure is the value of standardization of substance, format, and quality. At bottom, this solves a coordination problem among firms. Standardization through mandatory disclosure improves comparability, and thus increases the value of information to its users. Although firms have surmounted this collective action problem in the past—​for example, through accounting and stock exchange rules—​mandatory disclosure may accelerate the standardization process.

9.1.2.2 The empirical evidence Despite the foregoing arguments, legal scholars have long debated how far issuers should be given discretion over disclosure to public markets.18 Recent empirical 14  See Edward B. Rock, Securities Regulation as Lobster Trap:  A  Credible Commitment Theory of Mandatory Disclosure, 23 Cardozo Law Review 675 (2002). 15  For a more comprehensive review see Luca Enriques and Sergio Gilotta, Disclosure and Financial Market Regulation, in The Oxford Handbook of Financial Regulation 511 (Niamh Moloney, Eilis Ferran, and Jennifer Payne eds., 2015). 16 John C. Coffee, The Future as History:  The Prospects for Global Convergence in Corporate Governance and its Implications, 93 Northwestern University Law Review 641 (1999). 17  See e.g. Frank H. Easterbrook and Daniel R. Fischel, Mandatory Disclosure and the Protection of Investors, 70 Virginia Law Review 669 (1984). 18 See e.g. Roberta Romano, The Advantage of Competitive Federalism for Securities Regulation (2002); Merritt B. Fox, Retaining Mandatory Securities Disclosure: Why Issuer Choice Is Not Investor Empowerment, 85 Virginia Law Review 1335 (1999).

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literature supports the conventional view that publicly traded firms under-​report information—​and especially negative information—​if disclosure is not mandated. While early studies of the U.S. mandatory disclosure regime suggested otherwise, at least for exchange-​traded companies, they suffered from serious methodological weaknesses.19 More recent studies provide stronger evidence of benefits. One reports that large U.S. firms trading on over-​the-​counter markets realized highly significant positive abnormal returns when they were first made subject to continuous mandatory disclosure requirements in 1964.20 Another study finds that mandatory disclosure is associated with a dramatic reduction in the volatility of stock returns.21 Moreover, non-​U.S. studies point in the same direction, with several cross-​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.24 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.25 Notwithstanding that, there is widespread support for the proposition that mandatory disclosure improves social welfare. Today, the debate is not so much on whether mandatory disclosure is justified as on how broad its scope should be (both in terms of addressees and contents) and how effective enforcement can be ensured in different institutional contexts.26

9.1.2.3 The benefits of information Mandatory disclosure serves the principal, though not exclusive, purpose of enhan­ cing price informativeness. The familiar yet remarkable fact is that in modern markets the disparate traders—​savvy stock pickers, arbitrageurs, algo-​traders, short sellers, and others—​impound new information into price extremely rapidly. As hinted, this not only enhances liquidity by attracting uninformed traders, but also allows companies to use market prices as benchmarks of performance, to guide investment decisions, acquire other companies, and better compensate managers.27 Similarly, 19  See Christian Leuz and Peter D. Wysocki, The Economics of Disclosure and Financial Reporting Regulation: Evidence and Suggestions for Future Research, 54 Journal of Accounting Research 525 (2016) (providing a rich survey of the theoretical and empirical literature). 20 See Michael Greenstone, Paul Oyer, and Annette Vissing-​Jorgensen, Mandated Disclosure, Stock Returns and the 1964 Securities Acts Amendments, 121 Quarterly Journal of Economics 399 (2006). 21  See Allen Ferrell, Mandated Disclosure and Stock Returns:  Evidence from the Over-​the-​Counter Market, 36 Journal of Legal Studies 213 (2007). 22  See Allen Ferrell, The Case for Mandatory Disclosure in Securities Regulation Around the World, 2 Brooklyn Journal of Business Law 81, 88–​99 (2007) for a review. 23  Luzi Hail and Christian Leuz, International Differences in the Cost of Equity Capital: Do Legal Institutions and Securities Regulation Matter? 44 Journal of Accounting Research 485 (2006). 24 Hans B. Christensen, Luzi Hail, and Christian Leuz, Capital-​ Market Effects of Securities Regulation: Prior Conditions, Implementation, and Enforcement, 29 Review of Financial Studies 2885 (2016). 25  See e.g. ibid., at 2916. 26 See Benjamin E. Hermalin and Michael S. Weisbach, Information Disclosure and Corporate Governance, 67 Journal of Finance 195 (2012); Leuz and Wysocki, note 19. 27  See Anat R. Admati and Paul Pfleiderer, Forcing Firms to Talk: Financial Disclosure Regulation and Externalities, 13 Review of Financial Studies 479 (2000); Ronald A. Dye, Mandatory versus Voluntary Disclosure: The Cases of Real and Financial Externalities, 65 Accounting Review 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.28 In short, issuers, sophisticated traders, and public investors alike rely on well-​informed public market prices. But mandatory disclosure supports public securities markets in ways that extend beyond its positive impact on pricing. Disclosure also greases the wheels for the other legal strategies of corporate law.29 On the governance side, informed shareholders can better exercise their decision and appointment rights. Thus, 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.30 On the regulatory side, information crucially affects the enforcement of rules and standards. To take an obvious example, shareholders might never detect dubious related-​party transactions if companies were not required to disclose them. The 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 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.

9.1.2.4 The scope of disclosure 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 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, 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 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 28 See Anjan V. Thakor, An Exploration of Competitive Signaling Equilibria with “Third Party” Information Production, 37 Journal of Finance 717 (1982); Tim S. Campbell and William A. Kracaw, Information Production, Market Signaling, and the Theory of Financial Intermediation, 35 Journal of Finance 863 (1980). 29  See Chapter 2.4. 30 See generally Paul G. Mahoney, Mandatory Disclosure as a Solution to Agency Problems, 62 University of Chicago Law Review 1047, 1080 (1995). 31  See Chapter 6.2.1.1. 32 See, e.g. Stephen J. Choi and Andrew T. Guzman, Portable Reciprocity:  Rethinking the International Reach of Securities Regulation, 71 Southern California Law Review 903 (1998); Romano, The Advantage, note 18. 33  Cf. Luca Enriques and Tobias H. Tröger, Issuer Choice in Europe, 67 Cambridge Law Journal 521, 529–​33 (2008) (highlighting the limited scope of regulatory arbitrage for issuers of shares as opposed to debt issuers 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.34 In contrast to the regulation of new issues of securities, the scope of continuing disclosure requirements for public issuers varies more among our core jurisdictions. The EU requirements are narrow in scope: they have traditionally extended only to firms traded on regulated markets.35 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 mandatory disclosure of material information36 has been extended to issuers having approved (or requested admission to) trading of their securities on a multilateral trading facility.37 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.38 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-​the-​counter markets.39 Disclosure requirements in other non-​EU jurisdictions are broader. In Japan, public companies subject to continuing disclosure duties include not only issuers of exchange-​ listed securities, but also issuers of securities registered with over-​the-​counter 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.40 The U.S. requirements are similar to Japan’s.41

9.1.2.5 The contents of disclosure The content of mandatory disclosure, like its scope, is broadly similar across jurisdictions. The 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

34  See Moloney, note 1, at 95–​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, 1-​5-​2, and 1-​7 Cabinet Order for Implementation of Financial Instruments and Exchange Act. 35  That is still currently the case with periodic and ownership disclosures: see Art. 1 Transparency Directive. Art. 4(1)(21) Markets in Financial Instruments Directive, 2014 O.J. (L 173) 349, defines a “regulated market” as a multilateral system, which brings together or facilitates the bringing together of multiple third-​party buying and selling interests in financial instruments according to its rules and/​ or systems, and which is authorized as such and functions regularly in accordance with the applicable rules set out in the Directive itself. 36  See Chapter 9.1.2.5. 37  Art. 17 Market Abuse Regulation, 2014 O.J. (L 173) 1. A “multilateral trading facility” is a multilateral system, which brings together multiple third-​party buying and selling interests in financial instruments, in accordance with non-​discretionary rules and in accordance with the applicable rules set out in the Markets in Financial Instruments Directive (Art. 4(1)(22)). 38 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 Consob Regulation on Issuers. 39  Art. 22 Lei 6.385, de 7 de dezembro de 1976 (Brazil); Arts. 1º and 13 CVM Instruction No. 480 (2009); Art. 1º CVM Instruction No. 461 (2007). 40  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. 41  §§ 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’s business and the identity of its management and large shareholders. Notwithstanding these commonalities, however, our core jurisdictions differ in their commitment to disclosure as a tool to support securities markets. To see why, consider that information subject to disclosure falls into one of four categories. The first is a basic description of the company, ranging from an inventory of its assets to an accur­ ate statement of its current financial position and past cash flows. This is the hard, “benchmark” data that would allow an investor to value the firm as a going concern if the future were exactly like the past. All jurisdictions require substantial disclosure of such hard data. 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.42 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,43 on the basis that they are costly for small and medium size firms to produce and that they are said to “encourage short-​term performance and discourage long-​term investment.”44 A second category of disclosure mandated in some jurisdictions encompasses “soft,” “projective,” or “forward-​looking” information. This includes management’s predictions about likely price changes in each of the multiple markets in which the firm operates (such as product, supply, capital, and labor markets), as well as management’s best estimates of likely changes in demand for the firm’s products, including any new products or 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 analysis. Despite the importance of projective data, forward-​looking information accounts for only a tiny fraction of mandated disclosure in our core jurisdictions.45 The U.S. pioneered the reporting of forward-​looking information by requiring that reports contain a “Management Discussion and Analysis of Financial Condition and Results of Operations” (“MD&A”),46 and encouraging (but not requiring) companies to disclose forward-​looking financial projections by shielding such projections from securities litigation.47 Japan followed suit by introducing MD&A reporting in 2003.48 The EU also mandates the disclosure of soft and projective information, but in a very

42  See Section 9.1.2.6. 43  See Art. 1(5) Directive 2013/​50/​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). 44  Ibid., preamble (4). 45 See e.g. Vivien Beattie, Bill McInnes, and Stella Fearnley, A Methodology for Analysing and Evaluating Narratives in Annual Reports: A Comprehensive Descriptive Profile and Metrics for Disclosure Quality Attributes, 28 Accounting Forum 205, 213 (2004). 46  Regulation 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. 47  1933 Securities Act, Rule 175 (adopted in 1979). 48 Cabinet Office Ordinance on Disclosure of Corporate Affairs, Form 2 (Precautions for Recording (36)) and Form 3-​2 (Precautions for Recording (16)) (as amended in 2014). Brazil introduced MD&A-​style reporting in 2009, but the scope of required forward-​looking information is comparatively circumscribed. The 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.49 As a matter of practice, larger issuers have since long voluntarily offered more forward-​looking information than was strictly required.50 The U.S., then, has been the leader in requiring disclosure of soft and future-​oriented information, the volume of which has in fact increased in recent years.51 Despite a lack of similarly strong requirements, an increase in volume can also be observed in other core jurisdictions as well.52 A third category of mandatory disclosure relates directly to governance issues and agency problems. As we have seen in previous chapters, this category includes information about top management compensation, as well as information about the corporate value that finds its way to insiders and controlling shareholders.53 It also includes information that is ancillary to informed voting by shareholders, an area which is highly litigation-​ intensive in Germany, where courts take voting-​related disclosures very seriously,54 and well-​developed, thanks to federal regulation of proxy voting and best practices, respectively in the U.S. and the UK.55 Finally, a fourth category of mandatory disclosure is “event-​related” disclosure—​ that is, new “material” or “price sensitive” information about the issuer that is likely to have an impact on the market price of securities. Here, the U.S., on the one hand, and 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,56 unless it falls within one of the many pre-​identified mandated disclosure items,57 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.58 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.59

49  Arts. 4(2)(c) and 5(4) Transparency Directive merely require that firms traded on a regulated market report “principal risks and uncertainties that they face” on a yearly and half-​yearly basis. 50  See Gary K. Meek, Clare B. Roberts, and Sidney J. Gray, Factors Influencing Voluntary Annual Report Disclosures by U.S., U.K. and Continental European Multinational Corporations, 26 Journal of International Business Studies 555, 558 (1995). 51  See Marilyn F. Johnson, Ron Kasznik, and Karen K. Nelson, The Impact of Securities Litigation Reform on the Disclosure of Forward-​Looking Information by High Technology Firms, 39 Journal of Accounting Research 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 h ​ arbor rule). 52  See e.g. for the UK, Paul L. Davies and Sarah Worthington, Gower & Davies Principles of Modern Company Law 774–​5 (9th edn., 2012). In Japan, it has been customary for listed corporations to disclose their earnings forecast for the next term. See http://​www.jpx.co.jp/​equities/​listed-​co/​ format/​forecast/​index.html (in Japanese). 53  See Chapter 6.2.1.1. 54  See e.g. Ulrick Noack and Dirk Zetzsche, Corporate Governance Reform in Germany: The Second Decade, 15 European Business Law Review 1033, 1044 (2005). 55  See Loss et al., note 1, 700–​811; Davies and Worthington, note 52, 406–​9. 56  See e.g. Marc I. Steinberg, Insider Trading, Selective Disclosure, and Prompt Disclosure: A Comparative Analysis, 22 University of Pennsylvania Journal of International Economic Law 635, 657–​8 (2001). 57  See Form 8-​K (17 CFR 249.308). 58  See Donald C. Langevoort and G. Mitu Gulati, The Muddled Duty to Disclose under Rule 10b-​5, 57 Vanderbilt Law Review 1639, 1664–​71 (2004). 59  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. 2o CVM Instruction 358 (2002) (Brazil). To 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, 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 looks. On the one hand, the granular and ever-​expanding itemized disclosure requirements in the U.S. combine with pro-​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.60 On the other hand, a standard—​as in the EU and Brazil—​that relies on information having the character of “price-​sensitivity” leaves scope for discretion in deciding when a piece of information is ripe for disclosure (it must be “of a precise nature” in the EU61) and material (what does it mean that it “may 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.62 That said, the European Court of Justice has so far interpreted the concept of “inside information” broadly, and lawmakers followed the Court’s lead in reforming the market abuse relevant disclosure rules in 2014.63 Even an “intermediate step in a protracted process,” such as the commencement of merger negotiations, is to be disclosed if it is itself of a precise nature and price sensitive.64

9.1.2.6 Accounting methods Financial reporting regimes—​the provision of information about a firm’s past and current financial position—​have evolved from two very different models.65 One, the “continental European” model, originated in seventeenth century France with the goals of protecting creditors and facilitating the taxation of firms. The other, the “Anglo-​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 of creditors, insiders, and the state strongly influenced a continental European model of accounting, while the interests of equity holders informed the Anglo-​American accounting model.66 These disparate interests point toward different valuation methods. Traditionally, 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 with an impact higher than pre-​set quantitative thresholds (Art. 24-​5 Financial Instruments and Exchange Act and Art. 19 Cabinet Office Ordinance on Disclosure of Corporate Affairs). 60  See James D. Cox, Robert W. Hillman, and Donald C. Langevoort, Securities Regulation: Cases and Materials 728 (7th edn., 2013); Steinberg, note 56, at 659. 61  Although the Court of Justice of the European Union interpreted the term “precise” 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. 62  Art. 157, § 5º Lei das Sociedades por Ações and Art. 6o 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). 63  See Case C-​19/​11 Geltl v Daimler ECLI:EU:C:2012:397; recitals (16) and (17) and Art. 7 Market Abuse Regulation. 64  Art. 7(3) Market Abuse Regulation. 65  See Bruce Mackenzie et al., Interpretation and Application of International Financial Reporting Standards 3–​4 (2014). 66  Indeed, even today the U.S. and UK distinguish between financial and tax 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 Trojan Horse? The Dynamics of Resistance against IFRS, 36 University of Pennsylvania Journal of International Law 89, 144–​5 (2014).

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assets on the balance sheet at the lower of historical cost or market value.67 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 assets.68 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.69 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” be70—​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 assets.71 Indeed, the financial crisis has dramatically highlighted the pro-​cyclical effects of marking assets to market when market prices are purportedly “distressed,” and therefore below the normal-​times hold-​to-​maturity value of complex financial assets.72 Nevertheless the divergence between the Continental and Anglo-​ American approaches toward accounting should not be exaggerated. As indicated above, both models have always used historical cost to value non-​financial assets.73 In addition, accountants are conservative by profession, which should discourage them from overvaluing financial assets under fair value accounting.74 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’s endorsement of International Financial Reporting Standards, which draw heavily from the U.S./​UK approach.75 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.76 As a result, financial reporting methodologies converged throughout the 1990s and the 2000s. 67  See Joanne M. Flood, Interpretation and Application of Generally Accepted Accounting Principles 978–​81 (2014). 68 See Alexander Bleck and Xuewen Liu, Market Transparency and the Accounting Regime, 45 Journal of Accounting Research 229 (2007) (historical costs give management a veil under which they can potentially mask a firm’s true economic performance). 69  ”Fair 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 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 Werner, Fair Value Accounting under IAS/​IFRS:  Concepts, Reasons, Criticisms, in International Accounting 127 (Greg N. Gregoriou and Mahamed Gaber eds., 2006). 70  See FAS 157: for the Financial 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 information available (unobservable inputs). 71  See Guillaume Plantin, Haresh Sapra, and Hyun Song Shin, Marking-​to-​Market:  Panacea or Pandora’s Box, 46 Journal of Accounting Research 435 (2008) (marking to market is especially problematic when assets are long-​lived, illiquid, and senior). 72  See Franklin Allen and Elena Carletti, Mark-​to-​Market Accounting and Liquidity Pricing, 45 Journal of Accounting and Economics 358 (2008); Plantin et al., note 71. See also International Monetary Fund, Global Financial Stability Report 58–​66 (2008). 73  See e.g. Janice Loftus, A Fair Go to Fair Value, in Gregoriou and Gaber, note 69, at 41. 74  See e.g. Sugata Roychowdhuroy and Ross L. Watts, Asymmetric Timeliness of Earnings, Market-​ to-​Book and Conservatism in Financial Earnings, 44 Journal of Accounting and Economics 2 (2007). 75  See Gelter and Kavame Eroglu, note 66, 148. 76 See Werner F. Ebke, Rechnungslegung und Publizität in europarechtlicher und rechtsvergleichender Sicht, in Internationale Rechnungslegungsstandards für börsenunabhängige Unternehmen? 67 (Werner F. Ebke, Claus Luttermann, and Stanley Siegel eds., 2007).

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Since the crisis, however, criticism of fair value accounting has increased77 and Germany has backtracked from the idea of imposing it, leaving companies a free choice on the matter.78 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.79 All in all, the extent to which accounts drawn up 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, legal origins, and enforcement intensity.80 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.81 For example, U.S. GAAP are said to rely on detailed rules to reduce the risk of shareholder litigation alleging faulty accounting—​a concern that is much less salient elsewhere.82 Conversely, jurisdictions with low litigation risk, such as European ones, have embraced the principle-​oriented IFRS, which leave more room for managerial discretion. Ironically, flexibility may help explain the global popularity of IFRS, even though flexibility reduces the comparability of financial statements between and within IFRS jurisdictions.83 But comparability across or within jurisdictions can also be difficult under rule-​oriented accounting systems, insofar as rules cannot anticipate all cases and must be supplemented by standards anyway.84

9.1.2.7 Protecting exit rights: making commitments credible The 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 attract investors with the implicit promise of full disclosure and high liquidity, and then “go dark” by abandoning their status as public companies. But buyers would discount that possibility and refuse to pay the “premium” otherwise associated with securities regulation. That 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.85 This is, however, 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 77  See Gelter and Kavame Eroglu, note 66, 159–​63. 78  See Bilanzrechtsmodernisierungsgesetz (BilMoG) (2009). 79  See Gelter and Kavame Eroglu, note 66, 103–​4. 80  See Mary E. Barth et al., Are IFRS-​Based and US GAAP-​Based Accounting Amounts Comparable? 54 Journal of Accounting and Economics 68 (2012). 81 Yuan Ding, Ole-​Christian Hope, Thomas Jeanjean, and Hervé Stolowy, Differences Between Domestic Accounting Standards and IAS: Measurement, Determinants and Implications, 26 Journal of Accounting and Public Policy 26 (2007). 82  See e.g. Gelter and Kavame Eroglu, note 66, 124. 83  See Christopher Nobes and Robert Parker, Comparative International Accounting ch. 7 (12th edn., 2012). 84  See William W. Bratton, Enron, Sarbanes-​Oxley and Accounting:  Rules Versus Principles Versus Rents, 48 Villanova Law Review 1023 (2003). 85  See Rock, note 14.

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the number of a company’s shareholders drops below given thresholds.86 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).87 Public companies that are exchange-​listed must also comply with the rules governing voluntary delisting.88 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.89 This public law approach reinforces the effectiveness of delisting-​related company law requirements, which some jurisdictions deploy. So, for instance, the NYSE requires a board resolution and notice,90 while the Main Market of the London Stock Exchange requires supermajority shareholder approval.91 After lengthy debate, Germany now places the delisting decision in the hands of corpor­ate management,92 but imposes an exit right for (minority) shareholders at a fair price.93 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 of the company’s free float.94 86  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 legal capital drops below 500 million yen. See §§ 12(g)(4) and 15(d) 1934 Securities Exchange Act (U.S.) and Art. 24(1) Financial Instruments and Exchange Act and Art. 3–​6(1) Cabinet Order for the Enforcement of the Financial Instruments and Exchange Act (Japan). In 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. 87  See e.g. Moloney, note 1, at 133–​4. 88  Delisting may also be involuntary, for failure to meet listing standards or rule violations. See Shinhua Liu, The Impact of Involuntary Foreign Delistings:  An Empirical Analysis, 10 Journal of Emerging Markets 22 (2005) (identifying 103 foreign firm delistings from U.S. markets between 1990 and 2003, 100 being threshold-​related and three due to failure to meet other non-​numerical standards). 89 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 when the stock exchange delists shares of a corporation “in violation of the exchange rules,” there is no provision in the Tokyo Stock Exchange listing rules spelling out the conditions for voluntary delisting. The practice of the Tokyo Stock Exchange, however, is said to be restrictive: corporations that have been permitted to delist voluntarily were those that were also cross-​listed on other exchange(s). 90  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 of the shareholders in favor and not more than 10 percent against. Rock, note 14, at 683. The 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. 91  FCA Listing Rule 5.2.5. 92 The Frosta decision (BGH, Oct. 8, 2013—​II ZB 26/​12, NJW 2014, 146) thus reversed the earlier Macrotron decision (BGH, Nov. 25, 2002—​II ZR 133/​01, BGHZ 153, 47), which required shareholder approval. 93  This exit right was reinstalled in late 2015 in response to commonly perceived gaps in minority protection following Frosta (note 93). Revised § 39 Börsengesetz now requires an exit right at the weighted average market price of the previous six months. For details, see Walter Bayer, Delisting: Korrektur der Frosta-​ Rechtsprechung durch den Gesetzgeber, Neue Zeitschrift für Gesellschaftsrecht 1169 (2015). 94  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 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 mechanism that effectively reduces the pressure to tender. Art. 10, § 2o 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. Both are meant to curb behavior, such as misleading statements or price manipulation, which may alienate investors from 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 impact: that is, it may raise the cost of capital for all companies in the market. The 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 public agents’ decisions) or semi-​private:95 the latter is the case with stock exchange-​ devised listing or admission to trading requirements.96

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 structure, supermajority requirements, and so on, that policymakers (and stock exchanges) impose on publicly traded companies.97 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, 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 the officials—​to be particularly risky without offsetting economic merit. In practice, most securities offerings are now exempt from state regulators’ review.98 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.99 Thus, the UK’s Financial Services and Markets Act 2000 authorizes the UK Listing Authority to refuse a listing application that it considers detrimental to the 95  Of course, quality controls also exist that are purely private, such as when the intermediary setting up a 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 Italia/​Mercato Alternativo del Capitale: Rules for Companies 33 (2016) (available at ); for Alternext, see . 96  These are only semi-​private because they are subject to securities regulators’ approval: regulators 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 or rather public regulations in disguise. 97  See Chapters 3.1, 3.2., 3.3, 3.4, 6.2.3, and 7.3.1. 98  Section 18, Securities Act 1933, as amended (15 U.S. Code § 77r). 99  See Art. 11 Consolidated Admission and Reporting Directive, 2001 O.J. (L 184) 1, applicable to “official” listed segments.

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interests of investors.100 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 of trading and investor protection.”101 However, quality-​ control provisions have fallen from favor among European policymakers as well: the powers we have described are seldom, if ever, used.102

9.1.3.1.2  Quality checks upon entering public markets In addition to investor protections based on mandatory disclosure for securities offerings and merit regulation, our core jurisdictions provide for minimum quality rules, whether self-​regulatory or public, to screen issuers entering the public market. “Official” or “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 first section, the Tokyo Stock Exchange requires at least 20,000 unit shares, 4 billion yen in market capitalization, 2,200 shareholders, and a high minimum pre-​tax profit calculated over a two-​year period.103 Other exchanges impose similar, although mostly less rigorous, requirements.104

9.1.3.2 Market manipulation (securities fraud) and insider trading restrictions Finally, our jurisdictions use regulatory strategies (rules and standards) to curb abusive practices on securities markets. In particular, all of them ban the dissemination of false or misleading statements about an issuer, whether by the issuer itself or by third parties105 (known as market manipulation in Europe, and securities fraud in the U.S.),106 and provide for some restrictions on trades by those who are in possession of inside information about an issuer (insider trading). 100  Financial Services and Markets Act 2000 (UK) section 75(5). 101  Art. 64 Consolidated Law on Financial Intermediation (Italy). 102  See also Moloney, note 1, 171–​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. 103  Tokyo Stock Exchange, Securities Listing Regulations, Rule 308. 104  For NYSE’s requirements, which are based on pre-​tax corporate income ($10 million in the aggregate for the previous three years) or, failing that, on a “Valuation/​Revenue Test” or an “Assets and Equity Test,” see New 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 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 Euronext Rulebook, Harmonised Rules), a minimum (and usually waivable) foreseeable market capitalization (e.g. €40 million in Italy, Art. 2.2.2 Listing Rules for the markets set up and managed by Borsa Italiana SpA) and a minimum of three years of prior business (e.g. for Germany and the UK, see § 3 Börsenzulassungsverordnung; § 6.1.7 Listing Rules). The 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. 105  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 trade-​based manipulation). 106  See Art. 1 Market Abuse Regulation, 2014 O.J. (L 173) 1 (EU); 17 C.F.R. § 240.10b-​5 (U.S.); CVM Instruction No. 8 (1979) (Brazil); Arts. 158–​9 Financial Instruments and Exchange Act (Japan).

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The 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 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.107 However, most of our jurisdictions have moved away from the idea that insider trading presupposes the misappropriation of a corporate asset (or, similarly, the violation of a fiduciary duty). 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. This rationale has made its way into European legislation and case law and is reflected in a broad-​sweeping ban on trading by any person possessing insider information, irrespective of that person’s relationship with the company and how the information was acquired.108 It has traditionally also been advocated by the U.S. SEC, yet so far without success.109 An economically better grounded justification for a 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 super­ ior information would lead them to increase bid-​ask spreads.110 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, public and private enforcement and gatekeeper control—​for this purpose.112 Yet jurisdictions differ dramatically 107  See Chapter 6.2.4. 108  See Art. 8 and Preamble 24, Market Abuse Regulation. See also ECJ, Case C-​45/​08 Spector Photo Group [2009] E.C.R. I-​12073. For the scope of insider trading prohibitions in the U.S., Brazil, and Japan see Chapter 6.2.4. 109 See Dirks v SEC, 103 Supreme Court Reporter 3255 (1983); U.S. v. Newman, 733 Federal Reporter 3d 438 (2d Cir. 2014). 110  See Chapter 6.2.4. 111  See Zohar Goshen and Gideon Parchomovsky, On Insider Trading, Markets and “Negative” Property Rights in Information 87 Virginia Law Review 1230 (2001). 112  See Chapter 2.3.2.

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in the mix of enforcement modes they 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 powers such as self-​regulatory bodies and stock exchanges.113 All of our major jurisdictions devote significant resources to public enforcement of securities laws. Two 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.114 Enforcement budgets 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.115 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 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.116 In the wake of the crisis, however, even the UK has been putting considerably more weight on formal public enforcement.117 These 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, and Tyco International and, more recently, on a number of investment managers and corporate directors for insider trading.118 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 bodies and stock exchanges as private enforcers, due to their hybrid nature. 114  Howell E. Jackson and Mark J. Roe, Public and Private Enforcement of Securities Regulation: Resource-​Based Evidence, 93 Journal of Financial Economics 207, Table 2 (2009), also showing that, by comparison, France, Italy, Germany, and Japan have roughly the same population-​adjusted enforcement staff; data are from the mid-​2000s. Brazil has the lowest population-​adjusted enforcement staff of our core jurisdictions. Note that the evidence consolidates issuer behavior and market trading enforcement. 115  Ibid. (note that the data is not adjusted for per capita market capitalization). The exception is Italy, where the enforcement budget is closer to U.S.–UK levels, but staffing remains far below them. 116  See Jackson and Roe, note 114, 235; John Armour, Enforcement Strategies in UK Corporate Governance:  A  Roadmap and Empirical Assessment, in Rationality in Company Law:  Essays in Honour of Dan D. Prentice 71, 87–​92 (John Armour and Jennifer Payne eds., 2009). 117  See Eilís Ferran and Look Chan Ho, Principles of Corporate Finance Law 413 (2nd edn., 2014). See also Brooke Masters, Don’t Hold Your Breath Waiting for a Tesco Fraud Case, The Financial Times, 1–​2 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 deals with lower level conspirators”). 118  See e.g. Tebsy Paul, Friends with Benefits: Analyzing the Implications of United States v. Newman for the Future of Insider Trading, 5 American University Business Law Review 109, 124 (2015).

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and Brazil are more lenient when it comes to punishing securities fraud,119 while in Japan, public enforcement relies mainly (and increasingly) on administrative fines. Moreover, as discussed in Chapter  6, higher levels of U.S.  private enforcement go hand-​in-​hand with higher levels of public enforcement.120 Vibrant private litigation prompts public enforcers to be more active themselves while, conversely, private litigation feeds on evidence gathered by public enforcers.121

9.2.2 Private enforcement The 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. The 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” (knowing or reckless misconduct in the UK) in the case of violations of on-​going and periodic disclosure requirements.123 Despite the more lenient standards of liability, reliance on private enforcement (i.e. securities litigation) is much greater in the U.S.:124 the securities class action based on the “fraud on the market” theory is one of the most important mechanisms for enfor­ cing mandatory disclosure requirements, notwithstanding past U.S. Congress efforts to cabin it.125 The 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) securities markets.126 119  See e.g. for France, Nicolas Rontchevsky, L’harmonisation des sanctions pénales, Bulletin Joly Bourse 139, 1 March 2012, n° 3. 120  See Chapter 6.2.5.4. 121  See James D. Cox, Randall S. Thomas, and Lynn Bai, There Are Plaintiffs and … There Are Plaintiffs: An Empirical Analysis of Securities Class Action Settlements, 61 Vanderbilt Law Review 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 Prospekt-​ und Kapitalmarktinformationshaftung 9, 125–​7 (Klaus J. Hopt and Hans-​Christoph Voigt eds., 2005). On Japan see text accompanying notes 128–​9. 123 See Hopt and Voigt, note 122, 9, 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, at hm-​treasury.gov.uk) (outlining the rationale for the looser standard). 124  Between 1997 and 2014, around 200 securities fraud cases seeking class-​action status have been filed every year in federal courts, with numbers somewhat 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 period, due to below-​average filing rates and increasing dismissal rates. 125  See e.g. John C. Coffee, Jr., Entrepreneurial Litigation: Its Rise, Fall, and Future 64–​85 (2015). 126 See Basic Inc. v.  Levinson, 485 United States Reports 224 (1988), and, more recently, Halliburton Co. v. Erica P. John Fund Inc., 134 Supreme Court Reporter 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 by the market. Like bounty hunters in the Old West, a law firm that settles a securities class action (a very frequent occurrence) earns lucrative attorney’s fees.127 What is peculiar is that settlement agreements virtually never require managers and directors to pay for the damages: the money invariably comes from the issuers’ (or rather their D&O insurers’) coffers.128 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.129 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, 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 of running their corporations. In addition, there are reputational concerns: directors of companies that face shareholder suits appear to suffer modest but discernible negative impacts on their future career prospects.130 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 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 heavily discount the negative impact on the company’s credibility, and ultimately on the stock price, of the—​however less than 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 The incidence of private

127  See e.g. Michael Klausner, Personal Liability of Officers in U.S. Securities Class Actions, 9 Journal of Corporate Law Studies 349 (2009). See also Chapter 6.2.5.4 (discussing shareholder lawsuits). 128  See e.g. John C. Coffee Jr., Reforming the Securities Class Action: An Essay on Deterrence and Its Implementation, 106 Columbia Law Review 1534 (2006). 129  See e.g. William W. Bratton, and Michael L. Wachter, The Political Economy of Fraud on the Market, 160 University of Pennsylvania Law Review 69 (2011). 130 See e.g. Eliezer M. Fich and Anil Shivdasani, Financial Fraud, Director Reputation, and Shareholder Wealth, 86 Journal of Financial Economics 306 (2007); Maria Correia and Michael Klausner, Are Securities Class Actions “Supplemental” to SEC Enforcement? An Empirical Analysis, Working Paper, Stanford Law School (2014). 131 For this line of argument, see James C. Spindler, Vicarious Liability for Bad Corporate Governance: Are We Wrong About Rule 10b-​5? 13 American Law and Economics Review 359 (2011). 132 See William T. Allen and Reinier Kraakman, Commentaries and Cases on the Law of Business Organization ch. 14 (5th edn., forthcoming). See also text preceding note 147. 133  For a recent overview of collective action mechanisms in Europe, see Martin Gelter, Risk-​ shifting Through Issuer Liability and Corporate Monitoring, 13 European Business Organization Law Review 497, 529–​32 (2013). See also Érica Gorga, The Impact of the Financial Crisis on Nonfinancial Firms:  The Case of Brazilian Corporations and the “Double Circularity” Problem in Transnational Securities Litigation, 16 Theoretical Inquiries in Law 131 (2015).

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lawsuits relating to disclosure violations is modest but increasing in Brazil, France, and Germany,134 steadily low in Italy,135 and, perhaps surprisingly, extremely rare in the UK.136 Japan has become an exception since the mid-​2000s: the introduction of strict liability for issuers in 2004 sparked a mini-​boom in litigation.137 That led to a change in the law ten years later when, with the purpose of curbing securities litigation, Japan retreated to a negligence standard for issuer liability in the secondary market.138 Whether litigation against issuers will deflate as intended is too early to tell. The U.S.  is much less of an outlier when it comes to private enforcement vis-​à-​ vis negligent gatekeepers. As indicated in Chapter 5,139 expansion of auditor liability, especially in the U.S., prompted both courts and legislatures to seek to rein in this form of litigation.140 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.141 The law also acts as a prop to market discipline (itself, broadly speaking, a form of private enforcement142): mandatory disclosure facilitates the reputational sanctioning of publicly traded firms that deviate from “best practices” and other non-​binding quality-​control recommendations. That is the case for EU jurisdictions’ codes of best practices, which are backed by a mandatory “comply or explain” rule.143 As discussed in Chapter  3, these codes establish much of the governance structure of European listed companies, including board composition and committee structure.144 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, they face the risk of a penalty in the form of a lower share price.145 Although some U.S. disclosure requirements come close,146 the U.S., Brazil, and 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

134  See Thierry Bonneau and France Drummond, Droit des Marchés Financiers No. 528 (3rd. ed. 2010); Hopt and Voigt, note 122, 99–​103 and 140. 135  See Andrea Perrone and Stefano Valente, Against All Odds: Investor Protection in Italy and the Role of Courts, 13 European Business Organization Law Review 31 (2012). 136  See Armour, note 116. 137  Gen Goto, Growing Securities Litigation against Issuers in Japan—​Its Background and Reality, Working Paper (2016), available at ssrn.com. 138  The burden of proving non-​negligence is on the defendant (Art.21-​2(2) FIEA). Japan has, however, kept strict liability for primary market disclosures (Art. 18 FIEA). 139  See Chapter 5.2.1.4. 140 See Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 United States Reports 164 (1994) (no aiding and abetting liability under Rule 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. 141  See, for the U.S., Stoneridge Investment Partners LLC v. Scientific Atlanta Inc. and Motorola Inc., 128 Supreme Court Reporter 761 (2008); for the UK, Caparo v Dickman, [1990] 2 AC 605. 142  See Armour, note 116. 143  See, for the UK, Listing Rules 9.8.6; for Germany, § 161 AktG; for France, Arts. 225–​37, al. 7 and L. 225-​68, al. 8 Code de commerce; for Italy, Art. 123-​II Consolidated Act on Financial Intermediation. 144  See Chapter 3.3.2. 145  See also Armour, note 116, 102–​9. 146  See Chapter 3.3.1. For the U.S., see e.g. § 972 Dodd Frank Act (requiring companies to explain whether and why the same person serves as the CEO 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 target of public enforcement actions.147

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. This is the case with audit services, whereby an outside team of specialized professionals, usually from a 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 assistance on securities law may further reinforce the investing public’s perception of an issuer’s compliance with applicable laws. Finally, in some markets an investment bank acts as a “sponsor” for a given company and is therefore under an obligation vis-​à-​vis the stock exchange to ensure that the company complies with its listing obligations.148 In screening financial information and issuers’ behavior more 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.149 However, reputational capital is not immutable or unperishable, especially when a firm, as opposed to an individual, is entrusted with it.150 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.151 Failures to spot, and react to, patently unlawful and outright fraudulent behavior do periodically catch the public 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 Thornton (a middle-​tier audit firm) with Parmalat in Italy. What is impossible to tell is whether, despite such failures, 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

147  Jonathan M. Karpoff, D. Scott Lee, and Gerald S. Martin, The Cost to Firms of Cooking the Books, 43 Journal of Financial and Quantitative Analysis 581 (2008); John Armour, Colin Mayer, and Andrea Polo, Regulatory Sanctions and Reputational Damage in Financial Markets, Journal of Financial and Quantitative Analysis (2017). 148  See e.g. UK Listing Rules, § 8. 149 See Reinier Kraakman, Gatekeepers:  The Anatomy of a Third-​Party Enforcement Strategy, 2 Journal of Law, Economics, and Organization 53 (1986); John C. Coffee, Gatekeepers: The Professions and Corporate Governance (2006). 150  See Reinier H. Kraakman, Corporate Legal Strategies and the Costs of Legal Controls, 93 Yale Law Journal 892–​3 (1984). 151  For an illustration, see Jonathan R. Macey, Efficient Capital Markets, Corporate Disclosure, and Enron, 89 Cornell Law Review 394, 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,152 suggests that their services are valued by market participants. As noted, securities laws have often assimilated such market practices by making it a requirement for issuers to hire gatekeepers. At the same time, and especially in the wake of spectacular gatekeeper failures, in all our jurisdictions the law has regulated gatekeepers in order to ensure the quality of their 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.153

9.3  Convergence and Persistence in Securities Regulation Issuers in all our major jurisdictions are subject to mandatory disclosure and the other securities law requirements we have briefly surveyed in this chapter. Such rules apply as soon—​and for 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 environment, on the one hand, and civil law jurisdictions, on the other, has narrowed. The most notable differences concern enforcement. The 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. The public enforcement of securities law breaks down in a slightly different way. The 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 formal 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.154 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.155 Where capital markets are large and highly developed, as in the U.S.  and the UK, securities law in action 152  See e.g. Paul G. Mahoney, Wasting a Crisis: Why Securities Regulation Fails 80 (2015). 153 Compare Macey, The Death of Corporate Reputation 253–​75 (2013), with Coffee, Gatekeepers, note 149, at 333–​56. 154  See e.g. John C. Coffee, Jr. and Hillary A. Sale, Redesigning the SEC: Does the Treasury Have a Better Idea? 95 Virginia Law Review 707, 727–​9 (2009). 155 See also Rafael La Porta, Florencio Lopez-​de-​Silanes, and Andrei Schleifer, The Economic Consequences of Legal Origins, 46 Journal of Economic Literature 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. This correlation, while not perfect, seems robust. The most straightforward explanation is that, in jurisdictions with more developed capital markets, ensuring that they function well yields larger economic and political benefits. Correspondingly, in such jurisdictions there will be higher demand for securities laws by well-​organized interest groups, such as institutional investors, investment banks, stock exchanges, gatekeepers, and securities lawyers.156 Consistently with this view, increasing equity ownership by (domestic and foreign) institutional investors and 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 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, more stringent securities laws are most often enacted.157 Where capital markets are already well-​developed and therefore more central to the political discourse, the public reaction to crises—​and associated demand for stricter laws—​will be stronger. Mediated by effective interest groups—​such as the plaintiff bar in the U.S.—​and policy entrepreneurs, politicians’ reaction will correspondingly be more intense. Hence, other things being equal, one can expect greater post-​crisis ratcheting-​up of securities laws in countries with well-​developed capital markets than in ones where capital markets are less important for the economy. Finally, differences in securities law regimes may again mirror 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. In addition, rules that 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. Thus, because they generally stand more to lose than to gain from rules that would better reflect companies’ value, they will tend to lobby against securities law reforms. Strong labor, which often goes hand in hand with strong ownership, also has reason to oppose strong securities laws:158 if such laws are successful in increasing the size and importance of capital markets for an economy159 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 hegemony which may otherwise pervade it.160 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

156  See generally Franklin Allen and Douglas Gale, Comparing Financial Systems (2000). 157 See e.g. Roberta Romano, The Sarbanes-​ Oxley Act and the Making of Quack Corporate Governance, 114 Yale Law Journal 1521 (2005). 158  See generally Mark J. Roe, Political Determinants of Corporate Governance (2003). 159  See Andrei Shleifer and Daniel Wolfenzon, Investor Protection and Equity Markets, 66 Journal of Financial Economics 3 (2002). 160  See e.g. Marco Pagano and Paolo Volpin, The Political Economy of Finance, 17 Oxford Review of Economic Policy 502, 504–​10 (2001).

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well-​functioning system of broad-​scope disclosure reduces the risk that markets draw negative implications from silence: because analysts may find a competitor’s silence to be informative also of another 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’ prospects. They 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, more informationally efficient markets can better signal (again, optimistic) managers’ quality to investors and therefore (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 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. A time lag between law enactment and effective enforcement is to be expected in an area that requires serious human capital investments on the part of both private and public players. In addition, features that are almost totally unrelated to corporate and securities 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 enforcement efforts,161 may be at play in ways that make convergence in enforcement less likely than convergence in the law on the books.

161  See generally Curtis J. Milhaupt and Katharina Pistor, Law and Capitalism ch. 10 (2008).

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10 Beyond the Anatomy John Armour, Luca Enriques, Mariana Pargendler, and Wolf-​Georg Ringe

A short book deserves a short conclusion. The preceding chapters survey the corporate laws of our core jurisdictions in areas ranging from the basic governance structure to securities markets. The laws are presented in terms of a handful of legal strategies that all jurisdictions deploy. These strategies are used to address the agency problems inherent in corporations: the conflicts between managers and shareholders, between minority and controlling shareholders, and between non-​shareholder constituencies and shareholders as a class. We do not summarize the contents of earlier chapters here. Rather, we focus more 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. Then, 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 of its functions. The motivating conceit is that these functions are similar the world over. Business organization everywhere gives rise to similar economic exigencies; 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, 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. This is in contrast to most works on comparative law, which focus on differences. 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. 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  To be sure, the book’s brevity and the scope of its 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 types and their application on an “average” basis to particular countries abstract from more granular differences in ownership structure both across and within countries. The Anatomy of Corporate Law. Third 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 10 © John Armour, Luca Enriques, Mariana Pargendler, and Wolf-Georg Ringe, 2017. Published 2017 by Oxford University Press.

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The 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. Not all differences in national corporate laws are 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. These 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, corporate law also reflects a synthesis of our societal values. That 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. Take, 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. And more fundamentally, it yields a common analytic framework that is independent of the internal categorizations of any legal system—​a huge advantage for comparative work.

10.2  Beyond the Scope The scope of this book’s subject matter, while broad, is not unlimited. One such limit is jurisdictional: for the sake of brevity and readability, the analysis is restricted to a number of key legal systems. Another limit is typological, as we limit our study to the legal form of the business corporation, explicitly excluding other forms of organization. This 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, our only real justification for their omission is a pragmatic reflection of the limitations in our own expertise. Nevertheless, our hope is that the 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 basic framework. On the one hand, there is little doubt that our analytical tools remain useful when transposed to this different context. The vast 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 standards—​a mechanism that relies heavily on courts as enforcement institutions. This 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 arbiters of the partitioning—​are willing to permit deviations both through dissolution and veil-​ piercing. And perhaps more fundamentally, the prevalence of state share ownership means that, quite apart from subtle divergences in the content of corporate law, there may be fundamental differences as to the very structure of the corporate form.3 We leave to future enquiry reflection on the extent to which these differences 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 the very definition of the corporate form that is the object of our study. There 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. The 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 Present 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 analyzing broad trends in the evolution of corporate law over time. This, too, is principally for pragmatic reasons. It means, however, that the analysis understates the impact of history and path dependence in shaping the legal institutions that we presently observe. Nevertheless, 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 run-​ up to the global financial crisis. Many aspects of these changes are contentious, and their implications are as yet incompletely understood. Consequently, the extent to which they reflect an evolution in the configuration of agency problems, as opposed 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,4 as does the extent to which they may be expected to persist. A recurring theme in many recent corporate law reforms is a desire to increase the protection available to investors, especially shareholders. This takes shape in the roll-​ out of three particular legal strategies. First, the affiliation strategy, through a continued appetite for ever-​broader disclosure requirements. Second, a growing enhancement of shareholders’ decision rights, as illustrated by the spread of “say on pay” votes around the world. Third, continued use and refinement of the trusteeship strategy in the form of independent directors and disinterested board approval. At a very high level of generality, these developments might be seen as tracking the considerable convergence in national ownership structures we note throughout the book. This 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 large and often international institutional investors—​but no controlling shareholder. However, a closer look at the evolution of share ownership suggests it would be unwise to take for granted that corporate law’s current investor-​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. This 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. This may, however, result in a convergence that is more formal than functional, if “investor-​oriented” 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 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 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. This 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.5 Many institutional investors are not organized as corporations, which may call into question the applicability of our framework to asset managers directly.6 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 4  This echoes the observation in Section 10.1 about overlapping explanatory accounts. 5  Bernard S. Black, Agents Watching Agents: The Promise of Institutional Investor Voice, 39 UCLA Law Review 811 (1991); Ronald J. Gilson and Jeffrey N. Gordon, The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights, 113 Columbia Law Review 863 (2013). 6  This echoes the point made in Section 10.2 concerning the scope of our enquiry.

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invest. The 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 performance targets. Which of these problems is thought to dominate has implications for how far the “investor-​oriented” model of corporate law continues to be appropriate.7 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. This 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 interests of shareholders are highly heterogeneous, which is usually the case in the presence of state 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 (“one-​share, one-​vote”) in continental Europe, both France and Italy have enacted reforms permitting greater divergence between voting rights and cash-​flow rights through tenure voting schemes, while iconic Silicon Valley firms such as Facebook, following in Google’s footsteps, have gone public with a voting structure allowing founders to retain voting control with low 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 short-​ term orientation in corporate management. Another current issue concerns the goals of corporate law. One broadly accepted view, which we articulate in Chapter 1, is that corporate law should seek to maximize shareholder value, because this ordinarily tends to serve the broader goal of advancing social welfare. 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. The financial crisis of 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. The 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, as we discuss in Chapter 4, a number of corporate law reforms have developed with the interests of external stakeholders in mind. There 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 7  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. The emerging scholarly consensus following the financial crisis is that concerns about externalities should at most affect the 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 a uniform legal regime of general applicability in favor of a more tailored corporate law regime based on the specific nature of a company’s business features. 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. This 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 changes such as these, which are driven by particular 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 technology and financial sectors already. Moreover, parallel technological developments in fields such as process authentication and automated decision-​making may come to reduce internal agency costs 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.

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Index References such as ‘178–╉9’ indicate (not necessarily continuous) discussion of a topic across a range of pages. Because the whole of this work is about ‘corporate law’, use of this term (and certain others which occur throughout) as an entry point has been restricted. Please look under the appropriate detailed entries. Wherever possible in the case of topics with many references, these have either been divided into sub-╉topics or only the most significant discussions of the topic are listed. accountants, see auditors accounting, see also auditors; GAAP; gatekeepers; IFRS conflicted transactions╇ 148 conservative╇ 126, 252–╉3 continental╇ 252–╉3 methods╇ 244, 250, 252, 254 standards╇ 120–╉2, 148, 250, 254, 263 true and fair view╇ 126, 252–╉4 accounts╇ 25–╉6, 102, 107, 114, 151, 156, 163, 209, 254, 268 acquisitions╇ 185–╉6, 199–╉200, 207–╉8, 212, 222, 227, 229–╉31, 233, 235, 240–╉1; see also control transactions compulsory╇ 190–╉1 actio pauliana╇ 134–╉5; see also insolvency activist hedge funds╇ 52–╉3, 59–╉60, 155, 216, 271 affiliation strategies╇ 32–╉3, 38, 49, 68–╉72, 88, 94–╉5, 100, 102, 119–╉20, 124, 127, 147– 52, 244–╉5; see also entry strategy; exit agency conflicts╇ 2, 79, 106, 172, 207, 240 costs╇ 29, 44, 47, 52–╉3, 55, 106, 109, 263, 268, 270–╉2 managerial╇ 46, 52–╉3, 60, 79, 81, 208 reduction╇ 30–╉8 problems╇ 2–╉5, 29–╉47, 76, 108–╉9, 115–╉17, 184–╉5, 207–╉8, 211, 243, 269–╉70 and legal strategies╇ 30 majority–╉minority shareholder╇ 2, 79 manager–╉shareholder╇ 2, 208, 211 minority–majority╇ 105, 231 non-╉shareholder╇ 79, 209 shareholder╇ 2, 37, 43, 100, 186 shareholder-╉creditor╇ 111–╉16, 119, 128 shareholder-╉non shareholder╇ 2, 79 agent incentives╇ 35, 49, 62–╉8, 139–╉40, 147, 153–╉6; see also rewards; trusteeship agents╇ 7–╉8, 29–╉33, 35–╉40, 42–╉3, 46, 65, 139, 223, 243–╉4 aggregate welfare╇ 22–╉4, 31, 98, 135 analysts, see financial analysts antifraud provisions╇ 151, 161, 167, 253; see also disclosure anti-╉takeover defenses, see control transactions appointment rights╇ 37–╉8, 51, 53, 55–╉6, 59, 64, 72–╉3, 80–╉1, 84, 90, 95–╉6, 101, 103, 105, 135–╉7, 139, 185, 236 appraisal rights╇ 34, 37, 88, 165, 167–╉8, 176–7, 179, 186–╉9, 200, 202

asset managers╇ 52, 60–╉2, 270–╉1 assets╇ 5–╉9, 11, 109–╉13, 115–╉18, 133, 135–╉6, 191–╉2, 194–╉6, 199–╉201, 253; see also divisions; mergers; related party transactions corporate, see corporate assets dilution╇111, 125 partitioning╇ 9, 110, 269 personal╇ 6, 9, 43, 111 sales╇ 96, 145, 174, 194–╉5 substitution╇ 111, 113–╉14, 134 audit committees╇50, 71 independence╇ 63–╉4, 99, 178 auditors╇ 35, 39, 43, 57, 71, 122–╉3, 150, 263; see also gatekeepers liability╇ 122–╉3, 151, 262 special╇ 151–╉2, 163 authority╇ 7–╉8, 11–╉12, 16, 37, 40, 85, 154–╉5, 177, 181, 264 bad faith╇ 29, 67, 71, 135 balance sheet(s)╇ 105, 125, 137, 148, 253 test╇117, 127 bankruptcy, see insolvency banks╇ 25–╉6, 59, 65, 70, 95–╉6, 100, 119–╉20, 124, 135, 140–╉3 best practices╇ 63, 76, 105, 154, 178, 213, 235, 251, 262, 264 bidders╇ 83, 205–╉6, 208–╉9, 211, 213–╉17, 219–20, 223–╉5, 227–╉9, 235–╉6, 238 potential╇ 35, 207–╉8, 217, 224–╉5, 228 bids╇ 39, 73, 178, 190, 205–╉10, 212–╉28, 230– 1, 233–╉7, 240, 255 competing╇ 208, 213–╉15, 225–╉6 hostile╇ 45, 72–╉3, 206–╉10, 213, 216, 220, 223, 226, 237–╉9, 241 mandatory╇ 207, 217, 227–╉8, 230, 234, 255 bilateral veto╇ 175–╉6 blockholders╇ 73–╉4, 87–╉8, 207, 209, 211, 224, 226–╉7, 230, 233, 241 blocks╇ 26, 153, 158, 183, 186, 207–╉8, 214, 223, 227, 231 controlling╇ 79, 83, 85, 103, 208, 232–╉4 boards of directors╇ 10–╉13, 50–╉1, 53–╉8, 85–╉6, 153–╉5, 175–╉8, 180–╉2, 201–╉2, 207–╉13, 216–╉24; see also agency, problems; appointment rights; control transactions; delegated management; judicial review approval╇ 85, 153, 206 committees╇ 46, 51, 63–╉4, 80, 84, 86, 137–╉8, 153, 155, 178

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274 boards of directors (Cont.) de facto or shadow directors  114, 128, 131, 133–​5, 163 director disqualification  129 director independence  85, 153, 220 director liability  69–​70, 85, 128, 162–​3 fiduciary duties  69–​70, 84, 129, 155, 162, 164, 218 independent directors  62–​7, 76–​7, 80–​1, 84–​6, 99, 101, 153–​5, 166–​8, 219–​20, 270–​1 and insolvency  127–​30 limits on board authority  84 management boards  50–​1, 55, 57, 59, 69, 71, 75, 91, 154, 200 one-​tier  50, 90, 154, 158 powers  172–​3, 181, 218, 238 removal of directors  55–​6, 75, 136–​7, 218–​19 self-​selecting  85 and shareholder interests  84 staggered boards  56, 176, 219, 222 structure  1, 5, 11–​12, 46, 65, 72, 177–​8 supervisory boards  50–​1, 54–​5, 63–​4, 74–​5, 90–1, 105–​6, 154, 156, 210, 219–​20 two-​tier boards  12, 18, 50–​51, 58, 154, 157–​8 bondholders  112, 114, 176 bons Breton  216–​17 Brazil  53–​7, 73–​4, 80–​4, 101–​5, 119–24, 130–​9, 150–​2, 165–​9, 249–​52, 268–​9 Break-​Through Rule  223, 235–​6, 241 business judgment rule  68–​70, 87, 154, 156, 167; see also duty of care; fiduciary duties capital, see legal capital capital markets, and issuer regulation 149 cash flow(s)  111, 136, 146, 250 rights  81–​2, 96, 179–​80, 236, 271 test 117, 127 centralized management, see delegated management CEOs (Chief Executive Officers)  50, 56, 67–​8, 71, 89, 94, 139, 149, 167, 209 charter amendments  20, 37, 57–​8, 72–​3, 84, 126, 174–​80, 190–​1, 199, 201 class approval requirements  178 court review  179 decision-making rights in relation to  174 majority–minority shareholder conflict in  178–​80 management–​shareholder conflict in  178 charters  16–​20, 56, 72–​3, 80, 175–​83, 185–​6, 190–​1, 216–​17, 235, 238 Chief Executive Officers, see CEOs China  41, 50, 234, 268 choice of law  19, 21–​2; see also regulatory competition civil law jurisdictions  6, 86, 103, 164, 264 civil liability  43, 68, 130, 146, 163 class actions  41, 44, 151, 167, 202, 260–​1, 264; see also enforcement closed corporations, see corporate form, closed/​ private corporation

Index closely held firms, and widely held firms 11, 147, 151 codetermination  14, 16, 19, 51, 58, 74–​5, 90–1, 105–​7, 220, 222 and takeovers  220, 222 tie-​breaking vote  91 collective action issues  30, 45–​6, 58, 60, 101, 106, 171, 179, 243, 246; see also enforcement common law/​civil law  164, 201–​2 community interest corporations 14 comparative law  3–​5, 51, 59, 64, 68, 76, 81, 85, 239, 241 compensation  30–​1, 36, 63, 66–​8, 92, 94, 149–​50, 155–​7, 163, 165; see also managers; rewards, strategy; say on pay aggregate  149–​50, 248 approval 68, 156 committees  63–​4, 67–​8, 100, 147, 155 disclosure  71, 94, 149–​50 equity-​based  62, 66, 100, 157, 245 loans as 158 competing bids  208, 213–​15, 225–​6 compliance  32–​3, 38–​44, 61, 63, 99, 101, 162, 244–​5, 261, 263; see also enforcement; social norms compulsory acquisitions  190–​1 compulsory share sales  190–​1 concentrated ownership  53, 65, 74, 85, 102–​4, 129, 234, 238, 265, 270 conflicted transactions  63, 88, 153, 156, 158, 161–​2, 164; see also control transactions; related party transactions fiduciary duties  88, 131–​4 liability  133, 162–​3 subordination of debt  131 consolidations, see mergers constituencies  12, 51, 53, 55, 62, 84–​5, 97–​8, 100, 102, 171–​2 contractual  23–​4, 79, 92–​3, 99 external  92–​5, 97, 99–​100, 102, 107 non-​shareholder  79–​80, 82, 84, 86, 88, 90, 92, 96, 98–​100, 102 constraints strategy  31, 69, 71, 84, 88, 91–​3, 97, 99; see also rules; standards consumers  13, 30, 93–​5, 115–​16, 132 continental accounting  252–​3 contracts  5–​12, 17–​20, 30–​1, 35–​6, 67–​8, 85–​6, 113, 118–​19, 174, 235; see also corporate law, and contracts; creditors employment  89, 194–​5 contractual constituencies  23–​4, 79, 92–​3, 99 contractual counterparties  2, 10, 79, 89, 92, 109 control  13–​15, 27, 81, 102–​4, 115, 135–​6, 178–​81, 218–​23, 227–​30, 232–​4 blocks  45, 79, 103, 115, 227, 232–​3 private benefits of  79, 103–​4, 167–​8, 221, 228–​9, 232–​3 rights  11, 31, 34, 47, 60, 66, 81, 83, 117, 141 shifts  184–​5, 195, 205–​12, 219, 221, 223, 230–5, 237–​40

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Index control transactions  45, 112, 146, 205–​43; see also bidders; hostile bids/​takeovers agency issues  207–​9, 211–​24, 231 board role in  211 competing bids  214 coordination problems  208–​9 among target shareholders  224–​31 decision rights  211–​12 defensive measures  207, 210–​11, 213, 215–19, 221–​3, 225, 236, 240 post-​bid  213, 216 pre-​bid  213, 215, 219, 222–​4 differences in regulation  236–​42 disclosure 224 issues on acquisition from controlling shareholder  231–​6 joint decision-​making  215–​21 mandatory bid  208, 227, 233 no frustration rule  213, 236 poison pills  208, 212, 216–​18, 220–​3, 228, 230–​1 sources of rules  210–​11 standards  218–​19 takeover regulation  210, 225 controllers  85–​6, 88, 152, 174, 188, 208, 211, 228–​9, 231, 233–​4 controlling blocks  79, 83, 85, 103, 208, 232–​4 controlling shareholders  79–​82, 84–​8, 103–​5, 145–​9, 153–​7, 162–​3, 165–​8, 188–​90, 206–​10, 231–​6; see also controllers convergence  51, 57, 68, 71, 76, 81, 120–​1, 150, 264–​6, 270 conversion  174, 196–​9 coordination  2, 49, 51–​2, 60, 101, 114, 224 costs  2, 12, 30–​2, 49, 52–​3, 57, 66, 80, 128, 140, 142, 208 problems  117–​18, 173, 206–​8, 218, 224–​9, 238, 242, 246, 267 shareholders  52, 58–​62 core jurisdictions  49–​50, 62–​3, 65–​7, 71–​3, 85–​7, 95–​104, 174–​6, 248–​51, 257–​9, 270–​1 corporate assets  8, 32, 40, 43, 68, 109–​12, 116–​17, 136, 139, 229; see also assets abuse  161, 164–​5, 168 corporate charters, see charters corporate constituencies, see constituencies corporate control, see control corporate distributions  36, 55, 58, 84, 86–​7, 103–​4, 112, 115, 125–​6, 181 corporate divisions, see divisions corporate form  1–​3, 8–​17, 19, 37, 49–​50, 93, 124, 198, 269, 272 basic characteristics  1 closed/​private corporation  3, 11, 14–​15 function 1 insolvent firms  117 nonprofit firms  14 open/​public corporation  11 and other forms  13–​16 piercing the corporate veil  114, 116, 131–​4, 269

275 special and partial  15, 198, 269 corporate governance  3–​5, 24–​7, 49–​52, 58–​61, 63–​9, 71–​6, 88–​90, 104–​8, 149–​51, 238–​41 codes  61, 63–6 corporate groups, see groups of companies corporate law, see also Introductory Note and contracts  17–​21 commonalities  3–​4 creditor friendliness  141 definition  1–​27 forces shaping  24–​8 goal  22–​5, 29, 186, 271 and insolvency law  17 and labor law  17, 91 corporate opportunity  145, 156; see also related party transactions corporate ownership, 25–​7, 82, 103; see also ownership costs, see agency, costs; coordination costs, transaction costs counterparties  2, 6–​7, 10, 44, 79, 89, 92, 109, 159, 173 courts  38–​40, 69–​72, 132–​3, 135–​40, 152–​3, 161–​4, 167–​8, 189–​92, 210, 251–​2 CRAs, see credit rating agencies credit bureaus 122; see also gatekeepers credit rating agencies  122–​3 creditor ownership 109 creditor–​creditor coordination  116–​19 creditors  2–​3, 5–​9, 14–​17, 23, 29–​31, 109–​43, 172, 192, 195–​8, 210 contractual covenants  119, 125, 143 and directors’ fiduciary duties  127–​8 and distressed firms  127–​40 and limited liability  2 and mergers  192 non-​adjusting  115–​16, 119, 132 personal  6–​7, 9, 117 protection  2, 45, 112–​13, 125–​6, 140–​1, 143, 192, 195, 210 secured  117–​18, 140 security 112, 119 and solvent firms  119–​27 transactions with  140–​3 criminal liability  44, 68, 130–​1, 164 criminal sanctions  44, 131, 160, 163, 165, 264 crisis managers  117, 127, 136–​9 cross-​border relocation  196–​7 cross-​shareholdings  26, 75–​6, 81, 238 cumulative voting  80–​1, 101 damages  99, 116, 129, 133, 160–​1, 163–​5, 246, 260–​1, 264 debt(s)  111–​13, 117, 119, 122, 126, 131, 136, 139, 141–​3, 195 renegotiation  113–​14, 118, 127–​8, 141 debt finance  109–​10, 112, 119–​20, 140–​3 debtors  111–​12, 117, 119–​20, 127–​8, 133–​6, 138, 141, 143 decision-​making  12, 69–​70, 105–​6, 173–​5, 212, 215, 223–​4, 226, 236–​7, 239 joint  221, 223–​4 power  50, 153, 172, 218

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276 decision rights  37–​8, 49, 51–​3, 57–​9, 81, 84, 95–​6, 137–​8, 166–​7, 175–​6; see also delegated management; shareholder(s) minority shareholders  84 strategy  37, 40, 84–​5, 90, 155–​8, 162, 184, 187, 199, 201 default, see insolvency default provisions  6, 18, 20–​1, 124, 126 defensive measures, see control transactions, defensive measures Delaware  54, 56, 68, 84–​7, 154–​7, 161–​4, 175–​9, 184–​9, 196, 199–​200 delegated management  1, 5, 7, 11–​13, 15, 37, 49–​52, 86, 117, 156; see also boards of directors; decision rights centralized management  5, 217, 223, 225, 237, 239 delisting 192 derivative action  162–​4; see also enforcement directors, see boards of directors disclosure  38–​9, 46–​7, 94–​5, 119–​21, 148–​51, 167, 222, 244, 246–​52, 254, 260–​1 mandatory  37–​8, 68, 71–​2, 88, 119–​20, 147, 244–​9, 251, 256–​7, 264 periodic  39, 166, 249, 252, 260 requirements  69, 71–​2, 100, 104, 121, 147–​8, 222, 225, 247–​9, 255; see also accounting benefits and costs  247 conflicted transactions  147–​51 as entry strategy  33, 88 function 38, 45 material information  120 policies  38–​9 public registers  119 rationale 38, 247 scope 47 selective 47, 251 discretion  29, 33, 66–​7, 70, 158, 180, 217, 219, 246, 248 dispersed ownership  2, 24, 27, 63, 73, 75, 103, 129, 185, 240 dispersed shareholders  58, 74–​5, 80, 128, 175, 181, 208, 233 dissolution  96, 126, 152, 191, 201, 269 partial 152, 167 distressed firms  127, 129, 131–​3, 135, 137, 139 and creditors  127–​40 distributions, see corporate distributions divergence  1, 25, 76, 140, 202, 210, 253–​4, 266, 269, 271 dividends, see corporate distributions divisions  58, 98, 174, 183–​5, 187, 189, 191, 193–​5, 237 dominant shareholders  49, 73–​4, 79, 81, 86, 164, 166–​7, 169, 202, 243 double voting rights  13, 82, 106 duty of care  69–​71, 129; see also fiduciary duties duty of loyalty  68, 84, 88, 97, 129, 156, 161–2, 164, 183, 248; see also fiduciary duties

Index electronic meetings 59 electronic voting 59 empirical evidence  18, 52, 61, 105, 111, 246–​7 employees  5, 17, 22–​4, 95, 100, 104–​6, 192–​5, 197–​8, 209–​10, 238; see also codetermination appointment and decision rights strategies 90–1 and control transactions  209–​10 incentives and constraints strategies  91–​2 information 91 jurisdictional differences and similarities  105–​7 and mergers  193 protection  89–​92 representatives/​representation  16, 90–​1, 193, 198, 210, 219 employment contracts  89, 194–​5 enforcement  38–​45, 104, 128, 160–1, 164–6, 168–​9, 247–​9, 258–​9, 261–​2, 264 antifraud provisions  128, 130, 151 collective action  46, 261 directorial liability  128–​30 disclosure requirements  46, 148 discovery 41, 151 gatekeeper control  42, 121–​4 initiators  40–​3 insider trading  39 intensity  115, 121, 169, 254, 259, 266 modes of  42, 151 private  41–​2, 70, 128, 130, 160, 165, 167, 169, 258, 260–​4 public  40–​2, 130, 147, 151, 169, 259–​60, 263–​4 rules and standards  39, 46, 160, 164 standing to sue  128–​9 entity shielding  6–​7, 9, 110–​111, 113, 116– 17, 269; see also assets, partitioning liquidation protection  6 priority rule 6 strong form  6, 15, 117 weak form 6 entrenchment  175–​6, 180–​1, 185 entry strategy  33–​4, 37, 244, 256 equal treatment  36, 84, 86–​8, 102, 104, 215, 225 equity-​based/​linked compensation  62, 66, 100, 157, 245 European company, see Societas Europaea ex ante strategies  37–​8, 119 ex post strategies  36–​8, 119, 218 executive compensation, see compensation executives, see managers exit  33–​4, 37–​8, 88, 179–​80, 187–​8, 226–​8, 230, 232–​4, 243–​4, 254–​5 compulsory buy-​out  232 exit strategy  34–​5, 37, 88, 152–​3, 186–​7, 202, 244 mandatory bid  208 rights  34, 69, 72, 166, 187–​8, 224, 226–​8, 230, 232–​4, 254–​5 external constituencies  92–​100, 102

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Index appointment and decision rights strategies  95–​7 incentives and constraints strategies  97–​100 jurisdictional differences and similarities  107–​8 externalities  23, 30, 43, 45, 65, 93, 115, 247, 272 fair price  183, 188–​9, 255 fair value  253–​4 fairness  37, 94, 148, 161–​4, 172, 180, 186–7, 189, 202; see also fiduciary duties; judicial review fiduciary duties  97–​9, 130–​1, 136, 161, 165–6, 215, 218, 225, 228, 231 auditors 122 directors and managers  69–​71, 84, 92, 128–9, 155, 161–​2, 164, 206 shareholders 131, 206 third parties  134–​5 fiduciary standards  69, 210, 232 financial analysts 147, 260 financial crisis  24–​5, 97, 99–​100, 122–​4, 142, 181–​2, 239, 241, 253, 271–​2 financial distress  114, 118, 128, 131; see also distressed firms; insolvency financial intermediaries  58–​9, 80, 82, 143, 150, 157, 248–​9, 255, 257, 262 France  55–​60, 73–​5, 102–​4, 125–​7, 129–​32, 134–​9, 149–​52, 154–​8, 163–​6, 186–​90 fraud  128, 132, 256, 258, 260–​1 risk 256, 263 securities  16, 69, 146, 151, 167, 257, 260–​1, 264 fraudulent conveyance 134 freeze-​outs  146, 174, 185, 188–​90; see also squeeze-​outs functional approach  3, 134, 268 fundamental changes  72, 88, 171–​203 definition  172–​4 explanation of differences  201–​3 GAAP (Generally Accepted Accounting Principles)  121, 126, 148, 151, 253–​4; see also accounting; IFRS gatekeepers  40, 42–​3, 117, 122–​4, 134, 151, 186, 256, 262–​5 control  42, 258, 263–​4 gender quotas  95–​6 general meetings, see shareholders’ meetings Generally Accepted Accounting Principles, see GAAP Germany  50–​1, 54–​60, 68–​72, 105–6, 131–2, 134–​9, 141–​3, 149–​53, 155–​8, 163–​7 courts  132, 134, 154, 190 law  55–​6, 71, 74–​5, 86–​7, 121, 163, 226, 228, 233, 235 going private 192, 255 golden shares  95–​6, 102, 107 good faith  33, 70, 98, 135, 147, 179, 191 governance  38–​9, 46–​7, 49, 79, 103, 105, 108, 127–​8, 177, 244 interests of shareholders as a class  49–​77 rights  27, 50, 52, 70, 94, 180, 270

277 strategies  31–​2, 35, 38–​40, 44–​6, 49, 93, 135, 140, 142–​3, 256; see also appointment rights; decision rights; rewards; trusteeship groups of companies  16–​17, 52, 87–​8, 109–10, 115, 121, 131–​4, 138–​9, 163–​4, 207–​8; see also intra-​group transactions; parent companies; pyramidal ownership structures; subsidiaries accounting 148 approval of conflicted transactions  87 piercing the corporate veil  133 regulation of  87, 133–​4, 162–​4 subsidiary indemnification  87, 133–​4, 163 hedge funds  26–​7, 52, 55, 60, 101, 108, 117, 143, 186; see also investors activist  52–​3, 59–​60, 155, 216, 271; see also investors, activist high-​powered incentives  35–​6, 62, 221 hostile bids/​takeovers  45, 72–​3, 206–​10, 213, 216, 220, 223, 226, 237–​9, 241 human rights  24, 93–​5, 160, 271 IAS (International Accounting Standard) 121, 148–​9, 254 IFRS (International Financial Reporting Standards)  121, 126, 148–​50, 252–​4; see also accounting; GAAP; IAS incentive strategy  34–​5, 84, 86, 93, 139–​40, 153; see also managers; rewards; trusteeship incentives  62, 86–​7, 91–​2, 110–​14, 117, 119–20, 128, 154–​5, 207–​8, 221–​2 alignment 32, 35, 37 high-​powered  35–​6, 62, 221 incumbent management  137, 207–​8, 211–​22, 225–​6, 237 independent directors  62–​7, 76–​7, 84–​6, 99, 101, 153–​5, 162, 166–​8, 219–​20, 270–1; see also boards of directors information  32–​4, 38–​40, 46–​7, 49–​50, 52–​3, 159–​61, 224–​6, 245–​8, 250–​2, 257–​8; see also disclosure asymmetry  52, 123, 171, 208, 219 benefits 248 sensitive  51, 60, 101, 159, 251 underproduction 246 initiation of decisions 37 insider trading  29, 31, 65–​6, 146, 150–​1, 158–​61, 244–​5, 248, 251–​2, 257–​9; see also related-party transactions insolvency  30, 70–​1, 113–​19, 126–​40, 143, 152–​3, 166, 184; see also creditors; restructurings and boards  114, 138 and corporate law  17 crisis manager  117, 136–​7 divergence in protecting creditors  140 filing 127, 136 fraudulent conveyance  134 liquidation 118 pre-​packaged bankruptcy  117–​18 reorganization  117–​18

278

278 insolvency (Cont.) role of courts  138, 140 subordination of debt  131 veto rights  138 vicinity of  114, 130, 134 workout 142 institutional investors  26, 49–​50, 53–​5, 60–61, 73–​5, 101, 104, 107–​8, 265, 270–​271 portfolio shares  60–​1 insurance  43, 105, 114, 116, 261 insurgents  53–​5 interest groups  22, 27, 169, 268, 270 dynamics  4, 25, 168–​9, 265–​6 International Accounting Standard, see IAS International Financial Reporting Standards, see accounting; GAAP; IFRS intra-​group transactions  87, 121, 149, 161, 164, 167, 169 investments  10, 13, 88–​9, 109, 111, 120, 123, 238, 240, 252 investor ownership  1, 13–​15, 49–​51, 106; see also ownership investor protection  60, 257, 260, 262, 265 disclosure 256 investors  13–​14, 59, 76–​7, 120, 151, 243–​4, 248–​50, 254–​5, 257–​8, 270; see also institutional investors activist  27, 50, 77, 101, 118, 270; see also activist hedge funds foreign 76 institutional  26, 49–​50, 53–​5, 60–​1, 73–​5, 101, 104, 107–​8, 265, 270–​1 issuers  97, 120–​1, 123, 230, 233, 243–​6, 248–​9, 251–​2, 254–​5, 257–​9, 261–​4; see also investor protection public  97, 248–​9 Italy  50–​1, 53–​9, 73–​5, 80–​3, 95–​7, 101–​5, 129–​39, 148–​50, 152–​8, 163–​6 Japan  55–​9, 75–​6, 94–​5, 119–​24, 129–​32, 134–​7, 149–​52, 154–​7, 177–​86, 249–​51 joint decision-​making  221, 223–​4 judicial review  167, 172, 182 board decisions  70, 155 labor directors  74–​5, 90, 105–​6 labor law  17, 92, 99, 133, 195 law and finance studies 27 lawmakers  24–​5, 80, 84–​5, 160, 168, 228, 234, 241, 252, 256 law-​on-​the-​books  72, 100, 102–​3 legal capital  13–​14, 110–​11, 124–​7, 129, 174, 177–​82, 201–​2, 243, 245–​7, 255–​6 authorized  180, 182, 202 increase 87 maintenance 125, 128 minimum 124 legal personality  1, 5–​11, 17, 31, 109–​10, 133, 197 legal strategies  29–​32, 36–​40, 42–​6, 49–​50, 71, 109–​10, 147, 237–​8, 244–​58, 267–​9; see also agency problems; governance, strategies; regulatory strategies

Index in corporate context  45 systematic differences across jurisdictions  45–​7 liability, see auditors; boards of directors; controlling shareholders; criminal liability; limited liability; shareholder(s), personal liability; third parties limited liability  1–​2, 5–​6, 8–​9, 11, 15–​17, 93, 109–​10, 116–​17, 243, 269; see also assets, partitioning liquidity  7, 10, 159, 161, 186–​7, 243–​5, 247, 249, 254, 256–​8 listed companies  53–​4, 63–​4, 73–​6, 80–​2, 104, 148–​51, 154–​9, 166–​9, 178–​82, 241 litigation, see enforcement; private litigation shareholder  41, 43, 70, 72, 130, 164–​5, 168, 219, 254, 261 management incumbent  137, 207–​8, 211–​22, 225–​6, 237 target  185, 206, 209–​10, 212, 214, 218, 224–​5, 228, 231, 237 management boards  50–​1, 55, 57, 59, 69, 71, 75, 91, 154, 200 managerial agency costs  46, 52–​3, 60, 79, 81, 208 managers  62, 65–​7, 72–​5, 145–​7, 158–​9, 164–​9, 184–​6, 245–​7, 261, 265–​6; see also agency problems; boards of directors conflicted transactions  145–​6, 153, 162; see also insider trading mandatory bid rule  88, 216–​17, 227–​30, 233–5, 237, 239 mandatory disclosure  37–​8, 68, 71–​2, 88, 119–​24, 147, 244–​9, 251, 256–​7, 264; see also disclosure, requirements mandatory law/​rules  18–​20, 106, 118, 171, 180, 199; see also rules markets  87–​8, 119, 227, 233–​5, 243–​6, 255–6, 258–​9, 263–​4, 266, 270–​1 public  10, 15, 45, 71, 88, 148–​9, 206, 243–4, 246, 257–​8 securities, see securities, markets mergers  37–​8, 69–​70, 84, 171–​2, 174, 183–​9, 192–​9, 201–​3, 205–​6, 231; see also control transactions; parent-​subsidiary mergers appraisal rights  186–​7 creditor protection  192 employee protection  192–​4 majority–​minority shareholder conflict  188–​92 management–​shareholder conflict  185–​8 protection of non-​shareholder constituencies  192–​4 shareholder approval  84, 184 third party evaluation  186 merit regulation  256–​7 minorities viii,  94 minority shareholder(s)  29–​31, 79–​92, 98–​106, 151–​3, 163–​5, 167–​8, 171–9, 181–3, 187–​92, 195, 201–​2, 208, 230–234; see also agency problems; controlling shareholders; exit; groups of companies; shareholder(s)

  279

Index appointment rights  80–​3 approval 84, 156 constraints and affiliation rights  88 corporate distributions  87, 152 and corporate groups  87, 164 decision rights  84 governance protection  79, 84 jurisdictional differences and similarities  100–​5 oppression 88, 152 protection  79–​88 remedies  151–​2 misappropriation  146, 158, 258; see also related-party transactions misconduct  42–​4, 130, 187 mutual funds  26, 34, 60–​1, 271 nest-​feathering 186 New York Stock Exchange, see NYSE nexus of contracts 5 no frustration rule  212–​14, 216–​18, 221–4, 236–​7, 239, 241; see also control transactions non-​listed companies  82, 151, 154, 184, 186 nonprofit corporations  12, 14–​15, 85 non-​shareholder constituencies  79–​80, 82, 84–​6, 88–​90, 92, 94–​6, 98–​100, 102, 104, 106; see also constituencies NYSE (New York Stock Exchange)  59, 63, 82–3, 99, 179, 181, 255, 257 officers  7, 12, 62–​3, 85, 99, 146, 148–​50, 154–​5, 159, 162; see also managers one-​share–​one-​vote, deviations from  80–​1, 83; see also double voting rights one-​tier boards  50, 90, 154, 158 open corporations, see corporate form opportunism  2, 27, 29, 31, 76, 88, 90, 192, 207–​8, 221–​3 organic changes  180, 184, 186, 188, 192, 202–​3; see also charter amendments; divisions; mergers oversight liability 99, 130 owners  2–​3, 5–​10, 12, 14, 29–​30, 38, 46–​7, 59, 109, 116–​17 ownership  10–​11, 13–​14, 24–​7, 46, 60–​1, 81, 92–​3, 102–​4, 141–​3, 221–​2; see also creditor ownership; investor ownership and agency problems  49 concentrated  53, 65, 74, 85, 102–​4, 129, 234, 238, 265, 270 and corporate law  141 and disclosure  46–​7 dispersed  2, 24, 27, 63, 73, 75, 103, 129, 185, 240 and enforcement  46 and legal strategies  46 state  14, 26, 42, 73, 96–​7, 107, 168, 271 structures  25–​6, 28, 46, 72–​4, 76, 140–​1, 169, 238, 241, 265–​7 parent companies  81, 110, 131, 134, 149, 163–​4, 174, 189; see also groups of companies; subsidiaries

279 parent-​subsidiary mergers  146, 154, 157, 167, 188 partnerships  2, 6, 10–​11, 14, 17 path dependence  24, 103, 169, 269 pay for performance  68, 92, 155, 157, 237; see also compensation; rewards, strategy penalties  39, 41–​5, 68, 159–​60, 262 performance  29–​30, 33, 35–​6, 44–​5, 62–​3, 65, 72, 95–​6, 247, 250 periodic disclosures  39, 166, 249, 252, 260 personality, legal, see legal personality piercing the corporate veil, see veil-​piercing poison pills  208, 212, 216–​17, 220–​3, 228, 230–​1; see also control transactions political economy  25, 39, 75, 109, 116, 234, 239, 265, 271; see also interest groups; ownership potential bidders  35, 207–​8, 217, 224–​5, 228 power(s)boards of directors  172–​3, 181, 218, 238 shareholder  60–​1, 73–​4, 103, 224 preemptive rights  87, 102, 177, 180, 182–​3, 200, 202 principals  29–​40, 42–​3, 46, 139, 175, 223, 243, 261 private benefits of control  79, 103–​4, 167–​8, 221, 228–​9, 232–​3 private companies/​corporations  10, 12, 15, 124, 151, 200; see also corporate form private litigation  165, 169, 260 privatizations  95–​7 profitability  105, 146, 245, 257 profits  13, 23, 35, 120, 149, 159–​60, 199–200, 215, 257, 271 proportionality  81, 180, 239 proxy advisers 61 proxy voting  33, 53–​6, 58–​61, 66, 72, 209, 216, 219–​20, 231, 240; see also shareholder voting public benefit  14, 93, 199 public companies/​corporations  27, 53, 57–​8, 121, 126, 183–​4, 186, 191, 199–​200, 254–​5; see also corporate form public interest  40, 96–​7, 99, 214, 241 public issuers, see issuers public markets  10, 15, 45, 71, 88, 148–​9, 206, 243–​4, 246, 257–​8 publicly traded firms  40, 42, 53, 55–​7, 70–​2, 94, 120, 122–​3, 130, 132 delisting 192 disclosure  71, 147, 151, 256 listing requirements  59, 80 pyramids 147 and unlisted firms  84, 146 pyramidal ownership structures  81–​2 qualified majorities  181–​2 qualified minorities 53 quality controls  71, 256–​7 ratification, see decision rights regulation  21–​4, 60–​1, 123, 148, 181–​2, 197, 206, 208, 224–​5, 234–​7

280

280 regulators  22, 39–​40, 93, 150, 201, 211, 220, 241–​2, 249, 256 regulatory competition  19, 21–​2, 197, 216 regulatory strategies  31–​3, 35, 38–​40, 45–​7, 49, 116, 140, 179, 244, 256–​7; see also entry strategy; exit; rules; standards reincorporation  196–​9, 201 related-​party transactions  38, 46–​7, 69, 87–​8, 121, 145–​71, 173, 188, 238, 248; see also insider trading; self dealing; tunneling abusive  147, 151, 158 corporate opportunities  155 definition 145 duty of loyalty (fairness)  156, 161–​2, 164 legal strategies for  147–​65 and ownership regimes  166–​9 prohibition 161 reasons for permitting  146–​7 relocation, cross-​border  196–​7 removal rights  55–​6, 75, 136–​7, 218–​19 removal strategies 37, 220 remuneration committees, see compensation, committees reorganization  117–​18, 127, 136–​8 reputation  35, 38, 44–​5, 63, 112, 119, 122, 162, 263, 265 restructurings  114, 117, 127, 137, 200, 203, 240; see also insolvency retail investors  26, 59, 62, 101, 264 rewards  35–​6, 39, 62, 66, 68, 120, 139, 220, 226; see also compensation; managers strategy  36–​8, 62, 66–​7, 92, 100, 139–​40, 218, 220–​1, 224, 226–​7 risk taking 111, 129 rules  4–​9, 16–​24, 29–​34, 54–​61, 124–​8, 157–62, 177–​80, 205–​15, 221–​34, 254–7; see also mandatory law/rules benefits of legal rules  19–​20 strategy  33, 119, 124, 128, 158–​61, 223 say on pay  36, 57, 67–​8, 97, 157, 270 secured creditors  117–​18, 140 securities  6–​7, 9, 110, 206, 227, 243–​6, 248–9, 251, 255–​6, 258 fraud  16, 69, 146, 151, 167, 257, 260–​1, 264 law enforcement  258–​64 laws  16, 41, 120, 148, 151, 210–​11, 222, 243–​4, 259, 263–​6 convergence and persistence  264–​6 litigation  151, 250, 260–​2 markets  11, 159, 226, 243–​67; see also markets, public regulation  41, 151, 160, 165, 189, 192, 219, 243–​59, 261, 263–​5 security interests  112–​13, 119, 143 selective disclosure 47, 251 self dealing  33, 37, 145–​6, 148, 151, 154, 158, 160–​161, 167, 174; see also related-party transactions sensitive information  51, 60, 101, 159, 251 shadow directors  114, 128, 131, 133–​4, 163 share issuance  171, 174, 177, 180–​3

Index authorized capital  180 majority–​minority conflict  181–​3 manager–​shareholder conflict  180–​1 shareholder(s), see also Introductory Note; agency problems; controlling shareholders; delegated management; exit; minority shareholder(s); ownership structures; shareholder voting agreements  17, 57, 80, 101, 174, 176–​7, 236 approval  57–​8, 147, 154–​8, 172, 180–​1, 184–​8, 199–​202, 213, 216–​18, 221–​3 as a class  49 collective action issues  30 controlling  79–​82, 84–​8, 103–​5, 145–​9, 153–​7, 162–​3, 165–​8, 188–​90, 206–​10, 231–​6 derivative action  164 dispersed  58, 74–​5, 80, 128, 175, 181, 208, 233 dominant  49, 73–​4, 79, 81, 86, 164, 166–​7, 169, 202, 243 engagement  60–​1, 149, 239 equal treatment  84, 226 friendliness 76 interests as a class  49–​77 jurisdictional variation explained  72–​7 liability  6–​8, 43, 86, 116, 131, 162–​3 litigation  41, 43, 70, 72, 130, 164–​5, 168, 219, 254, 261 majority  57, 72, 76, 79, 81, 172, 176, 186, 188, 202 minority  79–​81, 83–​9, 91–​2, 99–​105, 151–​3, 163–​5, 171–​4, 181–​3, 187–​92, 201–​2 personal assets  6, 9, 43, 111 personal creditors  6–​7, 9, 117 personal liability  8, 43, 99, 162, 265 ratification  37, 57, 68, 158, 168, 184 rights  57–​8, 66–​7, 74, 97, 102, 112, 166, 172, 177, 181–​2 target  206–​8, 211–​14, 216, 218–​19, 224–​9, 231, 235–​7, 240 shareholder activism  52, 55, 60–​1, 101, 178, 229; see also activist hedge funds; investors, activist shareholder value  13, 23–​4, 43, 65, 94, 97, 99, 245 shareholder voting  33, 57, 59–​60, 83–​4, 154, 156–​8, 180–​1, 184–​5, 196, 231; see also shareholders’ meetings cumulative voting  80 double voting rights  13, 82, 106 proportional voting  80 proxy voting  33, 53–​6, 58–​61, 66, 72, 209, 216, 219–​20, 231, 240 rights  59, 61, 81–​4, 103, 115, 150, 152, 178–​80, 234–​5, 271 super-​majority  84 voting by mail  72 shareholder–​creditor agency costs 115, 136, 141–​2 shareholder–​creditor agency problems 111–16, 119, 128

  281

Index shareholders, coordination  52, 58–​62 shareholders’ meetings,  50, 53–​9, 83–​4, 131, 156, 173, 179, 184–​7, 181, 191, 193, 200, 202–​12, 222, 236; see also shareholder voting special  55–​6 shares, see corporate distributions; transferable shares dual class  79, 81–​3, 103, 147, 177, 179 golden  95–​6, 102, 107 repurchase  66, 87, 125–​6, 180, 202 transferability  10–​11, 34, 88, 211, 243 significant corporate actions  146, 173–​4, 200–​3 significant transactions  34, 45, 167, 199–​202, 223 social norms 36 social welfare  23–​5, 31, 98, 107, 242, 247, 271 Societas Europaea  12, 22, 50–​1, 58, 64, 125–6, 153, 156, 187, 196–​8 SOEs, see state-​owned enterprises solvent firms, and creditors  119–​27 sources of corporate law  15–​17 special auditors  151–​2, 163 squeeze-​outs  174, 188, 190–​2, 205, 210, 230–​ 1; see also freeze-​outs staggered boards  56, 176, 219, 222 standards accounting  120–​2, 148, 250, 254, 263 in corporate governance  69, 87–​8, 161 fiduciary  69, 210, 232 standards strategy  33, 128, 134–​5, 161–​5, 176, 183, 192, 202, 218–​19, 222–​3 state capitalism  74, 96–​7 state-​owned enterprises  14, 74, 97, 107 state ownership  14, 26, 42, 73, 96–​7, 107, 168, 271 subsidiaries  133–​4, 149, 163–​4, 174, 188–​9, 192–​4, 197, 200, 231, 233; see also groups of companies supermajority requirements  56, 84, 172, 175–8, 181, 183–​4, 191, 236, 255–​6 supervisory boards  50–​1, 54–​5, 63–​4, 74–​5, 90–​1, 105–​6, 154, 156, 210, 219–​20 takeovers  33–​4, 82–​3, 175, 183–​4, 205–​7, 211, 215–​19, 221, 234–​5, 237–​40; see also bids; control transactions; mergers target companies  205–​7, 209, 211–​12, 215–16, 221, 224–​5, 227, 229, 234, 237 target management  185, 206, 209–​10, 212, 214, 218, 224–​5, 228, 231, 237

281 target shareholders  206–​8, 211–​14, 216, 218–19, 224–​9, 231, 235–​7, 240 tax law  17, 36, 66, 92, 99 tender offers, see control transactions terms of entry and exit  33–​5, 37 third parties  7, 9, 11, 19, 22, 98–​9, 108, 110, 134, 257–​8 liability  134–​5 torts  7–​8, 115–​16 transaction costs  2, 113, 125, 138, 146, 173 transactions  45, 114–​16, 134–​6, 145, 147–​51, 153–​63, 165–​7, 184–​5, 189–​91, 199–​201 control, see control transactions with creditors  140–​143 related-​party, see related-​party transactions significant  34, 45, 167, 199–​202, 223 undervalue, see undervalue transactions transferable shares  1, 3, 5, 10–​11, 13 trustees  12, 35–​6, 62, 65, 86, 91, 136, 139, 153, 167 trusteeship  35–​7, 49–​50, 62–​3, 66, 136, 139, 147, 155, 166–​7, 218–​19 strategy  35, 38–​9, 62, 85–​6, 99–​101, 139–40, 153–​4, 162, 185–​7, 220 tunneling  146, 166–​9; see also related-party transactions two-​tier boards  18, 51, 157 UK  55–​7, 59–​61, 73–​6, 129–​32, 134–​43, 155–​60, 181–​5, 220–​31, 259–​60, 262–​5 undervalue transactions  126, 134, 218, 253 United Kingdom, see UK United States, see U.S. unlimited liability 7, 9, 116 U.S.  54–​61, 63–​8, 70–​6, 82–​7, 120–6, 129–43, 148–​52, 154–​62, 179–​90, 247–​65 veil-​piercing  114, 116, 131–​4, 269 veto  36, 73, 155, 175–​6, 185, 202, 237; see also shareholder voting bilateral  175–​6 rights  30, 80, 126, 137–​8, 153, 218, 223 vicinity of insolvency  114, 130, 134; see also distressed firms voluntary liquidations 199 voting, see shareholder voting white knights  212, 214–​15, 225 worker codetermination, see codetermination workouts  118, 135, 142; see also insolvency works councils  17, 91, 102, 105, 192, 209

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